Gagnon Company reported the following sales and quality costs for the past four years. Assume that all quality costs are variable and that all changes in the quality cost ratios are due to a quality improvement program.
Required:
- 1. Compute the quality costs for all four years. By how much did net income increase from Year 1 to Year 2 because of quality improvements? From Year 2 to Year 3? From Year 3 to Year 4?
- 2. The management of Gagnon Company believes it is possible to reduce quality costs to 2.5 percent of sales. Assuming sales will continue at the Year 4 level, calculate the additional profit potential facing Gagnon. Is the expectation of improving quality and reducing costs to 2.5 percent of sales realistic? Explain.
- 3. Assume that Gagnon produces one type of product, which is sold on a bid basis. In Years 1 and 2, the average bid was $400. In Year 1, total variable costs were $250 per unit. In Year 3, competition forced the bid to drop to $380. Compute the total contribution margin in Year 3 assuming the same quality costs as in Year 1. Now, compute the total contribution margin in Year 3 using the actual quality costs for Year 3. What is the increase in profitability resulting from the quality improvements made from Year 1 to Year 3?
1.
Compute the quality costs for all four years and calculate the amount of increase in net income from year 1 to year 2, from year 2 to year 3, and from year 3 to year 4.
Explanation of Solution
Quality costs: Quality costs are costs that are incurred to avoid, identify and eliminate defects from products. Quality costs are classified into four components namely;
- “Prevention costs”.
- “Appraisal costs”.
- “Internal failure costs”.
- “External failure costs”.
Calculate the quality costs for all the four years:
Year | Percent of revenues | × | Sales revenues | = | Quality costs |
Year 1 | 25% | $20,000,000 | $5,000,000 | ||
year 2 | 22% | $22,000,000 | $4,840,000 | ||
Year 3 | 18% | $22,000,000 | $3,960,000 | ||
Year 4 | 14% | $24,000,000 | $3,960,000 |
Table (1)
Calculate the increase in net income from year 1 to year 2:
Calculate the increase in net income from year 2 to year 3:
Calculate the increase in net income from year 3 to year 4:
2.
Calculate the additional profit potential facing Company G and state whether expecting improved quality and reduced costs to 2.5 percent of sales is realistic.
Explanation of Solution
Calculate the profit potential:
Therefore, from the above calculation, it is ascertained that amount of profit potential is $2,760,000.
The 2.5 percent goal is the level identified by several quality experts that a company must strive to obtain. The experience of company G shows that it is an achievable goal
3.
Calculate the total contribution margin in year 3 assuming the same quality costs as in year 1 compute the total contribution margin in year 3 using the actual quality costs for year 3 and calculate the increase in profitability resulting from the quality improvements made from year 1 to year 3.
Explanation of Solution
Contribution Margin: The process or theory which is used to judge the benefit given by each unit of the goods produced is called as contribution margin.
Calculate the total contribution margin in year 3 assuming the same quality costs as in year 1 compute the total contribution margin in year 3 using the actual quality costs for year 3:
Year 3-No change | Year 3-change | |
Sales | $22,000,000 | $22,000,000 |
Variable expenses | (1)$14,473,684 | (6)$11,764,210 |
Contribution margin | $7,526,316 | $10,235,790 |
Table (2)
Calculate the increase in profitability:
Therefore, the amount of increase in profitability is $2,709,474.
Working notes:
(1)Calculate the variable expenses in year 3 assuming the same quality costs as in year 1:
(2)Calculate the quality cost per unit for year 1:
(3)Calculate the quality cost per unit for year 3:
(4)Calculate the decrease in per-unit variable quality cost:
(5)Calculate the decrease in per-unit total variable cost:
(6)Calculate the total variable cost for year 3:
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Chapter 14 Solutions
Cornerstones of Cost Management (Cornerstones Series)
- The controller of Emery, Inc. has computed quality costs as a percentage of sales for the past 5 years (20X1 was the first year the company implemented a quality improvement program). This information is as follows: Required: 1. Prepare a trend graph for total quality costs. Comment on what the graph has to say about the success of the quality improvement program. 2. Prepare a graph that shows the trend for each quality cost category. What does the graph have to say about the success of the quality improvement program? Does this graph supply more insight than the total cost trend graph does? 3. Prepare a graph that compares the trend in relative control costs versus relative failure costs. Comment on the significance of this trend.arrow_forwardRoss Company implemented a quality improvement program and tracked the following for the five years: By cost category as a percentage of sales for the same period of time: Required: 1. Prepare a bar graph that reveals the trend in quality cost as a percentage of sales (time on the horizontal axis and percentages on the vertical). Comment on the message of the graph. 2. Prepare a bar graph for each cost category as a percentage of sales. What does this graph tell you? 3. What if management would like to have the trend in relative distribution of quality costs? Express this as a bar graph and comment on its significance.arrow_forwardMuskogee Company had sales of 60,000,000 in 20x1. In 20x5, sales had increased to 75,000,000. A quality improvement program was implemented at the beginning of 20x1. Overall conformance quality was targeted for improvement. The quality costs for 20x1 and 20x5 follow. Assume any changes in quality costs are attributable to improvements in quality. Required: 1. Compute the quality cost-to-sales ratio for each year. Is this type of improvement possible? 2. Calculate the relative distribution of costs by category for 20x1. What do you think of the way costs are distributed? (A pie chart or bar graph may be of some help.) How do you think they will be distributed as the company approaches a zero-defects state? 3. Calculate the relative distribution of costs by category for 20x5. What do you think of the level and distribution of quality costs? (A pie chart or bar graph may be of some help.) Do you think further reductions are possible? 4. The quality manager for Muskogee indicated that the external failure costs reported are only the measured costs. He argued that the 20x5 external costs were much higher than those reported and that additional investment ought to be made in control costs. Discuss the validity of his viewpoint. 5. Suppose that the manager of Muskogee received a bonus equal to 10 percent of the quality cost savings each year. Do you think that gainsharing is a good or a bad idea? Discuss the risks of gainsharing.arrow_forward
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