Financial crisis analysis.

Find a current (within the last year) article on a company that has been faced with a significant financial crisis or challenge. It could be downsizing, starting up, significant news event or any other key event. Use any concept from the readings of this chapter and apply it to the company article that you have chosen.

Ensure you include the link and appropriately reference your article.

This should not exceed three-quarters of a page.

Reference:

Operating Decisions LEARNING OBJECTIVES After reading this chapter, you should be able to answer the following questions: How is the operations function in manufacturing companies different from the operations function in service companies? Why is it important to calculate the cost of unused capacity? How is this information used in decision making? How can a company maximize profitability by altering the product mix and improving bottleneck operations? How does the analysis of relevant costs in operating decisions improve decision making? Why is it important to monitor and control the costs of quality and environmental costs within companies? This chapter introduces the operations function in companies, and contrasts the different oper- ating decisions faced by manufacturing businesses and service businesses. Operational deci- sions, such as capacity utilization, the cost of spare capacity, and the product/service mix under capacity constraints are considered. The relevant costs in decisions related to making or buying components in manufacturing, equipment replacement, and the use of direct materials are examined. The cost of quality and environmental management accounting are also introduced. The Operations Function Operations is the business function that produces the goods and services to satisfy customer demand. This function, interpreted broadly, includes all aspects of purchasing, manufacturing, and distribution. While purchasing and distribution may be common to all industries, manufacturing is relevant to only 1/30 212 PART II USING ACCOUNTING INFORMATION FOR DECISION MAKING, PLANNING, AND CONTROL a manufacturing business. There will also be different emphases for different types of businesses, such as distribution for a retail business and the separation of "front office" (or customer related) functions from "back office" (or support) functions for a financial institution. Irrespective of whether the business is in manufacturing, retailing, or services, we can con- sider operations to be the all-encompassing processes that produce the goods or services which satisfy customer demand. In simple terms, operations is concerned with the conversion process between resources (materials, facilities, equipment, and people) and the products/services that are sold to customers. The operations function depends on factors such as quality, efficiency, capacity utilization, and environmental considerations. Each of these has cost implications, and the lower the cost of producing goods and services, the lower the price to the customer. Lower prices tend to increase volume, leading to economies of scale and increased profits (as we saw in Chapter 8). A useful analytical tool for understanding the conversion process is Michael Porter's value chain (1985), shown in Exhibit 9.1. According to Porter, every business is . . . a collection of activities that are performed to design, produce, market, deliver, and support its product. . . . A firm's value chain and the way it performs individual activities are a reflection of its history, its strategy, its approach to implementing its strategy, and the underlying economics of the activities themselves. (Porter, 1985, p. 36) Exhibit 9.1 Porter's Value Chain Firm Infrastructure Support Human Resource Management activities Technology Development Procurement Margin Primary Inbound Operations Outbound Marketing activities Logistics Logistics and Sales Service Source: Reprinted from Porter, M. E. (1985). Competitive advantage: creating and sustaining superior performance. 1985, 1998 by M. E. Porter. All rights reserved. O A1985, 1998 by M. E. Porter. All rights reserved. Porter separates business activities into primary and support activities. Primary activities start with the upstream activities of research, development, product design, and sourcing (which Porter "inbound logistics"). Support activities include the production ("operations") and distribution bound logistics") functions and the downstream activities of marketing and after-sales customer X Porter argues that profits and costs should be assigned to the value chain in order to call the profitability of each activity in the chain. If an activity costs more than the value it provides, it is considered a non-value-added activity and should be modified (i.e., cost-reduction efforts should be initiated) or eliminated from the value chain altogether. In many organizations, accounting systems can get in the way of analyzing the costs of each activity in the value chain. Accounting systems categorize costs through line items (see Chapter 3), such as salaries and wages, electricity expenses, and facility rent, rather than in terms of value ac- tivities that are technologically and strategically distinct. This "may obscure the underlying activities a firm performs" (Porter, 1985). Porter developed