Professional Documents
Culture Documents
1. The two dimensions are the cost dimension 5. Activity inputs are the resources consumed
and the process dimension. The cost di- by an activity in producing its output. Activity
mension is concerned with accurate as- output is the result or product of an activity.
signment of costs to cost objects, such as Activity output measurement simply means
products and customers. Activity-based the number of times the activity is per-
costing is the focus of this dimension. The formed.
second dimension — the process dimen-
sion — provides information about why work 6. Activity analysis is concerned with identify-
is done and how well it is done. It is con- ing activities performed by an organization,
assessing their value to the organization,
cerned with cost driver analysis, activity
analysis, and performance measurement. and selecting and keeping only those that
This dimension offers the connection to the are value adding. Selecting and keeping
value-adding activities brings about cost re-
continuous improvement world found in the
advanced manufacturing environment. duction and greater operating efficiency,
thus providing support for the objective of
2. A functional-based responsibility accounting continuous improvement.
system is characterized by four elements:
(1) a responsibility center, where responsi- 7. Value-added activities are necessary activi-
bility is assigned to an individual in charge ties. Activities are necessary if they are
mandated or if they are not mandated and
(responsibility is usually defined in financial
terms); (2) the setting of budgets and stan- satisfy three conditions: (1) they cause a
dards to serve as benchmarks for perform- change of state, (2) the change of state is
not achievable by preceding activities, and
ance measurement; (3) measurement of
performance by comparing actual outcomes (3) they enable other activities to be per-
formed. Value-added costs are costs caused
with budgeted outcomes; and (4) individuals
by activities that are necessary and efficient-
being rewarded or penalized according to
management policies. ly executed.
8. Nonvalue-added activities are unnecessary
3. In an activity-based responsibility accounting
activities or those that are necessary but in-
system, the focus of control shifts from re-
sponsibility centers to processes and teams. efficient and improvable. An example is
moving goods. Nonvalue-added costs are
Management is concerned with how work is
those costs caused by nonvalue-added ac-
done, not with where it is done. Process im-
provement and process innovation are em- tivities. An example is the cost of materials
handling.
phasized. Standards tend to be optimal, dy-
namic, and process oriented. Performance 9. (1) Activity elimination — the identification
measurement focuses on processes and ac- and elimination of activities that fail to add
tivities that define the processes. Finally, value. (2) Activity selection — the process of
there tends to be more emphasis on group choosing among different sets of activities
rewards than on individual rewards. caused by competing strategies. (3) Activity
4. Driver analysis is concerned with identifying reduction — the process of decreasing the
the root causes of activity costs. Knowing time and resources required by an activity.
the root causes of activity costs is the key to (4) Activity sharing — increasing the efficien-
improvement and innovation. Once a man- cy of necessary activities using economies
ager understands why costs are being in- of scale.
curred, then efforts can be taken to improve
cost efficiency. 10. Value-added standards represent the abso-
lute levels of efficiency for activities. The
costs that should be incurred for these abso-
109
lute levels are value-added costs. Any dif- 16. Activity-based customer costing can identify
ference between the actual costs incurred what it is costing to service different cus-
and the ideal costs are nonvalue-added tomers. Once known, a firm can then devise
costs. a strategy to increase its profitability by fo-
cusing more on profitable customers, con-
11. Trend reports will reveal the progress made
verting unprofitable customers to profitable
over time in reducing nonvalue-added costs.
ones where possible, and “firing” customers
12. A kaizen standard is the planned improve- that cannot be made profitable.
ment for the coming period. The kaizen sub-
cycle implements the improvement, checks
it, and locks it in and then begins a search 17. Activity-based supplier costing traces all
for additional improvements. The mainten- supplier-caused activity costs to suppliers.
ance subcycle sets a standard based on This new total cost may prove to be lower
prior improvements, executes, and checks than what is signaled simply by purchase
the results to make sure that performance price.
conforms to the new results. If not, then cor-
rective action is taken.
13. Benchmarking identifies the best practices
of comparable internal and external units.
