Cost Planning For The Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
Cost Planning For The Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
Cost Planning For The Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
QUESTIONS
10-1 A firm has two options for reducing costs to a target cost level:
a. Reduce costs to a target cost level by integrating new manufacturing
technology, using advanced cost management techniques such as activity-based
costing, and seeking higher productivity through improved organization and
labor relations. This method of cost reduction is common in specialized
equipment manufacturing.
b. Reduce cost to a target cost level by redesigning a popular product. This
method is the more common of the two, because it recognizes that design
decisions account for much of total product life cycle costs (see Exhibit 10-3). By
careful attention to design, significant reductions in total cost are possible. This
approach to target costing is associated primarily with Japanese manufacturers,
especially Toyota, which is credited with developing the method in the mid
1960s. This method of cost reduction is common in consumer electronics.
10-2 The sales life cycle refers to the phase of the products sales in the market - from
introduction of the product to decline and withdrawal from the market. In
contrast, the cost life cycle refers to the activities and costs incurred in
developing a product, designing it, manufacturing it, selling it and servicing it.
The phases of the sales life cycle are:
Phase One: Product Introduction. In the first phase there is little
competition, and sales rise slowly as customers become aware of the new
product. Costs are relatively high because of high R&D expenditures and capital
costs for setting up production facilities and marketing efforts. Prices are
relatively high because of product differentiation and the high costs at this
phase. Product variety is limited.
Phase Two: Growth. Sales begin to grow rapidly and product variety
increases. The product continues to enjoy the benefits of differentiation. There
is increasing competition and prices begin to soften.
Phase Three: 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 Four: Decline. Sales begin to decline, as does 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.
10-4 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 (Chapter 8) are also used in these early phases to manage cash flows;
there are large developmental costs at a time when sales revenues are still
relatively small. Then, as the strategy shifts to cost leadership in the latter
phases, the goal of the cost management system is to provide the detailed
budgets and activity-based costing tools for accurate cost information.
10-5 Target costing is a method by which the firm determines the desired cost for the
product, given a competitive market price, so that the firm can earn a desired
profit. It is used by several manufacturing firms, particularly in the automotive
and consumer products industries, such as Honda, Toyota, Ford, Volkswagen,
and Olympus camera.
10-6 Life-cycle costing considers the entire cost life cycle of the product, and thus
provides a more complete perspective of product costs and product profitability.
It is used to manage the total costs of the product across its entire life cycle. For
example, design and development costs may be increased in order to decrease
manufacturing costs and service costs later in the life cycle.
Step Five: Redesign the Manufacturing Process for Flexibility and Fast
Throughput
Consider a redesign of the product of production process, to achieve faster
throughput.
One could argue that any step could be the most important; for example step
one can be considered to be the most important because the analysis
undertaken is intended to improve the speed of product flow through the
constraint.
10-9 The purpose of the flow diagram is to assist the management accountant in the
first step of TOC, to identify the constraints.
10-10 The methods of product engineering and design in life-cycle costing are:
Basic engineering is the method in which product designers work independently
from marketing and manufacturing to develop a design from specific plans and
specifications.
Prototyping is a method in which functional models of the product are developed
and tested by engineers and trial customers.
Templating 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, or simultaneous engineering, is an important new
approach in which product design is integrated with manufacturing and
marketing throughout the products life cycle.
10-11 Value engineering is used in target costing to reduce product cost by analyzing
the tradeoffs between different types and levels of product functionality and total
product cost. Two common forms of value engineering are:
10-12 Activity-based costing (ABC) is used to assess the profitability of products, just
as is TOC. The difference is that TOC takes a short-term approach to
profitability analysis, while ABC develops a longer-term analysis. The TOC
analysis has a short-term focus because of its emphasis on materials related
costs only, while ABC includes all product costs. On the other hand, unlike TOC,
ABC does not explicitly include the resource constraints and capacities of
production operations. Thus, ABC cannot be used to determine the short-term
best product mix. ABC and TOC are thus complementary methods; ABC
provides a comprehensive analysis of cost drivers and accurate unit costs as a
basis for strategic decisions about long-term pricing and product mix. In
contrast, TOC provides a useful method for improving the short-term profitability
of the manufacturing plant through short-term product mix adjustments and
through attention to production bottlenecks.
