Management Accounting Information For Activity and Process Decisions

Chapter 5
Management
Accounting Information
for Activity and
Process Decisions
QUESTIONS
5-1 In evaluating the different alternatives from which managers can choose, it is
better to focus only on the relevant costs that differ across different alternatives
because it does not divert the manager’s attention with irrelevant facts. If some
costs remain the same regardless of what alternative is chosen, then those costs
are not useful for the manager’s decisions, as they are not affected by the
decision. Therefore, it is better to omit them from the cost analysis used to
support the decision.
5-2 No, sunk costs are not relevant costs. Sunk costs are the costs of resources that
have already been committed and, regardless of what decision is made by the
managers, these costs cannot be avoided. Therefore, they are irrelevant for the
decision.
5-3 The general principal is that sunk costs are not relevant costs. But, some
managers may consider sunk costs to be relevant because they may be
concerned about how others will perceive their original decision to incur these
costs, and may want to cover up their initial poor judgment.
5-4 Both direct labor (DL) and material (DM) costs can be either relevant or
irrelevant depending on the decision context and the alternatives that are
available to the managers. When considering the purchase of automated
equipment that will decrease the defect rate, both DL and DM are, in general,
relevant costs because these costs are likely to decrease if the new machine is
purchased. However, DM can be a sunk cost in the short-run if the materials
usable only with the old machine have been already purchased or purchase
commitments have been made. Similarly, if labor has been contracted for a
specified period and the company cannot eliminate the extra labor when the
automated equipment is purchased, then the DL cost also will be irrelevant in
the short-run.
– 207 –
Atkinson, Solutions Manual t/a Management Accounting, 5E
5-5 No, fixed cost are not always irrelevant. For example, in comparing the status
quo and a proposal to substantially increase the quantity of goods or services
provided, additional fixed costs (that is, costs not proportional to volume) may
be incurred to provide the increased quantity.
5-6 In the context of a make or buy decision, product sustaining costs such as
production engineering staff salaries are relevant if these costs can be eliminated
by assigning the staff to other tasks, or by laying off the engineers not required
when a part is outsourced. If it is possible to find an alternative use for the facilities
made available because of the elimination of a product or a component, the
facility-sustaining (business-sustaining) costs also are relevant.
5-7 Cash flows at different points in time cannot be compared directly because of
the time value of money that requires interest to be paid on bank deposits and
on borrowings from financial institutions.
5-8 Yes, avoidable costs are relevant because they can be eliminated when a part, a
product, a product line or a business segment is discontinued.
5-9 Two examples of costs that are not relevant in the short-run, but are relevant in
the long-run:
1. Costs of production engineering, if the number of engineers cannot be

changed in the short-run.
2. Facility rental costs, if the lease commits the firm for the short-run.
These costs can be avoided in the long-run.
5-10 Facility-sustaining (business-sustaining) costs are often not relevant for make-
or-buy decisions because the costs are incurred regardless of whether the
company makes or buys the products. However, if the freed-up facility can be
used for another purpose, or its lease agreement can be terminated, then these
costs become relevant.
5-11 There are several qualitative considerations that must be evaluated in a make-
or-buy decision. For example, one must question whether the outside supplier
has quoted a lower price to obtain the order, and plans to increase the price.
Also, the reliability of the supplier in meeting the required quality standards
and in making deliveries on time is important.
5-12 When a decision to outsource frees up space to produce an alternative product,

then the contribution margin on the alternative product is a relevant
opportunity cost in a make-or-buy decision.
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Chapter 5: Management Accounting Information for Activity and Process Decisions
5-13 The throughput contribution is the difference between revenues and direct
materials for the quantity of product sold. Investments equal the materials
costs contained in raw materials, work-in-process, and finished goods
inventories. Operating costs are all other costs, except for direct materials
costs, that are needed to obtain throughput contribution.
5-14 In process layouts, all similar equipment and functions are grouped together.
Process layouts typically occur in organizations in which production is done in
small batches of unique products. In process layouts, products are moved and
processed from one area to another until the product is completed. In contrast,
in product layouts, equipment is organized to accommodate the production of a
specific product. Product layouts are most effective for companies producing
high-volume products. Typically, products move and are processed along an
assembly line.
5-15 Cellular manufacturing involves the organization of a plant into a number of

cells. Within each cell, machines that are needed to manufacture a group of
similar products are arranged close to one another. This organization reduces
production cycle time, which is the time from receipt of raw materials from the
supplier to delivery of the finished good.
5-16 A JIT system is very different from a conventional manufacturing system. In a

JIT system, a good or service is produced or delivered only when a customer
requires it. JIT production requires a product layout with a continuous flow
once production starts. Underlying the JIT system is a continuous improvement
philosophy of eliminating or reducing delay, error, and waste, such as materials
movement, storage, rework, and waiting time. In a typical JIT system, all types
of inventories (raw materials, work-in-process, and finished goods) are
minimized. The ultimate measure of success with JIT occurs when the
processing cycle efficiency ratio equals 1.
Under many conventional manufacturing systems, goods are produced to a

production schedule that may not be directly tied to when customers require the
goods. All types of inventories are kept on hand just in case unforeseen events
occur. Little attention is given to studying efficient and inefficient activities,
and materials movement, storage, rework, and waiting time are part of the
conventional work environment.
– 209 –
5-17 Under many conventional manufacturing systems, goods are produced to a

production schedule that may not be directly tied to when customers require the
goods. Goods are produced in batches to reduce setting up, moving, and
handling costs, but batch processing increases the inventory levels in the
system. This is because at each processing station all items in the batch must
wait while the designated employees process the entire batch before moving all
parts in the batch to the next station. If the rate at which each processing area
handles work is unbalanced—because one area is slower or has stopped
working due to problems with equipment, materials, or people—work piles up
at the slowest processing station, increasing the work-in-process inventory
level at that station. Since supervisors evaluate many processing area managers
on their ability to meet production quotas, processing station managers try to
avoid the risk of having their facility idle. Many managers deliberately
maintain large stocks of incoming work in process so that they can continue to
work even if the processing area that feeds them is shut down. Similarly, to
avoid idling the next processing station and suffering the resulting
recriminations, managers may store finished work that they can forward to
supply stations further down the line when their stations are shut down because
of problems. Finally, inventories may be kept on hand just in case inputs to
various stages of the manufacturing process are defective.
Because cellular manufacturing and just-in-time production reduce the

production cycle time and focus on reducing waste by improving process and
product quality, and quality improvement programs reduce the defect rate,
work-in-process inventory is likely to decrease on the implementation of these
programs.
5-18 Reduction in time spent waiting for the next stage of production reduces both
production cycle time and work-in-process inventory levels.
5-19 The following three types of costs are incurred when implementing a cellular
manufacturing layout:
1. Costs of moving machines

2. Costs of reinstallation of machines
3. Costs of training the workers
– 210 –
5-20 Financial benefits resulting from a shift to cellular manufacturing, just-in-time

production, or continuous quality improvements may include the following:
1. Increased sales because the short production cycle time enables a

company to win customers by cutting the delivery time.
2. Reduction in the number of workers needed to move materials from one
area to another, due to close proximity of manufacturing processes and
reduction in work-in-process inventory levels.
3. Reduced material waste because of reduced damage caused by materials
handling. Lower work-in-process inventory levels also reduce the
potential for products to become obsolete.
4. Reduced cost of storage because less space is used to store the reduced
work-in-process inventory.
5. Reduced clerical costs for keeping inventory records.
6. Reduced financing costs of inventories
5-21 “Cost of nonconformance” refers to the cost an organization incurs when the
quality of products or services does not conform to quality standards..
5-22 Waste, rework and net cost of scrap are examples of internal failure costs.
5-23 Quality engineering, quality training, statistical process control and supplier
certification are examples of prevention costs.
5-24 Three examples of each of the following quality costs are:
(a) prevention costs—quality training, supplier certification and statistical

process control;
(b) appraisal costs—inspection and testing of incoming materials, process
control monitoring and product quality audits;
(c) internal failure costs—waste downtime due to defectives, rework costs
and scrap;
(d) external failure costs—product liability lawsuits, product recalls, and
warranty claims.
5-25 The additional cost of replacing a rejected unit that must be scrapped includes
all the incremental material and conversion costs already incurred on such a
unit that must be repeated. Furthermore, additional costs such as handling,
storage, etc. corresponding to the material that is lost also are included. From a
managerial perspective, opportunity cost may also be included if relevant.
– 211 –
5-26 Rework costs in clued direct rework labor, any additional direct materials used,
and if relevant, unit- and batch-related support. From a managerial perspective,
opportunity cost may also be included if relevant.
5-27 When evaluating the profit impact of an increase in the sales of a product, it is
important to evaluate the contribution margins on the increase in sales for that
product, and on the decrease in sales of other cannibalized products (other
products that lose customers to the product being evaluated). In addition, if
inventory and accounts receivable increase with sales, then the cost of carrying
these additional current assets are also relevant.
5-28 It appears to be good advice because it will avoid distracting attention and will
simplify decisions made by managers by elim inating irrelevant details.
However, it must be recognized that managers make a variety of nonroutine
decisions, and the relevant costs for these decisions depend on the context and
the alternatives available. Therefore, a single system reporting costs relevant
for only one set of routine decisions may prove inadequate for supporting the
full range of managerial decisions.
EXERCISES
5-29 (a) Relevant costs:

