BUKIDNON STATE UNIVERSITY Malaybalay City, Bukidnon 8700 Tel (088) 813-5661 to 5663; Telefax (088) 813-2717 www.buksu.edu.ph =================================================================================================== College of Business – Accountancy Department AE 23 Strategic Cost Management Hand-out – Chapter 8 COST MANAGEMENT FOR PRODUCT LIFE CYCLE: LIFE-CYCLE COSTING LONG-TERMPRICING TARGET COSTING THEORY OF CONSTRAINTS COST MANAGEMENT FOR PRODUCT LIFE CYCLE Life Cycle Costing - Consideration is given both to (1) the effect of the timeliness of operations on total costs and (2) the way in which costs change over the life cycle of the product. - Product life cycle is consideration in each of two aspects a) The cost life cycle b) The sales life cycle - Cost life cycle is the sequence of activities within the firm that begins with research and development, followed by design, manufacturing, marketing/ distribution and customer service. - Sales life cycle is the sequence of phases in the product's or service's life in the market -from the introduction of the product or service to growth in sales and finally maturity, decline and withdrawal from the market. - Important strategic cost management issues arise in each activity of the cost life cycle. - The methods helpful in analyzing the cost life cycle are a. Life-Cycle Costing - used throughout the cost life cycle to minimize overall cost b. Target Costing - used for managing costs primarily in the design activity. c. Theory of Constraints - method for managing manufacturing costs. - 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: 1) upstream costs 1 Jiffamae A. Centillas-Gelacio,CPA o Research and development o Design: prototyping, testing, concurrent engineering and quality development o Industries with high upstream costs include computer software, specialized industrial and medical equipment 2) manufacturing cost o Purchasing o Direct manufacturing costs o Indirect manufacturing costs 3) downstream costs o Marketing and distribution - packaging, shipping, samples, promotion, advertising o Service and warranty - recalls, service, product liability, customer support o Industries with high downstream costs include pharmacratic, performer, cosmetics and toiletries Figure 8-1: Life-Cycle Costing Why Design is Important - Decision making at the design stage is critical. Although the costs incurred at the design stage may be very small in relation to the total costs over the entire life cycle the decision stage decisions are important because they lock in most of the remaining life-cycle costs. - The critical success factors at the design stage include: 1. Reduced time-to-market. The speed of product development and the speed of delivery and efforts to reduce time-to-market are critical for a business firm to sustain its competitiveness. 2. Reduced expected service costs. By careful simple design and the use of interchangeable or modular components can reduce expected service costs. 2 Jiffamae A. Centillas-Gelacio,CPA 3. Improved ease-of-manufacture. The design must be easy to manufacture in order to reduce production costs and speed production. 4. 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 I. 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. II. Prototyping - This is a method in which functional models of the product are developed and tested by engineers and trial customers. III. Templating - This is a design method in which an existing product is scaled up or down to fit the specifications ·of the desired new product. IV. Concurrent Engineering - or simultaneous engineering, is an important new approach in which product design is integrated with manufacturing and marketing throughout the product's life cycle. - Figure 8-2 summarizes the characteristics of the Four Design Methods. Figure 8-2: Characteristics of the Four Design Methods 3 Jiffamae A. Centillas-Gelacio,CPA 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: If the price of a wallet phone is P225, Star will have to increase the research and development costs by P100,000 and the prototyping costs by P400,000 to improve the model for the higher price. Fixed customer service costs also would increase by P500 per month and variable distribution costs would increase by 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. 4 Jiffamae A. Centillas-Gelacio,CPA 2. What price will produce the most profit for Star for the wallet phone's life cycle? - The Pl50 price renders the highest expected profit. COST MANAGEMENT OVER THE SALES LIFE CYCLE - The sales life cycle is the sequence of phases in the product's or service's life in the market from the introduction of the product or service to growth in sales and finally, maturity, decline and withdrawal from the market. - Sales are at first small, then peak in the maturity phase and decline thereafter. - Figure 8-3 illustrates the sales life cycle of a product. Figure 8-3: The Sales Life Cycle of a Product Phases of The Sales Life Cycle - Phase 1: Product Introduction o In the first phase there is little competition, and sales rise slowly as customers become aware of the new product or service. o Costs are relatively high because of high R&D expenditures and capital costs for setting up production facilities and marketing efforts. o Process is relatively high because of product differentiation and the high costs at this phase. o - - Product variety is limited. Phase 2: Growth o Sales begin to grow rapidly and product variety increases. o The product continues to enjoy the benefits of differentiation. o There is increasing competition and prices begin to soften. Phase 3: Maturity o Sales continue to increase but at a decreasing rate 5 Jiffamae A. Centillas-Gelacio,CPA - o there is a reduction in the number of competitors and of