For internal units, information can be ga-
thered that reveals how the best unit
achieves its results; these procedures can
then be adopted by other comparable units.
For external units, the performance standard
provides an incentive to find ways to match
the performance (it may sometimes be poss-
ible to determine the ways the performance
is achieved).
14. If individuals are asked to reduce costs and
are told what the activity driver is, they may
decrease the level of the driver below that
which is optimal. Thus, it may be necessary
to also identify the optimal level of the cost
driver so that only nonvalue-added costs are
eliminated.
15. The activity volume variance is a measure of
the nonvalue-added costs. The unused ca-
pacity variance tells how much of the commit-
ted resources are not being used. This in-
formation is particularly important because it
helps managers know when they can take
actions to reduce nonvalue-added costs.
110
EXERCISES
5–1
Activity rates:
Machine rate = $1,800,000/60,000 = $30 per machine hour
Testing rate = $1,200,000/40,000 = $30 per testing hour
Rework rate = $600,000/20,000 = $30 per rework hour
Total overhead cost = ($30 × 50,000) + ($30 × 20,000) + ($30 × 5,000)
= $2,250,000
Improving the accuracy reduced the cost by $7.50, which is still less than the
$10 reduction needed. What this means is that although accuracy has a posi-
tive effect on the price, it is not the only problem. It appears that competitors
may be more efficient than Timesaver. This outcome then signals the need to
reduce costs.
2. Since testing and rework costs and setup and rework time are both reduced
by 50%, the activity rates remain the same, although the amount of cost as-
signed to the regular microwave will change:
This cost now is $11.25 less than the original allows management to reduce
the price by $10, increasing the competitive position of the regular model.
ABC is concerned with how costs are assigned, whereas ABM is not only
concerned with how they are assigned but also with how costs can be re-
duced. Cost accuracy and cost reduction are the dual themes of ABM.
111
5–2
Classification:
Situation Activity-Based Functional-Based
1 A B
2 A B
3 A B
4 B A
5 B A
6 B A
7 A B
Comments:
Situation 1: In a functional-based system, individuals are held responsible for the
efficiency of organizational units, such as the Grinding Department. In an activity-
based system, processes are the control points because they are the units of
change; they represent the way things are done in an organization. Improvement
and innovation mean changing the way things are done, or in other words, chang-
ing processes. Since processes, such as procurement, cut across functional
boundaries, teams are the natural outcome of process management. It is only
natural that the managers of purchasing, receiving, and accounts payable be part
of a team looking for ways to improve procurement.
112
5–2 Concluded
113
5–3
The ABM implementation is taking too long and is not producing the expected re-
sults. It also appears to not be integrated with the division’s official accounting
system, thus encouraging managers to continue relying on the old system (as
evidenced by the continued reliance on traditional materials and labor efficiency
variances). The fact that the ABC product costs are not significantly different in
many cases could be due to a lack of product diversity or perhaps due to poor
choices of pools and drivers. The lack of a competitive cost state suggests the
presence of significant nonvalue-added costs. The emphasis on the absence of
product cost differences, lack of cost reductions, and the attitude about activity
detail and the value content of inspection all reveal that plant managers have a
very limited understanding about ABM and what it can do. There clearly needs to
be a major effort to train managers to understand and use activity data. At this
point, there is no organizational culture that emphasizes the need for continuous
improvement. This need and the role ABM plays in continuous improvement
needs to be taught. The new ABM system also needs to be integrated to maximize
its chances for success.
5–4
1. David was concerned about meeting the schedule and staying within the 5
percent variance guideline. The first week’s production exceeded the guide-
line for both materials and labor, and he expected the same outcome for the
second week. By stopping inspections, no materials waste would be ob-
served and recorded for the second week, moving the usage variance back
within the 5 percent tolerance level. Accepting all units produced also will re-
duce the total labor time reported. Finally, using inspectors as production la-
bor and counting their time as inspection labor provides some “free” direct
labor time, which would also contribute to the reduction or elimination of an
unfavorable labor efficiency variance. David’s behavior is unethical. David
(and perhaps others) is deliberately subverting the organization’s legitimate
and ethical objective of providing a high-quality product used in the manufac-
ture of an airplane—in exchange for a favorable performance rating and, pre-
sumably, a good salary increase or bonus. Although no explicit information is
provided, the stress test seems to imply an important safety role for the bolts
in the airplane structure. If true, then David’s actions become even more
questionable.
