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Langfield Smith 8e IRM Ch16
Management Accounting (Monash University)
Studocu is not sponsored or endorsed by any college or university
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CHAPTER 16
MANAGING COSTS AND QUALITY
ANSWERS TO REVIEW QUESTIONS
16.1 In many medium- to large-sized businesses, traditional 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
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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
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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
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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.
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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.
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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 an accounting firm
would include preparing taxation returns and lodging taxation returns with the ATO.
Non-value-added activities do not add value for the customer or the business. Non-value-added activities in an
accounting firm would include picking up printing from a printer, arranging desks in the office and buying
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stationery for staff.
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 re-assignment
of staff to higher priority areas, the reconfiguring of roles and functions due to a change in patient mix, and
changed rostering of nurses.
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16.7 Activity-based performance measures focus on aspects deemed vital to the success of the business. These
aspects usually include quality, timely delivery and cost. The costing dimension of the activity-based
performance measure provides measures of activity costs, although costs are managed more effectively by
measuring and managing root cause cost drivers. Also, measures of quality and time, or any other key success
factors for the business, need to be developed for each major activity.
Cost driver analysis plays a vital role in selecting performance measures. Where the costs of an activity are
affected by some feature of a preceding activity, that feature should be selected as a performance measure.
Performance in each of the key success areas, such as cost, quality and delivery time, is often related. For
example, poor quality adversely affects both delivery time and cost. In some cases the measures in each area
conflict. Management must be aware of possible interrelationships between measures and specify the priority
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that is to be placed on conflicting measures.
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.
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16.9The four major steps of business process re-engineering are:
prepare a business process map
establish goals
reorganise work flow
implementation.
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16.10 A product life cycle is the time from the conception of the product through to the product design and years of
manufacturing and sales and then the abandonment of the product. The product costs that are incurred over the
life cycle include:
design and development of the product and the manufacturing processes
production costs, upstream costs and downstream costs for each year.
Traditional profitability reports deduct production costs (costs of goods sold) from revenue for the years in
which sales are made. During those years there can be other significant costs incurred specifically related to the
product (e.g. marketing and servicing costs). In addition, large costs may be incurred in research and design
before the first product is even sold. Similarly costs such as warranty costs may occur for years after the last
product is sold. Traditional product profitability reports may ignore large amounts of costs that relate to the
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product and may lead to errors when making product mix decisions. The life cycle cost forecast can enable
design staff to identify ways in which to modify the design to contain costs over the life cycle while meeting
other design requirements. As a control tool it can also be used as a monitoring base against which to compare
costs incurred, and to evaluate cost performance.
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 processes to be used for manufacturing, 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 cost management.
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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
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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 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 Kaizen is a cost reduction system where products currently in production are reviewed to undergo a cost
reduction. Target costing is a system of profit planning and cost management that determines the life cycle cost
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at which a proposed product must be produced to generate the firm’s desired level of profit. A method of target
costing is using the kaizen cost reduction system for currently produced products.
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.
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16.16 Three performance measures are used: throughput, investment and operating expense. Throughput is defined as
the rate at which a business generates profit through sales. Investment is defined as the resources that the
business has tied up in assets, such as inventory, buildings and machinery, less liabilities. Operating expense is
the cost of converting inventory into output, including the cost of labour, machine maintenance and utilities.
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. There is no difficulty in linking operational measures to business profitability as both 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.
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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 Quality costs are categorised as:
Internal failure costs: incurred when defects are identified before the product is dispatched to customers; e.g.
rework due to defects identified during quality checks and scrap
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External failure costs: incurred when defects are identified after the product has been sold to the customer;
e.g. repairing or replacing defective products (also includes future lost sales due to the poor customer
experience)
Appraisal costs: incurred when checking for defects; e.g. quality checks on deliveries and testing products
before dispatch
Prevention costs: incurred when trying to prevent defects or minimise appraisal activities; e.g. staff training
and upgrading to more reliable processes.
16.19 Internal failure costs are incurred when a product is found to be defective before it leaves the business. External
failure costs are those incurred after the product has been purchased by the consumer. Appraisal costs are those
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incurred to see whether defects exist. Prevention costs are incurred in preventing defects or minimising appraisal
activities. These costs can interact with each other.
For example, 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.
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16.20 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.
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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
Dentist:
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2

Repairing damaged equipment.

Searching for up-to-date methods of caring for patients’ teeth.

