CHAPTER 16
MANAGING COSTS AND QUALITY
ANSWERS TO REVIEW QUESTIONS
16.1 In many medium- to large-sized businesses, conventional planning and control systems are based on standard
costing and budgeting. Each year an annual budget is prepared to describe the business’s plans in financial
terms. The annual budgets for direct material and direct labour are based on the estimated production volume for
each major product line and their standard costs. A flexible manufacturing overhead budget, which estimates
both planned fixed and variable overhead costs, is prepared. In the non-manufacturing areas, departmental
budgets are usually based on the costs for last year, adjusted for the expected effects of inflation and any other
anticipated changes.
The plans are implemented by the operating managers. The performance of the managers and their departments
is assessed by comparing their actual results against the budget. In the manufacturing areas, monthly standard
costing reports show material price and quantity variances for the major inputs, and labour rate and efficiency
variances for the major production areas. The standard costing system also reports variable manufacturing
overhead spending and efficiency variances and fixed manufacturing overhead budget and volume variances. In
the non-manufacturing areas, control is based on a comparison of actual and budgeted costs for each department.
Managers investigate the variances and decided what action to take to push their actual results back towards the
planned outcomes or, possibly, what amendments need to be made to the plan.
At the department level, the primary measures of performance are the cost variances both in the manufacturing
and non-manufacturing areas. In addition, in the sales areas, variances from budgeted sales revenue are
measured. For the business as a whole, profit and return on investment are key measures of performance.
Cost management is different from the above approaches because it focuses on strategic goals and the costs that
need to be incurred to meet them. In addition, there is emphasis on managed cost reduction consistent with the
strategic direction. Rather than allocating cost, the key drivers of cost are found and the drivers of cost are
managed. In particular non-value-added costs are eliminated by programs directed to them. Cost management
also includes a process view where departments or cost centres are not viewed or managed in isolation, but
attention is given to reducing cost across the whole business. Localised cost cutting may, in fact, increase costs
or reduce revenue for the whole organisation.
16.2 Activity-based costing (ABC) is a methodology for measuring the cost of cost objects and the performance of
activities. Activity-based management (ABM) refers to the process of using information from activity-based
costing to analyse activities, cost drivers and performance so that customer value and profitability are improved.
16.3 Reducing costs through activity-based management involves following four steps:
 identifying the major opportunities for cost reduction
 determining the real causes of these costs
 developing a program to eliminate the causes and, therefore, the costs
 introducing some new performance measures to monitor the effectiveness of cost reduction efforts.
16.4 Activity cost drivers are the activities or factors that cause a cost to be incurred. Costs represent the consumption
of resources, and these resources are consumed in the performance of activities or some other direct cause factor.
In activity-based costing we recognise that activity costs are usually dependent on two different kinds of drivers:
resource drivers that indicate the rate at which an activity consumes the resource, and activity drivers that
measure the amount of activity consumed by or caused by a cost object. The resource driver is used to measure
the cost of resources consumed by an activity and the activity driver is used to measure the cost of an activity
consumed by (e.g. for a product) or, caused by (e.g. if the cost object is a manager), a cost object. Root cause
cost drivers are the basic factors that cause activities to be performed and their costs to be incurred. In most
cases, the root causes cost drivers are analysed in reducing non-value-added activities and their costs. Once the
root cause cost drivers have been identified, management can develop a program for reducing costs by
eliminating the root causes of these non-value-added activities. This program may involve a fundamental
restructure of processes (called business process re-engineering). While activity cost drivers focus on costs, root
cause cost drivers can be managed without conversion to costs.
16.5 Value-added activities add value for the customer or the business. Value-added activities in a motor vehicle
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
1
repair shop would include panel beating, replacing tyres and installing new windscreens.
Non-value-added activities do not add value for the customer or the business. Non-value-added activities in a
motor vehicle repair shop would include moving waiting vehicles from the parking bay to the repair bay,
cleaning the repair shop and bringing parts from stores.
16.6
Spare capacity could relate to a variety of resources: staff time, wards, equipment and patient registration
(admission) room are examples. If staff in the Emergency Department benefit from reduced waiting times and
improved throughput, they would have more time to spend on complex cases and would see serious cases more
promptly. This could result in their efforts being more effective, saving long-term complications and therefore
saving costs elsewhere. Some hospitals now schedule elective surgery such that at least one surgery ward can
be closed at weekends, saving staff costs, cleaning and power costs. Improved throughput times can reduce bed
occupancy, which will reduce laundry and food costs. Reduced bed occupancy can also lead to the reassignment of staff to higher priority areas, the reconfiguring of roles and functions due to a change in patient
mix, and changed rostering of nurses.
16.7
Performance measures are indicators of the work performed and results achieved. They are used to measure
performance in areas that are critical to the success of the business. Activity-based performance measures can
focus on cost drivers. By monitoring and managing cost drivers, a business can manage its costs. Monitoring
the costs over time provides feedback on the managers’ performance in cost management.
16.8 Business process re-engineering (BPR) is the radical restructuring of processes in the organisation. The aim is to
deliver strategic outcomes in the most efficient manner possible. It includes:
 establishing a business process map
 establishing goals
 reorganisation of work flows into coherent and efficient processes.
While process improvement programs rely on gradual improvement and small changes to processes, BPR relies
on the radical restructuring of the business.
16.9
The four major steps of business process re-engineering are:
prepare a business process map
establish goals
reorganise work flow
implementation.
16.10 Some examples of the life cycles of products are:
 computer chips: each generation, from Pentium 166, Pentium 3 and up to Intel Core and beyond, is getting
shorter
 fans, long life cycle: the product changes very little but may eventually be abandoned
 microwave, long life cycle: no dramatic changes in technology
 CD player, medium life cycle: being taken over by MP4 players and other technologies.
16.11 Nearly all of a product’s cost is committed during the pre-production stages. At that time decisions are made
about the quality of material to be used, the product’s features, the process to be used for manufacturing it, the
equipment required and so on. Spending more on the design stage can produce significant savings during the
production stage. However, too much could be spent on design and planning. Minimising the cost over the life
cycle is the goal of life cycle management.
16.12 Target costing is an approach used to control product costs. In the product planning stage market research is
used to estimate the price at which the product will need to be sold to attain a desired market share. The
business’s required profit margin is then deducted from the selling price to give a target cost. During the design
and development stage, engineers are required to design the product to meet the target cost. The design phase
includes a review of alternative production processes to achieve the desired cost. Value analysis is used to
eliminate any non-value-added aspects of the design. Once production is commenced, performance is assessed
against the target cost.
With its focus on the interrelationship between the design function and costs on the one hand, and the production
costs and function on the other, target costing is a life cycle management tool.
16.13 Target costing is not ‘simply the outcome of setting a target selling price and a target profit margin’. The target
cost is derived after defining the features and quality of the product, which determine the market in which it will
be sold. These two parameters—quality and features—are used to indicate the narrow selling price range that
prospective customers will be prepared to pay. The profit margin will relate to company policy with regard to
the acceptable profitability of products. The difference between the target selling price and target profit margin
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
2
is used to set the desired/targeted cost. That is the first step in target costing, followed by cost reduction
techniques such as value engineering (VE) that are designed to assist the achievement of that target cost. If the
target cost cannot be achieved, the process has provided guidance with regard to the profitability of the proposed
product, and whether it should be introduced or rejected.
16.14 Value engineering (VE) is a method of achieving target cost without sacrificing customer value. It involves
analysing the product’s design and the production process and modifying the design of some components to
make them easier to manufacture and maintain, substituting more cost-effective material which does not reduce
customer value and improving the efficiency of the production processes.
16.15 Under the theory of constraints, the rate of production is limited to the capacity of the bottlenecks. It is these
bottlenecks that need to be identified and removed. Preventing bottlenecks ensures that inventory does not build
up, preventing or reducing the associated costs of storage and of hidden poor quality. Improving efficiency at a
non-bottleneck will have no impact. From a cost management perspective, therefore, resources should be
concentrated at bottlenecks to improve financial performance overall.
16.16 Three performance measures are used: throughput, inventory and operating expense. Throughput is defined as
the rate at which a business generates money through sales. Inventory is defined as all the money that the
business spends in buying things that it intends to sell. Operating expense covers all the money that the business
spends in turning inventory into throughput.
Advantages: These measures help managers to identify and eliminate constraints. Because of their clearly
defined relationship with profitability, these measures can be used to guide decision making and assess
performance. The problem of linking operational measures to business profitability does not exist because the
operational measures are financial.
Disadvantages: Throughput accounting concentrates on the short term. Performance should not be guided and
assessed solely by short-term considerations. To survive, a business must identify strategic objectives, which
should form the basis for identifying key success factors and related performance measures.
16.17 Quality refers to the degree to which a product meets customers’ needs and expectations. The quality of design
is the degree to which the product’s design specifications meet customers’ expectations. The quality of
conformance is the degree to which the product meets its design specifications. This dual classification can be
applied to services as well as products. In determining quality costs, we focus on the costs of the quality of
conformance.
16.18 If appraisal costs increase, a higher percentage of defects will be identified earlier in the manufacturing process,
reducing failure costs. Higher appraisal costs also reduce the percentage of failures that reach the customer, thus
making even greater savings in failure costs.
If prevention costs increase there is an expectation that fewer defects will arise, hence failure costs will decrease.
Usually the decrease in failure costs is greater than the increase in prevention costs.
In cost management an increase in appraisal costs and prevention costs is often undertaken for the purpose of
reducing quality costs overall. However, there is usually a lag between investing in prevention and reducing
external failure costs (which are related to past period production) so total quality costs may rise initially.
16.19 Six Sigma is similar to total quality management in that they are both aimed at meeting customers’ requirements
by achieving continuous improvement in product quality. Six Sigma is a more structured approach to managing
quality, involving rigorous data analysis, with a focus on identifying, measuring, analysing, improving and
controlling business processes. The method involves collection and analysis of data in the design of both
existing processes and new products or processes. Six Sigma also uses its unique team-based structures and
systems to lead and implement process improvements. In contrast,, total quality management provides a more
general framework, or philosophy, for managing quality.
27.20 Quality accreditation is formal recognition that quality standards such as those in ISO 9000 have been met.
Total quality management differs from quality accreditation in that it is an internal management approach to
improving quality. Total quality management is not a formal certification process.
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
3
SOLUTIONS TO EXERCISES
EXERCISE 16.21 (25 minutes) Non-value-added activity: service firms
Note: For all three examples, there is a fine line between providing a level of service which the customer expects and
having facilities, staff or other resources lying idle. There is therefore no hard and fast list of activities and students
may come up with many other examples.
1
Library:

Repairing damaged returned books.

Searching for requested book on shelf that is nowhere to be found. This could be the result of a keying
error by the librarian in the first place

The movement of returned books from a temporary storage shelf to the permanent bookshelf. This doesn’t
add value to the services provided to the library users.

Numerous calls or letters to inform borrowers of overdue books. This could be costly if the borrower’s
contacts are not verified and are incorrect.
2
Pizza delivery company:

Resolving customer complaints regarding prices charged being different to those in advertisements. The
prices in advertisements could be wrong or the revised offers could be incorrect in the computer. Time
may be wasted on the telephone resolving the amount to be charged and the reason for the difference
between customer expectations and the computed amount. Further orders may be lost while customers
cannot get through on the telephone. If errors continue to occur, customers will shop elsewhere.

Cleaning used pizza trays. This doesn’t add value to the product from the customer’s perspective, can be
time-consuming and thus adds costs. More orders could be filled during this time, or staff may be
employed specifically to maintain a continuous supply of trays.

Providing refunds for incorrect orders delivered. This does not add value for customer or the business and
can lead to customer dissatisfaction and loss of sales. The cause of the errror needs to be determined to
prevent it recurring. The delivery person may have delivered two orders to the wrong addresses, or the
order may have been written down incorrectly but was delivered to the right person, or the kitchen may not
have made the pizza on the order.

Opening the outlet for 24 hours a day when there are no customers between 2 am and 4 am. This is clearly
a wasted cost if it is not valued by customers. The outlet may choose to close for those hours.
3
Veterinary clinic:

Rescheduling a patient’s appointment when the vet is called out to attend to an emergency situation on a
farm.

Waiting for a cage to be cleaned out after an animal has been discharged before another surgical procedure
can be undertaken.

Owners and their pets arriving late for clinic appointments, causing a long queue of patients in waiting
room.

Following up errors in client contact details on file.
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
4
EXERCISE 16.22 (40 minutes) Non-valued added activity: restaurant
1 Activity description
2 Value-added
or non-value-added
3 Root cause
Taking reservations
VA
Customer desires
reservation
Customers waiting for a
table
NVA
An error was made in
reservation; service is
slow; customers are slow;
customers arrive without
reservations
Seating customers
VA
Customer’s reservation (or
turn in line) comes up;
table becomes ready
Taking orders
VA
Kitchen staff need to know
what to prepare
Serving meals to
customers
VA
Meals are ready; customers
are hungry
Returning meal to kitchen
for revised preparation
NVA
An error was made in
explaining the menu; there
is an error in the printed
menu description; meal
was prepared incorrectly;
customer is picky
Customers eating meal
VA
Customers are hungry
Clearing the table
VA
Customers are finished
Delivering bill to table
VA
Customers need to know
amount of bill
Collecting payment
VA
Restaurant needs to collect
payment for services
rendered
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
5
EXERCISE 16.23 (20 minutes) Activity-based management; non-value-added activity; cost
drivers; performance measures: manufacturer
1&2
Non-value-added activities
Possible root-cause cost drivers
Store material
No JIT system; suppliers unable to deliver at short
notice; unable to predict production requirements
accurately.
Move raw materials to production
Factory layout, inadequate material movement
equipment; lack of JIT system
Set up extruding machine
Production scheduling, lack of training, equipment
that is difficult to set up.
Move product to assembly area
Factory design
Inspect and test helmet
Poor quality control in production area, poor quality
materials, lack of employee training
Move finished helmet to shipping
3
Factory layout, inadequate material movement
equipment
We need to identify root causes of this activity—that is, the causes of the defects, such as the number of defects
due to defective materials or poor workmanship—and measure these causes. As such we would focus on the
performance of ‘supplier’ activities that cause the inspection activity, such as extruding, assembling and
labelling activities, to identify causes of the defects. The ‘customer’ activity is the packaging. A relevant
measure would focus on the time for helmets to move into packaging, that is, the time taken to inspect and test
the helmet, and the percentage of helmets that failed inspection. Other possible performance measures would
include the inspection cost per helmet.
EXERCISE 16.24 (30 minutes) Activity-based management; cost driver analysis;
performance measures: manufacturer
1
The activities ‘inspect handles’ and ‘rework handles’ can be classified as non-value-added activities as they do
not add value for the customer. If the handles were made properly in the first place, they would not require
inspection or rework. (Students may argue that the customers are better off with the ‘inspect handles’ activity as
this helps to ensure that customers receive good quality paint brushes. However, under optimal conditions the
handles would not require inspection).
2
Possible root cause cost drivers for these two activities might include:


