SEMINAR 2 STRATEGIC COST MANAGEMENT

Target costing and non-value added costs

Palladium Company sells one of its products for P80 each. Sales volume averages 2,000 units per year.
Recently, its main competitor reduced the price of its product to P56. Palladium expects its sales to
drop dramatically unless it matches the competitor's price. In addition, the current profit per unit
must be maintained.

Information about the product (for production of 2,000) is as follows:

Standard Actual Actual

quantity quantity Cost
Materials (kg) 9,800 10,000 P40,000
Labor (hours) 2,400 2,500 20,000
Setups (hours) 400 12,000
Material handling (moves) 700 4,000
Warranties (number repaired) 500 20,000

Required
1. Calculate the target cost for maintaining current market share and profitability.
2. Calculate the non-value-added cost per unit.
3. If non-value-added costs can be reduced to zero, can the target cost be achieved?

Target costing Vs traditional costing

Baker Company produces a number of components that are used in home theater systems. Alfred
Gonzales, head of the company's market research department, has identified the need for a new
component that will most likely sell for P7,500. Projected volume levels are anticipated to reach 28,000
units in the first year, as several firmly entrenched competitors will be introducing a similar product
in the not-too-distant future.

Conversations with Baker's engineers and reviews of cost accounting data related to similar products
that the company manufactures resulted in the following cost estimates for the new component:

Direct materials P1,800

Direct labor 3,600
Manufacturing overhead 1,600
Distribution costs 500

Baker currently uses cost-plus pricing and adds a 20% markup on total production cost to arrive at
what is normally a competitive selling price.

Required
1. What is the anticipated selling price of the new component if Baker uses its current pricing
policy? What difficulties, if any, might the company face in the marketplace?
2. Assume that Baker decides to switch to target costing. What price would the company charge
for the new component?
3. With the switch to target costing, what would Baker have to do to the component's
manufacturing cost to achieve the normal profit margin on sales? Be specific and show
calculations.
4. Briefly describe a process that Baker can use to achieve your answer in requirement 3.

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Life-cycle costing
Grace Greeting Cards Company is starting a new business venture and is in the process of evaluating
its product lines. Information for one new product, traditional parchment grade cards, is as follows:
 Sixteen times each year, a new card design will be put into production. Each new design will
require P6,000 in setup costs.
 The parchment grade card product line incurred P750,000 in development costs and is
expected to be produced over the next four years.
 Direct costs of producing the designs average P5.00 each.
 Indirect manufacturing costs are estimated at P500,000 per year.
 Customer service expenses average P1.00 per card.
 Current sales are expected to be 2,500 units of each card design. Each card sells for P35.00.
 Sales units equal production units each year.

Required
1. What are the estimated life-cycle revenues?
2. What is the estimated life-cycle operating income for the first year?
3. What is the estimated life-cycle operating income per year for the years after the first year?
4. What is the total estimated life-cycle operating income?

JIT inventory system

Management of Laredo Enterprises recently decided to adopt a just-in-time inventory policy to curb
steadily rising costs and free-up cash for purposes of investment. The company anticipates that
inventory will decrease by P4,450,000, with the released funds to be invested at a 10% return for the
firm.

Additional data follow.

a. Reduced inventories should produce savings in insurance and property taxes of P46,000.
b. Reduced raw-material inventory levels and accompanying stockouts will cost Laredo
P85,000.
c. Laredo will lease 80% of an existing warehouse to another firm for P2.50 per square foot. The
warehouse has 40,000 square feet.
d. Four employees who currently earn P35,000 each will be directly affected by the just-in-time
adoption decision. Three employees will be transferred to other positions with Laredo; one
will be terminated.
e. A shift in suppliers is expected to result in the purchase and use of more expensive raw
materials. However, these materials should give rise to fewer warranty and repair problems
after Laredo's finished product is sold, resulting in a net savings for the company of P38,000.
f. Because of the need to handle an increased number of small shipments from suppliers,
Laredo will remodel production and receiving-dock facilities at a cost of P750,000. The
construction costs will be depreciated over a 10-year life.

Required
1. Compute the annual financial impact of Laredo's decision to adopt a just-in-time inventory
system.
2. In comparison with those of a traditional purchasing system, why would the number and size
of incoming supplier shipments change under a just-in-time system?

