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Question 2a

Pitlane Electronic Components (Pitlane) manufactures components for use in the electricity distribution network in Deeland. Demand from Pitlane’s biggest customer, to replace identical but worn out components, has been constant for many years. Pitlane has recently renewed an exclusive long-term supply agreement with this customer, who has always agreed to buy the components for their total standard cost plus a fixed profit margin of 15%. Variances between standard and actual costs of the components are negligible. Pitlane runs several production lines in two factories located in different areas of Deeland. The factories’ layout is poorly designed and the production process requires components to be transported around and between the factories.

The Deeland government wants to encourage renewable electricity generation. It is offering a three-year subsidy scheme, beginning in 2018, for consumers to have solar panels installed on the roofs of their homes. As an added incentive, businesses will be exempt from tax on profits made on the sale of solar panels and related components.

To take advantage of this scheme, Pitlane has built a prototype of a new electrical component, known as the ‘Booster’, which increases the output from domestic solar panels. The Booster will be sold to installers of solar panels and not directly to consumers. Pitlane’s marketing department has estimated market data for the duration of the scheme based on a similar scheme in Veeland (Appendix 1). As a result of its products being unchanged for many years, Pitlane has little recent experience of developing new products and estimating costs and potential revenues from them. It is expected that many competitor products will be launched during the scheme, at the end of which demand is expected to fall greatly, and production of the Booster will discontinue.

Pitlane’s shareholders insist that for the Booster project to go ahead, it must meet the financial performance objective of achieving a 15% net profit margin, after all costs, for the duration of the scheme.

The Booster’s total fixed costs during the scheme are estimated to be $10m, including $2·8m upfront development costs to enable the Booster to communicate the amount of solar energy generated directly to consumers’ smartphones via an app. The product development team at Pitlane believes this feature, and the use of highest quality packaging, will allow it to charge 10% more that the average price of its competitors. The marketing team, however, has questioned the overall value of these two features and whether customers would be prepared to pay extra for them, as most of the Deeland population do not yet own smartphones.

Pitlane has estimated the direct costs for the Booster (Appendix 2). The largest direct cost is for the four main sub-components. These are bought in bulk from six different suppliers in Deeland, though all are readily available from suppliers worldwide. The sub-components are fragile. During production of the Booster prototype, many sub-components were found to be damaged during the production process by workers incorrectly assembling them. This resulted in the completed prototype Boosters being scrapped after testing by the quality control department. The manufacturing director is concerned that the incorrect assembly of sub-components by workers may mean that it may not be profitable for Pitlane to start full scale production of Boosters. To counteract these quality problems, Pitlane will employ more highly skilled workers, who are paid around 30% more than most other workers in the business which is accounted for in the cost estimate given in Appendix 2. Pitlane staff have never been encouraged to suggest any ways to improve the manufacturing process.

Pitlane’s directors are concerned that the Booster project will not meet the shareholders’ financial performance objective. They have asked you, as a consultant experienced in target costing, Kaizen costing and other Japanese business practices, for your advice.

Required:

(a) Calculate the cost gap per unit in each of the three years of the Booster’s life, taking into account all estimated costs. (6 marks)

Appendix 1 – Estimated market data for Booster
2018 2019 2020
Total market size (units) 600,000 500,000 460,000
Average price of competitors products ($/unit) 180 170 160
Booster market share of total market 10% 15% 20%
Appendix 2 – Estimated unit direct cost of Booster
$
Sub-components 94
Assembly labour 21
Packaging 10
Distribution  2
Internal transport and handling
Total 134