CHAPTER 19

COSTING AND THE VALUE CHAIN

OVERVIEW OF EXERCISES, PROBLEMS, CASES,

AND INTERNET ASSIGNMENTS
Learning
Exercises Topic Objectives Characteristics
19–1 Accounting terminology 2, 3, 6 Conceptual
19–2 Value chain activities 1 Conceptual
19–3 Value-added activities 2, 3 Analytical, conceptual
19–4 Activity-based management 3 Analytical, mechanical
19–5 Target costing 4, 5 Mechanical
19–6 Just-in-time manufacturing 6 Mechanical, conceptual
19–7 Costs of quality 7 Mechanical, conceptual

Problems
19–1 Value-added activities 2, 6 Mechanical, conceptual
19–2 Activity-based management 2, 3, 4 Mechanical, conceptual, analytical
19–3 Target costing 4 Mechanical, analytical
19–4 Cost of quality 7 Mechanical, analytical
19–5 Value chain and costs 1-7 Conceptual, analytical, group

Cases
19–1 Activity-based management 2, 3, 4 Analytical, mechanical, conceptual
19–2 Just-in-time, value-added 1, 2, 6 Conceptual, analytical, group, ethics
activities

Business Week
Assignment
19–3 Business Week assignment: 1-7 Mechanical, conceptual, group, real
Eliminating non-value-added
activities

Internet
Assignment
19–1 Innovation and the value chain 1, 4, 5 Conceptual, analytical
19–2 Value chain reengineering 1-7 Conceptual, analytical

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DESCRIPTIONS OF PROBLEMS, CASES,
AND INTERNET ASSIGNMENTS
Below are brief descriptions of each problem, case, and the Internet assignments. These descriptions are
accompanied by the estimated time (in minutes) required for completion and by a difficulty rating. The time
estimates assume use of the partially filled-in working papers.

Problems
19–1 Castner Corporation 30 Medium
Identifying how value-adding activities can improve efficiency. The problem
also has an ethical component that requires students to decide if a company
should attempt to improve efficiency by downsizing. This is a good group
discussion problem.

19–2 The Kallapur Company 60 Strong

Comprehensive target costing problem that illustrates how the method used to
allocate fixed overhead affects the manufacturing cost per unit assigned to
different products. Activity-based management is also used in making
decisions on how to reach a target cost.

19–3 Meiger Mining 30 Medium

A target costing problem that requires the student to analyze an alternative
offered for reaching the desired target cost.

19–4 Arusetta, Inc. 40 Medium

A cost of quality problem that requires the construction of a categorical cost of
quality report. The student is also asked to analyze changes in specific quality
costs in light of the implementation of a total quality management program.

19–5 Tootise Roll Industries, Inc. 30 Medium

Students read the corporate principles and management discussion to find
references to Tootsie Roll’s value chain.

Cases
19–1 Mays Electronics 50 Medium
A target costing and activity-based management problem that requires students
to analyze the effects of several actions. Also illustrates how suggestions for
cost reductions can be elicited from numerous sources, such as suppliers,
customers, and employees.

19–2 Just-In-Time Frozen Dinners 40 Strong

Determining inefficiencies of a company by isolating value-adding and non–
value-adding activities.

108 © The McGraw-Hill Companies, Inc., 2005

Business Week Assignment
19–3 Business Week Assignment: Dell Computer Company 30 Medium
Students compute efficiency ratios for Dell Computer. Then students use the
opening story to pinpoint operating methods used by Dell that affect the ratios.

Internet Assignments
19–1 3M Corporation 30 Medium
Shows how one firm supports employee innovation. The student is asked to
relate these programs to various concepts covered in the chapter, such as life-
cycle costing and target costing.

19–2 Manufacturing Engineering, Inc. 30 Medium

Students are asked to access a sample reengineering project and assess the
usefulness of cost information.

