18 Costing And The Value Chain

19 COSTING AND THE VALUE CHAIN

Chapter Summary

The value chain is used to organize the discussion of several aspects of strategic cost management. These include activity-based management, target costing, just-in-time inventory procedures, and total quality management. Activity based management utilizes cost information from ABC systems to identify and eliminate non-value-added activities. While Chapter 17 focused on activity- based product costs, this chapter develops an extensive illustration to demonstrate the management of activities associated with period costs. This is done to emphasize the application of activity-based management across all phases of the value chain. Target costing begins with planning and market analysis of customer needs, then proceeds to product development to generate a target price. Value engineering leads to the most economically efficient combination of resources to create the product. Finally the target cost is attained through production and continuous improvement. A straightforward example illustrates the execution of the four phases of the target costing process. The development of just-in-time inventory and production systems was one of the earliest efforts of management to identify non-value-adding activities. The realization that investment of resources in inventory added no value to the customer initiated the development of the just-in-time philosophy. This philosophy emphasizes that all production is driven by customer demand. The chapter centers on the importance of supplier relationships, product quality, and flexible manufacturing in achieving the JIT objective of controlling product costs. The chapter concludes with a discussion of the components of quality costs and the tradeoffs between prevention and appraisal costs on one hand and the costs of internal and external failure on the other.

Learning Objectives

1. Define the value chain and describe its basic components.

2. Distinguish between non-value-added and value-added activities.

3. Explain how activity-based management is related to activity-based costing (ABC).

4. Describe the target costing process and list its components.

5. Identify the relationship between target costing and the value chain.

6. Explain the nature and goals of a just-in-time (JIT) manufacturing system.

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2005 Financial and Managerial Accounting: The Basis for Business Decisions, 13e 45 7. Identify the components of cost of quality.

8. Describe the characteristics of quality measures.

Brief Topical Outline

A The value chain 1 Value- and non-value-added activities - see Your Turn (page 804) B Activity-based management - see Case in Point (page 806) 1 Activity-based management across the value chain a Managing activities: an illustration (pages 806 - 808) - see Case in Point (page 808) 2 ABC: A subset of activity-based management - see Management Strategy (page 809) C The target costing process - see Case in Point (page 810) 1 Components of the target costing process 2 Target costing: an illustration - see Your Turn (page 812) and Cash Effects (page 814) 3 Characteristics of the target costing process D Just-in-time inventory procedures 1 JIT, supplier relationships, and product quality - see Case in Point (page 815) 2 Measures of efficiency in a JIT system 3 Measuring quality 4 A concluding comment E Total quality management and the value chain 1 Components of the cost of quality - see Case in Point (page 818) 2 Measuring the cost of quality - see Your Turn (page 819) 3 Productivity and quality F Concluding remarks - see A Second Look (page 820)

Topical coverage and suggested assignment

Homework Assignment (To Be Completed Prior to Class) Class Topical Meetings on Outline Discussion Chapter Coverage Questions Exercises Problems Cases Internet 1 A - B 1, 2, 3 1, 2, 3, 4 1, 2 2 C - D 7, 8, 10, 11, 12 5, 6 3 1 1

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Comments and observations

Teaching objectives for Chapter 19

Our goal in presenting this material is to help students to begin to think strategically about the development and use of cost information. In so doing our objectives are to:

1 Introduce the value chain as a structure for strategic cost management.

2 Explain the distinction between value-added and non-value-added activities across the value chain.

3 Show that activity-based costs are important to reducing and eliminating non-value-added activities.

4 Explain how activity-based costs can be used to manage not only production, but also activities across all components of the value chain.

5 Introduce target costing and its components.

6 Explain the JIT approach to identifying and reducing non-value-added activities.

7 Present measures of efficiency in a JIT manufacturing system.

8 Explain the trade-offs that exist among components of quality costs, and how those trade-offs change with technical progress.

New features in Chapter 19

Costing and the value chain was introduced in the twelfth edition and remains unchanged in the thirteenth edition.

General comments

Managing activities across the value chain represents a comprehensive integrated approach to the traditional management functions of planning and control. Eliminating non-value-added activities from the chain is central to this strategic approach to cost management. Exercise 3 is designed to acquaint students with the value chain and the identification of non-value-added activities in the chain. We have emphasized that the ABC model developed in a previous chapter can be usefully extended beyond product costing to a wide variety of period costs. Doing so provides an opportunity to use ABC information to manage across the entire value chain. This can be illustrated using Exercise 4. Although Problem 2 requires the calculation of target costs, it provides a comprehensive opportunity for students to use cost information to address activity-

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2005 Financial and Managerial Accounting: The Basis for Business Decisions, 13e 47 based management issues. We highly recommend reviewing this problem in class. Case 1 is a more extensive alternative. Target costing illustrates the use of cost information in planning and designing new products as well as reengineering existing ones. Problem 3 captures the use of cost estimates and budgets in the planning process. It also addresses the issue of process design to minimize production costs. Quality costing, like ABM, emphasizes activity management across the value chain. Prevention costs apply to the research and design phase, as well as in working with suppliers and vendors. Appraisal costs and internal failures are most closely identified with the suppliers and production component. Finally, external failure costs exert a significant impact on customer service. Managing quality activities across the value chain highlights the tradeoffs among these costs. Our Case in Point dealing with Texas instruments makes this point, as does Problem 4.

