Week 10 Suggested solutions to class questions

Case 18-19
1 (a) Sales Target costs - variable Target costs - fixed Total target cost Internal failure costs External failure costs Non-conformance costs Appraisal costs Prevention costs Conformance costs Total quality costs Total cost per Schedule 1.1 2000 m 15.000 6.000 2.000 8.000 1.600 2.000 3.600 0.500 2.000 2.500 6.100 14.100 % 100% 40% 13% 53% 2001 m 18.000 7.200 2.000 9.200 0.920 1.104 2.024 0.500 1.000 1.500 3.524 12.724 2002 m 100% 20.000 40% 8.000 11% 2.500 51% 10.500 0.525 0.525 57% 1.050 0.500 0.500 43% 1.000 100% 2.050 12.550 % % 100% 40% 13% 53%

59%

51%

41% 100%

49% 100%

1 (b) Explain the following cost classifications and give an example: Target cost Internal failure costs External failure costs Appraisal costs Prevention costs Compare conformance costs with non-conformance costs - over the three years the proportion of conformance costs increased, resulting in a decrease in the proportion of non-conformance costs, which is the more damaging to an organization. 2 (a) Key terms to be included in the corporate vision or mission statement
Close co-operation with customers Meet their specific design and quality requirements Improve effectiveness of all aspects of the cycle from product design to after sales service

2000

2001

2002

2 (b) Marketing % increase in sales Market share Financial Profit to sales Target cost to sales Quality costs to sales 2 (c) Quality Production achieving quality standards Returns from customers Costs of after sales service (m) Delivery Meeting planned delivery dates Average cycle time (weeks) 2 (d) Cycle time Average cycle time (weeks) Waste Components scrapped in production Idle machine capacity 2 (e)

120.00 12.50 14.40

111.11 15.38

46.67 53.33 40.67

48.89 51.11 19.58

47.50 52.50 10.25

95 3 1.5

97 1.5 1.25

98 0.5 1

90 6

95 5.5

99 5

5.5

7.5 10

5 6

2.5 2

Compare some of the internal trends with the external trends. e.g. Focus on prevention, appraisal and internal failure costs resulted in lower external failure costs, increased market share, increased on-time delivery etc.

Problem 19-4 1. (a) &(b)Traditional costing systems explain how products consume resources- ABC argues that it is activities rather than products that consume resources. Traditional costing systems also focus on volume driven cost drivers. Multiple products increase volumes and thus apparently contribute to fixed costs but they may also increase complexity and add overhead in a disproportionate manner. Multiple products also may reduce risk and uncertainty, smooth seasonal fluctuations, enable cross-selling through same marketing channels and strengthen brand name and penetration. 2. (a) Target costing Target costing begins with an objective such as target rate of return and works out the cost that can be allowed given the competitive conditions that constrain price. Just as Target costing may require management accountants to be more aware of design, designers have also to become more aware of the need to design to cost and quality targets set by competitive conditions. The resulting customer-oriented design is a team process with potential inputs from a number of disciplines. Best practice in terms of designing to cost is to assign costs to the functions of product rather than to blocks of components. This technique, which is sometimes known as attribute costing, aims to encourage creativity rather than continuity in design characteristics. The creativity of designers may also be guided by techniques such as value engineering or value analysis. Value in this context may be defined as the ratio of functionality to cost. Thus value may be improved by holding functionality and reducing cost or by increasing functionality while holding cost. Product improvement may stem from innate creativity; it may also emerge from an analysis of competitors products and processes through techniques associated with target costing such as tear-down analysis, reverse engineering and bench-marking (b) Life-cycle costing Traditional costing sometimes seems to focus too much on costs as they are incurred because incurred costs are more visible as they are 'booked' through routine cost accumulation systems. For example, product life-cycle costs may be expressed in the form of a product budget. With up to 90% of cost may be committed or locked-in at pre-production stages, management accountants have become more aware of the design and planning phases of the product lifecycle. The biggest gap is at the research and development stage where although this function may generate a relatively low proportion of a product's total product cost, decisions made here lock-in the costs incurred in the manufacturing and marketing phases. In recognition of the importance of the planning phase, life-cycle costing tries to estimate a products costs over its life-time. Life-cycle costing draws extensively on the techniques of target costing. Target costing is more than just a pricing technique as it manages costs rather than just passively measure them. The aim of target costing is to choose product and process technologies that give an acceptable profit at a planned level of output. As well as recognizing the importance of the design phase, life cycle costing also anticipates cost improvements during the manufacturing cycle. This aspect is sometimes known as Kaizen costing as it is part of the wider philosophy of continuous improvement. Some of the cost improvements will occur through a process of "learning-by-doing" as workers get more adept at their tasks. Some problems with target and lifecycle costing for Telmat One problem with target costing is that it may reveal an unpalatable view of a company's internal operations exposing uncompetitive practices and processes that were hidden by more traditional costing techniques. Another problem is that it may be too time-consuming. Thus while it may be appropriate in the car industry which is based on relatively mature technologies and

lengthy product life cycles, it is less appropriate in industries such as electronics where the rate of innovation is extremely rapid and time-to-market must be minimized. Telmat manufactures mobile phones, which typically have a relatively short product life-cycle. The other feature of lifecycle costing is that it implicitly assumes a relatively orderly value chain with a dominant customer who can plan the design and delivery of product.