Solutions Manual Vol. II, Financial and Managerial Accounting 13/e, Williams et al 109
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
1. Three criteria for successful business process management are: 1) focus on the core operations of the
business; 2) seek ways in which to drive costs out of these core operations; and 3) pay careful attention
to the needs of customers in order to create customer satisfaction.
2. A typical value chain begins with the research and development or product design stage. In this stage
new products, processes, and services are designed to meet customer needs. The next stage involves
the procurement of supplies and actual production. The marketing and distribution stage involves
providing customers with relevant information about the product and devising ways to get the product
to the customer. Activities in this stage include advertising and deciding whether to sell the product
through retail stores, mail order, and/or dealer networks. A fourth stage in a typical value chain
includes all aspects of customer service. Most activities in this stage take place after a product has been
sold, including warranty or repair work and technical support.
3. The R&D and design component of the value chain would include all activities pertaining to the type,
location, menu, and service characteristics of the new restaurant. Examples include (but are not limited
to): 1) researching what types of food are served in existing restaurants (Italian, Chinese, American,
etc.) and what level of service is offered (full service, buffet, fast food, etc.). This step could also
include surveying residents in the area as to their needs/desires for new restaurants; 2) searching for an
appropriate location for the restaurant; 3) developing specific menu items and recipes once the type of
food has been chosen; 4) decorating the interior of the restaurant to create the desired atmosphere.
4. The marketing component of a fire department’s value chain would include all activities designed to
educate citizens on how to reach the department and for which types of emergencies they should be
called. These activities could include (but are not limited to): 1) visits to inform school children on
when and how to call the fire department; 2) the use of public service announcements on radio and TV;
3) the inclusion of phone numbers on fire trucks, in phone books, and on public telephones.
Distribution would involve activities to ensure the department’s prompt response to emergencies by
getting personnel and equipment to where they are needed. These activities could include the use of
dispatch systems, priority rules for deciding the order in which calls are attended to, and the use of
mapping systems to help personnel locate the scene of an emergency.
5. Value-added activities add to the product’s or service’s desirability in the eyes of the consumer.
Customers would conceivably be willing to pay more for a product where such activities have taken
place, as compared to the same product where the activity has not taken place. One example is product
assembly. Non–value-added activities do not increase a product’s desirability. Customers are generally
not willing to pay explicitly for these types of activities. One example is the moving of goods from the
factory to the warehouse to await shipment. This activity in and of itself does not provide the customer
with any value.
6. The storage of the stereos results in explicit costs such as the cost of renting/owning the warehouse
space and the wages of personnel that move and watch over the inventory. There are also insurance
costs, as well as the possibility of theft and breakage. Additionally, there is the opportunity cost
involved in having capital tied up in the unsold inventory.
7. The overall objective of target costing is to provide an organization with a production process that
provides adequate profits on a product or service. After a target price and desired level of profit are
determined, the target cost is calculated that will yield the desired profit. If estimated costs are higher
than the target costs, efforts are undertaken to reduce them to the target level.

110 © The McGraw-Hill Companies, Inc., 2005

 8. Target costing is better applied at the earliest stages of the value chain because it is estimated that 80%
of production-related expenses are committed once production commences. It is much easier to design
a product and its related production process to meet a target cost than it is to reduce costs once
production has begun.
9. The objective of activity-based management is to use activity-based information, including costs, to
reduce and eliminate non-value-added activities throughout the entire value chain. The objective of
activity-based costing is mainly to assign production costs to individual products.
10. A JIT manufacturing system is a system of acquiring direct materials and scheduling production
processes “just in time” to meet customer demand. The basic goal of a JIT system is to minimize
non-value-added activities, such as storing inventory. Due to the lack of inventory, however, high
product quality also becomes an essential goal of a JIT system.
11. In a JIT system, goods are produced only in sufficient quantity to meet customer demand. Therefore,
the goods must be “defect-free,” or the company will be unable to meet demand. In contrast, in a
traditional system sizable inventories provide the manufacturer with a “cushion”; if defects are
discovered in finished goods, the company can still fill customer orders out of inventory. Thus, quality
is less critical in a traditional system than in a JIT system.
12. The idea behind JIT is to minimize not only inventory but also all non-value-added activities. Also,
with minimal inventories to serve as a reserve, a JIT system requires a high degree of commitment to
quality and to on-schedule production throughout the organization. The term philosophy reflects the
fact that people and departments throughout the organization must work together to achieve the goals
of a JIT system.
13. Prevention costs consist of the costs incurred by an organization to prevent defects from occurring.
Examples of prevention costs include employee training, efforts to design quality into the product or
production process, process quality audits, and the costs of evaluating supplier quality. Appraisal costs
are incurred to ensure that products conform to quality standards. The most common appraisal costs are
associated with product or raw materials inspections. Internal failure costs are incurred to correct low
quality output. Internal failure costs include extra production costs related to rework, retesting, and
reinspection, as well as the cost of scrap from items that cannot be repaired. External failure costs are
incurred when low quality output is allowed to enter the market and is purchased by consumers. These
costs include sales returns and allowances, warranty work, liability claims, lost sales, and the reduced
goodwill of customers.
14. Life-cycle costing consists of estimating the total costs incurred by a customer from the time of
purchase through final disposal of a proposed product. It is important to the target costing process
because it helps the firm establish the overall value the product will provide to a customer, which in
turn influences the price the customer would be willing to pay for it.
15. To become ISO 9000 certified, a firm must have a third party perform a detailed audit of the firm’s
processes and procedures related to quality conformance. Explicit documentation of the procedures
must also be prepared and audited.

