Capstone: redesigning the cost system of Halden Pumps

This capstone brings the course together. Halden's board has asked the new controller to review the company's cost system and recommend changes before next year's budget. The request follows a difficult year: residential dealers say the S-100 is overpriced, the C-900 custom line has grown but company profits have not, Halden Service's warranty costs keep rising, and the plant ran below its normal capacity. The controller's task is to diagnose the problems, design a better system, quantify what it shows, plan the implementation and report the results in a form the board can act on. The lesson works through each stage, drawing on earlier lessons; all figures are the illustrative Halden data used throughout the course.

Stage 1: diagnosis

The controller begins by asking what decisions the cost system must support and how well it supports them now. Interviews with the sales director, the plant manager, the service manager and the chief engineer, together with a review of the past three years' reports, produce a list of symptoms that match the warning signs from lesson 1:

• Product costs come from a single plantwide rate of $50 per direct labour hour, set when the S-100 dominated production. Sales staff ignore them when quoting custom work.
• Competitors sell residential pumps profitably at prices the cost system says would lose money.
• The C-900 shows the highest gross margin of any product, yet its growth has coincided with falling company profit.
• Customer service, warranty and field service costs are treated as period expenses and never reach product or customer profitability reports.
• Fixed overhead rates use a budget-based denominator, so product costs rise in slow years, and the production-volume variance is reported but not understood.
• Standards were last revised four years ago; the foundry's yield and the assembly line's labour mix routinely produce unfavourable variances that supervisors regard as normal.

Each symptom points to a lesson in this course. Together they suggest that the system was designed for a simpler business and has not kept up with Halden's growth in product variety and services.

Stage 2: design

The controller proposes a design with six elements, each tested against the cost-benefit principle from lesson 1: refine only where better information will change decisions enough to justify the extra effort.

Stage 3: quantify

The redesigned system produces three new views of Halden's profitability: product costs that reflect resource use, customer costs that reflect the cost to serve, and an explicit cost of unused capacity. The product view combines the ABC manufacturing costs from lesson 4 with the field service cost of each product line. Halden Service records warranty and service calls by pump model, so its warranty cost can be traced: in the past year it spent about $380,000 on warranty repairs, of which about $60,000 related to the S-100, $120,000 to the P-300 and $200,000 to the C-900.

# Product-line profitability: old system versus redesigned system (illustrative)
lines = {   # units, price, DM, DL hours, plantwide OH/unit, ABC OH/unit, warranty cost
    "S-100": (20_000, 175, 60, 1.0, 50.00, 29.06, 60_000),
    "P-300": (5_000, 390, 140, 2.0, 100.00, 110.12, 120_000),
    "C-900": (500, 1_650, 520, 6.0, 300.00, 1_036.36, 200_000),
}
WAGE = 32
print(f"{'Line':<6}{'Old margin':>12}{'New margin':>12}{'Old %':>8}{'New %':>8}")
tot_old = tot_new = 0
for name, (u, p, dm, h, pw, abc, warranty) in lines.items():
    rev = u * p
    old = rev - u * (dm + h * WAGE + pw)
    new = rev - u * (dm + h * WAGE + abc) - warranty
    tot_old += old; tot_new += new
    print(f"{name:<6}{old:>12,.0f}{new:>12,.0f}{old / rev:>8.1%}{new / rev:>8.1%}")
print(f"Total old {tot_old:,.0f}; total new {tot_new:,.0f} "
      f"(difference = warranty costs now assigned: {tot_old - tot_new:,.0f})")

Line    Old margin  New margin   Old %   New %
S-100      660,000   1,018,800   18.9%   29.1%
P-300      430,000     259,400   22.1%   13.3%
C-900      319,000    -249,180   38.7%  -30.2%
Total old 1,409,000; total new 1,029,020 (difference = warranty costs now assigned: 379,980)

The old system reported gross margins of $660,000 on the S-100, $430,000 on the P-300 and $319,000 on the C-900. After assigning activity costs and warranty costs, the S-100 earns about $1,019,000 (29 per cent of revenue), the P-300 about $259,000 (13 per cent), and the C-900 loses about $249,000. Total margin falls only by the $380,000 of warranty costs that were previously treated as period expenses; the rest is a redistribution among products, as ABC always is. The pattern is now unmistakable: the high-volume residential pump subsidizes the custom line.

