Atkinson, Solution Manual t/a Management Accounting, 6E
Chapter 8
Measuring Life-Cycle
Costs
QUESTIONS
8-1
The total-life-cycle costing approach is a comprehensive way for managers to
understand and manage costs through a product’s design, development,
manufacturing, marketing, distribution, maintenance, service, and disposal
stages. It refers to the process of managing all costs along the value chain.
Using this approach can lead to substantial cost savings. By some estimates,
80-85% of a product’s total life costs are committed by decisions made in the
RD&E stage, underscoring the importance of managing all costs along the
value chain.
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
Committed costs are those that the organization agrees must be set aside
(or committed) to cover product costs through the three major stages of the
life cycle. Costs incurred are the actual costs that the organization has paid
out over the three major stages of the product life cycle.
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 of the product. The following three substages typically occur
during this stage: (1) rapid growth from the first time the product is shipped
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Chapter 8: Measuring Life-Cycle Costs
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 costing is a method of profit planning and cost reduction that focuses
on reducing costs for products in the research, development and engineering
(RD&E) stage of the total life cycle of a product. It also considers all
aspects of the value chain and explicitly recognizes total-life-cycle costs.
8-7
The two essential financial elements needed to arrive at a target cost are the
target selling price and the target profit margin. The target cost is the
difference between the two.
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
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. Stated another way, value
engineering is an organized effort directed at analyzing the functions of the
various components for the purpose of achieving these functions at the
lowest overall cost without reductions in required performance, reliability,
maintainability, quality, safety, recyclability, and usability.
8-10 Target costing is most applicable during the research, development and
engineering (RD&E) stage of the total life cycle of a product.
8-11 Cross-functional teams guide the target costing process. These teams may
include, for example, representatives from the organization’s design
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Atkinson, Solution Manual t/a Management Accounting, 6E
engineering, manufacturing, management accounting, and marketing areas,
as well as representatives from among suppliers, customers, distributors,
and waste disposers. Supply chain management, which involves
developing cooperative, mutually beneficial long-term relations between
buyers and suppliers, plays a critical role in target costing when suppliers
actively participate in resolving cost reduction problems.
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.
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
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Chapter 8: Measuring Life-Cycle Costs
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.
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
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Atkinson, Solution Manual t/a Management Accounting, 6E
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 Target costing differs from traditional cost reduction methods through the
process by which costs are determined. Under traditional cost reduction,
after market research to determine customer requirements and product
specification, engineers and designers determine product design, then the
cost to produce the product. If the estimated cost is too high, then it may be
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Chapter 8: Measuring Life-Cycle Costs
necessary to modify the product design. The desired profit margin is found
by subtracting the estimated cost from the expected selling price.
Target costing begins in approximately the same way with market research
to determine customer requirements and product specification. From this
point on, procedures are quite different. The next step under target costing is
to determine the target selling price and target product volume. Then the
target profit margin is determined. The target cost is the difference between
the target selling price and target profit margin. Target costing focuses on
achieving the target cost. Product cost is not important in product design
under traditional cost-reduction methods, which focus on cost reduction at
the manufacturing stage. In contrast, target costing focuses on cost
reduction at the RD&E stage. Target costing uses the total life cycle costing
concept to focus on cost of ownership over the product’s life. In addition,
target costing involves cross-functional teams and close relationships with
suppliers. Market research is not a single event as it is under traditional cost
methods. Under target costing, market research is customer driven, with
customer input obtained continually throughout the process.
8-26 The relationship between value engineering and target costing is as follows:
Once a target cost has been set, the organization must determine target costs
for each component in a product. Value engineering is used to examine the
design of each component of a product to determine whether it is possible to
reduce costs while maintaining functionality and performance.
8-27 Return on sales (net income ÷ sales) is the most widely used profitability
measure to develop the target profit margin under target costing.
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,
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Atkinson, Solution Manual t/a Management Accounting, 6E
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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Chapter 8: Measuring Life-Cycle Costs
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%
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%
– 279 –
6.0%
1
12% =
12%
12%
34.8%
100%
Atkinson, Solution Manual t/a Management Accounting, 6E
(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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Chapter 8: Measuring Life-Cycle Costs
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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Atkinson, Solution Manual t/a Management Accounting, 6E
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.
– 282 –
Chapter 8: Measuring Life-Cycle Costs
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.
Target
Cost
$1,400
280
100
700
4,520
$7,000
Function Group
Chassis
Transmission
Air conditioner
Electrical system
Other function groups
Total
Customer Requirements
Safety
Comfort and convenience
Economy
Styling
Performance
Total
Importance
140
120
40
60
140
500
– 283 –
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%
Atkinson, Solution Manual t/a Management Accounting, 6E
Customer
Requirements
Safety
Comfort and
convenience
Economy
Chassis
0.3 
28% =
8.4%
0.3 
24% =
7.2%
0.2 
8% =
1.6%
Transmission
0.1 
28% =
2.8%
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%
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
(b)
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%
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
– 284 –
Action
Implied
Chapter 8: Measuring Life-Cycle Costs
(c)
The electrical system and other function groups are candidates for
cost reduction because their value indexes are less than 1.
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-lifecycle 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.
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Atkinson, Solution Manual t/a Management Accounting, 6E
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 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 (500,000 calculators  $75)
$37,500,000
Less: Target profit (15%  $75/calculator  500,000
calculators)
Target cost for 500,000 calculators
5,625,000
$31,875,000
Unit target cost ($31,875,000/500,000 calculators)
$ 63.75
8-39 To compute the return on sales (ROS) for Bill Mann, it is necessary to
determine Bill’s profit margin:
Sales (300,000 units  $500)
$150,000,000
Less: Expenses
90,000,000
= Profit Margin (ROS  Sales)
$60,000,000
ROS  $150,000,000 = $60,000,000, so ROS = 40%.
Thus, Bill Mann has not met the company-wide return-on-sales target of
45%. Assuming Bill’s initial target costs and target sales prices were
consistent with the company-wide return-on-sales target, Bill should explain
the causes for below-target performance. Potential problem areas include
manufacturing costs and misestimation of customer demand for the
products’ functionality at the target prices. Evaluating whether Bill has done
a good or poor job will involve determining the extent to which Bill could
control cost, and evaluating Bill’s judgment in setting prices.
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:
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Chapter 8: Measuring Life-Cycle Costs
(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.
(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.
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(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 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
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Chapter 8: Measuring Life-Cycle Costs
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 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 timeconsuming, 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
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Atkinson, Solution Manual t/a Management Accounting, 6E
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
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
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Chapter 8: Measuring Life-Cycle Costs
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 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
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Atkinson, Solution Manual t/a Management Accounting, 6E
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:

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:
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Chapter 8: Measuring Life-Cycle Costs

Information gathering and sharing methods

Type of benchmarking information:


Product

Functional (Process)

Strategic (includes management accounting methods)
Method of information collection:

Unilateral

Cooperative:

Database

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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Atkinson, Solution Manual t/a Management Accounting, 6E
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
Direct costs
(material plus labor)
Product Y
Per unit
X
Y
$ 9,000,000 $ 4,000,000 $0.09 $0.10
Environmental support
14,000,000
0.35
Nonenvironmental support 22,000,000 29,000,000 0.22 0.73
Total support
$22,000,000 $43,000,000 $0.22 $1.08
Total costs
$31,000,000 $47,000,000
Number of units
100,000,000 40,000,000
Cost per unit using ABC
$0.31
$1.18
(c)
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 even though Product X does not generate any environmental
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Chapter 8: Measuring Life-Cycle Costs
costs. In part (b), environmental support costs are assigned only to
Product Y.
(d)
Product X Product Y
Cost per unit using current cost driver rate
$0.50
$0.71
$0.75
$1.07
Price, 1.5  cost
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.
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.
8-46 (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:
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Atkinson, Solution Manual t/a Management Accounting, 6E

(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.
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Chapter 8: Measuring Life-Cycle Costs
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.
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.
1
Source: Institute of Management Accountants, Cases from Management Accounting Practice,
Instructor’s Manual, Volume 15. Adapted with permission.
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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.
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Chapter 8: Measuring Life-Cycle Costs
(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
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Atkinson, Solution Manual t/a Management Accounting, 6E
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.
• 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
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Chapter 8: Measuring Life-Cycle Costs
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.
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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Atkinson, Solution Manual t/a Management Accounting, 6E
 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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