Chapter 8

Measuring Life-Cycle Costs

QUESTIONS 8-1 In the Total-life-cycle costing (TLCC) approach, companies are required to manage all the costs incurred through all the stages of a products life-cycle viz. through product design and development, through manufacturing, marketing, distribution, maintenance, service, and, finally, disposal. This is why total-life-cycle costing is referred to as cradle-to-grave costing. The three ma!or stages of the total-life-cycle costing approach are "#$ research, development and engineering "%&'($, ")$ manufacturing, and "*$ post-sale service and disposal. Post-sale service cost refers to those costs that are incurred by an organization after the sale of its products to the customer i.e. these costs are incurred after the first unit of a product is in the hands of the customer. Disposal costs refer to those costs that are incurred for eliminating any harmful effects associated with the end of a products useful life i.e. these costs are incurred after the product is withdrawn from the market. In a products total-life-cycle, post-sales service cost is usually incurred prior to the disposal cost. The three substages of the %&'( stage are "#$ using market research to assess emerging customer needs that lead to idea generation for new products, ")$ product design, during which scientists and engineers develop the technical aspects of the product, and "*$ product development, during which the company creates the features critical to customer satisfaction and designs prototypes, production processes, and any special tooling required. &uring 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
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8-2

8-3

8-4

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

of the product. The following three substages typically occur during this stage- "#$ rapid growth from the first time the product is shipped through the growth stage of its sales, ")$ transition from the peak of sales to the peak in the service cycle, and "*$ 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 products life and lasts until the customer retires the final unit of a product. 8-6 Target cost is defined as the difference between the target selling price and the target profit margin. /nder the target costing approach, target cost is shown in the following equationCtc 0 S tc+ Ptc where, Ctc 0 Target cost S tc0 Target selling price Ptc0 Target profit margin

8- The different steps observed under target costing for determining the cost of a product are 1onducting market survey for inputs from customers regarding their perceived value of the product i.e. knowing the target selling price. &eciding upon the desired level of profit margin of the product. &educting the desired level of profit margin from the target selling price to arrive at the target cost of the product. 8-8 2or product development and target costing purposes, customers needs or requirements must be translated into product functions or components for engineering. 3 quality function deployment matri4 relates information about customer requirements "that is, features that customers require$ to a products functions or components. The matri4 may also include a competitive evaluation of the product. In this way, the matri4 highlights the relationship among competitive offerings, customer requirements, and a products design parameters. The matri4 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 inde4 "benefit5cost ratio$ for each component. If the value inde4 is less than one, the cost e4ceeds the benefit, and the component is a likely candidate for cost reduction in efforts to achieve the target cost. 8-! Cost analysis is an element of the target costing approach that involves determining what components of a product is to be targeted for cost reduction and then assigning a cost target to each of these components. 1ost analysis focuses on the interaction between components and parts.
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Chapter 8: Measuring Life-C cle Costs

8-1" In the conte4t of value engineering, a val#e in$e% is the ratio of the value "degree of importance$ to the customer and the percentage of total cost devoted to each component. It is a measure which helps to identify the components for cost reduction. 8-11 The 62& matri4 displays information about the three variables in a matri4 format. These variables are- features, functions "components$, and competitive evaluation. 8-12 The break-even time "7(T$ metric for the product development process measures the length of time from the pro!ects 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 "7(T$ metric brings together in a single measure three critical elements in an effective and efficient product development process. 2irst, for the company to break-even on its %'& process, its investment in the product development process must be recovered. 8o 7(T requires tracking the entire cost of the design and development process. It provides incentives to make the product development process faster and less costly. 8econd, 7(T 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. 3nd third, 7(T is denominated in timeit 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 &esirable behavioral consequences that are likely as people focus on improving the break-even time "7(T$ metric include collaboration and integration across organizational functions. 9eople from different disciplines come together at the start of every product development pro!ect to estimate the time and money they require to perform their tasks, and the impact of their efforts on the success of the entire pro!ect. The 7(T metric promotes discussion and facilitates decision-making during the pro!ect among people from the multiple functions as more information about the pro!ect, customers, and competitors becomes available.