10-13 TOC is appropriate for many types of manufacturing, service and not-for-profit
firms. It is most useful where the product or service is prepared or provided in a
sequence of inter-related activities as can be described in a network diagram
such as shown in Exhibit 10-6. The most common users of TOC to date have
been manufacturing firms who use it to identify machines or steps in the
production process which are bottlenecks in the flow of product and profitability.
10-14 Target costing is most appropriate for firms that are in a very competitive
industry, so that the firms in the industry compete simultaneously on price,
quality and product functionality. In very competitive markets such as this, target
costing is used to determine the desired level of functionality the firm can offer
for the product while maintaining high quality and meeting the competitive price.
10-15 Life-cycle costing is most appropriate for firms which have high upstream costs
(i.e. design and development) and downstream costs (i.e. distribution and
service costs). Firms with high upstream and downstream costs need to manage
the entire life cycle of costs, including the upstream and downstream costs as
well as manufacturing costs. Traditional cost management methods tend to focus
on manufacturing costs only, and for these firms, this approach would ignore a
significant portion of the total costs.
10-17 Takt time is the ratio of available manufacturing time for a period to the units of
customer demand for that period. Each unit must be produced within the Takt
time to satisfy customer demand. Takt time is computed for each manufacturing
operation, and those operations with longer Takt times are the constraints in the
manufacturing process.
10-18 Pricing based on the cost life cycle is a common form of pricing. It involves a
markup on full product cost or product life cycle cost. In contrast, pricing based
on the sales life cycle bases the product price on competitive factors, including
which phase of the sales life cycle (introduction, growth, maturity, or decline) the
product is currently in.
10-23 Takt time = 6,000 x 4 weeks per month/200,000 units per month = .12 hour/unit
or 7.2 minutes per unit
10-24 20 - 1 = 19 days
Note that new product development time and order taking time are not
considered part of the manufacturing cycle and are excluded from
cycle time.
1. The takt time for this product is the number of available hours / total
demand.
1., 2.
Cost and Activity Usage for Each Product Current Revised
A-10 A-25 A-10 A25
Direct Materials $ 143.76 $ 66.44 $ 78.65 $ 42.45
Number of parts 121 92 110 81
Machine hours 6 4 5 2
Inspecting time 1 0.6 1 0.5
Packing time 0.7 0.4 0.7 0.2
Set-ups 2 1 1 1
Activity-based Costs
3. The solution uses Goal Seek or trials in the Excel sheet. The number of
parts must be reduced to 101 or fewer to get at least $50 margin.
Cost and Activity Usage for Each Product Current Revised
A-10 A-25 A-10 A-25
Direct Materials $ 143.76 $ 66.44 $ 78.65 $ 42.45
Number of parts 121 92 101 81
Machine hours 6 4 5 2
Inspecting time 1 0.6 1 0.5
Packing time 0.7 0.4 0.7 0.2
Set-ups 2 1 1 1
Activity-based Costs
Cancun Jamaica
Package
Specifications Unit Cost Quantity Cost Quantity Cost
Oceanfront room;
number of nights $30 6 $180 4 $120
Meals:
Breakfasts $5 7 35 5 25
Lunches $7 7 49 5 35
Dinners $10 6 60 0 0
Scuba diving trips $15 4 60 2 30
Water skiing trips $10 5 50 2 20
Airfare (round trip $200 (Cancun),
from Miami) $355 (Jamaica) 1 200 1 355
Transportation to $15 (Cancun),
and from airport $10 (Jamaica) 1 15 1 10
TOTALS $649 $595
3. The airfare costs are the largest component of cost and this category
could have room for improvement. By further negotiating group discount
rates or searching for lower cost discount carriers, Take-a-Break could lower
its cost in this category.
Room costs also comprise a major portion of total package costs. While
Take-a-Break could negotiate deals with off-beachfront hotels or opt for non-
oceanfront rooms, this might decrease the value of the trip in the eyes of its
customers. A better option would be to further negotiate group rates with its
current hotel providers.
