CHAPTER 8 COST MANAGEMENT FoR _ PRODUCT LIFE CYCLE: ¥CLE COSTING AND LONG-TERM RICING; TARGET COSTING AND THEORY OF CONSTRAINTS FOR PRODUCT LIFE CYCLE on the time dimension of cost management. Consideration is the effect of the timeliness of operations on total costs and (2) the change over the sequence of phases in the product's or service 's life in the introduction of the product or service to growth in sales and and withdrawal from the market. ‘cost management issues arise in each activity of the cost life helpful in analyzing the cost life cycle are206 Chapter 8 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 the 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-Cycle 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 eost and downstream costs. See Figure 8-1. Figure 8-1: Life-Cycle Costing R&DS, Design, \ Production, S Marketing Customer, ae ODP Dsiibaon Service Upstream Activities Downstream Activities UFE-CYCLE COSTINGts of these costs follow: and development prototyping, testin; development with high upstream costs i with hi include co industrial and medical equipment aes 8. Concurrent engineering and quality ing and distribution — packaging, shipping, samples, promotion, ising and warranty — recalls, service, product liability, customer support Industries with high downstream costs include pharmacratic, performer, cosmetics and toiletries may be very small in relation to the total costs over the entire life stage decisions are important because they lock in most of the sle costs. factors at the design stage include: iced time-to-market. expected service costs. ease-of-manufacture. s planning and design. re-to-market ‘of product development market are critical and the speed of delivery and efforts | for a business firm to sustain© 208 Chapter 8 Reduced expected service costs By careful simple design and the use of interchangeable or modular components can reduce expected service costs. Improved 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 designers 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 i ens ict led fit the specifications of the desired new pei: ooo" Concurrent engineering rae enaieetcre or simultaneous engineering, is an important new ‘keting th : i i ne noe oe 2 eo with manufacturing andCost Planning. for Product Life Grcle 209 _ Figure 8-2 summarizes the characteristics of the Four Design Methods. _ Figure 8-2: Characteristics of the Four Design Methods Design Method | Design Speed Design Cost Effect on Downstream Costs Basic Fast Depends on desired | Can be very high; as ‘engineering complexity and marketing and functionality; should be | production are not Telatively low integral to the design : process _ Prototyping Slow Significant; materials, Potentially a significant labor and time reduction in : downstream costs Templating Fast Modest Unknown; can have costly unexpected Tesults if the scaling does not work in the . market or in production Concurrent Continuous Significant; design is | The best method for engineering an integral, ongoing reducing downstream process costs Illustrative Case I: Life-Cycle Costing and Pricing Star Communications Technologies, Inc., has introduced 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 we Variable Costs Manufacturing costs 25,000 P20 Marketing costs 20,000 isa Customer costs 3,000 8 Distribution costs 5,000 15 For price of P180 — average annual sales of 60,000 units. For price of P225 — average annual sales of 48,000 units.210 Chapter 8 If the price of a wallet phone is P25, Star will have to increase the research and development costs by P100,000 and the prototyping costs by P400,000 to improve e model for the higher price, Fixed customer service costs also would increase by P500 per month and variable distribution costs would increase by PS per unit to improve the customer service and distribution at the P225 level. At the lowest price level of P150, fixed 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 I: Life-Cycle Costing and Pricing Requirement 1; Life-Cycte costs for each decision Price P6000] Pp 16000 TP. 225.00 Units Soid 80,000 60,000 48,000 Revenues 12,000,000. | —P10,800,000 | 10,800,000 Costs R&D 400,000 | P400,000 | P 500,000 | more at P2265 Prototypes 800,000 | P- 800,000 | 1,200,000 | more at P225 Manufacturing Fixed P1j200,000 |_P 4,200,000 | P 1,200,000 | =25,000x 12 months x 4 years Variable [-P1,600,000 | ~P 1,200,000 | P 960,000 | = 20 per unit Marketing | Fed > | P 720,000] P 960,000] P 960000 | = 20,000 x 12 x 4 (15,000 at 150) Variable P aor 300,000 | P 240,000 | =5 per unit [Customer Service Fixed P i440 | _P_144 000 [_ P _168,000 | =3,000x 124 (3600 at P225) Variable P 640,000 |, P 40,000 | P 384,000 | =8 per unit Distribution Fixed P_ 240,000 | P 240000 | P 240,000 | = 5000x124 Variable P. 1,200,000 |_P 900,000 | P _ 960,000 | = 15 per unit (20 at P225 price) | Total Cost Ezaigoo | ecm |e 3800 Requirement 2 ‘The P150 price renders the highest expected profit.Cost Planning for Product Life Cycle... 