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CHAPTER 10 COST PLANNING FOR THE PRODUCT LIFE CYCLE: TARGET COSTING, THEORY OF CONSTRAINTS, AND STRATEGIC PRICING

QUESTIONS 10-1 A firm has two options for reducing costs to a target cost level: a. Reduce costs to a target cost level by integrating new manufacturing technology, using advanced cost management techniques such as activity-based costing, and seeking higher productivity through improved organization and labor relations. This method of cost reduction is common in specialized equipment manufacturing. b. Reduce cost to a target cost level by redesigning a popular product. This method is the more common of the two, because it recognizes that design decisions account for much of total product life cycle costs (see Exhibit 10-3). By careful attention to design, significant reductions in total cost are possible. This approach to target costing is associated primarily with Japanese manufacturers, especially Toyota, which is credited with developing the method in the mid 1960s. This method of cost reduction is common in consumer electronics. 10-2 The sales life cycle refers to the phase of the products sales in the market - from introduction of the product to decline and withdrawal from the market. In contrast, the cost life cycle refers to the activities and costs incurred in developing a product, designing it, manufacturing it, selling it and servicing it. The phases of the sales life cycle are: Phase One: Product Introduction. In the first phase there is little competition, and sales rise slowly as customers become aware of the new product. Costs are relatively high because of high R&D expenditures and capital costs for setting up production facilities and marketing efforts. Prices are relatively high because of product differentiation and the high costs at this phase. Product variety is limited. Phase Two: Growth. Sales begin to grow rapidly and product variety increases. The product continues to enjoy the benefits of differentiation. There is increasing competition and prices begin to soften. Phase Three: Maturity. Sales continue to increase but at a decreasing rate. There is a reduction in the number of competitors and product variety. Prices soften further, and differentiation is no longer important. Competition is based on cost, given competitive quality and functionality. Phase Four: Decline. Sales begin to decline, as does the number of competitors. Prices stabilize. Emphasis on differentiation returns. Survivors are able to differentiate their product, control costs, and deliver quality and excellent service. Control of costs and an effective distribution network are key to continued survival.
Blocher,Stout,Cokins,Chen:Cost Management, 4e 10-1 The McGraw-Hill Companies, Inc., 2008

10-3 The strategic pricing approach changes over the sales life cycle of the product. In the first phase, pricing is set relatively high to recover development costs and to take advantage of product differentiation and the new demand for the product. In the second phase, pricing is likely to stay relatively high as the firm attempts to build profitability in the growing market. Alternatively, to maintain or increase market share at this time, relatively low prices (penetration pricing) might be used. In the latter phases, pricing becomes more competitive, and target costing and life-cycle costing methods are used, as the firm becomes more of a price taker rather than a At least three factors that make sensitivity analysis prevalent in decision making including the following price setter, and efforts are made to reduce upstream (for product enhancements) and downstream costs. 10-4 At the introduction and into the growth phases, the primary need is for value chain analysis, to guide the design of products in a cost-efficient manner. Master budgets (Chapter 8) are also used in these early phases to manage cash flows; there are large developmental costs at a time when sales revenues are still relatively small. Then, as the strategy shifts to cost leadership in the latter phases, the goal of the cost management system is to provide the detailed budgets and activity-based costing tools for accurate cost information. 10-5 Target costing is a method by which the firm determines the desired cost for the product, given a competitive market price, so that the firm can earn a desired profit. It is used by several manufacturing firms, particularly in the automotive and consumer products industries, such as Honda, Toyota, Ford, Volkswagen, and Olympus camera. 10-6 Life-cycle costing considers the entire cost life cycle of the product, and thus provides a more complete perspective of product costs and product profitability. It is used to manage the total costs of the product across its entire life cycle. For example, design and development costs may be increased in order to decrease manufacturing costs and service costs later in the life cycle. 10-7 There are five steps in TOC analysis: Step One: Identify the Constraint Use a flow diagram. The constraint is a resource that limits production to less than market demand. Step Two: Determine the Most Efficient Utilization of Each Constraint Product mix decision: based on capacity available at the constraint, find the most profitable product mix. Maximize flow through the constraint: -reduce setups -reduce lot sizes -focus on throughput rather than efficiency

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10-2

The McGraw-Hill Companies, Inc., 2008

Step Three: Maximize the Flow Through the Constraint Drum-Buffer-Rope concept: maintain a small amount of work-in-process (buffer) and insert materials only when needed (drum) by the constraint, given lead times (rope). All resources are coordinated to keep the constraint busy without a buildup of work. Step Four: Increase Capacity on the Constrained Resource Invest in additional capacity if it will increase throughput greater than the cost of the investment. Do not move to investment until steps two and three are complete, that is, maximize the productivity of the process through the constraint with existing capacity. Step Five: Redesign the Manufacturing Process for Flexibility and Fast Throughput Consider a redesign of the product of production process, to achieve faster throughput. One could argue that any step could be the most important; for example step one can be considered to be the most important because the analysis undertaken is intended to improve the speed of product flow through the constraint. 10-8 TOC emphasizes the improvement of throughput by removing or reducing the constraints, which are bottlenecks in the production process that slow the rate of output. These are often identified as processes wherein relatively large amounts of inventory are accumulating, or where there appear to be large lead times. Using TOC the management accountant speeds the flow of product through the constraint, and chooses the mix of product so as to maximize the profitability of the product flow through the constraint. 10-9 The purpose of the flow diagram is to assist the management accountant in the first step of TOC, to identify the constraints. 10-10 The methods of product engineering and design in life-cycle costing are: Basic engineering is the method in which product designers work independently from marketing and manufacturing to develop a design from specific plans and specifications. Prototyping is a method in which functional models of the product are developed and tested by engineers and trial customers. Templating is a design method in which an existing product is scaled up or down to fit the specifications of the desired new product. Concurrent engineering, or simultaneous engineering, is an important new approach in which product design is integrated with manufacturing and marketing throughout the products life cycle.

