Chapter Review

15-5k Making the Connection Integrative Exercises

Part 3: Chapters 11–15

Zando Pharmaceuticals is an affiliate of the German-based Heisenberg Corporation, which

employs 40,000 worldwide. Zando's St. Louis facility houses the U.S. corporate headquarters
and Research and Development (R&D). It produces 30 products, using 28 different batch
processes. The facility has 2,000 employees on-site. In recent years, Zando's profitability has
suffered, which can be attributed to increased competition, customer dissatisfaction, and
regulatory pressures. Luis Alvarado, president of Zando, called a meeting to consider ways to
improve profitability. He labeled the meeting a strategic planning session and invited the
following officers: Kathy Shorts, environmental manager; Troy Lewis, head of R&D; Johnny
Mizukawa, vice president of production and quality; Larry Sower, vice president of finance;
and Doreen Savara, marketing vice president.

Luis:
“You all have received the quarterly financial reports for the last two years. The trends are
negative. We are losing market share, profits are decreasing, and our costs seem to be
increasing. We need to take actions to increase sales and reduce costs, and we need to do so as
quickly as possible. Given our research strengths, it seems to me that our best bet is to grow
revenues by introducing new products with proprietary rights. As far as costs are concerned,
we need to improve our performance on that dimension as well. Lower per-unit costs for new
and existing products are needed. Any suggestions?”

Troy:
“For our products, our ability to control costs resides in development—my area—rather than
manufacturing. We probably need to pay more attention to product and process design issues
to ensure a reasonably level per-unit cost. Revenues are also affected in this stage. Once we
patent a drug, the clock begins to tick, and we need to reduce time to market. Significantly,
reducing time to market will allow us to generate revenues for a longer period of time than we
are currently experiencing. It would also be helpful if we could reduce the cycle time for
product development. Both actions would increase revenues. Finally, we can increase revenues
by increasing the volume of new products.”

Johnny:
“There is a lot of merit to the observation that cost reduction opportunities reside mostly in
product development. Once a drug is approved, its approval includes the manufacturing
process. Any future changes in the manufacturing process require approval from the U.S. Food
and Drug Administration. Because of this, we have been reluctant, historically, to engage in
process improvement or reengineering. However, I wonder if we shouldn't reconsider this
longstanding policy. Some of the quality problems we have could be corrected by changing
some of our existing processes, and the costs saved may easily exceed any cost incurred from
seeking FDA approval. I think our quality costs are at least 15 percent of sales. That's a lot of
opportunity for improvement.”
Kathy:
“I agree that cost reduction—both in the product development stage and the manufacturing
stage—should be a key strategic theme. The environmental area also offers some very good
opportunities. A recent pollution prevention act passed by the legislature requires that we
calculate the costs of generating hazardous substances for each process. This act was the
incentive we needed to begin developing an environmental cost management system. The
results so far indicate that environmental costs are much more than we realized. They are
estimated to be in the range of 20 to 30 percent of total operating costs. Environmental costs
can be reduced by such things as computerizing chemical inventory, eliminating the use of
chlorinated solvents and other hazardous materials, reducing our use of virgin feedstocks, and
redesigning processes and products so that we can reduce toxic residue release. We can really
have a positive environmental impact while simultaneously reducing costs if more attention is
paid to environmental issues during product development.”

Doreen:
“I like what I am hearing because I think that it also affects our ability to increase market share
and revenues. For example, environmental impact is one of our major concerns. Some retail
pharmacy chains pay particular attention to green products, and right now we are not competing
well. Our environmental image is negative and needs to be improved. I am convinced that
doing so will allow us to increase market share. Quality is another important matter. We have
had to recall two batches of products during the past two years due to poor quality, and this has
hurt our image more than the environmental issue. Improving the processes to avoid these kinds
of problems will save us a lot of grief. Product image and reputation are essential to increasing
customer satisfaction and market share.”