211 “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 E 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 at first small, then peak in the maturity phase and decline thereafter. Fi f sales life cycle of a product. iereafter. Figure 8-3 illustrates the | Figure 8-3: The Sales Life Cycle of a Product Phases of The Sales Life Cycle Phase 1: Product Introduction Inthe 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 ofhigh 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 i Sales begin to grow rapidly and product variety increases. The product continues to enjoy the benefits of differentiation. There is competition and prices begin to soften. 3212 _ Chapter 8 Phase 3: Maturity Sales continue to increase but at a decreasing rate. there is a reduction in the number of competitors and of 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 service 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 recc\ver development costs and to take advantage of product differentiation and the nev demand for the product. In the second phase, Pricing is likely to stay relatively high as the firm attempts to build profitabil yin the growing market. Alternatively, to maintain or increase market share at this time, telatively low prices (penetration pricing) might be used. Inthe latter phases, pricing becomes more competitive, and target costing and life- cycle costing methods are used, as the firm becomes more of a price taker rather tay apes setter and pales efforts to reduce upstream (for product enhancement)ee Cost Planning for Product Life Cycle. 213 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 developmental costs at a time when sales revenues are still relatively small. As the strategy shifts to cost leadership in the Jatier phases, the goal of the ‘cost management system is to provide the detailed budgets and activity-based costing tools for accuratecost 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: Average Annual Change over | Change over the item This Year Last Year Last Four Years Annual sales 2,000,000 1.5% 19.6% Unit sales price P400. 2.0 69 [Unit profit P180 (0.8) 25 | Required: Determine what stage of the sales life cycle the leaf blower is in. Solution to Mustrative Case II: Sales Life-Cycle Analysis It scems 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 slowed, and the unit profit is 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.214 Chapter 8 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 of parts 1.85 per part | 2. Manufacturing supervision Hours of machine tme | P11.40 per hour 3._ Assembly Number of parts 2.55 per part | 4.__ Machine setup Each setup 43.30 per setup Inspection and testing Logged hours P35 per hour 6._ Packaging Logged hours PAS per hour OCI currently sells the BL-10 model for P1,050 and the L-25 model for P725. Manufacturing costs and activity usage for the two products are: BL-f0 025 Direct materials 128.50 58.19 Number of parts fat 88 Machine hours 64 32 Inspection time 13 06 dng time o7 4 fee 2 1 Required: 1. Calculate the product cost and product margin for each product. 2. Anew competitor has entered the market for Jens polishing equipment with a superior product at significantly lower prices ~ P750 for the BL-10 model and 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: BLA0 Ls Direct materials 117.50. 78.30 ‘Number of parts 6 a Machine hours ST 28 Inspection ime 1.0 05 wl O7 04 Sete 1 1Edition, E.B. CABRERA Calculate the total product cost with the new activity usage data, Cost Planning for Product Life Cycle ... * Activly-based costing is discussed in Chapter 9 ~ Cost Accounting and Control, 2018 25 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 Iitustrative Case IIT: Strategic Costing Requirements 1 and 2 Cost Poo! ‘Allocation Bas | Costing Rate x Malerals Handling | Number of parts 185 Mig supervision Machine hours 1140 ‘Assambly Number of parts 255 Setups 43.60 Inspection and Test | Hous 3500 | Packaging Hours 48.00 Costs and Activity Usage for Each Product Current Revised | C Bio | 126 | Blo | 1 Direct materials 1650] 5819] 1115] 483 Number of parts 121.00 | 8800) 9600} 7.00 Machine hours | 610] 320 870} 290 Inspection time 1.30] 0.60 100] 050 Packing ime | 070} 040 070} 040 | Set-ups. 2.00 4.00 4.00 | 1.00 ‘Activity-based costs ke Rale a 12650 | 5819 | T1180] «830 1.85 20385 | 16280| 177.80 | 142.45 11.40 6954] 3548] 6498] 3306 255 30855 | 22440] 244.80 | 196.5 4350 87.00} 4350] 4350| 4350 35.00 4550) 2100] 35.00) 17.50 1050} 600} 1050] 6.00 87144 | 95237 | 68788 | 487.16 Price 1050.00 | 725.00} 750.00 | 550,00 Margin 178.86 | 17263] 6212 | 6284 ‘Profit will stil be eamed even if prices are reduced as shown in the above schedule. Requirement 3 Target costing should be usefull to OCI to assist the firm in meeting the new competition by finding new ways to cut costs without reducing product quality or216 Chapter 8 » | BD 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 useful way to manage the needed trade-off between increased functionality and higher cost. Figure 8-4 shows the target costing in the cost life cycle. Figure 8-4: Target Costing in the Cost Life Cycle Si x i : Marketing & \\ Customer. R&D™ > Design» > Manuiactuing Distribution Service t TARGET COSTING With its positioning in the early, upstream phases of the cost life cycle, Target Costing can clearly help a firm reduce total costs. How to Reduce Costs to a Target Cost Level “1. Integrate new manufacturing technology using advanced cost management techniques such as activity-based costing and seeking higher productivity through improved organization and labor relations. 