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8-15 /sing percent of re!enues from ne" pro#ucts 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 e4isting products. :ith this approach, a companys products run the risk of becoming stale or being copied by competitive offerings, and prices and margins will consequently decline. 8-16 ;onfinancial measures that a company might use in order to motivate achieving the ob!ective of anticipating future customer needs include "#$ time spent with key customers at targeted accounts learning about their future opportunities and needs, and ")$ the number of new pro!ects launched based on customer input. 8-1 ;onfinancial measures that a company might use in order to motivate achieving the ob!ective of reducing product development cycle time across an array of products include "#$ number of pro!ects delivered on time, ")$ average time spent by pro!ects at the development, test, and launch stages of the development process, and "*$ total %&'( time from idea to market.

8-18 3ctivities 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. 8-1! &%plicit environ'ental 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. ('plicit environ'ental costs often pertain to the infrastructure required to monitor environmental issues. (4amples of implicit environmental costs include legal counsel, administration, employee education and awareness, and the loss of goodwill if environmental disasters occur. EXE CISES 8-2" The total-life-cycle costing approach differs from the traditional product costing in that it includes the research, development and engineering "%&'($, manufacturing, and post-sale service and disposal cycles. Traditional product costing is more narrowly focused and is concerned only with costs incurred during the manufacturing stage of the total product life cycle.

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Chapter 8: Measuring Life-C cle Costs

8-21 The benefits of using a total-life-cycle costing approach to product costing include providing managers with the <big picture= of managing costs over the research development and engineering. manufacturing. and post-sale service and disposal cycles. 8uch a perspective allows managers the opportunity to see how decisions made in one stage affect costs throughout the entire product life cycle. This perspective is not possible under the traditional product costing approach. The total-life-cycle costing approach should therefore lead to more cost-effective products and services. 8-22 The traditional accounting focus in managing costs is on the manufacturing stage of the total life cycle of a product. The most significant problem with this focus is that the traditional method ignores product costs before manufacturing "in the research, development and engineering "%&'($ stage$ as well as those that occur after manufacturing "in the post-sale and disposal stage$. The limited focus is especially problematic because it is common for >?->@A of a products life cycle costs to be committed by decisions made in the %&'( cycle. 8-23 (4hibit >-) illustrates the relationship between costs committed and costs incurred over the total life cycle of a product. The top curve, <cost committed,= shows how a very large percentage ">?+>@A$ 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. 1osts 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. ;ote 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- "#$ managers need to manage costs at the %&'( stage, ")$ all stages of the life cycle are important, and "*$ the %&'( 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. &isposal costs are most relevant when an organization has to eliminate any harmful effects associated with the end of a products life. 8-25 The features of target costing areB It is a method of profit planning and cost reduction.
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Atkinson, Solution Manual t/a Management Accounting, 6E

B B B B B

It focuses on reducing costs for products in the research development and engineering stage of the total life cycle of a product. Target costing uses the total-life-cycle concept. In other words, it considers all aspects of the value chain and e4plicitly recognizes total-life-cycle costs. Target costing is a customer driven approach. /nder target costing, market research is not a single event. rather customer inputs are obtained continually throughout the process. 9roduct engineers attempt to design costs out of the product before design and development ends and manufacturing begins. Its aim is continuous cost reduction.

8-26 Calue engineering is a process in which each component of a product is scrutinized to determine whether it is possible to reduce costs while maintaining functionality and performance. It is a key activity within target costing. Calue engineering consists of the following two sub-activities#. Identify components for cost reduction. It involves choosing which components of the product are to be selected for cost reduction. It requires the computation of value inde4. ). Denerate cost reduction and function enhancement ideas. (ngineers are engaged in creative thinking and brainstorming to identify what can be reduced, eliminated, combined, substituted, rearranged, or enhanced to provide the same or higher level of functionality from a component at less cost. 8-2 #. ). 1ost analysis, which is a key activity within target costing, is performed by the engineers. It involves the following five sub-activities&evelopment of a list of product components and functions- 1ost reduction efforts start by listing the various product components and identifying the functions that they perform and their current estimated cost. 9erformance of a functional cost breakdown- (ach of the various parts and components of a product performs a specific function. This step involves the identification of that function and estimation of the costs of those components. &etermine the relative importance of customers requirements- In order to connect a products functions to the features that customers want, engineers first assess the relative importance that customers place on the various features. They conduct a formal survey of prospective customers asking them to rank the relative importance of the products eight features.
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Chapter 8: Measuring Life-C cle Costs

,.

