Solution manual cost accounting 12e by horngren ch 19

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CHAPTER 19
BALANCED SCORECARD: QUALITY, TIME, AND THE THEORY OF
CONSTRAINTS
19-1 Quality costs (including the opportunity cost of lost sales because of poor quality) can be
as much as 10% to 20% of sales revenues of many organizations. Quality-improvement
programs can result in substantial cost savings and higher revenues and market share from
increased customer satisfaction.
19-2 Quality of design refers to how closely the characteristics of a product or service meet the
needs and wants of customers. Conformance quality refers to the performance of a product or
service relative to its design and product specifications.
19-3 Exhibit 19-1 of the text lists the following six line items in the prevention costs category:
design engineering; process engineering; supplier evaluations; preventive equipment
maintenance; quality training; and testing of new materials.
19-4 An internal failure cost differs from an external failure cost on the basis of when the
nonconforming product is detected. An internal failure is detected before a product is shipped to
a customer, whereas an external failure is detected after a product is shipped to a customer.
19-5 Three methods that companies use to identify quality problems are: (a) a control chart
which is a graph of a series of successive observations of a particular step, procedure, or
operation taken at regular intervals of time; (b) a Pareto diagram, which is a chart that indicates
how frequently each type of failure (defect) occurs, ordered from the most frequent to the least
frequent; and (c) a cause-and-effect diagram, which helps identify potential causes of failure.
19-6 No, companies should emphasize financial as well as nonfinancial measures of quality,
such as yield and defect rates. Nonfinancial measures are not directly linked to bottom-line
performance but they indicate and direct attention to the specific areas that need improvement to
improve the bottom line. Tracking nonfinancial measures over time directly reveals whether
these areas have, in fact, improved over time. Nonfinancial measures are easy to quantify and
easy to understand.
19-7 Examples of nonfinancial measures of customer satisfaction relating to quality include
the following:

1. the number of defective units shipped to customers as a percentage of total units of product
shipped;
2. the number of customer complaints;
3. delivery delays (the difference between the scheduled delivery date and date requested by
customer);
4. on-time delivery rate (percentage of shipments made on or before the promised delivery
date);
5. customer satisfaction level with product features (to measure design quality);
6.
market share; and
7. percentage of units that fail soon after delivery.

19-1


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19-8 Examples of nonfinancial measures of internal-business-process quality:
1. the percentage of defects for each product line;
2. process yield (rates of good output to total output at a particular process;
3. manufacturing lead time (the amount of time from when an order is received by production
to when it becomes a finished good); and
4. number of product and process design changes
19-9 Customer-response time is how long it takes from the time a customer places an order for
a product or a service to the time the product or service is delivered to the customer.
Manufacturing lead time is how long it takes from the time an order is received by
manufacturing to the time a finished good is produced. Manufacturing lead time is only one part
of customer-response time. Delays in delivering an order for a product or service can also occur
because of delays in receiving customer orders and delays in delivering a completed order to a
customer.

Customer
Order
Order
Order
response = receipt + manufacturing + delivery
time
time
lead time
time

19-10 No. There is a trade-off between customer-response time and on-time performance.
Simply scheduling longer customer-response time makes achieving on-time performance easier.
Companies should, however, attempt to reduce the uncertainty of the arrival of orders, manage
bottlenecks, reduce setup and processing time, and run smaller batches. This would have the
effect of reducing both customer-response time and improving on-time performance.
19-11 Two reasons why lines, queues, and delays occur is (1) uncertainty about when customers
will order products or services––uncertainty causes a number of orders to be received at the same
time, causing delays, and (2) limited capacity and bottlenecks––a bottleneck is an operation
where the work to be performed approaches or exceeds the available capacity.
19-12 No. Adding a product when capacity is constrained and the timing of customer orders is
uncertain causes delays in delivering all existing products. If the revenue losses from delays in
delivering existing products and the increase in carrying costs of the existing products exceed the
positive contribution earned by the product that was added, then it is not worthwhile to make and
sell the new product, despite its positive contribution margin. The chapter describes the negative
effects (negative externalities) that one product can have on others when products share common
manufacturing facilities.
19-13 The three main measures used in the theory of constraints are the following:
1. throughput contribution equal to revenues minus direct material cost of the goods sold;
2. investments equal to the sum of materials costs in direct materials, work-in-process and
finished goods inventories, research and development costs, and costs of equipment and

buildings;
3. operating costs equal to all costs of operations such as salaries, rent, and utilities (other than
direct materials) incurred to earn throughput contribution.

19-2


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19-14 The four key steps in managing bottleneck resources are:
Step 1: Recognize that the bottleneck operation determines throughput contribution of the
entire system.
Step 2: Search for, and identify the bottleneck operation.
Step 3: Keep the bottleneck operation busy, and subordinate all nonbottleneck operations to the
bottleneck operation.
Step 4: Increase bottleneck efficiency and capacity.
19-15 The chapter describes several ways to improve the performance of a bottleneck operation.
1. Eliminate idle time at the bottleneck operation.
2. Process only those parts or products at the bottleneck operation that increase throughput
contribution, not parts or products that will remain in finished goods or spare parts
inventories.
3. Shift products that do not have to be made on the bottleneck machine to nonbottleneck
machines or to outside processing facilities.
4. Reduce setup time and processing time at bottleneck operations.
5. Improve the quality of parts or products manufactured at the bottleneck operation.

19-3


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19-16 (30 min.) Costs of quality.
1.