3. $2,850 price per unit - $1,500 profit per unit = $1,350 per unit target cost
6. The contribution margin, gross margin, and operating profit are shown in
the right-hand portion of the table above. For example,
$2,785,500 = $176.183 x 30,000 - $2,500,000
The pricing methods yield prices from $176.00 to $202.00 The
highest price, $202, has the advantage that it provides the desired return on
investment, a more precise statement of the firms goal than in the other
methods. On the other hand, the lower price might be an advantage if the
firm is trying to achieve sales growth and is concerned about maintaining or
improving market share during turns in the business cycle for its customers.
This latter concern is especially important given that the demand for the
firms product is a derived demand, and there is little that Johnson can do to
influence total auto sales.
Price per Rental for 20% profit margin = $864,000 / 64,000 rentals in
ten years = $13.50
Source: The Right Stuff for the GIs of the Future, Business Week, August
15, 2005, pp 74-75.
Geoffrey Colvin, writing in Fortune, points out that many firms today have
less flexibility in setting prices. The factors that have traditionally provided
pricing power are brands, intellectual property, and high entry barriers:
Brands: Colvin points out that many brands, including Coke, Nike,
and McDonalds, are under attack from a number of sources, including
those who are opposed to what they see as the social ills caused by these
firms
Intellectual Property: Colvin points out that firms around the world are
having more success at copying, legally or illegally, the patented products
such as Viagra, or entertainment products music and movies
High Entry Barrier: As Michael Porter notes (chapter 2), high entry
barriers for an industry can protect it from competition, through high costs of
facilities, patents, government regulations, etc. However, Colvin notes that
many of these barriers can now be hurdled by companies that use new
technologies, including the Internet.
Source: Geoffrey Colvin, Pricing Power Aint What it Used to Be, Fortune,
September 15, 2003, p 52.
2. The cost index for wait staff is somewhat less than the importance index,
which indicates that Hannah should consider increasing the resources
applied to wait staff more wait staff, higher pay etc. In contrast, customer
satisfaction does not appear to reward the level of expenditure for food
ingredients; perhaps savings could be made here.
ICU 100: ($810 - $729 total costs)/$ 810 = 10% profit margin
ICU 900: ($1,520 - $1,361)/$1,520 = 10.46% profit margin
2. ICU 100: ($750 - $729 total costs)/ $750 = 2.8% profit margin
ICU 900: ($1,390 - $1,361)/$1,390 = 2.09% profit margin
3. The installation costs are the largest component of cost and this
category could have room for improvement. By redesigning the layout
of the systems or finding components that integrate more readily, the
installation times could then be reduced. Also, costs could be lowered
by contractual bargaining with electricians to reduce the per hour rates
for installation.
The video equipment and motion detectors are sources of
significant costs, but decreasing the quality or quantity of these items
would substantially change the effectiveness and value of the security
systems.
3. $800 price per unit - $75 profit per unit = $725 per unit target cost
1. The target cost, at the price of $1,500 and the desired margin of 20%
would be
2.
Currently With Cost Savings
Reductions
Manufacturing $1,000 $835 $85-25+105 = $165
Cost
Marketing Cost 200 200
GSA Cost 225 175 $50
Total Cost $1,425 $1,210 $215
The cost savings of $215 are not sufficient to get the product total cost
($1,210) down to the desired target cost of $1,200. Given that National
might be willing to pay a higher price, and since the cost difference is
relatively small, it seems that Morrow should in fact pursue the order. Here
are some other considerations:
a. Morrow should consider the short versus the long term issues of taking
on the order. In the short term, as noted in chapter 3, the fixed costs of
manufacturing the order will not change and therefore can be considered
irrelevant for the order if it is a one time special order. Thus, for a short term
analysis, Morrow should determine that portion of manufacturing, marketing,
and GSA costs that are fixed and exclude them from the analysis. In
contrast, if Morrow expects this to be a regular customer, that Morrow will be
supplying National these parts for several months or years, then the total
costs including fixed costs are relevant, as in the calculations above. In the
longer term, Morrow must cover all costs of production and sale, while in the
short term only the variable costs are relevant.
c. The problem notes that the manufacturing costs are standard full costs.