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 SOLUTIONS TO EXERCISES

Ex. 19–1 a. Non-value-added activity

b. None (It is more accurately described as activity-based costing.)
c. Value engineering
d. Life-cycle costing
e. Value-added activity
f. Activity-based management
g. None (It is typically described as cost plus pricing.)
h. Total quality management
i. Just-in-time manufacturing system

Ex. 19–2 a. Research and development activities of a management accountant might include
asking managers what types of information they need to make decisions and what
format would be the easiest for them to use. It could also include determining how well
the firm’s information system meets the needs of the managers and how it could be
improved.

b. Production activities would include the generation of cost reports, performing special
analyses, aiding in management decision making, evaluating performance, and
suggesting ways in which activities could be managed more efficiently.

c. Marketing activities would include efforts to inform managers about what types of
information are available from the management accounting system and how the
information can be used in decision making.

d. The customer service activities of a management accountant would include asking

managers whether the information provided is useful in their decision making and
whether it is in an easy to understand format. It might also include providing detailed
explanations of specific data items or the assumptions underlying the reports.

Ex. 19–3 1. Value-added

2. Non-value-added. Although the materials must be unloaded, it would be more effi-
cient if they were delivered straight to the Cutting Department as they were needed.
3. Non-value-added. The cost and/or time required to verify purchase orders could be
minimized by employing a bar coding system rather than visually counting items.
4. Non-value-added. The need for an inspection could be eliminated by having the
supplier guarantee the quality of the items delivered.
5. Non-value-added. The process of obtaining raw materials could be speeded up by
using an electronic ordering system connected directly to the supplier.
6. Non-value-added. This step could be eliminated if raw materials could be delivered
by the supplier directly to the Cutting Department.
7. Value-added
8. Non-value-added. This step could be eliminated if cut materials were produced and
delivered to the Assembly Department as needed.

112 © The McGraw-Hill Companies, Inc., 2005

 9. Non-value-added. The process of obtaining cut materials could be improved by elec-
tronically signaling the Cutting Department to produce and send over more materials.
10. Non-value-added. This additional movement could be eliminated if raw materials
were delivered directly from the Cutting Department.
11. Value-added

Ex. 19–4 a. BLAKE FURNITURE, INC.

Accounts Receivable Department
Activity Category
Billing and Financial
Labor Recording Customer Reporting Delinquent Total Labor
Category Payments Service & Analysis Accounts Resources
Manager ¼ time ¼ time ¼ time ¼ time
$15,000 $15,000 $15,000 $15,000 $ 60,000
Clerks ½ time ¼ time ¼ time 0
$75,000 $37,500 $37,500 $0 $150,000
Account 0 ¼ time ¼ time ½ time
Specialists $0 $20,000 $20,000 $40,000 $ 80,000
Total Activity
Resources $90,000 $72,500 $72,500 $55,000 $290,000

b. In addition to handling delinquent account activities, the account specialists perform cus-
tomer service activities and analysis activities that are not covered by the contract from
Paypro. Thus, the $80,000 in salary savings is an overestimate. If the contract were
accepted, Blake would still need one full-time specialist to perform these additional activ-
ities at a salary of $40,000 and the change would not save any of the manager's time.
Thus, if the contract were accepted, Blake would pay Paypro $50,000 while only saving
$40,000 in salary costs, for a net increase of $10,000. Based on the activity analysis, the
contract from Paypro should not be accepted.

Ex. 19–5 a. Target Cost = Target Price − Target Profit

Target Price = $40
Target Profit = .2 × $40 = $8
Target Cost = $40 − $8 = $32

b. Since the competitor is selling essentially the same product for $36, On Point should set
its target price at that level to remain competitive.
Target Cost = Target Price − Target Profit
Target Price = $36
Target Profit = .2 × $36 = $7.20
Target Cost = $36 − $7.20 = $28.80

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 c. The original estimated selling price of $40 would yield a profit of $8 per unit once the
target cost had been achieved. Total yearly profits would be:
20,000 units × $8 = $160,000
At a selling price of $36, the profit per unit once the target cost had been reached
would be $7.20. Total yearly profits under this price would be:
21,000 units × $7.20 = $151,200
Thus, total yearly profits would be lower under the $36 selling price.

Ex. 19–6 a. The only value-added activities are assembly and painting.

b. Total cycle is 20 days (5 + 6 + 3 + 2 + 3 + 1)

c. Manufacturing Value-Added Time (3 days in assembly + 3 days in painting)

= =
Efficiency Ratio Total Cycle Time 20 days
= 6/20 = 30 %

d. JIT and TQM implementation would allow for the elimination of inspection and storage
time, which would reduce cycle time to 9 days (20 − 5 − 6). Nanner’s new manufacturing
efficiency ratio would be:

Manufacturing Value-Added Time (3 days in assembly + 3 days in painting)