• Acquisition cost of Ford Escort
• Repairs on the Impala
• Annual operating costs on the Ford Escort
• Annual operating costs on the Impala
Irrelevant costs:
• Acquisition cost of Impala
– 212 –
(b) Don will buy the Ford Escort if he bases the decision only on the available cost
information.
Year 1: (If Don buys the Ford Escort)
Cash savings:
Repairs on the Impala $5,400
Operating cost—Impala 2,900
8,300
Cash expenditures:
Acquisition cost—Ford Escort 5,400
Operating cost—Ford Escort 1,800
7,200
First Year Savings $1,100
(c) Additional quantitative considerations:

1. Number of years before car is replaced (decision horizon).
2. Expected resale values of both cars when they will be replaced.
3. Cost of capital (interest rate) to consider the time value of money.
(See Chapter 11.)
Qualitative consideration:
1. Subjective preference for driving an Impala rather than a Ford
Escort.
5-30 Per Unit As Is Rework

Sales price $4 $10.00
Rework cost — $5.50*
Net after rework $4 $4.50
*55,000 ÷ 10,000
Gilmark should rework the lamps.
– 213 –
5-31 (a) The original cost of $50,000, accumulated depreciation of $40,000, and
annual operating costs (before overhaul) of $18,000 are all irrelevant
when the choice is between overhauling the old machine and replacing it
with a new machine. Note that the $18,000 operating costs are not sunk
costs, yet they are irrelevant.
(b) Relevant costs include the acquisition cost of the new machine, the cost
of overhauling the old machine, current salvage of $4,000 for the old
machine and the annual operating costs for both the new machine and the
overhauled old machine.
(c) Replacement Overhauling Difference

Net acquisition cost $66,000a $25,000 $41,000
Operating costs for
5 years 65,000b 70,000c (5,000)
Total relevant costs $131,000 $95,000 $36,000
a
$70,000 – $4,000 = $66,000
b
$13,000 × 5 = $65,000
c
$14,000 × 5 = $70,000
It costs Ideal Company $36,000 more with the new grinding machine
than overhauling the old one. Therefore, the plant manager should
overhaul the old grinding machine. However, this analysis is incomplete
as it ignores the time value of money, considered in Chapter 11.
5-32 (a) Insource Outsource

(Make) (Buy)
TV sets:
$600 × 1,000 $600,000 $600,000
Picture tube:
$55.00 × 1,000 55,000
$65.00 × 1,000 65,000
Relevant costs $655,000 $665,000
– 214 –
(b) Insource Outsource

(Make) (Buy)
TV sets:
$600 × 1,000 $600,000 $600,000
Picture tube:
$42.00 × 1,000 42,000
$65.00 × 1,000 65,000
Relevant costs $642,000 $665,000
5-33 (a) Assumptions need to be made about the avoidability of the support costs
if Kane outsources the component.
(b) If the unit-related, batch-related, and product-sustaining support costs are

all avoidable, then Kane will certainly reduce costs by outsourcing the
component. Facility costs may be unavoidable if the facility cannot be
converted to alternative uses when the component is outsourced.
However, even if the facility costs are unavoidable, Kane would reduce
costs by outsourcing. In this case, the cost savings per unit if the
component is outsourced would be:
Purchase price $64.50

Avoidable costs ($73.10 – $6.90) 66.20
Savings per unit $1.70
(c) Other factors relevant to the decision are the supplier’s ability to live up
to expected quality and delivery standards, and the likelihood of
suppliers increasing prices of components in the near future.
– 215 –
5-34 Premier should make the gear model G37 because it costs $87,000 less to make
than to buy.
Make Buy
Cost of purchase: $120 × 20,000 = $2,400,000
Direct material cost: $55 × 20,000 = $1,100,000
Direct labor cost: $30 × 20,000 = 600,000 —
Variable support: $25 × 20,000 = 500,000 —
Fixed support $15 × 20,000 = 300,000 300,000
Savings in facility-sustaining costs — (113,000)
Relevant costs $2,500,000 $2,587,000
5-35 Year 1 Year 2 Year 3 Year 4 Year 5

Cash inflow:
Sale of old machine $40,000 (5,000)
Saving because old
machine not
repaired 20,000
Salvage value of
new machine $10,000
Decrease in annual
operating costs 20,000 $20,000 $20,000 $20,000 $20,000
Cash outflow:
Purchase of new
machines (120,000) 0 0 0 0
Net cash inflow
(outflow) ($40,000) $20,000 $20,000 $20,000 $25,000
Cumulative cash
inflow (outflow) ($40,000) ($20,000) $0 $20,000 $45,000
Joyce Printers should not replace the machines if they do not expect to use the
new machines for more than four years. (See Chapter 11 for formal coverage of
net present value analysis.)
– 216 –
5-36 (a) The offer by Superior Compressor should not be accepted if facility-
sustaining support costs are unavoidable.
Cost per unit Make Buy

Cost of purchase $200
Variable cost:
Direct material $ 80
Direct labor 60
Unit-related support 26
Batch-related support 22
Product-sustaining support 8
Relevant cost per unit $196 $200
(b) The maximum acceptable purchase price is $213 per unit if the plant
facilities are fully utilized at present and the incremental cost of adding
more capacity is approximated well by the $17 per unit facility-
sustaining support cost.
5-37 Benefits from cellular manufacturing operations are estimated to be $767,200

as shown below:
Before the After the

Change Change Difference
Sales $1,260,000 $1,700,000 $440,000
Costs:
Direct material (378,000) (340,000) 38,000
Direct labor (277,200) (255,000) 22,200
Variable support (352,800) (170,000) 182,800
Fixed support (151,200) (85,000) 66,200
Inventory carrying costs (24,000) (6,000) 18,000
Profit $76,800 $844,000 $767,200
5-38 Prevention costs are incurred to ensure that companies produce products
according to quality standards. Prevention costs include quality engineering,
training of employees in methods designed to maintain quality, etc. Appraisal
costs are related to inspecting products to make sure that they meet both
internal and external customers’ requirements. Inspection of purchased parts
and materials and process control monitoring are examples of appraisal costs.
Internal failure cost occurs when the manufacturing process produces a
defective component or product. The cost of downtime in production as a
result of defects is an example of an internal failure cost. External failure costs
– 217 –
are incurred when a customer in the field detects a problem with a product or
the product fails. Examples of external failure costs include warranty costs,
service calls, and product liability recalls.
5-39 Of the four quality costing categories, an external failure cost is the most
damaging to the organization. Customer satisfaction and future sales may be
jeopardized. Moreover, product liability lawsuits can be extremely costly to the
organization not only in dollars, but also in terms of corporate reputation. One
key example of this is the Ford Pinto.
5-40 A grocery store is organized using a process layout—similar foods are grouped
together to make it easier for customers to find what they want. A grocery store
might be reorganized into a modified cell layout. For example, someone
wanting to prepare a certain meal, like lasagna, might find all the required
ingredients in one place. However, this approach is likely to be costly and
impractical and make stock rotation difficult.
PROBLEMS
5-41 (a) In determining the minimum prices, it is important to know which costs
will change with each catering job. Assumptions will need to be made
about how well the event-related and customer-related costs represent
resource usage. (For example, one might assume practical capacity was
used to determine the costs.) Event-related costs should correspond to
each catering event, while customer-related costs should correspond to
maintaining a relationship with the customer, not the number of events
with the same customer. One might also assume the facility-sustaining
costs are committed in the short run and will not change with the
addition of one more catering job.
(b) Other factors in setting the price may include the price competition
Carmen faces, the likely demand from this customer for future catering
events, and the current demand for Carmen’s Catering.
– 218 –
(c)
Menu 1 Menu 2
Direct materials and direct labor, 100 meals $1,300 $1,600
Event-related support 100 100
Customer-related support 22 22
Total $1,422 $1,722
Cost per meal $14.22 17.22
Assuming facility-sustaining costs are not avoidable in the short run,

