Question

Problem Three

NON-VALUE-ADDED COSTS, ACTIVITY COSTS, ACTIVITY COST REDUCTION (LO 4)

John Thomas, vice president of Mallett Company (a producer of a variety of plastic products), has been supervising the implementation of an ABC management system. One of John's objectives is to improve process efficiency by improving the activities that define the processes. To illustrate the potential of the new system to the president, John has decided to focus on two processes: production and customer service.

Within each process, one activity will be selected for improvement: materials usage for production and sustaining engineering for customer service (sustaining engineers are responsible for redesigning products based on customer needs and feedback). Value- added standards are identified for each activity (the level of efficiency so that no waste exists). For materials usage, the value-added standard calls for six kilograms per unit of output (although the plastic products differ in shape and function, their size—as measured by weight—is uniform). The value-added standard is based on the elimination of all waste due to defective moulds. The standard price of materials is $5 per kilogram.

For sustaining engineering, the standard is 58 percent of current practical activity capacity. This standard is based on the fact that about 42 percent of the complaints have to do with design features that could have been avoided or anticipated by the company.

Current practical capacity (at the end of 2009) is defined by the following requirements: 6,000 engineering hours for each product group that has been on the market or in development for five years or less and 2,400 hours per product group of more than five years. Four product groups have less than five years' experience, and 10 product groups have more. Each of the 24 engineers is paid a salary of $60,000. Each engineer can provide 2,000 hours of service per year. No other significant costs are incurred for the engineering activity.

Actual materials usage for 2010 was 25 percent above the level called for by the Value-added standard; engineering usage was 46,000 hours. A total of 80,000 units of output were produced. John and the operational managers have selected some improvement measures that promise to reduce non-value-added activity usage by 40 percent in 2011. Selected actual results achieved for 2011 are as follows:

Units produced        80,000

Materials used        584,800

Engineering hours   35,400

The actual prices paid for materials and engineering hours are identical to the standard or budgeted prices.

Required:

For 2010, calculate the non-value-added usage and costs for materials usage and sustaining engineering.

2.   Using the budgeted improvements, calculate the expected activity usage levels for 2011. Now, calculate the 2011 usage variances (the difference between the expected and actual values), expressed in both physical and financial measures, for materials and engineering. Comment on the company's ability to achieve its targeted reductions. In particular, discuss what measures the company must take to capture any realized reductions in resource usage

Answer 1

Solution:-

1. Nonvalue-added usage and costs, 2010:

Particulars	AQ*	SQ**	Nonvalue usages	Nonvale cost
			AQ - SQ	(AQ - SQ) SP
Materials	600,000	480,000	120,000	600,000
Engineering	48,000	27,840	20,160	604,800
				$ 1,204,800

* 1.25 × 6 × 80,000; (4 × 6,000) + (10 × 2,400) (AQ for engineering represents the actual practical capacity acquired).

**6 × 80,000; (0.58 × 24,000) + (0.58 × 24,000).

Note: SP = Price of activity quantity; SP for materials is $5; SP for engineering is $30 ($1,440,000/48,000).

2. Expected values for the coming year (2011):

Materials: SQ = 480,000 + 0.6(120,000) = 552,000 Kg

Engineering: SQ = 27,840 + 0.6(20,160) = 39,936 engineering hours

Particulars	AQ*	SQ
			AQ - SQ	(AQ - SQ) SP
Materials	584,800	552,000	32,800	$ 164,000 U
Engineering	35,400	39,936	(4,536)	$ 136,080 F

* For engineering, the expected value is a measure of how much resource usage is needed (this year), and so progress is measured by comparing with actual usage, not activity availability.

The company failed to meet the materials standard but beat the engineering standard. The engineering outcome is of particular interest. The actual usage of the engineering resource is 35,400 hours, and activity availability is 48,000. Thus, the company has created 12,600 hours of unused engineering capacity. Each engineer brings a capacity of 2,000 hours. Since engineers come in whole units, the company now has six too many! Thus, to realize the savings for the engineering activity, the company must decide how to best use these available resources. One possibility is to simply lay off six engineers, thereby increasing total profits by the salaries saved ($360,000). Other possibilities include reassignment to activities that have insufficient resources (assuming they could use engineers, e.g., perhaps new product development could use six engineers). The critical point is that resource usage reductions must be converted into reductions in resource spending, or the efforts have been in vain.

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