the notion of cost drivers, which he defined as the structural factors that influence the cost of an activity and are "more or less" under the control of the business. He proposed that the cost drivers of each value activity be analyzed to enable comparisons 2/30 CHAPTER 9 OPERATING DECISIONS 213 with competitor value chains. This would result in the relative cost position of the business being improved by better control of the cost drivers or by reconfiguring the value chain, while maintaining a differentiated product. This is an approach that is supported by strategic management accounting (see Chapter 16). The value chain as a collection of interrelated business processes is a useful concept in under- standing businesses that produce either goods or services. However, we can extend the idea of the value chain by considering the industry value chain or set of connections between suppliers, the organization, distribution channels, and customers. Exhibit 9.2 demonstrates the concept of the in- dustry value chain. Exhibit 9.2 Industry Value Chain Supplier Company Wholesaler Retailer Customer activities activities activities activities activities Strategically managing a company's industry value chain would mean that the company would focus not only on creating value with its own activities but also on creating relationships between business partners and working together to reduce costs and increase efficiencies in the movement of goods and information. Through linking these various stakeholders in the industry value chain, a company will gain strategic advantage over its competitors. CASE IN POINT The Automotive Industry Value Chain The value chain in the automotive industry is complex and relies on solid relationships and connec- tions among automakers and the other firms in the chain. The chain begins at the design stage. Automakers such as Toyota and General Motors design vehicles based on the latest consumer trends and needs. The automakers then source raw materials from suppliers of steel, rubber, plastic, and other materials needed to make components. "First tier" large parts suppliers such as General Electric and Canadian-based Magna International make parts that are incorporated into the vehicle, such as seats and interiors, while "second tier" smaller suppli- ers sell components for parts to the first-tier suppliers. Still other suppliers, such as Cooper Tire, make vehicle replacement parts. The components are then assembled by the automakers. To reduce inventory carrying costs, more automakers are having parts delivered to factories on a just-in-time (JIT) basis (see Chapter 7 for a discussion of JIT practices). Many parts suppliers are located close to assembly plants. The automakers spend large budgets on marketing their products. The last link in the industry value chain is distribution and sales. Most vehicles are delivered to dealerships for sales to consumers. While there are no Canadian-owned automobile manufacturers, global firms have many assembly plants in Canada and many second-tier parts suppliers are based in Canada. The automo- tive industry is considered Canada's most important manufacturing and export sector, accounting for almost one-third of the value of the country's manufactured exports. Sources: Duke University, Department of Sociology, Professor Gary Gereffi's Research Team I report, 2007, Global value chain, available at www.duke.edu/web/soc142/team1/valuechain.html; Sturgeon, T., Van Biesebroeck, J., & Gereffi, G., The North American automotive value chain: Canada's role and prospects, International Journal of Technological Learning Innovation and Development, 2(1/2), 2009, pp. 25-52. 3/30 OX o 214 PART II USING ACCOUNTING INFORMATION FOR DECISION MAKING, PLANNING, AND CONTROL Managing Operations: Manufacturing A distinguishing feature between a manufacturing organization and a service organization is the need to carry inventories. This topic was covered in detail in Chapter 7. Inventory enables the timing difference between production capacity and customer demand to be smoothed. This is, of course, not possible in the supply of services. As was discussed in Chapter 7, manufacturing firms purchase raw materials (unprocessed goods) and undertake the conversion process through the application of labour, machinery, and know-how to manufacture finished goods. The finished goods are then available to be sold to customers. The three main types of manufacturing include custom, batch, and continuous manufacturing (discussed in Chapter 7). In a manufacturing business, the materials are identified by a materials requisition record, which is a list of all the components that go to make up the completed project, and a labour time record, which is a list of the labour hours for the conversion process. In relation to the cost of materials and labour, overhead is allocated to cover the manufacturing costs that are not included in either the materials requisition or the time record (this will be discussed in more detail in Chapter 11). The manufacturing process and its relationship to accounting can be seen in Exhibit 9.3. When a custom product is completed, the accumulated cost of materials, labour, and overhead is the cost of that custom product. For a batch, the total job cost is divided by the number of units produced to determine