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10-3

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10-11 Value engineering is used in target costing to reduce product cost by analyzing the tradeoffs between different types and levels of product functionality and total product cost. Two common forms of value engineering are: Design analysis is a process where the design team prepares several possible designs of the product, each having similar features but different levels of performance on these features and different costs. Functional analysis is a process where each major function or feature of the product is examined in terms of its performance and cost. 10-12 Activity-based costing (ABC) is used to assess the profitability of products, just as is TOC. The difference is that TOC takes a short-term approach to profitability analysis, while ABC develops a longer-term analysis. The TOC analysis has a short-term focus because of its emphasis on materials related costs only, while ABC includes all product costs. On the other hand, unlike TOC, ABC does not explicitly include the resource constraints and capacities of production operations. Thus, ABC cannot be used to determine the short-term best product mix. ABC and TOC are thus complementary methods; ABC provides a comprehensive analysis of cost drivers and accurate unit costs as a basis for strategic decisions about long-term pricing and product mix. In contrast, TOC provides a useful method for improving the short-term profitability of the manufacturing plant through short-term product mix adjustments and through attention to production bottlenecks. 10-13 TOC is appropriate for many types of manufacturing, service and not-for-profit firms. It is most useful where the product or service is prepared or provided in a sequence of inter-related activities as can be described in a network diagram such as shown in Exhibit 10-6. The most common users of TOC to date have been manufacturing firms who use it to identify machines or steps in the production process which are bottlenecks in the flow of product and profitability. 10-14 Target costing is most appropriate for firms that are in a very competitive industry, so that the firms in the industry compete simultaneously on price, quality and product functionality. In very competitive markets such as this, target costing is used to determine the desired level of functionality the firm can offer for the product while maintaining high quality and meeting the competitive price. 10-15 Life-cycle costing is most appropriate for firms which have high upstream costs (i.e. design and development) and downstream costs (i.e. distribution and service costs). Firms with high upstream and downstream costs need to manage the entire life cycle of costs, including the upstream and downstream costs as well as manufacturing costs. Traditional cost management methods tend to focus on manufacturing costs only, and for these firms, this approach would ignore a significant portion of the total costs.

Blocher,Stout,Cokins,Chen:Cost Management, 4e

10-4

The McGraw-Hill Companies, Inc., 2008

10-16 Strategic pricing is used to help a firm develop and implement its strategy for success as its products and services mature in the market place. The focus for new products is typically differentiation and there is a heavy focus on research and development, while cost control becomes more important as the product matures. In contrast, life-cycle costing is used to manage the costs of the product over its entire cost life-cycle - from research and development and product testing to manufacturing and finally distribution and customer service. 10-17 Takt time is the ratio of available manufacturing time for a period to the units of customer demand for that period. Each unit must be produced within the Takt time to satisfy customer demand. Takt time is computed for each manufacturing operation, and those operations with longer Takt times are the constraints in the manufacturing process. 10-18 Pricing based on the cost life cycle is a common form of pricing. It involves a markup on full product cost or product life cycle cost. In contrast, pricing based on the sales life cycle bases the product price on competitive factors, including which phase of the sales life cycle (introduction, growth, maturity, or decline) the product is currently in.

Blocher,Stout,Cokins,Chen:Cost Management, 4e

10-5

The McGraw-Hill Companies, Inc., 2008

BRIEF EXERCISES 10-19 Current profit per unit = $50 - $ 38 - $8 = $4/unit Target total cost = $45 - $4 = $41 Target manufacturing cost = $45 - $4 - $8 = $33

10-20 Price = 1.4 x ($38) = $53.20 10-21 Price = 1.10 x ($38 + $8) = $50.60 10-22 The introduction phase 10-23 10-24 10-25 10-26 Takt time = 6,000 x 4 weeks per month/200,000 units per month = .12 hour/unit or 7.2 minutes per unit 20 - 1 = 19 days 2 days in production (May 20-May 21) (21-1=20 days cycle time) Kaizen, continuous improvement = .1

10-27 $140 - $140 x (.25) = $105

Blocher,Stout,Cokins,Chen:Cost Management, 4e

10-6

The McGraw-Hill Companies, Inc., 2008

EXERCISES 10-28 Target Costing (15 min) 1. The unit cost is currently $548.60 = $13,715,000/25,000 The current profit per item is $610 - $548.60 = $61.40 Thus, the target cost to meet the competitive price is: $550 - $61.40 = $488.60 2. The target cost can probably be achieved by efforts in two areas: a. The standard cost analysis shows an unfavorable materials variance of $500,000 ($7,000,000 - $6,500,000) or $20 per unit, a very significant variance. Efforts to reduce or eliminate this variance will make the firm much more competitive. Notice that the labor usage variance for indirect labor is favorable, and the direct labor variance is unfavorable. It may be that additional work is needed setting the standards. b. The standard cost shows an unfavorable direct labor variance of $125,000 ($2,625,000 - $2,500,000), or $5 per unit, an opportunity for cost savings. c. The remaining manufacturing costs can be considered nonvalue adding costs, since they do not add to the functionality or quality of the product. Efforts can be made to reduce the total cost of these manufacturing costs, which now total a significant $4,090,000 or $163.60 per unit.

Blocher,Stout,Cokins,Chen:Cost Management, 4e

10-7

The McGraw-Hill Companies, Inc., 2008

10-29 Manufacturing Cycle Efficiency (10 min) MCE = total processing time/total cycle time = 23/(23+3+6+3+1+5+2+6+2) = 23/51 = 45% Note that new product development time and order taking time are not considered part of the manufacturing cycle and are excluded from cycle time. The level of MCE is best interpreted by reference to the prior MCE values for the firm or to an industry average. A number closer to one is better. When comparing to an industry average, management should make sure that the measures are calculated in the same manner. In this case, Waymouth has improved significantly on its MCE relative to the prior data, and is higher than the industry average.

Blocher,Stout,Cokins,Chen:Cost Management, 4e

10-8

The McGraw-Hill Companies, Inc., 2008

10-30 Takt Time (10 min) 1. The takt time for this product is the number of available hours / total demand. Total manufacturing time = 70hr x 60 min x 60 sec = 252,000 seconds 8,400 8,400 = 252,000 84,000 = 30 seconds per unit

2. The processing line is not properly balanced. Operation 2 exceeds takt time by 4 sec. and Operation 3s time is somewhat less than takt time. To balance the line, so that products can be expected to come off the line every 30 seconds as needed, the capacity of operation 2 should be increased so that it could speed up its operation. Similarly, operation 3 could reduce capacity and resources to save money; we do not need this operation to move so fast. 3. The strategic role of takt time is to help operations managers to balance the operations and to improve the speed of throughput and reduce cycle time. The management accountants role is to provide information on the costs of processing time and capacity, and the value of increasing throughput. TOC analysis attempts to accomplish this by maximizing the flow through the constraints/operations.

Blocher,Stout,Cokins,Chen:Cost Management, 4e

10-9

The McGraw-Hill Companies, Inc., 2008

10-31. Target Costing (30 min) 1., 2.