The ratios of each COQ category to revenues and to total quality costs for each period are as follows:
Costen, Inc.: Semi-annual Costs of Quality Report
(in thousands)
6/30/2006

12/31/2006

6/30/2007

12/31/2007

% of Total
% of Total
% of Total
% of Total
% of
Quality
% of
Quality
% of
Quality
% of
Quality
Actual Revenues
Costs
Actual Revenues

Costs
Actual Revenues
Costs
Actual Revenues
Costs
(1)
(2) =
(3) =
(4)
(5) =
(6) =
(7)
(8) =
(9) =
(10)
(11) =
(12) =
(1) ÷ $8,240 (1) ÷ $2,040
(4) ÷ $9,080 (4) ÷ $2,159
(7) ÷ $9,300 (7) ÷ $1,605
(10) ÷ $9,020 (10) ÷ $1,271
Prevention costs
Machine maintenance
Supplier training
Design reviews
Total prevention costs
Appraisal costs
Incoming inspection
Final testing
Total appraisal costs

Internal failure costs
Rework
Scrap
Total internal failure costs
External failure costs
Warranty repairs
Customer returns
Total external failure costs
Total quality costs

165
570
735
$2,040

Total production and revenues

$8,240

$440
20
50
510
108
332
440
231
124
355

6.2%

5.3%

4.3%

8.9%
24.7%

25.0%

$440
100
214
754

21.6%

123
332
455

17.4%

202
116
318

36.0%
100.0%

85
547
632
$2,159
$9,080

19-4

8.3%

5.0%

3.5%

7.0%
23.8%

34.9%

$390
50
210
650

21.1%

90
293
383

14.7%

165
71
236

29.3%
100.0%

72
264
336
$1,605
$9,300

7.0%

4.1%

2.5%

3.6%
17.2%

40.5%

$330
40
200

570

6.3%

44.9%

23.9%

63
203
266

3.0%

20.9%

14.7%

112
67
179

2.0%

14.1%

20.9%
100.0%

68

188
256
$1,271

2.8%
14.1%

20.1%
100.0%

$9,020


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2.
From an analysis of the Cost of Quality Report, it would appear that Costen, Inc.’s
program has been successful because:
Total quality costs as a percentage of total revenues have declined from 24.7% to
14.1%.
External failure costs, those costs signaling customer dissatisfaction, have declined
from 8.9% of total revenues to 2.8% of total revenues and from 36% of all quality
costs to 20.1% of all quality costs. These declines in warranty repairs and customer
returns should translate into increased revenues in the future.
Internal failure costs as a percentage of revenues have been halved from 4.3% to 2%.
Appraisal costs have decreased from 5.3% to 3% of revenues. Preventing defects
from occurring in the first place is reducing the demand for final testing.
Quality costs have shifted to the area of prevention where problems are solved before
production starts: total prevention costs (maintenance, supplier training, and design
reviews) have risen from 25% to 44.9% of total quality costs. The $60,000 increase in

these costs is more than offset by decreases in other quality costs.
Because of improved designs, quality training, and additional pre-production
inspections, scrap and rework costs have almost been halved while increasing sales
by 9.5%.
Production does not have to spend an inordinate amount of time with customer
service since they are now making the product right the first time and warranty
repairs and customer returns have decreased.
3.
To estimate the opportunity cost of not implementing the quality program and to help her
make her case, Jessica Tolmy could have assumed that:
Sales and market share would continue to decline if the quality program was not
implemented and then calculated the loss in revenue and contribution margin.
The company would have to compete on price rather than quality and calculated the
impact of having to lower product prices.
Opportunity costs are not recorded in accounting systems because they represent the results of
what might have happened if the company had not improved quality. Nevertheless, opportunity
costs of poor quality can be significant. It is important for Costen to take these costs into account
when making decisions about quality.

19-5


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19-17 (20 min.) Costs of quality analysis, nonfinancial quality measures.
1. & 2.
Revenues

Costs of Quality
Prevention costs

Design engineering
Preventive equipment maintenance
Supplier evaluation
Total prevention costs

2007
$20,000,000
Percentage
of Revenues
Cost
(4) = (3) ÷
(3)
$20,000,000

$ 210,000
110,000
80,000
400,000

Appraisal costs
Inspection of production
Product-testing labor and equipment
Incoming materials inspection
Total appraisal costs

220,000
530,000
50,000
800,000

Internal failure costs
Scrap and rework
Breakdown maintenance
Total internal failure costs

720,000
180,000
900,000

External failure costs
Cost of returned goods
Customer support
Warranty repair
Total costs of quality

120,000
80,000
1,000,000
1,200,000
$3,300,000

19-6

2008
$25,000,000
Percentage
of Revenues
Cost
(2) = (1) ÷
(1)

$25,000,000

2.0%

$ 600,000
200,000
200,000
1,000,000

4.0%

4.0%

170,000
250,000
80,000
500,000

2.0%

4.5%

670,000
80,000
750,000

3.0%

6.0%
16.5%

300,000
65,000
635,000
1,000,000
$3,250,000

4.0%
13.0%


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Percentage of Revenues

Preston Corp: Costs of Quality as a
Percentage of Revenues
20.0%

16.5%
13.0%

15.0%

2007

10.0%
5.0%

4.5%

4.0%
2.0%

4.0%
2.0%

Prevention

Appraisal

6.0%
3.0%

2008
4.0%

0.0%
Internal
Failure

External
Failure

Total

COQ Category

Between 2007 and 2008, Preston’s costs of quality have declined from 16.5% of sales to 13% of
sales. The analysis of individual costs of quality categories indicates that Preston began
allocating more resources to prevention activities––design engineering, preventive maintenance

and supplier evaluations in 2008 relative to 2007. As a result, appraisal costs declined from 4%
of sales to 2% of sales, costs of internal failure fell from 4.5% of sales to 3%, and external failure
costs decreased from 6% of sales to 4%. The one concern here is that, although external failure
costs have decreased, the cost of returned goods has more than doubled, on a 25% rise in
revenues. Preston’s management should investigate the reasons for this and initiate corrective
action.
3.
Examples of nonfinancial quality measures that Preston Corporation could monitor in its
balanced scorecard as part of a total quality-control effort are the following:
a. number of defective units shipped to customers as a percentage of total units shipped;
b. ratio of good output to total output at each production process; and
c. percent of customers who would buy another Preston product or recommend it as
their top choice to other potential buyers.

