Nico Parts, Inc., produces electronic products with short life cycles (of less than two years). Development has to be rapid, and the profitability of the products is tied strongly to the ability to find designs that will keep production and logistics costs low. Recently, management has also decided that post-purchase costs are important in design decisions. Last month, a proposal for a new product was presented to management. The total market was projected at 200,000 units (for the two-year period). The proposed selling price was $130 per unit. At this price, market share was expected to be 25 percent. The manufacturing and logistics costs were estimated to be $120 per unit.
Upon reviewing the projected figures, Brian Metcalf, president of Nico, called in his chief design engineer, Mark Williams, and his marketing manager, Cathy McCourt. The following conversation was recorded:
BRIAN: Mark, as you know, we agreed that a profit of $15 per unit is needed for this new product. Also, as I look at the projected market share, 25 percent isn’t acceptable. Total profits need to be increased. Cathy, what suggestions do you have?
CATHY: Simple. Decrease the selling price to $125 and we expand our market share to 35 percent. To increase total profits, however, we need some cost reductions as well.
BRIAN: You’re right. However, keep in mind that I do not want to earn a profit that is less than $15 per unit.
MARK: Does that $15 per unit factor in preproduction costs? You know we have already spent $100,000 on developing this product. To lower costs will require more expenditure on development.
BRIAN: Good point. No, the projected cost of $120 does not include the $100,000 we have already spent. I do want a design that will provide a $15-per-unit profit, including consideration of preproduction costs.
CATHY: I might mention that post-purchase costs are important as well. The current design will impose about $10 per unit for using, maintaining, and disposing our product. That’s about the same as our competitors. If we can reduce that cost to about $5 per unit by designing a better product, we could probably capture about 50 percent of the market. I have just completed a marketing survey at Mark’s request and have found out that the current design has two features not valued by potential customers. These two features have a projected cost of $6 per unit. However, the price consumers are willing to pay for the product is the same with or without the features.
Required:
- 1. Calculate the target cost associated with the initial 25 percent market share. Does the initial design meet this target? Now calculate the total life-cycle profit that the current (initial) design offers (including preproduction costs).
- 2. Assume that the two features that are apparently not valued by consumers will be eliminated. Also assume that the selling price is lowered to $125.
- a. Calculate the target cost for the $125 price and 35 percent market share.
- b. How much more cost reduction is needed?
- c. What are the total life-cycle profits now projected for the new product?
- d. Describe the three general approaches that Nico can take to reduce the projected cost to this new target. Of the three approaches, which is likely to produce the most reduction?
- 3. Suppose that the Engineering Department has two new designs: Design A and Design B. Both designs eliminate the two nonvalued features. Both designs also reduce production and logistics costs by an additional $8 per unit. Design A, however, leaves post-purchase costs at $10 per unit, while Design B reduces post-purchase costs to $4 per unit. Developing and testing Design A costs an additional $150,000, while Design B costs an additional $300,000. Assuming a price of $125, calculate the total life-cycle profits under each design. Which would you choose? Explain. What if the design you chose cost an additional $500,000 instead of $150,000 or $300,000? Would this have changed your decision?
- 4. Refer to Requirement 3. For every extra dollar spent on preproduction activities, how much benefit was generated? What does this say about the importance of knowing the linkages between preproduction activities and later activities?
1.
Calculate the target cost associated with the initial 25 percent market share, find out whether the initial design meet this target and compute the total life-cycle profit that the current design offers.
Explanation of Solution
Target costing: Target costing is a business procedure that targets at the earliest stages of new product and service development, before creating and designing of production techniques.
Life-cycle cost management: Life cycle cost management is an approach that creates a “conceptual framework” by facilitating the ability of the management to make use of “internal and external linkages”.
Calculate the amount of target cost:
Therefore, the amount of target cost is $115 per unit.
Calculate the expected total life-cycle profit:
In this case, the expected cost is $122, therefore, the target cost is not met and the expected total life-cycle profit is $400,000.