114
5–4 Concluded
3. The first week’s experience indicates a fairly high defect rate—between 7 and
8 percent—which was expected to continue for the second week. Apparently,
item-by-item inspection is the company’s way of ensuring reliable bolt per-
formance. Abandoning the inspection process for a week simply to meet in-
ternal reporting standards seems like a weak excuse, even if a return to nor-
mal practices is expected. All too often, this sort of rationalization leads to
repeated violations of norms to meet short-term goals, and it becomes part of
the culture—to the point where it doesn’t appear to be wrong anymore. Fun-
damentally, the need for inspection and the high reject rate suggests that the
company needs to think about ways of improving its manufacturing process
to reduce the number of defective units. This is why an activity- or strategic-
based approach may be more suitable because they both have a process fo-
cus that emphasizes quality and efficiency. Production of defective units
would not be encouraged.
115
5–5
The following are possible sets of questions and answers (provided as examples
of what students could suggest):
Cleaning oil:
116
5–6
Nonvalue-added:
Comparing documents (state detection) $90,000 (0.15 × $600,000)
Resolving discrepancies (rework) $420,000 (0.70 × $600,000)
Value-added:
Preparing checks $60,000 (0.10 × $600,000)
Mailing checks $30,000 (0.05 × $600,000)
5–7
Questions 2–6 represent a possible sequence for the activity of comparing doc-
uments, and Questions 1 and 3–6 represent a possible sequence for resolving
discrepancies. The two activities have a common root cause.
117
5–8
2. The effect is to reduce the demand for the activity of resolving discrepancies
by 30 percent. By so doing, Whitley will save 21 percent (0.30 × 0.70) of its
clerical time. Thus, about four clerks can be eliminated (21% * 20 clerks = 4
clerks eliminated) by reassigning them to other areas or simply laying them
off. This will produce savings of about $120,000 per year (4 clerks * $30,000
salary). This is an example of process improvement—an incremental increase
in process efficiency resulting in a cost reduction.
5–9
EDI eliminates the demand for virtually all the activities within the bill-paying
process. Some demand may be left for payment activities relative to the acquisi-
tion of nonproductive supplies. Assuming conservatively that 90 percent of the
demand is gone, then there would be a need for perhaps two clerks (10% * 20
clerks = 2 remaining clerks). This would save the company $540,000 (18 clerks *
$30,000 salary) per year for this subprocess alone. Additional savings would be
realized from reduction of demands for purchasing and receiving activities.
Switching to an EDI procurement structure is an example of process innovation.
118
5–10
*For example, process design, product design, and quality approach or philoso-
phy.
5–11
The activity volume variance measures the nonvalue-added cost. The unused
capacity variance is a measure of the potential to reduce the spending on an
activity and, thus, reduce the nonvalue-added costs.
119
5–11 Concluded
4. By reducing the demand by another 6,000 units, the unused capacity will now
equal 7,200 orders—an amount equivalent to 1.5 purchasing agents. Thus,
the number of purchasing agents can be reduced from 6 to 5, saving $42,000.
120
5–12
1. Willson Company
Value- and Nonvalue-Added Cost Report
For the Year Ended December 31, 2005
Value-Added Nonvalue-Added Actual
Costs Costs Costs
Purchasing parts $ 450,000 $ 180,000 $ 630,000
Assembling parts 2,160,000 234,000 2,394,000
Administering parts 1,980,000 858,000 2,838,000
Inspecting parts 0 1,125,000 1,125,000
Total $4,590,000 $2,397,000 $6,987,000
5–13
1. Willson Company
Nonvalue-Added Cost Trend Report
For the Year Ended December 31, 2006
2005 2006 Change
Purchasing parts $ 180,000 $ 90,000 $ 90,000 F
Assembling parts 234,000 72,000 162,000 F
Administering parts 858,000 660,000 198,000 F
Inspecting parts 1,125,000 675,000 450,000 F
Total $2,397,000 $1,497,000 $900,000 F
Note: The above amounts were computed for each year, using the following
formula: (AQ – SQ)SP.