19-7


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19-18 (25 min.) Costs-of-quality analysis, nonfinancial quality measures.
1. & 2.
Frostaire
% of
Revs.

Coolaire
% of
Revs.

Revenues

(20,000 units

$1,500 per unit; 40,000 units

$500/unit)

$30,000,000

$20,000,000

Prevention costs: Design
(7,500 hrs; 2,500 hrs

$80 per hour)

600,000

2.00%

200,000

1.00%

1,000,000

3.33%

300,000

1.50%

300,000

1.00%

480,000

2.40%

320,000

1.07%

576,000

2.88%

350,000
$2,570,000

1.17%
8.57%

Appraisal: Testing and inspection
(1 hr/unit

20,000 units; 0.15 hr/unit

40,000 units

$50/hour)

Internal failure: Rework
(5%

20,000 units

$300 per unit; 10%

40,000 units

$120 /unit)

External failure: Repair
(4%

20,000 units

$400/unit; 8%

40,000 units

$180/unit)

Lost contribution due to poor quality
(500

($1,500 – $800); 4,000

($500 – $300))

Total cost of quality

800,000 4.00%
$2,356,000 11.78%

Overall, Frostaire seems to be of higher quality than Coolaire. The total cost of
quality for Frostaire is 8.57% of revenues, versus 11.78% for Coolaire. This quality
advantage may be related to Ambrose's ability to sell Frostaire at $1,500 per unit
versus Coolaire at $500 per unit and also to the larger lost contribution due to poor
quality from Coolaire than from Frostaire ($800,000 or 4% of revenues due to
Coolaire; $350,000 or 1.17% of revenues due to Frostaire).
In the Frostaire line, the focus of quality efforts is on prevention and appraisal (total
of 5.33% of revenues spent on quality, versus 2.5% in the case of Coolaire); in the
Coolaire line, quality resources are mostly spent on internal and external failure costs
and opportunity costs (total of 9.28% of revenues versus 3.24% for Frostaire).
3.
Examples of nonfinancial quality measures that Ambrose Industries could monitor in its
balanced scorecard as part of a total-quality program:
a. number of defective units shipped to customers as a percentage of total units shipped;
b. ratio of good output to total output at each production process; and
c. percent of customers who would buy another Ambrose product or recommend it as
their top choice to other potential buyers.

19-8


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19-19 (25 min.) Nonfinancial measures of quality and time.

1.
2006

2007

a.

Percentage of defective units shipped

400
= 4%
10,000

330
= 3%
11,000

b.

On-time delivery

8,500
= 85%
10,000

9,900
= 90%
11,000

c.

Customer complaints as a
percentage of units shipped

500
= 5%
10,000

517
= 4.7%
11,000

d.

Percentage of units reworked
during production

600
= 6%
10,000

627
= 5.7%
11,000

2.
The calculations in requirement 1 indicate that ESC’s performance on both quality and
timeliness has improved. Quality has improved because: (a) percentage of defective units
shipped has decreased from 4% to 3%; (b) customer complaints have decreased from 5% to
4.7%; and (c) percentage of units reworked during production has decreased from 6% to 5.7%.

Timeliness has improved as on-time delivery has increased from 85% to 90%. Of course, there is
a relationship between the improvements in quality and timeliness. Better quality and less rework
reduces delays in production and enables faster and on-time delivery to customers.
3a.
2006
The output per labor-hour
in 2006 and 2007
can be calculated as follows

10,000
90,000

2007
0.11

11,000
110,000

0.10

3b.
Output per labor-hour may have declined from 2006 to 2007 either because workers were
less productive or more likely because the initial implementation of the quality program may
have resulted in lost production time as employees were trained and became more adept at
solving production quality problems. As workers implement good quality practices and defects
and rework decrease over time, it is possible that both quality and productivity (output per laborhour) will increase.
3c.
It is not clear that the lower output per labor-hour will decrease operating income in
2007. The higher labor costs in 2007 could pay off in many ways. Higher quality and lower
defects will likely result in lower material costs because of lower defects and rework. Internal

and external failure costs will also be lower, resulting in lower customer returns and warranty
costs. Customer satisfaction will likely increase, resulting in higher sales, higher prices, and
higher contribution margins. Indeed the 10% increase in the number of units produced and sold
in 2007 may well have been due to quality improvements. Overall, the benefits of higher quality
in 2007 may very well exceed the higher labor costs per unit of output.
19-9


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19-20 (25 min.) Quality improvement, relevant costs, and relevant revenues.
1.
Relevant costs over the next year of choosing the new lens = $55
$1,100,000

20,000 copiers =

Relevant Benefits over
the Next Year of Choosing
the New Lens
Costs of quality items
Savings on rework costs
$40 12,875 rework hours
Savings in customer-support costs
$20 900 customer-support-hours
Savings in transportation costs for parts
$180 200 fewer loads
Savings in warranty repair costs
$45 7,000 repair-hours
Opportunity costs

