C H A P T E R 8

Evaluating Products and ProcessesEvaluating Products and Processes

Learning Objective 1

Explain how evaluation leads to planning and why products and processes must be continuously evaluated.

How Does Evaluation Lead Us Back to Controlling?

Stage 3: Evaluating

Stage 1: Planning

Stage 2: Controlling

Define Dimensions of Quality*Performance:Features:

Reliability:

Conformance:Durability:

Serviceability:Aesthetics:

Perceived quality:

*David A. Garvin, “Competing on the Eight Dimensions of Quality,” Harvard Business Review, 65, Nov-Dec 87, pp. 101-109.

Doesn’t malfunction during specified period.Meets established standards.A measure of product life.The speed and ease of repair.How a product looks, feels, tastes, and smells.As seen by a customer.

Primary operating characteristic. Supplements to basic functioning characteristics.

Learning Objective 2

Understand why benchmarking is so important and how it is conducted.

Benchmarking is used by companies to target areas for improvement by comparing the company’s financial and operating performance against the performance of other companies or the performance of internal departments against each other.

What is Benchmarking?

What are the Four Steps of Benchmarking?

Decide which of the practices and procedures identified in step 3 can be best employed.

Collect detailed information on benchmark’s practices and procedures.

Select benchmark(s) from competing companies or internally.

Analyze performance and set goals for improvement.

Learning Objective 3

Understand the concept of differential costs and revenues, and be able to identify those costs and revenues that are relevant to the product and process decisions.

Define Differential Costs and Sunk Costs Before making a decision, the associated costs

and revenues related to each decision must be identified.

The costs and revenues that are different for alternatives are relevant to each alternative.

Differential costs:

future costs that change as a result of a decision.

Sunk costs:

past costs that cannot be changed by current and future decisions; disregarded when determining the differential costs of a project.

Before making a decision, the associated costs and revenues related to each decision must be identified.

The costs and revenues that are different for alternatives are relevant to each alternative.

Differential costs:

future costs that change as a result of a decision.

Sunk costs:

past costs that cannot be changed by current and future decisions; disregarded when determining the differential costs of a project.

List Three Different Approaches toDecision Making

Differential Costs: Only the costs unique to each alternative are identified.

Total Cost: All costs are identified with each alternative.

Qualitative Considerations: Factors that affect a decision but are not subject to measurement in dollar terms.

Example 1: Differential Costs

The following costs relate to a customer’s order of 100 printed shirts. Identify the differential costs.

Variable costs:Shirts. . . . . . . . . . . . . . . . . . . . . $400Printing labor. . . . . . . . . . . . . . . 75

Fixed costs:Print screen. . . . . . . . . . . . . . . . $ 95Machine depreciation . . . . . . . . 50Manager’s salary. . . . . . . . . . . . 90

Total. . . . . . . . . . . . . . . . . . . $710

Variable costs:

Fixed costs:

Example 1: Differential Costs

The print screen is a differential cost since a screen must be created for this order.

The printing labor for the shirts is a differential cost since it is a future expense due to the order.

The cost of the shirts is a differential cost since it would not be an expense if the job were not taken.

Shirts. . . . . . . . . . . . . . . . . . . . . $400Printing labor. . . . . . . . . . . . . . . 75

Print screen. . . . . . . . . . . . . . . . 95

Variable costs:Shirts. . . . . . . . . . . . . . . . . . . . . $400Printing labor. . . . . . . . . . . . . . . 75

Fixed costs:Print screen. . . . . . . . . . . . . . . . 95

Total differential costs . . . . . $570

Example 1: Differential Costs

Depreciation is the allocation of a past cost and therefore is not a differential cost.

A salary is not a differential cost because the salary will be paid regardless of the specific order.

Example 2: Differential CostsMike bought a machine two years ago for $2,000. If he buys a new machine for $3,000, he can sell the old machine for $500. The electricity cost for both machines is $0.30 per hour. The old machine requires maintenance costs of $500 a year, while the new machine will only incur costs of $200 per year. What are the differential costs?