3
inspect handles: saw or lathe not set up properly, poor workmanship on the lathe or saw, poor quality
timber
rework handles: similar drivers to ‘inspect handles’.
If the activities ‘inspect handles’ and ‘rework handles’ are caused by faulty workmanship in operating the lathe,
performance measures such as percentage of good output or number of defects might help eliminate these two
subsequent non-value-added activities.
EXERCISE 16.25 (20 minutes) Business process re-engineering; internet search
Research into the implementation of BPR in financial institutions includes a description of the implementation of BPR
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
6
in Chase Manhattan Bank. (Shin, N and Jemella, DF, Business process reengineering and performance improvement,
Business Process Management Journal, Vol. 8, No.4 2002); http://www.brittenassociates.com/documents_articles/BPR
%20and%20performance%20management_Chase%20case%20study.pdf accessed 4 July 2011)
Step
1
As outlined in the chapter
Steps undertaken by Chase Manhattan
Prepare business process map
Energise (about 10% of time): provide
motivation and vision to make change possible:
- make a ‘case for action’
- define project organisation and the teams
- prepare project plan
- establish communication plan
2
Establish goals
Focus (about 30% of time): analyse current
situation for purpose of understating it
thoroughly:
- assess process performance, business and
customer context
- identify characteristics of environment that
can be changed, built upon or expanded during
next stage—where change will bring greatest
benefit
- quick hits—process improvement ideas that
can be quickly implemented
3
Reorganise workflow
Invent (40% of time): determine what
redesigned business system should look like:
-responsiveness to executive goals
- rethink how work is done
4
Implementation
Launch (20%): draw roadmap to
implementation
- evaluate risk factors
- build blueprint
Note that Chase Manhattan seeks to begin by minimising the resistance to change mentioned in Step 4 of the chapter.
This case study relates six successful applications of BPR by Chase Manhattan, using this approach. A useful
discussion could cover whether the differences (both those seen above, and those seen between this and the cases
related by students) reflect a different philosophy, whether they exist because the applications are in a financial
institution, and whether there are differences due to the cases being ten or more years old—have there been advances in
the meantime, as seen in students’ examples?
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
7
EXERCISE 16.26 (20 minutes) Life cycle costing: manufacturer
1
At this stage BRII appears to have a gross profit margin of $150 (400 – 150 – 100), but many costs are not
included and we could question the reliability of the manufacturing overhead costs.
2
The important point here is that there are many costs associated with a product other than its manufacturing
costs. These include the costs of research and development, product and process design, tooling, marketing,
distribution and customer support.
Over its life cycle BRII appears to offer a margin on manufacturing costs of approximately $4 500 000 [30 000
units  ($400 – $250)]. This means that the estimated non-manufacturing costs would have to be greater than
this amount before the product was not viable. (Although the company is likely to require a profit margin rather
than just cover its costs!) The non-manufacturing costs which we should include are research and development
costs, product planning, finance costs, marketing costs, after sales support costs, and additional administration
costs.
(Students should be warned that this is just a rough guide.) More work needs to be done to assess the overhead
costs (both manufacturing and non-manufacturing) of BRII, possibly using ABC. Also any analysis should take
account of the time value of money.
EXERCISE 16.27 Target costing and activity-based management: manufacturer
1
The target cost for the Glammaglob gadget would be $200 ($250 selling price – $50 profit).
2
The target profit is $50.
3
The target price is $250
4
If the estimated unit cost of the gadget is $230, then our cost reduction objective is $30 (the amount by which
the estimated cost exceeds the target costs). In order to apply the concept of target costing to achieve the
objective, the company should set up a cross-functional team to investigate possible cost savings in the area of
product design, manufacturing process and material costs and obtain a commitment from each functional
department about the amount of cost saving they can achieve to help lower the current cost to the target cost.
EXERCISE 16.28 Target costing; internet search
Samsung has launched a new product called Smart TV. It has new features that include:
Smart Hub—with 3D sound, easy to download apps, a better 3 D experience, 3D converting that converts 2D to 3D,
and many other advantages over the previous model.
Search All—facilitates searching on the web, through files such as videos and photos on your PC, searching for content
relating to the program being watched or VOD, Apps and Social Networking Services.
Your Video—analyses your movie preferences to recommend movies.
Web Browser—allows you to search the web on the big screen instead of a PC, and includes bookmarking.
Social TV—allows you to watch TV with others who are not physically with you as you can be connected to blogging
and chatting services while watching live TV.
All Share—wirelessly connects to all compatible mobile devices, such as phones.
Samsung could use target costing in the design of this product. There would be a problem identifying the likely initial
sales price. They are likely to sell it for far more as a new release than their old TVs, and then reduce the price later as
competing products are introduced. Copy products normally hit the market in 3 to 6 months after a truly innovative
product. The initial price must be high enough to take advantage of the novelty value but not so high that it is
prohibitive for people who like to lead the way in their possession of household gadgets. Samsung would hope to have
enough circulating for their product to be promoted by word of mouth as well as through formal advertising and store
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
8
demonstrations. Forecasts of sales numbers and sales price over a long period can provide an average price per set. The
normal profit margin can then be deducted to find the target price. An analysis of all costs to be incurred would be
derived and targets for each element drawn up so that the final product will achieve acceptable profitability.
Decisions would need to be made very early about the trade-off between extra research and development costs and the
quality and depth of advance in the technology to be incorporated. Samsung appear to have decided to put enormous
amounts of investment into taking very large strides forward in the technology, to achieve a goal of being market
leader, at least for a while. They must believe that this will earn high margins, at least at first, and also establish their
reputation in the supply of quality TVs.
The design of the TVs will commit Samsung to most of the costs over the life of the TV. They can use target costing to
guide their acceptance of production processes as once they have determined a particular production process and
selected production equipment they cannot readily changed them over the life of the product. Components are likely to
be outsourced so negotiation with suppliers will take place and long-term contracts for supply at set prices (perhaps
with adjustment for a cost of living index) can be entered into.
EXERCISE 16.29 (15 minutes) Life cycle management and target costing: manufacturer
1
2
3
The cost for XRP to remain competitive and meet the requirements of Solarcare’s parent company would be 72
cents per unit.