Contribution margin from increased sales
Cost savings and additional contribution margin

$ 515,000
18,000
36,000
315,000
900,000
$1,784,000

Because the expected relevant benefits of $1,784,000 exceed the expected relevant costs of the
new lens of $1,100,000, Photon should introduce the new lens. Note that the opportunity cost
benefits in the form of higher contribution margin from increased sales is an important
component for justifying the investment in the new lens.
2. The incremental cost of the new lens of $1,100,000 is greater than the incremental savings in
rework and repair costs of $884,000 ($515,000 + $18,000 + $36,000 + $315,000). Investing in
the new lens is beneficial, provided it generates additional contribution margin of at least
$216,000 ($1,100,000 – $884,000). Contribution margin per unit is $900,000 ÷ 150 copies =
$6,000 per copier. Therefore, Photon needs additional unit sales of at least $216,000 ÷ $6,000 =
36 copiers to justify investing in the new lens on financial considerations alone.

19-10


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19-21 (20 25 min.) Customer-response time, on-time delivery.
1.
Pizzas delivered in 30 minutes or less
Pizzas delivered in between 31 and 45 minutes

Pizzas delivered in between 46 and 60 minutes
Pizzas delivered in between 61 and 75 minutes
Total

January-June
150,000
= 25%
600,000
300,000
= 50%
600,000
120,000
= 20%
600,000
30,000
= 5%
600,000

July-December
198,000
= 30%
660,000
363,000
= 55%
660,000
66,000
= 10%
660,000
33,000
= 5%

660,000

100%

100%

Yes, customer-response time has improved from January–June 2007 to July–December 2007.
The percentage of pizzas delivered in less than 30 minutes increased by 5%, and pizzas delivered
in less than or equal to 45 minutes increased by 10% [85% (30% + 55%) in July–December
minus 75% (25% + 50%) in January–June]. In turn, pizzas delivered in greater than 45 minutes
decreased by 10% [25% (20% + 5%) in January–June minus 15% (10% + 5%) in July–
December].
2.
In the January-June 2007 period, Pizzafest should quote a customer-response time of (a)
45 minutes to achieve on-time delivery performance of 75% (75% of all pizzas were delivered
within this time frame) and (b) 60 minutes to achieve on-time delivery performance of 95%
(95% of all pizzas were delivered within this time frame).
3.
Yes. In the July-December 2007 period, Pizzafest would achieve on-time delivery
performance of (a) 85% (greater than its target performance level of 75%) if it had quoted a
customer-response time of 45 minutes and (b) its target performance level of 95% if it had
quoted a customer-response time of 60 minutes.
4a

Contribution margin from selling 20,000 additional pizzas
20,000 ($13 $7)
Cost of having to give 15,000 pizzas free because
of late deliveries, 15,000 $7
Increase in operating income from making the free pizza offer

$120,000
105,000
$ 15,000

4b.
Pizzafest should carefully monitor the quality of its pizzas. In its desire to deliver pizzas
on time, Pizzafest should not compromise on the time needed to cook the pizza, nor should it
increase oven temperatures beyond acceptable levels in order to cook the pizza faster.
Pizzafest should also ensure that drivers responsible for delivering the pizza drive
carefully. In their desire to reach a customer quickly, road safety should not be compromised.

19-11


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4c.

Some ways to reduce customer-response times are:
(i)
Start making the pizza soon after a customer calls. Waiting to start making a pizza
is a nonvalue-added delay.
(ii) Ensure that adequate labor is available to start preparing the pizza for cooking, and
adequate oven capacity is available to minimize waiting time before cooking
commences.
(iii) Have an adequate number of drivers available to deliver the pizzas.
(iv) Maintain ovens well to avoid down time.
(v) Clean ovens quickly after a pizza is done in preparation for cooking the next pizza.
(vi) Keep some basic cheese pizzas ready ahead of time so that only toppings need to
be added after an order is received.

(vii) Make sure each pizza cooked is of good quality (not overcooked or undercooked)
so that no pizzas have to be thrown away and redone. Poor quality will cause
delays.

19-22 20 min.)

Waiting time, banks.

1.
If the branch expects to receive 40 customers each day and it takes 5 minutes to serve a
customer, the average time that a customer will wait in line before being served is:

Average number
of customers

=

2

=

Available time
counter is open

Time taken to
serve a customer

Average number
of customers

2

Time taken to
serve a customer

(40 25)
1,000
1,000
[40 (5) 2 ]
=
=
=
200
2 [300 (40 5)] 2 (300 200 ) 2 100

= 5 minutes

2. If the branch expects to receive 50 customers each day and the time taken to serve a
customer is 5 minutes, the average time that a customer will wait in line before being served is:
(50 25)
50 25 1,250
[50 (5) 2 ]
=
=
=
=
100
2 [300 (50 5)] 2 (300 250 ) 2 50

= 12.5 minutes

3. If the branch expects to serve 50 customers each day and the time taken to serve a customer
is 4 minutes, the average time that a customer will wait in line before being served is:
=

(50 16)
50 16
[50 (4) 2 ]
=
=
= Error! = 4 minutes
2 [300 (50 4)] 2 (300 200 ) 2 100

19-12


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19-23 (20–25 min.) Waiting time, relevant costs, and relevant revenues.
1.
If the branch expects to serve 60 customers each day and it takes 4 minutes to serve a
customer, the average time that a customer will wait in line before being served is:
=
2.