Carmen’s minimum price should cover at least the $14.22 for menu 1
and $17.22 for menu 2 from a short-run perspective. From a long-run
perspective, Carmen’s Catering should charge a price that covers the
costs above, as well as a portion of the facility-sustaining costs and a
contribution toward profit.
5-42 Incremental costs:

Machine moving and reinstallation ($100,000)
Incremental benefits:
Increase in contribution margin
$200,000 × 0.31 = 62,000
Savings in inventory carrying costs
$200,000 × 0.25 × 0.15 = 7,500
Net benefit (loss) from a change in plant layout in year 1 $(30,500)
The proposed change in plant layout should not be implemented because its
costs are greater than its benefits, if only one year’s benefits are considered.
The methods in Chapter 11 should be used to evaluate the benefits over the
entire useful life of the machine.
– 219 –
5-43 Make Buy

Cost of purchase: $30 × 12,000 $360,000
Manufacturing cost:
Direct material $132,000
Direct labor 108,000
Unit-related support 48,000
Batch-related support 60,000 30,000a
Product-sustaining support 24,000 4,800b
Facility-sustaining support 24,000 24,000
Allocated corporate support 60,000 60,000
Savings in rental costs 0 (20,000)
Total costs $456,000 $458,800
a
50% × 60,000 = 30,000
b
20% × 24,000 = 4,800
(a) Based on the cost analysis above, Tanner Appliance Company should
make part M4 in-house.
(b) The costs (and cost savings) that differ between the two alternatives are
relevant for this decision. That is, direct material, direct labor, unit-related
support, differential batch-related support, differential product-sustaining
support, and savings in rental costs are relevant for this decision.
(c) In deciding whether to purchase part M4 from the outside supplier,
Tanner should consider factors such as the supplier’s reliability in
maintaining quality and on-time delivery, and permanence of the offered
price.
5-44 (a) Acquisition cost and depreciation expense for the existing elevator
system are irrelevant.
(b) Relevant cost Existing System New System
Acquisition cost — $875,000
Salvage value of existing system at present — (100,000)
Operating costs for 6 years $900,000 48,000
Salvage value after 6 years (25,000) (100,000)
$875,000 $723,000
The decision to replace the existing elevator system with the new one will
require net present value analysis that considers the time value of money.
– 220 –
5-45 (a) Selling price per unit $4.00

Variable cost per unit 3.30
Contribution margin per unit $0.70
Number of units 50,000
Increase in operating income $35,000
Genis Battery Company should accept the special order because it is
operating under capacity and this order can generate $35,000 in
additional operating income.
(b) Average unit costs can be misleading. The decision must be based on
incremental costs.
(c) Other customers may also demand a reduced price. Therefore, their
reaction to the reduced price for the special order must also be taken into
account.
5-46 (a) Net cost saving over 4 years with new machine
Cash inflow:
Salvage value difference $ 2,000
Decrease in annual operating costs (4 years × $60,000) 240,000
Reduction in rework cost 10,000a
Cash outflow:
Acquisition of new machine ($360,000 – $100,000) (260,000)
Net cash inflow (outflow): ($ 8,000)
a
0.05 (100,000 × 4) × $1 = $20,000
– 0.025 (100,000 × 4) × $1 = –$10,000
Reduction in rework $10,000
Syd Young should not replace the old machine due to net cash outflow
of ($8,000).
(b) The acquisition cost of the old machine is a sunk cost.
– 221 –
(c) Other considerations:

1. Will sales increase because of lower defects with the new machine
2. What is the cost of capital used to discount future cash flows? In this
case, discounting will only make the new machine appear worse.
5-47 Both the theory of constraints and activity-based costing support aspects of
process improvement and improved profitability, but differ in many other
respects. The theory of constraints emphasizes the short-run optimization of
throughput contribution, and downplays operating costs (except direct
materials) because they are viewed as difficult to alter in the short-run.
Consequently, analyses of activities and cost drivers are not conducted as they
are in activity-based costing. Proponents of activity-based costing take a long-
term perspective in which managers can alter capacity resources. Therefore, it
is viewed as beneficial to produce accurate cost information by tying actual
resources consumed to cost objects, such as products, services, channels, and
customers. The theory of constraints and activity-based costing might
conceivably be used together.
5-48 (a) PCE in minutes under the traditional system equals [120/(120 + 80 + 240
+ 40)] = [120/480] = 0.25. PCE under the JIT system equals [75/(75 + 20
+ 60 + 5)] = [75/160] = 0.47.
(b) Based on the calculations above, Walker Brothers should implement the
JIT system since the processing cycle efficiency is almost double that of
the traditional system (0.47 vs. 0.25).
5-49 Cellular manufacturing refers to the organization of the plant into a number of
cells so that within each cell, all machines required to manufacture a group of
similar products are arranged in close proximity to each other. The shape of a
cell is often a U shape, which allows workers convenient accessibility to
required parts. The machines in a cell manufacturing layout are usually flexible
and can be adjusted easily, or even automatically, to make the different
products. Often the number of employees needed to produce a product can be
reduced due to the new work design. The U shape also provides better “visual
control” because employees can observe more directly what their co-workers
are doing. Cellular manufacturing layouts reduce costs and quality problems
associated with conventional manufacturing and facilities layouts. Usually
production cycle time is improved with a cellular manufacturing approach.
– 222 –
A just-in-time manufacturing system requires making a good or service only

when the customer, internal or external, requires it. It is most appropriately
used in repetitive manufacturing for products such as automobiles or electronic
components. Just-in-time production requires a product layout with a
continuous flow (no delays) once production starts. This means that there must
be a substantial reduction in setup costs in order to eliminate the need to
produce in batches, therefore, processing systems must be reliable. A just-in-
time production system is based on the elimination of all nonvalue-added
activities such as materials movement, storage, rework, and waiting times in
order to reduce cost and time. It is an approach to continuous improvement and
requires employee empowerment and involvement to eliminate the need to
perform nonvalue-added activities. Just-in-time production encompasses all
facets of making the good or service, including developing the design,
acquiring the factors of production, making the good or service, delivering it to
the customer, and following up after the delivery. Critical performance
indicators in just-in-time systems include inventory levels, which should be as
low as possible; the number of failures, whether these are material, people, or
machine failures, with a goal of zero; moving with a goal of zero; and the
amount of storing activities with a goal of zero. The ultimate measure of
success with JIT occurs when the manufacturing cycle efficiency ratio equals 1
that is, when processing time equals total production time.
The cellular manufacturing approach is not inconsistent with the philosophy of

JIT as cellular manufacturing also focuses on continuous improvement. In fact,
some JIT systems use manufacturing cells to make specific components as part
of the finished product.
5-50 (a) Impact of dropping JT484 on operating income:
Reduction in contribution margin $100,000

Cost savings:
Utilities (9,000)
Supervision (30,000)
Maintenance (7,000)
Administrative (30,000)
Decrease in operating income $24,000
Therefore, JT484 should not be eliminated.
(b) No, the decision to retain JT484 will only be reinforced by the sales
manager’s comments.
– 223 –
5-51 Estimated cost savings as a result of the quality improvement:
Savings from decrease in reject rate

(0.064 – 0.051) × [(494 – 63 – 225) + (386 – 89) + (70 – 16)] × 10,000 $72,410
Savings from reduction in inventory carrying cost
($386,000 – $270,000) × 0.15 $17,400
Total annual savings $89,810
5-52 (a) Selling price per unit: $105.00