a cost per unit. In process costing, which is used for continuous manufac turing, at the end of the accounting period, the total costs are divided by the volume produced to give a cost per unit of volume. The actual cost per unit can be compared to the budget or standard cost per unit. Any variation needs to be investigated and corrective action taken (we explain this in Chapter 15). Exhibit 9.3 The Manufacturing Process and Its Relationship to Accounting Inputs Conversion Outputs Raw materials Labour costs Finished goods cost cost Overhead costs including factory rent, depreciation, materials handling, indirect labour The distinction between custom and batch manufacturing is not always clear. Some products are produced on an assembly line as a batch of similar units but with some customization, since technology allows each unit to be unique. For example, motor vehicles are assembled as "batches of one," since technology facilitates the sequencing of different specifications for each vehicle along a common production line. Within the same model, different colours, transmissions (man- ual or automatic), steering (right-hand or left-hand drive), and other customized features can be accommodated. 4/30 CHAPTER 9 OPERATING DECISIONS 215 Any manufacturing operation involves a number of sequential activities that need to be sched- uled so that materials arrive at the appropriate time at the correct stage of production and labour is available to carry out the required process. Organizations that aim to have materials arrive in pro- duction without holding buffer inventories are said to operate a just-in-time (JIT) manufacturing system (discussed in Chapter 7). Most manufacturing processes require an element of set-up time, during which equipment settings are made to meet the specifications of the next production run (a custom product or batch). These settings may be made by manual labour or by computer. Investments in computer and robotics technology have changed the shape of manufacturing industry. These investments involve substantial costs that need to be justified by an increased volume of production or by efficiencies that reduce production costs. OManaging Operations: Services Fitzgerald et al. (1991) emphasized the importance of the growing service sector and identified four key differences between products and services: intangiblety, heterogeneity, simultaneity, and perish- ability. Services are intangible rather than physical and are often delivered in a "bundle"; customers may value the various aspects of the service differently. Services involving high labour content are X heterogeneous; that is, there may be little consistency in the service. The production and consump- tion of services are simultaneous, so that services cannot be inspected before they are delivered. Services are also perishable, so that, unlike physical goods, there can be no inventory of services that have been provided but remain unsold. Fitzgerald et al. also identified three different service types. Professional services are "front office," people-based services involving discretion and the customization of services to meet cus- tomer needs so that the process is more important than the service itself. Examples include law- yers, accountants, and management consultants. Mass services involve limited contact time with staff and little customization. Examples of mass services are rail transport, airports, and retailing. The third type of service is the service shop, a mixture of the other two extremes with emphasis on customer service. Examples of service shops are banks and hotels. Fitzgerald et al. emphasize how cost traceability differs between each of these service types. Their research found that many service companies do not try to cost individual services accu- rately for either price-setting or profitability analysis, with the exception of time-recording practices of professional service firms. According to Fitzgerald et al., in mass services and ser- vice shops there are . . . multiple, heterogeneous and joint, inseparable services, compounded by the fact that individual customers may consume different mixes of services and may take differ- ent routes through the service process. (p. 24) Note that, in describing operations, we will use the term production to refer to both goods and services and use manufacturing where raw materials are converted into finished goods. Accounting information has an important part to play in operational decisions for both manu- facturing and service companies. Typical questions that may arise include the following: . What is the cost of spare capacity? . What product/service mix should be produced when there are capacity constraints? . What are the costs that are relevant for operational decisions? This chapter considers each of these in turn. 5/30 216 PART II USING ACCOUNTING INFORMATION FOR DECISION MAKING, PLANNING, AND CONTROL Accounting for the Cost of Spare Capacity Production resources (material, facilities/equipment, and people) allocated to the process of supply- ing goods and services provide a capacity. The utilization of that capacity is a crucial performance driver for businesses, as the investment in capacity often involves substantial outlays of funds which need to be recovered by utilizing that capacity fully in the