From numbers to decisions

The controller is careful not to recommend dropping the C-900. Its engineering and set-up resources are partly committed, it brings in municipal customers who also buy P-300s, and it keeps Halden's engineering team capable of serving demanding industrial clients. Instead, the controller models a package of changes: reprice the C-900 and require a minimum order of ten pumps, so that batch sizes double and set-ups halve; use the S-100's cost advantage to cut its dealer price modestly and win back residential share lost in lesson 10; and launch a seal improvement programme to cut warranty failures.

# Testing the proposed action package (illustrative)
WAGE = 32
setup_rate, eng_rate = 1_500, 5_000

def c900(units, price, setups, warranty, eng_factor=1.0):
    # unit-level ABC overhead per C-900 excluding set-ups: machining, engineering,
    # inspection and facility from lesson 4; eng_factor scales engineering changes
    other_oh = 75_000 + eng_factor * 200_000 + 75_000 + 18_182
    oh = other_oh * units / 500 + setups * setup_rate
    return units * (price - 520 - 6 * WAGE) - oh - warranty

def s100(units, price, warranty):
    oh_per_unit = 29.06
    return units * (price - 60 - WAGE - oh_per_unit) - warranty

base = s100(20_000, 175, 60_000) + c900(500, 1_650, 100, 200_000)
plan = s100(22_400, 168, 45_000) + c900(420, 1_950, 42, 120_000, eng_factor=0.75)
print(f"S-100 and C-900 margin now:      {base:>11,.0f}")
print(f"S-100 and C-900 margin proposed: {plan:>11,.0f}")
print(f"Improvement:                     {plan - base:>11,.0f}")

S-100 and C-900 margin now:          769,618
S-100 and C-900 margin proposed:   1,076,143
Improvement:                         306,525

The model assumes that a $7 cut in the S-100's dealer price lifts volume by 12 per cent, that a C-900 price of $1,950 and a ten-pump minimum lose 16 per cent of custom volume while cutting set-ups from 100 to 42 a year and engineering changes by a quarter, and that the seal programme cuts warranty costs on both lines. On those assumptions, the margin of the two lines rises from about $770,000 to about $1,076,000, an improvement of about $307,000 a year, before the cost of the seal programme. The assumptions about customer response are the most uncertain part, so the controller presents a range: if S-100 volume rises only 5 per cent and C-900 volume falls 30 per cent, the improvement shrinks but remains positive, as the next block shows.

# Pessimistic case for the action package (illustrative)
WAGE = 32
def c900(units, price, setups, warranty, eng_factor=1.0):
    other_oh = 75_000 + eng_factor * 200_000 + 75_000 + 18_182
    return units * (price - 520 - 6 * WAGE) - other_oh * units / 500 - setups * 1_500 - warranty
def s100(units, price, warranty):
    return units * (price - 60 - WAGE - 29.06) - warranty
base = s100(20_000, 175, 60_000) + c900(500, 1_650, 100, 200_000)
pessimistic = s100(21_000, 168, 50_000) + c900(350, 1_950, 35, 130_000, eng_factor=0.85)
print(f"Base margin        {base:>11,.0f}")
print(f"Pessimistic margin {pessimistic:>11,.0f}")
print(f"Improvement        {pessimistic - base:>11,.0f}")

Base margin            769,618
Pessimistic margin     949,813
Improvement            180,195

Even with weaker volume responses, smaller warranty savings and only a 15 per cent cut in engineering changes, the package improves margin, because the C-900 loses less money at a higher price and the S-100 still sells more. Most of the gain comes from the C-900. The controller also reports the break-even response for the S-100 price cut. Measured against full ABC cost, each pump earns about $54 before the cut and $47 after it, so volume must rise about 15 per cent to break even. Measured against variable cost only (materials, labour and $5 of variable machining overhead), each pump contributes $78 before and $71 after, so the break-even rise is about 10 per cent. The assumed 12 per cent rise sits between the two, so the controller recommends testing the price cut with a group of dealers for one quarter before rolling it out. The savings in set-up and engineering cost are real only if Halden redeploys the freed set-up technician and engineering hours, as lesson 4 warned, for example to the new S-50 compact pump launched through target costing in lesson 11.