121
5–14
122
5–14 Continued
2. Behavioral analysis:
Setting up equipment: Using the number of setups as a driver may cause a
buildup of inventories. Since reducing the number of setups will reduce setup
costs, there will be an incentive to have fewer setups. Reducing the number
of setups will result in larger lots and could create finished goods inventory.
This is in opposition to the goal of zero inventories. On the other hand, if se-
tup time is used as the driver, managers will have an incentive to reduce se-
tup time. Reducing setup time allows managers to produce on demand rather
than for inventory.
123
5–14 Concluded
Creating scrap: Using the number of defective units as a driver should en-
courage managers to reduce defective units. Assuming that defective units
are the source of scrap, this should reduce scrap costs. Similarly, using
pounds of scrap should encourage managers to find ways to reduce scrap. In
both cases, the behavioral consequences could be two-edged. If the reduc-
tion of scrap (defective units) is achieved by increasing quality/productive ef-
ficiency, the effect is compatible with the objective of creating a competitive
advantage. If the reduction is achieved by allowing defective units to flow
through to finished goods, then the effect will be to alienate customers, not
win their favor (customer realization decreases). Neither driver appears to
dominate. One solution is to report the trend in warranty activity with the
trend in scrap activity. This may discourage any kind of pass-on behavior.
Welding subassemblies: Using welding hours should encourage management
to find ways of reducing the welding hours required per product. This would
be more likely to induce managers to look at possible root causes such as
product design and process design rather than number of welded subassem-
blies. There is some value in looking for ways to reduce the number of welded
subassemblies, perhaps redesigning the product to eliminate welding.
Materials handling: Both drivers seem to have positive incentives. Seeking
ways to reduce the number of moves or distance moved should lead manag-
ers to look at root causes. Reorganizing the plant layout, for example, should
reduce either the number of moves or the distance moved. Hopefully, the ac-
tivity drivers will lead to the identification of executional drivers that can be
managed so that the activity can be reduced and eventually eliminated.
Inspecting parts: Hours of inspection can be reduced by working with suppli-
ers so that greater incoming quality is ensured. Similarly, the number of de-
fective parts can be reduced by working with suppliers so that incoming qual-
ity is increased. Hours of inspection, however, can be reduced without
increasing quality. This is not true for the number of defective parts. Using
the number of defective parts appears to be a better choice.
124
5–15
1. First quarter: Setup time standard = 10 hours (based on the planned im-
provement: 15 hours – 5 hours)
Second quarter: Setup time standard = 8 hours (based on the planned im-
provement: 9 hours – 1 hour)
2. Kaizen subcycle:
• Plan (five-hour reduction from process redesign)
• Do (try out setup with new design)
• Check (time required was nine hours, a six-hour reduction)
• Act (lock in six-hour improvement by setting new standard of nine hours
and using same procedures as used to give the nine-hour outcome; and,
simultaneously, search for new improvement opportunity; in this case, the
suggested changes of the production workers.)
Repeat kaizen subcycle:
• Plan (one-hour reduction from setup procedure changes)
• Do (train and then implement procedures)
• Check (actual time required was 6.5 hours, a 2.5-hour reduction)
• Act (lock in improvement by setting standard of 6.5 hours and begin search
for new improvement)
3. Maintenance subcycle:
First quarter (end of):
• Establish standard (nine hours based on improved process design)
• Do (implement repetitively the improved standard)
• Check (see if the nine-hour time is maintained)
• Act (if the nine-hour time deteriorates, find out why and take corrective ac-
tion to restore to seven hours.)
Second quarter: Same cycle using 6.5 hours as the new standard to maintain
Note: The maintenance cycle described begins after observing the actual im-
provement. The actual improvement is locked in. The maintenance standard
at the beginning of the first quarter is 15 hours.