Variable cost per unit:
Direct material $30.00
Direct labor 20.00
Variable support 10.00
Commission 10.50 70.50
Contribution margin
per unit: $34.50
Increase in inventory:
Raw materials $3,600,000 × (2/12) $600,000
Work-in-process $3,600,000 × (1/12) +
[2,400,000 + (1,200,000
× 0.5)] × (1/12) 450,000
Finished goods $7,200,000 × (2/12) 1,200,000
Total increase
in inventory $2,250,000
Additional inventory
carrying costs $2,250,000 × 0.12 $270,000
Incremental profit:
Increase in contribution
margin from new sales $34.50 × 120,000 $4,140,000
Decrease in contribution
margin from
cannibalization $20 × (300,000 – 240,000) (1,200,000)
Increase in capacity-
related cost (2,000,000)
Additional inventory
carrying costs (270,000)
Increase in profits if the
new model is introduced $670,000
– 224 –
(b) Yes. Introducing the new product will increase profits by $670,000.
(c) Let Q be the breakeven point in units for the new product.
Increase in inventory:
Raw material: $30 × Q × (2/12) $5.00Q
Work-in-process: [$30 + ((20 + 10) × 0.5)] × $3.75Q
Q × (1/12)
Finished goods: $60 × Q × (2/12) $10.00Q
$18.75Q
Additional inventory carrying costs = $18.75Q × 0.12 = $2.25Q
Decrease in sales of old product = $20 × (Q/2)
Breakeven point:
$34.5 Q – $20 × (Q/2) – $2.25 Q – $2,000,000 = 0
Q = 89,888 units
5-53 (a) Because the distinctive desserts are a source of competitive advantage,
Beau should carefully consider the quality, freshness, and distinctiveness
of the desserts from the outside providers, as well as the providers’
reliability in delivering the desserts. Beau will want to consider the
possibility of price increases from an outside bakery. For the in-house
option, Beau may have concerns about his ability to hire a suitable
replacement pastry chef. If Beau hires a new pastry chef, the chef may be
more responsive than the outside bakers to Beau’s customers’ tastes.
Also, there would be no concern about delivery to Beau’s Bistro.
(b) This question is designed to generate discussion about the trade-offs
among the options. Although the second bid is lower-cost than the first,
the first bid promises continual developments of gourmet desserts; the
second bid promises only traditional desserts. In-house pastry production
is the highest-cost option. The ultimate decision should take into account
not only the costs of the different options, but also the issues in part (a)
and the anticipated effect on demand and revenue (for pastry and for
Beau’s Bistro) under each option.
– 225 –
5-54 (a) The costs and benefit shown below are relevant for the outsourcing
decision. All but the –$20,000 sale of office equipment are annual costs.
Costs
In-house Outside
Call Center Call Center
Labor $650,000
Rent 60,000
Phone 35,000
Other support 42,000
Office equipment ($20,000)
Outside call center 700,000
$787,000 $680,000
(b) Hollenberry must consider the outside call center’s reliability and quality of
service in responding to Hollenberry’s customers. Given Hollenberry’s
worldwide operations, the greater number of multilingual operators
available at the outside call center could be an important feature. Finally,
Hollenberry must factor in the prospect of laying off employees, many of
whom have worked at Hollenberry for over 20 years.
(c) If the outside call center can meet Hollenberry’s expectations for reliability
and quality, including better service for international customers, financial
considerations point toward Hollenberry outsourcing the call center
function. However, although the outsourcing decision seems financially
sound, there is great potential for decreasing the remaining employees’
morale because of the layoffs. This question is designed to generate
discussion about trade-offs among the company’s stakeholders, including
employees. One alternative to firing Hollenberry’s call center employees is
reassigning the employees to other jobs and relying on attrition to eventually
reduce employee costs to Hollenberry’s desired level. However, this would
increase the cost of the outsourcing option and reduce its financial
benefits.
5-55 Before the rearrangement, PCE in minutes for Whisper Voice Systems equals
[70/(70 + 45 + 55 + 30)] = 70/200 = 0.35. After the rearrangement, PCE in minutes
equals [30/(30 + 10 + 20 + 15)] = 30/75 = 0.40. The percentage improvement in
PCE after the rearrangement is [(0.4 – 0.35)/0.35] = .143 or 14.3%. Thus, the change
exceeds Ray Brown’s requirement of a 12% improvement in PCE.
– 226 –
5-56 (a) The approach used at McDonalds in which customers wait in several lines is
consistent with the push or conventional manufacturing approach. As one
comes into McDonalds it is clear that they have been, and are building
inventory in each of the specific bins that they use for, let’s say, Big Macs,
fish sandwiches, regular hamburgers, etc. Having inventory at predefined
levels keeps the production process going. The motivation to use the
traditional production method is to sustain a certain level of inventory to
reduce the time the customer has to wait for an order. Notice in McDonalds
that hot lights are used to keep the sandwiches warm. One goal of this
approach is that customers perceive that they can get their sandwich very
quickly due to the inventory of sandwiches always on hand. On the other
hand, Wendy’s uses more of a pull or JIT system. As you enter into
Wendy’s, notice that you cannot really observe any sandwich inventory
building up. The idea in forming one line is that each person has the
perception (and often the reality) that each sandwich is made on the spot.
This procedure is designed to show customers how fresh the sandwiches
are. The motivation to use a just-in-time approach is to improve the quality
of the food and to reduce waste by eliminating the need to throw out food
that has been sitting too long. As processing time and setup costs drop, the
organization can move closer to just-in-time, reducing the waste and quality
problems that arise with batch production.
(b) From a customer’s perspective, it does depend on what one favors. If a
customer goes to a fast food restaurant, his or her goal is to get food quickly.
On any particular day, the customer may be in a great hurry and wish to run
in and run out of a fast food establishment. Having multiple lines at a place
like McDonalds may be very appealing as far as the perception of the speed
with which one can get a meal (compared to a single line at Wendy’s). On
another day, perhaps having a meal made freshly on the spot, without any
“warming” time under hot lights is more appealing than the speed of getting
the food. Of course, one may simply like the taste of one company’s
hamburgers over another’s.
From management’s perspective, apart from taste, competing in selling
hamburgers may depend on other variables such as the speed with which an
order is filled versus tailoring the production process to individual taste. The
traditional push production process can lead to a lot more waste than the JIT
system, because if a batch of hamburgers is made and demand drops, the
quality of the food deteriorates and often has to be thrown out. However, if
the line at Wendy’s is very long and customers begin to get impatient, the
freshness of the food may begin to lose its appeal.
– 227 –
5-57 (a) The article reports that customer service representatives are commonly
evaluated on time to complete a call or whether they sell a new product to the
customer. The article further states that companies should evaluate service
representatives on the basis of how well they resolve the customer’s problem. For
example, a company can track improvement in the number of problems that are
resolved on the customer’s first call.
(b) The cost of quality framework can be applied to customer service processes
by considering the customer’s experience with the customer service representative
as the “product” for which the company desires to satisfy customer expectations.
The article mentions a number of activities that can be viewed as helping to
prevent customer dissatisfaction with customer service. These activities include
training customer service representatives in listening skills and knowledge of the
company’s products, arranging for representatives to hear a customer talk about
positive and negative interactions with the call center, and encouraging
representatives to share their challenges and successes. Making sure that the
company treats representatives well can also be included among prevention
activities.
Appraisal issues arise in choosing measures to evaluate whether representatives are

likely providing high quality service to customers. As stated in part (a), measuring
the time to complete a call from a customer or the number of times a new product
is sold are less likely to provide insight into the customer’s perception of customer
service quality, and may induce representatives to focus on achieving a good score
on the measure instead of resolving the customer’s problem. Measuring
improvement in the number of problems resolved on the customer’s first call is
much more likely to provide the desired insight and better aligns the
representative’s incentives with resolving the customer’s problem. The article
further suggests evaluating customer-satisfaction ratings for each representative,
not merely the average, because the average can mask important problems. Once a
company identifies problems or needed areas of improvement, the company can
arrange for appropriate training (a prevention activity).
As in other contexts, attention should be given to prevention of poor quality, with

the intent of reducing external failures, which in this context is a customer who
is dissatisfied with the customer service experience. The low-quality
experience may cause negative financial consequences for the company. For
example, the customer may switch to a competitor company or may tell many
other potential customers about the negative experience and thereby influence
the customers to purchase the good or service from a competitor company.
– 228 –
5-58 There really is no one “correct way” to allocate the $2,000,000 of quality costs
to the four categories. Clearly, managers hope that they can minimize quality
costs as much as possible. But, in this hypothetical example, we are assuming
that managers, a priori, have much more discretion than they probably do.
Probably the most desirable quality cost trend would be to load costs up at the
prevention stage and to incur some costs during the appraisal stage. By
increasing prevention costs, such as extensive training and quality engineering,
and appraisal costs, such as maintenance of test equipment, process control
monitoring and inspection of incoming materials, an organization can reduce
other quality costs, especially those related to internal and external failure. As
far as the allocation of the $2,000,000 goes, the “correct” trend is a high level
of costs for prevention, followed next by lower costs for appraisal, internal
failure and external failure.
5-59 (a) Quality Cost Report for Renwal Company