Working note:
(1)Calculate the amount of expected cost:
Note:
2. a
Compute the target cost for the $125 price and 35 percent market share.
Explanation of Solution
Calculate the new target cost:
Therefore, the amount of new target cost is $110 per unit.
b.
Ascertain the amount of cost reduction needed.
Explanation of Solution
Cost reduction of $5.43
Working note:
(2)Calculate amount of current projected cost:
Note:
c.
Calculate the total life-cycle profits projected for the new project.
Explanation of Solution
Calculate the total life-cycle profits:
Therefore, the amount of total life cycle profits is $669,900.
Note:
d.
Explain the three common approaches that Incorporation N can take to reduce the projected cost to this new target and find out the approach that is likely to produce the most reduction.
Explanation of Solution
Three common approaches used to decrease costs in the design stage are as follows:
- 1. Reverse engineering is used to check whether several “efficiencies” can be learned from competitors;
- 2. Value analysis is used to check whether the functional design can be enhanced; and
- 3. Process improvement is used to check whether a more competent process design can be recognized.
Among the three approaches, the most potential approaches are the last two.
3.
Compute the total life-cycle profits under each design, state the design that could be chosen, explain if the design chosen cost an additional of $500,000 instead of $150,000 or $300,000 and ascertain if this can change the decision.
Explanation of Solution
Compute the total life-cycle profits for design A:
Therefore, the total life-cycle profit for design A is $1,080,000.
Note:
Compute the total life-cycle profits for design B:
Therefore, the total life-cycle profit for design B is $1,500,000.
- Design B meets the target profit and gives the maximum life-cycle income. Therefore design B must be chosen.
- If Design B costs an extra of $500,000 instead of an additional $300,000, then it could have generated a life-cycle income of $1,300,000 which is still higher than the income generated by Design A ($730,100).
- This explains that, more precautious steps must be taken while using per-unit targets, mainly if the life cycle is short.
Working notes:
Design A:
(3)Compute profit per unit:
Design A | Amount |
Sales | (4)$8,750,000 |
less life-cycle costs: | |
Production and logistics | (5)$7,420,000 |
Preproduction activities | (6)$250,000 |
Life-cycle income (a) | $1,080,000 |
Units (b) | 70,000 |
Profit per unit | $15.43 |
Table (1)
Note: The amount of $15.43 is rounded.
(4)Calculate the amount of sales:
Note:
(5)Calculate the life-cycle costs of production and logistics:
Note:
(6)Calculate the life-cycle costs of preproduction activities:
Design B:
(7)Compute profit per unit:
Design B | Amount |
Sales | (8)$12,500,000 |
less life-cycle costs: | |
Production and logistics | (9)$10,600,000 |
Preproduction activities | (10)$400,000 |
Life-cycle income (a) | $1,500,000 |
Units (b) | 100,000 |
Profit per unit | $15 |
Table (2)
(8)Calculate the amount of sales:
Note 1:
Note 2: In the case of design B, the post purchase cost is less than $5, that is $4. Therefore, the percent of market share will be 50%.
(9)Calculate the life-cycle costs of production and logistics:
Note:
(10)Calculate the life-cycle costs of preproduction activities:
4.
Calculate the amount of benefit generated for every extra dollar spent on preproduction activities and state the importance of knowing the linkages between preproduction activities and later activities.
Explanation of Solution
Calculate the amount of benefit generated for every extra spent on preproduction activities:
- Therefore, $2.67 of benefits will be recognized for every extra dollar spent on “preproduction activities”.
- The profitability of a firm can be increased in long-run by making use of the linkages among “preproduction activities and other activities” taking place in the later phases of the “production and consumer life-cycle stages”.