production of products/services. Capacity may also be a limitation for the production and distribution of goods and services where market demand exceeds capacity. A weakness of traditional accounting is that it equates the cost of using resources with the cost of supplying resources. However, often the cost of resources supplied is not equal to the resources used, with the difference being unused capacity: Cost of resources supplied - Cost of resources used = Cost of unused capacity Consider a company that has ten staff members, each costing $30,000 per year, who provide banking services, where the cost driver (the cause of the activity) is the number of banking trans- actions. Assuming that each member of staff can process 2,000 transactions per year, the cost of resources supplied is $300,000 (10 X $30,000) and the capacity number of transactions is 20,000 (10 X 2,000). The standard cost per transaction would be $15 ($300,000/20,000 transactions). If, in fact, 18,000 transactions were carried out during the year, the cost of resources used would be $270,000 (18,000 @ $15) and the cost of unused capacity would be $30,000 (2,000 @ $15, or $300,000 resources supplied - $270,000 resources used). Traditional accounting systems do not recognize this value of unused capacity-it is simply buried in the expenses of the organization and not specifically recognized as unused capacity cost. Although there can be no carry forward of an "inventory" of unused capacity in a service deliv ery function, management information is more meaningful if the standard cost is maintained at $15 and the cost of spare capacity is identified separately. Management action can then be taken to re- duce the cost of spare capacity to zero, either by increasing the volume or by business or by reducing the capacity (i.e., the number of staff). Capacity Utilization and Product Mix When demand exceeds the capacity of the business to produce goods or deliver services as a result of scarce resources (whether that is space, equipment, materials, or staff), the scarce resource is the limiting factor. That is, the scarce resource will limit the number of units of each product or service that the company can produce and therefore sell. A business will want to maximize its profitability by OCapacity Utilization and Product Mix When demand exceeds the capacity of the business to produce goods or deliver services as a result of scarce resources (whether that is space, equipment, materials, or staff), the scarce resource is the limiting factor. That is, the scarce resource will limit the number of units of each product or that the company can produce and therefore sell. A business will want to maximize its profital selecting the optimum product/service mix. The product/service mix is the mix of products X vices sold by the business, each of which may have a different selling price and cost. Therefore, Wine.. demand exceeds capacity, it is necessary to rank the products/services with the highest contribution margin per unit of the limiting factor (i.e., the scarce resource). For example, Beaufort Accessories makes three parts (F, G, and H) for automobiles, each with a different selling price and variable costs, and each requiring a different number of machine hours, which are shown in Exhibit 9.4. However, Beaufort has an overall capacity limitation of 10,000 machine hours. The first step is to identify the ranking of the products by calculating the contribution margin per unit of the limiting factor (machine hours, in this case) for each product. This is shown in Exhibit 9.5. 6/30 CHAPTER 9 OPERATING DECISIONS 217 Exhibit 9.4 Beaufort Accessories: Cost Information Part F Part G Part H Selling price per unit $150 $200 $225 Direct material cost per unit $50 $80 $40 Direct labour cost per unit $50 $60 $125 Contribution margin per unit $50 $60 $60 Machine hours per unit 2 5 Estimated sales demand (units) 2,000 2,000 2,000 Required machine hours based on estimated demand 4,000 8,000 10,000 Exhibit 9.5 Beaufort Accessories: Product Ranking Based on Contribution Margin per Machine Hour Part F Part G Part H Contribution margin per unit $50 $60 $60 Machine hours per unit Contribution per machine hour $25 $15 $12 Ranking (preference) 2 3 Although both Part G and Part H have higher contributions per unit, the contribution per machine hour (the unit of limited capacity) is higher for Part F. Profitability will be maximized by using the limited capacity to produce as many Part Fs as can be sold, followed by Part Gs. Based on this rank- ing, the available production capacity can be allocated as follows: Production Contribution 2,000 of Part F @ 2 hours = 4,000 hours 2,000 @ $50 per unit = $100,000 Based on the capacity limitation of 10,000 hours, 6,000 hours remain, so Beaufort can produce three-quarters of the demand for Part G (6,000 hours available/8,000 hours to meet demand) equivalent to 1,500 units of Part G (3/4 of 2,000 units). 1,500 of Part G @ 4 hours = 6,000 hours 1,500 @ $60 per unit = $90,000 Maximum contribution $190,000 There is no available capacity for Part H In this case, based solely on the capacity analysis, the company will use all of its machine hours to produce Parts F and G as there is no remaining capacity to produce Part H. This decision, of course, will need to be made considering other factors such as the following: . Will demand for Parts F and G decline as a result of the company not producing Part H? Will customers seek a new supplier that can provide all parts? 