To provide a more concrete foundation for the internal linkage concepts, let’s consider a specific numerical example. Assume that a firm produces a variety of high-tech medical products. One of the products has 20 parts. Design engineers have been told that the number of parts is a significant cost driver (operational cost driver) and that reducing the number of parts will reduce the demand for various activities downstream in the value chain. Based on this input, design engineering has produced a new configuration for the product that requires only eight parts. Management wants to know the cost reduction produced by the new design. They plan on reducing the price per unit by the per-unit savings. Currently, 10,000 units of the product are produced. The effect of the new design on the demand for four activities follows. Activity capacity, current activity demand (based on the 20-part configuration), and expected activity demand (based on the 8-part configuration) are provided.
Additionally, the following activity cost data are provided:
Material usage: $3 per part used; no fixed activity cost. Assembling parts: $12 per direct labor hour; no fixed activity cost. Purchasing parts: Three salaried clerks, each earning a $30,000 annual salary; each clerk is capable of processing 5,000 purchase orders. Variable activity costs: $0.50 per purchase order processed for forms, postage, etc. Warranty repair: Two repair agents, each paid a salary of $28,000 per year; each repair agent is capable of repairing 500 units per year. Variable activity costs: $20 per product repaired.
Using the information in the table and the cost data, the potential savings produced by the new design are given in Exhibit 11-6. Cost behavior of individual activities is vital for assessing the impact of the new design. Knowing the cost of different design strategies is made possible by assessing the linkages of activities and the effects of changes in demand for the activities. Notice the key role that the resource usage model plays in this analysis. The purchasing activity currently supplies 15,000 units of activity capacity, acquired in steps of 5,000 units. (Capacity is measured in the number of purchase orders see Exhibit 11-7, on the following page, for a graphical illustration of the activity’s step-cost behavior.) Unused activity for the current product configuration is 2,500
Material usage: $3 per part used; no fixed activity cost. Assembling parts: $12 per direct labor hour; no fixed activity cost. Purchasing parts: Three salaried clerks, each earning a $30,000 annual salary; each clerk is capable of processing 5,000 purchase orders. Variable activity costs: $0.50 per purchase order processed for forms, postage, etc. Warranty repair: Two repair agents, each paid a salary of $28,000 per year; each repair agent is capable of repairing 500 units per year. Variable activity costs: $20 per product repaired.
Using the information in the table and the cost data, the potential savings produced by the new design are given in Exhibit 11-6. Cost behavior of individual activities is vital for assessing the impact of the new design. Knowing the cost of different design strategies is made possible by assessing the linkages of activities and the effects of changes in demand for the activities. Notice the key role that the resource usage model plays in this analysis. The purchasing activity currently supplies 15,000 units of activity capacity, acquired in steps of 5,000 units. (Capacity is measured in the number of purchase orders see Exhibit 11-7, on the following page, for a graphical illustration of the activity’s step-cost behavior.) Unused activity for the current product configuration is 2,500
units (15,000 - 12,500). Reconfiguring the product reduces the demand from 12,500 orders to 6,500 orders. This increases the unused activity capacity to 8,500 units (15,000 - 6,500). At this point, management has the capability of reducing resource spending on the resources acquired in advance of usage. Since activity capacity is acquired in chunks of 5,000 units, resource spending can be reduced by $30,000 (the price of one purchasing clerk). Furthermore, since demand decreases, resource spending for the resources acquired as needed is also reduced $3,000 by the variable component ($0.50 x 6,000). A similar analysis is carried out for the warranty activity. The activity-based costing model and knowledge of activity cost behavior are powerful and integral components of strategic cost management.
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