Working note:
(11)Calculate the amount of increase in benefits:
Cost Analysis | Amount |
Life-cycle profits, Design B | $1,500,000 |
Less: Life-cycle profits, initial design | $400,000 |
Increase in profits | $1,100,000 |
Additional development cost | $300,000 |
Increase in benefits | $800,000 |
Table (3)
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Chapter 11 Solutions
Cornerstones of Cost Management (Cornerstones Series)
- Boxer Production, Inc., is in the process of considering a flexible manufacturing system that will help the company react more swiftly to customer needs. The controller, Mick Morrell, estimated that the system will have a 10-year life and a required return of 10% with a net present value of negative $500,000. Nevertheless, he acknowledges that he did not quantify the potential sales increases that might result from this improvement on the issue of on-time delivery, because it was too difficult to quantify. If there is a general agreement that qualitative factors may offer an additional net cash flow of $150,000 per year, how should Boxer proceed with this Investment?arrow_forwardHudson Corporation is considering three options for managing its data warehouse: continuing with its own staff, hiring an outside vendor to do the managing, or using a combination of its own staff and an outside vendor. The cost of the operation depends on future demand. The annual cost of each option (in thousands of dollars) depends on demand as follows: If the demand probabilities are 0.2, 0.5, and 0.3, which decision alternative will minimize the expected cost of the data warehouse? What is the expected annual cost associated with that recommendation? Construct a risk profile for the optimal decision in part (a). What is the probability of the cost exceeding $700,000?arrow_forwardAt Stardust Gems, a faux gem and jewelry company, the setting department is a bottleneck. The company is considering hiring an extra worker, whose salary will be $67,000 per year, to ease the problem. Using the extra worker, the company will be able to produce and sell 9,000 more units per year. The selling price per unit is $20. The cost per unit currently is $15.85 as shown: What is the annual financial impact of hiring the extra worker for the bottleneck process?arrow_forward
- The demand for solvent, one of numerous products manufactured by Logan Industries Inc., has dropped sharply because of recent competition from a similar product. The companys chemists are currently completing tests of various new formulas, and it is anticipated that the manufacture of a superior product can be started on November 1, one month in the future. No changes will be needed in the present production facilities to manufacture the new product because only the mixture of the various materials will be changed. The controller has been asked by the president of the company for advice on whether to continue production during October or to suspend the manufacture of solvent until November 1. The following data have been assembled: The production costs and selling and administrative expenses, based on production of 10,000 units in September, are as follows: Sales for October are expected to drop about 40% below those of September. No significant changes are anticipated in the fixed costs or variable costs per unit. No extra costs will be incurred in discontinuing operations in the portion of the plant associated with solvent. The inventory of solvent at the beginning and end of October is not expected to be significant (material). Instructions 1. Prepare an estimated income statement in absorption costing form for October for solvent, assuming that production continues during the month. 2. Prepare an estimated income statement in variable costing form for October for solvent, assuming that production continues during the month. 3. What would be the estimated operating loss if the solvent production were temporarily suspended for October? 4. What advice should you give to management?arrow_forwardMallette Manufacturing, Inc., produces washing machines, dryers, and dishwashers. Because of increasing competition, Mallette is considering investing in an automated manufacturing system. Since competition is most keen for dishwashers, the production process for this line has been selected for initial evaluation. The automated system for the dishwasher line would replace an existing system (purchased one year ago for 6 million). Although the existing system will be fully depreciated in nine years, it is expected to last another 10 years. The automated system would also have a useful life of 10 years. The existing system is capable of producing 100,000 dishwashers per year. Sales and production data using the existing system are provided by the Accounting Department: All cash expenses with the exception of depreciation, which is 6 per unit. The existing equipment is being depreciated using straight-line with no salvage value considered. The automated system will cost 34 million to purchase, plus an estimated 20 million in software and implementation. (Assume that all investment outlays occur at the beginning of the first year.) If the automated equipment is purchased, the old equipment can be sold for 3 million. The automated system will require fewer parts for production and will produce with less waste. Because of this, the direct material cost per unit will be reduced by 25 percent. Automation will also require fewer support activities, and as a consequence, volume-related overhead will be reduced by 4 per unit and direct fixed overhead (other than depreciation) by 17 per unit. Direct labor is reduced by 60 percent. Assume, for simplicity, that the new investment will be depreciated on a pure straight-line basis for tax purposes with no salvage value. Ignore the half-life convention. The firms cost of capital is 12 percent, but management chooses to use 20 percent as the required rate of return for evaluation of investments. The combined federal and state tax rate is 40 percent. Required: 1. Compute the net present value for the old system and the automated system. Which system would the company choose? 