1 - Target Costing/Life Cycle Costing [est. 35 minutes] The marketing department of Bream Hot Water Ltd has recommended that the company introduce a new solar hot water system, to be called the Sunstruck. To compete effectively with existing models offered by other companies, the Sunstruck would need to be priced at $800. The company requires a target profit margin on sales for all new products of at least 30 per cent of sales. The technology in solar energy is developing rapidly, and therefore the Sunstruck is expected to be obsolete within three years of entering the market. Initial estimates of the Sunstruck's cost of manufacture per unit are : Direct material Direct labour Manufacturing overhead * $250 125 125 $500 *Manufacturing overhead is applied at 100 per cent of direct labour cost The Marketing Department is keen to introduce the Sunstruck as soon as possible. However, the management accountant is concerned about the non-manufacturing costs likely to be associated with the new product. He asks the departments that are upstream and downstream of manufacturing to estimate the costs in their departments associated with the development, production and sale of the Sunstruck. He receives the following information : Estimated costs associated with the proposed Sunstruck Department Year 5 Year 1 Research and Development Product and Process Design Marketing Customer Support 200 1 500 3 000 1 000 (in $'000s) Year 2 700 800 250 Year 3 Year 4 500 800 400 750 The forecast sales of the Sunstruck are as follows: Year 2 Year 3 Year 4 10 000 units 15 000 units 5 000 units Required: 1. Calculate the target cost for the Sunstruck that will meet the target selling price of $800 and the target profit margin of 30 per cent on sales. Compare this with the estimated manufacturing cost. On this basis, would you recommend the development and introduction of the Sunstruck model? 2. Prepare a life cycle budget for the Sunstruck that covers each year from Year 1 to Year 5. 3. What is the estimated average unit cost of the Sunstruck over its entire life cycle? On this basis, would you recommend the development and introduction of the Sunstruck model? 4. Explain how Bream could use life cycle management to reduce the manufacturing cost of the Sunstruck solar hot water system. Which part of the value chain may warrant additional expenditure? Explain. Question 2 - Customer Profitability Analysis [est. 40 minutes] You have recently been appointed Management Accountant of Fortune Electronics Pty Ltd, a Melbourne based manufacturer of specialised audio products. The Company's products have short lifecycles due to the rapidly evolving technologies prevalent in the industry and the fast changing nature of consumer demand. Total sales for 2009/10 were slightly under $16.0m, with > 90% being through 3 State distributors (one each in Victoria, New South Wales and Queensland). For the 2009/10 financial year, net profit before tax was 4.5% of sales, or $717,750. End user sales are through retail stores operated by the Distributors in their designated territories. The distributor business model enables individual retail stores to place orders directly with Fortune, for shipment directly to the store placing the order. Despatch notes are forwarded to the store, with copies to the central office of the relevant distributor. Invoices are forwarded only to the distributor central offices to ensure that purchase prices remain confidential. Review of the Company's distributor sales analysis for 2009/10 revealed the following: Customer Total Sales % of distributor Sales Flemington AV Pty Ltd $8,400,000 56 Eagle Farm Sound and Screen Pty Ltd $3,150,000 21 (Queensland exclusive Distributor - operates 18 stores) Randwick Electronic Accessories Pty Ltd $3,450,000 23 (Victorian exclusive Distributor - operates 15 stores (New South Wales exclusive Distributor operates 12 stores) Because the industry is very price sensitive, Fortune adopts a strict pricing structure based on achieving a gross margin on all sales to its distributors of 15%. Following a recent interstate visit to the New South Wales and Queensland distributors, the managing director has expressed concern that some customers never seem satisfied with the level of service being provided, no matter how extensive that may be. Reflecting on his comments, you investigate some of the special arrangements that the Sales Manager, who receives a commission of 0.2% of all Distributor sales, has put into place for each of the distributors and discover that: Flemington AV (appointed 8 years ago and still managed personally by the managing director) accepts product in standard packaging and orders regularly in relatively predictable quantities. Warranty returns have been constant at 2% of orders shipped for the past 3 years, a rate that is considered \"normal\" for the industry. Eagle Farm Sound and Screen, (appointed 3 years ago after approaching your Company directly) is the fastest growing distributor, and have increased their business with you by around 30% in each of the past 2 years. Warranty return rates are double those of Caulfield. Randwick Electronic Accessories (appointed 5 years ago by the sales manager) requires unique packaging and bar-coding and appears to have weak stock control systems as 50% of orders placed require urgent shipment to meet out of stock situations. Your company has to date met all of the costs associated with these requirements. Randwick also return an unusually high amount of stock, sometimes quoting \"ordered in error\" but quite frequently citing \"DOA\" (dead on arrival) as the reason for the return. Total warranty returns for the past 18 months have been 4 times higher than those experienced by Flemington. These findings support the informal views of the managing director, suggesting that satisfying some of the extraordinary expectations of the 2 interstate distributors appears to be costing a significant amount of money, thereby possibly distorting the true profitability of those customers. After sifting through lots of information, you identify the following as the key drivers and costs of distributor activity: Activity Cost Driver Cost per activity/event Account Management Interstate visits (Travel, accommodation, entertaining etc.) $4,000 Order processing/Number of shipments $100 Normal Packaging including freight Customer orders placed/shipments made Shipments despatched Additional freight for urgent shipments Customer URGENT orders $50 Special Packaging and bar-coding Shipments despatched $250 Warranty Processing Costs Number of returns $600 Sales Managers commission Total sales 0.2% of sales $75 Further analysis of distributor sales for 2009/10 indicates: Flemington AV Account Management Zero visits Orders processed/Number of shipments Normal Packaging Interstate Randwick Electronic Accessories Eagle Farm Sound and Screen 6 Interstate visits 3 Interstate visits 1200 1250 750 1200 shipments Nil 750 shipments Special Packaging Nil 1250 shipments nil Warranty Costs 24 returns 100 returns 30 returns Required: (Part 1) (i) Prepare a customer profitability analysis for the 3 Distributors (ii) Comment on the relative profitability of the 3 Distributors You subsequently discuss the above findings with the managing director and sales manager, each of whom has different views on what corrective actions should be implemented. The managing director believes that the distributor business model should be changed, and that the key drivers that you have identified should be charged directly to the distributor concerned. He is adamant that the pricing and gross margin structure should remain unchanged. The sales manager argues strongly that maintaining consistent pricing is outdated and inconsistent with market reality. During the meeting he states that \"...the cost of operating in some markets is simply higher than in others and doesn't necessarily reflect differing levels of commitment and capability of the distributor...\" He suggests that a better approach would be to scrap the existing pricing policy, and introduce new (and different) selling prices for each distributor, calculated to cover the cost of the various unique competitive circumstances that he argues exist in each territory. After the meeting the managing director asks you for your opinion regarding the alternative approaches. Required: (Part 2) (iii) Which of the two approaches do you recommend - the managing directors or the sales managers? Explain why you have made this recommendation and describe the advantages and disadvantages of each of the two alternatives. (iv) Given the relatively low margins earned by Fortune, suggest how the distributor business model could be changed to improve profitability