WEEK 8 (UNIT 7) - TUTORIAL SOLUTIONS

REVIEW QUESTION
16.6 Spare capacity could relate to a variety of resources: staff time, wards, equipment and patient registration
(admission) room are examples. If staff in the Emergency Department benefit from reduced waiting times
and improved throughput, they would have more time to spend on complex cases and would see serious
cases more promptly. This could result in their efforts being more effective, saving long-term complications
and therefore saving costs elsewhere. Some hospitals now schedule elective surgery such that at least one
surgery ward can be closed at weekends, saving staff costs, cleaning and power costs. Improved throughput
times can reduce bed occupancy, which will reduce laundry and food costs. Reduced bed occupancy can
also lead to the re-assignment of staff to higher priority areas, the reconfiguring of roles and functions due
to a change in patient mix, and changed rostering of nurses.

EXERCISE 16.21 (25 minutes) Non-value-added activity: service firms

Note: For all three examples, there is a fine line between providing a level of service which the customer expects
and having facilities, staff or other resources lying idle. There is therefore no hard and fast list of activities and
students may come up with many other examples.

1 Dentist:
• Repairing damaged equipment.
• Searching for up-to-date methods of caring for patients’ teeth.
• Updating the reception area. This doesn’t add value to the services provided to patients.
• Numerous calls or letters to inform patients of appointments. This could be costly if the patient’s
contact details are incorrect.

2 Fashion retailer:
• Resolving customer complaints when products in advertised ‘special offers’ are not available.
• Returning defective clothes to the manufacturer or ringing the supplier for more supplies.
• Unpacking stock and putting it on display. Displaying stock can be very time-consuming.
• Repairing a DVD monitor that displays fashion shows. While playing the DVDs would be value
adding to the customer, the need to repair the player is not.

3 University business school:

• Preparing a classroom for group work by moving desks and chairs.
• Students arriving late for lectures, causing repetition of information to some students.
• Contacting students who did not hand in assessment items.
EXERCISE 16.28 Target costing: manufacturer
1 The target cost for the Glammaglob gadget would be $400 ($500 selling price – $100 profit).
2 The target profit is $100.
3 The target price is $500
4 If the estimated unit cost of the gadget is $460, then our cost reduction objective is $60 (the amount by
which the estimated cost exceeds the target costs). In order to apply the concept of target costing to achieve
the objective, the company should set up a cross-functional team to investigate possible cost savings in the
area of product design, manufacturing process and material costs, and obtain a commitment from each
functional department about the amount of cost saving it can achieve to help lower the current cost to the
target cost.

EXERCISE 16.31 (15 minutes) Theory of constraints: fast(?) food outlet

1

2 The number of customers per hour that cannot be served is 10 (30 less 20), so by 8 pm there are 40
customers waiting. The last customer will get his cold hamburger at 10 pm!

3 They need to get production up to at least 30 customers per hour, although there is potential to increase it
to 40 per hour if Mick and Daisy can increase their throughput to keep up with Donald. So, both Mick and
Daisy need some assistance. They could buy an automatic toaster! Alternatively, Minnie could help support
them as she only takes an order every two minutes.
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 will be
more profitable, although the After-five Wear has a higher return on sales.
After-five wear Weekend wear

Sales revenue $1 400 000 $2 600 000

Cost of goods sold 1 000 000 1 800 000
Gross margin $400 000 $800 000

Promotion costs 8 000 80 000

Distribution costs 12 000 240 000
Net profit $380 000 $480 000

2 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 $80 000 $400 000
Net loss $80 000 $400 000

YEAR 2/3 (p.a.) After-five wear Weekend wear

Sales revenue $1 400 000 $2 600 000
Cost of goods sold 1 000 000 1 800 000
Gross margin $400 000 $800 000
Promotion costs 8 000 80 000
Distribution costs 12 000 240 000
Net profit $380 000 $480 000

Profit over the life cycle* $680 000

$560 000
* The life cycle profit = Year 1 (loss) + 2 × (Year 2/3 results)
After-five = −$80 000 + (2 × $380 000) = $680 000
Weekend Wear = −$400 000 + (2 × $480 000) = $560 000

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

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

4 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’ lives is required. It could also require information on the
 volume of production and sales. In addition, a more accurate analysis recognising the time value of
money can be performed by discounting three years estimated cash flows using the firm’s required rate of
return.