Customer and capacity views

The customer view, built with time-driven ABC, shows that the 20 per cent of dealers who place frequent small expedited orders consume more than half of customer service capacity. The controller recommends a dealer portal, a small expedite fee and an installer training programme, expected to reduce customer service minutes by about 15 per cent. The capacity view shows about $63,600 of unused machining capacity at practical capacity, plus about $44,100 a quarter of unused customer service capacity. Rather than cut staff immediately, the controller proposes to absorb the capacity with the S-100 volume growth and the S-50 launch, and to defer two planned hires in customer service.

Stage 4: implementation

A redesign succeeds only if people use it. The controller's implementation plan follows the lessons of ABC projects in lesson 4:

• Sponsorship: the chief executive and the board's audit committee approve the project and its objectives.
• A cross-functional team: the controller, the plant manager, the chief engineer, the sales director and the service manager meet monthly.
• A pilot: run the new system alongside the old one for two quarters, reconcile the two each month and explain differences before using the new costs for pricing.
• Integration: capture driver quantities (set-ups, engineering change orders, inspection hours, service tickets) automatically in the ERP and ticketing systems, rather than through manual surveys.
• Training and communication: explain to every product manager why their product costs changed, using the activity data rather than accounting jargon.
• Review: update activity rates, time equations and standards annually, and whenever processes change significantly.

External reporting is unaffected in principle: inventories will still be measured at full absorption cost using normal capacity, as required for financial statements. But because the ABC product costs differ from the plantwide costs, the year-end inventory value will change, and the auditors must be satisfied that the new allocation is rational and consistently applied. The controller documents the change in the accounting policy file and discusses it with the auditors before the first year-end under the new system.

Governance, ethics and contract costing

Cost system changes affect managers' bonuses, product pricing and, where government contracts exist, revenue. The controller therefore establishes three safeguards. First, allocation bases and capacity assumptions are documented and approved before the year begins, not adjusted after results are known. Second, the cost of unused capacity is reported separately and not loaded onto any product, customer or contract. Third, product managers can challenge activity data through a formal review, but cannot change the methodology.

Halden sells C-900 pumps to a federal agency under a cost-reimbursable contract that incorporates the Contract Cost Principles in SACC 1031-2. The contract requires costs to be determined using Halden's generally accepted, consistently applied cost accounting practices, with indirect costs allocated on bases that reflect the benefit each contract receives. Changing to ABC is permissible, but Halden must disclose the change, apply it consistently to all work, and be able to show the contracting authority that the new allocation does not shift costs onto the government contract. CPA Canada's code of professional conduct requires the controller to act with integrity and objectivity throughout.

The board report

The final deliverable is a short report for the board, built around decisions rather than accounting methods. The controller's report has five parts: a one-page summary of findings and recommendations; product-line profitability under the old and new systems, with the reasons for the differences; customer profitability and the whale curve; the action package with its expected effect and the range of outcomes; and the implementation plan, timetable and cost (about $120,000 of consulting, software configuration and staff time over nine months). Detailed activity data, variance analyses and reconciliations go in appendices for the audit committee.

The report closes with the limits of the analysis: activity costs are estimates, customer responses to price changes are uncertain, and some benefits, such as retaining municipal customers through the custom line, cannot be measured precisely. Stating these limits openly is part of the professional judgement this course has emphasized. A cost system's value lies not in precision for its own sake but in helping managers make better decisions with their eyes open.