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JIT purchasing system
Putnam Enterprises currently purchases a total of 50,000 sensors annually from Utah Electronics at
P80 per unit. The firm places 25 purchase orders during the year at an average cost of P10 per order.
Putnam's management is contemplating a switch to a just-in-time purchasing system that would
require an increase in orders to 200.

Required
1. Compute the average order size under both the current system and the proposed just-in-time
system. Also, calculate the change in annual purchase-order processing cost.
2. Explain why the number of orders will increase under a just-in-time system.
3. What benefits might Putnam experience to help offset the increase in purchase-order
processing cost?

JIT & backflush costing

Grand Marine Company (GMC) manufactures sailcloth used by sailmakers that produce sails for
sailboats. The company’s sailcloth is the conventional polyester-based sail material and is used widely
in recreational boating. Sailmakers throughout the world use GMC’s sailcloth. The manufacture of
sailcloth has a small number of processes, and GMC integrates them carefully so that there is very
little work in process inventory. The product is measured in yards of cloth, which is prepared in rolls
42 inches wide. Because it has little work in process inventory, GMC also uses backflush costing to
simplify the accounting for its operations.

GMC has the following information for the most recent accounting period. The beginning inventory
of polyester fiber was P142,000 and the ending inventory was P147,000.

Polyester fiber purchases P 690,000

Conversion costs incurred 1,300,000
Standard cost per yard of cloth
Direct materials 4.35
Conversion costs 8.50
Units produced – in yards of cloth 155,000

Required
Show entries for manufacturing costs, completion of 155,000 yards of product, and the closing entries.

Total quality management cost of quality (TQM/COQ)

Apollo Manufacturing Company’s quality control report for August of the current year contains the
following items:

Liability costs associated with defective products P10,000

Disposal costs of defective products failing inspection 20,000
Disposal costs of raw materials failing inspection 30,000
Technical (computer) support provided to vendors 40,000
Lost sales due to poor quality and defective products 50,000
Advertising costs to offset perception of poor product quality 60,000
Raw materials used to correct defects before product was sold 70,000
Testing and inspecting a sample of finished goods 80,000

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Required
On the August quality control report, compute the total of the following COQ categories:
1. conformance costs?
2. non-conformance costs?
3. prevention costs?
4. appraisal costs?
5. internal failure costs?
6. external failure costs?

Quality improvement
Design Products Company is committed to its quality program. It works with all areas of the
company to establish sound quality programs within reasonable budget guidelines. For next year, it
has budgeted P1,000,000 for prevention costs and P700,000 for appraisal costs. Internal failure has a
budget of P100 per failed item, while external failure has a total budget of P600,000.

Product Testing has proposed to management a change in the next year’s budget for a new method of
testing products. If management decides to implement the new method, P2 per unit of appraisal costs
will be saved, up to a level of 200,000 tests. No additional savings are expected past the 200,000 level.
The new method involves P90,000 in training costs and P60,000 in yearly testing supplies.

Traditionally, 3% of all completed items have to be reworked. External failure costs average P120 per
failed unit. The company's average external failures are 1% of units sold. The company carries no
ending inventories.

Required
1. What is the adjusted budget for appraisal costs, assuming the new method is implemented
and 800,000 units are tested during the manufacturing process next year?
2. How much do internal failure costs change, assuming 600,000 units are tested under the new
method and it reduces the amount of unacceptable units in the manufacturing process by
40%?
3. What would be the change in the external failure budget, assuming external failures are
reduced by 60% and the same facts as in Requirement 2?

Theory of constraints (TOC); throughput margin; relevant costs

The Mayfield Corporation manufactures filing cabinets in two operations – machining and finishing.
It provides the following information:

Machining Finishing
Annual capacity (in units) 100,000 80,000
Annual production (in units) 80,000 80,000
Fixed operating costs (excluding direct materials) P64,000,000 P40,000,000
Fixed operating costs per unit (P64,000,000/80,000) P800
(P40,000,000/80,000) P500

Each cabinet sells for P7,200 and has direct materials costs of P3,200 incurred at the start of the
machining operation. Mayfield has no other variable costs. Mayfield can sell whatever output it
produces. The following requirements refer only to the preceding data. There is no connection
between the requirements.

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Required
1. Mayfield is considering using some modern jigs and tools in the finishing operation that
would increase annual finishing output by 1,000 units. The annual cost of these jigs and tool
is P3,000,000. Should Mayfield acquire these tools? Explain.
2. The production manager of the Machining Department has submitted a proposal to do faster
setups that would increase the annual capacity of the department by 10,000 units and cost
P500,000 per year. Should Mayfield implement the change? Show your calculations.