Annual Percent of
Quality Cost Category Cost Sales*
Prevention Costs:
Quality training $125,000 0.125%
Quality engineering 500,000 0.500%
Statistical process control 250,000 0.250%
Supplier certification 90,000 0.090%
Research of customer needs 75,000 0.075%
Total $1,040,000 1.040%
Appraisal Costs:
Inspection of and testing of in-coming $400,000 0.400%
materials
Maintenance of test equipment 350,000 0.350%
Process-control monitoring 1,000,000 1.000%
Product-quality audits 475,000 0.475%
Total $2,225,000 2.225%
Internal Failure Costs:
Waste $700,000 0.700%
Net cost of scrap 635,000 0.635%
Rework costs 1,200,000 1.200%
Downtime due to defectives 125,000 0.125%
Total $2,660,000 2.660%
– 229 –
External Failure Costs:

Product-liability lawsuits $4,500,000 4.500%
Repair costs in the field 850,000 0.850%
Warranty claims 2,345,000 2.345%
Returned products 1,200,000 1.200%
Product recalls 2,000,000 2.000%
Total $10,895,000 10.895%
Total Quality Costs: $16,820,000 16.820%
*Total sales were $100,000,000.
(b) The most obvious problem at Renwal is the extremely high external-
failure costs of almost 11%. Since as a norm many companies would like
to keep their quality costs below 4% to 5% of sales, Renwal Company’s
quality costs are out of line. Note in particular that product-liability
lawsuits, warranty claims, and product recalls are the biggest external-
failure costs. Renwal must find out why its products seem to be failing in
the field.
Renwal should first turn to an analysis of its other quality costs. Quality
costs are incurred throughout the total life cycle of a product. If Renwal
does not control quality costs early in the research, development, and
engineering stage by ensuring good product design, then design
problems will lead to increased quality costs later on.
At Renwal both prevention and appraisal costs are a relatively small

percent of total quality costs (1.04% and 2.225% respectively). Renwal
should consider putting more effort into quality training, quality
engineering, and statistical process control. The company should also
determine whether to spend more money on appraisal. There could be a
problem with Renwal’s test equipment that would require the company
to incur higher maintenance costs.
With regard to internal-failure costs, Renwal also apparently incurs a

great deal of rework costs. The product seems to require many additional
costs that need not be incurred if the company could produce it correctly
the first time. Perhaps the production process is at fault, or maybe
Renwal’s workers are not well trained.
– 230 –
Note that Renwal’s quality-related costs are very low at the prevention
stage. They increase for the appraisal and internal-failure cost categories.
The external failure costs are extremely high. This pattern of quality
costs is what most organizations hope to avoid because the highest
category of quality costs corresponds to poor quality recognized only
after products are in customers’ hands.
The more desirable quality-cost trend is the reverse of Renwal’s pattern.

That is, organizations desire to have the greatest proportion of quality
costs incurred in the prevention stage. By increasing quality training and
quality engineering costs during this stage, a company can reduce other
quality costs. With the company’s products failing less frequently in the
customers’ hands, customer satisfaction should increase and the
company’s reputation should improve.
5-60 (a) Quality Cost Report for Ideal Company

Quality Cost Annual Percent of
Category Cost Sales*
Prevention Costs:
Quality training $ 150,000 0.20%
Quality engineering 200,000 0.27%
Statistical process control 300,000 0.40%
Supplier certification 350,000 0.47%
Total $1,000,000 1.33%
Appraisal Costs:
Inspection of and testing of in-coming
Materials $ 300,000 0.40%
Process-control monitoring 350,000 0.47%
Product-quality audits 350,000 0.47%
Total $1,000,000 1.33%
Internal Failure Costs:

Waste $ 900,000 1.20%
Net cost of scrap 1,500,000 2.00%
Rework costs 2,000,000 2.67%
Downtime due to defectives 600,000 0.80%
Total $5,000,000 6.67%
– 231 –
External Failure Costs:

Product-liability lawsuits $ 500,000 0.67%
Repair costs in the field 375,000 0.50%
Warranty claims 420,000 0.56%
Returned products 380,000 0.51%
Product recalls 325,000 0.43%
Total $2,000,000 2.67%
Total Quality Costs: $9,000,000 12.00%

*Total sales were $75,000,000
(b) Since as a norm many companies would like to keep their quality costs
below 4% to 5% of sales, Ideal Company’s total quality costs are
relatively high. The highest level of quality costs occur for internal
failure (6.67%) and external failure (2.67%) compared to lower levels for
prevention and appraisal (1.33% each). Therefore, management should
investigate why internal failure costs are so high, especially for scrap and
rework costs. Regarding external failure costs, the two highest are for
product liability lawsuits and warranty claims. Nevertheless, these costs
are relatively low as a percentage of sales. The company should
investigate whether placing more emphasis on prevention and appraisal
would decrease internal failure and external failure costs.
CASES
5-61 (a) Yes. Mike should accept Premier’s offer, since it results in an overall
increase in profit of $219,083.
1. Contribution margin on Premier sales:

Selling price per bicycle $125
Less variable costs per bicycle:
Direct material $50
Direct labor 30
Support 25 105
Contribution margin per bicycle $20
Total contribution margin on 40,000
bicycles per year (40,000 × $20) $800,000
– 232 –
2. Contribution margin on cannibalized sales:

Selling price per bicycle $185.00
Less variable costs per bicycle
Direct material $48.00
Direct labor 30.00
Support 25.00
Commission 18.50 121.50
Contribution margin per bicycle $63.50
Total contribution margin on 8,000
bicycles per year (8,000 × $63.50) ($508,000)
3. Inventory carrying costs:
Raw material $50 × 40,000 × (1/12) $166,667
Work-in-progress $(50 + 0.5 × (30 + 25)) ×
40,000 × (1.5/12) $387,500
Finished goods: $105 × 40,000 × (0.5/12) $175,000
Additional inventory for Premier order $729,167
Additional inventory carrying costs (× 10%) ($72,917)
Net increase in profits:
$800,000 − $508,000 − $72,917 $219,083
(b) Strategic and other factors that need to be considered include:
Reputation problems—Customers finding the same bicycle at Premier

Stores may perceive the quality of Diamond’s Bicycles to be low. On the
other hand, if they find that the same quality bicycles are available at
Premier Stores for lower prices, then sales of “original” Diamond
bicycles and in general the price of “quality” bicycles will go down.
Existing customer loyalty may go down.
Long-term capacity implications—The ideal capacity is tied up now with

the low margin offer from Premier Stores. When demand goes up, future
expansion is costly. This implies that the contract with Premier Stores
needs to be finalized based on long-term growth of the market.
Retail distributor problems—The existing retail distributors are specialty

bicycle stores. They will be annoyed when they find that Diamond sells
the same bicycle at a much lower price to Premier Stores than what they
are paying, and that this action enables Premier Stores to undercut the
specialty stores. As a result, many of these stores may refuse to carry
Diamond’s bicycles, or decide not to promote and push Diamond’s
– 233 –
bicycles as much as before, resulting in substantial decreases in