(60 16)
60 16
[60 (4) 2 ]
=
=

= Error!= 8 minutes
2 60
2 [300 (60 4)] 2 (300 240 )

Suppose the bank counter is kept open for 336 minutes. Then

[60 (4) 2 ]
2 [336 (60 4)]

=
=

2

60 16
336 240

60 16
= 5 minutes
2 96

The counter must be kept open for 336 minutes to reduce average waiting time to 5 minutes.
3.

Incremental operating income from providing new services
Incremental teller cost
(1 additional hour $10 per hour)
Net increase in operating income
from providing new services

$30
10
$20

Yes, the bank should offer the new services since the relevant benefits exceed the relevant costs.

19-24 (15 min.) Theory of constraints, throughput contribution, relevant costs.
1.
Finishing is a bottleneck operation. Therefore, producing 1,000 more units will generate
additional throughput contribution and operating income.
Increase in throughput contribution ($72 – $32)
Incremental costs of the jigs and tools
Net benefit of investing in jigs and tools

1,000

$40,000
30,000
$10,000

Mayfield should invest in the modern jigs and tools because the benefit of higher throughput
contribution of $40,000 exceeds the cost of $30,000.
2.
The Machining Department has excess capacity and is not a bottleneck operation.
Increasing its capacity further will not increase throughput contribution. There is, therefore, no
benefit from spending $5,000 to increase the Machining Department's capacity by 10,000 units.
Mayfield should not implement the change to do setups faster.

19-13

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19-25 (15 min.) Theory of constraints, throughput contribution, relevant costs.
1.
Finishing is a bottleneck operation. Therefore, getting an outside contractor to produce
12,000 units will increase throughput contribution.
Increase in throughput contribution ($72 – $32) 12,000
Incremental contracting costs $10 12,000
Net benefit of contracting 12,000 units of finishing

$480,000
120,000
$360,000

Mayfield should contract with an outside contractor to do 12,000 units of finishing at $10 per
unit because the benefit of higher throughput contribution of $480,000 exceeds the cost of
$120,000. The fact that the cost of $10 per unit is double Mayfield's finishing cost of $5 per unit
is irrelevant.
2.
Operating costs in the Machining Department of $640,000, or $8 per unit, are fixed costs.
Mayfield will not save any of these costs by subcontracting machining of 4,000 units to Hunt
Corporation. Total costs will be greater by $16,000 ($4 per unit
4,000 units) under the
subcontracting alternative. Machining more filing cabinets will not increase throughput
contribution, which is constrained by the finishing capacity. Mayfield should not accept Hunt's
offer. The fact that Hunt's costs of machining per unit are half of what it costs Mayfield in-house
is irrelevant.

19-26 (15 min.) Theory of constraints, throughput contribution, quality.

1.
Cost of defective unit at machining operation which is not a bottleneck operation is the
loss in direct materials (variable costs) of $32 per unit. Producing 2,000 units of defectives does
not result in loss of throughput contribution. Despite the defective production, machining can
produce and transfer 80,000 units to finishing. Therefore, cost of 2,000 defective units at the
machining operation is $32 2,000 = $64,000.
2.
A defective unit produced at the bottleneck finishing operation costs Mayfield materials
costs plus the opportunity cost of lost throughput contribution. Bottleneck capacity not wasted in
producing defective units could be used to generate additional sales and throughput contribution.
Cost of 2,000 defective units at the finishing operation is:
Loss of direct materials $32 2,000
Forgone throughput contribution ($72 – $32)
Total cost of 2,000 defective units

2,000

$ 64,000
80,000
$144,000

Alternatively, the cost of 2,000 defective units at the finishing operation can be calculated as the
lost revenue of $72 2,000 = $144,000. This line of reasoning takes the position that direct
materials costs of $32 2,000 = $64,000 and all fixed operating costs in the machining and
finishing operations would be incurred anyway whether a defective or good unit is produced.
The cost of producing a defective unit is the revenue lost of $144,000.

19-14

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19-27 (30 min.) Quality improvement, relevant costs, and relevant revenues.
One way to present the alternatives is via a decision tree, as shown below.
Make T971
Implement
new design

Do not make T971

Do not implement
new design

The idea is to first evaluate the best action that Thomas should take if it implements the
new design (that is, make or not make T971). Thomas can then compare the best mix of products
to produce if it implements the new design against the status quo of not implementing the new
design.
1.
Thomas has capacity constraints. Demand for V262 valves (370,000 valves) exceeds
production capacity of 330,000 valves (3 valves per hour
110,000 machine-hours). Since
capacity is constrained, Thomas will choose to sell the product that maximizes contribution
margin per machine-hour (the constrained resource).
Contribution margin per
machine-hour for V262

= $8 per valve

Contribution margin per
machine-hour for T971

= $10 per valve

3 valves per hour = $24

2 valves per hour = $20.

Thomas should reject Jackson Corporation’s offer and continue to manufacture only
V262 valves.

19-15


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2.
Now compare the alternatives of (a) not implementing the new design versus
(b) implementing the new design. By implementing the new design, Thomas will save 10,000
machine-hours of rework time. This time can then be used to make and sell 30,000 (3 valves per
hour 10,000 hours) additional V262 valves. The relevant costs and benefits of implementing
the new design follow:
The relevant costs of implementing the new design

$(315,000)

Relevant benefits:
a
(a) Savings in rework costs ($3 per V262 valve 30,000 valves)
(b) Additional contribution margin from selling another
30,000 V262 valves (3 valves per hour 10,000 hours)

because capacity previously used for rework is freed up
($8 per valve 30,000 units)
Net relevant benefit

90,000

240,000
$

15,000

a

Note that the fixed rework costs of equipment rent and allocated overhead are irrelevant, because these costs
will be incurred whether Thomas implements or does not implement the new design .