= =
Efficiency Ratio Total Cycle Time 9 days
= 6/9 = 66.67%

Ex. 19–7 a. LUMBLE MANUFACTURING

Quality Cost Report
For the Year Ended Dec. 31, 20__
Prevention costs:
Machine maintenance............................................................................................. $ 2,000
Appraisal costs:
Inspections ............................................................................................................... $12,000
Internal failure costs:
Scrap and rework ............................................................................... $ 8,000
Machine repair.................................................................................... 4,000 $12,000
External failure costs:
Warranties........................................................................................... $22,000
Returns................................................................................................. 6,000
Lost sales.............................................................................................. 5,000 $33,000
Total quality costs ............................................................................................... $59,000

b. Prevention and Appraisal Costs ($2,000 + $12,000) $14,000

= = = 5.6%
as a Percentage of Sales $250,000 $250,000

c. Internal and External Failure ($12,000 + $33,000) $45,000

= = = 18%
Costs as a Percentage of Sales $250,000 $250,000

114 © The McGraw-Hill Companies, Inc., 2005

 SOLUTIONS TO PROBLEMS
30 Minutes, Medium PROBLEM 19–1
CASTNER CORPORATION

a. Value-added production activities:

Cutting materials
Bending materials
Assembling finished products
Painting finished products

b. Non-value-added production activities:

Inspecting materials
Storing materials
Moving materials into production
Setting up production equipment

c. Total cycle time:

Production Activity Number of Days

Inspecting materials................................................................................................ 3
Storing materials..................................................................................................... 17
Moving materials into production......................................................................... 3
Setting up production equipment .......................................................................... 2
Cutting materials .................................................................................................... 6
Bending materials ................................................................................................... 5
Assembling finished products ................................................................................ 9
Painting finished products ..................................................................................... 5
Total cycle time ....................................................................................................... 50 days

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 PROBLEM 19–1
CASTNER CORPORATION (concluded)

d. Manufacturing efficiency ratio:

Value-Added Time ÷ Total Cycle Time
Castner’s total cycle time was computed in part c above. Its value-added time is shown below:

Value-Added Activity Days

Cutting materials ................................................................................................................ 6
Bending materials ............................................................................................................... 5
Assembling finished products ............................................................................................ 9
Painting finished products ................................................................................................. 5
Total value-added time....................................................................................................... 25 days

Given total value-added time of 25 days and a total cycle time of 50 days, Castner’s manufacturing
efficiency ratio must be 50%:
25 days ÷ 50 days = 50%

e. The following activities might be reduced or eliminated if Castner implements a JIT system:
Inspecting materials—reduced or eliminated
Storing materials—possibly reduced or eliminated
Moving materials into production—reduced

f. There is no simple answer to this question. It may be argued that Castner does indeed have a
responsibility to those employees who have devoted their careers to the company. It may also be
argued that the company has an ethical responsibility to its shareholders and should make what-
ever decisions are necessary to maximize shareholder wealth. Management should try to find new
positions for these employees within the company before laying them off. If no other positions are
available, they will be faced with a difficult decision regarding downsizing activities.

116 © The McGraw-Hill Companies, Inc., 2005

60 Minutes, Strong PROBLEM 19–2
THE KALLAPUR COMPANY

a. Target Cost: KAP1

Target Cost = Target Price − Target Profit
Target Price = $120
Target Profit = .15 × $120 = $18
Target Cost = $120 − $18 = $102

Target Cost: QUIN

Target Cost = Target Price − Target Profit
Target Price = $220
Target Profit = .15 × $220 = $33
Target Cost = $220 − $33 = $187

b. If fixed overhead is allocated based on units of production, the fixed overhead cost per unit is
equal to $50 calculated as follows:

Allocation Rate Fixed Overhead $2,000,000

= =
per Unit Total Units of Production 25,000 + 15,000 = $50 per unit

Total manufacturing cost per unit:

KAP1 QUIN
Direct materials cost per unit.............................................................................. $ 30 $ 45
Direct labor cost per unit .................................................................................... 24 60
Variable overhead cost ........................................................................................ 6 15
Fixed overhead cost ............................................................................................. 50 50
Total manufacturing cost per unit.............................................................. $110 $170

Since the cost per unit of KAP1 is above the target cost of $102, it is not earning the desired 15%
return. The cost per unit of QUIN is well below the target cost of $187, so it is earning a return
greater than the desired rate.

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 PROBLEM 19–2
THE KALLAPUR COMPANY (continued)

c. Given that it takes 2 hours ($24 total labor cost per unit/$12 per hr. wage rate) to produce each
unit of KAP1 and 5 hours ($60 total labor cost per unit/$12 per hr. wage rate) to produce each
unit of QUIN, the total expected labor hours needed for the year are:

25,000 units of KAP1 × 2 hours per unit

+ 15,000 units of QUIN × 5 hours per unit
= 50,000 hours + 75,000 hours
= 125,000 hours

If fixed overhead is allocated on the basis of direct labor hours, the allocation rate per hour is
equal to $16 calculated as follows:

Allocation Rate Fixed Overhead $2,000,000

= = = $16 per hour
per Unit Total Direct Labor Hours 125,000 hours

Total manufacturing cost per unit:

KAP1 QUIN
Direct materials cost per unit.............................................................................. $30 $ 45
Direct labor cost per unit .................................................................................... 24 60
Variable overhead cost ........................................................................................ 6 15
Fixed overhead cost (2 hours × $16/hr, 5 hours × $16/hr)................................ 32 80
Total manufacturing cost per unit.............................................................. $92 $200

Since the cost per unit of KAP1 is below the target cost of $102, it is earning a return greater than
the desired rate. The cost per unit of QUIN is above the target cost of $187, so it is not earning the
desired return.

