Californian instruments, Inc.
California Instruments, Inc.
The issue enlightened by this case consists of an order (and especially the costs regarding it) made by the Army to a company entitled California Instruments, Inc. This company "manufactures precision instruments and instrumentation for electronics suites"(Case Study). The Army had had a previous contract with CI, from which it bought 210 precision instruments. This second collaboration with CI, made in about one year time, required the firm to make safety improvements to the products already delivered. Thus, we must mention the fact that the Army severely depended on the help provided by California Instruments. Being the manufacturers of the previous devices, they were the ones designated to offer the means for the products' safety modifications.
The person put in charge by the Army was Dave Freeburg. He was accountable for the success of this procedure in due time. The Army had chosen CI due to the fact that they had previous experience and they also possessed the equipment required to accomplish the task. On behalf of CI, Henry Davis was the person assigned to take care of the order. His main tasks were to see to the fulfillment of the design specification, to create a Bill of Materials (BOM) and to elaborate the response to RFP. In two weeks time, David succeeded to draw up a draft of the proposal.
The next step was to evaluate the proposal by visiting the firm. For this matter, Davis assigned a cost analyst, Jim Hanson, to approach the affair. The fact-finding visit consisted of a set of questions related to the material and labor costs. When Hanson depicted a difference between the costs proposed in the BOM and the material costs, Davis explained that this was due to the uncertainty in regard to some modifications. Also, concerning the labor costs, Hanson had a dissimilar opinion from Davis'. Jim considered the amount to be far greater than the expected one, while Davis motivated that the predictions were made on the basis of past payroll information.
In addition to all the costs mentioned above, the company had to find the necessary equipment and to restore it because it hadn't been in use for a long period of time. This procedure implied an additional wage cost. Moreover, the storing of the instruments at the end of the process determined another cost.
As a conclusion, Davis emphasized the fact that he had no historical cost to take into account and that his estimations were based on the collective experience within the company. The fact-finding visit resulted in a future meeting with the aim to reach an agreement. On one side, the company was interested in receiving a profit and providing quality products for the Army. On the other side, the Army also required qualitative products, but at a reasonable price. Therefore, the future meeting was aiming to accomplish the goals of each party. Both the Army and California Instruments, Inc. were hoping to reach a profitable agreement for each of them.
Costs and Prices
As former producer of the instruments which required modifications, CI enjoyed some sort of monopoly power. In the case of monopoly, the buyer is constrained to purchase only from one seller which can price his products or services at whatever level he desires. In this case, the monopoly power may not be at such a high level; however a similar approach can be taken into account. The Army was aware of the fact that California Instruments possessed all the required instruments in order to make the safety improvements. Thus, CI was the first company to be approached. Due to the fact that the Army was meant to ensure citizens' safety, it firstly decided to work with CI due to the company's good expertise in the domain.
In order to establish the price, the parties agreed upon a firm fixed-price contract. This type of contact stipulates that the contractor sets a price before doing his part of the deal. This approach is the opposite of the cost-plus contract in which the contractor establishes the prices as the job progresses.
An analysis of the BOM (Bill of Materials) leads us to the following conclusions. The direct materials cost was about three times lower than the direct labor cost. This implies the fact that the productivity per employee was crucial to the cost and, implicitly the price, of the service performed.
The overheads were also very high. In general, overheads imply the facilities which are not directly involved in the manufacturing on the product, the indirect labor and materials costs. The profit margin was of 12%, representing an appropriate amount under these conditions. It seemed that the company did not try to take advantage of the Army's strong necessity for its service. According to the BOM, the unit price was in amount of $462.05. As there were 210 products to be improved, the total sum was of $97,030.50.
The second evaluation of the costs incurred was made by Jim Hanson. During his visit at the company, he acquired information about each type of cost and made comparisons between the costs provided by the BOM and the ones in the proposal. As a result, he discovered that there was a significant difference between the material costs from the two papers. Davis accounted for this variation by employing the idea that the costs in the proposal were based on past recordings. However, in the case of the future costs incurred, these were expected to increase. A firm-based contract must take into consideration all the possible fluctuations which are foreseeable in the future. A contractor who does not pay the required attention to these expenditures may accept an order which will lead him to a loss (a significant one or a paltry loss depending on his past estimations).
Another issue approached was the labor cost. In the view of Hanson, both the number of hours required and the remuneration rate were far greater than what he had conceived. However, in this case as well, Davis disclosed the past payrolls in which the wages of the employees involved in the manufacturing process were taken into consideration. From the categories of workers, only four were selected to get involved in the procedure. Their activity was essential for the success of the improvements. Therefore, CI could not exclude any of them. There were two persons in charge with the actual production process and another two were responsible for the supervision and the quality of the precision instruments. Taking into account the fact that this was an order made by the Army (a governmental agency), faulty devices were quite unacceptable and the company had to strive in order to achieve the goal in the due time (as sooner as possible, like the Army desired).
Another significant cost consisted of the overheads. These expenditures were changed from departmental rates view to the plant-wide rates view. Therefore, instead of allocating them to each department separately, California Instruments decided to create a single predetermined overhead rate which was used in computing the final costs of the process. Even if the Army did not agree to this approach, CI was strongly determined to maintain this method. Therefore, for the remainder of the fiscal year 1999 the overhead rate was of 127.5% and for the fiscal year 2000, a rate of 132.3% was established. In addition to that, another issue was changed in regard to the company's cost allocation. The overhead distribution base included all direct labor costs as well, instead of the old method which involved only the manufacturing labor. In fact, CI's labor costs were divided in the following manner: 15% encompassed engineering labor and the rest of 85% accounted for the direct factory labor costs.
The cost analysis leads us to another increase due to the preservation of the necessary equipment. This means that, due to the fact that the instruments had not been used for some time, they had to be restored. All this work entailed by the removing from the warehousing, refurbishing and setting up implied and additional cost. The company was unable to abolish this cost and, moreover, it was unable to get rid of another cost involved by the repackaging and storing the instruments after use. Thus, these costs were reflected in working hours which implied larger labor wages for the employees. In amounts, the expenses were approximated at 225 hours which accounted for the following procedures: removal from the storage and cleaning (125), setup (55), unpacking, packing and storing (45). With an average labor rate estimated as $8.75 per hour and a working period of 225 hours, the expenditure increase was of $1,968.75. As CI had never been confronted with such a situation, Davis explained that these costs, such as some of the previous ones, were estimated on the basis of experience. Without any historical costs (which would have been very useful as a basis for the evaluation), the company could only predict the future charges and hope that the fluctuations…