Cost a nd Activity Usa ge for Ea ch Product Direct Materials Number of parts Machine hours Inspecting time Packing time Set-ups Activity-ba se d Costs Direct Materials Materials Handling Mfg Supervision Assembly Set-ups Inspection and Test Packaging Total Price Margin $ $ $ $ $ $ $ $ $ $ 143.76 272.25 141.00 308.55 89.20 35.00 10.50 1,000.26 1,050.00 49.74 $ $ $ $ $ $ $ $ $ $ 66.44 207.00 94.00 234.60 44.60 21.00 6.00 673.64 725.00 51.36 $ $ $ $ $ $ $ $ $ $ 78.65 247.50 117.50 280.50 44.60 35.00 10.50 814.25 825.00 10.75 $ $ $ $ $ $ $ $ $ $ 42.45 182.25 47.00 206.55 44.60 17.50 3.00 543.35 595.00 51.65 $ Current A-10 A-25 143.76 $ 66.44 121 92 6 4 1 0.6 0.7 0.4 2 1 Revised A-10 A25 $ 78.65 $ 42.45 110 81 5 2 1 0.5 0.7 0.2 1 1

3. The solution uses Goal Seek or trials in the Excel sheet. The number of parts must be reduced to 101 or fewer to get at least $50 margin.
Cost and Activity Usage for Each Product Direct Materials Number of parts Machine hours Inspecting time Packing time Set-ups Activity-based Costs Direct Materials Materials Handling Mfg Supervision Assembly Set-ups Inspection and Test Packaging Total Price Margin $ $ $ $ $ $ $ $ $ $ 143.76 272.25 141.00 308.55 89.20 35.00 10.50 1,000.26 1,050.00 49.74 $ $ $ $ $ $ $ $ $ $ 66.44 207.00 94.00 234.60 44.60 21.00 6.00 673.64 725.00 51.36 $ $ $ $ $ $ $ $ $ $ 78.65 227.25 117.50 257.55 44.60 35.00 10.50 771.05 825.00 53.95 $ $ $ $ $ $ $ $ $ $ 42.45 182.25 47.00 206.55 44.60 17.50 3.00 543.35 595.00 51.65 $ Current A-10 A-25 143.76 $ 66.44 121 92 6 4 1 0.6 0.7 0.4 2 1 Revised A-10 A-25 $ 78.65 $ 42.45 101 81 5 2 1 0.5 0.7 0.2 1 1

Blocher,Stout,Cokins,Chen:Cost Management, 4e

10-10

The McGraw-Hill Companies, Inc., 2008

Problem 10-31 (continued) 4. Target costing should be useful to BSI to assist the firm in meeting the new competition by finding new ways to cut costs without reducing product quality or functionality.

Blocher,Stout,Cokins,Chen:Cost Management, 4e

10-11

The McGraw-Hill Companies, Inc., 2008

10-32 Travel Costs; Target Costing (20 min) 1.


Cancun Unit Cost $30 Quantity 6 7 7 6 4 5 1 1 $180 35 49 60 60 50 200 15 $649 Cost Jamaica Quantity 4 5 5 0 2 2 1 1 $120 25 35 0 30 20 355 10 $595 Cost

$5 $7 $10 $15 $10 $200 (Cancun), Airfare (round trip $355 (Jamaica) from Miami) $15 (Cancun), Transportation to and from airport $10 (Jamaica) TOTALS

Package Specifications Oceanfront room; number of nights Meals: Breakfasts Lunches Dinners Scuba diving trips Water skiing trips

Cancun: ($750 - $649 total costs)/$ 750 = 13.47% profit margin Jamaica: ($690 - $595)/$690 = 13.77% profit margin 2. Cancun ($710 - $649 total costs)/ $710 = 8.59% profit margin Jamaica: ($650- $595)/$650= 8.46% profit margin 3. The airfare costs are the largest component of cost and this category could have room for improvement. By further negotiating group discount rates or searching for lower cost discount carriers, Take-a-Break could lower its cost in this category. Room costs also comprise a major portion of total package costs. While Take-a-Break could negotiate deals with off-beachfront hotels or opt for non-oceanfront rooms, this might decrease the value of the trip in the eyes of its customers. A better option would be to further negotiate group rates with its current hotel providers.

Blocher,Stout,Cokins,Chen:Cost Management, 4e

10-12

The McGraw-Hill Companies, Inc., 2008

10-33 Target Costing in A Service Firm (20 min) 1. cost per unit = ($4,500,000 + $1,750,000 + $750,000 + $5,000,000) / 8,000 = $1,500 per unit profit per unit = ($3,000 price per unit - $1,500 cost per unit) = $1,500 per unit 2. Machine setups do not add value to the golf carts. $750,000 total cost / 8,000 units = $93.75 per unit of non-value added costs 3. $2,850 price per unit - $1,500 profit per unit = $1,350 per unit target cost 4. Cost must be reduced by $3,000 - $2,850 = $150. First and foremost, Weekend Golfer should focus on getting back on budget. Inefficiencies in materials usage have led an extra $37.50/unit in cost ($4.500.000$4,200,000)/8,000). Also, getting labor on budget would save an additional $43.75/unit ($1,750,000/125,000 = $14 per hour; 25,000 hours excess X $14 = $350,000; $350,000/8,000 = $43.75). Labor and materials costs should be reduced by $43.75 + $37.50 = $81.25. Additional savings could come from reducing the non-value added costs from machine setups. This could be done through product design and manufacturing process reengineering. Also, a careful examination of mechanical assembly might reveal cost saving opportunities because this category currently comprises half of the cost per unit. Cutting hours off of mechanical assembly through product innovation or a process change would provide more savings.

Blocher,Stout,Cokins,Chen:Cost Management, 4e

10-13

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10-34 Pricing (25 min) The price, contribution, and profit information is as follows. 1. $176.183 = $3,410,000 X 1.55 / 30,000 2. $184.60 = $4,260,000 X 1.3 / 30,000 3. $189.444 = $113.67 / (1 - .4) 4. $189.333 = $142.00 / (1 - .25) 5. $202.00 = $142.00 X (! + .4225) Where: .4225 = ($12,000,000X.15) / (30,000X$142)
Total Variable Costs Total Fixed Costs Total Manufacturing Cost Total Selling and Administrative Total Life Cycle Cost Per unit Manufacturing Cost Per unit Life Cycle Cost $ 2,500,000 1,760,000 3,410,000 850,000 4,260,000 113.67 142.00 Desired Rate for Markup 55% 30% 40.00% 25.00% 15% 42.25%

Method: Markup on full manufacturing cost Markup on life cycle costs Price to Achieve Desired GM % Price to Achieve Desired LCC % Price to Achieve Desired ROA of

$ $ $ $ $

Price 176.183 184.600 189.444 189.333 202.000

ANSWER TO PART 6. Contribution Gross Operating Margin Margin Profit $ 2,785,500 $ 1,875,500 $ 1,025,500 3,038,000 2,128,000 1,278,000 3,183,333 2,273,333 1,423,333 3,180,000 2,270,000 1,420,000 3,560,000 2,650,000 1,800,000

6. The contribution margin, gross margin, and operating profit are shown in the right-hand portion of the table above. For example, $2,785,500 = $176.183 x 30,000 - $2,500,000 The pricing methods yield prices from $176.00 to $202.00 The highest price, $202, has the advantage that it provides the desired return on investment, a more precise statement of the firms goal than in the other methods. On the other hand, the lower price might be an advantage if the firm is trying to achieve sales growth and is concerned about maintaining or improving market share during turns in the business cycle for its customers. This latter concern is especially important given that the demand for the firms product is a derived demand, and there is little that Johnson can do to influence total auto sales.

