Trimester 2, 2017 | ACC804 Advanced Management Accounting

Week 5 Lecture Illustration Example

Example: 1 Just-in-time purchasing, cost savings: manufacturer

(Adapted from Langfield-Smith, 2012, p. 727)

Pacific Player Ltd has recently decided to adopt a just-in-time inventory policy to curb its steadily rising
costs and to free up cash for investment. The company anticipates that inventory will decrease from
$3,600,000 to $600,000, and the freed up funds can be invested at 8 per cent annum. The following data
applies:
- Reduced inventory should produce savings insurance and property taxes of $27,000 per annum.
- The company will lease 75 per cent of its existing warehouse to another firm for $40 per square
metre per year. The warehouse has 30,000 square meters.
- Because there is now the need to handle an increased number of small deliveries from suppliers,
Pacific Player will need to remodel its production and receiving dock at a cost of $600,000. These
construction costs will be depreciated over a 10-year life.
- A change in suppliers is expected to result in more expensive raw materials. However, these
materials should give rise to fewer warranty and repair problems after Pacific Players finished
products are sold, resulting in a net savings of $25,000 per year.
- Two employees who currently earn $60,000 each will be transferred to other positions in the
company, due to the introduction of JIT. A further employee who earns $75,000 per annum will
be made redundant.
- Reduced raw material inventory levels and accompanying stock-outs will cost the company about
$70,000 per year.

Required:
1. Calculate the annual financial impact on year profit of the decision to adopt the JIT system.
2. Recalculate the financial impact of adopting the JIT system I the following information changes:
the cost of remodeling the receiving dock is $750,000 and freed-up funds can be invested at 6 per
cent.

1 Annual financial impact:

Return on released funds [($3 600 000 $600 000) 8%] $240 000
Savings in insurance and property taxes 27 000
Lease revenue (30 000 square metres 75% $40) 900 000
Depreciation on remodelled facilities ($600 000 10 years) (60 000)
Savings in warranty and repair costs 25 000
Salary savings* 75 000
Added stockout costs (70 000)
Increase in profits due to the JIT system $1 137 000
* Note: The cost of the two transferred employees is excluded because Pacific Player will continue to have
these individuals on the payroll.

2 The effects of changing cost and rate of investment on the annual savings of adopting JIT is as follows:
 Return on released funds [($3 600 000 $600 000) 6%] $180 000
Savings in insurance and property taxes 27 000
Lease revenue (30 000 square metres 75% $40) 900 000
Depreciation on remodelled facilities ($750 000 10 years) (75 000)
Savings in warranty and repair costs 25 000
Salary savings* 75 000
Added stockout costs (70 000)
Increase in profits due to the JIT system $1 062 000

Example: 2 Target Costing: manufacturing company

(Adapted from Langfield-Smith, 2012, p. 777)

Alexis Klark, managing director of Pharsalia Electronics (PE), is concerned about the prospects of one of
its major products. She has been reviewing a marketing report with Jeff Keller, marketing product
manager, for their 10-disc car compact disc (CD) changer. The report indicates a price reduction is needed
to meet anticipated competitors reductions in sales prices. The current selling price for their 10-disc car
CD changers is $350 per unit. It is expected that within three months PEs two major competitors will be
selling their 10-disc car CD changers for $3,000 per unit. This concerns Klark, because the current cost of
producing and selling the CD changers is $315, which yields a $35 profit on each unit sold.
The situation is especially disturbing because PE had implemented an activity-based management (ABM)
system about two years ago. The ABM system helped them better identify activity costs, root cause cost
drivers, and the cost reduction opportunities. Changes made as a result of adopting ABM reduced costs on
this product by approximately 15 per cent over the last two years. Now it appears that costs will need to
be reduced considerably more to remain competitive and to earn a profit on the 10-disc car CD changers.
Total costs to produce, sell, and service the CD changer units are as follows:

10-disc car CD changer per unit

Material
Purchased components $110
All other materials 40
Manufacturing activities
Setups 16
Material handling 17
Inspection 23
Cutting, shaping, and drilling 30
Bending and finishing 24
Other
Finished goods warehousing 5
Selling costs 30
Customer service 20
Total unit cost $315

Klark has decided to hire Donald Collins, a consultant, to review the situation and to implement any
changes that are needed. After two week of review, discussion and analysis, Collins suggested that PE
adopt a just-in-time (JIT) system to help reduce costs. He also suggested that using target costing would
help in meeting the new target selling price of $300.
By changing to a JIT manufacturing system, PE expects that material handling, inspection, and finished
goods warehousing will all be eliminated. However, the cost of other manufacturing activities will
increase by 10 per cent due to more highly skilled labour. Customer service costs are expected to be
reduced by 50 per cent.

