Atkinson6esm Chapter 08

Chapter 8 Measuring Life-Cycle Costs

QUESTIONS 8-1

In the Total-life-cycle costing (TLCC) approach, companies are required to manage all the costs incurred through all the stages of a product’s life-cycle viz. through product design and development, through manufacturing, marketing, distribution, maintenance, service, and, finally, disposal. This is why total-life-cycle costing is referred to as ‘cradle-to-grave’ costing.

8-2

The three major stages of the total-life-cycle costing approach are (1) research, development and engineering (RD&E), (2) manufacturing, and (3) post-sale service and disposal.

8-3

Post-sale service cost refers to those costs that are incurred by an organization after the sale of its products to the customer i.e. these costs are incurred after the first unit of a product is in the hands of the customer. Disposal costs refer to those costs that are incurred for eliminating any harmful effects associated with the end of a product’s useful life i.e. these costs are incurred after the product is withdrawn from the market. In a product’s total-life-cycle, post-sales service cost is usually incurred prior to the disposal cost.

8-4

The three substages of the RD&E stage are (1) using market research to assess emerging customer needs that lead to idea generation for new products, (2) product design, during which scientists and engineers develop the technical aspects of the product, and (3) product development, during which the company creates the features critical to customer satisfaction and designs prototypes, production processes, and any special tooling required.

8-5

During the post-sale service and disposal stage, organizations have to consider both the costs involved in providing service to products as soon as they are in the hands of customers, as well as the costs of ultimately disposing – 41 –

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of the product. The following three substages typically occur during this stage: (1) rapid growth from the first time the product is shipped through the growth stage of its sales, (2) transition from the peak of sales to the peak in the service cycle, and (3) maturity from the peak in the service cycle to the time of the last shipment made to a customer; disposal occurs at the end of a product’s life and lasts until the customer retires the final unit of a product. 8-6

Target cost is defined as the difference between the target selling price and the target profit margin. Under the target costing approach, target cost is shown in the following equation: Ctc = S tc– Ptc where, Ctc = Target cost S tc= Target selling price Ptc= Target profit margin

8-7 The different steps observed under target costing for determining the cost of a product are: • Conducting market survey for inputs from customers regarding their perceived value of the product i.e. knowing the target selling price; • Deciding upon the desired level of profit margin of the product; • Deducting the desired level of profit margin from the target selling price to arrive at the target cost of the product. 8-8

For product development and target costing purposes, customers’ needs or requirements must be translated into product functions or components for engineering. A quality function deployment matrix relates information about customer requirements (that is, features that customers require) to a product’s functions or components. The matrix may also include a competitive evaluation of the product. In this way, the matrix highlights the relationship among competitive offerings, customer requirements, and a product’s design parameters. The matrix is used to compute functional (component) rankings of how important each component is to customers, and these rankings are in turn used to compute a value index (benefit/cost ratio) for each component. If the value index is less than one, the cost exceeds the benefit, and the component is a likely candidate for cost reduction in efforts to achieve the target cost. 8-9 Cost analysis is an element of the target costing approach that involves determining what components of a product is to be targeted for cost reduction and then assigning a cost target to each of these components. Cost analysis focuses on the interaction between components and parts. – 42 –

Chapter 8: Measuring Life-Cycle Costs

8-10 In the context of value engineering, a value index is the ratio of the value (degree of importance) to the customer and the percentage of total cost devoted to each component. It is a measure which helps to identify the components for cost reduction. 8-11 The OFD matrix displays information about the three variables in a matrix format. These variables are: features, functions (components), and competitive evaluation. 8-12 The break-even time (BET) metric for the product development process measures the length of time from the project’s beginning until the product has been introduced and generated enough profit to pay back the investment originally made in its development. 8-13 The break-even time (BET) metric brings together in a single measure three critical elements in an effective and efficient product development process. First, for the company to break-even on its R&D process, its investment in the product development process must be recovered. So BET requires tracking the entire cost of the design and development process. It provides incentives to make the product development process faster and less costly. Second, BET stresses profitability. It encourages marketing managers, manufacturing personnel, and design engineers to work together to develop a product that meets real customer needs, including offering the product through an effective sales channel at an attractive price, and at a manufacturing cost that enables the company to earn profits that can repay the product development investment cost. And third, BET is denominated in time: it encourages the launch of new products faster than the competition so that higher sales can be earned sooner to repay the product development investment. 8-14 Desirable behavioral consequences that are likely as people focus on improving the break-even time (BET) metric include collaboration and integration across organizational functions. People from different disciplines come together at the start of every product development project to estimate the time and money they require to perform their tasks, and the impact of their efforts on the success of the entire project. The BET metric promotes discussion and facilitates decision-making during the project among people from the multiple functions as more information about the project, customers, and competitors becomes available.

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8-15 Using percent of revenues from new products as a performance metric may fail to stimulate highly innovative products because this metric can lead product developers to introduce new products that are small variations of existing products. With this approach, a company’s products run the risk of becoming stale or being copied by competitive offerings, and prices and margins will consequently decline. 8-16 Nonfinancial measures that a company might use in order to motivate achieving the objective of anticipating future customer needs include (1) time spent with key customers at targeted accounts learning about their future opportunities and needs, and (2) the number of new projects launched based on customer input. 8-17 Nonfinancial measures that a company might use in order to motivate achieving the objective of reducing product development cycle time across an array of products include (1) number of projects delivered on time, (2) average time spent by projects at the development, test, and launch stages of the development process, and (3) total RD&E time from idea to market. 8-18 Activities included in environmental costing include selecting suppliers whose philosophy and practice in dealing with the environment match those of buyers, disposing of waste products during the production process, and incorporating postsale service and disposal issues into management accounting systems. 8-19 Explicit environmental costs include the direct costs of modifying technology and processes, costs of cleanup and disposal, costs of permits to operate a facility, fines levied by government agencies, and litigation fees. Implicit environmental costs often pertain to the infrastructure required to monitor environmental issues. Examples of implicit environmental costs include legal counsel, administration, employee education and awareness, and the loss of goodwill if environmental disasters occur. EXERCISES 8-20 The total-life-cycle costing approach differs from the traditional product costing in that it includes the research, development and engineering (RD&E), manufacturing, and post-sale service and disposal cycles. Traditional product costing is more narrowly focused and is concerned only with costs incurred during the manufacturing stage of the total product life cycle.