Blocher,Stout,Cokins,Chen:Cost Management, 4e

10-14

The McGraw-Hill Companies, Inc., 2008

10-35 Life Cycle Costing (20 min) Total Fixed Costs $ 2,300 3,000 5,400 6,920 6,000 21,000 $ 44,620 Total variable costs $2.50 + .50 + .50 = $3.50 Life-Cycle Costs = $ 21,000 for fleet of canoes 446,200 (annual fixed costs x 10 years) 224,000 ($3.50 var. costs x 6,400 rentals per yr x 10 years) $691,200 Life-Cycle Revenues needed for 20% profit margin = $691,200 / 0.80 = $864,000 Price per Rental for 20% profit margin = $864,000 / 64,000 rentals in ten years = $13.50

Blocher,Stout,Cokins,Chen:Cost Management, 4e

10-15

The McGraw-Hill Companies, Inc., 2008

10-36

Sales Life-Cycle Analysis (5 min)

Activities and Market Characteristics Decline in sales Advertising Boost in production Stabilized profits Competitors entrance into market Market Research Market Saturation Start Production Product Testing Termination of Product Large Increase in sales

Life Cycle Stage Decline Introduction Growth Maturity Growth Introduction Maturity Introduction Introduction Decline Growth

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10-16

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10-37 Pricing Military Contracts (10 min) This is a complex issue which Pentagon officers and congressional leaders continue to squabble over. In this particular case, Senator McCain argued that the contract should be re-written to reduce the fixed fee from 10% to 3% and the incentive fee should be increased from 5% to 12%. This means that the total potential fee of 15% would be retained, but that a much larger portion of the fee would have to be earned on performance measures (the incentive fee).

Source: The Right Stuff for the GIs of the Future, Business Week, August 15, 2005, pp 74-75.

Blocher,Stout,Cokins,Chen:Cost Management, 4e

10-17

The McGraw-Hill Companies, Inc., 2008

10-38 Pricing Power (10 min) This exercise is intended for a brief class discussion. The objective is to identify the factors that are critical in allowing some firms to have more pricing flexibility than others. The discussion should touch on the importance of distinguishing cost leadership firms, for whom the market price is set by low-cost global suppliers, and who therefore have little pricing flexibility, versus differentiated firms, who will have more flexibility in setting prices because of the innovation and features of their product or service. Also, considering the sales life cycle can help. Firms in the introduction and growth phases of their product or service life cycle will have more flexibility about setting prices than those in the mature phase of the life cycle, where there is more effective price competition. Geoffrey Colvin, writing in Fortune, points out that many firms today have less flexibility in setting prices. The factors that have traditionally provided pricing power are brands, intellectual property, and high entry barriers: Brands: Colvin points out that many brands, including Coke, Nike, and McDonalds, are under attack from a number of sources, including those who are opposed to what they see as the social ills caused by these firms Intellectual Property: Colvin points out that firms around the world are having more success at copying, legally or illegally, the patented products such as Viagra, or entertainment products music and movies High Entry Barrier: As Michael Porter notes (chapter 2), high entry barriers for an industry can protect it from competition, through high costs of facilities, patents, government regulations, etc. However, Colvin notes that many of these barriers can now be hurdled by companies that use new technologies, including the Internet.

Source: Geoffrey Colvin, Pricing Power Aint What it Used to Be, Fortune, September 15, 2003, p 52.

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10-18

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10-39 Target Costing Using QFD (20 min) 1. The calculations are shown below:
First: Customer Criteria and Ranking Importance 40 90 70 200 Cost Relative Importance 20.0% 45.0% 35.0% 100% Percent of Total 41.7% 33.3% 25.0% 100%

Taste Comfort Enjoyment Total Second: Components and Cost Components Menu and Food Preparation Wait Staff Food Ingredients Total

$ $

10 8 6 24

Third: Determine How Components Contribute to Customer Satisfaction Components Menu and Food Preparation Wait Staff Food Ingredients Taste Customer Criteria Comfort Enjoyment 60% 20% 60% 10% 60% 30% 20% 10% 30% 100% 100% 100%

Fourth: Determine Importance Index for Each Component Customer Criteria Components Taste Comfort Enjoyment Relative Importance of this criteria 20.0% 45.0% 35.0% Importance The % contribution of each component to each customer criteria is: Index* Menu and Food Preparation 60% 20% 60% 42.00% Wait Staff 10% 60% 30% 39.50% Food Ingredients 30% 20% 10% 18.50% 100% 100% 100% 100.00% Importance Index 42.0% 39.5% 18.5% 100.0% Relative Cost 41.7% 33.3% 25.0% 100.0%

Components Menu and Food Preparation Wait Staff Food Ingredients

2. The cost index for wait staff is somewhat less than the importance index, which indicates that Hannah should consider increasing the resources applied to wait staff more wait staff, higher pay etc. In contrast, customer satisfaction does not appear to reward the level of expenditure for food ingredients; perhaps savings could be made here.
Blocher,Stout,Cokins,Chen:Cost Management, 4e 10-19 The McGraw-Hill Companies, Inc., 2008

PROBLEMS 10-40 Target Costing in a Service Firm (20 min) ICU 900 Quantity Cost 3 $450 1 75 8 120 7 56 2 30 1,100 110 26 520 $1,361

1.

ICU 100 Unit Cost Quantity Cost Video camera $ 150 1 $150 Video monitor 75 1 75 Motion detector 15 5 75 Floodlight 8 3 24 Alarm 15 1 15 Wiring .10/ft 700 70 Installation 20/hr 16 320 Total $729

ICU 100: ($810 - $729 total costs)/$ 810 = 10% profit margin ICU 900: ($1,520 - $1,361)/$1,520 = 10.46% profit margin 2. ICU 100: ($750 - $729 total costs)/ $750 = 2.8% profit margin ICU 900: ($1,390 - $1,361)/$1,390 = 2.09% profit margin 3. The installation costs are the largest component of cost and this category could have room for improvement. By redesigning the layout of the systems or finding components that integrate more readily, the installation times could then be reduced. Also, costs could be lowered by contractual bargaining with electricians to reduce the per hour rates for installation. The video equipment and motion detectors are sources of significant costs, but decreasing the quality or quantity of these items would substantially change the effectiveness and value of the security systems.

