Question 7-3

Value engineering is a systematic evaluation of all aspects of the value-chain business functions,
with the objective of reducing costs while satisfying customer needs. Value engineering via
improvement in product and process designs is a principal technique that companies use to achieve
target costs per unit.
Question 7.11
The downward demand spiral occurs when full costing is used as a basis for pricing, causing an
increase in price when demand for a companys product falls. The price therefore exceeds those of
competitors products and demand consequently drops further. Higher and higher unit costs result
in still less competitive prices, hence the downward demand spiral. Pricing decisions need to
consider competitors and customers as well as costs.
Exercise 7-17 Target operating profit value-added costs, service company
1.

The classification of total costs in 2014 into value-added, non-value-added, or in the grey area in
between follows:
Value
Added
(1)

Grey
Area
(2)

Doing calculations and preparing drawings

75% A$400 000
A$300 000
Checking calculations and drawings
4% A$400 000
A$16 000
Correcting errors found in drawings
7% A$400 000
Making changes in response to client
requests 6% A$400 000
24 000
Correcting errors to meet government
building code, 8% A$400 000
Total professional labour costs
324 000
16 000
Administrative and support costs at 40%
(A$160 000 A$400 000) of professional
labour costs
129 600
6 400
Travel
18 000
Total
A$471 600 A$22 400

Non-valueTotal
added
(4) =
(3)
(1)+(2)+(3)
A$300 000
16 000
A$28 000

28 000
24 000

32 000
60 000
24 000

A$84 000

32 000
400 000
160 000
18 000
A$578 000

Doing calculations and responding to client requests for changes are value-added costs because
customers perceive these costs as necessary for the service of preparing architectural drawings.
Costs incurred on correcting errors in drawings and making changes because they were
inconsistent with building codes are non-value-added costs. Customers do not perceive these costs
as necessary and would be unwilling to pay for them. Stratum should seek to eliminate these costs
by making sure that all associates are well-informed regarding building code requirements and by
training associates to improve the quality of their drawings. Checking calculations and drawings is
in the grey area (some, but not all, checking may be needed). There is room for disagreement on
these classifications. For example, checking calculations may be regarded as value added.
Reduction in professional labour-hours by
a. Correcting errors in drawings (7% 8 000)
b. Correcting errors to conform to building code (8% 8 000)
Total
Cost savings in professional labour costs (1 200 hours A$50)
Cost savings in variable administrative and support
costs (40% A$60 000)
Total cost savings
Current operating profit in 2014

560 hours
640 hours
1 200 hours
A$ 60 000
24 000
A$ 84 000
A$322 000
1

Add cost savings from eliminating errors

Operating profit in 2014 if errors eliminated

84 000
A$406 000

3.
Currently 85% 8000 hours = 6800 hours are billed to clients generating revenues of
A$900 000. The remaining 15% of professional labour-hours (15% 8000 = 1200 hours) is lost in
making corrections. Stratum bill clients at the rate of A$900 000 6800 = A$132.35 per
professional labour-hour. If the 1200 professional labour-hours currently not being billed to clients
were billed to clients, Stratum revenues would increase by 1200 hours A$132.35 = A$158 824
from A$900 000 to A$1 058 824.
Costs remain unchanged
Professional labour costs
Administrative and support (40% A$400 000)
Travel
Total costs
Stratum operating profit would be
Revenues
Total costs
Operating profit

A$400 000
160 000
18 000
A$578 000
A$1 058 824
578 000
A$480 824

Exercise 7-19 Target costs, effect of product-design changes on product costs

1. and 2. Manufacturing costs of HJ6 in 2014 and 2015 are as follows:
2014

Total (1)
Direct materials
A$1 2003 500;
A$1 1004 000
Batch-level costs
A$8 00070;
A$7 50080
Manuf.
operations costs
A$5521 000;
A$5022 000
Engineering
change costs
A$12 00014;
A$10 00010
Total
3.