Since the costs are given at standard, this means that there are no apparent
inefficiencies reflected in the reported $1,425. However, the question still
remains whether the standard costs are properly determined. Should the
standards be revised?
The target cost to meet the competitive price is $109 - $30 = $79.
Target Cost
Sales $20.00 x 100,000 x .90 = $1,800,000
Desired profit 320,000
Total cost allowed $1,480,000
Total costs excluding warehousing:
Purchase $1,000,000 x .98 = $980,000
Purchasing order $150 x 700 = 105,000
Distributing $75 x 500 = 37,500
Fixed operating cost $250,000 1,372,500
Maximum warehousing cost $ 107,500
2. When the value index is compared to the target cost, the percentage
investment in hull & keel and standing rig looks too low
The value index for hull & keel is 35.5% while the cost index is 30%; the
value index for the standing rig is 20.1% while the cost is only 15%. Ranger
might benefit from additional design enhancement of features related to
these two components.
PEC-1 PEC-2
Price $200 $250
Materials cost 110 137.50
Throughput margin 90 112.50
Constraint time (min) 45 75
Throughput/minute $2.00 $1.50
PEC-1 PEC-2
Demand 40 15
Production plan, PEC-1 40
Constraint time used, 40x45=1,800 2,000 -1,800=200
remaining
Production plan, PEC-2 200/75=2.667; round to 2
Total Throughput 40 x $90 = $3,600 2 x $112.50 = $225.00
First, summarize key information and obtain hours capacity in each process:
Second, identify the constraint. In this case the constraint is staining time,
where there is a need for 85 more hours of capacity
2. Part one above solves the first two steps of the TOC, to identify the
constraint and determine the most profitable product mix. The third step, to
maximize flow through the constraint, would require Colton to look for ways
to speed up the staining operation, by simplifying it, by training the operator,
or other means. In the fourth TOC step, Colton could consider adding a part
time employee to add capacity at the constraint, though it might be difficult
to find a skilled employee who wanted part time work. Adding a full time
employee would be unnecessary and wasteful, unless the motel contract
works out. In the final TOC step, Colton should consider the possibility of
re-design, by for example using a different type of stain that requires less
time and skill.
With the information available Don can complete the first two steps of
TOC as shown below. The analysis shows that the reactor process is
the constraint, and that in the short run, Polymer 1 is the most
profitable product. The most profitable product mix is 60 units of
Polymer 1 and 35 units Polymer 2. Until the production delays can be
dealt with (TOC steps 3-5), Don should advise IPC to meet all the
sales demand of Polymer 1 and to advise customers of Polymer 2
there would be some delays in the shortterm. Then, IPC should work
quickly to relieve the constraint, reactor time, by applying the third,
fourth and fifth TOC steps. Without specialized technical knowledge
of the manufacturing processes in this industry, one can only
speculate about what these steps might be.
Departments
1 2 3 4
Machine Hours needed
611 1,000= 500= 1,000= 1,000=
500x2 500x1 500x2 500x2
613 400= 400= 0 800=
400x1 400x1 400x2
615 2,000= 2,000= 1,000= 1,000=
1,000x2 1,000x2 1,000x1 1,000x1
Total hours needed 3,400 2,900 2,000 2,800
Hours Available 3,000 3,100 2,700 3,300
Excess (deficiency) (400) 200 700 500
2. The best product mix is 400 units of Product 613, 500 units of
product 611, and 800 units of product 615.
611 613 615
Price $196 $123 $167
Variable Cost* 103 73 97
Throughput/unit $93 $50 $70
Machine hours in Dept 1 2 1 2
Throughput/hour $46.50 $50.00 $35.00
* For example, variable cost for 611 = $(7+12+21+24+9+27+3)
Production/sales Plan
Total hours available in Dept 1 3,000
First: 400 units of 613; 400x1 hours 400
Second: 500 units of 611; 500x2 hours 1,000
Hours remaining
1,600
Third: 800 units of 615; 1,600/2 hours per unit = 800
All 3,000 hours used
2.