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Chapter 8: Measuring Life-Cycle Costs

8-21 The benefits of using a total-life-cycle costing approach to product costing include providing managers with the “big picture” of managing costs over the research development and engineering; manufacturing; and post-sale service and disposal cycles. Such a perspective allows managers the opportunity to see how decisions made in one stage affect costs throughout the entire product life cycle. This perspective is not possible under the traditional product costing approach. The total-life-cycle costing approach should therefore lead to more cost-effective products and services. 8-22 The traditional accounting focus in managing costs is on the manufacturing stage of the total life cycle of a product. The most significant problem with this focus is that the traditional method ignores product costs before manufacturing (in the research, development and engineering (RD&E) stage) as well as those that occur after manufacturing (in the post-sale and disposal stage). The limited focus is especially problematic because it is common for 80-85% of a product’s life cycle costs to be committed by decisions made in the RD&E cycle. 8-23 Exhibit 8-2 illustrates the relationship between costs committed and costs incurred over the total life cycle of a product. The top curve, “cost committed,” shows how a very large percentage (80–85%) of product life cycle costs are assigned or committed to by an organization during the premanufacturing (research development and engineering) stage of the total product life cycle. Costs continue to be committed up through the end of the life cycle, but these costs level off during the manufacturing and post-sale service and disposal stages. The bottom curve, “costs incurred,” illustrates the actual costs incurred by the organization over the various stages of the life cycle. Note that a small percentage of costs are incurred during the research, development and engineering stage, but these costs increase significantly during the manufacturing and post-sale service and disposal stages. The implications are: (1) managers need to manage costs at the RD&E stage, (2) all stages of the life cycle are important, and (3) the RD&E stage is the critical stage in managing later costs. 8-24 The disposal phase of the post-sale service and disposal stage of a product begins when the first unit of product is retired by the customer and ends when the last unit of product is retired by the customer. Disposal costs are most relevant when an organization has to eliminate any harmful effects associated with the end of a product’s life. 8-25 The features of target costing are: • It is a method of profit planning and cost reduction. – 45 –

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• • • • •

It focuses on reducing costs for products in the research development and engineering stage of the total life cycle of a product. Target costing uses the total-life-cycle concept. In other words, it considers all aspects of the value chain and explicitly recognizes total-life-cycle costs. Target costing is a customer driven approach. Under target costing, market research is not a single event; rather customer inputs are obtained continually throughout the process. Product engineers attempt to design costs out of the product before design and development ends and manufacturing begins. Its aim is continuous cost reduction.

8-26 Value engineering is a process in which each component of a product is scrutinized to determine whether it is possible to reduce costs while maintaining functionality and performance. It is a key activity within target costing. Value engineering consists of the following two sub-activities: 1. Identify components for cost reduction. It involves choosing which components of the product are to be selected for cost reduction. It requires the computation of value index. 2. Generate cost reduction and function enhancement ideas. Engineers are engaged in creative thinking and brainstorming to identify what can be reduced, eliminated, combined, substituted, rearranged, or enhanced to provide the same or higher level of functionality from a component at less cost. 8-27 Cost analysis, which is a key activity within target costing, is performed by the engineers. It involves the following five sub-activities: 1. 2.

3.

Development of a list of product components and functions: Cost reduction efforts start by listing the various product components and identifying the functions that they perform and their current estimated cost. Performance of a functional cost breakdown: Each of the various parts and components of a product performs a specific function. This step involves the identification of that function and estimation of the costs of those components. Determine the relative importance of customers’ requirements: In order to connect a product’s functions to the features that customers want, engineers first assess the relative importance that customers place on the various features. They conduct a formal survey of prospective customers asking them to rank the relative importance of the product’s eight features. – 46 –

Chapter 8: Measuring Life-Cycle Costs

4.

5.

Relating features to functions: It involves the conversion of the relative rankings of features into an importance ranking for each product function. The components carry out the functions of a product and are the key design parameters, this step relates customer rankings to the components that best meet that particular requirement. For generating this relationship, the engineers use a tool called a quality function deployment (QFD) matrix. Develop relative functional rankings: The QFD matrix enables the engineers to convert feature rankings into functional or component rankings

8-28 Some of the potential problems in implementing a target costing system from a behavioral point of view are: (a) conflicts that arise between parties involved in the target costing process, (e.g., the conflict that arises between suppliers and the target costing organization when too much pressure is placed on suppliers to cut their costs), (b) burnout among employees, and (c) some employees (such as senior executives) reject the idea and do not understand its value. 8-29 A manager asked to benchmark another organization’s target costing system would want information pertaining to the method by which target prices and target margins (and consequently, target costs) are set, supplier relations, how the organization uses value engineering to reduce costs, and the organizational structure and culture needed to manage the target costing process. While these are critical variables on which to gather information, target costing always has to be studied and understood in relation to the specific organization involved. 8-30 The target costing relationship is expressed in the following equation form: C = S − P , where C is the target cost, S is the target selling price, and P is the target profit margin. This equation differs from the other two types of traditional equations relating to cost reduction in the following ways. The first traditional cost reduction method is expressed as follows: P = S − C . The desired profit margin, P, is found by subtracting the estimated cost, C, from the expected selling price, S. The second traditional approach, known as the cost-plus method, expresses the relationship among variables as S = C + P . Under cost-plus, an expected profit margin is added to the expected product cost. Price is simply the result of the sum of these two variables. Unlike the traditional approaches, target costing focuses on achieving a particular cost target.