118 © The McGraw-Hill Companies, Inc., 2005

 PROBLEM 19–2
THE KALLAPUR COMPANY (continued)

d. The allocation rates of each overhead activity are calculated as follows:

Overhead Cost
Allocation Rate per Unit of Activity =
Total Activity Units

$400,000
Machine Setups: Rate per Setup = = $800 per Setup
(100 + 400)

$600,000
Purchase Orders: Rate per Order = = $2,000 per Purchase Order
(200 + 100)

$500,000
Machining: Rate per Machine Hour = = $62.50 per Machine Hour
(2,000 + 6,000)

$200,000
Inspection: Rate per Batch = = $2,500 per Batch
(50 + 30)

$300,000
Shipping: Rate per Shipment = = $600 per Shipment
(300 + 200)

Total fixed overhead allocated per unit:

KAP1 QUIN
Setup costs (100 × $800, 400 × $800) ............................................................ $ 80,000 $ 320,000
Purchase orders (200 × $2,000, 100 × $2,000) ............................................. 400,000 200,000
Machining (2,000 × $62.50, 6,000 × $62.50)................................................. 125,000 375,000
Inspection (50 × $2,500, 30 × $2,500)............................................................ 125,000 75,000
Shipping (300 × $600, 200 × $600) ................................................................ 180,000 120,000
Total fixed overhead allocated...................................................................... $ 910,000 $ 1,090,000
÷ units produced............................................................................................. ÷ 25,000 ÷ 15,000
Fixed overhead cost per unit......................................................................... $36.40 $72.67

Total manufacturing cost per unit:

KAP1 QUIN
Direct materials cost per unit.............................................................................. $30 $ 45
Direct labor cost per unit .................................................................................... 24 60
Variable overhead cost ........................................................................................ 6 15
Fixed overhead cost ............................................................................................. 36.40 72.67
Total manufacturing cost per unit.............................................................. $96.40 $192.67

Since the cost per unit of KAP1 is below the target cost of $102, it is earning a return greater than
the desired rate. The cost per unit of QUIN is above the target cost of $187, so it is not earning the
desired return.

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 PROBLEM 19–2
THE KALLAPUR COMPANY (continued)

e. The only fixed overhead activities that are value-added are machining and shipping. The propor-
tion of these costs to total fixed overhead is:
($500,000 + $300,000)/$2,000,000 = 40%.
Reducing the number of setups needed to product QUIN would be a logical activity to start with in
trying to reach the target cost. This activity is non-value-added and QUIN appears to require a
disproportionate number of them.

f. Reducing the number of setups required for one product while not reducing the related overhead
cost will change the allocation rate per setup and the total manufacturing cost per unit for each
product.

$400,000
New allocation rate per setup = = $3,200 per setup
(100 + 25)

Total fixed overhead allocated per unit:

KAP1 QUIN
Setup costs (100 × $3,200, 25 × $3,200) ........................................................ $ 320,000 $ 80,000
Purchase orders (200 × $2,000, 100 × $2,000) ............................................. 400,000 200,000
Machining (2,000 × $62.50, 6,000 × $62.50)................................................. 125,000 375,000
Inspection (50 × $2,500, 30 × $2,500)............................................................ 125,000 75,000
Shipping (300 × $600, 200 × $600) ................................................................ 180,000 120,000
Total fixed overhead allocated...................................................................... $ 1,150,000 $ 850,000
÷ units produced............................................................................................. ÷ 25,000 ÷ 15,000
Fixed overhead cost per unit......................................................................... $46 $56.67

Total manufacturing cost per unit:

KAP1 QUIN
Direct materials cost per unit.............................................................................. $ 30 $ 45
Direct labor cost per unit .................................................................................... 24 60
Variable overhead cost ........................................................................................ 6 15
Fixed overhead cost ............................................................................................. 46 56.67
Total manufacturing cost per unit.............................................................. $106 $176.67

Since the cost per unit of KAP1 is above the target cost of $102, it will not earn the desired 15%
return. The cost per unit of QUIN is below the target cost of $187, so it will earn a return greater
than the desired rate.

