Chapter 8

COST MANAGEMENT FOR PRODUCT LIFE CYCLE:

LIFE-CYCLE COSTING AND LONG-TERM PRICING;
TARGET COSTING AND THEORY OF CONSTRAINTS

LEARNING OBJECTIVES

 Decide the concepts of the cost life cycle and sales life concept
 Explain and apply the methods in analyzing strategic cost management issues of the cost-life cy-
cle such as
 Life-cycle costing
 Target costing
 Theory of constraints
 Distinguish between upstream costs, manufacturing and downstream costs of a product’s life
cycle
 Realize the importance of decision making at the design stage of a product
 Describe the characteristics of the common design models
 Explain the strategic cost management over the product’s sales life cycle
 Describe Target Costing and how it is applied in the cost-life cycle
 Know the techniques in reducing costs to a target cost level
 Explain the steps in implementing a target cost approach
 Describe the concept of the theory of constraints and how it is applies to improve the speed in
improving speed in the manufacturing process

COST MANAGEMENT FOR PRODUCT LIFE CYCLE

Life Cycle Costing
This chapter focuses on the time-dimension of cost management. Consideration is given both to (1) the
effect of the timeliness of operations on total costs and (2) the way in which costs change over the life
cycle of the product. Product life cycle is consideration in each of two aspects:
a) The cost life cycle
b) The sales life cycle

Cost life cycle is the sequence of activities within firm that begins with research and development,
followed by design, manufacturing, marketing/distribution and customer service.

Sales life cycle is the sequence of phases in the product’s or service’s life in the market – from the
introduction of the product or service to growth in sales and finally maturity, decline withdrawal from
the market.

Important strategic cost management issues arise in each activity of the cost life cycle. The methods
helpful in analyzing the cost life cycle are

A. Life-Cycle Costing
B. Target Costing and
C. Theory of Constraints

Life-Cycle Costing is used throughout the cost life cycle to minimize overall cost.
Target Costing is used for managing costs primarily in the design activity.
Theory of Constraints is a method for managing manufacturing costs.

Two of the methods, target costing and theory of constraints are particularly applicable to
manufacturing firms because they deal primarily with product design and manufacture. However,
each method also can be applied to service firm, to improve the efficiency and speed of the processes
involved in providing the service.
 A. COST MANAGEMENT FOR THE PRODUCT LIFE-CYCLE

Life cycling costing is a management technique used to identify and monitor the costs of product or
service throughout its life cycle. It provides a long-term perspective of product costs and product or
service profitability. For instance, a product that is designed quickly and carelessly, with little
investment in design costs, may have significantly higher marketing and service costs later in the life
cycle. Managers are interested in the total cost, over the entire life cycle, and not manufacturing costs
only.

Total cost over the product’s life cycle often is broken down into three components-upstream costs,
manufacturing cost and downstream costs.

FIGURE 8-1 Life-Cycle Costing

Marketing Custo
R&D Production & mer
Design Service

Upstream Activities Downstream Activities

LIFE-CYCLE COSTING

The sub components of these costs follow:

Upstream costs
Research and development
Design: prototyping, testing, concurrent engineering and quality
development
Industries with high upstream costs include computer software, specialized industrial and
medical equipment

Manufacturing costs
Purchasing
Direct manufacturing costs
Indirect manufacturing costs

Downstream costs
Marketing and distribution- packaging, shipping, samples, promotion, advertising
Service and warranty- recalls, service, product, liability, customer support
Industries with high downstream costs include pharmacratic, performer, cosmetics and
toiletries
Why Design is Important

Decision making at the design stage is critical. Although the costs incurred at the design stage may be
very small in relation to the total costs over the entire life cycle the decision stage decisions are
important because they lock in most of the remaining life-cycle costs.

The critical success factors at the design stage include:

1. Reduced time-to-market.
2. Reduced expected service costs.
3. Improves ease-of-manufacture.
 4. Process planning and design.

Reduced time-to-market
The speed of product development and the speed of delivery and efforts to reduce time-to-
market are critical for a business firm to sustain its competitiveness.

Reduced expected service costs

By careful simple design and the use of interchangeable or modular components can reduce
expected service costs.

Improves ease-of-manufacture
The design must be easy to manufacture in order to reduce production costs and speed
production.

Process planning and design

The plan for the manufacturing process should be flexible, allowing for fast setups and product
changeovers, using computer-integrated manufacturing computer assisted design and
concurrent engineering.

Common Design Models

The four common design methods are:

a. Basic engineering
b. Prototyping
c. Templating and
d. Concurrent engineering

Basic engineering
This is a method in which product designer’s work independently from marketing and
manufacturing to develop a design from specific plans and specifications.
Prototyping
This is a method in which functional models of the product are developed and tested by engineers
and trial customers.
Templating
This is a design method in which an existing product is scaled up or down to fit the specifications
of the desired new product.

Concurrent engineering
Concurrent engineering or simultaneous engineering is an important new approach in which
product design is integrated with manufacturing and marketing throughout the product’s life
cycle.

