Production Planning and Control
Summer term 2012
Prof. Dr. Jörg Becker
WIRTSCHAFTS
INFORMATIK
Exercise 5: Hardware Cost Estimation
Meeting: Please try to prepare this exercise upfront for meeting on 18.06.20121
1) Traditional cost estimating – Direct cost vs. activity-based costing
ERCIS Ltd. manufactures high-quality pens. For many years the company manufactured only one type
of pen (namely, ballpoint pens) but last year the company also began to manufacture fountain pens.
The decision to begin manufacturing fountain pens was taken only after the company’s marketing
manager confirmed that there was a significant niche market for fountain pens and the company’s cost
accountant estimated that the cost of production for such pens would be much less than the selling
price predicted by the marketing manager.
When the fountain pen was introduced, sales (in terms of both quantity and price) were higher than
expected. Nevertheless, the overall profits of ERCIS Ltd. have declined steadily. As a result, the cost
accountant decided that he should re-examine his estimate of the cost of producing the fountain pen,
with particular reference to overhead cost. In his original analyses, he allocated all manufacturing
overhead costs to products in proportion to direct labour cost. However, in his re-examination he
decided that activity-based costing (ABC) should be used in order to gain a more thorough
understanding of the situation. The following data is available for the most recent month:
Direct cost of production, per unit of each product:
Ballpoint pen
Direct materials cost
Direct labour cost
11.25€
2.50€
Fountain pen
18.75€
5.00€
32,000
Fountain pen
4,000
Number of units of each product produced and sold:
Ballpoint pen
Units produced and sold
Manufacturing overhead costs for the month:
Activity cost pool
Machine running costs
Stores requisitions
Materials movements
Production set-ups
Activity measure
Machine hours
Number of requisitions
Number of movements
Number of batches
Total
Cost
91,000€
189,500€
67,500€
102,000€
450,000€
Activity levels in relation to each product:
Activity
Machine hours
Number of requisitions
Number of movements
Number of batches
1
Ballpoint pen
Fountain pen
7,500
500
325
50
Total
10,000
500
125
25
17,500
1,000
450
75
Detailed instructions for solving these exercises will be provided during the presentation.
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Your task:
a) Calculate the costs per unit for each of the two types of pen, if all manufacturing overheads are
allocated to the products in proportion to direct labour cost using an overhead allocation rate.
b) Calculate the cost per unit of each of the two types of pen, if all manufacturing overheads are
allocated to products using activity-based costing.
c)
Explain why the calculated cost per unit of the fountain pen is much higher in part b) than in part
a), and suggest what additional factors (i.e., other than those reflected in the calculations here)
may have contributed to the decline in the company’s profitability since the fountain pen was
introduced.
d) Now think of an alternative scenario: You are asked to design a brand new ballpoint pen which
should be sold as the new flagship of ERCIS’ portfolio. During the conception you are forced to
consider different designs and therefore alternative manufacturing steps.
Is the activity based costing approach your method of choice for this purpose? Why or why not?
Additionally, list two alternatives and shortly describe their advantages and disadvantages in the
given scenario in comparison to the traditional approaches.
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2) Introduction to Target Costing
Due to the unsuccessful introduction of fountain pens, ERCIS Ltd. plans to return to the traditional
ballpoint pen business with the release of a brand new product. For this purpose, the research
department has developed drafts for two ballpoint pen models: a classic model, which consists of a
single barrel as body and uses a cap with a clip for securing the pen’s tip, and a modern variant, whose
body consists of three screwed parts, provides a small rubber coating for a firmer grip and a push
button for releasing the tip.
Push button
Plug
Cap with clip
Worm
Inner cap
Worm
Barrel
Barrel
Ink cartridge
Rubber grip
Ink cartridge
Stopper
Feed
Cap with clip
Tip
Ball point
Worm
Spring
Feed
Tip
Ball point
With the purpose of avoiding a new failing of the cost estimations accompanying the development of
the new ballpoint pen, you – as a prospective cost engineer – are asked to help with the decision for
one of the two models and to perform a cost calculation for the different parts under consideration of
the product’s prospective utility for the customers. Since you heard about target costing as a method
which allows the considering of market forces and customer requirements during the cost estimation,
you decide for a correspondent approach.
As a first step, the research department hands over a table with the potential product attributes and
values for both models:
Attribute
Writing comfort
Reliability
Prestige
Safety from loss of parts
Planned selling price
Value
classic
modern
high (with rubber coating)
medium (abrasion of mechanical
parts like spring and push button)
high
high (no loose parts)
4.50€ per piece
low (without rubber coating)
high (no additional mechanical parts)
medium
medium (cap could get lost)
3.25€ per piece
Tab. 1
Beside this, the two drafts were part of a customer survey for determining the desired characteristics of
a ballpoint pen (scale 0-1; higher is better). Moreover, qualitative cost impacts for realizing the
different characteristics have been estimated by the research department (+: increase of costs; ○: no
increase of costs). All relevant results are subsumed in the following table (Tab. 2):
Attribute
Writing comfort
Reliability
Prestige
Safety from loss of parts
Planned selling price
modern
Part-worth / qualitative cost impact
classic
0.7 / +
0.5 / +
0.6 / +
0.7 / +
0
0.4 / ○
0.6 / ○
0.5 / ○
0.5 / +
0.5
Tab. 2
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The importance of an attribute or factor is represented by the range of its levels (difference between
highest and lowest part-worth) divided by the sum of the ranges across all the attributes. This provides
the relative importance of each attribute based on the range of its part-worth estimates.
a)
Please perform the accordant calculations. How can the results be interpreted?
