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# Siemens Electric Motor Works

## Activity Based Costing

Case Summary
• This case illustrates how managers at Siemens Electric Motor
Works used their product costing system to support their
decision to change strategies.
• The case exposes you to a simple activity-based cost system
and is, therefore, ideal for introducing the concepts of
activity-based costing.
• In the late 1970’s, Siemens Electric Motor Works (EMW) found
itself facing an environment in which it was becoming
increasingly difficult to compete.
• Managers began to understand that continued survival in the
A/C motor market required changing strategies.
• As a result, they made a decision to de-emphasize the
production of standard motors and to specialize in the
production of small lots of custom motors.
• The custom motor business required the evaluation of many
motor designs and a way of accurately estimating the
production cost of literally thousands of potential products.
• Early on, the only tool managers had to assist them in their
estimation was their product costing system.
been extended and updated over time, had essentially the
same structure in 1970 as it did in 1926.
• EMW managers found this system totally inadequate to the
job they faced, and so set out to develop a new cost system.
• The system they came up with was an activity-based cost
system, which by design accounted for the costs of order
processing and the handling of special components in a way
that the traditional system could not.
• Costs that varied with the number of orders processed, and
costs that varied with the number of special components
required in a motor design had become an important part of
the total cost of production.
• By isolating these costs and allocating them appropriately,
managers were able to get more “accurate” estimates of the
cost of producing a custom motor.
• Therefore, the task of evaluating orders and deciding which
ones to accept for production could be done more profitably.
Assignment Questions

## • Calculate the cost of the five orders in Exhibit 4 under the

traditional and new systems. Hint: first calculate the cost of
processing an order and handling a special component.
• Calculate traditional and new system costs for each order if 1
unit, 10 units, 20 units, and 100 units are ordered. Graph the
product costs against volume ordered.
• Does the new system support the strategy of the firm in ways
that the traditional system cannot? Is Mr. Karl-Heinz Lottes
over-estimating the value of the new system?
Q1. What were the competitive conditions
facing EMW in the late 1970s?
• The Eastern bloc countries has an insurmountable advantage
over EMW due to lower labor rates.
• EMW will be forced out of business unless it changes its
strategy.
• EMW chooses strategy of becoming a custom motor firm.
Q2. What were the outcomes of managers at
EMW deciding to change strategy?
• Production process becomes more complex.
• Production technology changes to high technology.
• Volume and number of products produced increased
dramatically.

## Note: The Eastern bloc countries cannot follow this strategy

manufacturing.
Q3. How did EMW’s new strategy change the
way products were manufactured?
• In the 1970s EMW manufactured about 200 different types of
motors, by 1987 they were manufacturing 10,000 unique
products.
• 1970’s manufacturing was nearly all large batch production
for inventory. Only 20% of motors produced were custom
motors, and the authors suspect that “customizations” were
fairly trivial.
• 1980s manufacturing is dominated by low volume custom
orders. However, a significant number of the motors produced
are still to fill large orders of standard motors.
Note: The EMW facility was well run with manufacturing
technology ranging from hand-manufacture of “low”
technology small volume motors through flexible machining
systems for high volume custom components. The diversity of
production technologies in one facility makes it a very difficult
environment in which to calculate product costs.
Q4. Was the strategy successful?
• While it is not possible from case facts to determine
unambiguously if the strategy was successful (largely because
we cannot observe what would have happened had EMW
stuck to its old course) certain points can be made:
• EMW is still in business.
• EMW’s product mix has shifted considerably.
• Siemens Corporation has invested heavily in EMW; so senior
management clearly believes in new strategy.
Q5. What is EMW’s product mix? or To what
extent has EMW adopted the new strategy?
• Exhibit 2 provides the data to look at the mix of business at
EMW.
• Low volume orders: 74% of orders are for under 5 motors and
account for 12% of total volume and 88% of orders are for
under 20 motors and account of 25% of total volume.
• High volume orders: 3% of orders are for over 100 motors
and account for 44% of total volume, and 12% of orders are
for over 20 motors and account for 75% of total volume.

## • Seimens has maintained its standard motor business and

added 25% in low volume custom motors. A simple and
productive way to think about EMW’s production facility is to
view it as two factories within a factory (with two different
production processes). One factory produces high volume
standard motors, and the other volume custom motors.
Q6 Describe the 1970s cost system at EMW.
1970’s Cost System
• The important points to be brought out are:
• There are 600 machine-based cost centers
• Three allocation bases are used:
- DM direct materials to trace material costs
- direct labor hours or machine hours to trace manufacturing
- cost to date to allocate support overhead
Q7. Describe the new cost system at EMW.
New Cost System
The important points to be brought out are:
• Existing system retained, new cost system is an add-on.
• Simple system structure, two additional allocation bases.
Q8. How did the “traditional” cost system trace
the overhead costs of order processing and
special components handing to the products?

