Seligram case

We are a consulting firm hired by Seligram to come up with a solution for their
costing system and to enable them to be competitive on their business propositions. 

Executive summary

Electronic Testing Operation (now onwards “ETO”) was founded in 2001 by

Seligram, Inc, operating as a cost center and in 2006 and during the same year, ETO
had to address the issue of its cost system being inadequate.

Heterogeneous allocation in the costing system

In fact, ETO's existing cost center has proven to be obsolete because of the
heterogeneous allocation of costs. This allocation risks causing a loss of clients, a
loss of profitability and competitiveness.  The choice of allocation of overheads must
take some changes into account, in order to remain fair and appropriate for the
customer, who must not bear costs that they do not have to bear. To restore the
accuracy of the costing system, a new costing system is to be implemented.

Solution
Once the critical issues of the existing cost system were identified two alternatives,
which are the cost system proposed by the accounting manager and the cost system
proposed by the consultant, were analyzed and compared to the existing cost
system.
More in detail, the proposed alternative methods have a higher degree of complexity
but at the same time increase the level of accuracy in allocating costs.
In the present case, the preferred method, supported by the analyses carried out by
means of the elaborate, turns out to be the one proposed by the consultant since
greater accuracy is preferred.
Choosing a new costing system is supposed to bring more fairness to the pricing of
prestations. It will limit the risk of losing clients and lack of competitiveness. 

Future changes 
Finally, the elaborate includes the upcoming changes regarding the acquisition of a
new machine for ETO. It was analyzed whether to integrate the new machine into the
costing system or whether it should be treated as a separate cost center.
So it will be possible to see how the best solution is using a separate cost center for
the new machine that will allow clients to be charged for what was used for their
tests. Moreover, this method is also more flexible to the changes due to technology
and has no effect on the prices of other tests, keeping ETO competitive in the
market. 
 I. Introduction 

Company presentation & business model

Electronic Testing Operation was founded in 2001 by Seligram, Inc, operating as a
cost center and in 2006. Currently, there are approximately 60 hourly personnel and
40 administrative and technical employees. ETO’ expenses were $7.9 million (see
Exhibit 1).

ETO was a captive division in Seligram, Inc, aiming to consolidate electronic testing
from 11 different divisions, which could reduce 20 million dollars in five years. On the
other hand, it could provide maximized 10% capacity to outside clients. However, if
its testing services are not satisfied by other divisions, they would use the outside
testing service. Therefore, ETO’s cost system is important in determining the volume
of testing done.
In 2006, as technology of testing advanced and existing testing equipment was
aging, the current cost system faced challenges. 1) Demand increase: number of
lots would account for 30% of Seligram's shipments in the next 5 years; 2)
Production Efficiency decline: Since the founding of the division in 2003, direct labor
hours per lot tested has been; 3) Heterogeneous allocation: low-technology is
expensive than high-technology; 4) Customer complain increase: This increase in
automation lead to a smaller base of direct labor. In conclusion, new equipment will
add to depreciation, raise burden rate and drive out customers of low tech products
(25%).

Hence, Seligram’s management sought solutions from inside and outside. The
division’s accounting manager proposed to set two cost pools based on the type of
cost. The first pool includes 
administrative functions, charged on a rate per direct labor dollar. The second pool
contains all the other burden costs, charged on machine hours. An external
Consultant suggested a three-burden-pool, two different test rooms for separate
burden centers and a common technical and administrative pool.

Their new-proposed system is actually a two-stage system but with a different

number of intermediates. Their first innovation is to assign costs that are more
homogeneous in the same pool based on the way they use resources. And the
second innovation is to allocate costs from the intermediate cost pool to the product.
Thus, it’s easier to trace the cost driver.

II. The costing system

Cost system and pricing issue

The existing system measured two indicators: the direct labor and the burden. Direct
labor came directly from the hours spent on the task. The burden is an aggregate
gathering: software, tooling, development, and administrative costs. Total burden
costs were divided by the sum of testing and engineering labor dollars to arrive at a
burden rate per direct labor dollar. When then multiplying the direct labor of a lot per
the burden rate the existing cost system gave the price per lot.
The price per lot was directly linked to the hours of direct labor spent per lot.
However, this process of allocation became obsolete since the size of the lot
decreased significantly and the complexity rose to a state-of-the-art technology and
gaps between competitors and Seligram started to appear.
For the less complex, the company prices were above competition and for the more
complex tests, Seligram was above competitors’ prices.
This discrepancy encourages the management to consider other costing systems.

