Operations Management Overview

Exercise in Cost Accounting: De Niro, Scorsese and Pesci, Inc. DSP, Inc. is a home maintenance services operation, started by three men, De Niro, Scorsese and Pesci. Services offered: Plumbing, Window Cleaning, Gutter Guard Installation, and Landscaping. There is ample demand for these services. However, there is also a shortage of qualified workers in the area. DSP has had a motto: Teach Your Children Well, ever since their younger days. They have employed their children, 5 high-school graduates, to run operations. 1 DSP, Inc.: Labor Costs Monthly wage per employee = $2,000 including benefits Hours budgeted per employee per month = 200 hours Monthly capacity with 5 employees = 1,000 hours Total Direct Labor cost per month = $10,000 Direct labor rate = $10,000/1,000 = $10 per hour 2 DSP, Inc.: Revenue & Cost Data Plumbing Window Cleaning Gutter Guards Landscaping

Current Monthly Output 90 jobs 70 jobs 80 jobs 60 jobs Labor Hours/job 2 hours 4 hours 3 hours 5 hours Revenue/job $130 $170 $200 $250

Material Cost $30 $10 $70 $75 Labor Cost $20 $40 $30 $50 Job Type Note: Total number of jobs per month = 90 + 70 + 80 + 60 = 300 jobs. At current output level, capacity used = 90(2) + 70(4) + 80(3) + 60(5) = 1,000 hours per month

3 DSP, Inc.: Overheads Standard cost accounting: Allocate indirect costs product based on the volume of the cost driver they have consumed. There may be more than one single cost driver. Examples are labor cost, number of jobs, etc. Here it is # of Jobs. Monthly Administrative Overhead (Salaries) = $18,000. Monthly Non-Administrative Overhead (Rent, Truck Fleet Maintenance, Marketing, Depreciation) = $9,000. Overhead is currently allocated to products based on production volume. Current volume is 300 jobs per month. Administrative Overhead $18,000/300 = $60 per job. Non-Administrative Overhead = $9,000/300 = $30 per job . 4 DSP, Inc.: Summary Cost Table ` Market Current Output Revenue /Job Material Cost /Job Labour Hours/Job Labor Cost /Job Administrative /Job Non Administrative /Job Profit /Job Window Plumbing Cleaning 250 160

90 70 130 170 30 10 2 4 20 40 60 60 Gutte r Landscap Guards ing 145 120 80 60 200 250 70 75 3 5 30 50 60 60 30

30 30 30 -10 30 10 35 300 18000 9000 5 DSP, Inc. DSP is using all its labor capacity, and is absorbing all overheads. So there is no labor variance or overhead absorption variance to worry about. Therefore, the total profit is: 90(-$10) + 70($30) + 80($10) + 60($35) = $4,100 per month. 6

DSP, Inc., Demand for Services Suppose the monthly demand for these services is: Plumbing: Window cleaning: 250 jobs 160 jobs Gutter guard installs: 145 jobs Landscaping: 120 jobs Suppose, too, that DSP, Inc., can choose which products to go after. What is the best product offering for DSP, Inc., that will maximize its profit? 7 DSP, Inc.: Summary Cost Table Plumbing Window Cleaning Gutter Guards Landscaping Current Output

90/250 70/160 80/145 60/120 Labor Hours/job 2 hours 4*100= 400 3 hours 5*120 = 600 Revenue/job $130 $170 $200 $250 Material Cost $30

$10 $70 $75 Labor Cost $20 $40 $30 $50 Administrative Overhead Allocation $60 $60 $60 $60 Non-Administrative Overhead Allocation $30

$30 $30 $30 -$10 $30 $10 $35 Job Type Profit 8 DSP, Inc. We may think the Total Profit is: 120*35=4200 100*30 =3000 4200+3000= 7200 Profit 9 DSP, Inc.: Summary Cost Table Job Type Window

Cleaning Landscaping Current Output 100/160 120/120 Labor Hours 4*100= 400 5*120 = 600 Revenue/job (170*100) 17000 $47000 (250*120) 30000 Material Cost (10*100) 1000 $10000

