Question 1. Managing cost and quality (16 marks)

Alexis Klark, managing director of Pharsalia Electronics (PE), is concerned about the prospects of one of

its major products. She has been reviewing a marketing report with Jeff Keller, the marketing product

manager for that product. The report indicates that a price reduction is needed to meet anticipated reductions

by competitors. The current selling price of the product is $700 per unit. It is expected that PE's two major

competitors will be selling a very similar product for $600 per unit within three months. The competition

concerns Klark because the current cost of producing and selling their product is $630, which yields a $70

profit on each unit sold.

The situation is alarming because PE implemented an activity-based management system about two

years ago. The ABM system helped them better identify activity costs, root cause cost drivers and cost

reduction opportunities. Changes made due to adopting ABM reduced costs on this product by

approximately 15 per cent over the last two years. Now it appears that costs will need to be reduced

considerably more to remain competitive and make a profit on the product. Total unit costs to produce, sell

and service the products are as follows:

Product costs per unit Material

Purchased components

$220

All other material

80

Manufacturing activities

Setups

32

Material handling

34

Inspection

46

Cutting, shaping and drilling

60

Bending and finishing

48

Other

Finished goods warehousing

10

Selling costs

60

Customer service

40

Total unit cost

$630

Klark has decided to hire Donald Collins, a consultant, to review the situation and implement any needed

changes. After two weeks of review, discussion, and analysis, Collins suggested that PE adopt a just-in

time (JIT) system to help reduce costs. He also suggested that using target costing would help in meeting

the new target price of $600.

By changing to a JIT manufacturing system, PE expects material handling, inspection, and finished goods

warehousing to be eliminated. However, the cost of other manufacturing activities will increase by 10 per

cent due to the need for more highly skilled labour. Customer service costs are expected to be reduced by

50 per cent.3

Required

1. What are the relation between PE's target cost per unit and the current profit, assuming that the current

profit margin remains unchanged (8 Marks)?

2. Explain If the JIT system is implemented, will PE meet the target cost (4 Marks)?

3. Explain four steps in ABM to reduce the product cost (4 Marks)