120 © The McGraw-Hill Companies, Inc., 2005

 PROBLEM 19–2
THE KALLAPUR COMPANY (concluded)

g. With the new machine, the allocation rate per setup is calculated as follows:
$200,000
New allocation rate per setup = = $2,000 per setup
(20 + 80)

Total fixed overhead allocated per unit:

KAP1 QUIN
Setup costs (20 × $2,000, 80 × $2,000) ............................................................ $ 40,000 $ 160,000
Purchase orders (200 × $2,000, 100 × $2,000) ............................................... 400,000 200,000
Machining (2,000 × $62.50, 6,000 × $62.50)................................................... 125,000 375,000
Inspection (50 × $2,500, 30 × $2,500).............................................................. 125,000 75,000
Shipping (300 × $600, 200 × $600) .................................................................. 180,000 120,000
Total fixed overhead allocated........................................................................ $ 870,000 $ 930,000
÷ units produced............................................................................................... ÷ 25,000 ÷ 15,000
Fixed overhead cost per unit........................................................................... $34.80 $62

Total manufacturing cost per unit:

KAP1 QUIN
Direct materials cost per unit.............................................................................. $30 $ 45
Direct labor cost per unit .................................................................................... 24 60
Variable overhead cost ........................................................................................ 6 15
Fixed overhead cost ............................................................................................. 34.80 62
Total manufacturing cost per unit.............................................................. $94.80 $182

The machine should be purchased because total manufacturing costs can be reduced by $200,000,
which will increase profits by $200,000. If QUIN is redesigned, there will be no increase in profits,
just a reallocation of fixed costs between the two products.

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30 Minutes, Medium PROBLEM 19–3
MEIGER MINING

a. Target Cost = Target Price − Target Profit

Target Price = $8
Target Profit = .2 × $8 = $1.60
Target Cost = $8 − $1.60 = $6.40

b. Site A Site B
Total cost per ton:
Variable costs ................................................................................................... $3.80 $4.00
Fixed costs ($440,000/200,000 tons; $480,000/160,000 tons) ........................ 2.20 3.00
Total cost per ton ......................................................................................... $6.00 $7.00

Thus, to meet the demanded 20% return, only Site A should be opened since its cost per ton is less
than the target cost of $6.40. Site B, with costs of $7.00 per ton, will not generate the desired
return.

c. If the conveyor is purchased, the total fixed costs associated with Site B will increase by $35,000
($25,000 purchase price plus $10,000 in additional restoration costs) to a total of $515,000. Thus,
the cost per ton of operating Site B would be:

Variable costs per ton .............................................................................................................. $3.00

Fixed costs per ton ($515,000/160,000 tons) .......................................................................... 3.22
Total cost per ton ............................................................................................................. $6.22

If the conveyor is purchased, the resulting cost per ton for Site B will be below the $6.40 target
cost and the mine will generate a sufficient return. Thus, the conveyor should be purchased and
Site B opened.

122 © The McGraw-Hill Companies, Inc., 2005

40 Minutes, Medium PROBLEM 19–4
ARUSETTA, INC.
a. ARUSETTA, INC.
Quality Cost Report

2004 2005
Prevention costs:
Product design $ 5 0 0 0 $ 1 5 0 0 0
Process reengineering 8 0 0 0 1 2 0 0 0
Supplier certification 5 0 0 2 5 0 0
Preventive maintenance 1 3 0 0 2 6 0 0
Quality training 1 2 0 0 4 0 0 0
Total prevention costs $ 1 6 0 0 0 $ 3 6 1 0 0
Appraisal costs:
Raw materials inspections $ 4 8 0 0 $ 2 3 0 0
Final inspections 1 0 0 0 0 7 0 0 0
Total appraisal costs $ 1 4 8 0 0 $ 9 3 0 0
Internal failure costs:
Scrap $ 2 0 0 0 $ 1 2 0 0
Rework 3 1 0 0 2 8 0 0
Equipment repair 8 5 0 0 3 0 0 0
Total internal failure costs $ 1 3 6 0 0 $ 7 0 0 0
External failure costs:
Warranty expense $ 2 2 0 0 0 $ 1 8 5 0 0
Liability claims 5 0 0 0 8 5 0 0
Returns 7 0 0 0 4 5 0 0
Lost sales 1 0 0 0 0 1 0 0 0 0
Total external failure costs $ 4 4 0 0 0 $ 4 1 5 0 0

Total quality costs $ 8 8 4 0 0 $ 9 3 9 0 0

b. Prevention costs increased by $20,100 from 2004 to 2005 but external failure costs only decreased
by $2,500. One explanation for this somewhat surprising result is that a high proportion of the
external failure costs are made up of warranty expense and product liability claims. These costs
likely still include products that were made before the TQM program was started. It is
encouraging that product returns, which are comprised of the most recently sold/produced
products, has dropped significantly. Overall, it may take several years before the program’s
impact on external failure costs is known.

c. Yes, the increase in maintenance costs was justified. Repair costs decreased by $5,500, while
maintenance costs only increased by $1,300.

d. Lost sales due to quality problems are often the result of a poor reputation. It may take several
years from the time a successful quality program is implemented for a firm to improve its
reputation. In the meantime, sales will continue to be lost due to past poor quality.