Blocher,Stout,Cokins,Chen:Cost Management, 4e

10-20

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10-41 Target Costing, Strategy (15 min) 1. cost per unit = ($2,700,000 + $1,000,000 + $300,000 + $4,000,000) / 10,000 = $800 per unit profit per unit = ($875 price per unit - $800 cost per unit) = $75 2. Machine setups do not add value to the tables. $300,000 total cost / 10,000 units = $30 per unit of non-value added costs 3. $800 price per unit - $75 profit per unit = $725 per unit target cost 4. Cost must be reduced by $800 - $725 = $75. First and foremost, Benchmark should focus on getting back on budget. Inefficiencies in materials usage have led to an extra $15.88/unit in cost { [(25,000/425,000) x $2,700,000]/10,000 = $15.88}. Also, getting labor on budget would save an additional $15/unit { [$1,000,000 x (15,000/100,000)]/10,000 }. This would get costs down to $769.12 per unit ($800 - $15 - $15.88). Part of the additional $44.12 ($75 - $15 - $15.88) of savings needed to attain the $725 target cost could come from reducing the non-value added costs from machine setups. This could be done through product design and manufacturing process reengineering. Also, a careful examination of mechanical assembly might reveal cost saving opportunities because this category currently comprises half of the cost per unit. Cutting 2 hours off of mechanical assembly through product innovation or a process change would provide more than $30 of savings (at $4,000,000/320,000 = $12.50 per hour; savings of 2 hours per unit would save 2 x $12.50 = $31.25 per unit)

Blocher,Stout,Cokins,Chen:Cost Management, 4e

10-21

The McGraw-Hill Companies, Inc., 2008

10-42 Target Costing (20 min) 1. The target cost, at the price of $1,500 and the desired margin of 20% would be TC = $1,500 - .2 x $1,500 = $1,200 2. Manufacturing Cost Marketing Cost GSA Cost Total Cost Currently $1,000 200 225 $1,425 With Cost Reductions $835 200 175 $1,210 Savings $85-25+105 = $165 $50 $215

The cost savings of $215 are not sufficient to get the product total cost ($1,210) down to the desired target cost of $1,200. Given that National might be willing to pay a higher price, and since the cost difference is relatively small, it seems that Morrow should in fact pursue the order. Here are some other considerations: a. Morrow should consider the short versus the long term issues of taking on the order. In the short term, as noted in chapter 3, the fixed costs of manufacturing the order will not change and therefore can be considered irrelevant for the order if it is a one time special order. Thus, for a short term analysis, Morrow should determine that portion of manufacturing, marketing, and GSA costs that are fixed and exclude them from the analysis. In contrast, if Morrow expects this to be a regular customer, that Morrow will be supplying National these parts for several months or years, then the total costs including fixed costs are relevant, as in the calculations above. In the longer term, Morrow must cover all costs of production and sale, while in the short term only the variable costs are relevant.

Blocher,Stout,Cokins,Chen:Cost Management, 4e

10-22

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Problem 10-42 (continued) b. Morrow appears to compete in what Robin Cooper calls the confrontation strategy (When Lean Enterprises Collide, Harvard Business School Press, 1995) wherein each competitor must simultaneously compete on the basis of price, quality and functionality. In Morrrows case, functionality refers not only to meeting product specifications but also to delighting the customer with meeting delivery times, reducing lead times, and minimizing billing and shipping errors, as Morrow has done. In a confrontation type of competition, target costing is particularly valuable, as Cooper points out, because it provides the firm a mechanism for balancing, and choosing the proper bundle of the three aspects of competition: price, quality and functionality. For example, to be most competitive, Morrow must spend extra dollars to ensure that there are few if any billing and shipping errors, while at the same time reducing the costs of manufacturing the product, and maintaining or improving product quality. c. The problem notes that the manufacturing costs are standard full costs. Since the costs are given at standard, this means that there are no apparent inefficiencies reflected in the reported $1,425. However, the question still remains whether the standard costs are properly determined. Should the standards be revised?

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10-43 Target Costing; Health Care (20 min) 1. The unit cost is $85 = $77,817,500/915,500 The current profit per item is $115 - $85 = $30 The target cost to meet the competitive price is $109 - $30 = $79. 2. The unit cost is $86.46 = $83,109,090/961,275 Note: $77,817,500 + ($77,817,500X6.8%) = $83,109,090 The current profit per item is $125 - $86.46 = $38.54 The target cost is $124 - $38.54 = $85.46 3. A critical success factor is the relationship with network providers. Establishing a good working relationship with its providers improves the likelihood that the clinicians will follow the HMOs protocols. Customer satisfaction is essential, so MD Plus should measure and monitor the satisfaction levels of their patients, employees, network providers and referring physicians. Since quality of care is a critical component of customer satisfaction, a continuous quality improvement department could be established to monitor the organizations effectiveness and efficiency.

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10-44 Target Cost; Warehousing (20 min) Current Year Operating Income Sales $20 x 100,000 = $2,000,000 Costs: Purchase $10 x 100,000 = $1,000,000 Purchasing order $150 x 1,000 = 150,000 Warehousing $30 x 8,000 = 240,000 Distributing $80 x 500 = 40,000 Fixed operating cost 250,000 1,680,000 Operating income $320,000 Target Cost Sales $20.00 x 100,000 x .90 = Desired profit Total cost allowed Total costs excluding warehousing: Purchase $1,000,000 x .98 = Purchasing order $150 x 700 = Distributing $75 x 500 = Fixed operating cost Maximum warehousing cost $1,800,000 320,000 $1,480,000 $980,000 105,000 37,500 $250,000 1,372,500 $ 107,500

Warehousing costs must be reduced from $240,000 to $107,500, a reduction of $132,500.

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10-45

Target Costing; International (20 min) 1. Target manufacturing cost = Current manufacturing cost + U.S. Differential = $56 + Price differential - Cost differential = $56 + $16 - $10 = $62 Or: Target cost = target price differential advertising and shipping desired US profit $62 = $90 - $10 - $18 2. The cost differential is $62 - $56 = $6 Harpers cannot add the lighter weight feature, though it is the most desired, as the cost of $6.75 is greater than the cost differential of $6. The best approach might be to add the extra-soft insole ($3) and the longer-wearing sole ($3). 3. Strategically, the decision to sell shoes in the United States makes very good sense. To compete effectively in a competitive global market such as shoes, a firm has to have an effective presence in all the key markets, which would include the United States. The experience of competing in the United States should bring profits (due to the higher prices) and the knowledge obtained from dealing with the different customers. This knowledge can be used to improve the firms competitiveness in other markets.