Required:
1. Determine PEs target cost per unit assuming that the current profit margin remains unchanged.
2. If the JIT system is implemented, will PE meet the target cost?
3. Outline other steps that the company could undertake to further reduce the product cost.

1 Pharsalia Electronics' current profit on sales is 10 per cent [($350 $315)/$350]. Therefore, the target cost
for the new product must be $300 less 10 per cent, or $270 [$300 ($300 10%)].

2 The proposed changes to the just-in-time manufacturing process at Pharsalia Electronics will bring costs down
to $267 per unit, which is below the $270 target cost limit. Revised costs under the JIT manufacturing process
are calculated as follows:

Increase/
Current (Decrease) Revised

Material:
Purchased components $110 $110.00
All other 40 40.00

Manufacturing activities:
Cutting, shaping and drilling 30 $ 3.00 33.00
Bending and finishing 24 2.40 26.40
Setups 16 1.60 17.60
Material handling 17 (17) 0
Inspection 23 (23) 0

Other:
Finished goods warehousing 5 (5) 0
Selling 30 30.00
Customer service* 20 (10) 10.00

Total cost $315 $(48) $267

*50% reduction
 3 Pharsalia could undertake an ABM exercise to identify non-value adding time. There could be an attempt at
reducing set up time. Typically this is undertaken at the time of adopting a JIT approach since there will now
be far more set ups. Selling costs per unit are now more than 10% of sales price. An analysis of these may
reveal ways to save some of these costs.

Example: 3 Life cycle costing: manufacturer

(Adapted from Langfield-Smith, 2012, p. 774-775)

Ellipsis Electronics Ltd produces speakers for high-fidelity sound systems. Because of the rapid rate of
technological innovation in the hi-fi market, most of the companys products have short life cycles. The
marketing manager, Jean wills, believes that new product introductions are the key to Ellipsiss success.
However, the managing director, Joseph lacopetta, is concerned that the frequent changes in product lines
are eroding the companys profitability. He believes that many of the new products have such short life
cycles that they never fully recover their costs. He asks the management accountant, Stan Willox, to help
him.
Willox decides to review the profitability of the Easy Ear Speaker System (EESS), which has just been
phased out after only three years on the market. First, Willox prepares a conventional analysis of the
profitability of the EESS:

Year 1 Year 2 Year 3

Sales revenue $75,000 $142,500 $52,500
Less Cost of goods sold:*
Direct materials 15,000 28,500 10,500
Direct labour 7,500 14,250 5,250
Applied manufacturing overhead 11,250 21,375 7,875
* The company uses a JIT system, which means that inventories are minimal and all manufacturing costs
flow directly to the cost of goods sold.

In addition to these manufacturing costs, Willox is able to isolate the following costs associated with the
ESS:

Year 0 Year 1 Year 2 Year 3

Research and development $17,000
Product design 10,000
Process design 15,000 $5,000 $3,000
Tooling costs 20,000
Marketing costs 8,000 12,000 6,000 $8,000
Warranty claims 10,000 4,000 1,000
After-sales service 3,000 5,500 2,000

Required:
1. Assess the profitability of the EESS in years 1, 2 and 3 using the conventional approach, which
includes manufacturing costs only.
2. Assess the profitability of the EESS based on its life cycle costs.
3. Given this information, what action should lacopetta take when considering future products?
1 Conventional profitability analysis:
Year 1 Year 2 Year 3
75 142 52
Sales revenue 000 500 500
33 64 125 23
Less Cost of goods sold 750 625
41 78 375 28
Gross profit 250 875
2 Life cycle profitability analysis:
Year 0 Year 1 Year 2 Year 3 Total
Sales revenue $75 000 $142 500 $52 500 $270 000
Less
Manufacturing cost 33 750 64 125 23 625 121 500
Research and development 17 000 17 000
Product design 10 000 10 000
Process design 15 000 5 000 3 000 23 000
Tooling costs 20 000 20 000
Marketing costs 8 000 12 000 6 000 8 000 34 000
Warranty claims 10 000 4 000 1 000 15 000
After-sales service 3 000 5 500 2 000 10 500
Total product costs 70 000 63 750 82 625 34 625 251 000
Net proft / (loss) $(70 000) $11 250 $59 875 $17 875 $19 000

3 Iacopetta should insist that products are evaluated across their entire life cycle. (This should include an
assessment of the projected life cycle revenues and costs, prior to the acceptance of the proposed project.)