product variety. o Prices soften further, and differentiation is no longer important. o Competition is based on cost, given competitive quality and functionality. Phase 4: Decline o Sales begin to decline, as do the number of competitors. o Prices stabilize. o Emphasis on differentiation returns. o Survivors are able to differentiate their product, control costs, and deliver quality and excellent service. o 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 - First Phase: pricing is set relatively high to recover development costs and to take advantage of product differentiation and the new demand for the product. - Second Phase: pricing is likely to stay relatively high as the firm attempts to build profitability in the growing market. Alternatively, to maintain or increase market share at this time, relatively low prices (penetration pricing) might be used. - Latter Phases: pricing becomes more competitive, and target costing and life­cycle costing methods are used, as the firm becomes more of a price taker rather than a price setter and makes efforts to reduce upstream (for product enhancement) and downstream costs. Cost Management System - Together with the change in strategy and pricing, there is a change in the cost management system. - At the introduction and into the growth phases, the primary need is for value chain analysis, to guide the design of products in a cost-efficient manner. - Master budgets also are used in these early phases to manage cash flows; there are large developmental costs at a time when sales revenues are still relatively small. - As the strategy shifts to cost leadership in the latter phases, the goal of the cost management system is to provide the detailed budgets and activity-based costing tools for accurate cost information. 6 Jiffamae A. Centillas-Gelacio,CPA 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: Required: Determine what stage of the sales life cycle the leaf blower is in. - It seems that sales are stabilizing since they only grew 1.5% over the past year and the average annual growth over the past four years was 19 .6%. - The unit sales price has also 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. 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: OCI currently sells the BL-IO model for P 1,050 and the L-25 model for P725. Manufacturing costs and activity usage for the two products are: 7 Jiffamae A. Centillas-Gelacio,CPA Required: 1. Calculate the product cost and product margin for each product. 2. A new competitor has entered the market for lens polishing equipment with a superior product at significantly lower prices -P750 for the BL-IO 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: Calculate the total product cost with the new activity usage data. Can OCl make a profit with the new costs, assuming that OCI must meet the price set by the new competitor? 3. What cost management method might be useful to OCI at this time and why? Solution to Illustrative Case III: Strategic Costing Requirements 1 and 2 8 Jiffamae A. Centillas-Gelacio,CPA Requirement 3 Target costing should be useful to OCI to assist the firm in meeting the new competition by finding new ways to cut costs without reducing product quality or functionality. TARGET COSTING - 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 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 - With its positioning in the early, upstream phases of the cost life cycle, Target Costing can clearly help a firm reduce total costs. 9 Jiffamae A. Centillas-Gelacio,CPA How to Reduce Costs to a Target Cost Level o Integrate new manufacturing technology using advanced cost management techniques such as activity-based costing and seeking higher productivity through improved organization and labor relations. o Redesign the product or service. o This approach is more common than the first one because it recognizes that design decisions account for much of the product life cycle costs. o Many firms employ both methods-operational control to achieve productivity gains and target costing to determine low-cost design. Steps in Implementing a Target Cost Approach I. Determine the market price. II. Determine the desired profit. III. Calculate the target cost at market price less desired profit. IV. Use value engineering to identify ways to reduce product cost. o Value Engineering is used in target costing to reduce product cost by analyzing the trade-offs between (1) different types and levels of products functionality and (2) total product cost. o An important first step in value engineering is a consumer analysis performed during the design stage of the new or revised product. o The consumer analysis identifies critical consumer preferences that define the desired functionality for the new product. o The type of value engineering used depends on the functionality of the product. o 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. o In contract to the first group customer preferences here are rather stable. o Target costing is more useful for products in the first group because there are a large number of features about which the firm has some discretion. o 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. 