2. Repeat the net present value analysis of Requirement 1, using 12 percent as the discount rate. 3. Upon seeing the projected sales for the old system, the marketing manager commented: Sales of 100,000 units per year cannot be maintained in the current competitive environment for more than one year unless we buy the automated system. The automated system will allow us to compete on the basis of quality and lead time. If we keep the old system, our sales will drop by 10,000 units per year. Repeat the net present value analysis, using this new information and a 12 percent discount rate. 4. An industrial engineer for Mallette noticed that salvage value for the automated equipment had not been included in the analysis. He estimated that the equipment could be sold for 4 million at the end of 10 years. He also estimated that the equipment of the old system would have no salvage value at the end of 10 years. Repeat the net present value analysis using this information, the information in Requirement 3, and a 12 percent discount rate. 5. Given the outcomes of the previous four requirements, comment on the importance of providing accurate inputs for assessing investments in automated manufacturing systems.arrow_forwardAt the beginning of the last quarter of 20x1, Youngston, Inc., a consumer products firm, hired Maria Carrillo to take over one of its divisions. The division manufactured small home appliances and was struggling to survive in a very competitive market. Maria immediately requested a projected income statement for 20x1. In response, the controller provided the following statement: After some investigation, Maria soon realized that the products being produced had a serious problem with quality. She once again requested a special study by the controllers office to supply a report on the level of quality costs. By the middle of November, Maria received the following report from the controller: Maria was surprised at the level of quality costs. They represented 30 percent of sales, which was certainly excessive. She knew that the division had to produce high-quality products to survive. The number of defective units produced needed to be reduced dramatically. Thus, Maria decided to pursue a quality-driven turnaround strategy. Revenue growth and cost reduction could both be achieved if quality could be improved. By growing revenues and decreasing costs, profitability could be increased. After meeting with the managers of production, marketing, purchasing, and human resources, Maria made the following decisions, effective immediately (end of November 20x1): a. More will be invested in employee training. Workers will be trained to detect quality problems and empowered to make improvements. Workers will be allowed a bonus of 10 percent of any cost savings produced by their suggested improvements. b. Two design engineers will be hired immediately, with expectations of hiring one or two more within a year. These engineers will be in charge of redesigning processes and products with the objective of improving quality. They will also be given the responsibility of working with selected suppliers to help improve the quality of their products and processes. Design engineers were considered a strategic necessity. c. Implement a new process: evaluation and selection of suppliers. This new process has the objective of selecting a group of suppliers that are willing and capable of providing nondefective components. d. Effective immediately, the division will begin inspecting purchased components. According to production, many of the quality problems are caused by defective components purchased from outside suppliers. Incoming inspection is viewed as a transitional activity. Once the division has developed a group of suppliers capable of delivering nondefective components, this activity will be eliminated. e. Within three years, the goal is to produce products with a defect rate less than 0.10 percent. By reducing the defect rate to this level, marketing is confident that market share will increase by at least 50 percent (as a consequence of increased customer satisfaction). Products with better quality will help establish an improved product image and reputation, allowing the division to capture new customers and increase market share. f. Accounting will be given the charge to install a quality information reporting system. Daily reports on operational quality data (e.g., percentage of defective units), weekly updates of trend graphs (posted throughout the division), and quarterly cost reports are the types of information required. g. To help direct the improvements in quality activities, kaizen costing is to be implemented. For example, for the year 20x1, a