Chapter 11, Problem 25P

Cortalo, Inc., manufactures riding lawn mowers. Cortalo uses JIT manufacturing and carries insignificant levels of inventory. Cortalo manufactures everything needed for the riding lawn mowers except for the engines. Several sizes of mowers are produced. The most popular line is the small mower line. The engines for the small mower line are purchased from two sources: Verity Engines and Villa Machining. The Verity engine is the more expensive of the two sources and has a price of $330. The Villa engine is $297 per unit. Cortalo produces and sells 13,200 units of the small mower. Of the 13,200 engines purchased, 2,400 are purchased from Verity Engines, and 10,800 are purchased from Villa Machining. Although Linda Vasquez, production manager, prefers the Verity engine, Mark Shorts, purchasing manager, maintains that the price difference is too great to buy more than the 2,400 units currently purchased. Mark, however, does want to maintain a significant connection with Verity just in case the less expensive source cannot supply the needed quantities. Even though Linda understands the price argument, she has argued in many meetings that the quality of the Verity engine is worth the price difference. Mark remains unconvinced.

Li Sun, controller, has recently overseen the implementation of an activity-based costing system. He has indicated that an ABC analysis would shed some light on the conflict between production and purchasing. To support this position, the following data have been collected:

1. I. Activity cost data:

^aAll units are tested after assembly, and a certain percentage are rejected because of engine failure.

^bDefective engines are removed, replaced (supplier will replace any failed engine), and retested before being sold to customers. Engine failure often causes collateral damage, and other parts need to be remanufactured and replaced before the unit is again functional.

^cDue to late or failed delivery of engines.

^dRepair work is for units under warranty and almost invariably is due to engine failure. Repair usually means replacing the engine. This cost plus labor, transportation, and other costs make warranty work very expensive.

1. II. Supplier data:

Upon hearing of the proposed ABC analysis, Linda and Mark were both supportive. Mark, however, noted that even if the analysis revealed that the Verity engine was actually less expensive, it would be unwise to completely abandon Villa. He argued that Verity may be hard pressed to meet the entire demand. Its productive capacity was not sufficient to handle the kind of increased demand that would be imposed. Additionally, having only one supplier was simply too risky.

Required:

1. 1. Calculate the total supplier cost (acquisition cost plus supplier-related activity costs). Convert this to a per-engine cost to find out how much the company is paying for the engines. Which of the two suppliers is the low-cost supplier? Explain why this is a better measure of engine cost than the usual purchase costs assigned to the engines.
2. 2. Consider the supplier cost information obtained in Requirement 1. Suppose further that Verity can supply only a total of 6,000 units. What actions would you advise Cortalo to undertake with its suppliers? Comment on the strategic value of activity-based supplier costing.