125
5–15 Concluded
5–16
1. JIT Non-JIT
Salesa $25,000,000 $25,000,000
Allocationb 1,500,000 1,500,000
a
$125 × 200,000, where $125 = $100 cost + ($100 × 0.25) markup on cost, and
200,000 is the average order size times the number of orders
JIT : 400 orders * 500 average order size = 200,000
Non-JIT: 40 orders * 5,000 average order size = 200,000
b
0.50 × $3,000,000
2. Activity rates:
Ordering rate = $1,760,000/440= $4,000 per sales order
Selling rate = $640,000/80 = $8,000 per sales call
Service rate = $600,000/300 = $2,000 per service call
126
5–16 Concluded
JIT Non-JIT
Ordering costs:
$4,000 × 400 $ 1,600,000
$4,000 × 40 $ 160,000
Selling costs:
$8,000 × 40 320,000
$8,000 × 40 320,000
Service costs:
$2,000 × 200 400,000
$2,000 × 100 200,000
Total $ 2,320,000 $ 680,000
3. It sounds like the JIT buyers are switching their inventory carrying costs to
Carbon without any significant benefit to Carbon. Carbon needs to increase
prices to reflect the additional demands on customer-support activities. Fur-
thermore, additional price increases may be needed to reflect the increased
number of setups, purchases, and so on, that are likely occurring inside the
plant. Carbon should also immediately initiate discussions with its JIT cus-
tomers to begin negotiations for achieving some of the benefits that a JIT
supplier should have, such as long-term contracts. The benefits of long-term
contracting may offset most or all of the increased costs from the additional
demands made on other activities.
127
5–17
1. Supplier cost:
First, calculate the activity rates for assigning costs to suppliers:
Inspecting components: $240,000/2,000 = $120 per sampling hour
Reworking products: $760,500/1,500 = $507 per rework hour
Warranty work: $4,800,000/8,000 = $600 per warranty hour
Next, calculate the cost per component by supplier:
Supplier cost:
Vance Foy
Purchase cost:
$23.50 × 400,000 $ 9,400,000
$21.50 × 1,600,000 $ 34,400,000
Inspecting components:
$120 × 40 4,800
$120 × 1,960 235,200
Reworking products:
$507 × 90 45,630
$507 × 1,410 714,870
Warranty work:
$600 × 400 240,000
$600 × 7,600 4,560,000
Total supplier cost $ 9,690,430 $ 39,910,070
Units supplied ÷ 400,000 ÷ 1,600,000
Unit cost $ 24.23* $ 24.94*
*Rounded
The difference is in favor of Vance; however, when the price concession is
considered, the cost of Vance is $23.23, which is less than Foy’s component.
Lumus should accept the contractual offer made by Vance.
128
5–17 Concluded
2. Warranty hours would act as the best driver of the three choices. Using this
driver, the rate is $1,000,000/8,000 = $125 per warranty hour. The cost as-
signed to each component would be:
Vance Foy
Lost sales:
$125 × 400 $ 50,000
$125 × 7,600 $ 950,000
$ 50,000 $ 950,000
Units supplied ÷ 400,000 ÷ 1,600,000
Increase in unit cost $ 0.13* $ 0.59*
*Rounded
129
PROBLEMS
5–18
130
5–18 Continued
131
5–18 Concluded
3. Behavioral analysis:
Setting up equipment: Using the number of setups as a driver may cause a
buildup of inventories. Since reducing the number of setups will reduce setup
costs, there will be an incentive to have fewer setups. Reducing the number
of setups will result in larger lots and could create finished goods inventory.
This is in opposition to the goal of zero inventories. On the other hand, if se-
tup time is used as the driver, managers will have an incentive to reduce se-
tup time. Reducing setup time allows managers to produce on demand rather
than for inventory.
Performing warranty work: Using the number of defective units as a driver
should encourage managers to reduce defective units. Assuming that defec-
tive units are the source of warranty work, this should reduce warranty costs.