PROBLEM 16.46 (35 minutes) Quality costs analysis: manufacturer

1 Warranty costs: external failure
Reliability engineering: prevention
Rework at LTL’s manufacturing plant: internal failure
Manufacturing inspection: appraisal
Transportation costs to customer sites to fix problems: external failure
Quality training for employees: prevention

2 & 3 Cost of quality report:

Model ABC Model XYZ

$ % costs of % $ % costs %
quality sales* of quality sales*

Internal failure (rework at LTL):

80 units  35%  $2850 $79 800 12.09 2.22

100 units  25%  $2400 $60 000 9.22 1.48

External failure:

Warranty costs:

80 units  70%  $1800 100 800

100 units  10%  $600 6 000

Transportation to customers: 44 250 22 500

Total 145 050 21 98 4.03 28 500 4.38 0.70

Appraisal (inspection):

300 hours  $75 22 500 3.41 0.62

500 hours  $75 37 500 5.76 0.92

Prevention:

Reliability engineering

1600 hours  $225 360 000

2000 hours  $225 450 000

Quality training 52 500 75 000

 Total 412 500 62 51 11.46 525 000 80.65 12.96

Total cost of quality $659 850 99.99 18.33 $651 000 100.01 16.06
* Sales revenue: $45 000  80 = $3 600 000; $40 500  100 = $4 050 000
4 Yes, the company is ‘investing’ its quality expenditures differently for the two machines. LTL is spending
more on prevention and appraisal for Model XYZ—almost 87 per cent of the total quality expenditures,
compared to approximately 66 per cent for Model ABC. The net result appears to be lower internal and
external failure costs for Model XYZ (less than 14 per cent compared with over 34 per cent) and lower
total quality costs as a percentage of sales (16.06 per cent for XYZ and 18.33 per cent for ABC). Two
issues worthy of note in this case are as follows:
• The investment in prevention is lower for ABC than for XYZ but the increase in this investment may
also have been more recent than for XYZ. There is a lag between investing in prevention and seeing
the fruits of this in the reduction of failure costs, especially external failure costs that may be
attributable to units from past production.
• The external failure costs in ABC are almost double the internal failure costs, while in XYZ they are
less than half. The difference is at least partly due to the greater investment in appraisal in XYZ but
could also be affected by how effective appraisal practices are in each model and the timing of the
investment in prevention.
This problem illustrates the essence of total quality management (TQM) systems when compared with traditional
quality control procedures. Overall costs are lower with TQM when compared with systems that focus on ‘after-
the-fact’ detection and rework.
CASE 16.48 (80 minutes) Activity-based costing; activity-based management; non-
value-added costs; BPR; target costing: manufacturer
1 There are many possible answers here. The Adelaide company might be able to price its mettwurst at $5.50
because:
• it has modern manufacturing facilities that enable it to produce at a cost much lower than
Schmidtke’s
• it may have an ABC costing system that gives it an accurate picture of the cost of producing
mettwurst
• it may not use a cost-based pricing system
• it may only make mettwurst in large production runs
• it may produce a much larger annual volume than Schmidtke’s and achieve substantial economies of
scale.

2 The absorption cost per stick of mettwurst = $7.00 / 1.40 = $5

3 Absorption costing systems tend to overstate the cost of high-volume products, like the mettwurst, and
understate the cost of low-volume products. This is due to the application of manufacturing overhead costs
using a volume-based cost driver, when many of the manufacturing overhead costs are not driven directly
by the volume of production but by other factors, such as the number of batches produced. Schmidtke’s
plantwide rate assumes that each product consumes overhead resources in direct proportion to the amount
of direct labour it consumes. In fact different products are likely to have different overhead consumption
patterns that are not necessarily related to the amount of direct labour they require. High-volume lines, like
the mettwurst, tend to consume fewer overhead resources than is assumed in the average plantwide
overhead rate and low-volume products tend to consume more. High-volume products require less than
average overhead support because they are simple to make and they are produced in relatively large batches.
Large batch sizes mean relatively low per unit costs for batch-related activities.

4 The target cost = $5.50/1.40 = $3.93.

5 Candidates for elimination as non-value-added activities may vary from one student to another. Possibilities
and reasons for the classification as non-value-added are given below. Remember a non-value-added
activity is one that does not add any value in the eyes of the customer or for the business and, therefore,
can be eliminated.
 Activity Reasons the activity is non-value-added

Inspect meat If use quality supplier could eliminate the need for
incoming inspection without any detriment to the
customer.