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8-31 (a) Percent Contribution of Each Component to Customer Requirements

Customer Requirements Tastes/smells like expresso Easy to clean

Brew Basket 0.7 × 20% = 14% 0.5 × 16% = 8%

Looks nice Has 6+ cup capacity Starts automatically on time Has multiple grinder settings

0.1 × 16% = 1.6% 0.1 × 8% = 0.8% 0.5 × 12% = 6%

Heating Display Element Panel 0.3 × 20% = 6%

0.4 × 16% = 6.4% 0.5 × 8% = 4% 0.5 × 12% = 6%

0.4 × 8% = 3.2%

22.4%

10.8%

0.8 × 12% = 9.6%

9.6%

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20%

8% 12%

1× 16% = 16% 0.9 × 4% = 3.6% 0.2 × 12% = 2.4%

Relative Feature Ranking

16%

0.1 × 4% = 0.4%

Keeps the coffee warm Automatic shutoff Converted component ranking

Carafe

Component Body/ Coffee Water Warmer Well

16% 4% 12%

16.4%

6.0%

1× 12% = 12%

12%

34.8%

100%

Chapter 8: Measuring Life-Cycle Costs

(b) Value Index for Kitchenhelp’s Coffeemaker Component or Function Brew Basket Carafe Coffee Warmer Body/ Water Well Heating Element Display Panel

(2) Component Cost

(3) Relative Importance

18.0% 4.0% 6.0% 18.0% 8.0% 46.0%

22.4% 10.8% 9.6% 16.4% 6.0% 34.8%

(3) ÷ (2) Value Index

Action Implied

1.24 2.70 1.60 0.91 0.75 0.76

Enhance Enhance Enhance Reduce cost Reduce cost Reduce cost

The body/ water well, heating element, and display panel are candidates for cost reduction because their value indexes are less than 1.

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8-32 As shown below, Greyson’s new break-even time occurs during Quarter 3 of Year 4, approximately 15 months later than the initial 30 months (Year 3, Quarter 2). (000)

Y1, Q1

Y1, Q2

Y1, Q3

Y1, Q4

Y2, Q1

Y2, Q2

Y2, Q3

Y2, Q4

Market Research $(100) $(50) Product Development (80) (150) (150) (150) (150) (150) (150) Selling Price Cost per unit Margin/unit Sales quantity Contribution MSDA expenses Product profit Quarterly Profit/Loss $(100) $(130) $(150) $(150) $(150) $(150) $(150) $(150) Cumulative Profit/Loss $(100) $(230) $(380) $(530) $(680) $(830) $(980) $(1,130)

(000)a

Y3, Q1

Y3, Q2

Y3, Q3

Y3, Q4

Y4, Q1

Y4, Q2

Y4, Q3

Y4, Q4

Market Research Product Development $(60) Selling Price $19 $18 $18 $17 $17 $16 $15 $15 Cost per unit 10 10 10 10 10 10 10 10 Margin/unit $9 $8 $8 $7 $7 $6 $5 $5 Sales quantity 25 35 45 50 50 50 40 30 Contribution $225 $280 $360 $350 $350 $300 $200 $150 MSDA expenses 120 120 120 120 120 120 120 120 Product profit $105 $160 $240 $230 $230 $180 $80 $30 Quarterly Profit/Loss $45 $160 $240 $230 $230 $180 $80 $30 Cumulative Profit/Loss $(1,085) $(925) $(685) $(455) $(225) $(45) $35 $65 a All amounts except selling price, cost per unit, and margin per unit are in 1,000s.

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Chapter 8: Measuring Life-Cycle Costs

8-33 As shown below, Greyson will now never reach a break-even time. Beginning with Y4, Q4, Greyson will incur quarterly losses of $20,000 and will never show a positive cumulative profit. (000)

Y1, Q1

Y1, Q2

Y1, Q3

Y1, Q4

Y2, Q1

Y2, Q2

Y2, Q3

Y2, Q4

Market Research $(100) $(50) Product Development (80) (150) (150) (150) (150) (150) (150) Selling Price Cost per unit Margin/unit Sales quantity Contribution MSDA expenses Product profit Quarterly Profit/Loss $(100) $(130) $(150) $(150) $(150) $(150) $(150) $(150) Cumulative Profit/Loss $(100) $(230) $(380) $(530) $(680) $(830) $(980) $(1,130)

(000)a

Y3, Q1

Y3, Q2

Y3, Q3

Y3, Q4

Y4, Q1

Y4, Q2

Y4, Q3

Y4, Q4

Market Research Product $(60) Development Selling Price $18 $17 $17 $16 $15 $15 $15 $15 Cost per unit 10 10 10 10 10 10 10 10 Margin/unit $8 $7 $7 $6 $5 $5 $5 $5 Sales quantity 20 30 40 45 45 35 30 20 Contribution $160 $210 $280 $270 $225 $175 $150 $100 MSDA 120 120 120 120 120 120 120 120 expenses Product profit $40 $90 $160 $150 $105 $55 $30 $(20) Quarterly $(20) $90 $160 $150 $105 $55 $30 $(20) Profit/Loss Cumulative Profit/Loss $(1,150) $(1,060) $(900) $(750) $(645) $(590) $(560) $(580) a All amounts except selling price, cost per unit, and margin per unit are in 1,000s.