@.

%elating features to functions- It involves the conversion of the relative rankings of features into an importance ranking for each product function. The components carry out the functions of a product and are the key design parameters, this step relates customer rankings to the components that best meet that particular requirement. 2or generating this relationship, the engineers use a tool called a quality function deployment "F2&$ matri4. &evelop relative functional rankings- The F2& matri4 enables the engineers to convert feature rankings into functional or component rankings

8-28 8ome 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 e4ecutives$ re!ect the idea and do not understand its value. 8-2! 3 manager asked to benchmark another organizations 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. :hile these are critical variables on which to gather information, target costing always has to be studied and understood in relation to the specific organization involved. 8-3" The target costing relationship is e4pressed in the following equation formC = 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 e4pressed as follows- P = S C . The desired profit margin, P, is found by subtracting the estimated cost, C, from the e4pected selling price, S. The second traditional approach, known as the cost-plus method, e4presses the relationship among variables as S = C + P . /nder cost-plus, an e4pected profit margin is added to the e4pected product cost. 9rice is simply the result of the sum of these two variables. /nlike the traditional approaches, target costing focuses on achieving a particular cost target.

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8-31 "a$
Percent Contri)#tion of &ac* Co'ponent to C#sto'er +e,#ire'ents 1omponent 7ody5 1offee :ater :armer :ell %elative 2eature %anking )?A #EA ?., >A 0 *.)A >A #)A # #EA 0 #EA ?.K ,A 0 *.EA ?.) #)A 0 ).,A ?.> #)A 0 K.EA # #)A 0 #)A )).,A #?.>A K.EA #E.,A E.?A *,.>A #EA ,A #)A #)A #??A

1ustomer %equirements Tastes5smells like e4presso (asy to clean Iooks nice Has EJ cup capacity 8tarts automatically on time Has multiple grinder settings Leeps the coffee warm 3utomatic shutoff 1onverted component ranking

7rew 7asket ?.G )?A 0 #,A ?.@ #EA 0 >A

1arafe

Heating &isplay (lement 9anel ?.* )?A 0 EA

?.# #EA 0 #.EA ?.# >A 0 ?.>A ?.@ #)A 0 EA

?., #EA 0 E.,A ?.@ >A 0 ,A ?.@ #)A 0 EA

?.# ,A 0 ?.,A

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Chapter 8: Measuring Life-C cle Costs

"b$ Calue Inde4 for Litchenhelps 1offeemaker 1omponent or 2unction 7rew 7asket 1arafe 1offee :armer 7ody5 :ater :ell Heating (lement &isplay 9anel ")$ 1omponent 1ost #>.?A ,.?A E.?A #>.?A >.?A ,E.?A "*$ %elative Importance )).,A #?.>A K.EA #E.,A E.?A *,.>A "*$ ")$ Calue Inde4 #.), ).G? #.E? ?.K# ?.G@ ?.GE 3ction Implied (nhance (nhance (nhance %educe cost %educe cost %educe cost

The body5 water well, heating element, and display panel are candidates for cost reduction because their value inde4es are less than #.