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10-46 Target Costing; Quality Function Deployment (QFD) (30 min) 1.


Criteria Safety Styling Performance Comfort Customer Rating 33 15 20 32 100

Components Hull and Keel Standing Rig Sails Electrical Other

Target Cost Percent $ 36,000 30.00% 18,000 15.00% 20,000 16.67% 16,000 13.33% 30,000 25.00% $ 120,000 100% Safety Styling Performance Comfort 50% 30% 20% 10% 30% 10% 100% 50% 100%

Component/ Criteria Hull and Keel Standing Rig Sails Electrical Other

30% 30% 10% 20% 10% 100%

40% 20% 10% 10% 20% 100%

Component/ Criteria Criteria Value Hull and Keel Standing Rig Sails Electrical Other

Safety

33% 9.90% 9.90% 3.30% 6.60% 3.30%

Styling

15% 6.00% 3.00% 1.50% 1.50% 3.00%

Value Performance Comfort Index 20% 32% 100% 10.00% 9.60% 35.50% 4.00% 3.20% 20.10% 6.00% 3.20% 14.00% 0.00% 0.00% 8.10% 0.00% 16.00% 22.30% 100.00%

Comparison of Cost and Value Value Index Cost Index Hull and Keel 35.50% 30.00% Standing Rig 20.10% 15.00% Sails 14.00% 16.67% Electrical 8.10% 13.33% Other 22.30% 25.00% 100.00% 100.00%

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Problem 10-46 (continued) 2. When the value index is compared to the target cost, the percentage investment in hull & keel and standing rig looks too low The value index for hull & keel is 35.5% while the cost index is 30%; the value index for the standing rig is 20.1% while the cost is only 15%. Ranger might benefit from additional design enhancement of features related to these two components. In contrast, the expenditures for electrical equipment are somewhat higher than would be indicated by customer preferences. Overall, this suggests that consideration be given to redesign of the boat to bring it more in line with customer value.

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10-47 Theory of constraints (25 min) First, identify the constraint: Time Required PEC-1 PEC-2 40x10 + 40 x 15x25=375 25=1,400 40x80=3,200 40x45=1,800 15x(45+30) =1,125 40x60=2,400 15x40=600 Total 1,775 3,200 2,925 3,000 Time Available 2,000 3,500 2,000 3,500

Receiving and testing Machining Assembly Final Assembly

By inspection, the constraint is Assembly, where there are 2,000 minutes of time available, but 2,925 minutes required, a deficit of 925 minutes Second: Determine the most profitable product mix Price Materials cost Throughput margin Constraint time (min) Throughput/minute PEC-1 $200 110 90 45 $2.00 PEC-2 $250 137.50 112.50 75 $1.50

Based on the profitability analysis, PEC-1 is the most profitable product, given the constraint on Assembly time. So the most profitable product mix is 40 units of PEC-1 and 2 units of PEC-2: Demand Production plan, PEC-1 Constraint time used, 2,000 -1,800=200 remaining Production plan, PEC-2 200/75=2.667; round to 2 Total Throughput 40 x $90 = $3,600 2 x $112.50 = $225.00
Blocher,Stout,Cokins,Chen:Cost Management, 4e 10-29 The McGraw-Hill Companies, Inc., 2008

PEC-1 40 40 40x45=1,800

PEC-2 15

10-48 Theory of Constraints (30 min)


First, summarize key information and obtain hours capacity in each process:

Product Table Sofa Activity First Second Third Fourth Fifth

Demand Price Materials Cost 400 $ 250 $ 100 150 450 250 Time Available 280 =2 staff x 35hr x 4 weeks 280 700 =175 x 4 280 = 2 workers x 35 x 4 140

Time Required in hrs/unit Name Table Sofa Cut 0.5 0.2 Sand 0.5 0.5 Assemble 0.75 1.5 Stain 0.8 0.3 Cut Fabric 0 0.8

Second, identify the constraint. In this case the constraint is staining time, where there is a need for 85 more hours of capacity
Part Two: Identify the Constraint Table Cut .5x400=200 Sand .5x400=200 Assemble .75x400=300 Stain .8x400=320 Cut Fabric 0 Sofa
.2x150=30 .5x150=75 1.5x150=225 .3x150=45 .8x150=120

Total Time (hours) 230 275 525 365 120

Time Available 280 280 700 280 140

Slack Time 50 5 175 -85 20

Next, determine the most profitable product, as determined by the requirements of the staining operation. Since the sofa requires substantially less staining time, and because it has higher throughput, it is the most profitable product.
Part Three: Identify Most Profitable Product Table Sofa Price $ 250.00 $ 450.00 Materials Cost 100.00 250.00 Throughput Margin $ 150.00 $ 200.00 Constraint time 0.8 0.3 Throughput/time $ 187.50 $ 666.67

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Problem 10-48 (continued) Finally, determine the most profitable product mix. Since sofas are the most profitable through the staining constraint, we fill the sofa demand first, and then with the remaining staining capacity, fill as much of the table demand as possible. See below for calculations.
Part Four: Identify Most Profitable Product Mix Units of Product (see note) Throughput/time Total Throughput $ $ Tables Sofas Total

293 188 $ 54,938 $

150 667 100,000 $ 154,938

Note: Sofas are most profitable and go first; total time for sofas = 150 x .3 = 45hrs; Total hours available for Tables = 280-45 = 235 hours; total tables that can be manufactured = 235/.8 = 293 tables.

2. Part one above solves the first two steps of the TOC, to identify the constraint and determine the most profitable product mix. The third step, to maximize flow through the constraint, would require Colton to look for ways to speed up the staining operation, by simplifying it, by training the operator, or other means. In the fourth TOC step, Colton could consider adding a part time employee to add capacity at the constraint, though it might be difficult to find a skilled employee who wanted part time work. Adding a full time employee would be unnecessary and wasteful, unless the motel contract works out. In the final TOC step, Colton should consider the possibility of re-design, by for example using a different type of stain that requires less time and skill.

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10-49 Theory of Constraints ( 30 min) With the information available Don can complete the first two steps of TOC as shown below. The analysis shows that the reactor process is the constraint, and that in the short run, Polymer 1 is the most profitable product. The most profitable product mix is 60 units of Polymer 1 and 35 units Polymer 2. Until the production delays can be dealt with (TOC steps 3-5), Don should advise IPC to meet all the sales demand of Polymer 1 and to advise customers of Polymer 2 there would be some delays in the shortterm. Then, IPC should work quickly to relieve the constraint, reactor time, by applying the third, fourth and fifth TOC steps. Without specialized technical knowledge of the manufacturing processes in this industry, one can only speculate about what these steps might be. First: Identify the Constraint Total Time Required for Each activity for Given Demand Time Required for Total Time Slack Polymer 1 Polymer 2 Time Available Time Filtering 60x2= 120 Stripper 60x(1+1)= 120 Reactor 60x3= 180 Final Filter 60x2= 120 Mixing 60x3= 180 40x(2+2)= 160 40x(2+1)= 120 40x5 = 200 40x 1 = 40 40x3 = 120 280 240 380 160 300 320 320 320 160 320 40 80 -60 0 20

The reactor is the constraint , since there is a demand of 380 hours but only 320 hours available.