Xderm Yderm Total
Sales $3,000,000 $2,000,000 $5,000,000
Cost of goods sold 1,900,000 1,600,000 3,500,000
Gross profit $1,100,000 $ 400,000 $1,500,000
Research and dev. (720,000) (180,000) (900,000)
Selling expenses (80,000) (20,000) (100,000)
Profit before taxes $300,000 $ 200,000 $ 500,000
3.Now, the two products have the same return on sales. This
illustrates that including the upstream and downstream costs can be
very important in getting a useful analysis of product profitability.
Failing to include these non-manufacturing costs, as Waters did at
first, may lead to incorrect marketing and management decision
making, as the firm may have a biased and incorrect idea of the most
profitable product(s). Calculation return on sales (not required) shows
that each product has the same return under life cycle costing.
1. A product life cycle statement would aggregate the three years into
one that shows the totals in each category for the life of the
product.
3.
L40 2005 2006 2007
Revenues $ 800 % $ 2,300 % $ 3,100 %
Costs 0 0 0
Research and Development 1,400 74.1% - 0.0% - 0.0%
Prototypes 350 18.5% 50 3.1% - 0.0%
Marketing 60 3.2% 600 37.5% 475 23.3%
Distribution 60 3.2% 120 7.5% 130 6.4%
Manufacturing 20 1.1% 770 48.1% 1,350 66.2%
Customer Serivce - 0.0% 60 3.8% 85 4.2%
Total Cost 1,890 1,600 2,040
The analysis shows how the distribution of costs for both products shifts
from research and development in the first year to manufacturing and
customer service in the last year. The shift is most pronounced for L40
which has high development costs.
Costs
R&D $1,000,000
Clinical Trials $2,108,000
Manufacturing
Fixed $5,000,000 x 5 = $25,000,000
Variable $68x3,000,000 = $204,000,000
Packaging
Fixed $380,000 x 5 =$1,900,000
Variable $20 x 3,000,000 = $60,000,000
Distribution
Fixed $1,125,000 x 5 = $5,625,000
Variable $6.50 x 3,000,000= $19,500,000
Advertising
Fixed $2,280,000 x 5 = $11,400,000
Variable $12 x 3,000,000= $36,000,000
Total Cost $366,533,000
Price $235
Units Sold 3,000,000
Revenues $705,000,000
Costs
R&D $1,000,000
Clinical Trials $2,108,000
Manufacturing
Fixed $1,500,000 x 5 =$7,500,000
Variable $80 x 3,000,000= $240,000,000
Packaging
Fixed $380,000 x 5 = $1,900,000
Variable $60,000,000
Distribution
Fixed $1,125,000 x 5 =$5,625,000
Variable $19,500,000
Advertising
Fixed $2,280,000 x 5 =$11,400,000
Variable $36,000,000
Total Cost $385,033,000
It appears that selling the drug patent is the best alternative since
receiving $425,000,000 ($300,000,000 + $25,000,000 x 5) over the
five year period is greater than the operating incomes of both the other
options. However, in order to determine the real value of selling the
patent one needs to consider the present value of the annuity stream,
the $25,000,000 at the end of every year for the next 5 years. Assume
a discount rate of 10%, and the present value of the five-year annuity
(an annuity factor of 3.791 at 10%) is $25,000,000 x 3.791 =
$94,775,000. Thus the total value of the sale of the patent is
$94,775,000 + $300,000,000 = $394,775,000. The best alternative is
selling the patent.
Note that the activities BG and GE are not crashed in the final solution
because they are not on the critical path. Reducing time on these
activities will not reduce the overall project time.
3. The total incremental costs Bob Peterson will have to pay for this
revised accelerated delivery schedule amount to $8,300, or a new
total project cost of $73,400 from the original $65,100, and a saving of
10 days.
Cramped space
Focus on speed
everywhere Reduced
(no concern for Throughput Orders delayed, some
downtime or orders and profits
throughput..) lost
WIP up
Increased
holding cost