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8-32 3s shown below, Dreysons new break-even time occurs during Fuarter * of Mear ,, appro4imately #@ months later than the initial *? months "Mear *, Fuarter )$.
"???$ M#, F# M#, F) M#, F* M#, F, M), F# M), F) M), F* M), F,

Narket %esearch O"#??$ O"@?$ 9roduct &evelopment ">?$ "#@?$ "#@?$ "#@?$ "#@?$ "#@?$ "#@?$ 8elling 9rice 1ost per unit Nargin5unit 8ales quantity 1ontribution N8&3 e4penses 9roduct profit Fuarterly 9rofit5Ioss O"#??$ O"#*?$ O"#@?$ O"#@?$ O"#@?$ O"#@?$ O"#@?$ O"#@?$ 1umulative 9rofit5Ioss O"#??$ O")*?$ O"*>?$ O"@*?$ O"E>?$ O">*?$ O"K>?$ O"#,#*?$

"???$a

M*, F#

M*, F)

M*, F*

M*, F,

M,, F#

M,, F)

M,, F*

M,, F,

Narket %esearch 9roduct &evelopment O"E?$ 8elling 9rice O#K O#> O#> O#G O#G O#E O#@ O#@ 1ost per unit #? #? #? #? #? #? #? #? Nargin5unit OK O> O> OG OG OE O@ O@ 8ales quantity )@ *@ ,@ @? @? @? ,? *? 1ontribution O))@ O)>? O*E? O*@? O*@? O*?? O)?? O#@? N8&3 e4penses #)? #)? #)? #)? #)? #)? #)? #)? 9roduct profit O#?@ O#E? O),? O)*? O)*? O#>? O>? O*? Fuarterly 9rofit5Ioss O,@ O#E? O),? O)*? O)*? O#>? O>? O*? 1umulative 9rofit5Ioss O"#,?>@$ O"K)@$ O"E>@$ O",@@$ O"))@$ O",@$ O*@ OE@ a 3ll amounts e4cept selling price, cost per unit, and margin per unit are in #,???s.

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Chapter 8: Measuring Life-C cle Costs

8-33 3s shown below, Dreyson will now never reach a break-even time. 7eginning with M,, F,, Dreyson will incur quarterly losses of O)?,??? and will never show a positive cumulative profit.
"???$ M#, F# M#, F) M#, F* M#, F, M), F# M), F) M), F* M), F,

Narket %esearch O"#??$ O"@?$ 9roduct &evelopment ">?$ "#@?$ "#@?$ "#@?$ "#@?$ "#@?$ "#@?$ 8elling 9rice 1ost per unit Nargin5unit 8ales quantity 1ontribution N8&3 e4penses 9roduct profit Fuarterly 9rofit5Ioss O"#??$ O"#*?$ O"#@?$ O"#@?$ O"#@?$ O"#@?$ O"#@?$ O"#@?$ 1umulative 9rofit5Ioss O"#??$ O")*?$ O"*>?$ O"@*?$ O"E>?$ O">*?$ O"K>?$ O"#,#*?$

"???$a

M*, F#

M*, F)

M*, F*

M*, F,

M,, F#

M,, F)

M,, F*

M,, F,

Narket %esearch 9roduct O"E?$ &evelopment 8elling 9rice O#> O#G O#G O#E O#@ O#@ O#@ O#@ 1ost per unit #? #? #? #? #? #? #? #? Nargin5unit O> OG OG OE O@ O@ O@ O@ 8ales quantity )? *? ,? ,@ ,@ *@ *? )? 1ontribution O#E? O)#? O)>? O)G? O))@ O#G@ O#@? O#?? N8&3 #)? #)? #)? #)? #)? #)? #)? #)? e4penses 9roduct profit O,? OK? O#E? O#@? O#?@ O@@ O*? O")?$ Fuarterly O")?$ OK? O#E? O#@? O#?@ O@@ O*? O")?$ 9rofit5Ioss 1umulative 9rofit5Ioss O"#,#@?$ O"#,?E?$ O"K??$ O"G@?$ O"E,@$ O"@K?$ O"@E?$ O"@>?$ a 3ll amounts e4cept selling price, cost per unit, and margin per unit are in #,???s.