Diamond’s sales through its existing retail distribution channels.
Transportation cost—Premier Stores requires Diamond to deliver the

bikes to Premier’s regional warehouse. Transportation costs should be
factored into the analysis.
5-62 (a) Costs in the following items are relevant to Polley’s decision: 1, 2, 3, 4,
5, 7, 9, 10, and 13. Item 6 is not relevant because it is a sunk cost, and
items 8, 11, and 12 are not relevant because the costs do not differ across
the two options.
(b) Polley is likely to consider the decreased health risks for workers with
the new solvent, decreased risks of violating OSHA regulations and
incurring penalties, and decreased risks of negative media coverage.
Polley is also likely to consider the potential increase in demand for
Kwik Clean’s services if the company markets its environmentally safer
process. Polley may also try to assess whether individual customers are
more sensitive to such marketing than are business customers.
(c) For operations with potential environmental pollution, prevention can

involve efforts to ensure pollution does not occur. Prevention efforts
might include changing processes, as Polley is considering. Appraisal
efforts might include inspections to ensure pollution levels are within
acceptable limits or workers are following prescribed procedures for
dealing with pollution or hazardous wastes. Internal failures are failures
(accidental spillages or leakages of hazardous wastes, or illegal levels of
pollutants) that are detected and cleaned up or corrected before reaching
the public. Finally, external failures are failures that are not detected,
cleaned up, or corrected before reaching the public. As in the cost of
quality framework for manufacturing operations, environmental
pollution external failures are often the most costly to the firm. If
prevention efforts are feasible, attention should be focused on
prevention. Given that some pollution or hazardous wastes are generated,
efforts should also be focused on appraisal, with the intent of minimizing
internal failures and external failures.
– 234 –
5-63 Total net annual benefit from the new machine:
Increase in contribution margin $648,000a

Decrease in inventory carrying costs 63,000b
Less increase in lease costs (410,000)c
Net annual benefit from new machine $301,000
a
[($56–$32) × 48,000]–[(56–$42) × 36,000] = $648,000
b
Inventory levels with the old machine:
Raw materials 36,000 × $12 × 4/12 = $144,000

Work-in-process 36,000 × $25 × 3/12 = $225,000
Finished goods 36,000 × $46 × 2/12 = $276,000
$645,000
Inventory levels with the new machine

Raw materials 48,000 × $11 × 1.5/12 = $ 66,000
Work-in-process 48,000 × $20 × 1.5/12 = $120,000
Finished goods 48,000 × $36 × 1/12 = $144,000
$330,000
Change in annual inventory carrying costs:
($330,000 – 645,000) × 20% = $63,000 decrease
c
$900,000–$490,000 = $410,000 increase
(b) Rossman should replace its old machine with the new machine because
the penalty of $280,000 for early termination of the lease is more than
offset by the net annual benefit of $301,000 for each of four years with
the new machine.
(c) A manager evaluated on the basis of net income may decide not to
replace the existing machinery if there is considerable uncertainty about
the projections for increased sales or reduced costs, given the relatively
small benefit in the first year based on the stated projections. This benefit
is $301,000 – $280,000 = $21,000. Thus, a manager with a short-term
focus may not lease the new machinery even though it would increase
Rossman’s income over the long-run.
– 235 –
5-64 (a) The company may be monitoring time spent talking to customers, and if
it is monitoring the content of the calls, the company may be evaluating
how polite the CS representatives are.
(b) The customer is likely thinking about measures or issues such as the
following:
• Time from the first phone call to CS until the TV is repaired and
returned
• Number of phone calls required
• Time per phone call
• Total time spent on phone calls
• Time between a phone call and the response from CS or WD
authorizing repair
• Time spent writing to the company to report on the unpleasant
experience trying to get the TV repaired
• Politeness of CS reps and supervisor
• Ability to resolve the problem with one phone call
(b) Instead of faxing or mailing the receipt, the customer can be allowed to
email the receipt by other electronic means, such as using a scanner to
produce an electronic copy or taking a digital photo. The company could
also think about ways to eliminate the need for CS to forward the warranty
authorization to another department, in order to increase the likelihood that
the customer’s request can be handled with one phone call and less delay.
For example, if a customer knows that the request is for warranty repair, he
or she could be allowed to deal with WD directly instead of relaying the
information back and forth between the customer, CS, and WD. The
company could also develop a better system for determining which
approved repair shops are the closest to the customer’s address.
(d) RS3 can clearly learn from RS4’s approach of diagnosing the problem
shortly after the TV arrives in the shop. This allows the shop to order parts
shortly after the TV enters the shop, with the result that the total time that the
TV spends in the shop is likely to much shorter than in RS3. RS3’s approach
introduces unnecessary waiting time, a nonvalue-added activity from the
customer’s perspective. In addition, RS3 needs space to store all the items
waiting for diagnosis or parts. The customer faces additional waiting time
because of RS3’s inability to pick up TVs on a timely basis.
– 236 –
5-65 (a) In the following diagram, “(v)” indicates activities that add value from
the customer’s perspective, and “(n)” indicates activities that do not.
Woodpoint Furniture Manufacturing Process Flow Chart
Order raw materials (n) Assemble batch (v)

↓ ↓
(If a piece is defective , return it to
Place raw materials into storage (n)
appropriate area for rework) (n)
↓ ↓
Remove wood from storage (n) Move batch to painting or staining area (n)
↓ ↓
Move batch to saw area (n) Store batch in painting or staining area (n)
↓ ↓
Saw wood (v) Paint or stain batch (v)
↓ ↓
Move batch to sanding and planing area (n) Move batch to assembly area (n)
↓ ↓
Store batch in sanding and planing area (n) Complete assembly (v)
↓ ↓
Sand and plane required pieces (v) Inspect batch (n)
↓ ↓
(If a piece is damaged by planing or
(If a product is defective, return it to
sanding, reorder piece from saw area and
appropriate area for rework) (n)
store remainder of batch) (n)
↓ ↓
Move batch to assembly area when all
Package product(v)
planing and sanding is complete (n)
↓ ↓
Store batch in assembly area (n) Move products into storage (n)
↓
Ship product when ordered by a customer (v)
(b) The response must specify what Woodpoint Furniture Manufacturing’s

customers are likely to require. Presumably quality, cost, and service (in
terms of product features and cycle time to fill order) will be important.
The current production system should be evaluated based on its ability to
allow the organization to meet whatever customer requirements are
specified. If the specified items are quality, cost, and cycle time then
each activity should be measured in terms of the time that it adds to the
cycle time, the quality problems that it creates, and its cost. Possible
specific measures include number of reworked pieces, number of
defective pieces, number of missing pieces, and number of furniture
items that fail inspection.
– 237 –
5-66 (a) Customers will specify precisely the quantity and grade of steel (service)
that they want. Because steel is both bulky and can deteriorate, it is very
expensive to store. Therefore most customers are likely to want the steel
at the precise time that they intend to use it (service). Because steel is
used to make other products, users expect the steel to have the properties
that the steelmaker claims it has (quality). Fierce international
competition has made cost a key competitive factor (cost).
(b) There are many steps in this process where steel is moved and stored.
Activity involving moving or storing steel does not add value. Activity
that reheats or reforms the steel does not add value unless the activity
simultaneously changes the chemistry of the steel in a way that the
customer values. Remember, the customer does not care what process
and intermediate forms that the steel took to reach its final form. The
intermediate forms of the steel, like ingots, slabs, and blooms are
required because of the process design, not because of customer
requirements. Sometimes people make claims such as, “You cannot cast
sheet steel, you have to cast slabs and roll the slabs into sheet steel.”
Many steel companies believed this and built their facilities around this
assumption. Some people always believed that the step of making slabs
could be avoided and that steel sheet could be cast directly from the
continuous slab caster. Today, it seems that we are very close to seeing
that technology with its accompanying cost savings.
(c) In the short-run, technology is fixed. Therefore key performance indicators

will focus on what people can control. This includes the use of labor (labor
productivity ratios like employee hours per ton of steel, are widely used to
assess performance in the steel industry), the use of raw materials (material
yield ratios, like the weight of finished product to the weight of raw
materials used, are also widely used in the steel industry, particularly to
monitor the material yield loss as the steel is continuously reshaped into the
final product), and the use of equipment (measures of output per shift from
each of the major facilities such as the blast furnace, the basic oxygen
furnace, and the hot strip mill are widely used).
Quality, which means the ability of the process to produce the type of steel
that it intended to make, is also very closely monitored. Steel that does not
meet standards and cannot be sold as a downgrade product must be
scrapped and reprocessed. Therefore, percent of original (before reworking
or regrading) production that meets standard would be an important
measure. Administrative people also carefully track whether orders are
delivered on time and if they are complete. Therefore, measures such as
– 238 –
percentage of order delivered complete and on time would be useful. For

most steel companies, the most important key performance measure has
nothing to do with the customer. The issue is employee safety and a
common measure is employee days lost due to injury.
5-67 Precision Systems 1