Diagnostic 
We compared 3 costing systems to determine which one would work best for the
company:
 The existing costing system
 The accountant costing system
 Our consultant costing system

As the complexity of the model used increases, so does its accuracy in allocating
costs. In fact, the existing cost model, which uses a single burden rate in which it is
assumed that all overhead costs are consumed in constant proportion to direct labor,
has lower total costs than the other two models in which cost allocation is more
complex. 

Going into the specifics, the second system, the one proposed by the accounting
managers, is a two-stage system: overhead costs are considered in the form of two
pools, one relating Engineering & Administrative costs to direct labor and the other
relating the total cost of the test room to the total hours of machinery use.

The third system, proposed by the consultants, is the most complex of all. Here
again, a two-stage system can be seen, but the overhead costs are divided into three
intermediate cost pools. The first cost pool, which concerns the Engineering &
Administrative costs, is that of the second cost system, while the costs for the test
rooms are divided between the main test room and the mechanical test room, just as
for the hours, Main Test Room Hours and Mechanical Test Room Hours are used. In
the latter case, the costs will be allocated even more precisely to each product
present. 

Recommendation 
Here it is shown the percentage change of the total costs of each product under the
second and third system compared to the first existing system. 
The cost system, among the three presented, which is the most accurate and precise
is the third one: cost system proposed by the consultant. It is straightforward to say
that the more cost pools one uses, the more detailed the information and the more
accurate the system appears to be. Having three cost centers in fact allows the
system to capture in detail how overhead costs are consumed at each stage of the
production process for each product. 
However, a trade-off may emerge: greater accuracy implies greater complexity (3
cost centers more complex than 2 cost centers, and 2 cost centers more complex
than 1 cost centers) and, as a result, greater complexity implies additional costs for
implementing the model. Just think of the costs for redesigning the system, the costs
for calculation, the costs of managers who have to fully understand how it works... 
The choice of which cost system is most optimal is based on the trade-off between
greater accuracy and the cost of redesign. In the present case, based on the data
provided and the calculations performed, it appears that the third system with more
cost pools is the best. 
 
 
III. The new machine 
 
Integration of a new machine in the costing system
The new technologies have brought the company to invest in additional equipment.
This equipment will also increase ETO’s capacities. For cost management purposes,
our company was asked to review how the new machine could be incorporated in the
costing system. Indeed, the new machine can be treated as a separate cost center or
as part of the main test room.
 
Separate cost center
First, we modeled the separate cost center, it allows the machine costs to be incurred
only by the work/ contracts that need the new machine. However, given the
depreciation chosen by the accounting team, which is the double declining balance,
the cost is quite high during the first year. Our company will not be as competitive as
the others during this year when pricing the contracts. 
Yet, during the first year, companies might be willing to pay a premium for a
competitive advantage other companies do not have. 
 
New machine as part of the main test room
The new machine can be accounted as a part of the main test room. It will allow a
more stable burden rate and to smooth the cost of the new machine in a large total of
costs. Yet, all the clients of the main test room will “pay” for the machine even if they
do not need it. The additional costs, especially in year 1, might result in the company
losing clients because of excessive prices. 

Recommandation
The separate cost center for the acquisition of the new machine seems to be the best
option. Not all the clients will support the cost of acquisition of the new machine and it
will prevent the company from losing clients. The separate cost center for the new
machine is not an ideal option since there are huge differences within the time frame
for the cost of the machine deducted each year. Yet, from a business perspective, it
is the most favorable option to use a separate cost center as opposed to a global
cost for the test room. 

IV. Conclusion of the study

Summing up, the analysis of the case allows us to answer some questions so that we
can draw conclusions. 
If one were to answer the question "which cost system is preferable among the three
presented?", one would immediately say the third cost system, that is the one
proposed by the consultants, for which three intermediate cost pools are presented to
allocate overhead costs. However, it should never be too hasty in making choices
and one must consider that alongside the advantage of precision and accuracy,
disadvantages may arise. In particular, cost disadvantages related to the design of a
system that turns out to be the most complex of the three presented and analyzed. 
Furthermore, when the question arises about the way the new machine should be
treated in the cost center, we recommend separating the new machine from the main
test room. In this way, customers will pay for their specific tests when using the new
machine without any consequence on the prices of other tests, keeping ETO
competitive in the market.