FIGURE8-2 Characteristics of the Four Design Methods

Design Design Design Cost Effect on Downstream

Method Speed Costs
Basic Fast Depends on desired Can be very high; as
engineerin complexity and marketing and production
g functionality; should be are not integral to the design
relatively low process
Prototypin Slow Significant; materials, Potentially a significant
 g labor and time reduction in downstream
costs
Templatin Fast Modest Unknown; can have costly
g unexpected if the scaling
does not work in the market
or in production
Concurren Continuou Significant; design is an The best method for
t s integral, ongoing process reducing downstream costs
engineerin
g

ILLUSTRATIVE CASE I. Life Cycle- Costing and Pricing

Star Communication Technologies Inc., has introduce a new phone so small that it can be carried
in a wallet. Star invested P400,000 in research and development for the technology, and another
P800,000 to design and test the prototypes. Star predicts a four-year life cycle for this model and
gathered this cost data for the wallet phone:
Monthly Fixed Cost Variable Cost
Manufacturing Cost P25,000 P20
Marketing Cost 20,000 5
Customer Cost 3,000 8
Distribution Cost 5,000 15

Sales prediction:
For price of P150 – average annual sales of P80,000 units
For price of P180 – average annual sales of P60,000 units
For price of P225 – average annual sales of P48,000 units

If the price of a wallet phone is P225, Star will have to increase the research and development
costs by P100,000 and the prototyping costs by P400,000 to improve the model for the higher
price. Fixed customer service costs also would increase by P500 per month and variable
distribution costs would increase by P5 per unit to improve the customer service and distribution
at the P225 level. At the lowest price level of P150fixed marketing costs would be reduced by
P5,000 per month because the low price would be the principal selling feature.

Required:

1. Determine the life cycle costs for each pricing decision.

2. What price will produce the most profit for Star for the wallet phone’s life cycle?

Solution to Illustrative Case 1: Life Cycle Costing and Pricing

Requirement 1 : Life Cycle costs for each decision

Price P150.00 P180.00 P225.00

Units Sold 80,000 P60,000 P48,000
revenues P12,000,000 P10,800,000 P10,800,000

Costs
R&D P400,000 P400,000 P500,000 more at P225
 Prototypes P800,000 P800,000 P1,200,000 More at P225

Manufacturing
Fixed P1,200,000 P1,200,000 P1,200,000 =25,000 X 12
months x 4
years
Variable P1,600,000 P1,600,000 P960,000 =20 per unit
Marketing
Fixed P720,000 P960,000 P960,000 =20,000 x 12 x
4 (15,000 at
P150)
Variable P400,000 P300,000 P240,000 = 5 per unit
Customer
Service
Fixed P144,000 P144,000 P168,000 =3,000 x 12 x 4
(3,500 at P225)
Variable P640,000 P480,000 P384,000 =8 per unit
Distribution
Fixed P240,000 P240,000 P240,000 =5,000 x 12 x 4
Variable P1,200,000 P900,000 P960,000 =15 per unit (20
at P225 price)

Total Costs P7,344,000 P4,176,000 P3,988,000

Requirement 2
The P150 price renders the highest expected profit.

COST MANAGEMENT OVER THE SALES LIFE CYCLE

The sales life cycle is the sequence of phases in the product’s or service’s life in the market from the
introduction of the product or service to growth in sales and finally, maturity, decline and withdrawal
from the market. Sales are first small, then peak in the maturity phase and decline thereafter.

FIGURE 8-3 THE SALES LIFE CYCLE OF A PRODUCT

Sales

Growth Maturity

Introduction

Decline

Time

Phases of The Sales Life Cycle

Phase 1: Product introduction

The first phase there is little competition, and sales rise slowly as customers become aware of
the new product or service. Costs are relatively high because of high R&D expenditures and
 capital costs for setting up production facilities and marketing efforts. Process are relatively
high because of product differentiation and the high costs at this phase. Product variety is
limited.

Phase 2: Growth
Sales begin to grow rapidly and product variety increases. The product continues enjoy
the benefits of differentiation. There is increasing competition and prices begin to soften.

Phase 3: Maturity
Sales continue to increase but at a decreasing rate. There is a reduction in the number of
competitors and product variety. Prices soften further, and differentiation is no longer
important. Competition is based on cost, given competitive quality and functionality.

Phase 4: Decline
Sales begin to decline, as do the number of competitors. Prices stabilize. Emphasis on
differentiation returns. Survivors are able to differentiate their product, control costs, and
deliver quality and excellent service. Control of costs and an effective distribution network are
key to continued survival.

Management Focus

In the first phase, the focus of management is on design, differentiation, and marketing. The focus
shifts to new product development and pricing strategy as competition develops in the second phase.
In the third and fourth phases, management’s attention turns to cost control, quality and service as
the market continues to become more competitive. Thus, the firm’s strategy for the product or services
changes over the sales life cycle, from differentiation in the early phases to cost leadership in the final
phases.