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8-34 To use activity-based costing to help control and reduce environmental costs, the activities that cause environmental costs must be identified. ;e4t, the costs associated with the activities must be determined. These costs must then be assigned to the most appropriate products, distribution channels and customers. 3s 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. (nvironmental costs include e4plicit 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. /sing traditional cost systems, environmental-related costs are often hard to pinpoint because they are usually hidden in support cost pools. ! O"LEMS 8-35 "a$ To prepare an e4hibit similar to (4hibit >-K, first compute the relative cost percents illustrated in (4hibit >-E and the relative rankings illustrated in (4hibit >-G. 2unction Droup 1hassis Transmission 3ir conditioner (lectrical system 6ther function groups Total 1ustomer %equirements 8afety 1omfort and convenience (conomy 8tyling 9erformance Total Target 1ost O#,,?? )>? #?? G?? ,,@)? OG,??? Importance #,? #)? ,? E? #,? @?? 9ercent of 1ost )?.? ,.? #., #?.? E,.E #??.? %elative %anking in 9ercent )>A ),A >A #)A )>A #??A

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Chapter 8: Measuring Life-C cle Costs

1ustomer %equirements

1omfort and convenience (conomy 8tyling

1hassis ?.* )>A 0 >.,A ?.* ),A 0 G.)A ?.) >A 0 #.EA ?.# #)A 0 #.)A ?.* )>A 0 >.,A )E.>A

Transmission ?.# )>A 0 ).>A

?.) >A 0 #.EA

2unction Droup 3ir 1ondi(lectrical tioner 8ystem ?.# )>A 0 ).>A ?.# ?.# ),A 0 ),A 0 ).,A ).,A ?.# ?.# >A 0 >A 0 ?.>A ?.>A

6ther 2unction Droups ?.@ )>A 0 #,A ?.@ ),A 0 #)A ?., >A 0 *.)A ?.K #)A 0 #?.>A ?., )>A 0 ##.)A @#.)A

%elative 2eature %anking

)>A ),A

>A

#)A )>A #??A

9erformance

?.) )>A 0 @.EA #?.?A *.)A

?.# )>A 0 ).>A >.>A

1onverted component ranking

"b$ The value inde4 is a benefit5cost ratio, obtained by dividing the relative importance in column "*$ by the associated relative cost column ")$. ")$ 2unction Droup 1hassis Transmission 3ir conditioner (lectrical system 6ther function groups 1ost )?.?A ,.?A #.,A #?.?A E,.EA "*$ %elative Importance )E.>A #?.?A *.)A >.>A @#.)A "*$ ")$ Calue Inde4 #.*, ).@? ).)K ?.>> ?.GK 3ction Implied (nhance (nhance (nhance %educe cost %educe cost

"c$ The electrical system and other function groups are candidates for cost reduction because their value inde4es are less than #.

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8-36 The traditional focus of cost management has been only on manufacturing processes. /nder this approach, pre-manufacturing costs, such as research and development, and post-manufacturing costs, such as service, are considered period costs, and companies e4pense 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$, often lead managers to focus myopically on their own departments costs. In particular, for the manufacturing function, defining product costs as those solely related to the manufacturing process ignores many costs associated with the entire life cycle cost of a product. /nderstanding the total life cycle costs "TI11$ 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. 2or e4ample, if a company can reduce a products 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. 3 TI11 system provides information for managers to understand and manage costs through a products 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.= 8-3 Dregoire Drant is shortsighted. The manufacturing cycle of the total-life-cycle costing approach is only one of three ma!or stages of the product life cycle concept. The other life cycle concepts are research, development and engineering, and post-sale service and disposal. :hile each concept is useful within its respective functional area, from a total-life-cycle costing "TI11$ perspective, it is important to integrate the concepts and to understand them in their entirety. 8uch integration allows managers to see the $ig picture and to manage whole-life product costs in a comprehensive fashion. 2or e4ample, poor decisions in the research development and engineering stage may lead to much higher costs in the manufacturing and post-sale service stages. Thus, it is in Dregoires best interest to understand what is occurring in the research development and engineering stage. In order for managers at Dregoires company to fully adopt the TI11 view, it will probably be necessary to break down what are called <functional silos.= 2unctional silos are traditional parts of organizations that are often thought "by those in them$ to be self-contained. 7reaking these down often means
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reorganizing the company into cross-functional teams who share a vision of integration across their previous functions. 3nother critical aspect to understanding the importance of the TI11 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 TI11 perspective. 8-38 The target cost for a 1alcutron calculator is computed as followsTarget sales ">??,??? calculators P O#??$ Iess- Target profit ")?A P O#??5calculator P >??,??? calculators$ Target cost for @??,??? calculators /nit target cost "OE,,???,???5>??,??? calculators$ O>?. 8-3! To compute the return on sales "%68$ for %oger Twickenham, it is necessary to determine %ogers profit margin8ales "E,?,??? units OG@?$ O,>?,???,??? Iess- (4penses )E,,???,??? 0 9rofit Nargin "%68 8ales$ O)#E,???,??? %68 O,>?,???,??? 0 O)#E,???,???, so %68 0 ,@A. Thus, %oger Twickenham has met the company-wide return-on-sales target of *@A. Thus, it seems %ogers targets were better achieved than the companywide return-on-sales target, which e4plains the causes for his good performance. 8-4" 8ome studies of target costing in Qapan 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"#$ 8enior e4ecutives and workers may re!ect target costing. (ducation 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. O>?,???,??? #E,???,??? OE,,???,???

