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Exercise 5-36

Make or buy, relevant costs, opportunity cost. Kentucky Motors has manufactured
compressor parts at its plant in Pitcairn, Indiana , for the past 18 years . An outside
suppliers, Superior Compressor Company, has offered to supply compressor model A238
are as follows:
Direct materials $80
Direct labor 60
Unit-related support 26
Batch-related support 22
Product-sustaining support 8
Facility-sustaining support 17
Total costs $213
a. Should Superior Compressor's offer be accepted if the plant is presently operating
below capacity?

The offer by Superior Compressor should not be accepted if facilitysustaining support costs are unavoidable.
Cost per unit
Cost of purchase

Make

Variable cost:
Direct material
Direct labor
Unit-related support
Batch-related support
Product-sustaining support

$ 80
60
26
22
8

Relevant cost per unit

$196

Buy
$200

$200

b. What is the maximum acceptable purchase price if the plant facilities are fully utilized
a present and if any additional available capacity can be deployed for the production of
other compressor?

The maximum acceptable purchase price is $213 per unit if the plant
facilities are fully utilized at present and the incremental cost of adding more
capacity is approximated well by the $17 per unit facility-sustaining support
cost.
Exercise

5-37

Bogden Company introduced JIT manufacturing last year and has


prepared the following data to assess the benefits from the change.
Category
Production

Before

the

cycle

Inventories
sales

Cost

as

Direct
Variable
Fixed

After

68

days

time
$160,00

Total

Direct

Change

percent

Labor
support
support

Change

30

days

$40,000

$1,260,000

materials

the

$1,700,000
of

30%
22%

sales:
20%
15%

28%

10%

12%

5%

Inventory financing cost are 15% per year. Estimate the total financial
benefits that resulted from the switch to JIT manufacturing operations.
Benefits from cellular manufacturing operations are estimated to be
$767,200 as shown below:
Before the
Change

After the
Change

Difference

Sales
Costs:
Direct material
Direct labor
Variable support
Fixed support
Inventory carrying costs
Profit

$1,260,000

$1,700,000

$440,000

(378,000)
(277,200)
(352,800)
(151,200)
(24,000)
$76,800

(340,000)
(255,000)
(170,000)
(85,000)
(6,000)
$844,000

38,000
22,200
182,800
66,200
18,000
$767,200

Exercise 5-43
Make or buy Tanner Appliance Company manufacturers 12,000 units of part M-4
annually. The part is used in the production of one of its prinicpal products. The
following unit cost information is available on part M4:
Direct material $11
Direct Labor 9
Unit-related support 4
Batch-related support 5
Product-sustaining 2
Facility-sustaining support 2
Allocated corporate support 5
Total costs $38
A potential supplier has offered to manufacture this part for Tanner Appliance for $30 per
unit. If Tanner Appliance outsources the production of part M4, 50% of batch related and
80% of product-sustaining activity resources can be eliminated. Furthermore, the
production facility now being used to produce this part can be used for a fast-growing
new product line that would otherwise require the use of a neighboring facility at a rental
cost of $20,000 per year.
a. Should Tanner Appliance purchase part M4 from the outside supplier?

Make

Buy

Cost of purchase: $30 12,000

$360,000

Manufacturing cost:
Direct material
Direct labor
Unit-related support
Batch-related support
Product-sustaining support
Facility-sustaining support
Allocated corporate support
Savings in rental costs

$132,000
108,000
48,000
60,000
24,000
24,000
60,000
0

30,000a
4,800b
24,000
60,000
(20,000)

Total costs

$456,000

$458,800

a
b

50% 60,000 = 30,000


20% 24,000 = 4,800

Based on the cost analysis above, Tanner Appliance Company should make
part M4 in-house.
b. What costs are relevant for the decision?
The costs (and cost savings) that differ between the two alternatives are relevant for this
decision. That is, direct material, direct labor, unit-related support, differential batchrelated support, differential product-sustaining support, and savings in rental costs are
relevant for this decision.
c. What additional factors should Tanner consider?
In deciding whether to purchase part M4 from the outside supplier, Tanner should
consider factors such as the suppliers reliability in maintaining quality and on-time
delivery, and permanence of the offered price.
Exercise 5-47
ABC and TOC Discuss the similarities and difference between activity-based costing and
the theory of constraints as well as situations in which one approach might be preferable
to the other.