4 200 000

560 000

2015

Per unit (2)

=(1)/ 3 500

Per unit (4) =

Total (3) (3)/
4 000

1 200 4 400 000

160

1 100

600 000

150

1 155 000

330 1 100 000

275

168 000
6 083 000

48
100 000
1 738 6 200 000

25
1 550

Target manuf. cost per unit of HJ6 in 2015 = Manuf. cost per unit in 201490%
= A$17380.90
= A$1564.20

Actual manufacturing cost per unit of HJ6 in 2015 was A$1550. Hence, Medical
Instruments did achieve its target manufacturing cost per unit of A$1564.20.
4. To reduce the manufacturing cost per unit in 2015, Medical Instruments reduced the
cost per unit in each of the four cost categoriesdirect materials costs, batch-level costs,
manufacturing operations costs and engineering change costs. It also reduced machinehours and number of engineering changes madethe quantities of the cost drivers. In
2014, Medical Instruments used 6 machine-hours per unit of HJ6 (21 000 machine-hours
3500 units). In 2015, Medical Instruments used 5.5 machine-hours per unit of HJ6 (22
000 machine-hours 4000 units). Medical Instruments reduced engineering changes
from 14 in 2014 to 10 in 2015. Medical Instruments achieved these gains through value
engineering activities that retained only those product features that customers wanted
while eliminating non-value-added activities and costs.

Problem 7-28 Capacity concepts, effect on operating profit

1.

Capacity Concept
Theoretical capacity
Practical capacity

Budgeted Fixed
Manuf.
Overhead per
Period

(2)

(3)
360
350

24
20

28 000 000

350

20

14 000 000
14 000 000

175
175

20
20

Barrels
per
Hour

Budgeted

Budgeted Fixed
Manufacturing

Denominator
Level (Barrels)

Overhead Rate
per Barrel

(5) = (2)
Theoretical capacity
Practical capacity
Normal capacity
utilisation
Master-budget utilisation
(a) January-June 2009
(b) July-December 2009

Hours of
Production
per Day

(1)
A$28 000 000
28 000 000

Normal capacity utilisation

Master-budget utilisation
(a) January-June 2015
(b) July-December 2015

Capacity Concept

Days of
Production
per Period

(4)
540
500

(3)

(4)
4 665 600
3 500 000

(6) = (1) (5)

A$ 6.00
8.00

400

2 800 000

10.00

320
480

1 120 000
1 680 000

12.50
8.33

The differences arise for several reasons:

a. The theoretical and practical capacity concepts emphasise supply factors,
while normal capacity utilisation and master-budget utilisation emphasise
demand factors.
b. The two separate six-month rates for the master-budget utilisation concept
differ because of seasonal differences in budgeted production.

2.

Using column (6) from above,

Per Barrel
Budgeted
Fixed Mfg.
Overhead
Rate per Barrel
(6)

Capacity
Concept
Theoretical
capacity
Practical capacity
Normal capacity
utilisation

Capacity Concept

Theoretical capacity

Budgeted
Total Mfg
Cost Rate
(8) =
(6) + (7)

Budgeted
Variable Mfg.
Cost Rate
(7)

A$6.00

A$30.20a

A$36.20

30.2

38.2

10

30.2

40.2

Fixed
Mfg. Overhead
Variance
(10) =
A$27 088 000 (9)

Fixed Mfg.
Overhead
Costs Allocated
(9) =
2 600 000 (6)
A$15 600 000

A$11 488 000

Practical capacity

20 800 000

6 288 000

Normal capacity utilisation

26 000 000

1 088 000

A$78 520 000

2 600 000 barrel

Absorption-Costing Income Statement

Theoretical
Capacity (a)

Practical
Capacity (b)

Normal
Capacity
Utilisation (c)

Revenues (2 400 000 barrel

A$45 per barrel)

Cost of goods sold
Beginning inventory
Variable mfg. costs
Fixed mfg. overhead costs
allocated

A$108 000 000

A$108 000 000

A$108 000 000

0
78 520 000

0
78 520 000

0
78 520 000

15 600 000

20 800 000

26 000 000

94 120 000

99 320 000

104 520 000

7 240 000

7 640 000

8 040 000

11 488 000 U
98 368 000
9 632 000
0
A$ 9 632 000

6 288 000 U
97 968 000
10 032 000
0
A$ 10 032 000

1 088 000 U
97 568 000
10 432 000
0
A$ 10 432 000

(2 600 000 units

A$6.00; A$8.00; A$10.00
per unit)
Cost of goods available
for sale
Deduct ending inventory

(200 000 units

A$36.20; A$38.20;
A$40.20 per unit)
Add: Adjustment for
variances (all unfavourable)
Cost of goods sold
Gross margin
Other costs
Operating income