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8-34 To use activity-based costing to help control and reduce environmental costs, the activities that cause environmental costs must be identified. Next, the costs associated with the activities must be determined. These costs must then be assigned to the most appropriate products, distribution channels and customers. As in all types of management accounting and control systems, it is only when managers and employees become aware of how the activities in which they engage generate environmental costs that they can control and reduce them. Environmental costs include explicit costs, such as the direct costs of modifying technology and processes, costs of cleanup and disposal, costs for permits to operate a facility, fines levied by government agencies and litigation fees. Implicit environmental costs are often more closely tied to the infrastructure required to monitor environmental issues. These costs include administration and legal counsel, employee education and awareness, and the loss of goodwill if environmental disasters occur. Using traditional cost systems, environmental-related costs are often hard to pinpoint because they are usually hidden in support cost pools. PROBLEMS 8-35

(a) To prepare an exhibit similar to Exhibit 8-9, first compute the relative cost percents illustrated in Exhibit 8-6 and the relative rankings illustrated in Exhibit 8-7.

Chassis Transmission Air conditioner Electrical system Other function groups Total

Target Cost $1,400 280 100 700 4,520 $7,000

Customer Requirements Safety Comfort and convenience Economy Styling Performance Total

Importance 140 120 40 60 140 500

Function Group

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Percent of Cost 20.0 4.0 1.4 10.0 64.6 100.0 Relative Ranking in Percent 28% 24% 8% 12% 28% 100%

Chapter 8: Measuring Life-Cycle Costs

Customer Requirements

Comfort and convenience Economy

Chassis 0.3 × 28% = 8.4% 0.3 × 24% = 7.2% 0.2 × 8% = 1.6%

Function Group Air CondiElectrical tioner System 0.1 × 28% = 2.8% 0.1 × 0.1 × 24% = 24% = 2.4% 2.4% 0.1 × 0.1 × 8% = 8% = 0.8% 0.8%

Transmission 0.1 × 28% = 2.8%

0.2 × 8% = 1.6%

Other Function Groups 0.5 × 28% = 14% 0.5 × 24% = 12% 0.4 × 8% = 3.2%

Relative Feature Ranking

28% 24%

8%

Styling

Performance

Converted component ranking

0.1 × 12% = 1.2% 0.3 × 28% = 8.4%

0.2 × 28% = 5.6%

26.8%

10.0%

0.1 × 28% = 2.8% 3.2%

0.9 × 12% = 10.8% 0.4 × 28% = 11.2%

8.8%

12% 28%

51.2%

100%

(b) The value index is a benefit/cost ratio, obtained by dividing the relative importance in column (3) by the associated relative cost column (2).

Cost

(3) Relative Importance

(3) ÷ (2) Value Index

20.0% 4.0%

26.8% 10.0%

1.34 2.50

Enhance Enhance

1.4%

3.2%

2.29

Enhance

10.0%

8.8%

0.88

Reduce cost

64.6%

51.2%

0.79

Reduce cost

(2) Function Group Chassis Transmission Air conditioner Electrical system Other function groups

Action Implied

(c) The electrical system and other function groups are candidates for cost reduction because their value indexes are less than 1.

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8-36 The traditional focus of cost management has been only on manufacturing processes. Under this approach, pre-manufacturing costs, such as research and development, and post-manufacturing costs, such as service, are considered period costs, and companies expense them in the period incurred. Thus, these costs are in no way linked to individual products. Traditional accounting procedures and the way that many organizations have been separated by department or function (e.g., design engineering, manufacturing, marketing, logistics, installation and postal service), often lead managers to focus myopically on their own department’s costs. In particular, for the manufacturing function, defining product costs as those solely related to the manufacturing process ignores many costs associated with the entire life cycle cost of a product. Understanding the total life cycle costs (TLCC) of a product or service, or the product costs incurred before, during, and after the manufacturing cycle is critical, as decision makers can more completely analyze and understand what creates product costs. For example, if a company can reduce a product’s design and development costs at the pre-manufacturing stage, it also is possible to reduce all other subsequent product-related (downstream) costs such as manufacturing and service-related costs. A TLCC system provides information for managers to understand and manage costs through a product’s design, development, manufacturing, marketing, distribution, maintenance, service, and disposal stages. The total life approach is also known as managing costs “from the cradle to the grave.” 8-37 Gregoire Grant is shortsighted. The manufacturing cycle of the total-life-cycle costing approach is only one of three major stages of the product life cycle concept. The other life cycle concepts are research, development and engineering, and post-sale service and disposal. While each concept is useful within its respective functional area, from a total-life-cycle costing (TLCC) perspective, it is important to integrate the concepts and to understand them in their entirety. Such integration allows managers to see the big picture and to manage whole-life product costs in a comprehensive fashion. For example, poor decisions in the research development and engineering stage may lead to much higher costs in the manufacturing and post-sale service stages. Thus, it is in Gregoire’s best interest to understand what is occurring in the research development and engineering stage. In order for managers at Gregoire’s company to fully adopt the TLCC view, it will probably be necessary to break down what are called “functional silos.” Functional silos are traditional parts of organizations that are often thought (by those in them) to be self-contained. Breaking these down often means – 54 –

Chapter 8: Measuring Life-Cycle Costs

reorganizing the company into cross-functional teams who share a vision of integration across their previous functions. Another critical aspect to understanding the importance of the TLCC perspective is management education. The company should consider educational programs in which their managers can learn about the benefits of and gain commitment to the TLCC perspective. 8-38 The target cost for a Calcutron calculator is computed as follows: Target sales (800,000 calculators × $100)

$80,000,000

Less: Target profit (20% × $100/calculator × 800,000 calculators)