Differences concerning the willingness to pay for the models can be calculated on the basis of a linear
function which compares the price (y-axis) with its part-worth (x-axis).
b) Against the background of the two given points, please specify this function. Additionally, please
use the part-worths to calculate the overall utility per model (without considering the part-worth
for the selling price), insert these values in the newly gained function and compare the values.
How can the results be interpreted (under consideration of the qualitative cost impacts for the
different attributes / models)?
Since the part-worth for the planned selling price has not been considered in the last calculation, a
price-sale-function shall be used for determining the optimal price for the products. Against the
background of the market survey, the following linear price-sale-function has been identified
(y: quantity of sales; p: price):
( )
c)
Please use this function to calculate the price and sales amount combination which maximizes the
turnover (remember: turnover is defined as ( )
).
Additionally, please calculate the new overall utility for the classic ballpoint pen model on the
basis of the new price. What price would be required for motivating the customers to change from
the classic model to the modern model?
On the basis of the present results, the management advises you to concentrate the further calculations
on the classic ballpoint pen model. The determined price and sales amount combination now allows
the calculation of the so called “allowable costs in the broader sense” for the classic ballpoint pen
model. The “allowable costs i. b. s.” result from the comparison of the sales exposure with all costs
that are allowed to occur during the product life cycle under the consideration of the market and
competitive environment and the expected return.
d) Please calculate the “allowable costs in the broader sense” for the classical model by considering
an expected return of 10% of the sales exposure.
Due to the aspect that the “allowable costs in the broader sense” form a highly aggregated and hardly
meaningful measure, it is necessary to further detail its parts. One option is a function-oriented
approach for eliminating the overhead costs (e.g. for research, marketing, sales etc.) from the further
calculations. Consequently, the following target costing approach only considers the production costs
(including the assembly costs). These costs are consequently called “allowable costs in the narrow
sense”.
e)
Please calculate the “allowable costs in the narrow sense” under consideration of overhead costs
in the amount of 54,000€.
On the basis of these calculations and the specifications for the product characteristics, the research
department details the draft for the classic ballpoint pen and determines the materials to be used.
Against the background of an older, already produced model you are asked to estimate the costs for
the different components of the new model (“drifting costs”). Thereby the following table (Tab. 3) has
been created as a result:
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Component
Plug
Barrel
Ink cartridge
Feed
Cap with clip
Tip
Ball point
Assembly
∑
Drifting costs in €
Share of expenses in %
0.2
0.4
0.5
0.1
0.2
0.15
0.25
0.2
2
10
20
25
5
10
7.5
12,5
10
100
Tab. 3
f)
Please compare the drifting costs and the allowable costs. What is the maximum amount of costs
for the production of the classic ballpoint pen that still guarantees the covering of the sales
exposure as well as the overhead costs?
Subsequently, it is required that the different components are weighted. Ideally, the relative required
resources for realizing a product’s attribute correspond with the customers’ utility for the particular
attribute. For comparing these values it is required to eliminate those attributes from the product
profile that do not bind any operational resources. In the present case the attribute price is affected by
this elimination. Moreover, the then calculated net product utility has to be normed to 100%.
g) Please calculate the net utility for the different attributes of the ballpoint pen and insert the values
into the following matrix (Tab. 4).
Against the background of the so far calculated values for the net utility it is then required to
determine the actual components that realize the desired attributes. After consultation with other
departments of the company (controlling, research and development, production etc.), the following
matrix (Tab. 4) has been created:
Attributes
Writing comfort
Components
Plug
Barrel
Ink cartridge
Feed
Cap with clip
Tip
Ball point
Assembly
Share of net utility
for the functions
Reliability
Prestige
5%
20%
10%
Safety from loss
of parts
5%
15%
5%
20%
5%
10%
5%
Share of net
utility for the
components
10%
30%
15%
5%
20%
5%
10%
5%
100%
Tab. 4
Consequently, you are provided with the share of net utility for the different components of the
classical ballpoint pen model. Using these data, you are now able to calculate the component-specific
target costs index. The target costs index indicates, whether the idealistic demand of an allocation of
costs according to the share of utility for the components is achieved. Following this approach, a
product attribute or function which is judged to be more relevant for the customer, is allowed to cause
higher target costs. The target costs index can be calculated as follows:
h) Please calculate the target cost index for the different components. How can the results be
interpreted?
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In practice, a demand for target costs indices with a value of 1 is too narrow. Instead, a tolerance
region is defined in which the different components should be located. In a diagram, the x-coordinate
is enriched with the percentaged share of utility for the components whereas the percentaged share of
costs for the components is written down on the y-coordinate. The angle bisector denotes the idealistic
demand of a target costs index with a value of 1. Following the approach of Tanaka, the tolerance
(
) and
region can be defined with the functions
(
) . The parameter q
thereby allows the adjustment the tolerance region’s width. For selecting the parameter q the following
recommendations exist: The nearer the target costs for the overall product are situated at the level of
the maximal allowed costs on the market, the smaller the tolerance region and consequently the chosen
parameter q should be selected.
i)
Please draw the complete diagram with the parameter q=10 and under consideration of the angle
bisector. How can the results be interpreted for the different components and what is your
conclusion for the upcoming discussion with the management and the research department?
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