Both the theory of constraints and activity-based costing support


aspects of process improvement and improved profitability, but differ

in many other respects. The theory of constraints emphasizes the


short-run optimization of throughput contribution, and downplays
operating costs (except direct materials) because they are viewed as
difficult to alter in the short-run. Consequently, analyses of activities
and cost drivers are not conducted as they are in activity-based
costing. Proponents of activity-based costing take a long-term
perspective in which managers can alter capacity resources.
Therefore, it is viewed as beneficial to produce accurate cost
information by tying actual resources consumed to cost objects, such
as products, services, channels, and customers. The theory of
constraints and activity-based costing might conceivably be used
together.
Exercise 5-48
Cycle time efficiency and JIT Walker Brother Company is considering installing a JIT
manufacturing system in the hope that it will improve its over all processing cycle
efficiency. Data from the traditional system and estimates for the JIT system are
presented here for their Nosun Product.
Time Category Traditional System JIT System
Storage 4hours 1 hours
Inspection 40 minutes 5 minutes
Moving 80 minutes 20 minutes
Processing 2 hours 75 minutes
a. Calculator processing cycle efficiency (PCE) under the traditional and JIT systems for
the Nosun Product.

PCE in minutes under the traditional system equals [120/(120 + 80 + 240 +


40)] = [120/480] = 0.25. PCE under the JIT system equals [75/(75 + 20 + 60
+ 5)] = [75/160] = 0.47.
b. Strictly based on your PCE calculation above, should Walker Brothers implement the
JIT system? Explain.

Based on the calculations above, Walker Brothers should implement the JIT
system since the processing cycle efficiency is almost double that of the
traditional system (0.47 vs. 0.25).
Exercise 5-50
Relevant costs: dropping a product Merchant Company manufacturers and sells three
models of electronic printers. Ken Gail, president of the company, is considering
dropping model JT484 from its product line because the company has experienced losses
for this product over the past three quarters. The following product-level operating data
have been compiled for the most recent quarters:

Category Total JT284 JT384 JT484


Sales $1,000,000 $500,000 $200,000 $300,000
Variable costs 600,000 300,000 100,000 200,000
Contribution margin $400,000 $200,000 $100,000 $100,000
Fixed costs:
Rent $50,000 $25,000 $10,000 $15,000
Depreciation 60,000 30,000 12,000 18,000
Utilities 40,000 20,000 5,000 15,000
Supervision 50,000 15,000 5,000 30,000
Maintenance 30,000 15,000 6,000 9,000
Administrative 100,000 30,000 20,000 50,000
Total Fixed costs $330,000 $135,000 $58,000 $137,000
Operating income (loss) $70,000 $65,000 $42,000 ($37,000)

In addition, the following information is also available:

Factory rent and depreciation will not be affected by a decision to drop model JT484.
Quarterly utility bills will be reduced from $40,000 to $31,000 if JT484 is dropped.
Supervision costs for JT484 can be eliminated if dropped.
The maintenance department will be able to reduce quarterly costs by $7,000 if JT484 is
dropped.
Elimination of JT484 will make it possible to eliminated two administrative staff
positions with combined salaries of $30,000 per quarter.

a. Should Merchant Company eliminate JT484.