Updating the reception area. This doesn’t add value to the services provided to patients.

Numerous calls or letters to inform patients of appointments. This could be costly if the patient’s contact
details are incorrect.
Fashion retailer:

Resolving customer complaints when products in advertised ‘special offers’ are not available.

Returning defective clothes to the manufacturer or ringing the supplier for more supplies.
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3

Unpacking stock and putting it on display. Displaying stock can be very time-consuming.

Repairing a DVD monitor that displays fashion shows. While playing the DVDs would be value adding to
the customer, the need to repair the player is not.
University business school:

Preparing a classroom for group work by moving desks and chairs.

Students arriving late for lectures, causing repetition of information to some students.

Contacting students who did not hand in assessment items.
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EXERCISE 16.22 (40 minutes) Non-valued-added activity: hospital
1 Activity description
2 Value-added
or non-value-added
3 Root cause
Making appointments for
doctors
VA
Patients require
appointments
Patients waiting for a bed
NVA
An error was made in bed
allocations; service is
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slow; patients’ treatments
take longer than expected;
patients arrive without
appointments
Taking orders for lunch by
patients
VA
Kitchen staff need to know
what to prepare
Serving lunch to patients
VA
Meals are ready; patients
are hungry
Returning meal to kitchen
for revised preparation
NVA
An error was made in
explaining the menu; there
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is an error in the printed
menu description; meal
was prepared incorrectly;
patient is allergic to nuts
Patients eating meal
VA
Patients are hungry
Taking vital signs of
patients
VA
Patients need to know their
health status
Collecting payment
VA
Patient needs to make
payment for services
rendered
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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
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3
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
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
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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
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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:

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’.
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3
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.
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EXERCISE 16.25 (20 minutes) Lean thinking; cost management: internet search
A web search of the implementation of lean thinking should reveal a wide range of adopters. However, students may
select similar or the same well known organisations.
One approach in assigning this exercise to a tutorial group is for the instructor to allocate different organisations to
students and then the discussion can focus on what they found. Another approach is to form groups in which each
individual student reports back on an allocated organisation, but the group then performs an analysis to compare the
different organisations’ experiences.
Suitable organisations include other CBD councils and regional councils.
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EXERCISE 16.26 (20 minutes) Life cycle costing: manufacturer
1
At this stage BRII appears to have a gross profit margin of $225 (600 – 225 – 150), 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 $6 750 000 [30 000
units  ($600 – $375)]. This means that the estimated non-manufacturing costs would have to be greater than
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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 (15 minutes) Life cycle management and target costing: manufacturer
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1
2
The cost for XRP to remain competitive and meet the requirements of Solarcare’s parent company would be
$1.44 per unit.

target selling price to remain competitive = $3.00 – ($3.00 × 20%) = $2.40

target cost to achieve a 40 per cent return on sales = $2.40  (1 – 0.40) = $1.44
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.
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3
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.
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EXERCISE 16.28 Target costing: manufacturer
1
The target cost for the Glammaglob gadget would be $400 ($500 selling price – $100 profit).
2
The target profit is $100.
3
The target price is $500
4
If the estimated unit cost of the gadget is $460, then our cost reduction objective is $60 (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 it can achieve to help lower the current cost to the target cost.
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EXERCISE 16.29 Target costing; internet search
When Samsung launched a new product called Smart TV, it had new features that included:

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.
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
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
sale price. They were likely to sell it for far more as a new release than their old TVs, and then reduce the price later as
competing products were 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
demonstrations. Forecasts of sales numbers and sales price over a long period can provide an average price per set. The
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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 appears 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 earns high margins, at least at first, and also establishes their
reputation in the supply of quality TVs.
The design of the TVs would have committed Samsung to most of the costs over the life of the TV. They could use
target costing to guide their acceptance of production processes as once they determined a particular production process
and selected production equipment they could not readily change them over the life of the product. Components were
likely to be outsourced so negotiation with suppliers would have taken place and long-term contracts for supply at set
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prices (perhaps with adjustment for a cost of living index) could have been entered into.
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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
The current output is 105 units per hour. Department B is the constraint on improving throughput. The efficiency
drive in Department B will increase the output from Department B to 157.50 units per hour (105 units plus 50
per cent improvement), which will increase production output to 157.50 units per hour. Support proposal.
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2
The current output is 180 units per hour. The efficiency drive in Department B will increase the potential output
from Department B to 315 units per hour (210 units plus 50 per cent improvement), but this will not increase
production output as Department A is producing only 180 units per hour and Department C can only process 195
units per hour. Do not support the proposal. There is better value in increasing the efficiency of Departments A
and C, rather than Department B.
3
The current output is 150 units per hour. The efficiency drive in Department B will increase the potential output
from Department B to 315 units per hour (210 units plus 50 per cent improvement), but this will not increase
production throughput. This is because Department A can only provide Department B with 180 units per hour
and Department C can only process 150 units per hour. Do not support proposal. There is better value in
increasing the efficiency of Departments A and C, rather than Department B.
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EXERCISE 16.31 (15 minutes) Theory of constraints: fast(?) food outlet
1
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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.
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EXERCISE 16.32 (30 minutes) Cost of quality report: manufacturer
1
Valley Fabrications Ltd
Cost of Quality Report for the month of April
Current month’s
Percentage
cost
of total
Internal failure costs:
Cost of faulty goods that are scrapped
$16 800
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Cost of rewelding faulty joints discovered during processing
3 800
4.9
20 600
26.6
Repairs of faulty products returned by customers
12 000
15.5
Costs of recalling faulty product
20 000
25.9
3 600
4.7
35 600
46.1
External failure costs:
Legal fees related to product recall
Prevention costs:
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Cost of sending machine operators to a three-week
quality training program
11 600
15
600
0.8
12 200
15.8
Operating an X-ray machine to detect faulty welds
5 400
7
Product inspection into finished goods warehouse
3 400
4.4
8 800
11.4
Costs to confirm a supplier’s quality accreditation
Appraisal costs:
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Total quality costs
2
$77 200
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.
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EXERCISE 16.33 (35 minutes) Cost of quality report: manufacturer
1
Versatile Electrics
Cost of Quality Report for the month of May
Current month’s
Percentage
cost
of total
$38 000
20.1
Internal failure costs:
Costs of rework on faulty instruments
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Costs of defective parts that cannot be salvaged
12 200
6.4
50 200
26.5
85 000
44.9
External failure costs:
Replacement of instruments already sold, which
were still covered by warranty
85 000
Prevention costs:
Training of quality control inspectors
10 000
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10 000
Appraisal costs:
Inspection of electrical components purchased from
outside suppliers
Tests of instruments before sales
Total quality costs
24 000
12.7
20 000
10.6
44 000
23.3
$189 200
100.0
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2
Failure costs are 71.4 per cent of the quality costs, with external failure costs accounting for 44.9 per cent of the
quality costs. The cause of the high failure costs is the lack of investment in the prevention of defects
(5.3 per cent). The fact that the customers discover a majority of the failures is due to the low appraisal activity
(23.3 per cent). External failure costs are far more costly than internal scrap or rework as a poor experience by
the customer can lead to the loss of customers and a widespread perception of poor quality outputs when
disappointed customers mention this to others. Hence an underestimated external failure cost results from not
including the impact from losing future sales due to upsetting customers. The company should spend more on
prevention to reduce the failure costs. Perhaps investment on better equipment or higher quality inputs would
reduce defects. Since there can be a lag between investment in prevention and reaping its benefits, appraisal
could be increased to prevent defects from reaching customers. 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
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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.
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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.
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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.
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(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.
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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.
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(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.
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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
