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####### 11COCHLEARLTD.ABC ANALYSISGroup 8CMS 22321 – Spring2019####### Hannah Viljoen####### Sundayna Hout####### Abe YahCOCHLEARLTD.ABC ANALYSISGroup 8####### 1COCHLEAR LTD. ABC ANALYSISExecutive SummaryThe primary purpose of the report is to address costing issues at Cochlear Ltd using Activity Ba...

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CMS 22321 – Spring

Group 8 COCHLEAR

Hannah Viljoen Sundayna Hout Abe Yah

LTD. ABC ANALYSIS

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COCHLEAR LTD. ABC ANALYSIS Executive Summary The primary purpose of the report is to address costing issues at Cochlear Ltd using Activity Based Costing to analyse cost consumption of its Baha Sound Processor range. Specifically, this report relates to cost examination of the Baha 5 Sound Processor and the Baha 5 Power Sound Processor. Cost information was gathered using real-world data and academic research. Direct materials, direct labour costs and indirect costs were derived using global market rates and averages.

FINDINGS: RECOMMENDATIONS:

Table of Contents CMS 22321 – Spring 2019................................................................1 COCHLEAR LTD. ABC ANALYSIS................................................................2 Executive Summary......................................................................................................... 2

SECTION 1: The Value Chain.............................................................4 BACKGROUND................................................................................................................... 4 INTRODUCTION: COCHLEAR AND THE INDUSTRY........................................................4

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3 ANALYSIS OF VALUE CHAIN............................................................................................. 4 UPSTREAM......................................................................................................................... 4 PRODUCTION PROCESS................................................................................................... 4 DOWNSTREAM.................................................................................................................. 4 SUPPORT ACTIVITIES....................................................................................................... 4

SECTION 2: The Costing System.......................................................4 TRADITIONAL VS ABC...................................................................................................... 4 ADVANTAGES AND DISADVANTAGES OF ABC...............................................................5 COST CLASSIFICATION..................................................................................................... 5 DIRECT COSTS................................................................................................................... 5 INDIRECT COSTS............................................................................................................... 7 ACTIVITY COST POOLS..................................................................................................... 8 COST DRIVERS.................................................................................................................. 8 COST HIERARCHIES.......................................................................................................... 9

SECTION 3: Product Costing...........................................................10 PRODUCTION CAPACITY................................................................................................ 10 DIRECT MATERIAL........................................................................................................... 10 DIRECT LABOUR.............................................................................................................. 11 CALCULATION OF OVERHEAD USING ABC...................................................................11

SECTION 4: Bibliography................................................................11 SECTION 5: Appendix.....................................................................11

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SECTION 1: The Value Chain

Exhibit 1.

R&D

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Cochlear Pty Ltd’s research and development department consists of 300 specialists who are based in top technologically advanced countries such as Australia, the United States, Belgium, and Sweden. Since 2018, Cochlear Pty Ltd has invested around $1.7 billion towards research and development (Cochlear Pty Ltd 2018, p.12). As a company that mainly produces hearing medical devices, Cochlear strives to research and develop solutions to drive better hearing performance outcomes. This is accomplished through improving sound processing algorithms, electrode technology, wireless connectivity, and biology research. The company further seeks to continuously expand its portfolio of implantable hearing devices (Cochlear Pty Ltd 2015, p.14).

DESIGN Key identical features of the Baha 5, Baha Power, and Baha SuperPower Sound Processors (Cochlear Pty Ltd 2019) include:   

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The integration of SmartSoundIQ technology that is created to recreate natural hearing though apprehending and automatically adapting sounds in users’ surroundings. Dual microphones that assist in the filtering out of background noise. Baha 5 Smart Iphone or Android application that is developed to allow users to personalise their hearing experience through adjusting their sound processor settings, and tracking hearing information. True Wireless Connectivity feature that allows users to stream music, and make phone calls from their mobile phones The processors can be tracked when lost or misplaced through the ‘Find my Processor’ feature.