kaizen standard of 6 percent of the selling price per unit was set for rework costs, a 25 percent reduction from the current actual cost. To ensure that the quality improvements were directed and translated into concrete financial outcomes, Maria also began to implement a Balanced Scorecard for the division. By the end of 20x2, progress was being made. Sales had increased to 26,000,000, and the kaizen improvements were meeting or beating expectations. For example, rework costs had dropped to 1,500,000. At the end of 20x3, two years after the turnaround quality strategy was implemented, Maria received the following quality cost report: Maria also received an income statement for 20x3: Maria was pleased with the outcomes. Revenues had grown, and costs had been reduced by at least as much as she had projected for the two-year period. Growth next year should be even greater as she was beginning to observe a favorable effect from the higher-quality products. Also, further quality cost reductions should materialize as incoming inspections were showing much higher-quality purchased components. Required: 1. Identify the strategic objectives, classified by the Balanced Scorecard perspective. Next, suggest measures for each objective. 2. Using the results from Requirement 1, describe Marias strategy using a series of if-then statements. Next, prepare a strategy map. 3. Explain how you would evaluate the success of the quality-driven turnaround strategy. What additional information would you like to have for this evaluation? 4. Explain why Maria felt that the Balanced Scorecard would increase the likelihood that the turnaround strategy would actually produce good financial outcomes. 5. Advise Maria on how to encourage her employees to align their actions and behavior with the turnaround strategy.arrow_forward
- Artisan Metalworks has a bottleneck in their production that occurs within the engraving department. Jamal Moore, the COO, is considering hiring an extra worker, whose salary will be $55,000 per year, to solve the problem. With this extra worker, the company could produce and sell 3,000 more units per year. Currently, the selling price per unit is $25 and the cost per unit is $7.85. Using the information provided, calculate the annual financial impact of hiring the extra worker.arrow_forwardVariety Artisans has a bottleneck in their production that occurs within the engraving department. Arjun Naipul, the COO, is considering hiring an extra worker, whose salary will be $45,000 per year, to solve the problem. With this extra worker, the company could produce and sell 3,500 more units per year. Currently, the selling price per unit is $18 and the cost per unit is $5.85. Using the information provided, calculate the annual financial impact of hiring the extra worker.arrow_forwardJavier Company has sales of 8 million and quality costs of 1,600,000. The company is embarking on a major quality improvement program. During the next three years, Javier intends to attack failure costs by increasing its appraisal and prevention costs. The right prevention activities will be selected, and appraisal costs will be reduced according to the results achieved. For the coming year, management is considering six specific activities: quality training, process control, product inspection, supplier evaluation, prototype testing, and redesign of two major products. To encourage managers to focus on reducing non-value-added quality costs and select the right activities, a bonus pool is established relating to reduction of quality costs. The bonus pool is equal to 10 percent of the total reduction in quality costs. Current quality costs and the costs of these six activities are given in the following table. Each activity is added sequentially so that its effect on the cost categories can be assessed. For example, after quality training is added, the control costs increase to 320,000, and the failure costs drop to 1,040,000. Even though the activities are presented sequentially, they are totally independent of each other. Thus, only beneficial activities need be selected. Required: 1. Identify the control activities that should be implemented, and calculate the total quality costs associated with this selection. Assume that an activity is selected only if it increases the bonus pool. 2. Given the activities selected in Requirement 1, calculate the following: a. The reduction in total quality costs b. The percentage distribution for control and failure costs c. The amount for this years bonus pool 3. Suppose that a quality engineer complained about the gainsharing incentive system. Basically, he argued that the bonus should be based only on reductions of failure and appraisal costs. In this way, investment in prevention activities would be encouraged, and eventually, failure and appraisal costs would be eliminated. After eliminating the non-value-added costs, focus could then be placed on the level of prevention costs. If this approach were adopted, what activities would be selected? Do you agree or disagree with this approach? Explain.arrow_forward