7/30 218 PART II ICING ACCOUNTING INFORMATION FOR DECISION MAKING PLANNING AND CONTROI O218 PART II USING ACCOUNTING INFORMATION FOR DECISION MAKING, PLANNING, AND CONTROL X . Do the products have any interdependencies? Will customers wanting to purchase Part F also need to purchase Part H? As with most cost-analysis tools, an analysis of capacity constraints must be accompanied by a thor- ough review of other non-financial factors that may impact product demand. Theory of Constraints A different approach to limited capacity that focuses on the existence of bottlenecks in production and the need to maximize volume through the bottleneck (throughput) is the Theory of Constraints (ToC). Within the Theory of Constraints, only three aspects of performance are considered impor- tant: throughput contribution, operating expenses, and inventory. Throughput contribution is de- fined as sales revenue less the cost of direct materials: Throughput contribution = Sales - Direct materials All costs, other than direct materials, are considered fixed and independent of sales volume. Supporters of this view argue that direct materials are really the only true variable cost of a business. This assumption is often accurate when a company is committed to set production schedules and therefore to set employee schedules. The Theory of Constraints suggests that a company can increase profitability and maximize throughput contribution by reducing the effect of bottleneck resources. Bottleneck resources are those resources that limit the amount of product or service a company can provide. Common bottle- neck resources are machine hours, labour hours, and storage capacity. We also recognize that there is little point in maximizing non-bottleneck resources if this does not lead to increased throughput of a bottleneck that is not addressed. For example, if the available machine capacity is limiting the number of products the factory can produce, there is no point in hiring additional staff to operate the machines. Applying the Theory of Constraints to the Beaufort Accessories example and assuming that machine hours are the bottleneck resource, Exhibit 9.6 shows the throughput ranking. Under the Theory of Constraints, Part F retains the highest ranking, but Part H has a higher return per unit of the bottleneck resource than Part G after deducting only the variable cost of materials. This is a dif- ferent ranking than provided by the previous method, which used the contribution after deducting all variable costs. The difference is due to the treatment of variable costs other than materials. In this case, it is assumed in throughput costing that the cost of labour is fixed and will not vary with the number of units produced in the short term. Exhibit 9.6 Beaufort Accessories: Product Ranking Based on Throughput Part F Part G Part H Selling price per unit $150 $200 $225 Variable material cost per unit $50 $80 $40 Throughput contribution per unit $100 $120 $185 Machine hours per unit 5 Return per machine hour $50 $30 $37 Ranking (preference) 3 2 8/30 CHAPTER 9 OPERATING DECISIONS 219 Using the Theory of Constraints, Beaufort would focus its efforts on maximizing the number of machine hours available, since this is the bottleneck in the production process. Beaufort may con- sider purchasing an additional machine to produce the parts or modifying the machines so that they provide more capacity. Operating Decisions: Relevant Costs Operating decisions imply an understanding of costs, but not necessarily the costs that are defined by accountants. We have already seen in Chapter 8 the distinction between avoidable and unavoid- able costs. This brings us to the notion of relevant costs-the costs that are relevant to a particular decision. Relevant costs are the future, incremental cash flows that result from a decision. Relevant costs specifically do not include sunk costs-that is, costs that were incurred in the past-because nothing we do can change those earlier decisions. Relevant costs are avoidable costs because, by taking a particular decision, we can avoid the cost. Unavoidable costs are not relevant because, ir- respective of what our decision is, we will still incur the cost. Relevant costs may, however, be opportunity costs. An opportunity cost is not a cost that is paid out in cash. It is the loss of a future cash flow that takes place as a result of making a particular decision. O AMAKE VERSUS BUY A concern with subcontracting or outsourcing has dominated business in recent years as the cost of providing goods and services in-house is increasingly compared to the cost of purchasing goods on the open market. The make-versus-buy decision should be based on which alternative is less costly on a relevant cost basis; that is, taking into account only future, incremental cash flows. Gen- X erally, with a make-versus-buy decision, the relevant costs that must be considered are shown in Exhibit 9.7. Exhibit 9.7 Relevant Costs of Make v. Buy Decisions Make v. Buy: Relevant Costs . Purchase cost of component or product . Variable costs of producing the component or product Fixed costs that are avoidable For