16,000,000

Target cost for 500,000 calculators

$64,000,000

Unit target cost ($64,000,000/800,000 calculators) $80. 8-39 To compute the return on sales (ROS) for Roger Twickenham, it is necessary to determine Roger’s profit margin: Sales (640,000 units × $750) $480,000,000 Less: Expenses 264,000,000 = Profit Margin (ROS × Sales) $216,000,000 ROS × $480,000,000 = $216,000,000, so ROS = 45%. Thus, Roger Twickenham has met the company-wide return-on-sales target of 35%. Thus, it seems Roger’s targets were better achieved than the companywide return-on-sales target, which explains the causes for his good performance. 8-40 Some studies of target costing in Japan indicate that there are potential problems in implementing the system, especially if focusing on meeting the target cost diverts attention away from other elements of overall company goals. These potential problems include the following: (1) Senior executives and workers may reject target costing. Education about the benefits of target costing should be provided in order to gain top management commitment to target costing, and top management commitment should be communicated to employees involved in the target costing process.

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(2) Conflicts can arise between various parties involved in the target costing process. First, companies can put excessive pressure on subcontractors/suppliers to conform to the schedule and to reduce their costs. This can lead to alienation and/or failure of the subcontractor. Second, design engineers become very upset when other parts of the organization are not as cost conscious as they are. Since they work very hard to squeeze pennies out of the cost of a product, they think that other parts of the organization (administration, marketing, distribution) should also be as cost conscious. Often this is not the case. To overcome this problem, pressure can be reduced on subcontractors/suppliers by giving them reasonable grace periods over which cost reduction must occur. Simply demanding cost reduction immediately will exacerbate the conflict. The issue of design engineers also can be addressed by making other parts of the organization as cost conscious. Adopting a total-life-cycle costing approach and using cross-functional teams will help the organization to this end. (3) Employees in many Japanese companies working under target costing goals experience burnout due to the pressure to meet the target cost. Burnout is particularly evident for design engineers. This issue can be addressed by making target-costing goals tight, but attainable. Often organizations make the mistake of setting impossible goals. Design engineers also often fear that if they make the target, in the next period, the target will be “ratcheted up” and made even more difficult to achieve. Thus, they may consciously try to make sure that they do not achieve the target unless their jobs rest on it. The organization has to be careful not to burn out employees, and design engineers in particular, as they are extremely valuable to the organization. Burnout is probably the biggest issue related to the success or failure of target costing in Japan. (4) While the target cost may be met, there may be increased development time because of repeated value engineering cycles to reduce costs, which ultimately can lead to the product being late getting to market. For some types of products, being six months late to market may be far more costly than having small cost overruns. This is a very serious problem for the organization. Clearly, there is a tradeoff between continuing to reduce target costs and being very late to market. However, on average, many months of lost sales – 56 –

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will have a much more detrimental effect on the organization than whether target costs are met. Thus, the organization has to take a reasonable approach to target costing and not lose sight of the ultimate goal of selling the product and increasing market share. Time limits can be put in place for the length of time allowed to develop or introduce new products. 8-41 There are some similarities between traditional cost reduction and target costing, but the differences are more striking. Both the traditional costing method and target costing begin with market research into customer requirements followed by product specification. Under traditional cost reduction, companies engage in product design and engineering, and obtain prices from suppliers. Product cost at this stage is not a significant factor for product design. After the engineers and designers have determined product design, they estimate product cost and if the estimated cost is too high, then product design may have to change. The desired profit margin is found by subtracting the estimated cost from the expected selling price. Profit margin is the result of the difference between the expected selling price and the estimated production cost. Under another traditional method, cost-plus, the expected profit margin is added to the expected product cost and selling price is the result of the sum of these two variables. Under target costing, after market research to determine customer requirements and product specification, the process is quite different. The next step, determining a target selling price and target product volume, depends on the company’s perceived value of the product to the customer. The target profit margin results from a long-run profit analysis, often based on return on sales (net income/sales). The target cost is the difference between the target selling price and the target profit margin. Once the target cost is set, the company must determine target costs for each component. The value engineering process includes examination of each component of a product to determine whether it is possible to reduce costs while maintaining functionality and performance. In some cases, product design might change, materials used in production might need replacing, or manufacturing processes might require being redesigned. Suppliers also play a critical role in making target costing work. If manufacturers with market power decide that there is a need to reduce the cost of specific components, they will pressure suppliers to find ways to reduce costs. 8-42 Bringing in outside consultants to implement a target costing system can be effective, but costly. Consultants often have a great deal of knowledge that they can bring to an organization and in this sense the organization does not have to “start from scratch.” A downside of using consultants is that, in some – 57 –

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instances, consultants want to use an existing template for implementing a new method, such as target costing. The template is often designed generically and is meant to be superimposed on any organization. Some organizations object to this and want a more tailored approach, especially if they are in an industry in which the consultants have not worked at all. Consultants may agree to tailor the approach, but the cost of implementation of a target costing system will increase significantly. A second downside is that many organizational members may not be involved with implementing the changes. Thus, they may simply rely on what the consultants do. If organizational members do not understand what the consultants have done or how the system works, then the system will likely fail after the consultants leave. A second approach is for organizational members to develop a target costing system internally with little or no assistance from outside consultants. This approach can be satisfying, but it can be costly and time-consuming, especially if the organization has little experience in implementing these types of systems. The positive side of this is that organizational members may get more of a “buy-in” to the new method because they have to understand it well to convince others of the need to implement it. Once organizational members know that they can develop these systems themselves, they may be more confident in the future regarding the implementation of other organizational innovations. The third approach, known as benchmarking, requires that organizational members first understand their current cost reduction methods and then look externally to the best target costing systems of other organizations for guidance on change. Benchmarking is often highly cost-effective since organizations can save time and money avoiding the mistakes that other companies have made or by avoiding reinventing a process or method that other companies have already developed and tested. Benchmarking allows organizations to gain insights on target costing from others, but at the same time to assume responsibility for the changes. In this way, organizational members feel like they have ownership of the changes and this can lead to developing more confidence about future changes and improvements to their management accounting system. 8-43 The answer to this question is very similar to the solution for 8-41 but it is more detailed. The process involved in traditional cost reduction as practiced in the United States is significantly different from target costing. The traditional costing method begins with market research into customer – 58 –