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30 Minutes, Medium PROBLEM 19–5
TOOTSIE ROLL INDUSTRIES

a. Evidence about management concerns about the value chain:

R & D and Design. From p. 1, one of the Corporate Principles states “We invest in the latest and
most productive equipment.” Additional support is discussed on page 5 under manufacturing
where $14 million in capital projects includes projects to reengineer two major production lines.
In addition, under Sales and Marketing, p. 3, two new products were introduced; Black Ice, a new
flavor for the Blow Pop Line and a new product, Fluffy Stuff Cotton Candy Pops. The stated
corporate principles, reengineering efforts and new product lines provide evidence of an active
R&D and design component of their value chain.

Suppliers and Production. Two of the Corporate Principles, p. 1, support production efficiencies.
First, they state: “We run a trim operation and continually strive to eliminate waste, minimize cost
and implement performance improvements” and second, “We invest in the latest and most
productive equipment to deliver the best quality product to our customers at the lowest cost.
These statements show management’s concern for production efficiencies. In addition the
reengineering projects discussed above also show concern for production efficiencies. Regarding
suppliers, management identifies and comments on p. 5 under Purchasing, the suppliers of cocoa,
corn syrup, raw and refined sugar, packaging (corrugated and printed film) and their impact on
business.

Distribution and Marketing. The final Corporate Principle on page 1 states “We view our well
known brands as prized assets to be aggressively advertised and promoted to each new generation
of consumers.” In addition, in the extensive Sales and Marketing section the following evidence
can be found: 1) evidence about targeted promotional programs to shippers, retailers and other
consumers, 2) Line extensions for Tootsie Pop, Andes, Junior Mints, etc., 3) Thank you comments
on p. 5 include sales brokers and foreign distributors.

Customer Service. Although the final Corporate Principle is about promoting brands to
consumers, there is no mention of customer service in the principles section. In fact, customer
service is the part of the value chain least discussed by management.

b. Three Corporate Principles suggest cost information is important in managing the value chain:
• We run a trim operation and continually strive to eliminate waste, minimize cost and
implement performance improvements—Non-value-added activities, ABC and ABM and
JIT.
• We invest in the latest and most productive equipment to deliver the best quality product
to our customers at the lowest cost—total quality management, ABM, target costing.
• We seek to outsource functions where appropriate and to vertically integrate operations
where it is financially advantageous to do so—ABM.

124 © The McGraw-Hill Companies, Inc., 2005

 SOLUTIONS TO CASES
50 Minutes, Medium CASE 19–1
MAYS ELECTRONICS

a. Activity Classification
Setups Non-value-added
Material handling Non-value-added
Inspection Non-value-added
Customer support Value-added
Customer complaints Non-value-added
Warranty expense Non-value-added
Storage Non-value-added
Rework Non-value-added
Direct materials Value-added
Utilities Value-added
Manual insertion labor Value-added
Other direct labor Value-added

Note: Utilities costs are generally considered value-added because they are necessary to run
machinery and support direct labor workers, both of which are value-added activities.

b. Cost of non-value-added activities:

Activity Cost
Setups $125,000
Material handling 180,000
Inspection 122,000
Customer complaints 100,000
Warranty expense 170,000
Storage 80,000
Rework 75,000
Total non-value-added costs $852,000

Non-value-added cost per unit: $852,000/120,000 units = $7.10 per unit. If all non-value-added
costs could be eliminated, the cost per unit would decrease by $7.10. Thus, the consultant’s
estimate was theoretically correct.

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 CASE 19–1
MAYS ELECTRONICS (concluded)

c. To maintain current market share, the selling price per CB must drop to $14. Given a target
profit of $4, the target cost per CB equals $10 ($14 − $4). The current cost per unit is $16
($1,920,000/120,000 units) so to reach the target, costs must be reduced by $6 ($16 − $10).

To increase market share by 50%, the selling price per CB must drop to $12. Given a target profit
of $4, the target cost per CB equals $8 ($12 − $4). The current cost per unit is $16
($1,920,000/120,000 units) so to reach the target, costs must be reduced by $8 ($16 − $8).

d. The net cost reduction of switching to automated insertion is $100,000 ($90,000 + $20,000 +
$40,000 − $50,000). The per unit cost reduction would be $.83 ($100,000/120,000 units). To main-
tain current market share, the cost per unit must be reduced by $6 from part c. Switching to auto-
mated insertion does not result in enough cost savings to reach the target cost.

e. Total net cost reduction:

Net cost reduction

Automated insertion $100,000 (from part d)
Factory redesign 90,000 ($100,000 + $10,000 − $20,000)
Leasing machine 65,000 ($80,000 − $15,000)
Just-in-time system 40,000 ($45,000 − $5,000)
Quality training and bonus 207,000 ($122,000 + 120,000 − $35,000)
Total net cost reduction $502,000
The total net cost reduction per unit equals $4.18 ($502,000/120,000 units). From part c, the cost
per unit needed to be reduced by $6, so even with the combined actions, the target cost has still not
been reached.