example, the costs of in-house production of a computer processing service that averages 10,000 transactions per month are calculated as $25,000 per month. This cost is composed of $0.50 per transaction for stationery and $2 per transaction for labour. In addition, there is a $10,000 charge from head office as the share of the depreciation charge for equipment. An inde- pendent computer company has offered a fixed price of $20,000 per month to provide this same service. Based on this information, stationery and labour costs are variable costs that are both avoidable if processing is outsourced. The depreciation charge is likely to be a fixed cost to the business irre- spective of the outsourcing decision. It is therefore unavoidable. The fixed outsourcing cost will be incurred only if outsourcing takes place. The total costs for each alternative can be compared as shown in Exhibit 9.8. The $10,000 share of depreciation costs is not relevant as it is unavoidable. The relevant costs for this decision are there- fore those shown in Exhibit 9.9. 9/30 220 PART II USING ACCOUNTING INFORMATION FOR DECISION MAKING, PLANNING, AND CONTROL Exhibit 9.8 Total Costs: Make v. Buy Cost to Make Cost to Buy Stationery 10,000 @ $0.50 $5,000 Labour 10,000 @ $2 20,000 Share of depreciation costs 10,000 $10,000 Outsourcing cost 20,000 Total relevant cost $35,000 $30,000 Exhibit 9.9 Relevant Cost: Make v. Buy, Simplified Relevant Cost to Make Relevant Cost to Buy Stationery 10,000 @ $0.50 $5,000 Labour 10,000 @ $2 20,000 Outsourcing cost $20,000 Total relevant cost $25,000 $20,000 Based on relevant costs, a $5,000 per month saving would be realized by outsourcing the computer processing service. As you can see with the above example, you only need to include relevant costs in the analysis of a make versus buy decision. Irrelevant costs (in this case deprecation) complicate the analysis and can be excluded. EQUIPMENT REPLACEMENT A further example of the use of relevant costs is in the decision to replace plant and equipment. Once again, the concern is with future incremental cash flows, not with historical or sunk costs or with non-cash expenses such as depreciation. The relevant costs for an equipment replacement decision are shown in Exhibit 9.10. Exhibit 9.10 Relevant Costs of Equipment Replacement Decisions . Purchase price of new equipment . Trade-in value of old equipment . Change in operating costs per year . Change in income per year For example, Miramar Hotel Company replaced its kitchen one year ago at a cost of $120,000. The kitchen was to be depreciated over five years, although it will still be operational after that time. The hotal manneat hand the dining faciliter and nearde a Inrear bitchan with additional canoe O AEQUIPMENT REPLACEMENT A further example of the use of relevant costs is in the decision to replace plant and equipment. Once again, the concern is with future incremental cash flows, not with historical or sunk costs or with non-cash expenses such as depreciation. The relevant costs for an equipment replacement d are shown in Exhibit 9.10. X Exhibit 9.10 Relevant Costs of Equipment Replacement Decisions . Purchase price of new equipment . Trade-in value of old equipment . Change in operating costs per year . Change in income per year For example, Miramar Hotel Company replaced its kitchen one year ago at a cost of $120,000. The kitchen was to be depreciated over five years, although it will still be operational after that time. The hotel manager wants to expand the dining facility and needs a larger kitchen with additional capac- ity. A new kitchen will cost $150,000, but the kitchen equipment supplier is prepared to offer $25,000 as a trade-in for the old kitchen. The new kitchen will ensure that the dining facility earns addi- tional income of $25,000 for each of the next five years. The existing kitchen incurs operating costs of $40,000 per year. Due to labour-saving technol- ogy, operating costs, even with additional diners, will fall to $30,000 per year if the new kitchen is 10/30 CHAPTER 9 OPERATING DECISIONS 221 bought. These figures are shown in Exhibit 9.11. On a relevant cost basis, the difference between retaining the old kitchen and buying the new kitchen is a saving of $50,000 cash flow over five years. On this basis, it makes sense to buy the new kitchen. Exhibit 9.11 Relevant Costs: Equipment Replacement Retain Old Kitchen Buy New Kitchen Purchase price of new kitchen -$150,000 Trade-in value of old equipment +$25,000 Operating costs $40,000/yr. X 5 years -$200,000 $30,000/yr. X 5 years -$150,000 Additional income from dining of $25,000/yr. X 5 years +$125,000 Total relevant cost -$200,000 -$150,000 Before making a decision, Miramar must take into account that the original kitchen cost has been written down to $96,000 (a cost of $120,000 less one year's depreciation at 20% or $24,000). The original capital cost is a sunk cost and is therefore irrelevant to a future decision. The loss on sale of $71,000 ($96,000 written down value - $25,000 trade-in) will affect the hotel's reported profit for the given year and may impact income taxes paid. For this example, however, we are not considering tax implications and therefore this loss on sale of the equipment cost is not a future incremental cash flow and is therefore irrelevant to the