Zando Pharmaceuticals is an affiliate of the German-based Heisenberg Corporation, which employs 40,000 worldwide. Zandos St. Louis facility houses the U.S. corporate headquarters and Research and Development. It produces 30 products, using 28 different batch processes. The facility has 2,000 employees on-site. In recent years, Zandos profitability has suffered, which can be attributed to increased competition, customer dissatisfaction, and regulatory pressures. Luis Alvarado, president of Zando, called a meeting to consider ways to improve profitability. He labeled the meeting a strategic planning session and invited the following officers: Kathy Shorts, environmental manager, Troy Lewis, head of R&D, Johnny Mizukawa, vice president of production and quality, Larry Sower, vice president of finance, and Doreen Savara, marketing vice president. Luis: You all have received the quarterly financial reports for the last two years. The trends are negative. We are losing market share, profits are decreasing, and our costs seem to be increasing. We need to take actions to increase sales and reduce costs, and we need to do so as quickly as possible. Given our research strengths, it seems to me that our best bet is to grow revenues by introducing new products with proprietary rights. As far as costs are concerned, we need to improve our performance on that dimension as well. Lower per-unit costs for new and existing products are needed. Any suggestions? Troy: For our products, our ability to control costs resides in developmentmy arearather than manufacturing. We probably need to pay more attention to product and process design issues to ensure a reasonably level per-unit cost. Revenues are also affected in this stage. Once we patent a drug, the clock begins to tick, and we need to reduce time to market. Significantly, reducing time to market will allow us to generate revenues for a longer period of time than we are currently experiencing. It would also be helpful if we could reduce the cycle time for product development. Both actions would increase revenues. Finally, we can increase revenues by increasing the volume of new products. Johnny: There is a lot of merit to the observation that cost reduction opportunities reside mostly in product development. Once a drug is approved, its approval includes the manufacturing process. Any future changes in the manufacturing process require approval from the U. S. Food and Drug Administration. Because of this, we have been reluctant, historically, to engage in process improvement or reengineering. However, I wonder if we shouldnt reconsider this longstanding policy. Some of the quality problems we have could be corrected by changing some of our existing processes, and the costs saved may easily exceed any cost incurred from seeking FDA approval. I think our quality costs are at least 15 percent of sales. Thats a lot of opportunity for improvement. Kathy: I agree that cost reductionboth in the product development stage and the manufacturing stageshould be a key strategic theme. The environmental area also offers some very good opportunities. A recent pollution prevention act passed by the legislature requires that we calculate the costs of generating hazardous substances for each process. This act was the incentive we needed to begin developing an environmental cost management system. The results so far indicate that environmental costs are much more than we realized. They are estimated to be in the range of 20 to 30 percent of total operating costs. Environmental costs can be reduced by such things as computerizing chemical inventory, eliminating the use of chlorinated solvents and other hazardous materials, reducing our use of virgin feedstocks, and redesigning processes and products so that we can reduce toxic residue release. We can really have a positive environmental impact while simultaneously reducing costs if more attention is paid to environmental issues during product development. Doreen: I like what I am hearing because I think that it also affects our ability to increase market share and revenues. For example, environmental impact is one of our major concerns. Some retail pharmacy chains pay particular attention to green products, and right now we are not competing well. Our environmental image is negative and needs to be improved. I am convinced that doing so will allow us to increase market share. Quality is another important matter. We have had to recall two batches of products during the past two years due to poor quality, and this has hurt our image more than the environmental issue. Improving the processes to avoid these kinds of problems will save us a lot of grief. Product image and reputation are essential to increasing customer satisfaction and market share. Luis: We started with the need to improve financial performance by increasing revenues and reducing costs. So far, we have some very good suggestions to help achieve these two objectives, but I have some concerns. First, do we have the talent and capabilities to improve quality and environmental performance? Troy, do your professionals really understand what they need to do to improve process and product designs so that we can see the desired quality and environmental improvements? Also, how can we reduce the cycle time for products and the time to market once patented? Troy: Let me answer those question in order. First, we probably are lacking the understanding on the design issues. We will need to do some training to help our research scientists and chemical