Production Planning and Control Summer term 2012 Prof. Dr.

Jrg Becker Exercise 5: Hardware Cost Estimation

WIRTSCHAFTS INFORMATIK

Meeting: Please try to prepare this exercise upfront for meeting on 18.06.20121 1) Traditional cost estimating Direct cost vs. activity-based costing ERCIS Ltd. manufactures high-quality pens. For many years the company manufactured only one type of pen (namely, ballpoint pens) but last year the company also began to manufacture fountain pens. The decision to begin manufacturing fountain pens was taken only after the companys marketing manager confirmed that there was a significant niche market for fountain pens and the companys cost accountant estimated that the cost of production for such pens would be much less than the selling price predicted by the marketing manager. When the fountain pen was introduced, sales (in terms of both quantity and price) were higher than expected. Nevertheless, the overall profits of ERCIS Ltd. have declined steadily. As a result, the cost accountant decided that he should re-examine his estimate of the cost of producing the fountain pen, with particular reference to overhead cost. In his original analyses, he allocated all manufacturing overhead costs to products in proportion to direct labour cost. However, in his re-examination he decided that activity-based costing (ABC) should be used in order to gain a more thorough understanding of the situation. The following data is available for the most recent month: Direct cost of production, per unit of each product:
Ballpoint pen Direct materials cost Direct labour cost 11.25 2.50 Fountain pen 18.75 5.00

Number of units of each product produced and sold:

Ballpoint pen Units produced and sold 32,000 Fountain pen 4,000

Manufacturing overhead costs for the month:

Activity cost pool Machine running costs Stores requisitions Materials movements Production set-ups Activity measure Machine hours Number of requisitions Number of movements Number of batches Total Cost 91,000 189,500 67,500 102,000 450,000

Activity levels in relation to each product:

Activity Machine hours Number of requisitions Number of movements Number of batches Ballpoint pen 7,500 500 325 50 Fountain pen 10,000 500 125 25 Total 17,500 1,000 450 75

Detailed instructions for solving these exercises will be provided during the presentation. 1

Your task: a) Calculate the costs per unit for each of the two types of pen, if all manufacturing overheads are allocated to the products in proportion to direct labour cost using an overhead allocation rate. b) Calculate the cost per unit of each of the two types of pen, if all manufacturing overheads are allocated to products using activity-based costing. c) Explain why the calculated cost per unit of the fountain pen is much higher in part b) than in part a), and suggest what additional factors (i.e., other than those reflected in the calculations here) may have contributed to the decline in the companys profitability since the fountain pen was introduced.

d) Now think of an alternative scenario: You are asked to design a brand new ballpoint pen which should be sold as the new flagship of ERCIS portfolio. During the conception you are forced to consider different designs and therefore alternative manufacturing steps. Is the activity based costing approach your method of choice for this purpose? Why or why not? Additionally, list two alternatives and shortly describe their advantages and disadvantages in the given scenario in comparison to the traditional approaches.

2) Introduction to Target Costing Due to the unsuccessful introduction of fountain pens, ERCIS Ltd. plans to return to the traditional ballpoint pen business with the release of a brand new product. For this purpose, the research department has developed drafts for two ballpoint pen models: a classic model, which consists of a single barrel as body and uses a cap with a clip for securing the pens tip, and a modern variant, whose body consists of three screwed parts, provides a small rubber coating for a firmer grip and a push button for releasing the tip.
Plug
Push button Cap with clip Worm Inner cap

Barrel Ink cartridge

Worm Barrel Rubber grip

Ink cartridge

Stopper

Feed Cap with clip Tip Ball point

Worm Spring Feed Tip Ball point

With the purpose of avoiding a new failing of the cost estimations accompanying the development of the new ballpoint pen, you as a prospective cost engineer are asked to help with the decision for one of the two models and to perform a cost calculation for the different parts under consideration of the products prospective utility for the customers. Since you heard about target costing as a method which allows the considering of market forces and customer requirements during the cost estimation, you decide for a correspondent approach. As a first step, the research department hands over a table with the potential product attributes and values for both models:
Attribute Writing comfort Reliability Prestige Safety from loss of parts Planned selling price modern high (with rubber coating) medium (abrasion of mechanical parts like spring and push button) high high (no loose parts) 4.50 per piece
Tab. 1

Value classic low (without rubber coating) high (no additional mechanical parts) medium medium (cap could get lost) 3.25 per piece

Beside this, the two drafts were part of a customer survey for determining the desired characteristics of a ballpoint pen (scale 0-1; higher is better). Moreover, qualitative cost impacts for realizing the different characteristics have been estimated by the research department (+: increase of costs; : no increase of costs). All relevant results are subsumed in the following table (Tab. 2):
Attribute Writing comfort Reliability Prestige Safety from loss of parts Planned selling price modern Part-worth / qualitative cost impact classic 0.7 / + 0.5 / + 0.6 / + 0.7 / + 0
Tab. 2

0.4 / 0.6 / 0.5 / 0.5 / + 0.5 3

The importance of an attribute or factor is represented by the range of its levels (difference between highest and lowest part-worth) divided by the sum of the ranges across all the attributes. This provides the relative importance of each attribute based on the range of its part-worth estimates. a) Please perform the accordant calculations. How can the results be interpreted?