Strategic Pricing Strategy

The strategic pricing approach changes over the life cycle of the product or service. In the first phase,
pricing is set relatively high to recover development costs and to take advantage of product
differentiation and the new demand for the product. In the second phase, pricing is likely to stay
relatively high as the firm attempts to build profitability in the growing market. Alternatively, to
maintain or increase market share at this time, relatively low prices (penetration pricing) might be
used. In the latter phases, pricing becomes more competitive, and target costing and life-cycle costing
methods are used, as the firm becomes more of a price take rather than a price setter and makes
efforts to reduce upstream (for product enhancement) and downstream costs.

Cost Management System

Together with the change in strategy and pricing, there is a change in the cost management system.
At the introduction and into the growth phases, the primary need is for value chain analysis, to guide
the design of products in a cost-efficient manner. Master budgets also are used in these early phases
to manage cash flows; there are large development costs at a time when sales revenues are still
relatively small. As the strategy shifts to cost leadership in the latter phases, the goal of the costing
tools for accurate cost information.
Illustrative Case II: Sales Life-Cycle Analysis

The management accountant at the Aeron Manufacturing Company has collected these data in
preparation for a sales life-cycle analysis on one of its products, a leaf blower:

Item This Year Change over Average Annual Change

Last Year over the Last Four Years
Annual Sales P2,000,000 1.5% 19.6%
Unit sales price P400 2.0 6.9
 Unit profit P180 (0.8) 2.5

Required: Determine what stage of the sales life cycle the leaf blower is in.

Solution to Illustrative Case II: Sales Life-Cycle Analysis

It seems that sales are stabilizing since they only grew 1.5% over the past year and the average annual
growth over the past four years was 19.6%. The unit sales price has also showed, and the unit profit
its beginning decline. As a result, total profit is starting to level off. Because of these signs, it seems
that the leaf blower is in the early maturity stage.

Illustrative Case III: Strategic Costing and Pricing

Optic Care Inc. (OCI) manufactures specialized equipment for polishing optical lenses. There are two
models - one principally used for fine eyewear (l-25) and another for lenses used in binoculars,
cameras and similar equipment (BL-10).

The manufacturing cost of each unit is calculated by activity-based costing*,using these

manufacturing cost pools:

Cost Pools Allocation Base Costing Rate

1.Materials handling Number parts P1.85 per part
2.Manufacturing Hours machine time P11.40 per hour
supervision
3.Assembly Number parts P2.55 per part
4.Machine setup Each setup P43.30 per setup
5.Inspection and testing Logged hours P35 per hour
6.Packaging Logged hours P15per hour

OCI currently sells the BL-10 model for P1,050 and L-25 model for P725. Manufacturing costs and
activity usage for two products are:

Bl-10 L-25
Direct materials 126.50 58.19
Number parts 121 88
Machine hours 6.1 3.2
Inspection time 1.3 0.6
Packing time 0.7 0.4
Setups 2 1

Required:
1. Calculate the product cost and product margin for each product.
2. A new competitor has entered the market for lens polishing equipment with a superior product
at significantly lower prices – P750 for the BL-10 model Ann P550 for the L—25 model. To try
to compete, OCI Has made some radical improvements in the design and manufacturing of its
two products. While the costing rates have stayed the same, the materials costs and activity
usage rates have been decreased significantly :

Bl-10 L-25
Direct materials 111.50 48.30
Number parts 96 77
Machine hours 5.7 2.9
 Inspection time 10 0.5
Packing time 0.7 0.4
Setups 1 1

Calculate the total product cost with the new activity usage data.
Can OCI make a profit with the new costs, assuming that OCI must meet the price set by the
new competitor?
3. What cost management method might be useful to OCI at this time and why?

Solution to Illustrative Case II: Strategic Costing

Requirements 1 and 2

Requirement 3.
Cost Pool Allocation Bas Costing
Rate
Materials Handling Number of 1.85
Mfg. Supervision parts 11.40
Assembly Machine hours 2.55
Set-ups Number of 43.50
Inspection and parts 35.00
Test 15.00
Packaging Hours
Hours

Costs And Activity Usage for Each Product Current Received

BL-10 L-25 Bl-10 L-25
Direct materials 126.50 58.19 111.5 48.3
Number parts 121.00 88.00 96.00 77.00
Machine hours 6.10 3.20 5.70 2.90
Inspection time 1.30 0.60 1.00 0.50
Packing time 0.70 0.40 0.70 0.40
Setups 2.00 1.00 1.00 1.00

Activity-based
costs
Rate
Materials 126.50 58.19 111.50 48.30
Materials handling 1.85 223.85 162.80 177.60 142.45
Mfg. supervision 11.40 69.54 36.48 64.98 33.06
Assembly 2.55 308.55 224.40 244.80 196.35
Set-ups 43.50 87.00 43.50 43.50 43.50
Inspection & Test 35.00 45.50 21.00 35.00 17.50
Packaging 10.50 6.00 10.50 6.00
871.44 552.37 687.88 487.16
Price 1050.00 725.00 750.00 550.00
Margin 178.56 172.63 62.12 62.84

Target costing should be useful to OCI to assist the firm in meeting the new competition by finding
new ways to cut costs without reducing product quality or functionality.

B. TARGET COSTING
Target costing is a technique in which the firm determines the desired cost for the product or service,
given a competitive market price so the firm can earn a desired profit.