Key differences: 

The Baha Power and Baha SuperPower Sound Processors are designed for people with higher degree of hearing loss.

UPSTREAM Cochlear Pty Ltd is reliant on multiple suppliers to source components of its products. Crystalaid is one of the key manufacturers acquired by Cochlear Pty Ltd that is responsible for supplying Cochlear’s external implant system such as speech processors and other various accessories (Cochlear Pty Ltd 2006). Cochlear Pty Ltd strategically purchases and manages its supplies of product components and raw materials to meet its short-term demands. As of 2019, the company has purchased $70.3 million worth of raw materials that were issued to production (Cochlear Pty Ltd 2019). The product components, raw materials, work in progress, and finished goods inventories are warehoused and processed among five manufacturing facilities, in which the three major sites are located in Brisbane, Landcove, and Sydney Australia (Cochlear Pty Ltd 2017).

PRODUCTION PROCESS The Cochlear Baha Sound Processor series combines the sound processing capabilities of three products to provide patients with a variety of audio options (Cochlear Pty Ltd 2019). Representing a ubstantial aspect of operations, the production line is a heavy focus of Cochlear Pty Ltd, who pride themselves on state of the art manufacturing facilities located at the Macquarie University Campus and Lane Cove in Sydney, and another in Brisbane (Amatil 2018). The production process of these devices is listed below. 1. Assembly All electronic chip components of the Cochlear Baha Sound Processor are cut and arranged before being placed inside a solid titanium casing to ensure maximum durability (MED-EL 2016). This

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6 titanium casing and its contents are key in transmitting sound signals to the implant’s electrode array. 2. Precision Laser Welding Following this assembly, the titanium casing is lasered shut in order to protect the electronics from outside contamination. 3. Quality Control Rigorous quality control is undertaken to ensure the electronic chips, titanium casing and welded seams are able to satisfy reasonable testing standards (Cochlear Pty Ltd c.2016). 4. Cleaning As these medical products will be coming into human contact, appropriate procedures must be followed to ensure the highest standard of hygiene and achieved. Parts move through a cleaning room that features airlocked chambers to regulate temperature and prevent contamination. 5. Silicone Sealing Stringent biocompatibility measures require medical devices to possess specialised silicone adhesives to withstand the harsh sterilisation treatment that may feature high temperatures, chemicals or radiation. The assembled electronics encased within the titanium casings are placed onto a metal form and injected with silicone. Following the curing of this silicone, the metal form is opened, and the processor removed. 6. Packaging and Sterilisation Packaging and steralisation of medical devices is a requirement by law to insure the elimination of contamination risk and the potential for infection. Although shrouded by Cochlear for legal and disclosure reasons, it can be assumed that the most likely form of sterilisation for the Cochlear Baha Sound Processor is Chlorine Dioxide Gas Sterilisation (CDGS) (B. Linke 2011). This is due to the presence of electronic chips containing plastics and metals that are not able to withstand the extreme heat of steam. Radiation sterilisation is further discounted as these sound processors come into direct contact with skin and additionally interact with implanted underneath the skin. Therefore, this CDGS methodology is most likely. 7. Product Testing Product testing is conducted to ensure sound signals can be transmitted and received, and that all elements are fully functional. Aging and distribution testing must also be conducted to verify packaging integrity and strength (Steris Laboratories c.2016).

DOWNSTREAM SUPPORT ACTIVITIES Marketing: Cochlear’s marketing effort is towards raising awareness of the significant issue of hearing loss. The company draws in consumers to purchase its products through helping consumers identify their hearing problems. For example, one of its advertising campaigns involves a hearing test, where people assess their hearing abilities through listening to specific sounds of different sound frequencies (Sinclair 2016). The company is also concentrated on educating consumers about the surgical process of implanting Cochlear’s hearing device. The prime consumers’ misconception that Cochlear has to tackle is on the belief that Cochlear hearing implants are only for those who completely lose their hearing (Sinclair 2016). Distribution: Cochlear distributes and sells its products in over 100 countries. The distribution of Cochlear products happens through its warehouses in Sydney, Dubai, Hannover, London, Denver and Panama (Cochlear Pty Ltd 2018, p.8).

