12-29

Target prices, target costs, value engineering, cost incurrence, locked-in costs, activity based
costing.
Cutler Electronics makes a radio-cassette player, CE100, which has 80 components. Cutler sells
7,000 units each month for $70 each. The costs of manufacturing CE100 are $45 per unit, or
$315,000 per month. Monthly manufacturing costs incurred are:
Direct material costs
$182,000
Direct manufacturing labor costs
$28,000
Machining Costs (fixed)
$31,500
Testing costs
$35,000
Rework Costs
$14,000
Ordering Costs
$3,360
Engineering Costs (fixed)
$21,140
Total manufacturing costs
$315,000
Cutlers management identifies the activity cost pools, the cost driver for each activity, and the
cost per unit of the cost driver for each overhead cost pool as follows:
Manufacturing
Description of
Cost Driver
Cost per Unit of
Activity
Activity
Cost Driver
1. Machining Costs
Machining
Machine-hour
$4.50 per machinecomponents
capacity
hour
2. Testing Costs
Testing components
Testing-hours
$2 per testing-hour
and final product
(Each unit of CE100
is tested individually.)
3. Rework Costs
Correcting and fixing Units of CE100
$20 per unit
errors and defects
reworked
4. Ordering Costs
Ordering of
Number of orders
$21 per order
components
5. Engineering Costs
Designing and
Engineering-hour
$35 per engineeringmanaging of products capacity
hour
and processes
Cutlers management views direct material costs and direct manufacturing labor costs as variable
with respect to the units of CE100 manufactured. Over a long-run horizon, each of the overhead
costs described in the preceding table varies, as described, with the chosen cost drivers.
The following additional information describes the existing design:
a. Testing and inspection time per unit is 2.5 hours.
b. 10% of the CE100s manufactured are reworked.
c. Cutler places two orders with each component supplier each month. Each component is
supplied by a different supplier.
d. It currently takes 1 hour to manufacture each unit of CE100.
In response to competitive pressures, Cutler must reduce its price to $62 per unit and its costs by
$8 per unit. No additional sales are anticipated at this lower price. However, Cutler stands to lose
significant sales if it does not reduce its price. Manufacturing has been asked to reduce its costs

by $6 per unit. Improvements in manufacturing efficiency are expected to yield a net savings of
$1.50 per radio-cassette player, but that is not enough. The chief engineer has proposed a new
modular design that reduces the number or components to 50 and also simplifies testing. The
newly designed radio-cassette player, called New CE100 will replace CE100.
The expected effects of the new design are as follows:
a. Direct material costs for the New CE100 is expected to be lower by $2.20 per unit.
b. Direct manufacturing labor cost for the New CE100 is expected to be lower by $0.50 per unit.
c. Machining time required to manufacture the New CE100 is expected to be 20% less, but
machine-hour capacity will not be reduced.
d. Time required for testing New CE100 is expected to be lower by 20%.
e. Rework is expected to decline to 4% of New CE100s manufactured.
f. Engineering-hours capacity will remain the same.
Assume that the cost per unit of each driver for CE100 continues to apply to New CE100.
1. Calculate Cutlers manufacturing costs per unit of New CE100.
2. Will the new design achieve the per-unit costs-reduction targets that have been set for the
manufacturing costs of New CE100? Show your calculations.
3. The problem describes two strategies to reduce costs: (a) improving manufacturing efficiency
and (b) modifying product design. Which strategy has more impact on Cutlers costs? Why?
Explain briefly.
1.
Direct materials costs
Direct manufacturing labor costs
Machining costs
Testing costs
Rework costs
Ordering costs
Engineering costs
Total manufacturing costs

Old
CE100
$182,000
28,000
31,500
35,000
14,000
3,360
21,140
$315,000

Cost Change

$2.20 7,000 = $15,400 less

$0.50 7,000 = $3,500 less
Unchanged because capacity same
(20% 2.5 7,000) $2 = $7,000
(See Note 1)
(See Note 2)
Unchanged because capacity same

New
CE100
$166,600
24,500
31,500
28,000
5,600
2,100
21,140
$279,440

Note 1:
10% of old CE100s are reworked. That is, 700 (10% of 7,000) CE100s made are reworked.
Rework costs = $20 per unit reworked 700 = $14,000. If rework falls to 4% of New CE100s
manufactured, 280 (4% of 7,000) New CE100s manufactured will require rework. Rework costs
= $20 per unit 280 = $5,600.
Note 2 :
Ordering costs for New CE100 = 2 orders/month 50 components $21/order
= $2,100
Unit manufacturing costs of New CE100 = $279,440 7,000 = $39.92

2.

Total manufacturing cost reductions based on new design

= $315,000 $279,440
= $35,560

Reduction in unit manufacturing costs based on new design

= $35,560 7,000
= $5.08 per unit.

The reduction in unit manufacturing costs based on the new design can also be calculated as
Unit cost of old design, $45 ($315,000 7,000 units) Unit cost of new design, $39.92 = $5.08
Therefore, the target cost reduction of $6 per unit is not achieved by the redesign.
3.
Changes in design have a considerably larger impact on costs per unit relative to
improvements in manufacturing efficiency ($5.08 versus $1.50). One explanation is that many
costs are locked in once the design of the radio-cassette is completed. Improvements in
manufacturing efficiency cannot reduce many of these costs. Design choices can influence many
direct and overhead cost categories, for example, by reducing direct materials requirements, by
reducing defects requiring rework, and by designing in fewer components that translate into
fewer orders placed and lower ordering costs.