5.7.2: Cost Reduction and Process Improvement Decisions

Cost Reduction and Process Improvement Decisions

Managers use ABC systems to focus on how and where to reduce costs. They set cost reduction targets for the cost per unit of the cost-allocation base in different activity areas. For example, the supervisor of the distribution activity area at Plastim could have a performance target of decreasing distribution cost per cubic foot of products delivered from $5.80 to $5.40 by reducing distribution labor and warehouse rental costs. The goal is to reduce these costs by improving the way work is done without compromising customer service or the actual or perceived value (usefulness) customers obtain from the product or service. That is, the supervisor will attempt to take out only those costs that are nonvalue added.

Controlling cost drivers, such as setup-hours or cubic feet delivered, is another fundamental way that operating personnel manage costs. For example, the distribution department can decrease distribution costs by packing the lenses in a way that reduces the bulkiness of the packages delivered.

The following table shows the reduction in distribution costs of the S3 and C5 lenses as a result of actions that lower cost per cubic foot delivered (from $5.80 to $5.40) and total cubic feet of deliveries (from 45,000 to 40,000 for S3 and 22,500 to 20,000 for C5).

<p>A table shows the reduction in distribution costs for S3 and C5 lenses</p>

The table depicts distribution costs, updated distribution costs as a result of process improvements, and savings in distribution costs from process improvements for S3 lenses and C5 lenses. The details of the table are as follows:

Distribution costs

S3 lenses total, 45,000 cubic feet times 5.80 dollars per cubic feet: 261,000 dollars
S3 lenses per unit, 45,000 cubic feet times 5.80 dollars per cubic feet divided by 60,000 units: 4.35 dollars
C5 lenses total, 22,500 cubic feet times 5.80 dollars per cubic feet: 130,500 dollars
C5 lenses per unit, 22,500 cubic feet times 5.80 dollars per cubic feet divided by 15,000 units: 8.70 dollars

Distribution costs as a result of process improvements

S3 lenses total, 40,000 cubic feet times 5.40 dollars per cubic feet: 216,000 dollars
S3 lenses per unit, 40,000 cubic feet times 5.40 dollars per cubic feet divided by 60,000 units: 3.60 dollars
C5 lenses total, 20,000 cubic feet times 5.40 dollars per cubic feet: 108,000 dollars
C5 lenses per unit, 20,000 cubic feet times 5.40 dollars per cubic feet divided by 15,000 units: 7.20 dollars

Savings in distribution costs from process improvements

S3 lenses total: 45,000 dollars
S3 lenses per unit: 0.75 dollars
C5 lenses total: 22,500 dollars
C5 lenses per unit: 1.50 dollars

In the long run, total distribution costs will decrease from $$ text 391,500 end text thin space left parenthesis $ text 261,000 end text plus $ text 130,500 end text right parenthesis$ to $inline style $ text 324,000 end text thin space left parenthesis $ text 216,000 end text plus $ text 108,000 end text right parenthesis.$ In the short run, however, distribution costs may be fixed and may not decrease. Suppose all $391,500 of distribution costs are fixed costs in the short run. The efficiency improvements (using less distribution labor and space) mean that the same $391,500 of distribution costs can now be used to distribute $72,500 (= \frac{$ 319,500}{$ 5.40 pre cubic feet})$ cubic feet of lenses compared to the 67,500 cubic feet of lenses it currently distributes (see Exhibit 5-4). In this case, how should costs be allocated to the S3 and C5 lenses?

ABC systems distinguish costs incurred from resources used to design, manufacture, and deliver products and services. For the distribution activity, after process improvements,

$\begin{array}{rcl} Costs incurred & = & $ 391,500 \\ Resources used & = & $ 216,000 (for S 3 lens) + $ 108,000 (for C 5 lens) = $ 324,000 \end{array}$

On the basis of the resources used by each product, Plastim’s ABC system allocates $216,000 to S3 and $108,000 to C5 for a total of $324,000. The difference of $inline style straight $ text 67,500 end text thin space left parenthesis straight $ text 391,500 end text minus straight $ text 324,000 end text right parenthesis$ is shown as costs of unused but available distribution capacity. Plastim’s ABC system does not allocate the costs of unused capacity to products so as not to burden the product costs of S3 and C5 with the cost of resources not used by these products. Instead, the system highlights the amount of unused capacity as a separate line item to alert managers to reduce these costs, such as by redeploying labor to other uses or laying off workers.