10 Jiffamae A. Centillas-Gelacio,CPA o An overall desired level of achievement of performance for each function is obtained while keeping the cost of all functions below the target cost. o 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. o Design Analysis is the common form of value engineering for products in group two, industrial and specialized products. The design team prepare several possible designs of the product, each having similar features that have different levels of performance and different levels of performance and different costs. The design team works with cost management personnel to· select the one design that best meets customer preferences while not exceeding the target cost. o Other cost reduction approaches include cost tables and group technology. o Cost tables are computer-based databases that include comprehensive information about the firm's drivers. o 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. o Group technology is a method of identifying similarities in the parts of products a firm manufacture, 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, while 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. V. Use kaizen costing and operational control to further reduce costs. o The fifth step in target costing is to use kaizen costing and operational control to further reduce costs. o 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. 11 Jiffamae A. Centillas-Gelacio,CPA o 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. Illustrative Case IV: Target Costing MotoDrive manufactures a wide variety of parts for recreational boating, including part A and part B component for high-powered outboard boat engines. The component is purchased by original equipment manufacturers such as Mercury and Honda, for use in large, more powerful outboards. The units sell for P510, and sales volume averages 25,000 units per year. Recently, MotoDrive's major competitor reduced the price of its equivalent part to P450. The market is very competitive, and MotoDrive realizes it must meet the new price or lose significant market share. The controller has assembled these cost and usage data for the most recent year for MotoDrive's production of 25,000 units: Required: 1. Calculate the target cost for maintaining current market share and profitability. 2. Can the target cost be achieved? How? o The target cost can probably be achieved by efforts in two areas: 12 Jiffamae A. Centillas-Gelacio,CPA a) The standard cost analysis shows an unfavorable materials variance of P375,000 P5,500,000 -P5,125,000) or Pl5 per unit, a very significant variance. Efforts to reduce or eliminate this variance will make the firm much more competitive. Notice that the labor usage variances, both for direct and indirect labor, are favorable, so it appears no additional work is needed here, assuming the standards are properly set. b) The manufacturing costs except for direct materials and direct labor can be considered non-value adding costs, since they do not add to the functionality or quality of the product. Efforts can be made to reduce the total cost of these manufacturing costs, which now total a significant P3,999,000 or Pl159.96 per unit. THEORY OF CONTRAINTS - Most strategic initiatives undertaken by firm today focus on improving the speed of their operations throughout the cost life cycle. For many companies speed is a competitive edge. - Shorter sales life cycle in many industries mean that manufacturers are working to reduce product development time. - Theory of constraints is a process of identifying and managing 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. - Theory of Constraints (TOC) a technique used to improve speed in the manufacturing process and thus speed. - In contrast to target costing, which focuses on the early 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 the slow the production process. - Emphasis on 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 throughput are nonbinding constraints that receive less attention that bottlenecks or binding constraints. - The Theory of Constraints defines three measurements: 1. Throughput Contribution 2. Investments 13 Jiffamae A. Centillas-Gelacio,CPA Sum of materials costs in direct materials, work-in-process, and finished goods inventories; R&D costs; and costs of equipment and buildings. 3. Operating Costs All costs of operations (other, than direct materials) incurred to earn throughput contribution. Operating costs include salaries and wages, rent, utilities and depreciation. Steps in Theory of Constraints-Analysis Step 1: Identify the Binding Constraint(s) o the management accounts work with manufacturing managers and engineers to identify binding constraints by developing a network diagram of the flow of production. o A network diagram is a flowchart of the work done that shows the sequence of processes and the amount of the time required for each. o The purpose of the network diagram is to help the management accountant look for signs of a, bottleneck. o A bottleneck often is indicated by a process with relatively large amounts of inventory accumulating, or where there are long lead times. o Task analysis, which describes the activity of each process in detail, also could be used to identify binding constraints. Step 2: Determine the Most Efficient Utilization for Each Binding Constraint o the management accountant determines how to most effectively utilize the firm's resources. o The approach differs somewhat depending on whether there is one product, or two or more (as SPI has). o If there is one product, the management accountant looks for ways to maximize, the flow of production through the constraint. Step 3: Manage the Flows Through the Binding Constraint o the objective is to manage the flow of production in and out of the binding constraint to smooth the flow of production throughout the plant. o The orderly scheduling of production prevents the building of materials or work-inprocess inventory at various processes. o An important tool for managing product flow in this context is the drum-buffer-rope (DER) system, which is a system for balancing the flow of production through a binding constraint. Step 4: Add Capacity to the Constraint o As a longer-term measure to relieve the constraint and improve cycle time, management should consider adding capacity to the constraints by adding new or improved machines and/or additional labor. 