Week 3 Workshop Exercise Solutions

EXERCISE 16.27 (15 minutes) Life cycle management and target costing:
manufacturer
1

The cost for XRP to remain competitive and meet the requirements of Solarcares parent company would
be 72 cents per unit.

target selling price to remain competitive = $1.50 ($1.50 x 20%) = $1.20

target cost to achieve a 40 per cent return on sales = $1.20 (1 0.40) = $0.72

Solarcare could examine the distribution of expected costs over the remainder of XRPs life cycle. The
aim should be to examine each stage of the life cycle, to identify ways in which non-value-added
activities can be removed. It may be possible to spend more money in the design phase and reduce costs
in subsequent stages, such as manufacturing costs, or customer warranty claims. It may also be feasible to
spend more money during manufacturing, for example, to improve quality, and reduce subsequent costs,
such as customer warranty claims.

Solarcare could use value engineering to achieve the target cost while maintaining or increasing customer
value. For example, in applying value engineering, the design team at Solarcare could substitute a more
cost-effective material for the XRP Lens or improve the efficiency of the production processes.

EXERCISE 16.30 (15 minutes) The theory of constraints: manufacturer

This question shows the importance of identifying constraints (or bottlenecks) and removing them to improve
the overall rate of production, or throughput. Improvements in non-bottleneck areas will not increase the rate of
output.
1

The current output is 70 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 105 units per hour (70
units plus 50 per cent improvement), which will increase production output to 105 units per hour. Support
proposal.

The current output is 120 units per hour. The efficiency drive in Department B will increase the potential
output from Department B to 210 units per hour (140 units plus 50 per cent improvement), but this will
not increase production output as Department A is producing only 120 units per hour and Department C
can only process 130 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.

The current output is 100 units per hour. The efficiency drive in Department B will increase the potential
output from Department B to 210 units per hour (140 units plus 50 per cent improvement), but this will
not increase production throughput. This is because Department A can only provide Department B with
120 units per hour and Department C can only process 100 units per hour. Do not support proposal. There
is better value in increasing the efficiency of Departments A and C, rather than Department B.

EXERCISE 16.32 (30 minutes) Cost of quality report: manufacturer

1

Valley Fabrications Ltd

Cost of Quality Report for the month of April
Current months

Percentage

cost

of total

Internal failure costs:

Cost of faulty goods that are scrapped

$8 400

Cost of rewelding faulty joints discovered during processing3 800

18.6
8.4

12 200

27.0

6 000

13.3

10 000

22.1

1 800

4.0

17 800

39.4

5 800

12.8

600

1.3

6 400

14.1

Operating an X-ray machine to detect faulty welds

5 400

12.0

Product inspection into finished goods warehouse

3 400

7.5

8 800

19.5

$45 200

100

External failure costs:

Repairs of faulty products returned by customers

Costs of recalling faulty product
Legal fees related to product recall
Prevention costs:

Cost of sending machine operators to a three-week

quality training program
Costs to confirm a suppliers quality accreditation
Appraisal costs:

Total quality costs

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.

PROBLEM 16.36 (30 minutes) Activity-based management; cost cutting: manufacturer

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.

Cost of non-value-added activities:

Warehousing:

550 moves x $40a

$22 000

Outgoing shipments: 250 shipments x $15b

$ 3 750

Total

$25 750

Warehouse: $360 000 9000 inventory moves = $40 per move

Outgoing shipments: $225 000 15 000 shipments = $15 per shipment

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.

As the following figures show, the elimination of non-value-added activities allows Alligator.com to
achieve the target cost percentage for software only.

Activity

Cost driver
quantity

**

Books

Incoming receipts

2 000

70%

30%

1 400

Warehousing

9 000

80%

20%

6 650*

15 000

25%

75%

3 750

Outgoing shipments
*

Cost
Cost driver driver
quantity: quantity:
Software
Books
Software

(9000 moves x 80%) 550

(15 000 shipments x 75%) - 250

Activity

Books

Software

Incoming receipts
1400 purchase orders x $ 150a

$210 000

600 purchase orders x $ 150

$90 000

Warehousing
6650 moves x $ 40

$266 000

1800 moves x $ 40

$72 000

Outgoing shipments
3750 shipments x $ 15

$56 250

11000 shipments x $ 15
Total cost
Cost as percentage of sales:

$165 000
$532 250 $327 000
13.65%

12.58%

600
1 800
11 000**

Incoming receipts: $ 300 000 2000 purchase orders = $150 per purchase order.