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Problem 10-49 (continued) Second: Identify the most profitable product


Price Materials Cost Throughput Margin Constraint time(reactor) Throughput/time Polymer 1 $ 145 45 $ 100 3 $ 33 Polymer 2 $ 185 60 $ 125 4 $ 31

Third, Identify the most profitable product mix Since Polymer 1 is the most profitable product, its total demand of 60 is filled first. The remaining time on the reactor is used to complete as many units of Polymer 2 as possible: Capacity of reactor available for Polymer 2 = 320 60 x 3 = 140 140/4 = 35 units of Polymer 2
Polymer 1 Polymer 2 60 35 100 125 $ 6,000 $ 4,375 $ Total 10,375

Units Throughput/unit Total throughput

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10-50 Theory of Constraints (30 min) 1. Bakker will not be able to meet the demand. Department 1 is a constraint, based on machine time. We do not consider labor time because Bakker is able to hire and retain all the labor it needs. 1 1,000= 500x2 400= 400x1 2,000= 1,000x2 3,400 3,000 (400) 2 Departments 3 500= 500x1 400= 400x1 2,000= 1,000x2 2,900 3,100 200 1,000= 500x2 0 1,000= 1,000x1 2,000 2,700 700 4 1,000= 500x2 800= 400x2 1,000= 1,000x1 2,800 3,300 500

Machine Hours needed 611 613 615 Total hours needed Hours Available Excess (deficiency)

2. The best product mix is 400 units of Product 613, 500 units of product 611, and 800 units of product 615. 611 613 Price $196 $123 Variable Cost* 103 73 Throughput/unit $93 $50 Machine hours in Dept 1 2 1 Throughput/hour $46.50 $50.00 * For example, variable cost for 611 = $(7+12+21+24+9+27+3) Production/sales Plan

615 $167 97 $70 2 $35.00

Total hours available in Dept 1 First: 400 units of 613; 400x1 hours Second: 500 units of 611; 500x2 hours Hours remaining Third: 800 units of 615; 1,600/2 hours per unit = 800 All 3,000 hours used

3,000 400 1,000 1,600

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10-51

Life-Cycle Costing; Ethics (25 min) 1. Waters analysis based on the prepared report fails to consider the very significant amount of research and development and selling costs. It is unlikely that the two products consumed equal shares of these costs. As the calculations in part 2 below illustrate, the determination of profitability can be significantly affected by the tracing of these non-manufacturing costs each product. The idea is that life-cycle costing, including upstream and downstream costs (research and development, and selling costs, respectively) as well as the manufacturing costs, is necessary to get an accurate picture of each products overall profitability. Xderm Sales $3,000,000 Cost of goods sold 1,900,000 Gross profit $1,100,000 Research and dev. (720,000) Selling expenses (80,000) Profit before taxes $300,000 2. Yderm $2,000,000 1,600,000 $ 400,000 (180,000) (20,000) $ 200,000 Total $5,000,000 3,500,000 $1,500,000 (900,000) (100,000) $ 500,000

The life-cycle product line profitability analysis shows a much different result. 3.Now, the two products have the same return on sales. This illustrates that including the upstream and downstream costs can be very important in getting a useful analysis of product profitability. Failing to include these non-manufacturing costs, as Waters did at first, may lead to incorrect marketing and management decision making, as the firm may have a biased and incorrect idea of the most profitable product(s). Calculation return on sales (not required) shows that each product has the same return under life cycle costing. Return on Sales $300,000 $3,000,000 = 10% $ 200,000 $2,000,000 = 10% $ 500,000 $ 5,000,000 =10%

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10-52 Life Cycle Costing (25 min) 1. A product life cycle statement would aggregate the three years into one that shows the totals in each category for the life of the product. 2. L50 appears to be more profitable; 771 vs 670 life cycle profits.
L40 Revenues Costs Research and Development Prototypes Marketing Distribution Manufacturing Customer Serivce Total Cost Operating Profit L50 Revenues Costs Research and Development Prototypes Marketing Distribution Manufacturing Customer Serivce Total Cost Operating Profit $ 2005 800 1,400 350 60 60 20 1,890 (1,090) $ 2006 2,300 50 600 120 770 60 1,600 700 $ 2007 3,100 475 130 1,350 85 2,040 1,060 $ Total 6,200 1,400 400 1,135 310 2,140 145 5,530 670

2005 900 650 300 124 170 85 1,329 (429)

2006 1,900 30 200 200 700 20 1,150 750

2007 2,200 10 260 410 770 300 1,750 450

Total 5,000 650 340 584 780 1,555 320 4,229 771

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Problem 10-52 (continued) 3.


L40 Revenues Costs Research and Development Prototypes Marketing Distribution Manufacturing Customer Serivce Total Cost Operating Profit L50 Revenues Costs Research and Development Prototypes Marketing Distribution Manufacturing Customer Serivce Total Cost Operating Profit 2005 800 0 1,400 350 60 60 20 1,890 (1,090) 2006 2,300 % 0 50 600 120 770 60 1,600 700 2007 3,100 % 0 0.0% 0.0% 475 23.3% 130 6.4% 1,350 66.2% 85 4.2% 2,040 1,060

% 74.1% 18.5% 3.2% 3.2% 1.1% 0.0%

$ 0.0% 3.1% 37.5% 7.5% 48.1% 3.8%

2005 $ 900 650 300 124 170 85 1,329 (429)

2006 $ 1,900 0 48.9% 22.6% 30 9.3% 200 12.8% 200 6.4% 700 0.0% 20 1,150 750

2007 $ 2,200 0 0.0% 2.6% 10 17.4% 260 17.4% 410 60.9% 770 1.7% 300 1,750 450

0.0% 0.6% 14.9% 23.4% 44.0% 17.1%

The analysis shows how the distribution of costs for both products shifts from research and development in the first year to manufacturing and customer service in the last year. The shift is most pronounced for L40 which has high development costs.