Thomas should implement the new design since the relevant benefits exceed the relevant
costs by $15,000.
3.
Thomas Corporation should also consider other benefits of improving quality. For
example, the process of quality improvement will help Thomas's managers and workers gain
expertise about the product and the manufacturing process that may lead to further cost
reductions in the future. Improving quality within the plant is also likely to translate into
delivering better quality products to customers. The increased reputation and customer goodwill
may well lead to higher future revenues through greater unit sales and higher sales prices.

19-16


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19-28 (30 min.) Quality improvement, relevant costs, and relevant revenues.
1.
By implementing the new method, Tan would incur additional direct materials costs on all
the 200,000 units started at the molding operation.
Additional direct materials costs = $4 per lamp 200,000 lamps
The relevant benefits of adding the new material are:
Increased revenue from selling 30,000 more lamps
$40 per lamp 30,000 lamps

$800,000

$1,200,000

Note that Tan Corporation continues to incur the same total variable costs of direct
materials, direct manufacturing labor, setup labor and materials handling labor, and the same
fixed costs of equipment, rent, and allocated overhead that it is currently incurring, even when it
improves quality. Since these costs do not differ among the alternatives of adding the new
material or not adding the new material, they are excluded from the analysis. The relevant
benefit of adding the new material is the extra revenue that Tan would get from producing
30,000 good lamps.
An alternative approach to analyzing the problem is to focus on scrap costs and the
benefits of reducing scrap.
The relevant benefits of adding the new material are:
a. Cost savings from eliminating scrap:
Variable cost per lamp, $19a 30,000 lamps
b. Additional contribution margin from selling
another 30,000 lamps because 30,000 lamps
will no longer be scrapped:
Unit contribution margin $21b 30,000 lamps

Total benefits to Tan of adding new material to improve quality

$

570,000

630,000
$1,200,000

a

Note that only the variable scrap costs of $19 per lamp (direct materials, $16 per lamp; direct manufacturing labor, setup
labor, and materials handling labor, $3 per lamp) are relevant because improving quality will save these costs. Fixed
scrap costs of equipment, rent, and other allocated overhead are irrelevant because these costs will be incurred whether
Tan Corporation adds or does not add the new material.
b

Contribution margin per unit
Selling price
Variable costs:
Direct materials costs per lamp
Molding department variable manufacturing costs
per lamp (direct manufacturing labor, setup labor, and
materials handling labor)
Variable costs
Unit contribution margin

$40.00
$16.00

3.00
( 19.00)
$21.00

On the basis of quantitative considerations alone, Tan should use the new material.
Relevant benefits of $1,200,000 exceed the relevant costs of $800,000 by $400,000.
2.
Other nonfinancial and qualitative factors that Tan should consider in making a decision
include the effects of quality improvement on:
a.
gaining manufacturing expertise that could lead to further cost reductions in the
future;
b.
enhanced reputation and increased customer goodwill which could lead to higher
future revenues through greater unit sales and higher sales prices; and
c.
higher employee morale as a result of higher quality.
19-17


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19-29

(30–40 min.) Statistical quality control, airline operations.

1.
The + 2 rule will trigger a decision to investigate when the round-trip fuel usage is
outside the control limit:
Mean + 2

= 200 + 2

= 200 + (2

20) or 160 to 240 gallon-units

Any fuel usage less than 160 gallon-units or greater than 240 gallon-units will trigger a decision
to investigate.
The only plane to be outside the specified + 2 fuel usage control limit is the Spirit of
Sacramento on flights #5 (242 gallon-units), #7 (249 gallon-units), and #10 (244 gallon-units).
2.

Solution Exhibit 19-29 presents the SQC charts for each of the three 747s.
The Spirit of Atlanta has no observation outside the + 2 control limits. However, there
was an increase in fuel use in each of the last nine round-trip flights. The probability of nine
consecutive increases from an in-control process is very low, and this is a trend that should be
investigated.
The Spirit of Boston appears in control regarding fuel usage.
The Spirit of Sacramento has three observations outside the
+ 2 control limits.
Moreover, the mean of the fuel usage for the last six flights is 238 gallon-units compared to a
mean of 208 gallon-units for the first four flights. There is a rising trend, and some observations
are already greater than the acceptable upper limits for fuel consumption. This should be
investigated.
3.
The advantage of using dollar fuel costs as the unit of analysis in an SQC chart is that it
focuses on a variable of overriding concern to top managers (operating costs).
However, the disadvantages of using dollar fuel costs are:
a. Split responsibilities. Operations managers may not control the purchase of fuel, and

may want to exclude from their performance measures any variation stemming from
factors outside their control.
b. Offsetting factors may mask important underlying trends when the quantity used and
the price paid are combined in a single observation. For example, decreasing gallon
usage may be offset by increasing fuel costs. Both of these individual patterns are
important in budgeting for an airline.
c. The distribution of fuel usage in gallons may be different from the distribution of fuel
prices per gallon. More reliable estimates of the
and
parameters might be
obtained by focusing separately on the individual usage and price distributions.
Note: The above disadvantages are most marked if actual fuel prices are used. The use of
standard fuel prices can reduce many of these disadvantages.