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Cochlear offers its products to emerging markets. For instance, China has been its leading emerging market that continues to utilise government subsidy to purchase Cochlear’s hearing implants for children who suffer hearing loss (Cochlear Pty Ltd 2018, p.16). Through continuing to distribute and develop its relations with leading countries, Cochlear expands its presence and establishes brand awareness. Customer service:

Cochlear creates multiple programmes and tools as an after-sales support to its customers (Cochlear Pty Ltd 2019):  Cochlear Family programme: once a customer becomes a recipient of a Cochlear device and joins the Cochlear Family account, the consumer is able to have access to current and future information about the device. They include information about device basics, warranty details, and troubleshooting help.  Online communication and hearing support programme: Cochlear established the Communication Corner programme that provides consumers online and printable activities to help better listening and communication skills.  Cochlear has an insurance support team that assists customers who encounter denied medical coverage for its products.  The company provides a hotline number for customers’ enquiries.

SECTION 2: The Costing System TRADITIONAL VS ABC Traditional notions of cost accounting hold that products or services consume resources (Swain and Fawcett, 1992). As such, total product cost equates to the sum of direct labour, direct material and overhead costs. These systems are designed to reflect either job or process costing, allocating overheads to individual products or services on a volume basis. Typically, a traditional costing system relies on direct labour hours or machine hours used to determine an average factory overhead rate (Wang, 2016). Therefore, long term this method negates to accurately allocate costs that are reflective of other aspects of production such as design, delivery activities and sales (Cooper and Kaplan, 1992). Conversely, Activity Based Costing (ABC) organises multiple cost pools by activity to allocate overhead costs. This varies from traditional costing systems such as plant wide and departmental allocation, which utilise one cost pool per plant or department (Langfield-Smith et al, 2015). ABC is unique in that it places the focus on the relationship between expenses and specific resource consumption required for individual products such as a Cochlear Sound Processor. The implementation of ABC entails two stages, the first of which splits overhead activities into activity cost pools. The overall consumption of overhead absorbed by each activity is used to determine a percentage rate. Stage two sees this percentage multiplied by the total overhead to assign a dollar sum to each activity cost pool. As a result, this allocation of overhead based on actual consumption highlights a more accurate calculation of cost based on cost per unit of activity driver (Swain and Fawcett, 1992). Following the determination of each rate, these are then applied to individual products using the allocated driver for each activity. ABC further differs from its conventional counterparts as these systems typically allocate fixed overheads arbitrarily with no direct association or relation to production (M. Reyhanoglu, 2004). ABC contrastingly ABC apportions cost of activities based upon the products’ activity usage (Saylor Academy, 2012). Widely used, this costing system provides more accurate costing information as it pinpoints unprofitable activities and wasted expenses (Woodruff, 2019). In terms of Cochlear Ltd, ABC would allow management to better understand the cost behaviour of its’ product Baha Sound Processors and increase profitability by knowing where to eliminate arbitrary costs and exploit excess capacity.