Differential costs:

• $3,000 – cost of new machine• $500 – salvage value of old machine • $300 – difference in maintenance costs

Example 3: Total Costs

A machine, used in production, has been owned and used for seven years. The machine only has two more years before the company disposes of it and its useful life ends. It runs okay, yet the company could use a newer, more productive machine. Should the machine be used for two more years, or should the company purchase a new machine?

Note: When using the total-cost approach, we must look at all costs.

Example 3: Total Costs

Variable costs:

$1.10 x 10,000 hours $11,000$1.00 x 8,500 hours $ 8,500

Fixed costs:

Depreciation expense 3,000 4,500Book value of old machine 3,000Resale value of old machine 500

Total cost $14,000 $16,500

Difference $2,500

Old Machine New Machine

Learning Objective 4

Identify several examples of product and process evaluation decisions, and be able to analyze and select the best alternative for each example.

Special Orders

Should we make orbuy the componentor service we need?

BUYER SELLER

Should we acceptthe special orderfor our products

or services?

Make or Buy a ComponentThe Tree Company must decide whether to make or buy a chainsaw motor. A vendor will sell them the necessary motors for $14,000. The total cost figures to build the motors are as follows. Assuming excess capacity, what should The Tree Company do?

Direct materials. . . . . . . . . . . . .

$ 2,000Direct labor . . . . . . . . . . . . . . . .

6,000Variable overhead. . . . . . . . . . .

3,000Fixed overhead:

Direct . . . . . . . . . . . . . . . . . . .

$ 1,500Indirect . . . . . . . . . . . . . . . . . .

3,000 Total cost. . . . . . . . . . . . . . .

$15,500

Make or Buy a Component

Buy Make

Purchase cost. . . . . . . . . . . .$ 14,000Direct materials. . . . . . . . . . . $ 2,000Direct labor . . . . . . . . . . . . . . 6,000Variable overhead. . . . . . . . . 3,000

Fixed overhead: Direct . . . . . . . . . . . . . . . . 1,500 Indirect . . . . . . . . . . . . . . . Total cost. . . . . . . . . . . . . . . . $14,000 $12,500

Differential. . . . . . . . . . . . . . . $1,500

The Tree Company should make the motors.

Purchase Services or Provide Them Internally

Consider the differential costs of each alternative, as well as qualitative factors, such as:

The quality of the service. Whether space exists to house the service. Whether services can be delivered on time. Management’s interest in keeping workers on

the payroll.

Purchase Services or Provide Them Internally

Atlas Co. is considering outsourcing its payroll department to a payroll company. Listed below are the costs of both outsourcing and maintaining its current payroll department.

Cost of outsourcing:Payroll company. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000 Rent saved by eliminating payroll department. . . . . . . . . . . 24,000 Net cost of outsourcing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $44,000

Cost of maintaining payroll department:Total cost of payroll department. . . . . . . . . . . . . . . . . . . . . . $45,000 Less non-differential costs: Utilities & depreciation expense. . . . . . . . . . . . . . . . . . . . . (10,000)Differential costs of payroll department . . . . . . . . . . . . . . . . $35,000

Should Atlas Co. outsource its payroll department?

Purchase Services or Provide Them Internally

Atlas Co. is considering outsourcing its payroll department to a payroll company. Listed below are the costs of both outsourcing and maintaining its current payroll department.

Cost of outsourcing:Payroll company. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000 Rent saved by eliminating payroll department. . . . . . . . . . . 24,000 Net cost of outsourcing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $44,000

Cost of maintaining payroll department:Total cost of payroll department. . . . . . . . . . . . . . . . . . . . . . $45,000 Less non-differential costs: Utilities & depreciation expense. . . . . . . . . . . . . . . . . . . . (10,000)Differential costs of payroll department . . . . . . . . . . . . . . . . $35,000

Excess costs incurred by outsourcing . . . . . . . . . . . . . . $ 9,000

Add or Drop a Product

DROP: Replace a product or a product line with another that contributes more to indirect fixed costs.

ADD: Add a product or a product line that contributes (significantly) to indirect fixed costs.