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.
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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.
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PROBLEM 16.35 (50 minutes) Cost drivers; non-value-added costs: manufacturer
1
Predetermined overhead rate
=
budgeted manufacturing overhead
budgeted direct−labour hours
=
$1 536 000
40 000 hours
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=
$38.40 per hour
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2 & 3 There are several possible answers to this question.
Requirement 2
Requirement 3
Cost pool/ overhead costs
Cost driver
Candidate for
elimination
Cost Pool A
Production units
Factory supplies
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Cost pool/ overhead costs
Requirement 2
Requirement 3
Cost driver
Candidate for
elimination
Grinding wheels
Drill bits
Waste collection
X
Inspection of finished goods
X
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Cost pool/ overhead costs
Requirement 2
Requirement 3
Cost driver
Candidate for
elimination
Packaging
Cost Pool B
Raw material cost
Depreciation on trucks and forklifts
X
Depreciation on raw material warehouse
X
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Cost pool/ overhead costs
Requirement 2
Requirement 3
Cost driver
Candidate for
elimination
Depreciation on finished goods
warehouse
X
Depreciation on material conveyors
Purchasing
Wages of material handlers
X
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Cost pool/ overhead costs
Requirement 2
Requirement 3
Cost driver
Candidate for
elimination
Fuel for trucks and forklifts
Cost Pool C
X
Factory space
Natural gas (for heating)
Property taxes
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Cost pool/ overhead costs
Requirement 2
Requirement 3
Cost driver
Candidate for
elimination
Insurance
Building depreciation
Custodial labour
Cost Pool D
Machine hours
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Cost pool/ overhead costs
Requirement 2
Requirement 3
Cost driver
Candidate for
elimination
Electrical power
Machine maintenance—labour
Machine maintenance—materials
Depreciation on manufacturing
equipment
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Cost pool/ overhead costs
Requirement 2
Requirement 3
Cost driver
Candidate for
elimination
Lubricants
Cost Pool E
Number of production runs
Setup labour
Cost Pool F
Number of shipments of
finished goods
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Cost pool/ overhead costs
Requirement 2
Requirement 3
Cost driver
Candidate for
elimination
Shipping
Cost Pool G
Number of shipments of raw
materials
Inspection of raw materials
X
Receiving
X
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Requirement 2
Requirement 3
Cost pool/ overhead costs
Cost driver
Candidate for
elimination
Cost Pool H
Number of different raw
material and parts used in a
product
Supervision
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Cost pool/ overhead costs
Requirement 2
Requirement 3
Cost driver
Candidate for
elimination
Wages of parts clerks (find parts for
production departments)
X
Telephone service
Cost Pool I
Engineering specifications and
change orders
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Cost pool/ overhead costs
Requirement 2
Requirement 3
Cost driver
Candidate for
elimination
Engineering design
4
Total costs:
Receiving.......................................................................................................
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$20 000
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Inspection of raw material.............................................................................
2
0 000
Total...............................................................................................................
$40 000
Pool rate
=
budgeted cost
budgeted level of cost driver
=
=
$ 40 000
400
$100 per shipment
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PROBLEM 16.36 (30 minutes) Activity-based management; cost cutting: retailer
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 × $80a
$44 000
Outgoing shipments:
250 shipments × $30b
$ 7 500
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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 Brainfodder.net.au to
achieve the target cost percentage for software only.
Activity
Cost driver
Books
Software Cost driver Cost driver
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quantity:
Books
quantity
Incoming receipts
2 000
70%
30%
Warehousing
9 000
80%
20%
15 000
25%
75%
Outgoing shipments
*
**
1 400
6 650*
3 750
(9000 moves × 80%) – 550
(15 000 shipments × 75%) − 250
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quantity:
Software
600
1 800
11 000**
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Activity
Books
Software
Incoming receipts
1400 purchase orders × $ 300a
$420 000
600 purchase orders × $ 300
$180 000
Warehousing
6650 moves × $ 80
1800 moves × $ 80
$532 000
$144 000
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Outgoing shipments
3750 shipments × $ 30
$112 500
11000 shipments × $ 30
$330 000
Total cost
$1 064 500 $654 000
Cost as percentage of sales:
a
13.65%
12.58%
Incoming receipts: $ 600 000 ÷ 2000 purchase orders = $300 per purchase order.
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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 × 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
Possible root causes*
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(1)
Quality of engineering drawings
Number of engineering changes
(9)
Delays in production
Last minute order from customer, possibly JIT customer
(10)
Accuracy of paperwork with delivery
Incorrect amounts delivered
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(12)
Poor quality inputs used by supplier
Lack of quality checks before supplier dispatched them
(13)
Misspecification of parts
Incomplete specifications
Poor product design
Error by purchasing personnel when placing order
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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.
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
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.
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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
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Average delay for delinquent orders
(12)
Number of orders returned
Percentage of orders returned
(16)
Number of moves into storage
PROBLEM 16.38 (40 minutes) Basic elements of a production process; non-value-added
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activities; business process re-engineering: bakery
Parts 1 and 2 are depicted on the activity map on the following page. Non-value-adding activities are shaded. Students
may draw a slightly different activity map, but should still be able to distinguish between value-adding and non-valueadding activities. Potential candidates for non-value-added activities include:
1
Inspection of incoming materials. This could be eliminated if quality suppliers were used.
2
Storage of flour and raisins. This could be eliminated if these items were delivered only when needed (JIT).
3
Hand carting of flour and raisins. This could be improved by putting in conveyor belts or by requiring suppliers
to deliver direct to the mixing room.
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4
Storage of dough. This could be eliminated if the dough was mixed only as required.
5
Movement of dough into the bagel room and into and out of the bagel machines. This could be improved by
using a conveyor system or by reducing the distances the dough has to be moved.
6
Waiting for a boiling vat. This could be eliminated if more boiling vats were purchased.
7
Movement of bagels to the oven. This could be improved with a conveyor belt and by reducing distance between
the vats and the oven.
8
Waiting for the oven. This could be eliminated by producing at a rate that matches the oven capacity or by
purchasing an extra oven.
9
Loading and unloading the oven. This could be improved through automation.
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10
Inspection of bagels. This could be eliminated through better quality processing.
11
Movement to packing. This could be improved with a conveyor belt and by reducing the distance between the
baking and packing areas.
12
Movement to freezer. This could be improved with a conveyor belt and by reducing the distance between the
packing area and freezer.
13
Storing of frozen goods. This could be reduced or eliminated by producing just sufficient to meet customer
demand.
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Bagels Ltd activity map
Receive and
inspect
materials
Store ingredients
Move materials
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Mix
Dough
Store
Dough
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Move to oven
Boil bagels and
remove from vats
Move to boiling
vat
Move dough into
and out of bagel
machines
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Move dough to
bagel room
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Insert and remove
bagels from
oven
Inspect bagels
Remove faulty
Carry bagels to
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while cooling
bagels and store
packing room
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Dump bagels into
hopper
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Freeze and store
bagels
Move boxed
bagels to freezer
Place bagels in
boxes
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Pack and seal
bagels
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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.
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
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
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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.
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PROBLEM 16.40 (45 minutes) Business process re-engineering; throughput management:
manufacturer
1
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2
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.
3
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 waiting 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
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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).
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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.
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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
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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 Weekend Wear appears more profitable under the traditional
approach in terms of net profit and return on sale. However, the promotion and distribution cost can be traced to
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each product and after taking these costs into account the Weekend Wear will be more profitable, although the
After-five Wear has a higher return on sales.
After-five wear
Weekend wear
$1 400 000
$2 600 000
Cost of goods sold
1 000 000
1 800 000
Gross margin
$400 000
$800 000
8 000
80 000
Sales revenue
Promotion costs
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Distribution costs
Net profit
12 000
240 000
$380 000
$480 000
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2
Under the life cycle approach, the After-five Wear appears more profitable as it requires much less nonmanufacturing support.
YEAR 1
After-five wear
Weekend wear
Design costs
$80 000
$400 000
Net loss
$80 000
$400 000
YEAR 2/3 (p.a.)
Sales revenue
After-five wear
Weekend wear
$1 400 000
$2 600 000
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Cost of goods sold
1 000 000
1 800 000
Gross margin
$400 000
$800 000
8 000
80 000
12 000
240 000
Net profit
$380 000
$480 000
Profit over the life cycle*
$680 000
$560 000
Promotion costs
Distribution costs
* The life cycle profit = Year 1 (loss) + 2 × (Year 2/3 results)
After-five = −$80 000 + (2 × $380 000) = $680 000
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Weekend Wear = −$400 000 + (2 × $480 000) = $560 000
A complete life cycle analysis reports revenues and costs for each year of the products’ lives. 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’ lives is required. It could also require information on the volume of
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production and sales. In addition, a more accurate analysis recognising the 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
Traditional profitability analysis:
Sales revenue
Year 1
Year 2
Year 3
75 000
142 500
52 500
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Less Cost of goods sold
33 750
64 125
23 625
Gross profit
41 250
78 375
28 875
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2
Life cycle profitability analysis:
Year 0
Sales revenue
Year 1
Year 2
Year 3
Total
$75
000
$142
500
$52
500
$270
000
33 750
64 125
23
625
121
500
Less
Manufacturing cost
Research and development
17
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17
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000
000
Product design
10
000
10
000
Process design
15
000
Tooling costs
20
000
Marketing costs
8 000
5
000
3 000
23
000
20
000
12
6 000
8
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34
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000
000
000
10
000
4 000
Warranty claims
1
000
15
000
3
000
5 500
After-sales service
2
000
10
500
70 000
63 750
82 625
34
625
251
000
$(70
$11
$59
$17
$19
Total product costs
Net profit / (loss)
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000)
250
875
875
000
3
Iacopetta should insist that products are evaluated across their entire life cycle. (This should include an
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 traditional budgeting systems estimate profitability on an annual basis.

