P2: Costs of creating value

Answer: A. The key distinction is that ABC traces overhead costs to products via the specific activities that drive those costs — using multiple cost drivers — whereas traditional absorption costing spreads overheads across products using a single volume-based rate (such as labour hours or machine hours). This means the two methods can produce materially different product costs, particularly where the production mix is varied and overheads are not truly volume-driven. ABC does not eliminate overheads; it reallocates them more precisely, and neither system is universally more accurate for every product type.

Answer: B. ABM extends ABC by using the underlying activity cost data to manage and improve organisational performance — in particular, by identifying non-value-adding activities whose costs can be reduced or eliminated without harming the value delivered to customers. This is a strategic and operational application of ABC data, not just a product-costing exercise. ABM is applicable to service as well as manufacturing organisations, and its purpose is to reduce waste and improve efficiency rather than increase total costs.

Answer: C. JIT operates on the principle of producing and procuring materials only as and when they are needed, which eliminates the need for large buffer stocks and the holding costs associated with them. This requires reliable supplier relationships and predictable demand patterns to work effectively. JIT is the opposite of maintaining high inventory levels, and it actually aims to reduce waste — excess inventory is itself considered a form of waste under JIT philosophy. It is applicable across a range of organisations and production settings, not limited to any particular cycle length.

Answer: D. TQM is built on the principle of continuous improvement across all processes and functions throughout the organisation, with the overriding aim of meeting or exceeding customer expectations. It is not confined to production — TQM explicitly extends quality improvement to every function including sales, finance and HR. TQM is an ongoing management philosophy, not a one-off project with a defined end date. The philosophy also holds that quality improvements can ultimately reduce costs by eliminating failures, rework and waste, contrary to the assumption that quality always costs more.

Answer: A. The theory of constraints holds that every system has at least one binding constraint — a bottleneck that limits the whole system's throughput — and that the way to improve overall output is to identify that constraint, exploit it fully, and subordinate all other processes to support it. Maximising every process equally ignores the fact that improving non-bottleneck processes does not increase total throughput. The theory specifically focuses on the constraint rather than all activities, and attempting to increase capacity everywhere simultaneously is often an inefficient use of resources compared with targeting the actual binding constraint.

Answer: B. Kaizen costing sets an ongoing target of continuous, incremental cost reduction below the current actual cost level, building the expectation of improvement into the cost management process. Standard costing, by contrast, compares actual costs against a fixed predetermined standard that may remain unchanged for a period. The two approaches are genuinely distinct: Kaizen embeds the expectation of improvement whereas standard costing typically embeds the expectation of consistency. Kaizen encompasses cost reduction as a key objective alongside quality, and standard costing does not inherently produce lower costs than Kaizen over time.

Answer: C. BPR involves the fundamental, radical redesign of business processes from the ground up, aiming for dramatic performance improvements, which is inherently different from Kaizen's philosophy of continuous, incremental, small-step improvement embedded in everyday operations. The two represent genuinely different philosophies and pace of change, not variants of the same approach. The descriptions of gradual versus radical are correctly assigned: BPR is radical and Kaizen is incremental, not the reverse, and both have extensive real-world application records across many industries.

Answer: D. Target cost = selling price × (1 − profit margin) = £120 × (1 − 0.20) = £120 × 0.80 = £96. The current estimated cost is £104. Cost gap = current cost − target cost = £104 − £96 = £8. £16 is the gap between selling price and current cost (£120 − £104), which ignores the required profit. £24 is the required profit itself (20% × £120), not the cost gap. £20 takes 20% of £100 instead of 20% of the £120 selling price.

Answer: A. Value engineering is a key technique for closing a target cost gap — it involves analysing the product's design and components to find ways to reduce cost without reducing the value or functionality that customers actually need. Increasing the selling price is not always feasible in a competitive market, which is precisely why target costing works backwards from the market price rather than adding on the current cost. A cost gap does not automatically make a product unviable — it is an invitation to improve the design or process. Eliminating the profit target defeats the entire purpose of target costing as a technique.

Answer: B. Value chain analysis examines each of an organisation's primary and support activities, assessing the value each adds and the cost of providing it, which helps identify where competitive advantage can be created or sustained and where costs can be reduced without losing value. It is a strategic cost-management tool rather than a competitor pricing or revenue analysis tool. Understanding which employees make errors or which regions generate revenue are separate analytical questions, not what value chain analysis directly addresses.

Answer: C. Life cycle costing captures all costs across a product or asset's full life — from initial design and development, through manufacture and operation, to eventual disposal — giving a complete picture of total cost of ownership that a narrower focus on production-period costs alone would miss. Costs committed in the design phase often lock in the majority of a product's total life-time cost, making early-stage cost management particularly important. Life cycle costing encompasses production costs rather than ignoring them, and it is relevant for products and assets with any life cycle length, not only very short ones.