Target Cost = Competitive Price – Desired Profit

Target costing is a very way manage the needed trade-off between increased functionality and higher
cost.

FIGURE 8-4: TARGET COSTING IN THE COST LIFE CYCLE

Marketi Custo
Manufacturi
R&D ng ng & mer
Design Distribut Servic

TARGET COSTING

With its positioning in the early, upstream phases of the cost life cycle. Target Costing can clearly help
a firm educe total costs.

Steps in Implementing a Target Cost Approach

1. Determine the market price.

2. Determine the desired profit.
3. Calculate the target cost at market price less desired profit.
4. Use value engineering to identify ways to reduce product cost.
5. Use kaizen costing and operational control to further reduce costs.

The first three steps do not require additional explanation.

a. The role of value engineering
b. Kaizen costing and operational control.

a. Role of Value Engineering

Value engineering is used in target costing to reduce product cost by analyzing the trade-offs
between (1) different types and levels of products functionality and (2) total product cost. An
important first step in value engineering is a consumer analysis performed during the design
stage of the new or revised product. The consumer analysis identifies critical consumer
preferences that define the desired functionality for the new product.

The type of value engineering used depends on the functionality of the product. For one group
of products including camera, video equipment, functionality can be added or deleted relativity
easily. These are products that have frequent new models or updates and customer preferences
change frequently. On the other hand, for another group of products such as construction
equipment and heavy trucks, the functionality of the product must be designed into the
product rather than added on. In contract the first group customer preferences here are rather
stable.

Target costing is more useful for products in the first group because there are a large number
of features about which the firm has some discretion.

A common type of value engineering employed in these firms is functional analysis in which the
performance and cost of each major function or feature of the product is examined.
 An overall desired level of achievement of performance for each function is obtained while
keeping the cost of all functions below the target cost.

Another technique is benchmarking which is used to determined which features give the firm a
competitive advantage. Its objective is to come up with an overall bundle of features for the
product that achieve the desired balance of meeting consumer preferences while keeping the
costs below targeted level.

Design Analysis is the common form of value engineering for products in group two,
industrial and specialized products. The design team prepare several possible designs of the
product, each having similar features that have different levels of performance and different
levels of performance and different costs. The design team works with cost management
personnel to select the one design that best meets customer preferences while not exceeding
the target cost.
Other cost reduction approaches include cost tables and group technology.

Cost Tables are computer based databases that include comprehensive information about
firm’s drivers. Cost drivers include for example, the size of the product, the materials used in
its manufacture, and the number of features. Firms that manufacture different sized parts
from the same design (pipe fittings, tools and so on) use cost tables to show the difference in a
cost for parts of different sizes and different types of materials.

Group Technology is a method of identifying similarities in the parts of products a firm

manufactures, so the same parts can be used in two or more products, thereby reducing costs.
Large manufactures of diverse product lines, such as in the automobile, industry, use group
technology in this way. A point of concern in the use of group technology is that, while
manufacturing costs are reduced, service warranty costs might be increased if a failed part is
spread over many different models, with the result that a product recall will affect many more
customers.

b. Target Costing and Kaizen Costing

The fifth step in target costing is to use kaizen costing and operational control to further reduce
costs. Kaizen costing occurs at the manufacturing stage, so that the effects of value engineering
and improved design are already in place: the role for cost reduction at this phase is to develop
new manufacturing methods (such as flexible manufacturing system) and to use new management
techniques such as operational control, total quality management and the theory of constraints to
further reduce cost in the manufacturing process a product with a given design and functionality.

Illustrative Case IV. Target Costing

MotoDrive manufactures a wide variety of parts for recreational boating, including part
a and part b component for high powered outboard boat engines. The component is purchased
by original equipment manufacturers such as Mercury and Honda for use in large, more
powerful outboards. The units sell for P510 and sales volume averages 25,000 units per year.
Recently Motodrive’s major competitor reduced the price of its equivalent part to P450.
The market is very competitive and MotoDrive realizes it must meet the new price or lose
significant market share. The controller has assembled these cost and usage data for the most
recent year for Motodrive’s production 25,000 units.

Standard Actual Quantity Actual Cost

Cost
Materials P 5,125,000 P5,500,000
Direct Labor 1,750,000 1,670,000
Indirect Labor 2,500,000 2,359,000
Inspection 9hours and cost) - 2,000 350,000
 Materials handling (number of -
purchases and cost) 56,000 245,000
Machine setups (number and - 3,500 980,000
cost)
Returns and rework (number - 500 650,000
of times and cost) -
Total P11,169,000

Required:

1. Calculate the target cost for remaining current market share and profitability.
2. Can the target cost be achieved? How?

