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Question 1ii

Folt Manufacturing: Company information
Folt Manufacturing (Folt) is a company, which is majority owned by its management team. A number of years ago, it was bought out of a larger multinational business by the management team. The management were supported by a venture capital firm, who provided the remaining equity and now supply all the debt required by the business at market rates. The business manufactures and sells digital imaging devices for use in a variety of industrial situations.

A key component in its products is the image processing software which is included. Folt has a small team of software developers who are beginning to gain a reputation for innovative solutions.

Folt has faced increasing pressure in its home market of Beeland from manufacturers in countries with lower cost bases. As a result, it has decided to invest in developing its image processing software rather than compete on the manufacturing of the hardware (the imaging devices). It will continue to sell the imaging devices but the manufacturing will be outsourced.

Folt’s overall objective is unchanged and it is ‘to provide an adequate return to its capital providers while growing the business into a world-class supplier in its areas of expertise’. The chief executive officer (CEO) has identified three factors which are critical success factors (CSFs) to achieving this objective. These are:

1. Keep capital providers satisfied;
2. Build a world-class software development team; and
3. Ensure that quality of the imaging devices meets market standards.

Performance measurement system
The CEO requires assistance from a performance management expert to create an appropriate performance measurement system for Folt. First, he needs recommendations of suitably justified key performance indicators (KPIs) for each CSF.

The CEO has indicated that there should be a maximum of two KPIs per CSF in order to avoid information overload. Then, he wants an assessment of the use of this group of KPIs to measure the strategic performance of Folt.

Outsourced manufacturing: Initial plans
The company has selected a suitable manufacturer for the outsourced work. Xela Manufacturing (Xela) is based in Ceeland, which is a much lower cost environment than Beeland. Folt is preparing to enter into detailed contract negotiations with Xela.

The manufacturing will be done under licence from Folt. This means that Folt supplies the product designs but retains the intellectual rights to them and Xela manufactures to agreed standards of quality. Xela then despatches the devices back to Folt who add the software, package the product and send it to their customers. The quality standards will be set by the service level agreements (SLAs) which will be agreed in the contract.

In preparation for these negotiations, the CEO needs advice on the following three critical areas (target costing, responsibility for quality areas and sources of information) for the negotiation of the agreement.

Target costing
The CEO realises that he needs to understand the cost structure of the products in order to have a firm basis for price negotiation with Xela. He has heard that target costing could be helpful. Therefore, he needs to know how target costing works and how it might be used in this situation. In order to clarify the explanation, he has gathered information (Appendix 1) on one product (Product 123) which requires a redesign before being relaunched into the market. He wants an example calculation of the target cost gap and an explanation of how the result of this would impact on negotiations with Xela.

Responsibility for quality areas
The maintenance of existing quality is a critical concern for Folt, since it will focus on software as the key selling point but this will not be sufficient for market success if the hardware does not meet market standards. The CEO wants to understand, in terms of the four areas of quality costs, how responsibility for each area should be attributed between Folt and Xela.

Sources of information
Folt has appropriate information systems in place for its existing manufacturing operation. The CEO and board are happy with their operation at present. However, Xela has indicated that its current information systems are purely financial, aiming to collect the required information for its financial reporting duties. The CEO is worried about this and wants an assessment of the impact of this on the management of quality within the contract.

It is now 1 September 20X5.

Write a report to the CEO of Folt Manufacturing (Folt) to:
(ii) Respond to the CEO’s request for work on target costing. (10 marks)

Appendix 1
Information on Product 123
The company aims for a profit margin of 20% on Product 123. Target price is $175 per unit, based on sales and marketing department research.

Cost details:
1. The remaining commercial life of the product is two years.
2. It is estimated that 250,000 units will be sold over the remaining life of the product.
3. Materials cost $37 per unit.
4. Each unit will take 0·5 hours of labour at an average cost of $25 per hour.
5. Each unit will use 1·1 hours of machine time at an average cost (including overheads) of $32 per hour.
6. Packaging and delivery will cost $8 per unit.
7. The design costs of the unit are expected to total $2m.
8. Inspections cost $100,000 per annum – the redesign will not affect this.
9. The rate of failed products, either spotted by customers or by the inspection team, is expected to remain at 2·5%.
10. Failed products will be reworked at an average cost of $20 per unit.
11. The software package supplied by Folt costs $40 per unit.