Fundamentals of Cost Accounting 3rd Edition by William N. Lanen, Shannon W. Anderson, Michael Maher

Exercise 53

Quality Improvement

IPort Products makes cases for portable music players in two processes, cutting and sewing. The cutting process has a capacity of 100,000 units per year; sewing has a capacity of 120,000 units per year. Cost information follows:

Inspection and testing costs&	$ 60,000
Scrap costs (all in the cutting dept.).	195,000

Demand is very strong. At a sales price of $20 per case, the company can sell whatever output it can produce.

IPort Products can start only 100,000 units into production in the cutting department because of capacity constraints. Defective units are detected at the end of production in the cutting department. At that point, defective units are scrapped. Of the 100,000 units started at the cutting operation, 15,000 units are scrapped. Unit costs in the cutting department for both good and defective units equal $13 per unit, including an allocation of the total fixed manufacturing costs of $600,000 per year to units.

Direct materials (variable)	$ 5
Direct manufacturing, setup, and materials handling labor (variable)	2
Depreciation, rent, and other overhead (fixed)	6
	$13

The fixed cost of $6 per unit is the allocation of the total fixed costs of the cutting department to each unit, whether good or defective. (The total fixed costs are the same whether the units produced in the cutting department are good or defective.)

The good units from the cutting department are sent to the sewing department. Variable manufacturing costs in the sewing department are $3 per unit and fixed manufacturing costs are $50,000 per year. There is no scrap in the sewing department. Therefore, the company’s total sales quantity equals the cutting department’s good output. The company incurs no other variable costs.

The company’s designers have discovered a new type of direct material that would reduce scrap in the cutting department to 5,000 units. However, using the new material would increase the direct materials costs to $7.25 per unit in the cutting department for all 100,000 units. Recall that only 100,000 units can be started each year.

Required

a. Should IPort use the new material and improve quality? Assume that inspection and testing costs will be reduced by $20,000 if the new material is used. Fixed costs in the sewing department will remain the same whether 85,000 or 95,000 units are produced.

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b. What other nonfinancial and qualitative factors should management of IPort Products consider in making the decision?

Step 1 of 2

(a)

The new material used by the company shall reduce the scrap and inspection cost. This alternate should be considered and evaluate for improving the quality of direct material in order to reduce the waste. This alternate is evaluated by computing the profit in both the cases. In this way, we can determine that whether improved material should be used:

Income Statement if 15000 units are scrapped i.e. old material used

Particulars			Amount
Sales Revenue			$1,700,000.00
Cost of Goods sold
Cutting department
Direct Material @5	5*100000	$500,000.00
Direct Labour @ 2	2*100000	$200,000.00
Fixed cost		$600,000.00
Sewing department
Manufacturing cost	3*85000	$255,000.00
Fixed cost		$50,000.00
Inspection & Testing cost		$60,000.00
Scrap cost		$195,000.00	-$1,860,000.00
Net income			-$160,000.00

Income Statement if 5000 units are scrapped i.e. improved material used

Particulars			Amount
Sales Revenue			$1,900,000.00
Cost of Goods sold
Cutting department
Direct Material @5	7.25*100000	$725,000.00
Direct Labour @ 2	2*100000	$200,000.00
Fixed cost		$600,000.00
Sewing department
Manufacturing cost	3*95000	$285,000.00
Fixed cost		$50,000.00
Inspection & Testing cost		$40,000.00
Scrap cost		$65,000.00	-$1,965,000.00
Net income			-$65,000.00

The above two computations shows that by using the improved material, the net loss is reduced to USD 65,000 which is beneficial for the company. Hence, the new material should be adopted to reduce scrap.