Solution to Illustrative Case IV: Target Costing

Requirement 1

Current unit cost P11,169,0000 = P446.76

2,5000
Current Profit per item:
Current selling price P510
Current unit cost 446.76
Profit per item P 63.24
Target cost to meet the competitive price:
Competitors price P450
Less: Desired Profit 63.24
Target Cost P386.76

Requirement 2

The target cost can probably be achieved by efforts in two areas:

a. The standard cost analysis shows an unfavorable materials variance of (P375,000 P5,500,000 –
P5,125,000) or 15 per unit, a very significant variance. Efforts to reduce or eliminate this
variance will make the firm much more competitive. Notice that the labor usage variances, both
for direct and indirect labor, are favorable, so it appears no additional work is needed here,
assuming the standards are properly set.

b. The manufacturing costs except for direct materials and direct labor can be considered non
value adding costs, since they do nit add to the functionality or quality of the product. Efforts
can be made to reduce the total cost of these manufacturing costs, which now total a
significant P3,999,000 or 159,69 per unit.

C.THEORY OF CONSTRAINTS

Most strategic initiative undertaken by firm today focus on improving the speed of their operations
throughout the cost life cycle. For many companies speed is a competitive edge. Shorter sales life cycle
in many industries mean that manufacturers are working to reduce product development time.

Theory of constraints is a process of identifying and managing constraints in the making of products
or in the providing of services. It also describes methods to maximize operating income when faced
with some bottleneck and some nonbottleneck operations.

Theory of Constraints (TOC) a technique used to improve speed in the manufacturing process and
thus speed.
In contrast to target costing, which focuses on the early phase of the cost life cycle, the Theory of
Constraints focuses on manufacturing activity.

The Theory of Constraints defines three measurements.

1. Throughput Contribution:

Revenue Direct Materials

Cost of Goods sold

2. Investment:
Sum of materials costs in direct materials, work in process and finished goods inventories,
R&D costs; and cost of equipment and buildings.

3. Operating Costs:
All cost of operations ( other than direct materials) incurred to earn throughout contribution.
Operating costs include salaries and wages, rent, utilities and depreciation.

Steps in Theory of Constraints Analysis

Step 1: Identify the binding constraint(s)

In the first step in the management accounts works with manufacturing managers and
engineers to identify binding constraints by developing a network diagram of the flow of
production. A network diagram is a flowchart of the work done that shows the sequence of the
processes and the amount of the time required for each. The purpose of the network diagram
is to help the management accountant look for signs of bottle neck. A bottle neck often is
indicated by a process with relatively large amounts of inventory accumulating, or where there
are long lead times. Task analysis, which describes the activity of each process in detail, also
could be used to identify binding constraints.

Step 2: Determine the Most Efficient Utilization for Each Binding Constraint

In this step, the management accountant determines how to most effectively utilize the firms
resources. The approach differs somewhat depending on whether there is one product, or two
or more. If there is one product, the management accountant looks for ways to maximize the
flow of production through the constraints.

Step 3: Manage the Flows Through the Binding Constraint

In step 3, the objective is to manage the flow of production in and out of the binding
constraints to smooth the flow of production throughout the plant. The orderly scheduling of
production prevents the building of materials or work in process inventory at various
processes. An important tool for managing product flow in this context is the drum buffer rope
(DBR) system, which is a system for balancing the flow of production through a binding
constraint.

Step 4. Add Capacity to the Constraint

As a longer-term measure to relieve the constraint and improve cycle time management should
consider adding capacity to the constraints by adding new or improved machines and/ or
additional labor.

Step 5: Redesign the Manufacturing Process for Flexibility and fast Cycle Time
The most complete strategic response to the constraints is to redesign the manufacturing
process, including the introduction of new manufacturing technology, deletion of some hard to
manufacture products, and redesign of some product greater ease of manufacturing. Simply
removing one or more minor features on a given product might speed up the production
process significantly. The use of value engineering as described earlier might help at this point.
The problems requiring the application requiring the application of “theory of constraints” may
also be resolved using Linear Programming technique.

Illustrative Problem 8-1: Theory of constraints, throughput Contribution, quality,

relevant costs.

Basic data on Columbia Industries follow:

Columbia Industries manufactures electronic testing equipment. Columbia also installs the
equipment at customers sites and ensure that it functions smoothly. Additional information on
the manufacturing and installation departments is as follows (capacities are expressed in terms
of the number of its units of electronic testing equipment):

Equipment Equipment Installed

Manufacture
Annual capacity 400 units per year 300 units per year
Equipment manufactured and installed 300 units per year 300 units per year

Columbia manufacture only 300 units per year because the Installation Department has only
enough capacity to install 300 units. The equipment sells for P40,000 per unit (installed) and
has direct materials costs of P 15,000. All costs other than direct materials costs are fixed.

Case I

Columbia’s engineers have found a way to reduce equipment manufacturing time. The new
method would cost an additional P50 per unit and would allow Columbia to manufacture 20
additional units per year. Should Columbia implement the new method?

Answer:
It will cost Columbia P50 per unit to reduce manufacturing time. But manufacturing is not a
bottleneck operation; installation is. Therefore, manufacturing more equipment will not
increase sales and throughput contribution. Columbia Industries should not implement the
new manufacturing method.

Case II.

Columbia’s designer have proposed a change in direct materials that would increase direct
materials costs by P2,000 per unit. This change would enable Columbia to install 320 units of
equipment each year. If Columbia makes the change, it will implement the new design on all
equipment sold. Should Columbia use the new design?