19-18


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SOLUTION EXHIBIT 19-29
Plots of Round-Trip Fuel Usage for Jetrans Airlines
Spirit of Atlanta Fuel Consumption

Mean + 2 sigma

Gallon-units

240
220
Mean=200 gall-units

200
180

Mean -2 sigma

160
0

2

4

6

8

10

12

Flight Number

Spirit of Boston Fuel Consumption

Mean + 2 sigma

Gallon-units

240

220
Mean=200 gall-units

200
180

Mean -2 sigma

160
0

2

4

6

8

10

12

Flight Number

Spirit of Sacramento Fuel Consumption
x
Mean + 2 sigma

x

240

x

x
x

Gallon-units

x
x

220
x

x

Mean=200 gall-units

200
x

180
Mean -2 sigma

160
0

2

4

6
Flight Number

19-19

8

10

12


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19-30 (30–40 min.) Compensation linked with profitability, on-time delivery, and external
quality-performance measures.
1.
Detroit
Add: Profitability
2% of operating income
Add: On-time delivery
$10,000 if >= 98%
Deduct: Product quality
50% of cost of sales returns
Total: Bonus paid
Los Angeles
Add: Profitability

2% of operating income
Add: On-time delivery
$10,000 if >= 98%
Deduct: Product quality
50% of cost of sales returns
Total: Bonus paid
2.

Jan.-June

$33,000

July-Dec.

$ 32,000

10,000

0

(22,000)
$21,000

(17,500)
$ 14,500

$62,000

$74,000

0
(34,500)
$27,500

10,000
(25,000)
$59,000

Operating income as a measure of profitability

Operating income captures revenue and cost-related factors. However, there is no recognition of
investment differences between the two plants. The Los Angeles plant's operating income is
approximately double that of Detroit. This difference gives the Los Angeles plant manager the
opportunity to earn a larger bonus due to investment size alone. An alternative approach would
be to use return on investment (perhaps relative to the budgeted ROI).
98% on-time benchmark as a measure of on-time delivery performance
This measure reflects the ability of Pacific-Dunlop to meet a benchmark for on-time delivery.
Several concerns arise with this specific measure:
a. It is a yes-or-no cut-off. A 10% on-time performance earns no bonus, but neither does
a 97.9% on-time performance. Moreover, no extra bonus is paid for performance
above 98.0%. An alternative is to have the bonus be a percentage of the on-time
delivery percentage.
b. It can be manipulated by management. The Pacific-Dunlop plant manager may quote
conservative delivery dates to sales people in an effort to ―guarantee‖ that the 98%
target is achieved.
c. It reflects performance relative only to scheduled delivery date. It does not consider
how quickly Pacific-Dunlop can respond to customer orders.
Problems in (b) and (c) can be overcome by measuring customer response time (how long it
takes from the time a customer places an order for a product to the time the product is delivered
to the customer), in addition to on-time delivery.

19-20


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50% of cost of sales returns as a measure of quality
This measure incorporates one cost that arises with defective goods. However, there are several
concerns with its use:
a. Not all sales returns are due to defective work by the plant manager. Some returns are
due to tampering by the customer. Other returns arise from breakage during delivery
and installation.
b. It does not systematically incorporate customer opinion about quality. Not all
customers return defective goods.
c. It ignores important categories of the cost of defective goods. For example,
dissatisfied customers may decline to make any subsequent purchases.
These last two problems with the cost of sales measure may be overcome by taking a
customer satisfaction survey and incorporating a percentage of estimated lost contribution as a
result of quality problems. This new measure, however, is likely to be ―noisy‖ or very sensitive
to assumptions. A combination of measures may work well as a composite measure of quality.
3.
Most companies use both financial and nonfinancial measures to evaluate performance,
sometimes presented in a single report such as a balanced scorecard. Using multiple measures of
performance enables top management to evaluate whether lower-level managers have improved
one area at the expense of others. For example, did the on-time delivery performance of the
Detroit plant manager decrease in the July–December period relative to the January–June period
because the manager emphasized shipment of high-margin products to increase operating
income?
If on-time delivery is dropped as a performance evaluation measure, managers will concentrate
on increasing operating income and decreasing sales returns but will give less attention to ontime delivery. Consider the following situation: Suppose a manager must choose between (a)

delivering a high margin order that will add to operating income while delaying a number of
other orders and adversely affecting on-time performance, or (b) delaying the high margin order
and sacrificing some operating income, to achieve better on-time performance. What action will
the manager take? If on-time performance is excluded as a performance evaluation measure, the
manager will almost certainly choose (a). Only if on-time performance is included in the
manager's performance evaluation will the manager consider choosing option (b).

19-21


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19-31 (25–30 min.) Waiting times, manufacturing lead times.
1.

Average waiting time for an order of Z39
2

Annual average number

Manufacturing time
×

of orders of Z39

per order of Z39

=
Annual machine
2×

=

Annual average number
–

capacity
[50 × (80)2]

× per order of Z39

of orders of Z39

(50 × 6,400)

=

Manufacturing time

=

320,000

= 160 hours per order

2 × [5,000 – (50 × 80)]

2 × (5,000 – 4,000)

(2 × 1,000)

Average manufacturing

Average order waiting

Order manufacturing time
+
for Z39

lead time for Z39

=

time for Z39

= 160 hours + 80 hours = 240 hours per order
2.

Average waiting time for Z39 and Y28
Annual average number
of orders of Z39

2 × Annual machine
capacity
–

×

Manufacturing time
per order of Z39

2

+

Annual average number
of orders of Y28

Annual
Manufacturing
average number × time per order
of orders of Z39
of Z39

[50 × (80)2 ] + [25 × (20) 2]
2 × [5,000 – (50 × 80) – (25 × 20)]

–

Annual
average number
of orders of Y28

[(50 × 6,400) + (25 × 400)]
2 × [5,000 – 4,000 – 500]

330,000
= 330 hours
1,000
Average manufacturing = Average order + Order manufacturing

waiting time
lead time for Z39
time for Z39
=
330 hours + 80 hours = 410 hours

Average manufacturing = Average order + Order manufacturing
waiting time
lead time for Y28
time for Y28
= 330 hours + 20 hours = 350 hours

19-22

× Manufacturing time
per order of Y28

2

Manufacturing
× time per order
of Y28

(320,000 + 10,000)
2 × 500


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19-32 (60 min.) Waiting times, relevant revenues, and relevant costs

(continuation of 19-31).
1.