126 © The McGraw-Hill Companies, Inc., 2005

40 Minutes, Strong CASE 19–2
JUST-IN-TIME FROZEN DINNERS

a. A JIT manufacturing system is a “demand pull” system, in which materials are acquired and units
are produced only at the time and in the quantity necessary to meet customer demand. The basic
goals of the system are to increase efficiency by minimizing non-value-added activities and also to
increase product quality.

b. Non-value-added activities in Healthy Time’s operations and costs that might be eliminated:

— Materials storage is a non-value-added activity. The company stores in its warehouse enough
direct materials for approximately two weeks’ production. Reduction or elimination of this
inventory would reduce the costs of carrying inventory, including the cost of capital tied up in
inventory and the costs of maintaining storage facilities.
— The fresh-freezing equipment is idle four days each week. If smaller shipments were received
and frozen daily, possibly the company could reduce the amount of equipment needed for this
production process.
— Transporting materials, work in process, and finished goods back and forth between the ware-
house and the factory is a non-value-added activity. If materials were delivered directly to the
factory, sent directly through all processing departments, and then shipped from the factory,
the costs of shuttling inventory between the warehouse and factory could be eliminated. These
costs include the labor and equipment involved in the transportation process. Also, elimination
of the entire warehouse facility might be coupled with elimination of the need for
transportation.
— Excess production is a non-value-added activity. The company currently produces 2,000 units
per day in excess of its sales. Limiting production to demand would reduce all manufacturing
costs and also finished goods storage costs.

c. Description of a JIT system for Healthy Times:

The company operates from a single location—what is now the factory. Production and receipt of
direct materials are scheduled for each day of the week one week in advance. Each day’s produc-
tion is scheduled to fill specific customer orders. Direct materials are delivered daily to the factory
in the quantities needed for the day’s scheduled production.
Materials flow directly through the entire production cycle in one day. At the end of the day, the
day’s production is shipped by independent carrier to specific customers.
A small storage freezer at the factory contains a two-day supply of direct materials and also has
the capacity to store one day’s production of finished goods. This freezer serves as “insurance”
against a temporary interruption in supplies or delays in making shipments.

d. A JIT system should work at Healthy Times. Customer orders are received at least a week in
advance of delivery dates, which facilitates scheduling. Materials are available in abundance from
local suppliers. Therefore, it should be possible to arrange for reliable daily deliveries of materials.
Apparently all processing, including freezing and cutting, can be completed in one day, thus
eliminating the need for storage facilities. As deliveries are shipped by independent carriers, ship-
ments could be made on a daily basis from the factory as easily as from the warehouse.

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30 Minutes, Medium CASE 19–3
BUSINESS WEEK ASSIGNMENT:
DELL COMPUTER COMPANY

a. Inventory Turnover Rate = (Cost of Goods Sold ÷ Average Inventory) =

($27.7 billion÷$288 million) = 96.2 turns per year.
Days to Sell Inventory = (365 days ÷Inventory Turnover Rate)=(365÷96.2)= 3.8 days.

Receivables Turnover Rate=(Net Sales ÷ Average Accounts Receivable)=

($33.73 billion ÷ $2.482 billion) = 13.59 turns per year.
Days to Collect Receivables=(365 days ÷ Receivables Turnover Rate) =
(365 ÷ 13.59) = 27days.

b. Dell uses what they call a “direct business model”. They sell directly to customers without using
retail establishments. Thus when a customer buys a computer, it is immediately charged to the
credit card and Dell converts that credit card money into cash very quickly without having to wait
for a report from a retail establishment. In addition, Dell builds computers to order so it does not
have inventory in process sitting around. Finally, Dell manages its supply chain by expecting just
in time delivery that also reduces inventory on hand.

128 © The McGraw-Hill Companies, Inc., 2005

 SOLUTION TO INTERNET ASSIGNMENTS
30 Minutes, Medium INTERNET 19–1
3M

a. 3M’s web site has a long list of different innovations. However, the majority of these innovations
are changes in existing production processes or in characteristics of existing products. Thus the
innovations are usually targeted at the manufacturing phase of the value chain.

b. Many, but not all of the innovations discuss the fact that a team was involved in creating the
innovation.

c. Given that many of the innovations target existing products or processes, target costing would
likely be an effective tool to help with the reengineering process.

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30 Minutes, Medium INTERNET 19–2
MANUFACTURING ENGINEERING, INC.

a. The web site has a long list of different sample solutions. However, the majority of the samples are
changes in existing production processes or in characteristics. Thus the samples typically target
the manufacturing or production phase of the value chain.

b. Benefits vary, but frequently involve increased productivity and reduced wait time and
inventories in process.

c. Given that many of the sample descriptions target existing products or processes, target costing
and activity based management would likely be an effective tool to help with the reengineering
process.

130 © The McGraw-Hill Companies, Inc., 2005