(75*120) 9000 Labor Cost 10000 Administrative Overhead Allocation 18000 Non-Administrative Overhead Allocation 9000 Instead of 7200 Profit, We have 0 Profit, While with original plan we had 4100 Profit 10 DSP, Inc.: Summary Cost Table Job Type Window Cleaning Landscaping Current Output

100/160 120/120 Labor Hours 4*100 = 400 5*120 = 600 Revenue/job 170 250 Material Cost 10 75 Labor Cost 40 50 Administrative Overhead Allocation (18000/220)

81.82 (18000/220) 81.82 Non-Administrative Overhead Allocation (9000/220) 40.1 (9000/220) 40.1 11 DSP, Inc.: Activity-Based Costing DSP, Inc. wants to use a better method to allocate the overheads (using Activity-Based Costing). To accurately allocate Administrative Overhead, DSP gathers data on the time the administrators, Cromby, Steele and Nash, devote to the four products, each month. The data reveals the following breakdown on the time administration spends on the 4 products: Plumbing: 30%; Window Cleaning: 35% Gutter Guards: 20%; Landscaping: 15% 12 DSP, Inc.: Administrative Overhead Allocation using ABC Administrative Overhead to be allocated = $18,000 Job Type

Plumbing Window Cleaning Gutter Guards Landscaping 30% 35% 20% 15% Admin O/H Allocated = %age effort x $18,000 $5,400 $6,300 $3,600 $2,700 Number of Jobs

90 jobs 70 jobs 80 jobs 60 jobs $60 $90 $45 $45 Percentage Effort Administrative O/H Allocation per job 13 DSP, Inc.: Non-Administrative Overhead Allocation using ABC Non-Administrative Overhead to be allocated = $9,000. The allocation is made based on labor hours. Total labor hours = 1,000. So, Non-Admin. O/H rate = $9,000/1,000 = $9.00 per labor hour. Since Plumbing takes 2 hours, the Non-Admin. Overhead allocated to a Plumbing job is = $9 x 2 = $18. Thus the Non-Administrative Overhead allocation per job is:

Plumbing (2 hours): $18; W. Cleaning (4 hours): $36 $45 G. Guards (3 hours): $27; Landscaping (5 hours): 14 DSP, Inc.: Improved Allocation with ABC Plumbing Window Cleaning Gutter Guards Landscaping Current Output 90 jobs 70 jobs 80 jobs 60 jobs Labor Hrs./job 2 hours 4 hours

3 hours 5 hours Revenue/job $130 $170 $200 $250 Material Cost $30 $10 $70 $75 Labor Cost $20 $40 $30

$50 Administrative Overhead Allocation $60 $90 $45 $45 Non-Administrative Overhead Allocation $18 $36 $27 $45 Profit $2 -$6 $28

$35 Profit -$10 $30 $10 $35 Job Type 15 DSP, Inc., Demand for Services Suppose the monthly demand for these services is: Plumbing: Window cleaning: 250 jobs 160 jobs Gutter guard installs: 145 jobs Landscaping: 120 jobs Suppose, too, that DSP, Inc., can choose which products to go after. What is the best product offering for DSP, Inc., that

will maximize its profit? 16 DSP, Inc. Can DSP do better? Lets use ABC cost figures. Which is the most profitable product? Landscaping Compute profits if they first complete meeting the demand for the most profitable product, then focus on the next most profitable product, and so on. Use the following pages for your calculations. 17 DSP, Inc. First complete demand for 120 Landscaping jobs. That uses up 600 hours, leaving 400 hours of capacity. Next work on Gutter Guards. Each job takes 3 hours. Can complete 400/3 =133 jobs. (1 hour of labor unused.) With this product mix, the apparent profit seems to be: 120 x $35 + 133 x $28 = $7,924. Not the true profit. Why? Answer: Unabsorbed overheads. 18 DSP, Inc.: Reconciling Variances 120 Landscaping and 133 Gutter Guard jobs will each recover $45 of Administrative Overhead, that is: $45 x 120 + $45 x 133 = $11,385. Admin. Overhead Variance = $18,000 - $11,385 = $6,615. The 1 hour of unused labor gives a Labor Usage Variance of $10 and Non-Admin. Overhead Variance of $9.