14 Jiffamae A. Centillas-Gelacio,CPA Step 5: Redesign the Manufacturing Process/or Flexibility and Fast Cycle Time o The most complete strategic response to the constraint is to redesign the manufacturing process, including the introduction of new manufacturing technology, deletion of some hard-to-manufacture products, and redesign of some products for greater ease of manufacturing. o Simply removing one or more minor features on a given product might speed up the production process significantly. The use of value engineering as described earlier might help at this point. o The problems requiring the application of "Theory of Constraints" may also be resolved using Linear Programming technique. Illustrative Problem 8-1: Theory of Constraints, Throughput Contribution, Quality, Relevant Costs Basic data on Columbia Industries follow: Columbia Industries manufactures electronic testing equipment. Columbia also installs the equipment at customer's sites and ensures that it functions smoothly. Additional information on the Manufacturing and installation departments is as follows (capacities are expressed in terms of the number of units of electronic testing equipment): Equipment Equipment Installed Manufactured Annual capacity 400 units per year 300 units per year Equipment manufactured and installed 300 units per year 300 units per year Columbia manufactures only 300 units per year because the Installation Department has only enough capacity to install 300 units. The equipment sells for P40,000 per unit (installed) and has direct materials costs of P15,000. All costs other than direct materials costs are fixed. Case I. Columbia's engineers have found a way to reduce equipment manufacturing time. The new method would cost an additional P50 per unit and would allow Columbia to manufacture 20 additional units a year. Should Columbia implement the new method? Answer: It will cost Columbia P50 per unit to reduce manufacturing time. But manufacturing is not a bottleneck operation; installation is. Therefore, manufacturing more equipment will not increase sales and throughput contribution. Columbia Industries should not implement the new manufacturing method. Case II. Columbia's designers have proposed a change in direct materials that would increase direct materials costs by P2,000 per unit. This change would enable Columbia to install 320 15 Jiffamae A. Centillas-Gelacio,CPA units of equipment each year. If Columbia makes the change, it will implement the new design on all equipment sold. Should Columbia use the new design? Answer: Additional relevant costs of new direct materials, P2,000 x 320 units P640,000 Increase in throughput contribution, P25,000 x 20 units P500,000 The additional incremental costs exceed the benefits from higher· throughput contribution by P140,000, so Columbia Industries should not implement the new design. Alternatively, compare throughput contribution under each alternative. Current throughput contribution is P25,000 x 300 P7,500,000 With the modification, throughput contribution is P23,000 x 320 P7,360,000 The current throughput contribution is greater than the throughput contribution resulting from the proposed change in direct materials. Hence, Columbia Industries should not implement thenew design. Case III. A new installation technique has been developed that will enable Columbia's engineers to install 10 additional units of equipment a year. The new method will increase installation costs by P50,000 each year. Should Columbia implement the new technique? Answer: Increase in throughput contribution, P25,000 x 10 units P250,000 Increase in relevant costs P 50,000 The additional throughput contribution exceeds incremental costs by P200,000, so Columbia industries should implement the new installation technique. Case IV Columbia is considering how to motivate workers to improve their productivity (output per hour). One proposal is to evaluate and compensate workers in the Manufacturing and Installation departments on the basis of their productivities. Is the new proposal a good idea? Answer: Motivating installation workers to increase productivity is worthwhile because installation is a bottleneck operation, and any increase in productivity at the bottleneck will increase throughput contribution. On the other hand, motivating workers in the manufacturing department to increase productivity is not worthwhile. Manufacturing is not a bottleneck operation, so any increase in output will result only in extra inventory of equipment. Columbia Industries should encourage manufacturing to produce only as much equipment as the installation department needs, not to 16 Jiffamae A. Centillas-Gelacio,CPA produce as much as it can. Under these circumstances, it would not be a good idea to evaluate and compensate manufacturing workers on the basis of their productivity. Illustrative Case V: Theory of Constraints Kable Inc. manufactures a pact, XX3, used in automobiles. Three processes are involved in the production of XX3: drilling, inserting and packaging. Each process performed at a separate workstation and has these performance characteristics: • The drilling function can drill 30,000 parts per-hour. • The inserting function can insert 3,000 parts per 5 minutes. • The packaging function can package 10,000 parts per half hour. Required: How many units of XX3 can be manufactured in a week, and which process is the binding constraint? Solution to Illustrative Case V: Theory of Constraints - The packaging function is the constraint because only 20,000 parts can be packaged an hour whereas 30,000 can be drilled and 36,000 can be inserted. - Assuming a 40-hour work week, the number manufactured / week = 20,000 x 40hours = 800,000 / week 17 Jiffamae A. Centillas-Gelacio,CPA