target selling price to remain competitive = $1.50 – ($1.50 x 20%) = $1.20

target cost to achieve a 40 per cent return on sales = $1.20  (1 – 0.40) = $0.72
Solarcare could examine the distribution of expected costs over the remainder of XRP’s life cycle. The aim
should be to examine each stage of the life cycle, to identify ways in which non-value-added activities can be
removed. It may be possible to spend more money in the design phase and reduce costs in subsequent stages,
such as manufacturing costs, or customer warranty claims. It may also be feasible to spend more money during
manufacturing, for example, to improve quality, and reduce subsequent costs, such as customer warranty claims.
Solarcare could use value engineering to achieve the target cost while maintaining or increasing customer value.
For example, in applying value engineering, the design team at Solarcare could substitute a more cost-effective
material for the XRP Lens or improve the efficiency of the production processes.
EXERCISE 16.30 (15 minutes) The theory of constraints: manufacturer
This question shows the importance of identifying constraints (or bottlenecks) and removing them to improve the
overall rate of production, or throughput. Improvements in non-bottleneck areas will not increase the rate of output.
1
Current output is 35 units per hour. Throughput after efficiency drive in department B is 52.5 units per hour (35
units plus 50 per cent improvement). Support proposal.
2
Current output is 60 units per hour. Throughput after efficiency drive is still 60 units per hour. Efficiency drive
in department B does not improve throughput. It would be better to increase efficiency in department A.
3
Current output is 50 units per hour. Throughput after efficiency drive is still 50 units per hour. Efficiency drive
in department B does not improve throughput. It would be better to increase efficiency in department C.
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
9
EXERCISE 16.31 (15 minutes) The theory of constraints: fast(?) food outlet
1
2
The number of customers per hour that cannot be served is 10 (30 less 20), so by 8 pm there are 40 customers
waiting. The last customer will get his cold hamburger at 10 pm!
3
They need to get production up to at least 30 customers per hour, although there is potential to increase it to 40
per hour if Mick and Daisy can increase their throughput to keep up with Donald. So both Mick and Daisy need
some assistance. They could buy an automatic toaster! Alternatively, Minnie could help support them as she
only takes an order every two minutes.
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
10
EXERCISE 16.32 (30 minutes) Cost of quality report: manufacturer
1
Hills Metals Ltd
Quality cost report for the month of April
Current month’s
cost
Internal failure costs:
Cost of faulty goods that are scrapped
$4 200
Cost of rewelding faulty joints discovered during processing 1 900
6 100
External failure costs:
Repairs of faulty products returned by customers
3 000
Costs of recalling product
5 000
Legal fees related to product recall
900
8 900
Prevention costs:
Cost of sending machine operators to a three-week
quality training program
2 900
Costs to confirm a supplier’s quality accreditation
300
3 200
Appraisal costs:
Operating an X-ray machine to detect faulty welds
2 700
Product inspection into finished goods warehouse
1 700
4 400
Total quality costs
$22 600
2
Percentage
of total
18.6
8.4
27.0
13.3
22.1
4.0
39.4
12.8
1.3
14.1
12.0
7.5
19.5
100
It is difficult to make definitive statements about this without some idea of planning performance. However, the
failure costs appear too high. The company needs to spend more on prevention and appraisal. Increased
appraisal should bring down external failure costs as more failures will be detected internally. Increased
prevention costs should help to bring down both the internal and external failure costs and, in the longer term,
reduce the need for appraisal.
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
11
EXERCISE 16.33 (35 minutes) Cost of quality report: manufacturer
1
Universal Circuitry
Quality cost report for the month of May
Current month’s
cost
Internal failure costs:
Costs of rework on faulty instruments
$30 000 31.7
Costs of defective parts that cannot be salvaged
....9 000
39 000
41.2
External failure costs:
Replacement of instruments already sold, which
were still covered by warranty
12 000 12.7
12 000
Prevention costs:
Training of quality control inspectors
16 500 17.4
16 500
Appraisal costs:
Inspection of electrical components purchased from
outside suppliers
21 000 22.2
Tests of instruments before sales
6 1006.4
27 100
28.6
Total quality costs
$94 600 99.9
Percentage
of total
9.5
2
It is difficult to make definitive statements about this without some idea of planned performance. However, it
appears that the high appraisal costs could be providing future benefits, since the bulk of the failure costs are
internal failure costs. This reduces the impact from losing future sales due to upsetting customers. The company
could spend more on prevention to reduce the incurrence of some of the failure costs. Perhaps investment on
better equipment or higher quality inputs would reduce defects. Ultimately, the increased prevention costs
should help to bring down both the internal and external failure costs and, in the longer term, reduce the need for
appraisal.
3
The external failure costs are likely to be underestimated as they do not include the lost contribution on the
goods that had to be replaced, nor the contribution on future sales that are likely to be lost due to the company’s
poor reputation. They also omit the costs of servicing these customer complaints.
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
12
SOLUTIONS TO PROBLEMS
PROBLEM 16.34 (60 minutes) Key features of activity-based costing and activity-based
management: manufacturer
To:
The Managing Director
From: I. M Student, Management Accountant
Re:
Activity-based costing
Activity-based costing (ABC) overcomes a number of weaknesses inherent in our existing costing system. This report
describes these weaknesses, outlines the key features of ABC and describes how ABC could be used in improving
control at Runmoe.
1
Problems with existing information for control:
(a)
The nature of the standard costing variances: The standard costing variances are not timely and too
aggregated, particularly the overhead variances which embody the effects of many different costs. The
real problem is that the standard costing variances are not actionable as they reported the consequences
not the causes of problems.
(b)
The manufacturing overhead variances: The manufacturing overhead variances are based on budgeted
variable overhead costs, which are assumed to be driven by the volume of production (direct labour
hours), and budgeted fixed overhead costs, which are assumed to be fixed regardless of the volume of
production. In the modern business environment, like ours, it is likely that manufacturing overheads are a
major cost and that a large part of manufacturing overhead is not volume driven.
(c)
The non-manufacturing variances: Non-manufacturing variances are difficult to interpret as the items in
the budget often include a number of different costs bundled together as line items. Also, past
inefficiencies are embodied in the budgeted figures and many of the costs reflect rough allocations rather
than accurate assignments.
(d)
The control system focuses on costs and cost variances. The company’s strategic plan includes other
elements such as quality and delivery, as well as cost competitiveness. Standard costing can erode
performance as well as cost in these other areas, by encouraging the purchase of poor quality inputs and
the purchase and production of excessive inventories.
2
Key features of the two dimensional ABC model:
The model has two dimensions: costing and activity management. Costing is used to calculate the cost of cost
objects, such as products. The activity management dimension provides a dynamic view that reports what is
happening or has happened in the business.
There are five new terms in this activity-based costing model:
(a)
Activity attributes. These are simply characteristics of individual activities that managers need to know
about and wish to manage. In most cases they will include cost drivers and performance measures, as well
as the classification of activities as value added or non-value-added.
(b)
Root cause cost drivers. These are the basic factors that cause an activity to be performed and activity
costs to be incurred.
(c)
Non-value-added activities. These are activities that do not add value. in the eyes of the customer or do
not meet the needs of the business. Non-value-added activities can be eliminated without any adverse
effect on customer value or on the business.
(d)
Performance measures. These are indicators of the work performed and results achieved. They are used
to measure performance in areas that are critical to the success of the business.
(e)
Processes. A process is a series of activities that are linked together to achieve a specific objective.
Focusing on processes ensures that the business is managed using a supplier–customer perspective. Also,
it can simplify the management process by focusing on whole processes rather than individual activities.
3
The difference between activity-based costing and activity-based management:
Sometimes there is some confusion between activity-based costing and activity-based management. Twodimensional activity-based costing provides information about activities, cost drivers and performance, as well
as about the costs of cost object such as products. Activity-based management (ABM) refers to the process of
using information from activity-based costing to analyse activities, cost drivers and performance so that
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
13
customer value and profitability are improved.
Overall activity-based costing offers our company significant benefits in improved product costing as well as
improved information for control. However, ABC is much more complex than our existing system. I recommend
a detailed evaluation of the costs and benefits of ABC for Runmoe.
4
How ABC could be used to improve Runmoe’s control:
Costs can be controlled by identifying non-value-added activities and reducing or eliminating them by working
on their root-cause cost drivers. Other sources of value, such as delivery or quality, can be controlled through
activity performance measures relevant to these key success factors. The ABC system can be set up to monitor
any relevant activity attribute. Process analysis helps by identifying cost drivers and appropriate performance
measures by focusing on the major customers and suppliers for each activity (or process). Also using processes
can simplify the planning and control system as, in many cases, it may be possible to manage fewer aggregated
processes rather than many detailed activities.
PROBLEM 16.35 (50 minutes) Cost drivers; non-value-added costs: manufacturer
budgeted manufacturing overhead
1
Predetermined overhead rate
=
=
=
Chapter 16
budgeted direct - labour hours
$768 000
40 000 hours
$19.20 per hour
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
14
2 & 3 There are several possible answers to this question.
Requirement 2
Requirement 3
Candidate for
elimination
Cost pool/ overhead costs
Cost Pool A
Factory supplies
Grinding wheels
Drill bits
Waste collection
Inspection of finished goods
Packaging
Cost driver
Production units
Cost Pool B
Depreciation on trucks and forklifts
Depreciation on raw material
warehouse
Depreciation on finished goods
warehouse
Depreciation on material conveyors
Purchasing
Wages of material handlers
Fuel for trucks and forklifts
Raw material cost
Cost Pool C
Natural gas (for heating)
Property taxes
Insurance
Building depreciation
Custodial labour
Factory space
Cost Pool D
Electrical power
Machine maintenance—labour
Machine maintenance—materials
Depreciation on manufacturing
equipment
Lubricants
Machine hours
Cost Pool E
Setup labour
Number of production runs
Cost Pool F
Shipping
Number of shipments of finished goods
Cost Pool G
Inspection of raw materials
Receiving
Number of shipments of raw materials
Cost Pool H
Number of different raw material and
parts used in a product
X
X
X
X
X
X
X
X
X
Supervision
Wages of parts clerks (find parts for production departments)
Telephone service
Cost Pool I
Chapter 16
X
Engineering specifications and change orders
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
15
Engineering design
4
Total costs:
Receiving
Inspection of raw material.............................................................................
Total
Pool rate
=
budgeted cost
budgeted level of cost driver
=
$20 000
=
$50 per shipment
$10 000
10 000
$20 000
400
PROBLEM 16.36 (30 minutes) Activity-based management; cost cutting: manufacturer
1
Activity-based management refers to the use of activity-based costing information to analyse activities, cost
drivers and performance to improve profitability and customer value by improving processes and eliminating
non-value-added costs. A non-value-added activity is an activity that does not add value to a product from the
customers’ perspective or for the business. Such activities can be eliminated without harming overall quality,
performance or perceived value of a product.
2
Cost of non-value-added activities:
Warehousing:
550 moves x $80a
$44 000
Outgoing shipments:
250 shipments x $30b
$ 7 500
Total
$51 500
a
Warehouse: $720 000 ÷ 9000 inventory moves = $80 per move
b
Outgoing shipments: $450 000 ÷15 000 shipments = $30 per shipment
3
Extra inventory moves in the warehouse may be caused by books being shelved (i.e. stocked) incorrectly, poor
planning for the arrival and subsequent placement/stocking of new titles and other similar situations. Extra
shipments would likely be the result of errors in order entry and order filling, goods lost in transit, or damaged
merchandise being sent to customers.
4
As the following figures show, the elimination of non-value-added activities allows Alligator.com to achieve the
target cost percentage for software only.
Cost driver Cost driver
Cost driver
quantity:
quantity:
Activity
quantity
Books
Software
Books
Software
Incoming receipts
2 000
70%
30%
1 400
600
Warehousing
9 000
80%
20%
6 650*
1 800
Outgoing shipments
15 000
25%
75%
3 750
11 000**
*
(9 000 moves x 80%) – 550
**
(15 000 shipments x 75%) - 250
Activity
Books
Software
Incoming receipts
1400 purchase orders x $ 300a
$420 000
600 purchase orders x $ 300
$180 000
Warehousing
6650 moves x $ 80
$532 000
1800 moves x $ 80
$144 000
Outgoing shipments
3750 shipments x $ 30
$112 500
11000 shipments x $ 30
$330 000
Total cost
$1 064 500 $654 000
Cost as percentage of sales:
13.65%b
12.58% b
a
Incoming receipts: $ 600 000 ÷ 2000 purchase orders = $300 per purchase order.
b
$1 064 500 ÷ $7 800 000; $654 000 ÷ $5 200 000.
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
16
5
Additional cost cutting of $50 500 is needed for books to achieve the 13 per cent target of $1 014 000
($7 800 000 x 13 per cent). Tools that the company might use include customer-profitability analysis, target
costing, value engineering, benchmarking and business process re-engineering.
PROBLEM 16.37 (45 minutes) Activity analysis; non-value-added costs; cost drivers:
manufacturer
1
Activity
number
(1)
Possible root causes*
Quality of engineering drawings
Number of engineering changes
(6)
Quality of parts
Quality of vendor administration (invoicing, dispatch paperwork etc)
(10)
Accuracy of paperwork with delivery
Incorrect amounts delivered
(11)
Use of vendor that has not been certified as a high quality supplier
Critical importance of parts
(13)
Misspecification of parts
Incomplete specifications
Poor product design
Error by purchasing personnel when placing order
Vendor error
* This list is not necessarily complete. Other root causes may exist.
2
Non-value added activities (four activities)
 Inspection of parts. The inspection of parts doesn’t add value to the actual products. This process ensures
that the parts delivered are at the expected standard of quality. Using only ‘quality certified’ suppliers and
having supplier contracts that specify a certain level of quality are more cost effective ways of ensuring the
same or better outcome.
 Order follow-up. The time spent following up the order is not adding value to the parts. The costs cannot be
passed on to the customers and the activity can be avoided by engaging more reliable suppliers and tying
suppliers to firm delivery dates.
 Shipping parts back to vendor. The shipping cost to send back parts to vendor is not adding value to the
parts. This step can be avoided if the design specifications are clearly communicated to the vendor in the
first place, or if a supplier is engaged who does not delivery low quality parts or inaccurate orders.
 Moving parts to storage. The movement of parts to storage is not adding value to the parts. It would be more
cost effective if the parts were delivered to the stores by the vendor.
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
17
3
Suggested performance measures:
Activity
number
Performance measures
(5)
Average price paid
(6)
Number of vendors
Number of vendors that are pre-certified as dependable
(10)
Percentage of orders received on time
Average delay for delinquent orders
(12)
Number of orders returned
Percentage of orders returned
(16)
Number of moves into storage
PROBLEM 16.38 Non-value-added activities; business process re-engineering:
manufacturer
1
Skybolt’s manufacturing process
Cut metal
rod
Flatten
rod’s end
Wrap and
pack
bolts
Inspect
bolts
Cut a slot
in bolts’
head
Heat
treatment
Form threads
on bolts
Clean
bolts
2
Non-value-added activities are shaded in above diagram. Potential candidate for non-value-added activity is
inspection of bolts. This could be eliminated if the highly mechanised operation is reliable and the quality of the
incoming metal rods is assured.
3
The process for the bolts’ manufacturing could be re-engineered by buying heat-treated metal rods ready with
threads, so that cutting thread, cleaning and heat treatment processes can be eliminated. The said processes in the
manufacturing of bolts are costly and risk of disruption of production if one of the processes break down. The
processes of heat treatment, cutting thread and cleaning are less expensive to be carried out by the metal rod
supplier for the economies of scale.
Business process re-engineering (BPR) or process re-engineering involves fundamental changes in the business
processes, while the process improvement is the incremental continuous improvement of processes.
4
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
18
PROBLEM 16.39 (45 minutes) Non-value-added activities; throughput management:
manufacturer
1
Candidates for non-value-added activities include the following.
 Storing logs. Logs should come in and be sent straight to the debarker /chipper.
 Storing chips in bins. Chips should be sent by conveyor to digester.
 Transporting chips to digester. The digester should be placed near chipper.
 Store and reload fibres. Send fibres by conveyor to blow-tank in immediate proximity.
 Carry fibres by forklift to refining area.
 Transfer paper to labelling building. Label on the spot.
 Store and then reload for shipment. Ship as many as possible immediately.
2
To be non-value-added, an activity does not add value for the customer or for the business. Storage and moving
activities have no benefit to the customer or the company.
3
The theory of constraints appears important because of the amount of time the product is in storage. If the
company could get each of its production processes up to a similar capacity, then production could flow
smoothly through the factory from logs to paper with no interruptions. This would reduce substantially the
investment in work in process inventory. It could also ensure that Pickwick could meet customer demands
because the company could produce paper as it was ordered. The time taken to manufacture to the customer’s
orders could be substantially reduced.
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
19
PROBLEM 16.40 (45 minutes) Business process re-engineering; throughput management:
manufacturer
1
2
3
The process could be re-engineered by eliminating all storage areas and using conveyor belts to move material
wherever possible. Relocating processing steps adjacent to each other may reduce movement costs and cut costs.
A lot of effort and employee time is devoted to moving work in process. Logs are unloaded from the railroad
cars and subsequently reloaded into the de-barker. Small trucks are used to transport chips to the digester in the
plant building. Forklifts are used to transport separated fibres to the refining area. Workers are required to place
rolls on pallets. Finally, forklifts are used to transport rolls of paperboard to the labelling building.
The re-engineered process reflects mainly a short term perspective but improving production flow may have
strategic benefits in meeting customer needs more quickly. There is at the moment a lot of wait-time in the
production process. Work in process inventory waits at several points in the production process until the next
operation is ready to receive it. First, logs are stored in the wood yard. Second, chips are stored in bins near the
chipping machines. Third, fibres are stored near the digester. Fourth, separated fibres are stored on pallets near the
depressurised blow tank. Fifth, unlabelled rolls of paperboard are stored on pallets near the winding machines. As
the problem states, the partially-processed product sometimes waits for two to three days between production
operations. Eliminating this wait time will cut costs (short-run) and improve customer relationships (strategic).
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
20
PROBLEM 16.41 (25 minutes) The theory of constraints; business process re-engineering:
service organisation
1
Only 140 licences per hour can be completed, because this is the capacity of Area D.
2
Areas C and D need to increase their output to be able to reach the requirement of 250 returns per hour; C by
100 licenses and D by 110 licences.
3
Area A has the right staffing.
Area B has eight people who are processing 350 licences per hour, or 43.75 licences per hour each. To work at
the required rate of 250 licences, the section needs 250 / 43.75 = 5.7 staff. Two staff can be released.
Area C has ten people, who are processing 150 licences per hour, or 15 licences per hour each. To produce at the
right level they need 250 / 15 = 16.7 people; so they need seven more.
Area D has 17 people who are processing 140 licences per hour, or 8.2 licences per hour each. They need
250 / 8.2 = 30.5 people, or 14 more.
Area E has five people, who are processing 280 returns per hour, or 56 returns per hour each. To get to the
required level it needs 250 / 56 = 4.5 staff, so there is not much spare capacity.
The re-engineered process needs 0 – 2 + 7 + 14 = 19 more people. This cannot be done within the constraint of
45 people so the branch manager needs to think of a new process. In fact, the re-engineered process requires
more people to process 250 returns per hour than the original process did! Management needs to closely study
the activities in the major bottlenecks (C and D) to see how average throughput can be improved. In C, the
solution may lie in increasing the number of cameras. The activities in D are obviously very time-consuming,
since this has the slowest throughput per person. Staff may be released from areas A and B by combining these
activities in some fashion. It would appear from the description that the applications are handled twice, whereas
the same person could possibly undertake the two activities.
PROBLEM 16.42 (20 minutes) Life cycle budgeting; product profitability: manufacturer
1
If the analysis focuses on the gross margin, the Country Wear appears more profitable under the conventional
approach in terms of net profit and return on sale. However the promotion and distribution cost can be traced to
each product and after taking these costs into account the Country Wear still appears more profitable, although
the Evening Wear has a higher return on sales.
Evening wear
Country wear
Sales revenue
Cost of goods sold
Gross margin
$350 000$650 000
250 000 450 000
$100 000$200 000
Promotion costs
Distribution costs
Net profit
2 000 20 000
3 000 60 000
$95 000$120 000
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
21
2
Under the life cycle approach, the Evening Wear appears more profitable as it requires much less nonmanufacturing support.
YEAR 1
Evening wearCountry wear
Design costs
Net loss
$20 000$100 000
$20 000$100 000
YEAR 2 & 3
Sales revenue
Cost of goods sold
Gross margin
Evening wearCountry wear
$350 000$650 000
250 000 450 000
$100 000$200 000
Promotion costs
Distribution costs
Net profit
2 000 20 000
3 000 60 000
$95 000$120 000
Profit over the life cycle*
$170 000
$140 000
* The life cycle profit = Year 1 + 2 x Year 2/3
A complete life cycle analysis reports revenues and costs for each year of the products’ life. It could also
require information on the volume of production and sales.
3
The life cycle cost will be more useful as it ensures that products cover all their costs over their (often short) life
cycles.
4
In order to undertake a complete profitability analysis for the two product lines, a complete list of revenues and
costs for each year of the products’ life is required. It could also require information on the volume of
production and sales. In addition, a more accurate analysis recognising time value of money can be performed
by discounting three years’ estimated cash flows using the firm’s required rate of return.
PROBLEM 16.43 Life cycle costing: manufacturer
1
Conventional profitability analysis:
Year 1
75 000
33 750
41 250
Sales revenue
Less Cost of goods sold
Gross profit
2
Life cycle profitability analysis:
Year 0
Sales revenue
Less
Manufacturing cost
Research and development
Product design
Process design
Tooling costs
Marketing costs
Warranty claims
After-sales service
Total product costs
Net proft / (loss)
3
17 000
10 000
15 000
20 000
8 000
70 000
$(70 000)
Year 2
142 500
64 125
78 375
Year 3
52 500
23 625
28 875
Year 1
$75 000
Year 2
$142 500
Year 3
$52 500
Total
$270 000
33 750
64 125
23 625
5 000
3 000
12 000
10 000
3 000
63 750
$11 250
6 000
4 000
5 500
82 625
$59 875
121 500
17 000
10 000
23 000
20 000
34 000
15 000
10 500
251 000
$19 000
8 000
1 000
2 000
34 625
$17 875
Iacopetta should insist that products are evaluated across their entire life cycle. (This should include an
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
22
assessment of the projected life cycle revenues and costs, prior to the acceptance of the proposed project.)
4
Advantages of developing life cycle budgets for new products are as follows.