The direct approach is to look at incremental revenues and incremental costs.
Selling price per order of Y28, which has
an average manufacturing lead time of 350 hours
Variable cost per order
Additional contribution per order of Y28
Multiply by expected number of orders
Increase in expected contribution from Y28

$ 8,000
5,000
3,000
× 25
$75,000

Expected loss in revenues and increase in costs from introducing Y28

Product
(1)
Z39
Y28
Total

Expected Loss in
Revenues from
Increasing Average
Manufacturing Lead
Times for All Products

(2)
$25,000.00a
–
$25,000.00

Expected Increase in
Expected Loss in
Carrying Costs from
Revenues Plus
Increasing Average
Expected Increases
Manufacturing Lead in Carrying Costs of
Times for All Products
Introducing Y28
(3)
(4) = (2) + (3)
b
$6,375.00
$31,375.00
c
2,187.50
2,187.50
$8,562.50
$33,562.50

a

50 orders × ($27,000 – $26,500)
(410 hours – 240 hours) × $0.75 × 50 orders
c

(350 hours – 0) × $0.25 × 25
b

Increase in expected contribution from Y28 of $75,000 is greater than increase in
expected costs of $33,562.50 by $41,437.50. Therefore, SRG should introduce Y28.
Alternative calculations of incremental revenues and incremental costs of introducing Y28:

Alternative 1:
Introduce Y28
(1)
Expected revenues
$1,525,000.00a
Expected variable costs
875,000.00c
Expected inv. carrying costs
17,562.50e
Expected total costs
892,562.50
Expected revenues minus
expected costs
$ 632,437.50
a

b

c

d

(50 × $26,500) + (25 × $8,000)

(50 × $15,000) + (25 × $5,000)
e
(50 × $0.75 × 410) + (25 × $0.25 × 350)

Alternative 2:
Do Not
Introduce Y28
(2)
$1,350,000.00b
750,000.00d
9,000.00f
759,000.00

Relevant Revenues
and Relevant Costs
(3) = (1) – (2)
$175,000.00
125,000.00
8,562.50
133,562.50

$ 591,000.00

$ 41,437.50

50 × $27,000
50 × $15,000
f
50 × $0.75 × 240

19-23


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2.

Selling price per order of Y28, which has an average
manufacturing lead time of more than 320 hours
Variable cost per order
Additional contribution per order of Y28
Multiply by expected number of orders
Increase in expected contribution from Y28

$ 6,000
5,000
$ 1,000
×
25
$25,000

Expected loss in revenues and increase in costs from introducing Y28:

Product
(1)
Z39
Y28
Total

Expected Loss in

Revenues from
Increasing Average
Manufacturing Lead
Times for All Products
(2)
$25,000.00a
–
$25,000.00

Expected Increase in
Expected Loss in
Carrying Costs from
Revenues Plus
Increasing Average
Expected Increases
Manufacturing Lead in Carrying Costs of
Times for All Products
Introducing Y28
(3)
(4) = (2) + (3)
$6,375.00b
$31,375.00
c
2,187.50
2,187.50
$8,562.50
$33,562.50

a

50 orders × ($27,000 – $26,500)
(410 hours – 240 hours) × $0.75 × 50 orders
c
(350 hours – 0) × $0.25 × 25
b

Increase in expected contribution from Y28 of $25,000 is less than increase in expected costs of
$33,562.50 by $8,562.50. Therefore, SRG should not introduce Y28.

19-24


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19-33 (40 45 min.) Manufacturing lead times, relevant revenues, and relevant costs.
1a.

Average waiting time for an order of B7 if Brandt manufactures only B7
2
Average number
Manufactur ing
of orders of B7
time for B7
=

2

=

Average number Manufactur ing

of orders of B7
time for B7

Annual machine
capacity

(125 1,600 )
[125 (40) 2 ]
200,000
=
=
= 100 hours
(
2
1,000)
2 [6,000 (125 40)] 2 (6,000 5,000 )

Average manufactur ing = Average order wait ing + Order manufactur ing time
lead time for B7
time for B7
for B7
= 100 hours + 40 hours = 140 hours
1b.

Average waiting time for an order of B7 and A3 if Brandt manufactures both B7 and A3.
Average number
of orders of B7
2

Annual machine

capacity

Manufactur ing
time for B7
Average number
of orders of B7

2

Average number
of orders of A3

Manufactur ing
time for B7

=

[125 (40) 2 ] [10 (50) 2 ]
2 [6,000 (125 40) (10 50)]

=

[(125 1,600 ) (10 2,500 )] (200 ,000 25,000 )
=
2 [6,000 5,000 500 ]
2 500

=

225 ,000

= 225 hours
1,000

Average manufactur ing
lead time for B7

=

Manufactur ing
time for A3

Average number Manufactur ing
of orders of A3
time for A3

Average order wait ing Order manufactur ing
+
time for B7
time

= 225 hours + 40 hours = 265 hours

Average manufactur ing
lead time for A3

=

Average order wait ing Order manufactur ing
+
time for A3

time

= 225 hours + 50 hours = 275 hours

19-25

2