Theory of constraints; throughput accounting

Ride Company is engaged in the manufacturing and marketing of bicycles. Two bicycles are
produced. These are the “Roadster” which is designed for use on roads and the “Everest” which is a
bicycle designed for use in mountainous areas. The following information relates to the current year:

1. Unit selling price and cost data is as follows:

Roadster Everest
Selling price P200 P280
Material cost 80 100
Variable production conversion costs 20 60

2. Fixed production overheads attributable to the manufacture of bicycles will amount to

P4,050,000.
3. Expected demand is as follows: Roadster - 150,000 units; Everest - 70,000 units.
4. Each bicycle is completed in the finishing department. The number of each type of bicycle
that can be completed in one hour in the finishing department is as follows: Roadster – 6.25;
Everest – 5.00.
5. There are a total of 30,000 hours available within the finishing department.
6. Ride Company operates a just-in-time (JIT) manufacturing system with regard to the
manufacture of bicycles and aims to hold very little work in process and no finished goods
stocks whatsoever.

Required
1. Using relevant costing principles, calculate the mix (in units) of each type of bicycle which
will maximize net profit and state the value of that profit.
2. Calculate the throughput accounting ratio for each type of bicycle and briefly discuss when it
is worth producing a product where throughput accounting principles are in operation. Your
answer should assume that the variable overhead cost amounting to P4,800,000 incurred as a
result of the chosen product mix in Requirement 1 is fixed in the short-term.
3. Using throughput accounting principles, advise management of the quantities of each type of
bicycle that should be manufactured which will maximize net profit and prepare a projection
of the net profit that will be earned by Ride Company in the year ending.

ABM & pricing

Classic Confections makes very elaborate wedding cakes to order. The company’s owner Sandra
Albano, has provided the following data concerning the activity rates in its activity-based costing
system:

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 Activity cost pools Activity rate
Guest related P0.90 per guest
Tier related P34.41 per tier
Order related P150.00 per order

The measure of activity for the size-related activity cost pool is the number of planned guests at the
wedding reception. The greater the number of guests, the larger the cake. The measure of complexity
is the number of cake tiers. The activity measure for the order-related cost pool is the number of
orders. (Each wedding involves one order.) The activity rates include the costs of raw ingredients
such as flour, sugar, eggs, and shortening. The activity rates do not include the costs of purchased
decorations such as miniature statues and wedding bells, which are accounted for separately. The
average wedding has 125 guests and generally requires a three-tiered cake.

Data concerning two recent orders appear below:

Santos Wedding Nicolas Wedding

Number of reception guests 50 164
Number of tiers on the case 1 5
Cost of purchased decorations for cake P225.00 P588.60

Required
1. What amount would the company have to charge for the Santos wedding cake to breakeven
on that cake?
2. Assuming that the company charges P6,500 for the Nicolas wedding cake, what would be the
overall gross margin on the order?
3. Amapola Villamor wants to order a special cake for her 10th wedding anniversary celebration.
She wants the cake to be four tiers but, in addition, would like 20 special flowers added to the
top of the cake, which requires very intricate detailing instead of purchased decorations.
Villamor expects that attendance at the anniversary party will be 200 people. If Albano
decides to charge P50 for each special flower, which price should she quote? What price
should be charged if the company wants to make an overall gross margin of 35% on the
Villamor order?

ABM & environmental costs

Aquarius Company was evaluating the activity-based environmental costs of two different products:
Product X and Product Y. Information on two environmental activities is as follows:

Activity Driver Cost

Maintaining pollution equipment Maintenance hours P120,000
Toxic waste disposal Pounds of waste 80,000

Data on Product X and Product Y follows:

Product X Product Y
Production costs (non-environmental) P400,000 P500,000
Units produced 100,000 200,000
Maintenance hours for pollution equipment 1,000 4,000
Pounds of toxic waste 10,000 30,000

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Required
1. Assign the environmental activity costs to Product X and to Product Y.
2. Calculate the unit environmental cost of Product X.
3. Calculate the unit environmental cost of Product Y.
4. Calculate the overall unit cost of Product X.
5. Calculate the overall unit cost of Product Y.

End of Handouts