Differences concerning the willingness to pay for the models can be calculated on the basis of a linear function which compares the price (y-axis) with its part-worth (x-axis). b) Against the background of the two given points, please specify this function. Additionally, please use the part-worths to calculate the overall utility per model (without considering the part-worth for the selling price), insert these values in the newly gained function and compare the values. How can the results be interpreted (under consideration of the qualitative cost impacts for the different attributes / models)? Since the part-worth for the planned selling price has not been considered in the last calculation, a price-sale-function shall be used for determining the optimal price for the products. Against the background of the market survey, the following linear price-sale-function has been identified (y: quantity of sales; p: price): ( ) c) Please use this function to calculate the price and sales amount combination which maximizes the turnover (remember: turnover is defined as ( ) ). Additionally, please calculate the new overall utility for the classic ballpoint pen model on the basis of the new price. What price would be required for motivating the customers to change from the classic model to the modern model?

On the basis of the present results, the management advises you to concentrate the further calculations on the classic ballpoint pen model. The determined price and sales amount combination now allows the calculation of the so called allowable costs in the broader sense for the classic ballpoint pen model. The allowable costs i. b. s. result from the comparison of the sales exposure with all costs that are allowed to occur during the product life cycle under the consideration of the market and competitive environment and the expected return. d) Please calculate the allowable costs in the broader sense for the classical model by considering an expected return of 10% of the sales exposure. Due to the aspect that the allowable costs in the broader sense form a highly aggregated and hardly meaningful measure, it is necessary to further detail its parts. One option is a function-oriented approach for eliminating the overhead costs (e.g. for research, marketing, sales etc.) from the further calculations. Consequently, the following target costing approach only considers the production costs (including the assembly costs). These costs are consequently called allowable costs in the narrow sense. e) Please calculate the allowable costs in the narrow sense under consideration of overhead costs in the amount of 54,000.

On the basis of these calculations and the specifications for the product characteristics, the research department details the draft for the classic ballpoint pen and determines the materials to be used. Against the background of an older, already produced model you are asked to estimate the costs for the different components of the new model (drifting costs). Thereby the following table (Tab. 3) has been created as a result:

Component Plug Barrel Ink cartridge Feed Cap with clip Tip Ball point Assembly

Drifting costs in 0.2 0.4 0.5 0.1 0.2 0.15 0.25 0.2 2
Tab. 3

Share of expenses in % 10 20 25 5 10 7.5 12,5 10 100

f)

Please compare the drifting costs and the allowable costs. What is the maximum amount of costs for the production of the classic ballpoint pen that still guarantees the covering of the sales exposure as well as the overhead costs?

Subsequently, it is required that the different components are weighted. Ideally, the relative required resources for realizing a products attribute correspond with the customers utility for the particular attribute. For comparing these values it is required to eliminate those attributes from the product profile that do not bind any operational resources. In the present case the attribute price is affected by this elimination. Moreover, the then calculated net product utility has to be normed to 100%. g) Please calculate the net utility for the different attributes of the ballpoint pen and insert the values into the following matrix (Tab. 4). Against the background of the so far calculated values for the net utility it is then required to determine the actual components that realize the desired attributes. After consultation with other departments of the company (controlling, research and development, production etc.), the following matrix (Tab. 4) has been created:
Attributes Writing comfort Components Plug Barrel Ink cartridge Feed Cap with clip Tip Ball point Assembly Share of net utility for the functions Reliability Prestige 5% 20% 15% 5% 20% 5% 10% 5% Safety from loss of parts 5% Share of net utility for the components 10% 30% 15% 5% 20% 5% 10% 5% 100%

10%

Tab. 4

Consequently, you are provided with the share of net utility for the different components of the classical ballpoint pen model. Using these data, you are now able to calculate the component-specific target costs index. The target costs index indicates, whether the idealistic demand of an allocation of costs according to the share of utility for the components is achieved. Following this approach, a product attribute or function which is judged to be more relevant for the customer, is allowed to cause higher target costs. The target costs index can be calculated as follows:

h) Please calculate the target cost index for the different components. How can the results be interpreted?

In practice, a demand for target costs indices with a value of 1 is too narrow. Instead, a tolerance region is defined in which the different components should be located. In a diagram, the x-coordinate is enriched with the percentaged share of utility for the components whereas the percentaged share of costs for the components is written down on the y-coordinate. The angle bisector denotes the idealistic demand of a target costs index with a value of 1. Following the approach of Tanaka, the tolerance ( ) and region can be defined with the functions ( ) . The parameter q thereby allows the adjustment the tolerance regions width. For selecting the parameter q the following recommendations exist: The nearer the target costs for the overall product are situated at the level of the maximal allowed costs on the market, the smaller the tolerance region and consequently the chosen parameter q should be selected. i) Please draw the complete diagram with the parameter q=10 and under consideration of the angle bisector. How can the results be interpreted for the different components and what is your conclusion for the upcoming discussion with the management and the research department?