Answer: D. If inspection costs are driven by the number of batches rather than production volume, assigning them using a volume-based rate (such as per unit produced) will systematically undercharge high-batch, low-volume products and overcharge low-batch, high-volume products. ABC specifically addresses this by assigning inspection costs based on the actual cost driver — batches — giving a more accurate product cost. Assigning costs equally regardless of driver consumption ignores this insight entirely, and overheads need not all be volume-driven — recognising batch-level drivers is precisely what ABC is designed to do. Stopping inspection to avoid the problem would sacrifice quality control rather than solve the costing issue.

Answer: A. Internal failure costs arise from defects caught before delivery to the customer — scrap and rework are the classic examples, because the cost is incurred internally when defective output is identified and either discarded or corrected before leaving the organisation. Incoming inspection is an appraisal cost, since it is about detecting rather than the failure itself. Warranty refunds are external failure costs, because they arise after the defective product has already reached the customer. Training employees in quality procedures before production is a prevention cost, aimed at stopping defects from occurring in the first place.

Answer: B. Target costing starts from the market price that customers will actually pay — here £75 — deducts the required profit margin to arrive at the target cost, and then drives product design and engineering efforts to meet that target cost. This is the opposite of cost-plus pricing, which adds a margin to the current cost regardless of what the market will bear. Reducing the profit margin to zero would undermine the commercial case for the product, and a price gap does not necessarily mean the product is unviable — it means the design or cost structure needs to change, which is exactly what target costing is designed to prompt.

Answer: C. Value chain analysis explicitly considers linkages between activities, not just the cost of each activity in isolation — improving supplier delivery reliability (an inbound logistics improvement) reduces the uncertainty that forces the company to hold higher safety stocks, which in turn reduces inventory holding costs. These are interdependent activities, not independent ones, and value chain analysis is specifically designed to surface these cross-activity linkages. Supplier performance clearly affects internal costs by driving safety stock requirements, so both the logistics cost and the holding cost can be reduced together by addressing the root cause.

Answer: A. Target cost = selling price × (1 − profit margin) = £200 × (1 − 0.25) = £200 × 0.75 = £150. Cost gap = current estimated cost − target cost = £170 − £150 = £20. £50 is the required profit itself (25% × £200), not the cost gap. £30 is the gap between selling price and current cost (£200 − £170), which ignores the required profit, and £170 is the current cost. Treating 25% as a mark-up on cost would give a target cost of £160 and a gap of £10. The margin is on selling price, so the target cost formula is SP × (1 − margin%).

Answer: B. If the great majority of a product's life cycle costs are committed (i.e. determined by decisions made) during design — even though cash is not yet spent — then cost management effort focused at that early stage has the greatest leverage. By the time the product reaches production, most cost-reduction opportunities have already been foreclosed by design choices already made. This is the central insight behind target costing and life cycle costing: cost must be managed upstream. The production phase still deserves attention, but the marginal impact of cost management there is smaller once design decisions have been made.

Answer: C. JIT holds little or no buffer stock, so production depends directly on materials arriving on time and in the right quality exactly when needed. Any supplier failure — late delivery or defective materials — immediately halts production, with no safety stock to absorb the disruption. This is why strong, long-term supplier partnerships are essential for JIT to work. Maintaining large safety stocks is the opposite of JIT philosophy, and supplier reliability is critical because production schedules are tightly synchronised with delivery schedules, not insulated from them.

Answer: D. A cost driver in ABC is the factor that causes the cost of a specific activity to vary — for example, the number of purchase orders drives procurement costs, or the number of quality inspections drives quality control costs. Activity costs are assigned to products in proportion to their consumption of the cost driver. This is more accurate than using a single volume-based absorption rate, since it reflects the actual relationship between activities and their costs. Labour hours describe a traditional absorption cost driver, not the ABC concept, and fixed overhead variances are a standard costing concept entirely separate from ABC.

Answer: A. In Porter's value chain, primary activities are those directly involved in creating, delivering and selling the product or service — such as inbound logistics, operations, outbound logistics, marketing and sales, and after-sales service. Support activities underpin the primary activities by providing the human resources, technology, procurement and infrastructure needed for them to function. The distinction is based on the directness of the contribution to value creation, not on seniority of the people involved. Both primary and support activities can generate or protect value, and the distinction has real analytical significance for identifying where competitive advantage is created.

Answer: B. The costs-of-quality framework distinguishes between prevention costs (training, process design), appraisal costs (inspection) and failure costs (internal scrap/rework plus external warranties and reputation damage). Prevention is emphasised because catching a defect late — and especially after it reaches a customer — typically costs far more than preventing it in the first place. Inspection identifies defects but does not prevent them; it still incurs both the appraisal cost and the failure cost. TQM does consider costs explicitly through the costs-of-quality model, and the logic of preventing failure costs rather than bearing them applies equally in service organisations.

