Activity-Based Management and Target Costing

Dana Martin, president of Mays Electronics, is concerned about the end-of-the-year marketing report. According to Mary OBrien, marketing manager, a price decrease for the coming year is again needed to maintain the companys market share of integrated circuit boards (CBs). The current selling price of $18 per unit is producing a $2 per-unit profithalf the customary $4 per-unit profit. Foreign competitors keep reducing their prices, and to match their latest reduction, the price must drop from $18 to $14. This price drop would put Mayss price below the cost to produce and sell a CB. How could other firms sell for such a low price?

Determined to find out if there are problems with the companys operations, Dana has decided to hire a consultant to evaluate the way in which the CBs are produced and sold. After two weeks, the consultant has identified the following activities and costs associated with producing

120,000 CBs.

Activity	Cost
Set-Ups	$125,000
Materials Handling	180,000
Inspection	122,000
Customer Support	120,000
Customer Complaints	100,000
Warranty Expense	170,000
Storage	80,000
Rework	75,000
Direct Materials	500,000
Utilities	48,000
Manual Insertion Labor*	250,000
Other Direct Labor	150,000
Total Costs	$1,920,000

The consultant indicates that some preliminary activity analysis shows that per-unit costs can be reduced by at least $7. The marketing manager indicates that the market share for the CBs could be increased by 50 percent if the price could be reduced to $12.

Instructions

1. For each activity, determine whether it is value-added or non-value-added.
2. If all the non-value-added activities could be eliminated, by how much would the cost per CB decrease? Was the consultant correct in her preliminary cost reduction assessment?
3. Compute the target cost required to maintain Mayss current market share while earning the usual profit of $4 per unit. Also compute the target cost required to expand sales by 50 percent. By how much would the cost per unit need to be reduced to achieve each target?
4. The consultant also revealed the following: Switching to automated insertion would save $90,000 of direct labor, $20,000 in rework, and $40,000 in warranty costs. The yearly cost of the necessary machinery would be $50,000. With this additional information, what is the potential cost reduction per unit available? Can Mays achieve the target cost to maintain its current market share?
5. In an effort to reach the target cost, Mays solicited suggestions from customers, suppliers, employees, and other consultants. The following were found to be feasible.
   • Mayss production manager believes that the factory can be redesigned so that materials handling costs can be reduced by $100,000which would in turn result in a $10,000 savings in rework costs. The cost to redesign the factory would be $20,000.
   • A supplier suggests leasing a machine that would reduce set-up costs by $80,000. The yearly cost to lease the machine is $15,000.
   • A customer, KD, Inc., proposes setting up a just-in-time delivery system between Mays, KD, and Mayss largest raw materials supplier. This would reduce Mayss storage costs by $45,000, while increasing shipping costs by only $5,000.
   • An employee suggests that Mays train all its employees in quality control measures and then offer a bonus for meeting quality targets. An outside consultant estimates that the cost of the training and bonus would be $35,000. In return, inspections could be eliminated and rework, customer complaint costs, and warranty work could be reduced by $120,000.

If all of these suggestions are implemented, including the automation of the insertion process, would Mays reach the target cost needed to maintain its current market share?