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")$ 1onflicts can arise between various parties involved in the target costing process. 2irst, companies can put e4cessive pressure on subcontractors5suppliers to conform to the schedule and to reduce their costs. This can lead to alienation and5or failure of the subcontractor. 8econd, design engineers become very upset when other parts of the organization are not as cost conscious as they are. 8ince 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. 6ften this is not the case. To overcome this problem, pressure can be reduced on subcontractors5suppliers by giving them reasonable grace periods over which cost reduction must occur. 8imply demanding cost reduction immediately will e4acerbate the conflict. The issue of design engineers also can be addressed by making other parts of the organization as cost conscious. 3dopting a total-life-cycle costing approach and using cross-functional teams will help the organization to this end. "*$ (mployees in many Qapanese companies working under target costing goals e4perience burnout due to the pressure to meet the target cost. 7urnout is particularly evident for design engineers. This issue can be addressed by making target-costing goals tight, but attainable. 6ften organizations make the mistake of setting impossible goals. &esign engineers also often fear that if they make the target, in the ne4t 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 !obs rest on it. The organization has to be careful not to burn out employees, and design engineers in particular, as they are e4tremely valuable to the organization. 7urnout is probably the biggest issue related to the success or failure of target costing in Qapan. ",$ :hile 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. 2or some types of products, being si4 months late to market may be far more costly than having small cost overruns. This is a very serious problem for the organization. 1learly, there is a tradeoff between continuing to reduce target costs and being very late to market. However, on average, many months of lost sales
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will have a much more detrimental effect on the organization than whether target costs are met. Thus, the organization has to take a reasonable approach to target costing and not lose sight of the ultimate goal of selling the product and increasing market share. Time limits can be put in place for the length of time allowed to develop or introduce new products. 8-41 There are some similarities between traditional cost reduction and target costing, but the differences are more striking. 7oth the traditional costing method and target costing begin with market research into customer requirements followed by product specification. /nder traditional cost reduction, companies engage in product design and engineering, and obtain prices from suppliers. 9roduct cost at this stage is not a significant factor for product design. 3fter 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 e4pected selling price. 9rofit margin is the result of the difference between the e4pected selling price and the estimated production cost. /nder another traditional method, cost-plus, the e4pected profit margin is added to the e4pected product cost and selling price is the result of the sum of these two variables. /nder target costing, after market research to determine customer requirements and product specification, the process is quite different. The ne4t step, determining a target selling price and target product volume, depends on the companys 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 income5sales$. The target cost is the difference between the target selling price and the target profit margin. 6nce the target cost is set, the company must determine target costs for each component. The value engineering process includes e4amination of each component of a product to determine whether it is possible to reduce costs while maintaining functionality and performance. In some cases, product design might change, materials used in production might need replacing, or manufacturing processes might require being redesigned. 8uppliers 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 7ringing in outside consultants to implement a target costing system can be effective, but costly. 1onsultants 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.= 3 downside of using consultants is that, in some
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instances, consultants want to use an e4isting 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. 8ome organizations ob!ect to this and want a more tailored approach, especially if they are in an industry in which the consultants have not worked at all. 1onsultants may agree to tailor the approach, but the cost of implementation of a target costing system will increase significantly. 3 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. 3 second approach is for organizational members to develop a target costing system internally with little or no assistance from outside consultants. This approach can be satisfying, but it can be costly and time-consuming, especially if the organization has little e4perience 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. 6nce 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 e4ternally to the best target costing systems of other organizations for guidance on change. 7enchmarking 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. 7enchmarking allows organizations to gain insights on target costing from others, but at the same time to assume responsibility for the changes. In this way, organizational members feel like they have ownership of the changes and this can lead to developing more confidence about future changes and improvements to their management accounting system. 8-43 The answer to this question is very similar to the solution for >-,# but it is more detailed. The process involved in traditional cost reduction as practiced in the /nited 8tates is significantly different from target costing. The traditional costing method begins with market research into customer
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Chapter 8: Measuring Life-C cle Costs