Similarly, using warranty hours could encourage managers to find ways to
reduce warranty work by decreasing its causes. Alternatively, it may cause
them to look for more efficient means of performing warranty work. Increas-
ing the efficiency of a nonvalue-added activity has some short-run merit but it
should not be the focus. Of the two drivers, defective units is the most com-
patible with eventual elimination of the nonvalue-added activity.
Welding subassemblies: Using welding hours should encourage management
to find ways of reducing the welding hours required per product. This would
more likely induce managers to look at possible root causes such as product
design and process design than would number of welded subassemblies.
There is some value in looking for ways to reduce the number of welded sub-
assemblies, perhaps redesigning the product to eliminate welding.
Moving materials: Both drivers seem to have positive incentives. Seeking
ways to reduce the number of moves or distance moved should lead manag-
ers to look at root causes. Reorganizing the plant layout, for example, should
reduce either the number of moves or the distance moved. Hopefully, the ac-
tivity drivers will lead to the identification of executional drivers that can be
managed so that the activity can be reduced and eventually eliminated.
Inspecting components: Hours of inspection can be reduced by working with
suppliers so that greater incoming quality is ensured. Similarly, the number of
defective parts can be reduced by working with suppliers so that incoming
quality is increased. Hours of inspection, however, can be reduced without
increasing quality. This is not true for the number of defective parts. Using
the number of defective parts appears to be a better choice.
132
5–19
2. Setup $125,000
Materials handling 180,000
Inspection 122,000
Customer complaints 100,000
Warranties 170,000
Storing 80,000
Expediting 75,000
Total $852,000
Units produced and sold ÷120,000*
Potential unit cost reduction $ 7.10
*$1,920,000/$16 (total cost divided by unit cost)
The consultant’s estimate of cost reduction was on target. Per-unit costs can
be reduced by at least $7, and further reductions may be possible if improve-
ments in value-added activities are possible.
133
4. Current:
Sales $ 2,160,000 ($18 × 120,000 units)
Costs (1,920,000)
Income $ 240,000
$14 price (assumes that current market share is maintained):
Sales $1,680,000 ($14 × 120,000 units)
Costs (918,000) ($7.65* × 120,000 units)
Income $ 762,000
$12 price:
Sales $ 2,160,000 ($12 × 180,000 units)
Costs (1,377,000) ($7.65* × 180,000 units)
Income $ 783,000
*$16 – $8.35 = $7.65
The $12 price produces the greatest benefit.
134
5–20
135
5–20 Concluded
136
5–21
1. Nonvalue-added costs:
Materials (400,000 – 380,000)$21 $ 420,000
Labor (96,000 – 91,200)$12.50 60,000
Setups (6,400 – 0)$75 480,000
Materials handling (16,000 – 0)$70 1,120,000
Warranties (16,000 – 0)$100 1,600,000
Total $ 3,680,000
Units produced and sold ÷ 20,000
Unit nonvalue-added cost $ 184
Current cost less nonvalue-added cost:
$640 – $184 = $456
This is much less than the Santa Clara plant’s cost of $560. Thus, matching
the Santa Clara cost is possible and so is the target cost for expanding mar-
ket share. How quickly the cost reductions can be achieved is another matter.
Since the Santa Clara plant has experience in achieving reductions, it may be
possible to achieve at least a cost of $560 within a reasonably short time. As
plant manager, I would borrow heavily from the Santa Clara plant experience
and attempt to reduce the nonvalue-added costs quickly. I would also lower
the price to $624 and seek to take advantage of the increased market share—
even if it meant a short-term reduction in profits.
2. Benchmarking played a major role. The Santa Clara plant set the standard
and offered to share information on how it achieved the cost reductions that
enabled it to lower its selling price. The Lincoln plant responded by accepting
the offer of help and taking actions to achieve the same or greater cost reduc-
tions.
137
5–22
1. First quarter: Setup time standard = 8 hours (based on the planned im-
provement: 12 hours – 4 hours of reduced time)
Second quarter: Setup time standard = 4 hours (based on the planned im-
provement: 9 hours – 5 hours)
2. Kaizen subcycle:
• Plan (4-hour reduction from process redesign.)
• Do (Try out setup with new design.)