Answer:
Additional relevant costs of new direct materials,
P2,000X320 units P640,000
Increase in throughout contribution, P25,000 x 20 units P 500,00

The additional incremental costs exceed the benefits from higher throughout contribution by
P140,000, so Columbia Industries should not implement the new design?

Alternatively, compare throughput contribution under each alternative.

Current throughput contribution is P25,000 x 300 P7,500,000
With the modification, throughput contribution is
23,000x320 P 7,360,000
 The current throughput contribution is greater than the throughput contribution resulting
from the proposed change in direct materials. Hence Columbia Industries should not
implement the new design.

Case III

A new installation technique has been developed that will enable Columbia’s engineers to
install 10 additional units of equipment a year. The new method will increase installation costs
by P50,000 each year. Should Columbia implement the new technique?

Answer:
Increase in throughput contribution P25,000 x 1o units P 250,000
Increase in relevant costs P 50,000
The additional throughput contribution exceeds incremental costs by P200,000, so
Columbia Industries should implement the new installation technique.

Case IV

Columbia is considering how to motivate workers to improve their productivity (output per
hour).One proposal is to evaluate and compensate workers in the manufacturing and
installation departments on the basis of their productivities. Is the new proposal a good idea?

Answer:
Motivating installation workers to increase productivity is worthwhile because
installation is a bottleneck operation, and any increase in productivity at the bottleneck
will increase throughput contribution. On the other hand, motivating workers in the
manufacturing department to increase productivity is nit worthwhile. Manufacturing is
not a bottleneck operation, so any increase in output will result only in extra inventory
of equipment. Columbia Industries should encourage manufacturing to produce only as
much equipment as installation department needs, not to produce as much as it can.
Under these circumstances, it would not be a good idea to evaluate and compensate
manufacturing workers on their basis of their productivity.

Illustrative Case V: Theory of Constraints

Kable Inc. manufactures a part XX3, used in automobiles. Three processes are involved in the
production of XX3: drilling, inserting and packaging. Each process performed at a separate
workstation and has these performance characteristics:

 The drilling function can drill 30,000 parts per hour.

 The inserting function can insert 3,000 parts per 5 minutes.
 The packaging function can package 10,000 parts per half hour.

Required: How many units of XX3 can be manufacture in a week, and which process is the
binding constraints?

Answer:
The packaging function is the constraint because only 20,000 parts can be packaged an hour
whereas 30,000 can be drilled 36,000 can be inserted.
Assuming a 40 hour work week, the number manufactured/ week
= 20,000 x 40 hours = 800,000/ week.
 DIAGNOSTIC EXERCISES-THEORIES/PROBLEMS

QUESTIONS:
1. What is life cycle costing and why is it used?
2. Do cost management practices change over the product’s sales life cycle?
3. For what types firms is life cycle costing most appropriate and why?
4. Explain the difference in intended application between sales life cycle analysis and life cycle
costing?
5. What are the different methods of product engineering used in product design and life cycle
costing?
6. What is meant by the sales life cycle? What are the phases of the sales life cycle? How does
it differ from the cost life cycle?
7. Do pricing strategies change over the different phases of the sales life cycle? Explain how.
8. What is target costing, and what type of firms is use it?
9. For what types of firms is target costing most appropriate and why?
10. What is meant by the concept of the value engineering? How is it used in target costing?
11. Explain the two methods for reducing total product cost to achieve a desired target cost.
Which is most common in the consumer electronics industries? In the specialized
equipment manufacturing industries?
12. What is the main difference between activity-based costing and the theory of constraints?
When it is appropriate to use each one?
13. What is the role of the network diagram in the theory of constraints analysis?
14. What is meant by a binding constraint in the theory of constraint analysis? A non-binding
constraint?
15. Name the five steps of the theory of constraints and explain the purpose of each. Which is
the most important step and why?
16. For what types of firms is the theory of constraints analysis most appropriate and why?

Problem 1(Matching Market Characteristics with sales Life –Cycle Stages)

Activities and Market Characteristics Sales Life-Cycle Stage

Decline in sales _______________________________
Advertising _______________________________
Boost in production _______________________________
Stabilized profits _______________________________
Competitor’s entrance into market _______________________________
Market research _______________________________
Market saturation _______________________________
Start production _______________________________
Product testing _______________________________
Termination of product _______________________________
Large increase in sales _______________________________

Required: insert the appropriate life-cycle stage in the space provided after each activity.

Problem 2 (Life-Cycle Costing)

The following revenue and the cost data are for Round Manufacturing’s to radial saws. The RM 200 is
for the commercial market and the RM 800 is fir industrial customers. Both products are expected to
have three life cycles.