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. 3fter 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 e4pected selling price ( St ) . The profit margin is the result of the difference between the e4pected selling price and the estimated production cost. This relationship in the traditional system is e4pressed as- Pt = St Ct . 3nother widely used traditional approach is the cost-plus method. /nder cost-plus, an e4pected profit margin Pcp is added to the e4pected product cost Ccp where the subscript cp indicates numbers derived under cost-plus thinking. 8elling price Scp, then, is simply the result of the sum of these two variables. In equation form, this relationship for the cost-plus approach isScp = Ccp + Pcp . 3s in the first traditional method described above, product designers do not attempt to achieve a particular cost target. /nder 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. 3fter these initial steps, the process is quite different. The ne4t step, determining a target selling price ( Stc ) and target product volume, depends on the companys 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 income5sales$. %eturn on sales is the most widely used measure, as it can be linked most closely to profitability for each product. The target cost (Ctc ) is the difference between the target selling price and the target profit margin. ;ote that the tc subscript indicates numbers derived under the target costing approach. This relationship for the target costing approach is shown in the following equation- Ctc = Stc Ptc . 6nce the target cost is set, the company must determine target costs for each component. The value engineering process includes e4amination of each component of a product to determine whether it is possible to reduce costs while maintaining functionality and performance. In some cases, product design might change, materials used in production might need replacing, or manufacturing processes might require redesign. 2or e4ample, a product design change might
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involve using fewer parts or reducing specialty parts if the company can use more common components. 8everal iterations of value engineering usually are required before it is possible to determine the final target cost. 8uppliers also play a critical role in making target costing work. If manufacturers with market power decide that there is a need to reduce the cost of specific components, they will pressure suppliers to find ways to reduce costs. 1ompanies such as Toyota and ;issan might, in some cases, offer incentive plans to suppliers who come up with the best cost reduction ideas. 8-44 In theory there is no reason to assume that target costing, or at least parts of it, cannot be applied to service organizations. However, the method was developed for products requiring discrete manufacturing processes and short product life cycles. In a bank, products "or services, depending on how you look at it$ would include checking accounts, savings accounts, all types of loans, etc. The bank could follow the steps outlined in (4hibit >-, and do market research to determine customer requirements and product specification. 1ustomer 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. ;e4t, 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. /sing the five-stage benchmarking model below, the instructor may wish to select various approaches beginning with the choices on the dimensions in 8tage * and continuing into 8tage , for different members of the class and then have them compare the plans that they devise. 2or instance, in 8tage * you might ask some students to devise a plan for benchmarking organizations within the banking industry and for those outside of banking. 8ome might be asked to benchmark with many partners and some with few. 2or 8tage , the methods of information gathering and sharing can be varied. 8ome students can be assigned the unilateral form of benchmarking, while others can be assigned one of the three forms of cooperative benchmarking. :hat are the implications of eachR 3lso, 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 e4ercise for students. Stage %+ E? +