• Check (Time required was 9 hours, a 3-hour reduction.)
• Act (Lock in 3-hour improvement by setting new standard of 9 hours and
using same procedures as used to give the 9-hour outcome; simulta-
neously, search for new improvement opportunity—in this case, the sug-
gested changes of the production workers.)
3. Maintenance subcycle:
First quarter:
• Establish standard (9 hours based on improved process design.)
• Do (Implement repetitively the improved standard.)
• Check (See if the 9-hour time is maintained.)
• Act (If the 9-hour time deteriorates, find out why and take corrective action
to restore to 9 hours.)
Second quarter: Same cycle using 3 hours as the new standard to maintain.
Note: The maintenance cycle begins after observing the actual improvement.
The actual improvement is locked in.
138
5–22 Concluded
5–23
2. Activity rates:
Opening and closing accounts: $200,000/20,000 = $10 per account
Issuing monthly statements: $300,000/600,000 = $0.50 per statement
Processing transactions: $2,050,000/20,500,000 = $0.10 per transaction
Customer inquiries: $400,000/2,000,000 = $0.20 per minute
Providing ATM services: $1,120,000/1,600,000 = $0.70 per transaction
139
5–23 Continued
3. Costs assigned:
Low Medium High
Opening and closing:
$10 × 15,000 $ 150,000
$10 × 3,000 $ 30,000
$10 × 2,000 $ 20,000
Issuing monthly statements:
$0.50 × 450,000 225,000
$0.50 × 100,000 50,000
$0.50 × 50,000 25,000
Processing transactions:
$0.10 × 18,000,000 1,800,000
$0.10 × 2,000,000 200,000
$0.10 × 500,000 50,000
Customer inquiries:
$0.20 × 1,000,000 200,000
$0.20 × 600,000 120,000
$0.20 × 400,000 80,000
Providing ATM services:
$0.70 × 1,350,000 945,000
$0.70 × 200,000 140,000
$0.70 × 50,000 35,000
Total cost $ 3,320,000 $540,000 $210,000
Number of accounts ÷ 38,000 ÷ 8,000 ÷ 4,000
Cost per account $ 87.37 $ 67.50 $ 52.50
Average profit per account: $90.00 – $81.40 = $8.60
140
5–23 Concluded
4. First, calculate the profits from loans, credit cards, and other products by
customer category (using ABC data). Next, compare 50 percent of the cross
sales profits from low-balance customers with the total loss from the low-
balance checking accounts. If the cross sales profits are greater than the
loss, the president’s argument has merit.
5–24
1. GAAP mandates that all nonmanufacturing costs be expensed during the pe-
riod in which they are incurred. GAAP are the most likely cause of the prac-
tice. The limitations of GAAP-produced information for cost management
should be emphasized.
2. The total product consists of all benefits, both tangible and intangible, that a
customer receives. One of the benefits is the order-filling service provided by
Sorensen. Thus, it can be argued that these costs should be product costs
and not assigning them to products undercosts all products. From the infor-
mation given, there are more small orders than large (50,000 orders averaging
600 units per order); thus, these small orders consume more of the order-
filling resources. They should, therefore, receive more of the order-filling
costs.
The average order-filling cost per unit produced is computed as follows:
$4,500,000/90,000,0001 units = $0.05 per unit
1
(50,000 orders * 600 units per order) + (30,000 orders * 1,000 units per order) +
(20,000 orders * 1,500 units per order) = 90,000,000 units
Thus, order-filling costs are about 6 to 10 percent of the selling price, clearly
not a trivial amount.
Furthermore, the per-unit cost for individual product families can be com-
puted using the number of orders as the activity driver:
Activity rate = $4,500,000/100,000 orders
= $45 per order
The per-unit ordering cost for each product family can now be calculated:
Category I: $45/600 = $0.075 per unit
Category II: $45/1,000 = $0.045 per unit
Category III: $45/1,500 = $0.03 per unit
Category I, which has the smallest batches, is the most undercosted of the
three categories. Furthermore, the unit ordering cost is quite high relative to
5-24 Concluded
141
Category I’s selling price (9 to 15 percent of the selling price). This suggests
that something should be done to reduce the order-filling costs.