Management can prepare a comprehensive assessment of the profitability of a product over its entire life,
whereas conventional budgeting systems estimate profitability on an annual basis.

Life cycle budgeting includes upstream and downstream costs, whereas conventional costing treats these
as period costs.

Capacity requirements can be planned more accurately because products which are not profitable over
their entire life cycle will not be produced.

Pricing can be determined to recover the development costs over the entire life cycle of the product.
Disadvantages of life cycle budgeting are as follows.

The longer the life cycle, the more difficult it is to project revenues, costs, changing consumer tastes and
competitor activity.

The effect of inflation must be introduced into the budgeting/costing process, which is less of a problem
with annual conventional systems.

There is likely to be resistance to developing life cycle budgeting (although this in itself is no justification
for not trying) as staff/managers are more familiar with the annual budgeting system based on
responsibility centres rather than products.
5
Other performance measures which may be useful in managing new product development include:

actual life cycle costs versus budgeted life cycle costs

actual life break-even time versus budgeted break-even time

percentage of annual sales from new products introduced versus sales from existing products

time-based measures for each stage of new product development.
PROBLEM 16.44 Life cycle budgeting; life cycle management; target costing: manufacturer
1
The target cost for the Sunstruck model that will meet the required price of $800 and the required margin of 30
per cent is:
Target cost
=
Target selling price – target profit margin
=
$800 – ($800 x 0.30)
=
$560
The estimated manufacturing cost is $500. Therefore, the development and introduction of the Sunstruck model
should go ahead as the price of $800 will give a return on sales of (800 – 500) / 800 = 37.5 per cent, which is
above the required return of 30 per cent on sales.
2
Life cycle budget for Sunstruck Solar Hot Water Service:
Sales revenue
Less: Cost of goods sold
Gross margin
Less: non-manufacturing costs
Research and development
Product and process design
Marketing
Customer support
Net profit / (loss)
3
(in thousands of dollars)
Year 1
Year 2
Year 3
$13 600
$7 200
8 500
4 500
5 100
2 700
1 500
3 000
1 000
_____
$(5 500)
700
800
250
$ 3 350
500
800
$1 400
Year 4
$3 200
2 000
1 200
400
750
$50
Year 5
200
$(200)
Total
$24 000
15 000
9 000
1 500
3 700
2 700
2 000
$(900)
The estimated average unit cost of the Sunstruck model over its entire life cycle is:
Total costs / total units = $ 24 900 000 / 30 000 = $830.
On this basis, the development and introduction of the Sunstruck model is not recommended as the price is less
than the average cost per unit. However, the estimate of cost of goods sold should be reviewed before making
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
23
this decision, as the applied manufacturing overhead consists of both variable and fixed overhead. In estimating
the manufacturing overhead cost at $125 per unit, the analysis above has failed to recognise that the fixed
component of the overhead cost will not increase proportionately with the volume of production. In Chapter 19
we discuss the problems associated with using unitised fixed costs as a basis for decision making.
4
The company could put more resources into the product and process design phase, and develop cheaper ways to
manufacture. Evidence of life cycle cost behaviour suggests that most manufacturing costs are actually
committed during the design phase. It is difficult to achieve major efficiencies once a product actually goes into
production. Thus, additional spending on design can be more than offset by subsequent savings in
manufacturing costs, and also in customer service costs.
PROBLEM 16.45 (35 minutes) Quality costs analysis: manufacturing company
1
Warranty costs: external failure
Reliability engineering: prevention
Rework at LTL’s manufacturing plant: internal failure
Manufacturing inspection: appraisal
Transportation costs to customer sites to fix problems: external failure
Quality training for employees: prevention
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
24
2 & 3.Cost of quality report:
Model ABC
$
Model XYZ
% costs of
quality
% sales*
12.57 ye
ke ni
bukan ke
20.20
2.22
$
% cost
of
quality
% sales*
Internal failure (rework at
LTL):
160 units  35%  $1900
$106 400
200 units  25%  $1600
$80 000
16.77
1.48
22 000
4.61
0.41
25 000
5.24
0.46
External failure:
Warranty costs:
160 units  70%  $900
100 800
200 units  10%  $350
Transportation to customers:
Total
7 000
29 500
15 000
130 300
24.74
2.71
15 000
2.85
0.31
Appraisal (inspection):
300 hours  $50
500 hours  $50
Prevention:
Reliability engineering
1600 hours  $150
240 000
2000 hours  $150
300 000
Quality training
35 000
Total
Total cost of quality
275 000
52.21
5.73
350 000
73.38
6.48
$526 700
100.00
10.97
$477 000
100.00
8.83
*
Sales revenue:
$30 000  160; $27 000  200..................
$4 800 000
4
50 000
$5 400 000
Yes, the company is ‘investing’ its quality expenditures differently for the two machines. LTL is spending more
on prevention and appraisal for Model XYZ – almost 79 per cent of the total quality expenditures, compared to
approximately 55 per cent for Model ABC. The net result appears to be lower internal and external failure costs
for Model XYZ and, lower total quality costs as a percentage of sales (8.83 per cent for XYZ and 10.97 per cent
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
25
for ABC). This problem illustrates the essence of total quality management (TQM) systems when compared
with conventional quality control procedures. Overall costs are lower with TQM when compared with systems
that focus on ‘after-the-fact’ detection and rework.
Problem 16.46 (30 minutes) Target costing: manufacturing company
1
Pharsalia Electronics' current profit on sales is 10 per cent [($350  $315)/$350]. Therefore, the target cost
for the new product must be $300 less 10 per cent, or $270 [$300 – ($300  10%)].
2
The proposed changes to the just-in-time manufacturing process at Pharsalia Electronics will bring costs down
to $267 per unit, which is below the $270 target cost limit. Revised costs under the JIT manufacturing process
are calculated as follows:
Increase/
(Decrease)
Current
Material:
Purchased components
All other
$110
40
Revised
$110.00
40.00
Manufacturing activities:
Cutting, shaping and drilling
Bending and finishing
Setups
Material handling
Inspection
30
24
16
17
23
$ 3.00
2.40
1.60
(17)
(23)
33.00
26.40
17.60
0
0
Other:
Finished goods warehousing
Selling
Customer service*
5
30
20
(5)
(10)
0
30.00
10.00
$315
$(48)
Total cost
$267
*50% reduction
3
Pharsalia could undertake an ABM exercise to identify non-value adding time. There could be an attempt at
reducing set up time. Typically this is undertaken at the time of adopting a JIT approach since there will now
be far more set ups. Selling costs per unit are now more than 10% of sales price. An analysis of these may
reveal ways to save some of these costs.
4
Benefits include the experience of the consultants in designing and implementing such systems, their provision
of a software package that is adapted to the client’s needs (saving time on starting from scratch).
Disadvantages include the consultants’ probable lack of knowledge of the firm, and possibly the industry as
well. Acceptance by managers of what is implemented can be greater when designed and implemented
internally.
When one British bank implemented ABC during the 1990s they identified a lack of knowledge of ABC in
banking and were able to secure the services of two consultants from a large public accounting firm for the cost
of the consultants’ salary only. The contract was for 12 months. At the end of that period the public accounting
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
26
firm were able to lead the consulting industry in bank appointments due to their expertise, and the bank had
internal consultants who had been trained by the external consultants while they adapted their knowledge from
manufacturing to the financial services industry. (Norris, 2002; Innes and Norris, 1997)1
Problem 16.47 Quality improvement programs and quality costs: manufacturer
1
Some of the factors that are critical for an organisation to successfully implement a TQM are as follows.
(1) All levels of employee across the entire organisation must be educated about the quality management
program so that both internal and external customers’ expectations are understood and committed to, across
the entire value chain.
(2) The management must empower employees on the shop floor to take responsibility for quality
improvement tasks, so that they can take action to prevent quality problems, manage their own quality
inspection and correct the problems that do occur.
(3) The organisation must establish a quality management system supported by documented quality procedures
and practices.
(4) The organisation must manage processes rather than focusing solely on functional departments.
(5) The organisation, that is all employees, must commit to continuous improvement.
2
The cost of quality report indicates that LNTL has implemented the TQM program successfully. The total
quality cost has declined from second quarter on, both in total cost and as a percentage of production cost. The
trends in the four categories of quality costs over time as a percentage of the total cost of quality show:

external failure costs have halved

internal failure costs have decreased by 15%

appraisal costs have remained steady

prevention costs have almost doubled.
Clearly the prevention activities have been effective in reducing failure costs, particularly external failure.
3
Tony’s reaction to the TQM program is more favourable now than at the initial stage because he has seen the
benefits of TQM, both in improved production outcomes and an increased annual bonus (based on decreases in
the cost of quality). Initially Tony was unenthusiastic about the TQM program because of concerns about its
implications for his annual bonus He felt that quality is an abstract concept which does not lend itself to reliable
measures of the cost of quality, the basis for his annual bonus. He was also concerned that his bonus is based on
the cost of quality across the entire organisation and, therefore, there are many variables that influence LNTL’s
cost of quality over which he had little or no control. However, once TQM and cost of quality reporting were
implemented Tony could see the improvements in his production department as well as the increases in his
annual bonus.
1
Norris, G. (2002) "Chalk and Cheese: Grounded Theory Case Studies of The Introduction and Usage of Activity Based Information
in Two British Banks", The British Accounting Review 34, pp.223-255.
Innes, J. and Norris G. (1997) The Use of Activity Based Information - A Managerial Perspective, Chartered Institute of Management
Accountants, London.
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
27
4
The opportunity cost is the potential benefit that is given up when one course of action is chosen over another, in
this case it is the benefits forgone by not implementing the TQM program. There are many benefits associated
with the TQM program such as the cost savings in all four categories of quality related costs, measured in the
cost of quality report. However the COQ report does not provide a complete picture of the opportunity cost
savings that would have been given up if LNTL had not proceeded with TQM. Other benefits forgone by not
implementing TQM would include the contribution margin on future sales that are lost because of poor quality
products getting into the market. These ‘costs’ are difficult to measure, as unlike other quality costs, they are not
recorded within the transaction-based accounting system. However they can be very important to the long-term
viability of a business.
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
28
SOLUTIONS TO CASES
CASE 16.48 (80 minutes) Activity-based costing; activity-based management; non-valueadded costs; BPR; target costing: manufacturer
1
There are many possible answers here. The Adelaide company might be able to price its mettwurst at $5.50
because:

it has modern manufacturing facilities that enable it to produce at a cost much lower than Schmidtke’s

it may have an ABC costing system that gives it an accurate picture of the cost of producing mettwurst