- Bienestar, Inc., has two plants that manufacture a line of wheelchairs. One is located in Kansas City, and the other in Tulsa. Each plant is set up as a profit center. During the past year, both plants sold their tilt wheelchair model for 1,620. Sales volume averages 20,000 units per year in each plant. Recently, the Kansas City plant reduced the price of the tilt model to 1,440. Discussion with the Kansas City manager revealed that the price reduction was possible because the plant had reduced its manufacturing and selling costs by reducing what was called non-value-added costs. The Kansas City manufacturing and selling costs for the tilt model were 1,260 per unit. The Kansas City manager offered to loan the Tulsa plant his cost accounting manager to help it achieve similar results. The Tulsa plant manager readily agreed, knowing that his plant must keep pacenot only with the Kansas City plant but also with competitors. A local competitor had also reduced its price on a similar model, and Tulsas marketing manager had indicated that the price must be matched or sales would drop dramatically. In fact, the marketing manager suggested that if the price were dropped to 1,404 by the end of the year, the plant could expand its share of the market by 20 percent. The plant manager agreed but insisted that the current profit per unit must be maintained. He also wants to know if the plant can at least match the 1,260 per-unit cost of the Kansas City plant and if the plant can achieve the cost reduction using the approach of the Kansas City plant. The plant controller and the Kansas City cost accounting manager have assembled the following data for the most recent year. The actual cost of inputs, their value-added (ideal) quantity levels, and the actual quantity levels are provided (for production of 20,000 units). Assume there is no difference between actual prices of activity units and standard prices. Required: 1. Calculate the target cost for expanding the Tulsa plants market share by 20 percent, assuming that the per-unit profitability is maintained as requested by the plant manager. 2. Calculate the non-value-added cost per unit. Assuming that non-value-added costs can be reduced to zero, can the Tulsa plant match the Kansas City per-unit cost? Can the target cost for expanding market share be achieved? What actions would you take if you were the plant manager? 3. Describe the role that benchmarking played in the effort of the Tulsa plant to protect and improve its competitive position.arrow_forwardWright Plastic Products is a small company that specialized in the production of plastic dinner plates until several years ago. Although profits for the company had been good, they have been declining in recent years because of increased competition. Many competitors offer a full range of plastic products, and management felt that this created a competitive disadvantage. The output of the companys plants was exclusively devoted to plastic dinner plates. Three years ago, management made a decision to add additional product lines. They determined that existing idle capacity in each plant could easily be adapted to produce other plastic products. Each plant would produce one additional product line. For example, the Atlanta plant would add a line of plastic cups. Moreover, the variable cost of producing a package of cups (one dozen) was virtually identical to that of a package of plastic plates. (Variable costs referred to here are those that change in total as the units produced change. The costs include direct materials, direct labor, and unit-based variable overhead such as power and other machine costs.) Since the fixed expenses would not change, the new product was forecast to increase profits significantly (for the Atlanta plant). Two years after the addition of the new product line, the profits of the Atlanta plant (as well as other plants) had not improvedin fact, they had dropped. Upon investigation, the president of the company discovered that profits had not increased as expected because the so-called fixed cost pool had increased dramatically. The president interviewed the manager of each support department at the Atlanta plant. Typical responses from four of those managers are given next. Materials handling: The additional batches caused by the cups increased the demand for materials handling. We had to add one forklift and hire additional materials handling labor. Inspection: Inspecting cups is more complicated than plastic plates. We only inspect a sample drawn from every batch, but you need to understand that the number of batches has increased with this new product line. We had to hire more inspection labor. Purchasing: The new line increased the number of purchase orders. We had to use more resources to handle this increased volume. Accounting: There were more transactions to process than before. We had to increase our staff. Required: 1. Explain why the results of adding the new product line were not accurately projected. 2. Could this problem have been avoided with an activity-based cost management system? If so, would you recommend that the company adopt this type of system? Explain and discuss the differences between an activity-based cost management system and a traditional cost management system.arrow_forwardBienestar, Inc., implemented cellular manufacturing as recommended by a consultant. The production flow improved dramatically. However, the company was still faced with the competitive need to improve its cycle time so that the production rate is one bottle every four minutes (15 bottles per hour). The cell structure is shown below; the times above the process represent the time required to process one unit. Required: 1. 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