decision. However, a conflict of interest might be created in this scenario: The company will show a significant (non-cash) financial loss in the year in which the old kitchen is written off, which will have a negative impact on the overall profitability of the company as per the reported financial statements. This may impact the performance evaluation of the manager who makes this decision. Decisions that extend over a number of years, like the equipment replacement decisions, are also impacted by inflation. The time value of money with regards to capital expenditure decisions are explained in more detail in Chapter 12. RELEVANT COST OF MATERIALS As the definition of relevant cost is the future incremental cash flow, it follows that the relevant cost of direct materials is not the historical (or sunk) cost but the replacement price of the materials. Therefore, it is irrelevant whether those materials are held in inventory, unless such materials have only scrap value or an alternative use, in which case the relevant cost is the opportunity cost of the foregone alternative. The cost of using materials can be summarized as follows: . If the material is purchased specifically, the relevant cost is the purchase price. . If the material is already in inventory and is used regularly, the relevant cost is the purchase price (i.e., the replacement price). . If there is a surplus of the material in inventory as a result of previous overbuying, the relevant cost is the opportunity cost, which may be its scrap value or its value in any alternative use. Let's consider an example. Stanford Ceramics Ltd. has been approached by a customer who wants to place a special order and is willing to pay $16,000. The order requires the materials shown in Exhibit 9.12. 11/30 OExhibit 9.12 Materials Requirements Total Original Current Kilograms Kilograms in Purchase Scrap Purchase Material Required Inventory Price/Kg ValuelKg Price] A 750 0 $6. 8 1, 000 600 $3.50 $2.50 5.0c C 5CD 400 3.00 2.50 4.00 D 303 500 4.00 6.00 9.00 Material A would have to be purchased specically for this order. Material B is used regularly. and any inventory used for this order would have to be replaced. Material C is surplus to requirements and has no alternative use. Material D is also surplus to requirements. but can be used as a substitute for Material E. Material E, although not required for this order, is in regular use and currently costs $8.00 per kg. but is not in invenlory. The relevant material costs are shown in Exhibit 9.13. Exhibit 9.13 Relevant Cost of Materials Material Relevant Cost A 750 @ $6 (replacement price) $4,500 B 1.000 @ $5 {replacement price) 5.000 C 400 @ $2.50 (opportunity cost of scrap value) 1,000 100 @ 54 (replacement price) 400 D 300 @ $8 (substltute for material E) E Total relevant material cost 13.300 Proceeds of sale 16,000 incremental gain 52,700 As a result of the above. Stanford Ceramics would accepl Ihe special order because the additional income exceeds the relevant cost of materials. In the case of Material A. the material is purchased at the current purchase price. For Material B, even though some invenlory is held at a lower cost price. it is used regularly and has to be replaced at the current purchase price. For Material C, the 400 kg in inventory has no other value than scrap. which is the opportunity cost ofusing it in this order. The 100 kg of Material C not in inventory has to be purchased at the current replacement price. For Material D. the opportunity cost is either the scrap value or the saving made by using Material D as a substitute for Material E. As the substitution value is higher. this is what Stanford would do in the absence of this particular order. Therefore, the opportunity cost of Material D is the loss of the abil- ity to substitute for Material E. Quality Management and Control One aspect of operational management that dserves particular atlenlion is quality management and control. The importance of quality is often overlooked by managers but can signicandy impact the protability of an organization. If a company continually makes a poor-quality product, it will (NAPIER? OPERAlmGlilirSlDilS 223 lose customers and will also incur costs that are unnecessarycosts of quality. For example, the costs of repairing faulty products that have been sold and of honouring warranties for poor-quality products can be signicant. Recognizing the cost of quality and reducing these overall costs can be critical within a com- pany. Costs of quality can be classied into four categories: 1. Prevention costs include design. engineering. and training costs incurred to ensure that a prod- uct meets specications. 2. Appraisal costs include inspection costs and testing costs incurred to identify products that do not meet specications. 3. internal failure costs are the costs of rework. spoilage. and repairs that occur prior to the prod- uct being sent to the customer. 