Luis:
“We started with the need to improve financial performance by increasing revenues and
reducing costs. So far, we have some very good suggestions to help achieve these two
objectives, but I have some concerns. First, do we have the talent and capabilities to improve
quality and environmental performance? Troy, do your professionals really understand what
they need to do to improve process and product designs so that we can see the desired quality
and environmental improvements? Also, how can we reduce the cycle time for products and
the time to market once patented?”

Troy:
“Let me answer those questions in order. First, we probably are lacking the understanding on
the design issues. We will need to do some training to help our research scientists and chemical
engineers understand the consequences. We may need to hire a couple of professionals who
have experience in dealing with these issues. Second, we may need to make cycle time and
time to market significant performance measures and reward our people for actions that reduce
those measures. Our employees need to align their interests with those of the company. If we
can achieve this, we should see more revenue produced per employee.”

Luis:
“Good. Now, Johnny, tell us about production and quality. Do our manufacturing engineers
and production workers need help with environmental and quality issues?”

Johnny:
“Without question, training will be needed. Moreover, I really need to hire a couple of quality
engineers.”
Kathy:
“I also think that we need an environmental engineer with experience in pharmaceutical
manufacturing processes.”

Luis:
“Good. We certainly shouldn't ignore the necessary infrastructure to bring about the needed
changes. Larry, you have been relatively quiet, what do you think about all this? Do you have
any suggestions?”

Larry:
“Infrastructure is important. If this is all going to work, timely and accurate information will
be needed. It is hard to design products and processes with cost being a significant issue without
providing the right kind of cost information. We are in the process of revamping the cost
management information system so that it is activity based and so that we can provide quality
and environmental cost information. After listening to the comments made here, I might also
suggest that we need a strategic measurement system that can be used to align the interests of
our employees with our improvement strategy. People need to know what is important, that the
important factors are being measured, and that they are going to be evaluated and rewarded
based on these factors. Finally, I would encourage the use of target costing to help manage
costs during product development. To help you all understand the importance of good
information, I have assembled some activity data relating to two new products currently under
development. These two products will use the same process, using different setups. The data
are organized into resource, activity, and cost object modules with an accompanying list of
activity drivers to facilitate the use of an ABC software package recently acquired by Zando.”
Required
1. Use the comments from the executive meeting to identify strategic objectives and
possible performance measures for each of five perspectives: financial, customer,
environmental, process, and learning and growth. Would you recommend the
Balanced Scorecard for Zando? Why?
2. Suppose that Doreen suggested gainsharing in response to Troy's suggestion to reward
product development employees for improving cycle time and time to market. What is
gainsharing? How could it be used in the product development setting?
3. Determine the cost of all activities for the proposed new process. Now, assign the cost
of the secondary activity to the primary activities.
4. Classify the primary activities into three categories: environmental, quality, and other
(neither quality nor environmental). Did some activities end up in more than one
category? Explain.
5. Calculate the cost per unit for each of the proposed products using primary activity
rates. Now, calculate the environmental cost per unit and the quality cost per unit.
What does this tell you about the relative desirability of the two products?
6. Following Larry's suggestion, Luis decided to use target costing to help improve new
product profitability. Based on analyses by Luis and Doreen, the target prices for XK1
and XK5 are $50 per pound and $35 per pound, respectively. Luis has indicated that
any new product should earn a gross profit equal to 20 percent of sales. Based on this
information, answer the following:
a. What is the target cost for each product? Given this information, what should be
done?
b. Suppose Doreen indicates that sales for each product can be increased by 50
percent if the selling price is lowered by 10 percent. Assuming the same target
profit (Luis wants the original target profit per pound maintained), calculate the
new target costs. If all non-value-added costs were eliminated, could the target be
met? (Calculate the unit cost at the 50,000-unit level.) Now, calculate the effect on
total profits under a scenario where non-value-added costs are not eliminated
versus a scenario where all non-value-added costs are eliminated. (Include in this
analysis any possible increase in sales volume.)