it may not use a cost-based pricing system

it may only make mettwurst in large production runs

it may produce a much larger annual volume than Schmidtke’s and achieve substantial economies of scale.
2
The absorption cost per stick of mettwurst = $7.00 / 1.40 = $5
3
Absorption costing systems tend to overstate the cost of high-volume products, like the mettwurst, and
understate the cost of low-volume products. This is due to the application of manufacturing overhead costs using
a volume-based cost driver, when many of the manufacturing overhead costs are not driven directly by the
volume of production but by other factors, such as the number of batches produced. Schmidtke’s plant-wide rate
assumes that each product consumes overhead resources in direct proportion to the amount of direct labour it
consumes. In fact different products are likely to have different overhead consumption patterns that are not
necessarily related to the amount of direct labour they require. High-volume lines, like the mettwurst, tend to
consume fewer overhead resources than is assumed in the average plant-wide overhead rate and low-volume
products tend to consume more. High-volume products require less than average overhead support because they
are simple to make and they are produced in relatively large batches. Large batch sizes mean relatively low per
unit costs for batch-related activities.
4
The target cost = $5.50/1.40 = $3.93.
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
29
5
Candidates for elimination as non-value-added activities may vary from one student to another. Possibilities and
reasons for the classification as non-value-added are given below. Remember a non-value-added activity is one
that does not add any value in the eyes of the customer or for the business and, therefore, can be eliminated.
Activity
Reasons the activity is non-value-added
Inspect meat
If use quality supplier could eliminate the need for
incoming inspection without any detriment to the
customer.
Dispose of substandard meat
If use quality supplier there would be no substandard
meat.
Move to mincing room
If plant layout was improved and automated material
handling was introduced this activity could be
eliminated or reduced with no detriment to the
customer.
Load mincer
If automate loading, and/or increase mincer capacity
this activity could be eliminated or reduced with no
detriment to the customer.
Unload mincer
If automate unloading, and/or increase mincer capacity
this activity could be eliminated or reduced with no
detriment to the customer.
Move to mixing room
If plant layout was improved and automated material
handling was introduced this activity could be
eliminated or reduced with no detriment to the
customer.
Load mixer
If automate loading, and/or increase mixer capacity this
activity could be eliminated or reduced with no
detriment to the customer.
Unload mixer
If automate unloading, and/or increase mixer capacity
this activity could be eliminated or reduced with no
detriment to the customer.
Move to packing room
If plant layout was improved and automated material
handling was introduced this activity could be
eliminated or reduced with no detriment to the
customer.
Move to smokehouse
If plant layout was improved and automated material
handling was introduced this activity could be
eliminated or reduced with no detriment to the
customer.
Move to truck
If plant layout was improved and automated material
handling was introduced this activity could be
eliminated or reduced with no detriment to the
customer.
We do not know much about the other activities but it may be possible to reduce their cost by making them more
efficient.
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
30
6
The non-value-added activities must be analysed to identify their root-cause cost drivers. In searching for root
cause cost drivers it is necessary to go beyond the obvious and seek out basic causes. Once the root-cause cost
drivers have been eliminated, the company needs to work towards reducing and eliminating them. Possible root
cause cost drivers include:
Activity
Possible root-cause cost driver
Inspect meat
Wrong supplier. Inappropriate procedures in
selecting suppliers. Poorly specified supply contracts
As above
Poor plant layout. Outdated machinery. Insufficient
technical/engineering knowledge
Outdated machinery. Machine capacity too small.
Insufficient technical/engineering knowledge
Outdated machinery. Machine capacity too small.
Insufficient technical/engineering knowledge
Poor plant layout. Outdated machinery. Insufficient
technical/engineering knowledge
Outdated machinery. Machine capacity too small.
Insufficient technical/engineering knowledge
Outdated machinery. Machine capacity too small.
Insufficient technical/engineering knowledge
Poor plant layout. Outdated machinery. Insufficient
technical/engineering knowledge
Poor plant layout. Outdated machinery. Insufficient
technical/engineering knowledge
Poor plant layout. Outdated machinery. Insufficient
technical/engineering knowledge
Dispose of substandard meat
Move to mincing room
Load mincer
Unload mincer
Move to mixing room
Load mixer
Unload mixer
Move to packing room
Move to smokehouse
Move to truck
Overall, the cost driver analysis indicates that the company should evaluate increased automation, especially in
the material handling area, coupled with improved plant layout. There also appears to be a need to improve
supplier selection.
7
Probably it needs business process re-engineering because the process is so badly set up and needs complete
reorganisation and re-thinking of the way it is carried out.
8
Assuming that by the next year of operations the company has been able reduce the cost of each non-valueadded activity by 30 per cent, the activity-based cost per unit (including direct material) will be:
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
31
Annual volume 5000 sticks
Batch size 250 sticks
Inspect meat
$450
Dispose of substandard meat
375
Move to mincing room
360
Load mincer
810
Operate mincer
1 500
Unload mincer
630
Move to mixing room
270
Load mixer
900
Operate mixer
2 400
Unload mixer
720
Move to packing room
225
Pack meat into skins
2 500
Move to smoke house
300
Move to truck
750
Annual cost of all direct labour and manufacturing overhead activities
$12 190
Mettwurst
Bill of activities
Activity cost per unit
Direct material cost per unit
Manufacturing cost per unit
9
$2.438
2.160
$4.598
The selling price that would be obtained on a 40 per cent mark up of the ABC manufacturing cost is $6.44
(rounded), which is 93.7 cents above the competitor’s price for mettwurst. Schmidtke’s may be able to compete
effectively at this price, given its longstanding reputation. If not, the company should drop its price to $5.50. It
should continue to pursue the reduction of its non-value-added activities which will ensure the required 40 per
cent mark up is earned before long.
CASE 16.49 (60 minutes) Conventional approaches to control; activity-based management;
performance measures: manufacturer
1
There are three major problems with the existing approach to planning and control. First, it focuses solely on
financial performance, and ignores performance in other key areas, such as quality and delivery. Hans’ father
controlled all these factors without any planning and control system. However, as the company has grown and
the organisational structure has become more complex, it is not possible for Hans to control all areas in an
informal manner. Second, the measures of financial performance are very rough. The budget is based on last
year’s results plus some adjustment for planned changes. This means that any inefficiencies last year are built
into the budget for this year. There is no understanding of cost behaviour and, therefore, no accurate projection
of budgeted costs. Third, the sole emphasis on short-term financial performance can encourage non-goal
congruent behaviour. Short-term profits can be improved by deferring discretionary expenditures such as
research and development, staff training or product promotion, which can have a detrimental effect on profit
over the longer term.
2
No. Standard costing variances are likely to be untimely and too aggregated, particularly the overhead variances,
which consist of many different costs. The real problem is that the standard costing variances are not actionable
as they report the consequences, not the causes of problems. Also, the manufacturing overhead variances are
based on budgeted variable overhead costs, which are assumed to be driven by the volume of production (direct
labour hours), and budgeted fixed overhead costs, which are assumed to be fixed regardless of the volume of
production. In the modern business environment, it is likely that manufacturing overheads are a major cost and a
large part of manufacturing overhead is driven by factors other than production volume. The standard costing
system would probably have been confined to the manufacturing department, as it is difficult to build
meaningful standards for non-manufacturing functions such as administration and marketing. Thus, its impact
would have been limited.
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
32
3
To identify the areas of performance, the company should draw up a strategic plan and identify the areas of
strategic importance. This has not happened at Schmidtke’s. However, the company has a long history of fine
quality and reliable delivery performance, so it appears that both quality and delivery are important measures.
Because Schmidtke’s is being out-priced, costs (and various root cause cost drivers) will be an important
performance measure.
4
Activity-based management will definitely focus on managing activity costs, or more specifically the root causes
of those costs, and help the Schmidtkes to improve their cost structure if necessary. An ABM system can also
have quality and delivery measures built in as part of it.
5
The root-cause cost driver could be purchases of poor quality inputs. The measure for the preceding stage could
be a percentage of meat accepted.
6
Heidi could measure performance for each process, rather than for each activity. Alternatively, she could focus
on a few key activities. She may want to focus on issues that are of critical importance at the moment and
introduce the measures gradually.
7
Unlike the balanced scorecard approach, it does not necessarily drive the performance measurement system from
key strategies. Neither does it recognise the different performance information requirements of the various levels
of management. Nor does it ensure that the performance measures selected for the lower levels of management
are the key drivers or causes of the performance in strategically important areas. Also, the activity-based
approach does seek to identify the factors that are driving or impeding performance by taking a process view and
focusing on the relationship between suppliers and customers right across the organisation.
CASE 16.50 (45 minutes) Measuring and managing quality costs: manufacturer
1
Landers Ltd
Quality cost report
Internal failure costs:
Rework on defective wheels
Engineering costs to correct production line quality problems
Lost contribution on time to correct production line quality problems
Cost of faulty components that are scrapped
Cost of rewelding faulty joints discovered during processing
Cost of faulty bikes that are scrapped after finished goods inspection
External failure costs:
Cost of replacement bikes provided under warranty
Cost of bikes returned by customers and scrapped
Cost of repairs under warranty
Sales commissions on faulty bikes returned by customers
Contribution margin forgone on bikes returned by customers
Contribution margin forgone on lost future bike sales
Prevention costs:
Cost of quality training programs
Appraisal costs:
Quality inspection in the goods receiving area
Quality inspections during processing
Laboratory testing of bikes and components
Operating an X-ray machine to detect faulty welds
Inspection of each bike put into finished goods warehouse
Total quality costs
2
Current
month’s cost
Percentage
of total
$8 000
15 000
25 000
4 000
19 000
10 000
81 000
4.4
8.2
13.6
2.2
10.4
5.4
44.2
5 000
5 000
1 000
500
1 000
5 000
17 500
2.7
2.7
0.55
0.3
0.55
2.7
9.5
3 000
3 000
1.6
15 000
23 000
13 000
15 000
16 000
82 000
$183 500
8.2
12.5
7.1
8.2
8.7
44.7
100.0
The cost of quality report indicates that Landers costs of quality are very high compared to the overall
manufacturing costs (over 30% of manufacturing costs). It appears that the company achieves its high quality
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
33
through extensive appraisal activities. These appraisal activities result in a very high level of internal failure
costs and relatively low external failure costs, as quality problems are detected before the bikes leave the factory.
Prevention costs are very low. The company could reduce its cost of quality by increasing its expenditure on
prevention activities. Effective prevention activities should help the company get to the point where bikes and
components are made right the first time. In this environment it will be possible to reduce the level of appraisal
activities. Internal failure costs will also go down.
3
It was impossible to identify the cost of quality from the existing accounting system. Many of the quality costs
were hidden in manufacturing overhead cost accounts. Also some of the costs, such as contribution forgone on
current and future sales, are not recorded in conventional accounting systems.
Chapter 16
Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e
by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd
34