Life cycle budgeting includes upstream and downstream costs, whereas traditional costing treats these as
period costs.
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
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.
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
5
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.
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.
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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 $1600 and the required margin of 30
per cent is:
Target cost=
Target selling price – target profit margin
=
$1600 – ($1600 × 0.30)
=
$1120
The estimated manufacturing cost is $1000. Therefore, the development and introduction of the Sunstruck model
should go ahead as the price of $1600 will give a return on sales of (1600 – 1000) / 1600 = 37.5 per cent, which
is above the required return of 30 per cent on sales.
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2
Life cycle budget for Sunstruck Solar Hot Water Service:
(in thousands of dollars)
Year 1
Sales revenue
Less: Cost of goods sold
Gross margin
Year 2
Year 3
Year 4
$16 000
$24 000
$8 000
$48 000
10 000
15 000
5 000
30 000
6 000
9 000
3 000
18 000
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Year 5
Total
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Less: non-manufacturing costs
Research and development
3 000
Product and process design
6 000
1 400
Marketing
2 000
1 600
1 000
800
Customer support
_____
500
1 600
1 500
400
4 000
Net profit / (loss)
$(11 000)
$ 2 500
$6 400
$700
$(400)
$(1 800)
3 000
7 400
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5 400
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3
The estimated average unit cost of the Sunstruck model over its entire life cycle is:
Total costs / total units = $49 800 000 / 30 000 = $1660
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
this decision, as the applied manufacturing overhead consists of both variable and fixed overhead. In estimating
the manufacturing overhead cost at $250 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.
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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.
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PROBLEM 16.45 (30 minutes) Target costing: manufacturing company
1
Pharsalia Electronics’ current profit on sales is 10 per cent [($700  $630)/$700]. Therefore, the target cost for
the new product must be $600 less 10 per cent, or $540 [$600 – ($600  10%)].
2
The proposed changes to the just-in-time manufacturing process at Pharsalia Electronics will bring costs down
to $534 per unit, which is below the $540 target cost limit. Revised costs under the JIT manufacturing process
are calculated as follows:
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Increase/
(Decrease)
Current
Revised
Material:
Purchased components
All other
$220
$220.00
80
80.00
Manufacturing activities:
Cutting, shaping and drilling
60
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$ 6.00
66.00
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Bending and finishing
48
4.80
52.80
Setups
32
3.20
35.20
Material handling
34
(34)
0
Inspection
46
(46)
0
Finished goods warehousing
10
(10)
0
Selling
60
Other:
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60.00
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Customer service*
Total cost
40
(20)
$630
$(96)
20.00
$534
*50% reduction
3
Pharsalia could undertake an ABM exercise to identify non-value-adding time. There could be an attempt at
reducing setup time. Typically this is undertaken at the time of adopting a JIT approach since there will now
be far more setups. An analysis of these areas may reveal ways to save some of these costs.
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PROBLEM 16.46 (35 minutes) Quality costs analysis: manufacturer
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
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2 & 3 Cost of quality report:
Model ABC
$
Model XYZ
% costs of
quality
%
sales*
12.09
2.22
$
% costs
of quality
%
sales*
9.22
1.48
Internal failure (rework at LTL):
80 units  35%  $2850
$79 800
100 units  25%  $2400
$60 000
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External failure:
Warranty costs:
80 units  70%  $1800
100 800
100 units  10%  $600
6 000
Transportation to customers:
Total
44 250
145 050
22 500
21 98
4.03
28 500
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4.38
0.70
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Appraisal (inspection):
300 hours  $75
22 500
3.41
0.62
500 hours  $75
37 500
Prevention:
Reliability engineering
1600 hours  $225
360 000
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5.76
0.92
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2000 hours  $225
Quality training
Total
Total cost of quality
450 000
52 500
75 000
412 500
62 51
11.46
525 000
80.65
12.96
$659 850
99.99
18.33
$651 000
100.01
16.06
* Sales revenue: $45 000  80 = $3 600 000; $40 500  100 = $4 050 000
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4
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 87 per cent of the total quality expenditures, compared to
approximately 66 per cent for Model ABC. The net result appears to be lower internal and external failure costs
for Model XYZ (less than 14 per cent compared with over 34 per cent) and lower total quality costs as a
percentage of sales (16.06 per cent for XYZ and 18.33 per cent for ABC). Two issues worthy of note in this case
are as follows:
The investment in prevention is lower for ABC than for XYZ but the increase in this investment may also have
been more recent than for XYZ. There is a lag between investing in prevention and seeing the fruits of this
in the reduction of failure costs, especially external failure costs that may be attributable to units from past
production.
The external failure costs in ABC are almost double the internal failure costs, while in XYZ they are less than
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half. The difference is at least partly due to the greater investment in appraisal in XYZ but could also be
affected by how effective appraisal practices are in each model and the timing of the investment in
prevention.
This problem illustrates the essence of total quality management (TQM) systems when compared with
traditional quality control procedures. Overall costs are lower with TQM when compared with systems that
focus on ‘after-the-fact’ detection and rework.
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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.