## These costs were treated as support overhead and allocated

to the products based upon the cost to date.
Q9. How did the “new” cost system trace the
overhead costs of order processing and
special components handing to the products?
• These costs form the two new pools and are traced using
number of shop order and special components (Exhibit 3).
DM
Order Processing Cost 13800000
Special Component Cost 19500000

## No. of orders in 1987 65625

No. of Special Components 325000

## Per Order: 13800000/65625 210

Per Special Component 60
(19500000/325000)
Q10. Why did the “traditional” cost system
prove useless to managers?
order processing and special components handling to the
products based upon cost to date.
• Consequently, large volume orders of 100 motors received
approximately 100 times as much of these overhead costs as
an order of one.
• Yet the analysis of these costs show that each order consumes
number of units (but not the number of special components).
• The new system overcomes this bias by tracing an equal
amount of order processing overhead to each order and an
equal amount of special components handling overhead to
each type of special component required by an order’s design.
Q11. What are the reported costs of the five
orders in Exhibit 4 under the new system?
A B C D E

## Components 39.6 79.2 118.8 198.0 396.0

Order Processing
(Per Unit) 210.3 210.3 210.3 210.3 210.3
Component Handling
(Per Unit) 60.0 120.0 180.0 300.0 600.0

## Total 613.9 713.5 813.1 1012.3 1510.3

Q12. What are the reported costs of the five
orders in Exhibit 4 under the traditional
system?
A B C D E
Pre-Support Related
Base Motor 247.0 247.0 247.0 247.0 247.0
Components 32.2 64.4 96.6 161.0 322.0
Total pre-support
manufacturing costs (M.C.) 279.2 311.4 343.6 408.0 569.0

the pre-support M.C. 1.35 1.35 1.35 1.35 1.35

## Total Cost 376.92 420.39 463.86 550.8 768.15

Ratio to Traditional 1.629 1.697 1.753 1.838 1.966
Q13. Calculate traditional and new system costs
for each order if 1 unit, 10 units, 20 units, and
100 units are ordered. Graph the product
costs against volume ordered.
Revised Cost per unit
A B C D E
1 unit 613.9 713.5 813.1 1012.3 1510.3
10 units 370.6 416.2 461.8 553.0 781.0
20 units 357.1 399.7 442.3 527.5 740.5
100 units 346.3 386.5 426.7 507.1 708.1
Example Per Unit Total
Base Motor 304.00 6080.0
Components 118.80 2376.0
Order Processing 10.51 210.3
Component Handling 9.00 180.0
442.31 8846.3
• At any order quantity up to just less than 10 motors, the
traditional system underestimated the cost of motors. For
orders of 10 motors or more, using the traditional system
overestimated the costs of production.
Q14. Did changing to the new system make a
significant difference in reported product
costs? In the way managers make decisions?
• Managers at EMW felt the system helped support their new
strategy and did make a difference in the way they made
decisions, especially in deciding which orders to accept and
which to reject.
• Even though the shifted costs comprise only 9% of total costs,
allocating them under a different system made a major
difference in reported product costs.
Activity Based Costing
Background

## • Recall that Factory Overhead is applied to production in a

rational systematic manner, using some type of averaging.
There are a variety of methods to accomplish this goal.
• These methods often involve trade-offs between simplicity
and realism

## Simple Methods Complex Methods

Unrealistic Realistic

## • Historically, firms produced a limited variety of goods while

their indirect costs were relatively small.
allocate costs uniformly regardless of how they are actually
incurred
• The end-result:
• Over costing: a product consumes a low level of resources but
is allocated high costs per unit
• Under costing: a product consumes a high level of resources
but is allocated low costs per unit
Cross-subsidization

## • The results of over costing one product and under costing

another.
• The over costed product absorbs too much cost, making it
seem less profitable than it really is
• The under costed product is left with too little cost, making it
seem more profitable than it really is
An Example: Plastim
Plastim and Simple Costing
Plastim and ABC Illustrated
Plastim and ABC Rate Calculation
Plastim and ABC Product Costs
Plastim: Simple and ABC Compared
Conclusions

## • Each method is mathematically correct

• Each method is acceptable
• Each method yields a different cost figure, which will lead to
different Gross Margin calculations
• Only Overhead is involved. Total Costs for the entire firm
remain the same–they are just allocated to different cost
objects with in the firm
• Selection of the appropriate method and drivers should be
based on experience, industry practices, as well as a cost-
benefit analysis of each option under consideration
Cost Hierarchies

## • ABC uses a four-level cost structure to determine how far

down the production cycle costs should be pushed:
• Unit-level (output-level)
• Batch-level
• Product-sustaining-level
• Facility-sustaining-level
ABC and Service / Merchandising Firms

## • ABC implementation is wide spread in a variety of applications

outside manufacturing, including:
• HealthCare
• Banking
• Telecommunications
• Retailing
• Transportation
Next Session: Wilkerson Company

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