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10-53 Life Cycle Costing; Health Care; Discounting (30 min) If Cure-all were to manufacture the drug themselves, at a sales price of $235, the life-cycle costs would be the following: Price $235 Units Sold 3,000,000 Revenues $705,000,000 Costs R&D Clinical Trials Manufacturing Fixed Variable Packaging Fixed Variable Distribution Fixed Variable Advertising Fixed Variable Total Cost Operating Income $1,000,000 $2,108,000 $5,000,000 x 5 = $25,000,000 $68x3,000,000 = $204,000,000 $380,000 x 5 =$1,900,000 $20 x 3,000,000 = $60,000,000 $1,125,000 x 5 = $5,625,000 $6.50 x 3,000,000= $19,500,000 $2,280,000 x 5 = $11,400,000 $12 x 3,000,000= $36,000,000 $366,533,000 $338,467,000

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Problem 10-53 (continued) Outsourcing the manufacturing would result in the following life cycle costs assuming the cost as $235 per unit and the changes in the manufacturing costs: Price Units Sold Revenues Costs R&D Clinical Trials Manufacturing Fixed Variable Packaging Fixed Variable Distribution Fixed Variable Advertising Fixed Variable Total Cost Operating Income $235 3,000,000 $705,000,000 $1,000,000 $2,108,000 $1,500,000 x 5 =$7,500,000 $80 x 3,000,000= $240,000,000 $380,000 x 5 = $1,900,000 $60,000,000 $1,125,000 x 5 =$5,625,000 $19,500,000 $2,280,000 x 5 =$11,400,000 $36,000,000 $385,033,000 $319,967,000

Outsourcing the manufacturing results in a lower operating income than manufacturing the drug themselves.

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Problem 10-53 (continued) It appears that selling the drug patent is the best alternative since receiving $425,000,000 ($300,000,000 + $25,000,000 x 5) over the five year period is greater than the operating incomes of both the other options. However, in order to determine the real value of selling the patent one needs to consider the present value of the annuity stream, the $25,000,000 at the end of every year for the next 5 years. Assume a discount rate of 10%, and the present value of the five-year annuity (an annuity factor of 3.791 at 10%) is $25,000,000 x 3.791 = $94,775,000. Thus the total value of the sale of the patent is $94,775,000 + $300,000,000 = $394,775,000. The best alternative is selling the patent.

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10-54

Constraint Analysis; Flow Diagram (Appendix) (60 min)


1. Grace Vanders accelerated delivery schedule is unsatisfactory in

cutting 10 days from the total project schedule because not all of her crashed activities are included on the critical path. In order to reduce the completion time for a project, activities along the critical path need to be chosen to be crashed or reduced. Vanders selection of activities FJ, EF, and BG, which are on the critical path ABGEFJK, will reduce total project completion time only by three days but her selection of activities HJ, GH, CD, and DE have no impact on the critical path and thus will not reduce project time.

2. Below is a revised accelerated delivery schedule that meets both objectives: (1) delivery of the first plane two weeks (10 working days) ahead of schedule, and (2) at least incremental cost to Coastal. All the paths need to be evaluated when reducing a projects completion time. However, the selection of activities to crash should be taken from the critical path first and then the activities should be selected in order according to the smallest crash cost. The critical path now becomes ABCDEFJK and will take 57 days, having only reduced the total project completion date by eight days. Therefore, the activity CD (the next least costly available activity) needs to be crashed two days which will then bring all paths to 55 days or less. This analysis is shown in the tables below. The first path, ABGEFJK, crashed 10 days would cost $10,200, as shown below.
Activity Crashed START FJ EF JK BG AB GE Total Days Reduced 1 1 1 2 4 1 Incremental Cost per day $ 400 800 900 1,000 1,200 1,300 Incremental Cost $ 400 800 900 2,000 4,800 1,300 $10,200 ABGEFJK 65 64 63 62 60 56 55

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The second path, ABCDEFJK, which crashes less expensive activities, is less expensive overall, and thus a better crash schedule. The ABCDEFJK path, before crash, has a time of 64, so that the table begins with 64.
Activity Crashed START FJ EF JK AB CD Total Days Reduced 1 1 1 4 2 Incremental Cost per day $ 400 800 900 1,200 700 Incremental Cost $ 400 800 900 4,800 1,400 $8,300 ABCDEFJK 64 63 62 61 57 55

Note that the activities BG and GE are not crashed in the final solution because they are not on the critical path. Reducing time on these activities will not reduce the overall project time. 3. The total incremental costs Bob Peterson will have to pay for this revised accelerated delivery schedule amount to $8,300, or a new total project cost of $73,400 from the original $65,100, and a saving of 10 days.

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10-55 Production Planning and Control (30 min) There may be a happy ending to this story if Kristen and Bryan change the focus in the plant from productivity at each work station and meeting budgets to a focus on speed and throughput. The current emphasis on productivity at each work station has the effect that each employee has the incentive to work very hard to meet their productivity targets, without a consideration of the overall productivity of the entire plant. This is why work-in-process inventory builds up in places. Some operators are keen on moving the product through their work stations, and not concerned about what happens to it downstream. Also, the emphasis on meeting cost budgets (as in the case of the purchasing department manager), creates incentives to reduce costs in ways which can cause delays and defective products. The purchase of discounted material which apparently led to product defects is an example. The emphasis on individual productivity has other effects. Since it creates a focus only on moving product through individual processes, inadequate attention appears to be given to equipment maintenance or to the prevention of defects. There is insufficient attention to preventing quality defects. In contrast, there is excessive attention to correcting defects (re-work). To speed up the process, the rate of defects has to be reduced. The emphasis on correcting defects merely slows things down. Six-sigma firms such as Toyota and GE have learned it is less costly as well as faster to prevent defects rather than to spend time on inspection and re-work. Inspection and re-work are non-value adding processes that should be eliminated. Another unfortunate result of the cost allocation method in the plant is that department managers apparently have the incentive to reduce the amount of space in which they operate in order to reduce the overhead costs allocated to them. This means that some work stations, for example Eds, are possibly too small for efficient processing, leading to lower productivity and increased defects. Again, the focus of the accounting system has set things awry, and provided a dysfunctional incentive.

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Problem 10-55 (continued) To repair the situation, Kirsten and Bryan should refocus the plant on throughput and use a system like the theory of constraints. With the theory of constraints, managers and employees are rewarded for moving total product through the plant, not just through their individual work stations. Everyone in the plant has the incentive to look for bottlenecks and to find ways to reduce the effect of these bottlenecks. Moreover, employees have the incentive to work together to reduce the bottlenecks and improve throughput, since the focus is no longer on individual productivity, but on overall productivity, which is the plants ultimate goal.

Summary Presentation of Problem on Chalk Board: Problem Areas Manufacturing Outcomes Materials quality down Cramped space Focus on speed everywhere (no concern for downtime or throughput..) Defects up Profit Outcomes Costs up

Reduced Throughput WIP up

Orders delayed, some orders and profits lost Increased holding cost

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