engineers understand the consequences. We may need to hire a couple of professionals who have experience in dealing with these issues. Second, we may need to make cycle time and time to market significant performance measures and reward our people for actions that reduce those measures. Our employees need to align their interests with those of the company. If we can achieve this, we should see more revenue produced per employee. Luis: Good. Now, Johnny, tell us about production and quality. Do our manufacturing engineers and production workers need help with environmental and quality issues? Johnny: Without question, training will be needed. Moreover, I really need to hire a couple of quality engineers. Kathy: I also think that we need an environmental engineer with experience in pharmaceutical manufacturing processes. Luis: Good. We certainly shouldnt ignore the necessary infrastructure to bring about the needed changes. Larry, you have been relatively quiet, what do you think about all this? Do you have any suggestions? Larry: Infrastructure is important. If this is all going to work, timely and accurate information will be needed. It is hard to design products and processes with cost being a significant issue without providing the right kind of cost information. We are in the process of revamping the cost management information system so that it is activity-based and so that we can provide quality and environmental cost information. After listening to the comments made here, I might also suggest that we need a strategic measurement system that can be used to align the interests of our employees with our improvement strategy. People need to know what is important, that the important factors are being measured, and that they are going to be evaluated and rewarded based on these factors. Finally, I would encourage the use of target costing to help manage costs during product development. To help you all understand the importance of good information, I have assembled some activity data relating to two new products currently under development. These two products will use the same process, using different setups. The data are organized into resource, activity, and cost object modules with an accompanying list of activity drivers to facilitate the use of an ABC software package recently acquired by Zando. Resource Module (Projected General Ledger Costs of Manufacturing Process Associated with the Two Products) Materials $2,000,000 Salaries and wages 1,000,000 Energy 500,000 License fee (environmental) 200,000 Environmental fines 400,000 Depreciation, pollution control equipment 100,000 $4,200,000 Activity Module Resource Driver (Percentage Usage) Materials Labor Energy Fees Fines A. Supervising process* 0% 10% 0% 0% 0% Setting up 3 20 14 0 0 Blending chemicals 80 40 30 0 0 Producing waste 10 8 10 0 0 Disposing of hazardous waste 6 12 15 40 70 Inspecting products 0 7 6 0 0 Releasing air contaminants 0 0 0 60 30 Operating pollution control equipment 1 3 25 0 0 100% 100% 100% 100% 100% *Secondary activity whose costs are assigned to primary activities in proportion to the labor time used. Cost Object Module (Products and Projected Activity Usage) Cost Objects Antibiotic XK1 Antibiotic XK5 Expected output (pounds) 50,000 50,000 Setup hours 12,000 7,000 Direct labor hours (blending) 24,000 16,000 Pounds of waste 8,000 2,000 Pounds of hazardous waste 5,000 1,000 Hours of inspection 3,000 500 Tons of air contaminants 4.5 0.5 Machine hours (pollution control) 2,000 500 A. List of Activity Drivers Activity Drivers Activity Capacity Setup hours 20,000 Direct labor hours (blending) 40,000* Pounds of waste 10,000* Pounds of hazardous waste 8,000 Hours of inspection 4,000 Tons of air contaminants 5* Machine hours (pollution control) 3,000 * Capacity is flexible, i.e., acquired as needed, and always matches usage. Capacity for other activities is acquired in advance of usage. For example, setups are acquired in units (steps) of 950 hours. Projected usage for setups equals practical capacity.

Classify the primary activities into three categories: environmental, quality, and other (neither quality nor environmental). Did some activities end up in more than one category? Explain

Calculate the cost per unit for each of the proposed products using primary activity rates. Now, calculate the environmental cost per unit and the quality cost per unit. What does this tell you about the relative desirability of the two products?

Following Larrys suggestion, Luis decided to use target costing to help improve new product profitability. Based on analyses by Luis and Doreen, the target prices for XK1 and XK5 are $50 per pound and $35 per pound, respectively. Luis has indicated that any new product should earn a gross profit equal to 20 percent of sales. Based on this information, answer the following:

What is the target cost for each product? Given this information, what should be done?

Suppose Doreen indicates that sales for each product can be increased by 50 percent if the selling price is lowered by 10 percent. Assuming the same target profit (luis wants the original target profit per pound maintained), calculate the new target costs.

If all nonvalue-added costs were eliminated, could the target be met? (calculate the unit cost at the 50,000 unit level.) Now, calculate the effect on total profits under a scenario where nonvalue-added costs are not eliminated versus a scenario where all nonvalue-added costs are eliminated. (include in this analysis any possible increase in sales volume.)