2. Redesign the product or service. This approach is more common than the first one because it recognizes that design decisions account for mush of the product life cycle costs. _ Many firms employ both methods-operational control to achieve productivity gains and target costing to determine low-cost design.Cost Planning for Product Life Cycle .. 247 ‘Steps in Implementing a Target Cost Approach i. 2. 3. 4. S Determine the market price. Determine the desired profit. Calculate the target cost at market price less desired profit. Use Value engineering to identify ways to reduce product cost. Use kaizen costing and operational control to further reduce costs. The first three steps do not require additional explanation. The following sections explain the fourth and the fifth steps: a. The role of value engineering b. — r Kaizen costing and operational control a. Role of Value Engineering Value engineering is uséd 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 relatively 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 to the first group customer preferences here are rather stable. Target costing is more useful for products in the first group because there area 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.218 Chapter 8 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 determine 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 seyeral 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 the 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 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 manufacturers 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, whil manufacturing costs are reduced, service and 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,Cost Planning for Product Life Cycle... 219 Bb, Target Costing and Kaizen Costing The fifth step in target costing is to use kaizen costing and operational contro} 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 systems) and to use new management techniques such as operational control, total quality _ Management and the theory of constraints to further reduce costs. Kaizen means “continual improvement,” that is, the ongoing search for new ways to reduce costs in the manufacturing process of a product with a given design and functionality. justrative Case IV: Target Costing toDrive manufactures a wide variety of parts for recreational boating, including a and part b component for high-powered outboard boat engines. The nent is purchased by original equipment manufacturers such as Mercury and for use in large, more powerful outboards. The units sell for P510, and volume averages 25,000 units per year. ntly, 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 ice or lose significant market share. The controller has assembled these cost Actual Cost 5,500,000 4,670,000 | 2,359,000 | 350,000 | Actual Quantity 245,00 980,000 65.000 |220_ Chapter 8 Required: 1. Calculate the target cost for maintaining current market share and profitability. 2. Can the target cost be achieved? How? Solution to Illustrative Case IV: Target Costing Requirement 1 é 14,169,000 Current unit cost { 7.5600 sa 446.76 Current profit per item: Current seling price P510 ‘Current unit cost A476 Profit per iter. P6324 Tet al nee Pear ee Competitor’ price Less: Desired Profit 63.24 Target cost 386.75 Requirement 2 The target cost can probably be achieved by efforts in two areas: a. The standard cost analysis shows an f:vorable materials variance of 375,000 PS,500,000 — P5,125,000) o: 1°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. . The manufacturing Costs except for direct materials and direct labor can be considered non-value adding costs, since they do not add to the functionality or quality of the product. Efforts can be made to reduce the total cost of these manufacturin; costs, which total a significant P3,999,000 or P159.96 per unit, . eeCost Planning for Product Life Cycle... 221 UP LHEORYUF TORTRAINTS™ Most strategic initiatives undertaken by firm today focus on improving the speed of theit 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 constraint 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. This section presents one of the methods to improve speed, Theory of Constraints (TOC) a technique used to improve speed in the manufacturing process and thus speed. 5 Incontrast to target costing, which focuses on the early phases of the cost life cycle, the Theory of Constraints focuses on manufacturing activity. This theory focuses the manager’s attention on the constraints, or bottlenecks that slow the production process. TOC emphasis the improvement of throughput (overall .all rate of manufacturing output) by removing or reducing the bottlenecks in the production Process that slow the rate of output. Manufacturing and distribution processes that do not affect throughout are nonbinding constraints that receive less attention that bottlenecks or binding constraints. Fast throughput enables firms to be better prepared for quick product changeovers and changes in customer preferences, The Theory of Constraints defines three measurements. 1. Throughput Contribution: é Direct Materials fe ance { Cost of Goods Sold 2. Investments: ‘Sum of materials costs in direct materials,” work-in-process, and finished goods inventories; R&D costs; and costs of equipment and buildings.