RM200
Year 1 Year 2 Year 3
 Revenue Costs P 500,000 P2,000,000 P2,500,000
Research and development 1,000,000 -0- -0-
Prototypes 300,000 50,000 -0-
Marketing 60,000 320,000 475,000
Distribution 80,000 120,000 130,000
Manufacturing 20,000 800,000 1,000,000
Customer Service -0- 60,000 85,000
Income P (960,000) P650,000 P810,000

RM800
Year 1 Year 2 Year 3
Revenue Costs P 900,000 P1,800,000 P2,000,000
Research and development 1,150,000 -0- -0-
Prototypes 550,000 30,000 10,000
Marketing 124,000 200,000 260,000
Distribution 170,000 300,000 410,000
Manufacturing 85,000 600,000 700,000
Customer Service -0- 20,000 10,000
Income P (1,179,000) P650,000 P610,000

Required:

1. How would a product life-cycle income statement differ from this calendar-year income
statement?
2. Prepare a three-year-life-cycle income statement for both products. Which product appears to
be more profitable?
3. Prepare a schedule showing each cost strategy as a percentage of total annual costs. Pay
particular attention to the research and development and customer service categories. What do
you think this indicates about the profitability of each product over three-year-life-cycle?

Problem 3 (Target Costing in a Service Firm)

TARA Alarm Systems install home security. Two of TARA’s systems, the MCU 100 and the MCU 900,
have these characteristics:

Design Specifications MCU 100 MCU 900

Video cameras 1 3
Video monitors 1 1
Motion detectors 5 8
Floodlights 3 7
Alarms 1 2
Wiring 700 ft. 1,100 ft.
Installation 16 hrs. 26 hrs.

Cost Data for Both Systems

Video cameras P150/ea.
Video monitors P 75/ea.
Motion detectors P 15/ea.
Floodlights P8/ea.
Alarms P 15/ea.
Wiring P0.10/ea.
 Installation 20/hr.

The MCU 100 sells for P810 installed and the MCU 900 sells for P 1,520.

Required:
1. What are the current profit margins on both systems?
2. TARA’s management believes it must drop the price on the MCU 100 to P750 and the MCU 900
to P1,390 to remain competitive in the market. Recalculate profit margins for both products at
these price levels.
3. Describe two ways that TARA could cut is costs to get profit margins back to their original
levels.

Problem 4 (Target Costing, Strategy)

Benchmark Industries manufactures large workbenches for industrial use. Wally Garcia, the vice
president for marketing at Benchmark’s standard table because of aggressive pricing by competitors.
Benchmark’s table sells for P875 whereas the competition’s comparable table is selling in the P800
range. Garcia has determined that dropping price to P800 is necessary to regain the firm’s annual
market share of 10,000 tables. Cost data based on sales of 10,000 tables are:
Budgeted Amount Actual Amount Actual Cost
Direct materials 400,000 sq. ft. 425,000 sq. ft. P2,700,000
Direct labor 85,000 hrs. 100,000 hrs. 1,000,000
Machine setups 30,000 hrs. 30,000 hrs. 300,000
Mechanical 320,000 hrs. 320,000 hrs. 4,000,000
assembly

Required:
1. Calculate the current post and profit per unit.
2. How much of the current cost per unit is attributable to non-value-added activities?
3. Calculate the new target cost per unit for a sales price of P800 if the profit per unit is
maintained.
4. What strategy do you suggest for Benchmark to attain target cost calculates in requirement 3?

Problem 5 (Target Costing; Warehousing)

Yanny Ceramic, a wholesaler, has determined that its operations have three primary activities:
purchasing, warehousing and distributing. The firm reports the following pertinent operating data for
the year just completed:

Activity Cost Driver Quantity of Cost Cost per Unit of

Driver Cost Driver
Purchasing Number of purchasing 1,000 P100 per order
orders
Warehousing Number of moves 8,000 20 per move
Distributing Number of shipments 500 80 per order

Yanny buys 100,000 units at an average cost of P5 per unit and sells them at an average unit price of
P10. The firm also has a fixed operating cost of P 100,000 for the year.

Yanny’s customers are demanding a 5 percent discount for the coming year. Yanny expects to sell the
same quantity if the demand for price reduction can be met. Yanny’s suppliers, however, are willing to
give only 4 percent discount.
Required:
Yanny has estimated that the number of purchasing orders can be reduced to 800 and P5 decrease in
the cost of each shipment can be achieved with minor changes in operations. Any further cost saving
has to come from reengineering the warehousing process. What is the maximum cost (i.e., target cost)
for warehousing if the firm desires to earn the same amount of profit next year?

Problem 6 (Theory of Constraints, Throughout Contribution, Relevant Costs)

The Zashi Corporation manufactures filing cabinets in two operations – machining and finishing. It
provides the following information.

Machining Finishing
Annual capacity 100,000 units 80,000 units
Annual production 80,000 units 80,000 units
Fixed operating costs (excluding direct
materials P6,400,000 P4,000,000
Fixed operating costs per unit produced
(P 6,400,000 ÷ 80,000; P 4,000,000
÷ 80,000) P80 per unit P50 per unit

Each cabinet sells for P720 and has direct materials costs of P320 incurred at the start of the
machining operation. Zashi has no other variable costs. Zashi can sell whatever output it produces.
The following requirements refer only to the preceding data. There is no connection between the
requirements.

