Chapter 11 Strategic Cost Management 413

Y = $5,000,000 + $30X, where X = direct labor hours

The variable rate of $30 is broken down as follows:
Direct labor $ 9
Variable overhead 5
Direct materials 16

Because of competitive pressure, product engineering was given the charge to redesign
products to reduce the total cost of manufacturing. Using the above cost relationships,
product engineering adopted the strategy of redesigning to reduce direct labor content.
As each design was completed, an engineering change order was cut, triggering a series
of events such as design approval, vendor selection, bill of materials update, redrawing
of schematic, test runs, changes in setup procedures, development of new inspection
procedures, and so on.
After one year of design changes, the normal volume of direct labor was reduced from
250,000 hours to 200,000 hours, with the same number of products being produced.
Although each product differs in its labor content, the redesign efforts reduced the labor
content for all products. On average, the labor content per unit of product dropped
from 1.25 hours per unit to one hour per unit. Fixed overhead, however, increased from
$5,000,000 to $6,600,000 per year.
Suppose that a consultant was hired to explain the increase in fixed overhead costs.
The consultant’s study revealed that the $30 per hour rate captured the unit-level vari-
able costs; however, the cost behavior of other activities was quite different. For example,
setting up equipment is a step-fixed cost, where each step is 2,000 setup hours, costing
$90,000. The study also revealed that the cost of receiving goods is a function of the
number of different components. This activity has a variable cost of $2,000 per com-
ponent type and a fixed cost that follows a step-cost pattern. The step is defined by 20
components with a cost of $50,000 per step. Assume also that the consultant indicated
that the design adopted by the engineers increased the demand for setups from 20,000
setup hours to 40,000 setup hours and the number of different components from 100 to
250. The demand for other non-unit-level activities remained unchanged. The consultant
also recommended that management take a look at a rejected design for its products. This
rejected design increased direct labor content from 250,000 hours to 260,000 hours,
decreased the demand for setups from 20,000 hours to 10,000 hours, and decreased the
demand for purchasing from 100 component types to 75 component types, while the
demand for all other activities remained unchanged.

Required:
1. Using normal volume, compute the manufacturing cost per labor hour before the
year of design changes. What is the cost per unit of an “average” product?
2. Using normal volume after the one year of design changes, compute the manufac-
turing cost per hour. What is the cost per unit of an “average” product?
3. Before considering the consultant’s study, what do you think is the most likely
explanation for the failure of the design changes to reduce manufacturing costs?
Now use the information from the consultant’s study to explain the increase in
the average cost per unit of product. What changes would you suggest to improve
Golder’s efforts to reduce costs?
4. Explain why the consultant recommended a second look at a rejected design.
Provide computational support. What does this tell you about the strategic impor-
tance of cost management?

External Linkages, Activity-Based Supplier Costing 11-12

Plata, Inc., manufactures riding lawn mowers. Plata uses JIT manufacturing and carries L02
insignificant levels of inventory. Plata manufactures everything needed for the riding
lawn mowers except for the engines. Several sizes of mowers are produced. The most
popular line is the small mower line. The engines for the small mower line are purchased
414 Part Three Advanced Costing and Control

from two sources: Rivera Engines and Bach Machining. The Rivera engine is the more
expensive of the two sources and has a price of $300. The Bach engine is $270 per unit.
Plata produces and sells 13,200 units of the small mower. Of the 13,200 engines pur-
chased, 2,400 are purchased from Rivera Engines, and 10,800 are purchased from Bach
Machining. Although Bill Jackson, production manager, prefers the Rivera engine, Carlos
Lopez, purchasing manager, maintains that the price difference is too great to buy more
than the 2,400 units currently purchased. Carlos, however, does want to maintain a sig-
nificant connection with Rivera just in case the less expensive source cannot supply the
needed quantities. Even though Bill understands the price argument, he has argued in
many meetings that the quality of the Rivera engine is worth the price difference. Carlos
remains unconvinced.
Sam Miller, controller, has recently overseen the implementation of an activity-based
costing system. He has indicated that an ABC analysis would shed some light on the
conflict between production and purchasing. To support this position, the following data
have been collected:
I. Activity cost data:

Testing enginesa $240,000

Reworking productsb 400,000
Expediting ordersc 300,000
Repairing enginesd 540,000
a
All units are tested after assembly, and a certain percentage are rejected because of engine failure.
b
Defective engines are removed, replaced (supplier will replace any failed engine), and retested before being
sold to customers. Engine failure often causes collateral damage, and other parts need to be remanufactured
and replaced before the unit is again functional.
c
Due to late or failed delivery of engines.
d
Repair work is for units under warranty and almost invariably is due to engine failure. Repair usually
means replacing the engine. This cost plus labor, transportation, and other costs make warranty work very
expensive.

