A UK-based company that has decided to produce and sell watches has used a traditional costing system based on the number of units produced for charging overheads to its products. The company, SFT Limited, has decided to-iise targeLcostiog as a new management tool. The market in which the operates has become highly competitive in recent years and the company has carried out an extensive market survey which has revealed that there are three main functions for the three sorts of watches in the niche that the company is considering manufacturing in, namely, time, water resistance, and style.
Suppose you have recently been appointed as the company accountant and the CEO of the company has asked you to report to her explaining the nature of target costing as a cost management tool and to cost the ranges of the three watches being considered for manufacture and to make your recommendations accordingly. The following information and data are available to you:
The watches consist of three main components, a quartz mechanism, the case and the strap. The company, SFT Limited, sources components from outside suppliers and assembles the watches in its factory. The three main functions for the watches in the niche that the company has chosen; time, water resistance and style are provided as follows: time is provided by the quartz mechanism, water resistance by the case, and style by the strap. Replaceable batteries power all the watches. However, once the case is opened to replace the battery, the waterproof nature of the watch is lost. The market survey established three price points for the three new watches that the company now has in its design stage: (1) £30 for a basic watch (2) £50 for a basic chronograph and (3) £120 for a multifunctional watch. The company has determined, given its facility-sustaining costs and its cost of capital, that the three watches must provide a margin of £4, £8 and £15 to be acceptable. Based on initial specification the supplier of quartz mechanisms has quoted a price of £8, £15 and £40 for the three watches. Because these mechanisms use standard components and well-known technology, the Planning Department of SFT Limited considers these costs to be as low as they can be with the implication that any needed target cost reduction will not be feasible from the quartz mechanism.
There are many sources for the watch straps, and suppliers’ prices vary widely based on functionality, which include appearance, composition and wear. Suppliers’ quoted price ranges for the three watches are as follows: £2-£7, £6-£9 and £20-£30. For any given level of functionality chosen there is little price variation among suppliers because the watchstraps are commodity products produced cost effectively. The case provides style and water resistance, the latter being a critical function. All cases have to be guaranteed to a depth of 50 metres minimum. A customer focus group has found that customers generally prefer a guaranteed depth of 100 metres. Depending upon style and degree of water resistance the (sole) supplier quoted the following price ranges for the watch cases: £5-£15, £10 - £25 and £20 -£35. Superior style and water resistance thus increases the product price. Conversations with factory personnel indicated that the estimated costs of assembling, packaging, and shipping each watch were about £5, £7.
The Planning Department have concluded that for an investment estimated at about £4,000,000. SFT Limited could provide management advice to the sole supplier of watch cases. This advice would be related to developing better manufacturing methods which, it is estimated, would reduce the cost of each watch case supplied by about 25%. Also, that a further investment of about £8,000,000 SFT’s existing factory layout could be altered to accommodate more-efficient production The result would be to reduce assembly, packaging and shipping costs by about £2 per unit.
Write a brief report aimed at the CEO of SFT Limited, who is not an expert in finance, and, in your report, ensure that you include the following:
a) An explanation of target costing and its usefulness as a management tool and a discussion of what you consider to be the potential concerns in implementing a target costing system;
b) Calculations of the unit cost ranges for the three watches;
c) Identify how you would choose the specific strap and case for each watch;
d) An analysis indicating whether you would recommend that SFT Limited make the investment to improve the efficiency of the case supplier, and also whether or not it should make the investment to accommodate more-efficient production at its own factory resulting in a £2 reduction assembly, packaging and shipping costs.
The question belongs to Accounting and it discusses about writing a brief report to the CEO of SFT Limited recommending target costing, unit cost ranges and analysis indicating whether or not an investment should be made to improve efficiency of the supplier, etc have been discussed.
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