Additional cost cutting of $25 250 is needed for books to achieve the 13 per cent target of $507 000
($3 900 000 x 13 per cent). Tools that the company might use include customer-profitability analysis,
target costing, value engineering, benchmarking and business process re-engineering.

PROBLEM 16.42 (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 each product and after taking these costs into account the
Weekend Wear still appears more profitable, although the After-five Wear has a higher return on
sales.
After-five wear
Sales revenue

Weekend wear

$700 000

$1 300 000

500 000

900 000

$200 000

$400 000

Promotion costs

4 000

40 000

Distribution costs

6 000

120 000

Cost of goods sold

Gross margin

Net profit
$190 000
$240 000
Under the life cycle approach, the After-five Wear appears more profitable as it requires much less
non-manufacturing support.
YEAR 1

After-five wear

Weekend wear

Design costs

$40 000

$200 000

Net loss

$40 000

$200 000

YEAR 2 & 3

After-five wear

Sales revenue

Weekend wear

$700 000

$1 300 000

500 000

900 000

$200 000

$400 000

Promotion costs

4 000

40 000

Distribution costs

6 000

120 000

Net profit

$190 000

$240 000

Profit over the life cycle*

$280 000

$340 000

Cost of goods sold

Gross margin

* The life cycle profit = Year 1 + 2 x Year 2/3

A complete life cycle analysis reports revenues and costs for each year of the products life. It could also
require information on the volume of production and sales.

The life cycle cost will be more useful as it ensures that products cover all their costs over their
(often short) life cycles.

In order to undertake a complete profitability analysis for the two product lines, a complete list
of revenues and costs for each year of the products life is required. It could also require
information on the volume of production and sales. In addition, a more accurate analysis
recognising time value of money can be performed by discounting three years estimated cash
flows using the firms required rate of return.

PROBLEM 16.44 Life cycle budgeting; life cycle management; target costing:
manufacturer
1

The target cost for the Sunstruck model that will meet the required price of $800 and the required margin
of 30 per cent is:

Target cost

Target selling price target profit margin

$800 ($800 x 0.30)

$560

The estimated manufacturing cost is $500. Therefore, the development and introduction of the
Sunstruck model should go ahead as the price of $800 will give a return on sales of (800
500) / 800 = 37.5 per cent, which is above the required return of 30 per cent on sales.

Life cycle budget for Sunstruck Solar Hot Water Service:

(in thousands of dollars)

Year 1

Year 2

Year 3

Year 4

$8 000

$12 000

$4 000

$24 000

Less: Cost of goods sold

5 000

7 500

2 500

15 000

Gross margin

3 000

4 500

1 500

9 000

Sales revenue

Year 5

Total

Less: non-manufacturing costs

Research and development

1 500

1 500

Product and process design

3 000

700

Marketing

1 000

800

500

400

Customer support

_____

250

800

750

200

2 000

Net profit / (loss)

$(5 500)

$ 1 250

$3 200

$350

$(200)

$(900)

3 700
2 700

The estimated average unit cost of the Sunstruck model over its entire life cycle is:
Total costs / total units = $ 24 900 000 / 30 000 = $830.
On this basis, the development and introduction of the Sunstruck model is not recommended as the price
is less than the average cost per unit. However, the estimate of cost of goods sold should be reviewed
before making this decision, as the applied manufacturing overhead consists of both variable and fixed
overhead. In estimating the manufacturing overhead cost at $125 per unit, the analysis above has failed to
recognise that the fixed component of the overhead cost will not increase proportionately with the volume
of production. In Chapter 19 we discuss the problems associated with using unitised fixed costs as a basis
for decision making.

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.