Reduction in contribution margin

$100,000

Cost savings:
Utilities
Supervision
Maintenance
Administrative

(9,000)
(30,000)
(7,000)
(30,000)

Decrease in operating income

$24,000

Therefore, JT484 should not be eliminated.


b. Merchant's sales manager believes that it is important to continue to produce JT484 to
maintain a full product line. He expects the elimination of JT484 will reduce sales of the
remaining two products by 5% each. Will this information change your answer to (a).
Explain.
No, the decision to retain JT484 will only be reinforced by the sales managers
comments.
Exercise 5-51

Quality improvement programs and cost saving. Garber Valves Company manufactures
brass valves meeting precise specification standards. All finished valves are inspected
before packing and shipping to customers. Rejected valves are returned to the initals
production stage to be melted and recast. Such rework requires no new materials in
casting but requires new materials in finishings. The following unit cost data are
available:

Costs Casting Finishing Inspection Packing Total


Direct Material $225 $12 $0 $ 8 $245
Direct labor 84 121 24 16 245
Variable support 122 164 30 20 336
Fixed support 63 89 16 10 178
$494 $386 $70 $54 $1004

As a result of a quality-improvement program, the reject rate has decreased from 6.4% to
5.1% and the number of rejects has decreased by (6.4% - 5.1%) x (10,000) units.
Improvements I reject rates have also led to a decrease in work in process inventory from
$386,000 to $270,000. Inventory carrying costs are estimated to be 15% per year.
Estimated the annual cost savings as a result of the quality improvement.

Estimated cost savings as a result of the quality improvement:


Savings from decrease in reject rate
(0.064 0.051) [(494 63 225) + (386 89) + (70 16)] 10,000

$72,410

Savings from reduction in inventory carrying cost


($386,000 $270,000) 0.15

$17,400

Total annual savings

$89,810

Exercise 5-56
Facilities layout. One aspect of facilities layout for McDonald's is that when customers
come into the building , they can line up in one of several lines and wait to be served. In
contrast, customer's at Wendy's are asked to stand in one line that snakes around the front
of the counter and to wait for a single server.
a. What is the rationale for each approach ?

The approach used at McDonalds in which customers wait in several lines is


consistent with the push or conventional manufacturing approach. As one
comes into McDonalds it is clear that they have been, and are building
inventory
in each of the specific bins that they use for, lets say, Big Macs, fish
sandwiches, regular hamburgers, etc. Having inventory at predefined levels
keeps the production process going. The motivation to use the traditional
production method is to sustain a certain level of inventory to reduce the time
the customer has to wait for an order. Notice in McDonalds that hot lights are
used to keep the sandwiches warm. One goal of this approach is that customers
perceive that they can get their sandwich very quickly due to the inventory of
sandwiches always on hand. On the other hand, Wendys uses more of a pull or
JIT system. As you enter into Wendys, notice that you cannot really observe
any sandwich inventory building up. The idea in forming one line is that each
person has the perception (and often the reality) that each sandwich is made on
the spot. This procedure is designed to show customers how fresh the
sandwiches are. The motivation to use a just-in-time approach is to improve the
quality of the food and to reduce waste by eliminating the need to throw out
food that has been sitting too long. As processing time and setup costs drop, the
organization can move closer to just-in-time, reducing the waste and quality
problems that arise with batch production.

b. Which approach do you favor from (1) a customer's perspective and (2) management's
perspective? Explain.

From a customers perspective, it does depend on what one favors. If a customer


goes to a fast food restaurant, his or her goal is to get food quickly. On any
particular day, the customer may be in a great hurry and wish to run in and run
out of a fast food establishment. Having multiple lines at a place like
McDonalds may be very appealing as far as the perception of the speed with
which one can get a meal (compared to a single line at Wendys). On another
day, perhaps having a meal made freshly on the spot, without any warming
time under hot lights is more appealing than the speed of getting the food. Of
course, one may simply like the taste of one companys hamburgers over
anothers.
From managements perspective, apart from taste, competing in selling
hamburgers may depend on other variables such as the speed with which an
order is filled versus tailoring the production process to individual taste. The
traditional push production process can lead to a lot more waste than the JIT
system, because if a batch of hamburgers is made and demand drops, the quality
of the food deteriorates and often has to be thrown out. However, if the line at
Wendys is very long and customers begin to get impatient, the freshness of the
food may begin to lose its appeal.
Exercise 5-59
Preparing a cost of quality report. The following information shows last year's qualityrelated costs for the Renewal Company:

Item Amount
Quality engineering $500,000
Warranty claims 2,345,000
Product liability lawsuits 4,500,000

Research of customer needs 75,000


Maintenance of test equipment 350,000
Returned products 1,200,000
Rework costs 1,200,000
Quality training 125,000
Process control monitoring 1,000,000
Inspection of and testing of incoming materials 400,000
Repair costs in the field 850,000
Statistical process control 250,000
Product recalls 2,000,000
Waste 700,000
Net cost of scrap 635,000
Product quality 475,000
Downtime due to defects 125,000
Supplier certification 90,000

Total sales for the year were $100,000,000

a. Prepare a cost of quality report grouping costs into prevention, appraisal, internal
failure, and external failure. Also show costs as a percent of sales.

Quality Cost Report for Renwal Company

Quality Cost Category


Prevention Costs:
Quality training
Quality engineering
Statistical process control
Supplier certification
Research of customer needs
Total

Annual

Percent of

Cost

Sales*

$125,000
500,000
250,000
90,000
75,000
$1,040,000

0.125%
0.500%
0.250%
0.090%
0.075%
1.040%

Appraisal Costs:
Inspection of and testing of in-coming
materials
Maintenance of test equipment
Process-control monitoring
Product-quality audits
Total

$400,000

0.400%

350,000
1,000,000
475,000
$2,225,000

0.350%
1.000%
0.475%
2.225%

Internal Failure Costs:


Waste
Net cost of scrap
Rework costs
Downtime due to defectives
Total

$700,000
635,000
1,200,000
125,000
$2,660,000

0.700%
0.635%
1.200%
0.125%
2.660%

External Failure Costs:


Product-liability lawsuits
Repair costs in the field
Warranty claims
Returned products
Product recalls
Total

$4,500,000
850,000
2,345,000
1,200,000
2,000,000
$10,895,000

4.500%
0.850%
2.345%
1.200%
2.000%
10.895%

Total Quality Costs:

$16,820,000

16.820%

b. Interpret the data and make recommendations to Renwal's management.


(b)

The most obvious problem at Renwal is the extremely high externalfailure costs of almost 11%. Since as a norm many companies would like

to keep their quality costs below 4% to 5% of sales, Renwal Companys


quality costs are out of line. Note in particular that product-liability
lawsuits, warranty claims, and product recalls are the biggest externalfailure costs. Renwal must find out why its products seem to be failing in
the field.

Renwal should first turn to an analysis of its other quality costs. Quality
costs are incurred throughout the total life cycle of a product. If Renwal does
not control quality costs early in the research, development, and engineering
stage by ensuring good product design, then design problems will lead to
increased quality costs later on.
At Renwal both prevention and appraisal costs are a relatively small percent
of total quality costs (1.04% and 2.225% respectively). Renwal should
consider putting more effort into quality training, quality engineering, and
statistical process control. The company should also determine whether to
spend more money on appraisal. There could be a problem with Renwals
test equipment that would require the company to incur higher maintenance
costs.
With regard to internal-failure costs, Renwal also apparently incurs a great
deal of rework costs. The product seems to require many additional costs
that need not be incurred if the company could produce it correctly the first
time. Perhaps the production process is at fault, or maybe Renwals workers
are not well trained.
Note that Renwals quality-related costs are very low at the prevention stage.
They increase for the appraisal and internal-failure cost categories. The
external failure costs are extremely high. This pattern of quality costs is what
most organizations hope to avoid because the highest category of quality
costs corresponds to poor quality recognized only after products are in
customers hands.
The more desirable quality-cost trend is the reverse of Renwals pattern.
That is, organizations desire to have the greatest proportion of quality costs
incurred in the prevention stage. By increasing quality training and quality
engineering costs during this stage, a company can reduce other quality
costs. With the companys products failing less frequently in the customers
hands, customer satisfaction should increase and the companys reputation
should improve.