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requirements followed by product specification. Then, companies engage in product design and engineering, and they obtain prices from suppliers. Traditionally, at this stage, product cost is not a significant factor for product design. After the engineers and designers have determined product design, they estimate product cost (Ct ) , where the t subscript indicates numbers derived under a traditional, sequential design and development process. If the estimated cost is considered to be too high, then it might be necessary to modify product design. In order to find the desired profit margin ( Pt ) , it is necessary to subtract the estimated cost from the expected selling price ( St ) . The profit margin is the result of the difference between the expected selling price and the estimated production cost. This relationship in the traditional system is expressed as: Pt = St − Ct . Another widely used traditional approach is the cost-plus method. Under cost-plus, an expected profit margin Pcp is added to the expected product cost Ccp where the subscript cp indicates numbers derived under cost-plus thinking. Selling price Scp, then, is simply the result of the sum of these two variables. In equation form, this relationship for the cost-plus approach is: Scp = Ccp + Pcp . As in the first traditional method described above, product designers do not attempt to achieve a particular cost target. Under target costing, both the sequence of steps and way of thinking about determining product costs differ significantly from traditional costing. The first two steps, market research to determine customer requirements and product specification, are similar to traditional costing. After these initial steps, the process is quite different. The next step, determining a target selling price ( Stc ) and target product volume, depends on the company’s perceived value of the product to the customer. The target profit margin ( Ptc ) results from a long-run profit analysis, often based on return on sales (net income/sales). Return on sales is the most widely used measure, as it can be linked most closely to profitability for each product. The target cost (Ctc ) is the difference between the target selling price and the target profit margin. Note that the tc subscript indicates numbers derived under the target costing approach. This relationship for the target costing approach is shown in the following equation: Ctc = Stc − Ptc . Once the target cost is set, the company must determine target costs for each component. The value engineering process includes examination of each component of a product to determine whether it is possible to reduce costs while maintaining functionality and performance. In some cases, product design might change, materials used in production might need replacing, or manufacturing processes might require redesign. For example, a product design change might – 59 –

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involve using fewer parts or reducing specialty parts if the company can use more common components. Several iterations of value engineering usually are required before it is possible to determine the final target cost. Suppliers also play a critical role in making target costing work. If manufacturers with market power decide that there is a need to reduce the cost of specific components, they will pressure suppliers to find ways to reduce costs. Companies such as Toyota and Nissan might, in some cases, offer incentive plans to suppliers who come up with the best cost reduction ideas. 8-44 In theory there is no reason to assume that target costing, or at least parts of it, cannot be applied to service organizations. However, the method was developed for products requiring discrete manufacturing processes and short product life cycles. In a bank, products (or services, depending on how you look at it) would include checking accounts, savings accounts, all types of loans, etc. The bank could follow the steps outlined in Exhibit 8-4 and do market research to determine customer requirements and product specification. Customer requirements would include the desired interest rate on a checking account, the level of attention needed to open these accounts, the choices for colors and designs on checks, etc. Next, the “target selling price” or the cost to the customer of opening and maintaining the checking account would be determined as well as the target volume or the number of checking accounts that the company desires to service. The target profit margin would have to be determined based on calculations related to the amount of income earned from customer accounts. The target cost then would be the difference between the target selling price and the target profit margin. The following approach can be used. Using the five-stage benchmarking model below, the instructor may wish to select various approaches beginning with the choices on the dimensions in Stage 3 and continuing into Stage 4 for different members of the class and then have them compare the plans that they devise. For instance, in Stage 3 you might ask some students to devise a plan for benchmarking organizations within the banking industry and for those outside of banking. Some might be asked to benchmark with many partners and some with few. For Stage 4 the methods of information gathering and sharing can be varied. Some students can be assigned the unilateral form of benchmarking, while others can be assigned one of the three forms of cooperative benchmarking. What are the implications of each? Also, students need to determine the performance measures that they will use and a time frame over which the study will occur. This can be a very interesting and informative exercise for students. Stage 1: – 60 –

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•

Internal study and preliminary competitive analyses

•

Preliminary internal and external competitive analyses

•

Determining key areas for study

•

Determining scope and significance of the study

Stage 2: • Developing long-term commitment to the benchmarking project 

Gaining senior management support



Developing a clear set of objectives



Empowering employees to make change

•

Coalescing the benchmarking team 

Using an experienced coordinator



Training employees

Stage 3: • Identifying benchmarking partners •

Size of partners

•

Number of partners

•

Relative position within and across industries

•

Degree of trust among partners

Stage 4: • Information gathering and sharing methods •

Type of benchmarking information: 

Product



Functional (Process)

 •

Strategic (includes management accounting methods)

Method of information collection: 

Unilateral



Cooperative: Database



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Atkinson, Solution Manual t/a Management Accounting, 6E 

Indirect/third party



Group

•

Determining performance measures

•

Determining the benchmarking performance gap in relation to performance measures

Stage 5: • Taking action to meet or exceed the benchmark •

Making comparisons of performance measures

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CASES 8-45

(a)

Product X Direct costs (material plus labor)

