Now let's take a look at what's going on at the manufacturing company if we try to apply ABC. We talk about, again ABC, in manufacturing, and this is sort of one. The example that we will use will be very much simplified example, the company that will be called printed circuit boards incorporated that makes printed circuit boards and we will study only two that it makes, X and Y. Now, first, we have to see what old system they had because if we do not talk about this old system, we will not be able to identify the core of the problem. They are making printed circuit boards and, again, here are indirect cost pools. Now these are two, so this is procurement and this is sort of production support. Now these are cost allocation bases, again, cost object is the board, the product. Then here, there are also some direct costs. Direct costs are of two kinds. I would put it right away, so this is direct materials and direct manufacturing labor. Direct manufacturing labor. These are direct costs and they contribute to the bottom part so this is direct and the top part is indirect costs. As we know, this is the most interesting part. Now, we have to think about the cost allocation bases here. This is procurement here as a base with a direct materials and that will be 40 percent cost in direct materials. Here, we take direct manufacturing labor, but that will be 800 percent of direct labor. Basically, the story is that in production when we do something, we take the amount of time that is needed and then multiply by 800 percent. That is the system that has been used and this system results in certain numbers that we'll study on the next page of the flip chart. Well, you can see that this huge number that doesn't make any distinction between the kinds of operations you made. For example, let's say you put some piece there, a capacitor that costs 50 cents and then that takes the same amount of time compared to if you put manually a transistor that is a hundred dollars or let's say, some other piece that is, for this maybe as a poor example but you just put a chip that is a hundred dollars. So you use the same amount of time, the same amount of labor but the difference in costs would be the fielders of magnitude. That doesn't seem to be very smart. Let's still see how the system is used and what actual results does it produce. We have two kinds of boards, this is X and this is Y. And then we study. These are the direct costs, I'll drop manufacturing here and that includes as we know, direct materials, and then direct labor. Then let's say we calculated that and this is for board X this is 900 dollars and for board Y this is 420. Fuel materials here and then direct labor here is 48 dollars and 84 dollars here. Now, the total direct costs are therefore 948 for board X and then 504 for board Y. Great so far so good but now we come at the interesting part and this is indirect costs. What do we see here? We have procurement and again procurement was 40 percent of direct materials. Let's see so with a direct materials 900 and take 40 percent so here it's 360. It will be 40 percent and here it will be 168 because that's 40 percent of that. Great. Now we take this offensive part, this is production support and this is at the 800 percent of direct labor. We take direct labor, multiply that by eight times so this is 384 here and 672 there. The overall total indirect costs there, 744 here, this is the sum of these two and then it's 840 there and we arrive at the total cost that I will put in the red and that will be 1,692 here and 1,344 here. You can see that based on the old system, we can say that board X is much more expensive in production than board Y. Well, what can we do about that? We have to say, "Well, if this is the case, we cannot, for example, bring down the selling price of board X. And what has been noticed that recently, the company started to lose market share in boards X because it was selling that at a cost that was not quite competitive and looking at these numbers we can say, "Well, we can not go below this number because then we'll run a loss." But you can see that direct costs that are difficult to control here. This was 948 and 504 and it really seems that it's half of that that may maybe indeed board Y is cheaper. Well, now we would like to refine the system and take a look at maybe we are sort of overlooking something. This is a cost refining system at this company and it consists of steps. Step one, we identify a job so a number of boards. Then step two, we identify direct costs. So far so good and that's quite of clear. Now come step three, which is I will put in red or exclamation mark, this is cost pools using ABC. And then from here, there is step four, cost delegation basis. So these are drivers as we know in ABC. And then step five, cost allocation rates. As soon as we are done with that, we will be able to approach our cost assignment system better. Again, we said why is that? Because we saw that some pieces of the old system, they really would lead to strange results. Let's see what they did here. They identified the following activities. So this is activity, and that's the cost driver, which is the cost allocation base and this is the cost allocation rate. That's an important table. First of all, they found this is materials handling. So regardless of what that this is a chip or a capacitor or even a screw, whatever, we have to prepare these parts and here the cost driver clearly is the parts and they calculated their costs for the previous year and they said, "Well, that was like three dollars per part." Now, the next thing was the machine insertion. Some of the parts here they are inserted by the robot and that was clearly here, the driver is machine inserted parts. The rate is 0.75 per machine inserted part, I would note. Now, the next thing is manual insertion of some real delicate parts for example and here clearly this is manually inserted parts and the rate here is six per part, six dollars it's much higher. Now the next thing is let's say wave soldering so they just prepare everything and then, in one way, they just sold everything. Here are boards and this is let's say, 75 dollars per board. And finally, but importantly in this case is quality testing. Here we have test time and that's because we use expensive computers so therefore, it's 75 dollars per hour. Now, for example, how did we get this number? So they have budgeted number of parts for machine insertion let's say, four million and they calculated that the budget cost for these parts was three million dollars. They just calculated that then they divide one by the other and that gives you 0.75 dollars per part that is machine inserted. So far, we have prepared some important inputs and in what follows, we take these cost allocation rates and then just count the amount of these drivers used and that will give us the corresponding cost associated with this kind of activity. Now, no wonder that we will find some interesting things in our next episode, in which we will use all these numbers and arrive at the new refined indirect cost that is associated with the manufacturing of boards X and Y.