4. External failure costs include the costs of warranties. repairs. legal claims. and customer service after the product has been sent to or bought by the customer. identifying the cost of quality is important lo the continuous improvement process, as substantial improvements to business performance can be achieved by investing in prevention and appraisal, thereby avoiding the much larger costs usually associated with failure. Let's consider an example. Bigalow Industries reported the quality costs shown in Exhibit 9.14 for the years ended 2010 and 2011 (expressed in thousands of dollars). The overall costs of quality were much lower in 2011 than in 2010. During 2011, the company spent more on prevention, which resulted in a large reduction in failure costs and the overall costs of quality. In addition to the re- ported costs of quality, a company needs to be aware that costs of quality can extend beyond these reported costs and that an opportunity cost of lost sales can occur if customers receive substandard products. As such, Bigalow's decrease in extemal failure costs could potentially mean that fewer .l..r.._.:_t.. .._.-... ..... L..:__ 2.1:..-\"2 -_a tau4..-- .L. -_._..,._.. ...:u -__-_:...-- I..- -__-_._ ..... III C) Running time 65% 95% Available running hours 1,248 1,824 Hours per part 0.5 0.35 Production capacity (number of parts) 2,496 5,211 Market demand 2,500 Depreciation cost per part (New machine = $200,000/2,500) $ 0 $ 80 Material cost per part $ 75 $ 75 Labour and other costs per part $ 30 $ 20 Total cost per part $105 $175 Mark-up 50% $ 53 $ 88 Selling price $158 $263 Maximum selling price $158 Effective markdown on cost -10% 18/30 CASE STUDY 9.3: ALOHA INDUSTRIES - MAKE v. BUY CASE 229 If the capital investment was not made, volume an adequate return on investment being achieved. would decline as a result of quality and delivery perfor- VPC believes that, under a life-cycle approach, vol- mance. If existing prices were maintained, reported ume will increase and returns will be generated once profitability would decline by $175,000 per year ($175 - quality and delivery performance have improved $105 = $70 per part X 2,500 parts). If prices wer with the new equipment. On a relevant cost basis, increased to cover the depreciation cost, volume w the capital investment decision has been fall further and profitability would decline. , depreciation could be ignored as it did not This presents a challenge for the con any future, incremental cash flow. There is little choice but to make the capital in his case is a good example of how accounting ment if the business is to survive. However, unle. akes visible certain aspects of organizations and market demand increases, there is little likelihood of changes the way managers view events. O Amanual labour to sew the shirts. The Assembly Department is limited by the number of labour- hours amilable. The company has had to slow down the cutting process so that the sewers do not become overwhelmed by the amount of cut fabric entering the Assembly Department Further. demand has increased to 10,000 shirts per month and management is considering adding another sewer to the Assembly Department or having the Existing sewers work overtime 1.5 hours per day at an overtime rate of one and half times their regular pay. The cost of each sewer is 512 per hour, averaging 8 hours per day and 20 days per month. Currently. the company has 5 sewers and makes 10 shirts per day. a. What is the total production that the company could make in a month if it hired a new sewer? b. What is the total production that the company could make in a month ifil had the staff work an additional 1.5 hours per day? c. What is the overall cost difference between hiring a new sewer and having employees work extra time? Should the company hire a new sewer or pay existing sewers overtime to provide the capacity needed? d. What other factors would need to be considered when deciding which approach to take? P9.14 (Cost: of Quality) CompuTrain creates instructional DVDs that provide instruction on various software applications. Maya Sloan, the company president, just received a report of the company's quality costs and was surprised to see a dramatic decline in prevention costs as a percent age of total sales over the last two years. Maya was happy to see this decrease in quality costs. 240 PART II LISWE [[{OUNIING lMlOEMAIIN FDR IIEKISIUII MIKE, MIME, All) {DNIRDL 29/30 ls Maya correct in thinking this is a good thing? What negative outcome: may occur from this decrease in prevention Costs? P9.15 {Cort onImlr'ly and Environmental Costing) The Ceramic Co'ce House has been errperiencing declining sales over the last two quarters and has noticed a reduction in the number of customers. Gupta Sanjay. the store owner. recently negotiated a new supply contract with Bargain Beans. He has been able to purchase his coffee beans for a 20% discount over his last supplier. 3. Discuss the implications of using a cheaper coffee bean. Be specic as to how this will impact costs of quality. in. What environmental costs might a coffee house need to consider? What are some suggestions to reduce its overall environmental costs? REFERENCES Fitzgerald. L.. Iohnston. R,. Brignall. S.. Silvestro. R.. 8r Voss. C. (1991). Performance measurement in service businesses. London: Chartered Institute of Management Accountants. Forbes (online). (April 3, 2011). BP rising from deepwarer horizon abyss but not free yet. Retrieved from http:l/blogs.forbes.comlgreatspeculations.r'20l ll03lO41bp-rising-from-deepwaler-horizon- abyss-hut-not-free-yet. Porter. M. E. (1985). Competitive advantage: Creating and sustaining superior performance. New York, NY: Free Press. 30/30 \"I O <