Product Y

Total

$9,000,000 $4,000,000

Environmental support Nonenvironmental support Total support

14,000,000 22,000,000 29,000,000 $22,000,000 $43,000,000 $65,000,000

Total machine hours

10,000,000

6,000,000 16,000,000

Current cost driver rate Total support ÷ machine hours

$4.0625

Costs using current cost driver rate Direct costs (material plus labor)

$ 9,000,000 $ 4,000,000

Applied support: $4.0625 per machine hour

40,625,000 24,375,000

Total costs

$49,625,000 $28,375,000

Number of units Cost per unit

100,000,000 40,000,000 $0.50 $0.71

(b) Product X

(c)

Product Y

Per unit X Y

Direct costs (material plus labor)

$ 9,000,000 $ 4,000,000 $0.09 $0.10

Environmental support Nonenvironmental support Total support Total costs Number of units Cost per unit using ABC

14,000,000 0.35 22,000,000 29,000,000 0.22 0.73 $22,000,000 $43,000,000 $0.22 $1.08 $31,000,000 $47,000,000 100,000,000 40,000,000 $0.31 $1.18

Different methods are used to allocate support costs in part (a) and part (b). In part (a), environmental support costs are allocated to both products – 63 –

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even though Product X does not generate any environmental costs. In part (b), environmental support costs are assigned only to Product Y. (d) Cost per unit using current cost driver rate Price, 1.5 × cost

Product X Product Y $0.50 $0.71 $0.75 $1.07

Cost per unit using ABC Price, 1.5 × cost

$0.31 $0.47

$1.18 $1.77

Of the two costing systems here, the activity-based costing system more accurately assigns costs of resource usage to the two products. The cost system based on a plantwide rate results in product X essentially subsidizing product Y. Product Y’s price under this system does not even cover the product’s specific environmental costs as identified by the activity-based costing approach.. Consequently, the company should evaluate a price increase for product Y or ways to decrease productrelated costs for product Y. The company may be able to reduce product Y’s costs by using a process that reduces or eliminates hazardous wastes.

8-46

Product X’s price could be reduced and still generate a profit. In making such a decision, the company would evaluate expected changes in demand (if any) if product X’s price were reduced. (a) Pat Polley has listed or expressed concern about a number of explicit and implicit environmental costs. Explicit environmental costs include: • •

The net cost of purchasing and installing the new equipment Cost of removing the old equipment

•

Insurance for the equipment and the workers due to hazardous materials

•

Storage and disposal costs for hazardous wastes

Legal fees related to handling paperwork for hazardous waste liabilities • •

Risk of OSHA fines

•

Risk of liability due to accidental leakage

•

Labor cost of removing hazardous wastes

Implicit environmental costs include: – 64 –

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•

(b)

•

Negative media coverage that will reduce demand

Other environmental costs include: •

Training workers on handling hazardous wastes

•

Monitoring hazardous wastes

•

Filing reports on hazardous wastes

Possible productivity problems because of poor worker morale due to hazardous work environment Poor worker health or increased absenteeism because of exposure to hazardous wastes • •

Risk of liability due to increasingly stringent laws

•

Cost for permits related to hazardous waste

Legal counsel Employee education and awareness Loss of goodwill if environmental disasters occur (c) Kwik Clean faces a variety of environmental costs, including storage and disposal costs for hazardous wastes, legal fees, training costs, insurance, permit costs, and monitoring costs. Using traditional cost systems, environmental-related costs are often hard to pinpoint because they are usually hidden in support cost pools, often one general support cost pool. Activity-based costing can help control and reduce environmental costs because it identifies process activities, including activities that cause environmental costs. Next, the costs associated with the activities are determined. These costs are then assigned to the most appropriate products or services. Awareness of how Kwik Clean’s activities generate environmental costs, as well as awareness of the magnitude of the costs, establish a starting point for controlling and reducing them. 8-47

(a) Mercedes-Benz All Activity Vehicle (AAV)1 [Note: Additional information can be found in the following references: Albright, T. “The Use of Target Costing in Developing the Mercedes Benz M-Class,” International Journal of Strategic Cost Management (Autumn 1998): 13-23.

1

Source: Institute of Management Accountants, Cases from Management Accounting Practice, Instructor’s Manual, Volume 15. Adapted with permission. – 65 –

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Albright, T. and S. Davis. “The Elements of Supply Chain Management,” International Journal of Strategic Cost Management (Autumn 1999): 49-65.] The target costing case literature contains numerous examples of Japanese cost management practices; however, few cases describe the use of target costing by large companies outside Japan. The purpose of the Mercedes-Benz AAV case is to consider the competitive environment of a leading German automotive manufacturer and the company’s response to changing competitive conditions. The teaching plan generally follows the suggested student assignment questions. Additional material that can be introduced during the case discussion is indicated by a check mark. Student Assignment Questions (a) What is the competitive environment faced by MB? Students may identify a number of changes, including significant market share lost to Japanese companies such as Lexus. Stress the importance of a cultural change taking place within top management at Mercedes. Reinforce that Mercedes is a company that had never lost money until 1993. They simply built the best car their engineers could design and priced it above cost. Demand often exceeded supply. As a result, cost had never been a primary consideration. Changes include: • cost competition; • product innovation; • new segments (sports utility vehicle); • new market niches.