Answer: C. In ABM, a value-adding activity is one that the customer would recognise as contributing to the product or service they receive and would be willing to pay for — such as product design or direct manufacturing. A non-value-adding activity consumes resources without producing that customer-valued output, such as storage waiting time or internal rework. Identifying and reducing non-value-adding activities is a key use of ABC/ABM data. Not all activities add customer value — ABM exists precisely to surface this distinction. Some non-value-adding activities may be legally required (such as certain compliance activities), but that does not mean all are, and the distinction has nothing to do with the seniority of who performs the activity.

Answer: D. Value engineering involves analysing the product's design, components and processes to identify changes that preserve or maintain the same functional value for the customer at a lower cost — for example, substituting a less expensive material that performs identically, or redesigning a component to require fewer parts. Raising the selling price ignores the market constraint that makes target costing necessary in the first place. Cutting staff training risks quality failures that generate costs of their own, and accepting the gap by reducing the profit target defeats the purpose of target costing as a market-driven cost management discipline.

Answer: A. Kaizen target cost = current actual cost × (1 − reduction rate) = £200 × (1 − 0.02) = £200 × 0.98 = £196. The reduction is applied to actual current cost, not a fixed standard — this reflects Kaizen's philosophy of continuous improvement beyond the current position rather than meeting a fixed historical standard. £204 would be a cost increase, which reverses the direction. £160 might arise from misapplying a 20% reduction rather than 2%. £200 is the current cost with no reduction applied, which represents no improvement at all.

Answer: B. For assets such as nuclear plants, offshore oil platforms or complex industrial equipment, disposal or decommissioning costs can be very substantial, and excluding them from life cycle analysis would significantly understate the true cost of ownership. This can lead to misleading comparisons between assets or project alternatives, particularly when disposal profiles differ significantly. Disposal costs are not always immaterial — in some industries they are very large — and they do fall within the scope of life cycle costing, which explicitly aims to capture all costs from inception to disposal. They are often borne by the owner, not a third party.

Answer: C. Value chain analysis can be extended to consider the wider value system — the linked value chains of suppliers, the organisation itself, distributors and customers. Recognising these external linkages helps identify how supplier performance, upstream costs and customer requirements affect the organisation's own competitive position, and where opportunities for joint cost reduction or value enhancement may exist across organisational boundaries. Limiting analysis to the single legal entity misses this broader perspective entirely, and treating supplier costs as irrelevant contradicts the purpose of identifying external linkages. The value delivered to the end customer is shaped by activities far beyond the organisation's own production facility.

Answer: D. Throughput = selling price − direct material cost = £200 − £80 = £120 per unit. Cost per bottleneck hour = £30. Bottleneck time = 3 hours per unit. Total factory cost for this product per bottleneck unit = 3 × £30 = £90. TPAR = throughput per unit of bottleneck ÷ total factory cost per unit of bottleneck = £120 ÷ £90 = 1.33. A TPAR above 1.0 means the product generates more throughput than it consumes in factory cost, so it is worth producing. A common error is to include fixed overhead in the throughput figure (throughput is sales minus only direct materials, not all variable costs). 0.75 inverts the ratio (£90 ÷ £120), and 2.00 and 0.50 do not follow from the figures.

Answer: A. BPR's defining feature — radical, fundamental redesign of processes from scratch — also makes it inherently higher risk than incremental approaches such as Kaizen. Large-scale transformation can disrupt existing operations, encounter resistance to change, fail to deliver anticipated benefits, or take longer and cost more than planned. These are recognised failure modes that have characterised several high-profile BPR implementations. BPR is not a gradual, low-risk approach, and its outcomes are not predictable with certainty — uncertainty about the results is itself one of the key risks. Staff training costs may arise but are not the primary or defining risk.

Answer: B. Batch-level costs are incurred once per batch of production, regardless of how many units the batch contains — machine set-up is the classic example, since the same set-up cost applies whether the batch has 10 units or 1,000. This distinguishes it from unit-level costs (like direct materials, incurred once per unit), and facility-sustaining costs (like factory rent or the factory manager's salary, incurred to maintain overall capacity regardless of production activity). Understanding this hierarchy is central to ABC, since charging batch-level costs per unit using a volume-based rate systematically overcosts large batches and undercosts small batches.

Answer: C. Discovering that the wholesale stage earns a significantly higher margin than the retail stage is a signal worth investigating strategically — one option is backward integration (taking ownership of or establishing a wholesale operation) to capture more of the margin currently retained at that stage. Other options might include renegotiating terms with the wholesaler or finding ways to add more retail-stage value to justify a higher price. Immediately closing retail operations ignores the broader strategic context and the fact that margin comparisons are a starting point for analysis, not an automatic verdict. Raising price without understanding the wholesale margin advantage may not address the underlying structural issue.