Dispose of substandard meat If use quality supplier there would be no substandard

meat.

Move to mincing room If plant layout was improved and automated material
handling was introduced this activity could be
eliminated or reduced with no detriment to the
customer.

Load mincer If automate loading, and/or increase mincer capacity

this activity could be eliminated or reduced with no
detriment to the customer.

Unload mincer If automate unloading, and/or increase mincer capacity

this activity could be eliminated or reduced with no
detriment to the customer.

Move to mixing room If plant layout was improved and automated material
handling was introduced this activity could be
eliminated or reduced with no detriment to the
customer.

Load mixer If automate loading, and/or increase mixer capacity this

activity could be eliminated or reduced with no
detriment to the customer.

Unload mixer If automate unloading, and/or increase mixer capacity

this activity could be eliminated or reduced with no
detriment to the customer.

Move to packing room If plant layout was improved and automated material
handling was introduced this activity could be
eliminated or reduced with no detriment to the
customer.

Move to smokehouse If plant layout was improved and automated material

handling was introduced this activity could be
eliminated or reduced with no detriment to the
customer.

Move to truck If plant layout was improved and automated material

handling was introduced this activity could be
eliminated or reduced with no detriment to the
customer.

We do not know much about the other activities but it may be possible to reduce their cost by making them
more efficient.
6 The non-value-added activities must be analysed to identify their root-cause cost drivers. In searching for
root cause cost drivers it is necessary to go beyond the obvious and seek out basic causes. Once the root-
cause cost drivers have been eliminated, the company needs to work towards reducing and eliminating
them. Possible root cause cost drivers include:

Activity Possible root-cause cost driver

Inspect meat Wrong supplier. Inappropriate procedures in selecting

suppliers. Poorly specified supply contracts

Dispose of substandard meat As above

Move to mincing room Poor plant layout. Outdated machinery. Insufficient

technical/engineering knowledge

Load mincer Outdated machinery. Machine capacity too small.

Insufficient technical/engineering knowledge

Unload mincer Outdated machinery. Machine capacity too small.

Insufficient technical/engineering knowledge

Move to mixing room Poor plant layout. Outdated machinery. Insufficient

technical/engineering knowledge

Load mixer Outdated machinery. Machine capacity too small.

Insufficient technical/engineering knowledge

Unload mixer Outdated machinery. Machine capacity too small.

Insufficient technical/engineering knowledge

Move to packing room Poor plant layout. Outdated machinery. Insufficient

technical/engineering knowledge

Move to smokehouse Poor plant layout. Outdated machinery. Insufficient

technical/engineering knowledge

Move to truck Poor plant layout. Outdated machinery. Insufficient

technical/engineering knowledge

Overall, the cost driver analysis indicates that the company should evaluate increased automation,
especially in the material handling area, coupled with improved plant layout. There also appears to be a
need to improve supplier selection.

7 Probably it needs business process re-engineering because the process is so badly set up and needs complete
reorganisation and re-thinking of the way it is carried out.

8 Assuming that by the next year of operations the company has been able reduce the cost of each non-value-
added activity by 30 per cent, the activity-based cost per unit (including direct material) will be:
 Mettwurst Annual volume 5000 sticks

Bill of activities Batch size 250 sticks

Inspect meat $450

Dispose of substandard meat 375

Move to mincing room 360

Load mincer 810

Operate mincer 1 500

Unload mincer 630

Move to mixing room 270

Load mixer 900

Operate mixer 2 400

Unload mixer 720

Move to packing room 225

Pack meat into skins 2 500

Move to smoke house 300

Move to truck 750

Annual cost of all direct labour and manufacturing overhead activities $12 190

Activity cost per unit $2.438

Direct material cost per unit 2.160

Manufacturing cost per unit $4.598

9 The selling price that would be obtained on a 40 per cent mark up of the ABC manufacturing cost is $6.44
(rounded), which is 93.7 cents above the competitor’s price for mettwurst. Schmidtke’s may be able to
compete effectively at this price, given its longstanding reputation. If not, the company should drop its
price to $5.50. It should continue to pursue the reduction of its non-value-added activities which will ensure
the required 40 per cent mark up is earned before long.