Required:
1. Zashi is considering using some modern jigs and tools in the finishing operation that would
increase annual finishing output by 1,000 units. The annual cost of these jigs and tool is
P300,000. Should Zashi acquire these tools? Show your calculations.
2. The production manager of the Machining Department has submitted a proposal to do faster
setups that would increase the annual capacity of the Machining Department by 10,000 units
and cost P50,000 per year. Should Zashi implement the change? Show your calculations.

Problem 7 (Theory of Constraints, Throughput Contribution, Relevant Costs)

Refer to the information in Problem 6 in answering the following requirements. There is no connection
between the requirements.

Required:
1. An outside contractor offers to do finishing operation for 12,000 units at p100 per unit, double
the P50 per unit that it costs Zashi to do the finishing in-house. Should Zashi accept the
subcontractor’s offer? Show your calculations.
2. The Rainee Corporation offers machine 4,000 units at P40 per unit, half the P80 per unit that
it costs Zashi to do machining in-house. Should Zashi accept the subcontractor’s offer? Show
you calculations.

Problem 8 (Theory of Constraints, Throughput Contribution, Quality)

Refer to the information in Problem 6 in answering the following requirements. There is no connection
between the requirements.

Required:
1. Zashi produces 2,000 defective units at the machining operation. What is the cost to Zashi of
the defective items produced? Explain your answer briefly.
 2. Zashi produces 2,000 defective units at the finishing operation. What is the cost to Zashi of the
defective items produced? Explain your answer briefly.

Multiple Choice

1. The critical success factors for a business today are all:

a. planning-oriented c. sales-oriented
b. production-oriented d. customer-oriented

2. The Theory of Constraints (TOC) focuses on improving cycle time, the rate at which raw
materials are converted to finished product. This strategic management technique is primarily
concerned with the critical success factor of:
a. energy c. originality
b. quality d. speed

3. The key concept in TOC is:

a. benchmarking c. the bottleneck
b. throughout d. reengineering

4. Which of the following determines the desired cost for a product based upon given competitive
price?
a. benchmarking c. reengineering
b. target costing d. life-cycle costing

5. Target costing forces the firm to become more competitive, like:

a. reengineering c. activity-based costing
b. life-cycle costing d. benchmarking

6. Which of the following is not one of the steps in the life cycle of a product?
a. manufacturing, inspecting, packaging, warehousing
b. research and development
c. purchasing and receiving
d. marketing, promotion, distribution

7. In comparison to the Cost Life Cycle of a product, the Sales Life Cycle of a product is:
a. much shorter
b. much longer
c. exactly parallel, except that it is expressed in sales terms
d. different because it represents a sequence of phases relating to sales, not production.

8. In each of the phases of a product’s sales life cycle, management’s focus will be:
a. parallel c. different
b. on the next phase as well as the current one d. undifferentiated

9. Generally, firms will price a product more competitively at which stage of the products sales life
cycle?
a. product introduction c. maturity
b. growth d. decline

10. Because of the four stages of a product’s sales life cycle has a different emphasis, the cost
management system will be expected to provide data that is:
a. different at each stage c. lesser in amount in the later stages
b. common to all stages d. lesser in amount in the early stages
 11. The sequence of activities within the firm which begins with research and development,
followed by design, and manufacturing, marketing/ distribution, and customer service is
the :
a. sales life cycle c. market life cycle
b. target life cycle d. critical life cycle

12. The sequence of phases in the product or service’s life in the market- from the introduction of
the product or service to the growth in sales and finally maturity, decline, and withdrawal from
the market is the:
a. sales life cycle c. market life cycle
b. target life cycle d. cost life cycle

13. When a firm determines the desired cost for a product or service, given a competitive market
price, in order to earn a desired profit, the firm is:
a. target costing c. variable costing
b. life cycle costing d. absorption costing

14. Which one of the following is used in target costing to reduce product cost by analyzing the
tradeoffs between (1) different types and levels of product functionality and (2) total product
cost?
a. benchmarking c. productivity analysis
b. functional analysis d. value engineering

15. Which one of the following is a common type of value engineering in which each major function
or feature of the product is examines in terms of its performance and cost?
a. benchmarking c. productivity analysis
b. functional analysis d. functional engineering

16. Which one of the following is a common form of value engineering in which the designing team
prepares several possible designs of the product?
a. benchmarking c. productivity analysis
b. functional analysis d. design analysis

17. Which one of the following is not one of the five steps in TOC analysis?
a. Identify the binding constraint(s)
b. Determine the most efficient utilization for each binding constraint.
c. Manage the flow through put the binding constraint.
d. Deduct capacity from the constraint.

18. Which one of the following is true concerning TOC?

Short-Term Focus Long-Term Focus Cost Drivers
a. No No Yes
b. No Yes No
c. Yes No No
d. No Yes Yes

19. Which one of the following is a downstream cost?

a. research and development c. purchasing
b. packaging d. prototyping

20. Which one of the following industries has high upstream costs?
a. retail c. cosmetics
b. perfumes d. computer software

21. Which of the following is not a critical success factor at the design stage?
a. Improved ease-of-manufacture
b. Reduced time-to-market
 c. Reduced expected services costs
d. Enhanced quality

22. Which one of the following is not a common design method?

a. concurrent engineering c. templating
b. design engineering d. prototyping