3. With the pricing incentive feature, the average order size has been increased
to 2,000 units for all three product families. The number of orders now
processed can be calculated as follows:
Orders = [(600 × 50,000) + (1,000 × 30,000) + (1,500 × 20,000)]/2,000
= 45,000
Reduction in orders = 100,000 – 45,000 = 55,000
Steps that can be reduced = 55,000/2,000 = 27 (rounding down to nearest
whole number)
There were initially 50 steps: 100,000/2,000
Reduction in resource spending:
Step-fixed costs: $50,000 × 27 = $1,350,000
Variable activity costs: $20 × 55,000 = 1,100,000
$2,450,000
Customers were placing smaller and more frequent orders than necessary.
They were receiving a benefit without being charged for it. By charging for the
benefit and allowing customers to decide whether the benefit is worth the
cost of providing it, Sorensen was able to reduce its costs (potentially by
shifting the cost of the service to the customers). The customers, however,
apparently did not feel that the benefit was worth paying for and so increased
order size. By increasing order size, the number of orders decreased, de-
creasing the demand for the order-filling activity, allowing Sorensen to reduce
its order-filling costs. Other benefits may also be realized. The order size af-
fects activities such as scheduling, setups, and material handling. Larger or-
ders should also decrease the demand for these activities, and costs can be
reduced even more.
Competitive advantage is created by providing the same customer value for
less cost or better value for the same or less cost. By reducing the cost, So-
rensen can increase customer value by providing a lower price (decreasing
customer sacrifice) or by providing some extra product features without in-
creasing the price (increasing customer realization, holding customer sacri-
fice constant). This is made possible by the decreased cost of producing and
selling the bolts.
142
5–25
1. Supplier cost:
First, calculate the activity rates for assigning costs to suppliers:
Replacing engines: $3,200,000/4,000 = $800 per engine
Expediting orders: $4,000,000/400 = $10,000 per late shipment
Repairing engines: $7,200,000/5,000 = $1,440 per engine
Next, calculate the cost per engine by supplier:
Supplier cost:
Watson Johnson
Purchase cost:
$900 × 72,000 $64,800,000
$1,000 × 16,000 $16,000,000
Replacing engines:
$800 × 3,960 3,168,000
$800 × 40 32,000
Expediting orders:
$10,000 × 396 3,960,000
$10,000 × 4 40,000
Repairing engines:
$1,440 × 4,880 7,027,200
$1,440 × 120 172,800
Total supplier cost $ 78,955,200 $16,244,800
Units supplied ÷ 72,000 ÷ 16,000
Unit cost $ 1,096.60 $ 1,015.30
The Johnson engine costs less when the full supplier effects are considered.
This is a better assessment of cost because it considers the costs that are
caused by the supplier due to poor quality, poor reliability, and poor delivery
performance.
2. In the short run, buy 40,000 from Johnson and 48,000 from Watson. In the
long run, one possibility is to encourage Johnson to expand its capacity;
another possibility is to encourage Watson to increase its quality and main-
tain purchases from both sources.
143
MANAGERIAL DECISION CASE
5–26
1. Tim and Jimmy have been friends for a long time. The one-time nature of the
request and the alleged effect a redesign would have on Jimmy’s career op-
portunity both create strong pressure for Tim to provide the requested coop-
eration. Of course, even without any specific ethical standards, it is fairly
easy to see that falsification of reports to help ensure a promotion is not the
right thing to do. Tim should turn down the request and make every effort to
help Jimmy find a solution that will benefit him and the company. For exam-
ple, Tim might be able to use his influence to obtain extra development capi-
tal, including a sufficient amount to expedite the development so that the
production dates can still be met.
2. If Tim cooperates, he will violate (at least) the following ethical standards (see
Chapter 1): competence standard I-3 (Provide decision support information
and recommendations that are accurate, clear, concise, and timely); integrity
standards III-1 and III-2: and credibility standards IV-1 and IV-2.
RESEARCH ASSIGNMENT
5–27
144