This case study illustrates that quality cost information can play an important
role in alerting top management about the importance of quality improvement
in a nonmanufacturing department of a manufacturing firm. The case is based
on the following article by S. S. Kalagnanam and E. M. Matsumura: “Cost of
Quality in an Order Entry Department,” Journal of Cost Management, Fall
1995, pp. 68—74.
The required questions are designed to acquaint students with some of the
terminology of “cost of quality” and some aspects of conducting a cost of
quality study. Quality costs, defined as those that arise because poor quality
may exist or does exist, have been classified into the following four categories:
• Prevention (prevention of poor quality, or quality assurance);

• Appraisal (inspection and testing);
• Internal failure (costs such as rework or scrappage for nonconforming
products identified before delivery to customers);
• External failure (costs such as warranty expenses or freight charges for
nonconforming products delivered to customers).
This case focuses on prevention activities (see question (f)), as well as

internal failure and external failure costs for the order entry department at
Precision Systems, Inc. Internal and external failures are defined with respect to
the order entry department.
Suggested Solutions to Required Questions
(a) This question is designed to help students recognize how cost management
systems can interface with quality improvement efforts. As the case states,
in spite of PSI’s commitment to quality improvement, “the changes [in order
entry] would not have been so vigorously pursued if cost information had
not been presented. COQ information functioned as a catalyst to accelerate
the improvement effort.” This is because the cost figures captured the
attention of top management. Other responses might include the following:
(1) It made order entry aware of the dollar impact of its errors; (2) It
provided a means of prioritizing quality improvement efforts.
1
Source: Institute of Management Accountants, Cases from Management Accounting Practice, Instructor’s Manual,
Volume 12. Adapted with permission.
– 239 –
(b) There are many possible flows. For example, a sales representative may
contact order entry to request a quote for a system for a customer.
Subsequently, the customer contacts order entry to place the order; and order
entry then generates an order acknowledgement, which is sent to
manufacturing, invoicing, and sales administration. Once the system has been
shipped, an invoice is sent to the customer. Ultimately, collections will receive
the invoice. Customer support will contact the customer to arrange installation
and will be available to answer questions over the phone.
A request for parts from a service representative or directly from a customer

would be received by order entry, which would generate an order
acknowledgement that might then be routed to the stockroom, after which the
part would be shipped and the customer would be billed. A request for service
would result in an order acknowledgement being sent to the service
department (see the following chart).
– 240 –
SUPPLIERS PROCESS OUTPUT CUSTOMERS
Customers Sales
(place orders) Adminis-
tration
Sales
Representatives Order Entry Quote Invoicing Collections
(request
quotes)
Service OA Manufac-
Representatives (Order turing Shipping
Acknowl-
edgement)
Technical
Information and Stockroom Customer
Marketing Support
Departments
Service
– 241 –
(c) Items 1, 2, 5, 8, 10, and 12 are internal failures; the remainder are external
failure items. Internal customers affected by external failure items are listed
below.
Item Number Internal Customer(s) Affected

3 Manufacturing, service, stockroom, invoicing
4 Invoicing, accounting (profitability analysis)
6 Manufacturing, service, stockroom, invoicing, accounting
7 Shipping, invoicing, collections, customer support
9 Manufacturing, service, stockroom
11 Invoicing, collections, accounting
Other examples (not included in Exhibit 5-20):
Error Type Internal Customer(s) Affected

Incorrect serial # of system on OA* Service, customer support
Duplicate order Stockroom, shipping,
manufacturing, sales
administration
Incorrect sales rep. code Sales administration
*OA stands for order acknowledgement
(d) An initial step would be to interview employees in order entry, as well as its
suppliers and internal customers. Based on the interviews, data collection
forms can be developed. For internal failures, order entry staff would keep
track of the problems they encounter while preparing quotes and processing
orders. For external failures, internal customers of order entry would keep
track of the errors they encounter when using information from the quotes or
order acknowledgements (examples of forms appear at the end of this teaching
note: Form #1 pertains to internal failures and Form #2 pertains to external
failures).Suppliers to order entry, internal customers of order entry, and order
entry staff should be involved in making improvements to the order entry
process.
(e) Possible responses include the following:

Office equipment and office space;
Telephone (to clarify problems);
Computer costs (making changes on the computer);
Supplies (paper for printing new quotes or order acknowledgements);
Lost interest and other costs associated from late payments by customers
(due to invoicing mistakes resulting from order entry errors);
– 242 –
Lost sales from new customers (due to delay in preparing quotes);

Lost future sales from current dissatisfied customers (due to errors in order
entry);
Shipping costs on returns;
Rework costs;
Frustration and lower morale, possibly leading to poorer quality or high
turnover;
Costs related to duplication in manufacturing;
Crisis management costs (express shipping);
Lost revenues if underpricing;
Scrappage of returns.
(f) Students can brainstorm about possible improvements during a class

discussion. Possible responses follow.
Incremental Improvements
Empower employees.
Allow sales representatives to correct errors without approval.
Urge order entry to improve communication with manufacturing and
other departments.
Provide feedback to order entry on types of errors, numbers of errors, and
cost impact. Daily feedback (suggestions for improvement) can be
provided via computer.
Educate sales representatives about effects of errors and about the process.
Provide better training for sales representatives.
Train sales representatives to develop accurate quotes and take on the order
entry function.
Have sales representatives take responsibility for the process.
Track customer purchases to improve service to customers.
Survey customers about problems; use the responses to prioritize problems.
Stop the double entry of information.
Get input from order entry on development of forms.
Implement checking in order entry to help prevent order acknowledgement
errors.
Develop a reward system that motivates error-free performance of sales
representatives and order entry.
Benchmark.
– 243 –
Breakthrough Improvements
Develop a computer system to decrease the number of times data are

entered.
Develop a spreadsheet or computer program to check for
inconsistencies between P.O. and quotes. Check for duplication of
orders.
Check prices.
Develop a computer system that allows sales representatives to
prepare accurate quotes.
Install a computer system linking order entry, manufacturing,
invoicing, etc.
Use cross-functional teams to manage “large” costs or different
segments.
Develop a system that allows parts customers to get their own quotes
on-line.
Incremental Improvements Made by PSI
1. Key information for quotes is now obtained up-front by the sales

representative; earlier, the sales representative faxed partial information to
order entry and requested a quote. Order entry staff then spent a great deal of
time obtaining missing information. With this change, the sales
representative cannot request a quote until he or she has supplied key
information to order entry staff. This could be considered a prevention
activity.
2. Customers are asked to include quotation numbers on their purchase orders.
This allows PSI to match orders with quotes and avoid duplication in
manufacturing. PSI prepares its manufacturing plan based on the quotes
received because they have a reasonably good idea of which ones are likely
to become firm orders.
3. Proper tools are provided to the order entry staff:
Procedure manuals.
Guidelines for sales discounting. Previously, the order entry staff had to call
sales to seek clarifications regarding discounts.
Printed configuration guides that contain information in the format order
entry requires. Previously, the formats did not always match.
4. Order entry staff are now responsible for both quotes and orders. Previously,
some staff were responsible only for quotes, and other staff were responsible
only for orders. This change had an immediate impact, as the person who
prepared a quote now had responsibility for processing the subsequent order.
– 244 –
5. A regular feedback system is now in place. Each internal customer

department provides feedback to order entry once every quarter.
Benefits: Cycle time for preparing quotes was reduced by 60%, and cycle
time for processing orders was reduced by 50%. Also, order entry staff
experienced greater pride in their work.
Breakthrough Improvement Efforts by PSI as of 1993
Many of these improvements are prevention activities.