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(b) How has MB reacted to the changing world market for luxury automobiles? Students should identify the following changes implemented by management at Mercedes; try to get them to explain how different these approaches were from traditional strategies at Mercedes: • many new product introductions; • partnering with suppliers; • reduced parts and system complexity; • new emphasis on cost control; • layers of management reduced; • lead time from concept to introduction reduced. (c) Using Cooper’s cost, quality, functionality chart, discuss the factors on which MB competes with other automobile producers such as Jeep, Ford, and GM. (If the instructor wishes to give a brief mini-lecture on Robin Cooper’s survival triplet and confrontation strategy,2 this is a good point in the case discussion to do so.) The factors are: • price—at mid to upper range of zone; • quality—at upper range of zone; • functionality—at upper range of zone. An interesting point to discuss is that Mercedes does not produce the most expensive sports utility vehicle. This distinction is reserved for the Land Rover; however, they strategically placed themselves toward the luxury end of the spectrum. Also, unlike many Japanese examples, Mercedes does not use target costing as a strict cost control mechanism to produce the lowest priced product in its class.

2

Robin Cooper, When Lean Enterprises Collide, Boston: Harvard Business School Press, 1995. – 67 –

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(d) How does the AAV project link with MB strategy in terms of market coverage? The new introductions expand the product line of the traditionally luxuryoriented manufacturer. Recent product introductions include the following: • A Class; • C Class; • SLK; • E Class; • M Class. These new introductions include new sports cars and off-road vehicles. The C Class is a mid-sized vehicle sometimes referred to as the baby-Benz.  Let’s discuss the elements of the target costing model and how these elements are developed. At this point in the discussion I usually write the target costing formula on the board and ask students to consider sources of various inputs: • target selling price; • target profit margin; • target cost.  What are the sources of input for the projected target selling price? Students will most likely identify the following sources of information: • customer focus groups; • comparable products: existing, potential. Stress the broad, cross-functional aspects of acquiring consumer information. To compare products, the company had to evaluate existing competitive vehicles as well as vehicles under development.  What factors are considered when developing the required target profit margin? This question provides a link to finance classes. Most students have studied the concepts of weighted-average cost of capital. I recommend spending a few minutes reviewing these concepts and linking cost of capital to net present value (NPV) analysis. Because of the capital-intensive structure of automobile manufacturing, production volume is a critical factor in determining each model’s NPV. Students may identify the following points for determining a required target profit margin. – 68 –

Chapter 8: Measuring Life-Cycle Costs

• • • •

long-run profitability; cost of capital; profitability across the entire product mix (classes of vehicles); sales volume by class.

 The MB case suggests the target cost is “alive.” Is this consistent with the ideals of target costing? I generally emphasize that Mercedes did not consider the target cost to be locked in. It was a moving target. As engineering changes became necessary, the target cost was allowed to move. However, before making a change, market forces were considered. For example, changes included the addition of side airbags. In addition, the European press was critical of a simulated wood-grain part. Management decided the part would remain plastic because costs could not be passed on to the consumer. The main point to emphasize is the design of the vehicle is dynamic, thus costs must evolve to reflect the changing design characteristics. (e) Explain the process of developing an importance index for a function group or component. How can such an index guide managers in making cost reduction decisions? The index development process has five steps, as follows: • consumer importance category rankings; • target cost and percentage by function group; • category vs. function group matrix (function group contribution to customer requirements); • importance index of the various function groups; • target cost index. The instructor can make slides of Tables 1-5 to facilitate discussion. Index development is an important element in the early conceptualization phase of the AAV. The indexes help to quantify some very abstract concepts. Table 1. From conversations with potential consumer groups, a list of key categories was developed. Next, potential customers were asked to rate the importance of each category. Their responses were computed as a percentage. Thus, safety and comfort of the AAV were viewed as significantly more important than economy and styling. Table 2 represents a rough estimate of the target cost by function group and the relative percentage of each group of total target costs. The information is used later to create a target cost index. – 69 –

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Table 3 is best understood by reading each category as a column. The rows explain the relative importance of each function group to satisfying each category defined by customers. An interesting aspect of this table is that the link between consumer preferences and engineering components is made explicit. Table 4 builds on Table 3 by weighting the percentages computed in Table 3 by the importance percentages calculated in Table 1. The key point is to understand which function groups contribute the most (least) to important (less important) consumer categories. Table 5 results in a target cost index for each function group that attempts to capture cost and benefit trade-offs. As discussed in the case, this index may indicate a cost in excess of the perceived value of a function group. Thus, opportunities for cost reduction (aligned with customer requirements) may be identified. (f) How does MB approach cost reduction to achieve target costs? At this point, ask students to identify various value-engineering strategies. At Mercedes, reducing the cost of each function group was accomplished by reducing costs of various components that make up the function group. Stress the importance of this approach over an “across-the-board” cut. (g) How do suppliers factor into the target costing process? Why are they so critically important to the success of the MB AAV? From the conceptual phase through the production phase, the suppliers of systems for the AAV truly were partners. Suppliers attended regular meetings with the cost planners throughout the entire process. Thus, suppliers were: • design and development partners from very early stages of development, • responsible for meeting cost targets.

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 Why is the relationship with suppliers a crucial element in the success of the AAV? Suppliers provide entire systems for the AAV. The facility uses a JIT production system. In fact, many suppliers deliver directly to the assembly line, rather than to a small warehouse. The Black Warrior River separated Mercedes and a major system supplier. This supplier built a new production facility on the same side of the river as the Mercedes Benz plant to avoid possible delays associated with accidents on a major bridge. (h) What role does the accounting department play in the target costing process? Stress the fact that accountants were watchdogs in the target costing process. Their primary responsibility was to ensure costs did not exceed targets during the production phase. Thus, the accountants’ role was as follows: • cost control; • actual costs versus target costs: - development stage, - production stage.  What are some of the organizational barriers that may challenge managers attempting to introduce target costing systems? Try to get students to identify various impediments to target costing systems in the United States. Examples may include: • willingness to share cost data with suppliers; • suppliers treated as adversaries; • government regulations affecting exchange of information.

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