REPLACE: Drop a product or a product line that does not contribute to indirect fixed costs.

DROP: Replace a product or a product line with another that contributes more to indirect fixed costs.

ADD: Add a product or a product line that contributes (significantly) to indirect fixed costs.

REPLACE: Drop a product or a product line that does not contribute to indirect fixed costs.

Add or Drop a Product

Product A B C

Sales revenue. . . . . . . . . . $15,000 $10,000 $12,000

Variable costs. . . . . . . . . . 8,000 6,000 8,000

Contribution margin . . . . $ 7,000 $ 4,000 $ 4,000

Direct fixed costs . . . . . . . 5,000 3,000 5,000

Contribution to indirect fixed costs. . . . .$ 2,000 $ 1,000 $(1,000)

Identify which of the following products should be retained.

Add or Drop a ProductProduct A B C

Sales revenue. . . . . . . . . . $15,000 $10,000 $12,000

Variable costs. . . . . . . . . . 8,000 6,000 8,000

Contribution margin . . . . . $ 7,000 $ 4,000 $ 4,000

Direct fixed costs . . . . . . . 5,000 3,000 5,000

Contribution to indirect fixed costs. . . . . $ 2,000 $ 1,000 $(1,000)

Products A and B are contributing to indirect fixed costs and should be retained unless a more profitable product is available.

Product C should be dropped because it does not cover its own costs.

Best Utilization of a Critical Resource

Critical Resource Factor:

In a manufacturing process, it is the resource that limits operating capacity by its availability.

In deciding which product to manufacture, management should choose the item that provides the greatest contribution margin per unit of the most critical resource.

Best Utilization of a Critical ResourceHandy Designs has identified its critical resource as 10,000 machine hours. Using the following data, select the products that should be produced with the limited machine hours.

Product A B C

Selling price . . . . . . . . . . . $20 $16$10

Variable costs. . . . . . . . . . 11 10 5

Contribution margin . . . . . $ 9 $ 6$ 5

Machine hours requiredper unit. . . . . . . . . . . . . 3 2

1

Contribution permachine hour. . . . . . . . $ 3 $ 3

$ 5

Product C should be the first product produced.

Set Selling PricesHandset Software uses the following cost information to set the normal price on a new program. Computer Outlet has offered to buy the new program for $5 to sell as a store brand. Should Handset accept the offer?

Direct materials. . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Manufacturing overhead. . . . . . . . . . . . . . . . . . . . 20

Total manufacturing cost . . . . . . . . . . . . . . . . . . $40

Markup (50% of cost) . . . . . . . . . . . . . . . . . . . . . . 20

Estimated selling price . . . . . . . . . . . . . . . . . . . . $60

Set Selling Prices

Special order pricing takes into account the differential costs:

Sales price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $45Direct materials. . . . . . . . . . . . . . . . . . . . . . . . . $ 5Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15Variable overhead . . . . . . . . . . . . . . . . . . . . . . 8Differential fixed costs. . . . . . . . . . . . . . . . . . . . 10

Total variable and fixed costs. . . . . . . . . . . . . 38Expected contribution per unit . . . . . . . . . . . . . . . $ 7

Direct materials. . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15Manufacturing overhead. . . . . . . . . . . . . . . . . . . . 20 Total manufacturing cost . . . . . . . . . . . . . . . . . . $40Markup (50% of cost) . . . . . . . . . . . . . . . . . . . . . . 20 Estimated selling price . . . . . . . . . . . . . . . . . . . . $60

Expanded MaterialLearning Objective 5

Understand the theory of constraints and how focusing on scarce resources can direct activities in manufacturing companies.

Define the Theory of Constraints

A management philosophy that focuses on constraint resources and hold that they should operate at full capacity.

What are the Five Basic Steps to Employ the Theory of Constraints?

Understand the system’s constraints.

Decide how to exploit the system’s constraints.

Subordinate everything else to keeping the constraint resource at optimal capacity.Elevate the constraint by focusing on the constraint. Offload bottlenecks if possible.

If a constraint has been broken, go back to step 1.