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2
(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.
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 per cent
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
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
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implemented Tony could see the improvements in his production department as well as the increases in his
annual bonus.
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.
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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
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
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 plantwide rate
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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 plantwide 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.
5
Candidates for elimination as non-value-added activities may vary from one student to another. Possibilities and
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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.
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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
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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
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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
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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
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efficient.
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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
Dispose of substandard meat
As above
Move to mincing room
Poor plant layout. Outdated machinery. Insufficient
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technical/engineering knowledge
Load mincer
Outdated machinery. Machine capacity too small.
Insufficient technical/engineering knowledge
Unload mincer
Outdated machinery. Machine capacity too small.
Insufficient technical/engineering knowledge
Move to mixing room
Poor plant layout. Outdated machinery. Insufficient
technical/engineering knowledge
Load mixer
Outdated machinery. Machine capacity too small.
Insufficient technical/engineering knowledge
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Unload mixer
Outdated machinery. Machine capacity too small.
Insufficient technical/engineering knowledge
Move to packing room
Poor plant layout. Outdated machinery. Insufficient
technical/engineering knowledge
Move to smokehouse
Poor plant layout. Outdated machinery. Insufficient
technical/engineering knowledge
Move to truck
Poor plant layout. Outdated machinery. Insufficient
technical/engineering knowledge
Overall, the cost driver analysis indicates that the company should evaluate increased automation, especially in
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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:
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Mettwurst
Bill of activities
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
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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
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Move to smoke house
300
Move to truck
750
Annual cost of all direct labour and manufacturing overhead activities
Activity cost per unit
$12 190
$2.438
Direct material cost per unit
2.160
Manufacturing cost per unit
$4.598
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9
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.
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CASE 16.49 (60 minutes) Traditional 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
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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
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meaningful standards for non-manufacturing functions such as administration and marketing. Thus, its impact
would have been limited.
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 Schmidtke’s to improve their cost structure if necessary. An ABM system can also
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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
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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.
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CASE 16.50 (45 minutes) Measuring and managing quality costs: manufacturer
1
Landers Ltd
Cost of Quality Report
Current
Percentage
month’s cost
of total
$12 000
4.4
Internal failure costs:
Rework on defective wheels
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Engineering costs to correct production line quality problems
22 500
8.2
Lost contribution on time to correct production line quality problems
37 500
13.6
6 000
2.2
Cost of rewelding faulty joints discovered during processing
28 500
10.4
Cost of faulty bikes that are scrapped after finished goods inspection
15 000
5.4
121 500
44.2
7 500
2.7
Cost of faulty components that are scrapped
External failure costs:
Cost of replacement bikes provided under warranty
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Cost of bikes returned by customers and scrapped
7 500
2.7
Cost of repairs under warranty
1 500
0.55
750
0.3
Contribution margin forgone on bikes returned by customers
1 500
0.55
Contribution margin forgone on lost future bike sales
7 500
2.7
26 250
9.5
4 500
1.6
Sales commissions on faulty bikes returned by customers
Prevention costs:
Cost of quality training programs
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4 500
Appraisal costs:
Quality inspection in the goods receiving area
22 500
8.2
Quality inspections during processing
34 500
12.5
Laboratory testing of bikes and components
19 500
7.1
Operating an X-ray machine to detect faulty welds
22 500
8.2
Inspection of each bike put into finished goods warehouse
24 000
8.7
123 000
44.7
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Total quality costs
$275 250
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2
The cost of quality report indicates that Landers costs of quality are very high compared to the overall
manufacturing costs (more than 30 per cent of manufacturing costs). It appears that the company achieves its
high quality 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.
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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.
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