Managing cost and quality (35 Marks)

MountainBikes Ltd is a major Australian bicycle manufacturer. Over the last decade, bicycle manufacturers from Taiwan and Korea have been able to price their bikes below those of MountainBikes products, but the company has retained its market share due to the poor quality of the imported bikes. Recently, however, the quality of the imported bikes has improved, and MountainBikes has had to cut prices to maintain market share. The managing director, John Small, is concerned about the viability of the business at these lower prices and asks the accountant, Colleen Martin, to investigate the problem.

Martins initial investigation indicates that the lower prices cannot be sustained in the longer term, as they do not cover the costs of manufacture, or contribute to the companys selling and administrative costs. She looks for possible cost reductions. The company has always had a reputation for high quality, but Martin feels that there are substantial costs incurred in attaining this level of quality. She knows that there are extensive quality inspection checks throughout the production process and that many employees spend part of their time reworking defective parts. She also has noticed the buckets full of scrapped parts and components spread throughout the factory. These costs are not recorded separately in the existing accounting system. Martin asks Small to support the development of a cost of quality system.

Small:What do you mean, a system that records the costs of poor quality! Our bikes are among the best in terms of quality!

Martin:I know that John, and we know what it costs us to make our bikes, but weve got no idea how much of that cost is related to ensuring quality. I think the cost of quality here is very high. What if it is a third of our manufacturing costs? And what if we could reduce it without compromising our quality? We could keep our prices down and still make a good profit.

Small:Okay, Colleen. Give your cost of quality system a try, though I dont see how it will help. Everybody knows that good quality costs money. Even if we do find out our cost of quality, I dont see how it will help us reduce it.

Martin:John good quality doesnt seem to cost money in Taiwan and Korea. Their prices havent gone up, even though their quality has. Youll soon see that understanding quality costs can help you to reduce them and to improve quality at the same time.

Over the next six months Martin identifies the following costs of quality in Table 1 below:

During this period, total manufacturing costs were $600,000.

During this period total Sales Revenue was $750,000

Table 1 Quality Cost Report for MountainBikes Ltd

	Current Half-Yearly Cost	Percentage 6 Month's of Total Quality Costs
Prevention costs:
Cost of quality training programs	3,000
	$3,000	%
Appraisal costs:
Quality inspection in the goods receiving area	15,000
Quality inspections during processing	23,000
Laboratory testing of bikes and components	13,000
Operating an X-ray machine to detect faulty welds	15,000
Inspection of each bike put into finished goods warehouse	16,000
	$82,000	%
Internal failure costs:
Rework on defective wheels	8,000
Engineering costs to correct production line quality problems	15,000
Committed machine hours that become idle due to machine downtime during correction of production line quality problems	25,000
Cost of faulty components that are scrapped	4,000
Cost of rewelding faulty joints discovered during processing	19,000
Cost of faulty bikes that are scrapped after finished goods inspection	10,000
	$81,000	%
External failure costs:
Cost of replacement bikes provided under warranty	7,500
Cost of bikes returned by customers and scrapped	9,000
Cost of repairs under warranty	1,000
	$17,500	%
Total quality costs	$183,500	%

All requirements for Question 3 must be answered

1. A cost of quality report has been prepared for the six months grouping each quality cost into one of the four quality cost categories.

Calculate the total cost of each quality for each cost of quality category [e.g., Prevention is one category]. Write your answers in the above table {which can be copied into your assignment} You will need to add more columns. Calculate the cost of quality as:

(a) a percentage of Total Quality Costs for each cost item and for each category

(b) a percentage of Manufacturing Costs for each cost item and each category.

(c) a percentage of Total Sale Revenue for each cost item and each category

6 marks

2. Identify the three worst performing cost activities across the four cost categories and explain why you believe these to be the three worst cost activities. Suggest some reasons why they may have been incurred. Suggest some ways in which they could be reduced or eliminated.9 marks

3. Which cost category is the most important category to invest in so that the quality of the bikes can be improved, and so that quality costs can be reduced over time? Suggest three additional costs that could be added into this category to help the company work towards use the Zero-Defects strategic model and briefly explain how they would work.

6 marks

4. When John Small receives the cost of quality report, he is amazed and says,

Colleen, youre the accountant. Why didnt you tell me before this that our quality costs were this high?

Explain to Small why Martin was unable to tell him much about the cost of quality because of the existing accounting system. (Hint: compare traditional costing with ABC, ABM and Cost of Quality reporting).

4 marks

5. Before the competitors improved the quality of their products, Mountain Bikes Ltd was selling its bicycles for $187.50 but now must match the competitors selling price of $145.

If the company targets this selling price to retain its current half-yearly sales volume of 4,000 units for the next 6 months and it decides to maintain its usual profit margin (as 20% percentage of sales), what must be set as the new target cost? 6 marks

6. What is the new Revenue amount expected for the next 6 months if the company can increase its market share by 25% if selling at the new lower price? What is the expected profit or the next 6 months?

4 marks