Supplementary Exercises

Business Week Exercise

Read “Winning in China”, Business Week, January 27, 2003. The authors describes how Motorola launched a new global product line in Asia. China is the world’s largest user of cell phones, with more than 200 million subscribers. Discuss the components of the value chain and prepare a list of value added activities in the production of cell phones.

Group Exercise

The widespread adoption of total quality management, activity-based management, and just-in-time systems has important implications for manufacturers in the United States. Read "U.S.: A Temporary Reprieve for Manufacturing”, Business Week, September 29, 2003. Based on your reading, prepare a report to the class regarding the present and future roll of manufacturing in the US economy.

Internet Exercise

Did you ever stop to notice that all the credit, debit, and ATM cards that you carry have exactly the same thickness. This is true worldwide and is crucial to transactions processing. How did this worldwide coordination come to be? Explore the website of the International Organization for Standardization at www.iso.ch/ What are the goals of this organization? Write a brief report describing the information you are able to obtain from this site.

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10-MINUTE QUIZ A SECTION

Indicate the best answer for each question in the space provided. 1 Examples of value-added activities include all of the following except: a Product design. b Material movement. c Assembly activities. d Establish an effective distribution network.

2 Of the following components of total quality cost, which is most damaging to a company attempting to achieve a reputation as a world-class manufacturer? a Prevention costs. b Appraisal costs. c Internal failure costs. d External failure costs

3 Of the following processes which is chiefly concerned with products and services that have not yet been developed? a Just-in-time manufacturing. b Activity-based management. c Target costing. d Total quality management.

4 For a furniture manufacturer which of the following activities could be eliminated without changing the customer’s perception of the product’s desirability? a Inspection of incoming shipments of wood and fabrics. b Movement of work-in-process from one work station to another. c Set-up of machinery to produce different pieces of furniture. d All of the above.

5 The cost borne by the customer of disposing of nickel-cadmium batteries is a component of the batteries’: a Life-cycle cost. b Overhead cost. c Cost of quality. d Direct production cost..

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2005 Financial and Managerial Accounting: The Basis for Business Decisions, 13e 49 CHAPTER 19 NAME #

10-MINUTE QUIZ B SECTION Listed below are eight technical accounting terms introduced or emphasized in this chapter:

Activity-based management Life-cycle costing Value-added activity Nonvalue-added activity Target costing ...... Total quality management Just-in-time manufacturing system Cycle time

Each of the following statements may (or may not) describe one of these technical terms. In the space provided below each statement, indicate the accounting term described, or answer “None” if the statement does not correctly describe any of the terms.

a The process of using activity-based costs to help reduce or eliminate nonvalue-added activities. ______

b Can be eliminated without affecting the desirability of the product from the perspective of the customer ______

c The length of time for a product to pass completely through a specific manufacturing process. ______

d If eliminated, the desirability of the product to consumers is decreased. ______

e Consideration of all potential resources that will be consumed by a product from development through disposal. ______

f A method in which a product’s selling price is determined by adding a fixed profit margin to its production cost. ______

g An approach that explicitly monitors quality costs and rewards quality enhancing behavior. ______

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10-MINUTE QUIZ C SECTION

Listed below are eight components of the total cost of quality. In the space provided identify each as a cost of prevention, appraisal, internal failure, or external failure.

Product design

Product returns due to defects

Inspection of raw materials shipments

Employee training

Rework of defective units prior to shipment

Estimated lost sales due to poor quality

Warranty expense

Inspection of finished goods

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2005 Financial and Managerial Accounting: The Basis for Business Decisions, 13e 51 CHAPTER 19 NAME #

10-MINUTE QUIZ D SECTION

Diamond Corporation is considering the implementation of a JIT inventory system. The company recently analyzed its cycle time to determine the average number of days spent in each activity of its production process. A summary of the analysis is shown below:

Production Activity Number of Days Receiving materials 2 Inspecting materials 4 Storing materials 10 Moving materials into production 6 Setting-up production equipment 8 Cutting materials 6 Assembling materials 8 Painting finished products 4 Packaging finished products 2

a Diamond’s value-adding production activities include:

b Diamond’s total cycle time is ______days.

c Diamond’s manufacturing efficiency ratio is ______%.

d Which activities might be reduced or eliminated should Diamond implement a JIT system?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 52 Instructor’s Resource Manual SOLUTIONS TO CHAPTER 19 10-MINUTE QUIZZES

QUIZ A 1 B 2 D 3 C 4 D 5 A

QUIZ B

a Activity based management b Nonvalue-added activities c Cycle time d Value-added activity e Life cycle costing f Target costing g Total quality management

QUIZ C Prevention External failure Appraisal Prevention Internal failure External failure External failure Appraisal Internal failure

QUIZ D

a Cutting materials, Assembling materials, Painting finished products

b 50 days

c 18/50 = 36%

d Receiving materials, storing materials, moving materials into production

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2005 Financial and Managerial Accounting: The Basis for Business Decisions, 13e 53