1. PSI began working with a vendor to develop an on-line configuring program
that would configure their standard systems (order entry staff would avoid
keying-in part numbers).
2. PSI planned to acquire a new, more integrated order entry system that can
communicate with the configuring program and turn a quote into an order
acknowledgement when the order comes in. The system will also be able to
generate an invoice, thereby avoiding rekeying the information.
3. PSI began working toward providing sales representatives with a laptop
computer equipped with a built-in configuring program. It will allow them to
prepare quotes in the field.
The anticipated benefits include a reduction in errors caused by incorrect
or duplicate part numbers and a reduction in cycle time for preparing
quotes or processing orders and preparing invoices.
Prioritizing Improvement Activities
Three considerations in prioritizing improvement activities are the perceived

seriousness of the problems, the benefits of improvements, and the costs of the
improvements. In this case study, the breakthrough improvement projects involve
higher costs than the incremental improvement efforts. To identify the most
serious problems, a Pareto analysis can be performed.
In PSI’s case, correcting order acknowledgement errors became the highest
priority because of its associated cost of 7% of the salary and fringe benefits
budget (see Exhibit 5-21).
Update: Improvement Efforts by PSI as of 1996
The first incremental improvement, a stringent policy of sales representatives

filling out quote forms correctly, was abandoned because the forms quickly
became obsolete and the policy was unpopular with sales representatives. In
addition, the policy slowed the quotation process.
– 245 –
The initial vendor’s quote for the desired configuring program was judged
unaffordable. After an 18-month search, however, PSI was able to purchase a
new integrated information system (including materials resource planning and
accounting) that included a configuring program. In the meantime, PSI developed
an in-house configuring program that runs on the sales representatives’ laptop
computers. As a consequence, problems with missing, incorrect, or changed part
numbers have been greatly reduced. Information on part numbers originates in
manufacturing and is maintained and kept current by the marketing department.
A change from line-item pricing (listing each component part with its associated
price) to bundling (listing the component parts but providing only a bottom-line
price) reduced processing time because customers previously would call for
verification if any one of the component prices on the invoice differed from what
appeared on the quote.
The current cycle typically runs as follows:
• Sales representative prepares a quote using laptop computer configuring
program and e-mails it to order entry.
• Order entry reviews the quote and sends a quote packet to send to the
customer (pricing on quote is reviewed by order entry supervisor).
• When the customer’s order is received by order entry, the order is entered
into PSI’s system configuring program; the order entry supervisor approves
the order.
• The controller approves the order.
• The order acknowledgement is transmitted electronically to manufacturing.
• Manufacturing builds the product.
• The product is shipped.
• The invoice is generated the same day the product is shipped, with no further
review.
(g) Nonfinancial indicators that might be useful in improving quality in the order
entry department include:
• The frequency of the different types of errors.
• Time spent on correcting problems.
Frequency of reporting is an important issue when implementing a COQ

system. Options for frequency of tracking data and reporting include:
• Keep track of the information on a daily basis but report monthly. Continue
doing this until improvements are made and the information is no longer
needed. The assumption is that continuous improvement projects will be
undertaken to rectify the situation.
– 246 –
• Collect sample data for a specified period once every quarter or six-month
period, for example, and assess the changes in the magnitude of problems.
The assumption is that results from the sample data will be used to make
process improvements.
COQ information is useful for the following reasons:

• COQ quantifies the financial impact of the errors/problems, thereby
providing a universally understood method of assessing the seriousness of
the situation. As emphasized in question (a), COQ figures can play an
important role in alerting top management to the seriousness of quality
problems overall or in a particular area.
• Quality cost systems cut across departmental boundaries, thereby providing a
holistic measure of the benefits derived from improvement efforts.
COQ information should be used in conjunction with nonfinancial indicators,

as the latter provide the information actually required for making changes to
the system.
– 247 –
Form #1 - Class I (Internal) Failure

Completed by Order Entry Staff
Date Started _______________ Time Started ___________
Order serial #
Is this a new order? Yes I No (If not, please specify —)
Is this an engineering special? Yes / No
Is all information available and clear? Yes I No
Is the quotation # available on the Purchase Order? Yes I No
If not, how did you track down the quotation?
By dollar amount ____ By customer name ____ Called sales rep. ____
Other
Is all relevant information available and clear on the customer’s P.O.? Yes I No
Please provide below details of all the clarifications required.
Serial No. Explanation of problem / clarification How clarification obtained Time spent
How long did it take you to prepare the first draft of the order (including time
spent obtaining clarifications?
How much time did you spend inspecting the quote before finally giving it to
your supervisor for inspection?
Were there any changes as a result of your inspection(s)? Yes / No
Time taken to make changes _____ minutes/hours.
How many drafts of the order were printed including the one you gave to your
supervisor for inspection?
Complete after your supervisor has inspected the order
Were there any changes as a result of your supervisor’s inspection? Yes / No

Time taken to make changes _____ minutes/hours.
After your supervisor’s inspection, how many drafts of the order were printed in
addition to the final version mailed to the customer?
Date and time order sent out to your internal customer?
Other comments:
– 248 –
Form #2- Class II (External) Failure

Completed by Manufacturing Department (Immediate Internal Customer)
Order/ Quotation Nature of How clarification Time spent in

serial # error/clarification obtained obtaining
required/problem clarification
(including
waiting time)
Total number of errors

Number of orders/quotations received
Errors as a % of orders/quotations
– 249 –

Management Accounting Information For Activity and Process Decisions

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Chapter 5

1. Costs of production engineering, if the number of engineers cannot be

5-12 When a decision to outsource frees up space to produce an alternative product,

5-15 Cellular manufacturing involves the organization of a plant into a number of

5-16 A JIT system is very different from a conventional manufacturing system. In a

Under many conventional manufacturing systems, goods are produced to a

5-17 Under many conventional manufacturing systems, goods are produced to a

Because cellular manufacturing and just-in-time production reduce the

1. Costs of moving machines

5-20 Financial benefits resulting from a shift to cellular manufacturing, just-in-time

1. Increased sales because the short production cycle time enables a

5-24 Three examples of each of the following quality costs are:

(a) prevention costs—quality training, supplier certification and statistical

5-29 (a) Relevant costs:

Year 1: (If Don buys the Ford Escort)

(c) Additional quantitative considerations:

5-30 Per Unit As Is Rework

Gilmark should rework the lamps.

(c) Replacement Overhauling Difference

5-32 (a) Insource Outsource

(b) Insource Outsource

(b) If the unit-related, batch-related, and product-sustaining support costs are

Purchase price $64.50

5-35 Year 1 Year 2 Year 3 Year 4 Year 5

Cost per unit Make Buy

5-37 Benefits from cellular manufacturing operations are estimated to be $767,200

Before the After the

Assuming facility-sustaining costs are not avoidable in the short run,

5-42 Incremental costs:

5-43 Make Buy

5-45 (a) Selling price per unit $4.00

(b) The acquisition cost of the old machine is a sunk cost.

(c) Other considerations:

A just-in-time manufacturing system requires making a good or service only

The cellular manufacturing approach is not inconsistent with the philosophy of

5-50 (a) Impact of dropping JT484 on operating income:

Reduction in contribution margin $100,000

Therefore, JT484 should not be eliminated.

5-51 Estimated cost savings as a result of the quality improvement:

Savings from decrease in reject rate

5-52 (a) Selling price per unit: $105.00

Additional inventory carrying costs = $18.75Q × 0.12 = $2.25Q

Decrease in sales of old product = $20 × (Q/2)

$34.5 Q – $20 × (Q/2) – $2.25 Q – $2,000,000 = 0

Appraisal issues arise in choosing measures to evaluate whether representatives are

As in other contexts, attention should be given to prevention of poor quality, with

5-59 (a) Quality Cost Report for Renwal Company

External Failure Costs:

At Renwal both prevention and appraisal costs are a relatively small

With regard to internal-failure costs, Renwal also apparently incurs a

The more desirable quality-cost trend is the reverse of Renwal’s pattern.

5-60 (a) Quality Cost Report for Ideal Company

Internal Failure Costs:

External Failure Costs:

Total Quality Costs: $9,000,000 12.00%

1. Contribution margin on Premier sales:

2. Contribution margin on cannibalized sales:

(b) Strategic and other factors that need to be considered include:

Reputation problems—Customers finding the same bicycle at Premier

Long-term capacity implications—The ideal capacity is tied up now with

Retail distributor problems—The existing retail distributors are specialty

bicycles as much as before, resulting in substantial decreases in

Date Started _____ Time Started _