Melvan Metor is a major Australian bicycle manufacturer. Over the last decade, bicycle manufacturers from China have been able to price their bikes below those of Melvan Metors products, but the company has retained its market share due to the perceived poorer quality of the imported bikes. Recently, however, the perception of quality of the imported bikes has improved, and Melvan Metor has had to cut prices to maintain market share. The managing director, Lan is concerned about the viability of the business at these lower prices and asks you, the accountant, to investigate the problem.

Your 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. You look for possible cost reductions. The company has always had a reputation for high quality, but you feel 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. You asks Lan to support the development of a cost of quality system.

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

You: I know that Lan, 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.

Lan: Okay, 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.

You: Lan good quality doesnt seem to cost money in China. 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 12 months, you identify the following information that includes the annual costs of quality (in Table 1) as well as last years information and projected sales for this year on the top of the next page:

	Table 1: List of cost of quality non-conformance activities and their costs from smallest to largest cost
	Cost of repairs under warranty	$3,250
	Cost of bikes returned by customers and scrapped	6,950
	Cost of replacement bikes provided under warranty	16,500
	Cost of quality training programs	45,000
	Committed machine hours that become idle due to machine downtime during correction of production line quality problems	48,100
	Cost of faulty bikes that are scrapped after finished goods inspection	55,500
	Cost of faulty components that are scrapped	56,525
	Inspection of each bike put into finished goods warehouse	63,500
	Cost of rewelding faulty joints discovered during processing	63,540
	Operating an X-ray machine to detect faulty welds	74,620
	Rework on defective wheels	83,500
Quality inspections during processing		85,690
Laboratory testing of bikes and components		91,500
Engineering costs to correct production line quality problems		92,000
Quality inspection in the goods receiving area		101,600

annual total manufacturing costs were $8,157,750

annual total sales revenue was $11,250,000

annual total operating expenses were $1,967,250

annual Net Profit Before Tax (NPBT) was $1,125,000; which = 10% of Sales Revenue

4,500 bikes are sold annually

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

1. Group each quality cost item into its appropriate quality cost category and calculate the total cost of each quality process for each cost of quality category as well as a percentage of Manufacturing Costs for each cost item and each category [e.g., Prevention is one category].

2. When Lan receives the cost of quality report, she is amazed and says, You are the accountant. Why didnt you tell me before this information that our quality costs were this high?

Explain to Lan why the TPMS was unable to tell her much about the cost of quality because of the existing TPMS. (Hint: compare traditional Overhead costing of a TPMS to ABM activity analysis in a PPMS and the categorisation of quality costs to produce a Cost of Quality report from a SPMS).

3. Before the competitors improved the quality of their products, Melvan Metor was selling its bicycles for $2,500 but now must match the competitors selling price of $2,000 to retain its current 4,500 yearly bicycles sales volume.

Melvan Metor decides to maintain its usual profit margin (i.e., net profit before tax (NPBT)) as 10% percentage of sales revenue). What must be the new target manufacturing cost for Melvan Metor to achieve this 10% percentage of sales revenue with a selling price of $2,000?