Problem 19-5 1. (a) Cost reduction aims is not just to passively measure cost but actively reduce it. The hotel may try to break-down costs of similar operations in each hotel (e.g. swimming pool maintenance), find the lowest cost and see how that hotel is delivering the particular service. (b) Value analysis is an engineering-based technique that aims to relate functionality to cost by asking the questions such as: Can we achieve the same outcome with fewer inputs or can we achieve an improved outcome with the same inputs. At its most advanced, Value analysis will try to move away from specific products in order to analyse how to deliver value to consumers. This approach enables designers to be more creative in their search for new designs and processes. Value analysis is not necessarily a technique that can only be applied in engineering/manufacturing situations. In the case of a hotel, there may be a number of ways of creating value for guests. (c) Zero based budgeting questions existing levels of expenditure by building up a budget as it was the first time. The aim is to get away from tendencies for budgets to grow incrementally over time. Zero base budgeting is another technique that relates cost to outcomes. Under a zero-base budget, managers are required to justify all budgeted expenditures, not just changes in the budget from the previous year. The baseline is zero rather than last years budget. In addition to all of the schedules in the usual master budget, the manager must prepare a series of decision packages in which all of the activities of the department are ranked according to their relative importance and the cost of each activity is identified. Higher-level managers can then review the decision packages and cut back in those areas that appear to be less critical or whose costs do not appear to be justified. 2 & 3 In an advanced manufacturing operation, competitive advantage is often based on quality, flexibility and cost reduction. Direct labour will be a relatively low proportion of total costs and not the main cost driver. Standard costing may discourage flexibility and quality control in favour of long runs of a technically and qualitatively static product. JIT implies the development of a culture of a highly motivated, self-monitoring work-force which may be hindered by the scientific management model of Standard costing may be inappropriate for a high tech environment such as M plc especially if the standards fail to deliver continuous improvement or are derived from inappropriate cost drivers such as direct labour. Measures that pick up non-financial performance such as quality or set-up times may be more important.

Problem 18-13 (45 minutes)

1. This year % 2.5% 0.2 0.4 3.1 Last year % 1.7% 0.0 0.0 1.7

Amount Prevention costs: Machine maintenance 120 Training supplies 10 Quality circles 20 Total 150 Appraisal costs: Incoming inspection Final testing Total Internal failure costs: Rework Scrap Total External failure costs: Warranty repairs Customer returns Total Total quality cost

Amount

% 10.4% 0.0 0.0 10.4

20.3% 70 1.70 3.4 25.4 70

40 90 130

0.8 1.9 2.7

6.8 15.3 22.0

20 80 100

0.5 1.9 2.4

3.0 11.9 14.0

130 70 200

2.7 1.5 4.2

22.0 11.9 33.9

50 40 90

1.2 1.0 2.1

7.5 6.0 13.4

30 80 110 590

0.6 1.7 2.3 12.3%

5.1 13.6 18.6 100%

90 320 410 670

2.1 7.6 9.8 16.0%

13.4 47.8 61.2 100%

From the above analysis it would appear that Mercury, Ltd's program has been successful. Total quality costs have declined from 16.0% to 12.3% as a percentage of total production cost. In dollar amount, total quality costs went from 670,000 last year to 590,000 this year. External failure costs, those costs signaling customer dissatisfaction, have declined from 9.8% of total production costs to 2.3%. These declines in warranty repairs and customer returns should result in increased sales in the future. Appraisal costs have increased from 2.4% to 2.7% of total production cost. Internal failure costs have increased from 2.1% to 4.2% of production costs. This increase has probably resulted from the increase in appraisal activities. Defective units are now being spotted more frequently before they are shipped to customers. Prevention costs have increased from 1.7% of total production cost to 3.1% and from 10.4% of total quality costs to 25.4%. The 80,000 increase is more than offset by decreases in other quality costs. 2. The initial effect of emphasising prevention and appraisal was to reduce external failure costs and increase internal failure costs. The increase in appraisal activities resulted in catching more defective units before they were shipped to customers. As a consequence, rework and scrap costs increased. In the future, an increased emphasis on prevention should result in a decrease in internal failure costs. And as defect rates are reduced, resources devoted to appraisal can be reduced.

3. To measure the cost of not implementing the quality program, management could assume that sales and market share would continue to decline and then calculate the lost profit. Or, management might assume that the company will have to cut its prices to hang on to its market share. The impact on profits of lowering prices could be estimated.