II. Supplier data:

Bach Rivera

Engines replaced by source 990 10

Rework hours 4,900 100
Late or failed shipments 99 1
Warranty repairs (by source) 1,220 30

Upon hearing of the proposed ABC analysis, Bill and Carlos were both supportive.
Carlos, however, noted that even if the analysis revealed that the Rivera engine was actu-
ally less expensive, it would be unwise to completely abandon Bach. He argued that
Rivera may be hard pressed to meet the entire demand. Its productive capacity was not
sufficient to handle the kind of increased demand that would be imposed. Additionally,
having only one supplier was simply too risky.

Required:
1. Calculate the total supplier cost (acquisition cost plus supplier-related activity
costs). Convert this to a per-engine cost to find out how much the company is pay-
ing for the engines. Which of the two suppliers is the low-cost supplier? Explain
why this is a better measure of engine cost than the usual purchase costs assigned to
the engines.
2. Consider the supplier cost information obtained in Requirement 1. Suppose further
that Rivera can supply only a total of 6,000 units. What actions would you advise
Plata to undertake with its suppliers? Comment on the strategic value of activity-
based supplier costing.
Chapter 11 Strategic Cost Management 415

External Linkages, Activity-Based Customer Costing,

and Strategic Decision Making 11-13
Jazon Manufacturing produces several types of bolts. The products are produced in L02
batches according to customer order. Although there are a variety of bolts, they can be
grouped into three product families. The number of units sold is the same for each family.
The selling prices for the three families range from $0.50 to $0.80 per unit. Because the
product families are used in different kinds of products, customers also can be grouped
into three categories, corresponding to the product family they purchase. Historically,
the costs of order entry, processing, and handling were expensed and not traced to indi-
vidual products. These costs are not trivial and totaled $6,300,000 for the most recent
year. Furthermore, these costs had been increasing over time. Recently, the company had
begun to emphasize a cost reduction strategy; however, any cost reduction decisions had
to contribute to the creation of a competitive advantage.
Because of the magnitude and growth of order-filling costs, management decided to
explore the causes of these costs. They discovered that order-filling costs were driven by
the number of customer orders processed. Further investigation revealed the following
cost behavior:

Step-fixed cost component: $70,000 per step; 2,000 orders define a step*
Variable cost component: $28 per order
* Jazon currently has sufficient steps to process 100,000 orders.

The expected customer orders for the year total 140,000. The expected usage of the
order-filling activity and the average size of an order by product family are as follows:

Family A Family B Family C

Number of orders 70,000 42,000 28,000

Average order size 600 1,000 1,500

As a result of the cost behavior analysis, the marketing manager recommended the imposi-
tion of a charge per customer order. The president of the company concurred. The charge
was implemented by adding the cost per order to the price of each order (computed using
the projected ordering costs and expected orders). This ordering cost was then reduced
as the size of the order increased and eliminated as the order size reached 2,000 units.
(The marketing manager indicated that any penalties imposed for orders greater than this
size would lose sales from some of the smaller customers.) Within a short period of com-
municating this new price information to customers, the average order size for all three
product families increased to 2,000 units.

Required:
1. Jazon traditionally has expensed order-filling costs (following GAAP guidelines).
Under this approach, how much cost is assigned to customers? Do you agree with
this practice? Explain.
2. Consider the following claim: By expensing the order-filling costs, all products
were undercosted; furthermore, products ordered in small batches are significantly
undercosted. Explain, with supporting computations where possible. Explain how
this analysis also reveals the costs of various customer categories.
3. Calculate the reduction in order-filling costs produced by the change in pricing
strategy. (Assume that resource spending is reduced as much as possible and that the
total units sold remain unchanged.) Explain how exploiting customer linkages pro-
duced this cost reduction. Jazon also noticed that other activity costs, such as those
for setups, scheduling, and materials handling costs, were reduced significantly as a
result of this new policy. Explain this outcome, and discuss its implications.
416 Part Three Advanced Costing and Control

4. Suppose that one of the customers complains about the new pricing policy. This buyer
is a lean, JIT firm that relies on small frequent orders. In fact, this customer accounted
for 30 percent of the Family A orders. How should Jazon deal with this customer?
5. One of Jazon’s goals is to reduce costs so that a competitive advantage might be
created. Describe how the management of Jazon might use this outcome to help
create a competitive advantage.

11-14 Life-Cycle Cost Management and Target Costing

L03 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 postpurchase 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 postpurchase 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 project-
ed cost to this new target. Of the three approaches, which is likely to produce
the most reduction?