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ADVANTAGES AND DISADVANTAGES OF ABC As a global leader in the hearing assistance industry, Cochlear Ltd.’s impact on medicine has been both great and influential. Due to the heightened demand for medical assistance as disposable incomes in past decades have risen and patient access to healthcare has increased exponentially, product differentiation and volume of production has been amplified to cope with this demand. In the case of Cochlear Ltd, the industry standard in healthcare in recent decades has favoured ABC costing to more closely allocate fixed overheads of aspects of production that consume a greater portion of medical resources. The complex and specialised varied components of the Cochlear production process satisfy the parameters for ABC use. As asserted above, it is clear that a combination of human labour hours and machine hours are crucial in producing the Cochlear sound processors. These individual activities consume varying units of their respective cost drivers, thus highlighting the need for ABC to address this inequality of resource utilisation. As such, it is clear that this company growth requires changes in processes – namely the consideration of ABC to maintain accurate costings of specific activities. To demonstrate, Cochlear Ltd. Baha Sound processor range includes both the Baha® 5 Sound Processor and the Baha® 5 Power Sound Processor (Cochlear, 2019). Both products vary in terms of composition and complexity and therefore possess varying rates of consumption of company resources. By assisting in creating accurate cost data attributed to each product or in the case of Cochlear, each sound processor, ABC allows management to focus on the profitability of varying product types (Cooper and Kaplin, 1992). As cost pools and drivers break down the total cost of production, proportionate consumption of each product is revealed. In turn, as management is able to better understand the impact of expenses and revenues generated by various activities and departments, this allows for increasingly informed pricing strategy decisions (Swain and Fawcett, 1992). Due to the complexity of the Cochlear sound processor production process, this is beneficial as the analysis of cost of each component can highlight where costs can be curbed and profitability maximised. However, ABC is costly and difficult to implement where a complex production process is apparent. While traditional costing systems analyse limited overhead pools and therefore eliminate the time required to create the estimates (Hilton, 1994), heavy research and understanding of the company is necessary for ABC. As such, there is a risk for Cochlear’s employees to resist alternate costing methods as the implementation process is considered a “major organisational change” (Reyhanoglu, 2004).

COST CLASSIFICATION DIRECT COSTS DIRECT MATERIAL ITEM

RATIONALE

10 Layer Double-sided Circuit Board

According to Powerhouse Museum’s detailed description of each step of the production process (Powerhouse Museum, n.d.), Cochlear Ltd. most likely use 10 layer, double sided circuit boards as they are durable, lightweight, flexible, can be cut to the small custom sizes required by wearable technology and are able to withstand significant wear and tear. These circuit boards are the foundation for which all electrical components are connected as per the global registered patent (Santogrossi et al, 2015), and are therefore classified as direct materials. This component allows individuals to power the device on and off and control key features. This switch unit is unique to each product as must be costed as such. Therefore, it must be included as a direct material as the unit is inoperable without this addition. This diode emits various shades of light to visually indicate issues or functions of the processor. This, again, is unique to each item of stock and can be easily traced as such. As espoused by the Warren Centre for Advanced Engineering (The Warren Centre, 2010), lithium batteries are used in combination with

Push Button Switch

Dual-Colour Light

Lithium Battery

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Titanium Casing

Omni-Directional Microphone

Potentiometer

Silicone

the circuit board to power all electronics within the sound processor. Cochlear addresses the issue of weight and size by utilises ‘high density’ “Zinc-Air” and “Lithium Ion” technology sources. Depending on the model of processor, regular or power, batteries are either disposable or rechargeable (Sacic,...). The battery is a core component of the processor and as such, is deemed a direct material. Titanium alloys are used to encase the core circuit board and its components, in order to protect these electronics inherently exposed to greater risk of wear and tear. Titanium is hypoallergenic and nontoxic, and therefore biocompatible. Furthermore, titanium alloys are resistant to corrosion and have a high “strength-to-weight” ratio (Supra-Alloys, 2019) adding to the longevity and durability of the device. The omni-directional microphone is a key aspect of the sound processor that allows patients to receive audio signals which are then processed by the potentiometer discussed below. Audio signals vary from a person’s voice through to Bluetooth connectivity capabilities and further allow the patient to hear themselves speak. As such, this is a crucial item that must be included as a direct material. This variable resistor measures and harnesses electromotive force to control audio functions, frequencies and sound volumes on the sound processor. The potentiometer instrument enables the unit to control volume allowing an override of the microphones’ sensitivity should this become an issue for con...