So, the total of all the Variances is: $6,634. Actual profit with ABC is thus: $7924 - $6,634 = $1,290. So, optimal profit is less than earlier profit! Why? 19 DSP, Inc.: A Better Approach a) Consider only the variable costs in the profit equation use marginal profits. b) Focus on the constraint. Evaluate rate at which marginal profits are generated at the constraint (Throughput). Best product is the one with the highest Throughput. Complete demand on this product, move to next most profitable product, and so on, till you run out of capacity at constraint. c) Find total marginal profit, and subtract out fixed costs to get total net profit. 20 DSP, Inc. Capacity at the constraint (total labor hours) = 1,000 hours. Product Demand for product Plumbing 250 jobs W. Clean 160 jobs Marginal Profit (Rev. Var. Cost)

$130-$30 = $100 $170-$10 = $160 2 hours 4 hours # of hours needed per job Profit Generation Rate (Throughput) $50.00 per $40.00 per hour hour G. Guard 145 jobs Landscape 120 jobs $200-$70 $250-$75 = = $130 $175 3 hours 5 hours

$43.33 per hour $35.00 per hour Fixed costs are: Labor + Administrative O/H + Non-Admin. Overhead = $10,000 + $18,000 + $9,000 = $37,000. 21 DSP, Inc. Do 250 plumbing jobs first (250 x 2 = 500 hours). Next, do 145 gutter guards (145 x 3 = 435 hours). With the remaining 65 hours, you can complete 65/4 = 16 window cleaning jobs (64 hours) Net Marginal Profit = 250*$100 + 145*$130 + 16*$160 = $46,410. Net Marginal Profit = 250*$100 + 144*$130 + 17*$160 = $46,440. $46,440 - $37,000 = $9,440. 22 DSP, Inc.: Summary Summary: Optimal profit with Standard Costing : $0 Optimal profit with ABC: $1,290 Profit with arbitrary product mix: $4,100 Optimal profit with Throughput Accounting: $9,410 23 Traditional Decision

Making Inventory Valuation and Cost Accounting 2008, M. Srinivasan 24 An Inventory Conundrum Raw Material cost per unit: $10 WIP value per unit: $20 Finished Goods value per unit: $35 Sale Price per unit: $50 Other Operating Expenses: $4 Million in 2006; $3.75 Million in 2007 2006 2007 Beginning WIP Inventory (1000 units) 50 50 Beginning FG Inventory (1000 units) 40 40 Raw Material (1000 units) 400 330 Sales (1000 units) 400 400

Ending WIP Inventory (1000 units) 50 10 Ending FG Inventory (1000 units) 40 10 25 An Inventory Conundrum: The Income Statement 2002 2007 Sales (1000 $) Beginning WIP Inventory (1000 $) Beginning FG Inventory (1000 $) Raw Material Purchase (1000 $) Other Expenses (1000 $) Ending WIP Inventory (1000 $) Ending FG Inventory (1000 $) Cost of Goods Sold (1000 $) 20,000 1,000 1,400 4,000 4,000 1,000 1,400 8,000 20,000 1,000

1,400 3,300 3,750 200 350 8,900 Profit (1000 $) 12,000 11,100 26 Traditional Decision Making: Product Costs How can we calculate a companys profit? Net Profit = Sp Revenuep - Sc Expensec. But how do we use this information to, say, decide on launching a new product? Allocate! If we allocate overhead costs correctly: Net Profitp = Revenuep - Expensep, and so, Net Profit = Sp Net Profitp 27 Obtaining Accurate Product Costs How do we allocate overhead costs

properly so that product costs are accurate? Standard Costing Activity Based Costing (ABC) 28

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