Chapter 8: Measuring Life-C cle Costs

Internal study and preliminary competitive analyses 9reliminary internal and e4ternal competitive analyses &etermining key areas for study &etermining scope and significance of the study

Stage & &eveloping long-term commitment to the benchmarking pro!ect change 1oalescing the benchmarking team /sing an e4perienced coordinator Training employees Daining senior management support &eveloping a clear set of ob!ectives (mpowering employees to make

Stage ' Identifying benchmarking partners

8ize of partners ;umber of partners %elative position within and across industries &egree of trust among partners

Stage ( Information gathering and sharing methods

Type of benchmarking information 9roduct 2unctional "9rocess$ 8trategic "includes management accounting methods$ /nilateral 1ooperative

Nethod of information collection

&atabase
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Atkinson, Solution Manual t/a Management Accounting, 6E

Indirect5third party Droup

&etermining performance measures &etermining the benchmarking performance gap in relation to performance measures

Stage ) Taking action to meet or e4ceed the benchmark

Naking comparisons of performance measures

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Chapter 8: Measuring Life-C cle Costs

C#SES 8-45 "a$ &irect costs "material plus labor$ (nvironmental support ;onenvironmental support Total support Total machine hours 1urrent cost driver rate Total support machine hours 1osts using current cost driver rate &irect costs "material plus labor$ 3pplied supportO,.?E)@ per machine hour Total costs ;umber of units 1ost per unit "b$ 9roduct S &irect costs "material plus labor$ (nvironmental support ;onenvironmental support Total support Total costs ;umber of units 1ost per unit using 371 "c$ 9roduct M O K,???,??? O ,,???,??? ,?,E)@,??? ),,*G@,??? O,K,E)@,??? O)>,*G@,??? #??,???,??? ,?,???,??? O?.@? O?.G# 9er unit S M O,.?E)@ 9roduct S 9roduct M Total

OK,???,??? O,,???,??? #,,???,??? )),???,??? )K,???,??? O)),???,??? O,*,???,??? OE@,???,??? #?,???,??? E,???,??? #E,???,???

O K,???,??? O ,,???,??? O?.?K O?.#? #,,???,??? ?.*@ )),???,??? )K,???,??? ?.)) ?.G* O)),???,??? O,*,???,??? O?.)) O#.?> O*#,???,??? O,G,???,??? #??,???,??? ,?,???,??? O?.*# O#.#>

&ifferent methods are used to allocate support costs in part "a$ and part "b$. In part "a$, environmental support costs are allocated to both products
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even though 9roduct S does not generate any environmental costs. In part "b$, environmental support costs are assigned only to 9roduct M. "d$ 1ost per unit using current cost driver rate 9rice, #.@ cost 1ost per unit using 371 9rice, #.@ cost 9roduct S 9roduct M O?.@? O?.G# O?.G@ O#.?G O?.*# O?.,G O#.#> O#.GG

6f 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 S essentially subsidizing product M. 9roduct Ms price under this system does not even cover the products specific environmental costs as identified by the activity-based costing approach.. 1onsequently, the company should evaluate a price increase for product M or ways to decrease productrelated costs for product M. The company may be able to reduce product Ms costs by using a process that reduces or eliminates hazardous wastes. 9roduct Ss price could be reduced and still generate a profit. In making such a decision, the company would evaluate e4pected changes in demand "if any$ if product Ss price were reduced. "a$ 9at 9olley has listed or e4pressed concern about a number of e4plicit and implicit environmental costs. &%plicit environ'ental costs include

8-46

The net cost of purchasing and installing the new equipment 1ost of removing the old equipment Insurance for the equipment and the workers due to hazardous materials 8torage and disposal costs for hazardous wastes

Iegal fees related to handling paperwork for hazardous waste liabilities %isk of 68H3 fines %isk of liability due to accidental leakage Iabor cost of removing hazardous wastes

('plicit environ'ental costs include+ E, +

Chapter 8: Measuring Life-C cle Costs

;egative media coverage that will reduce demand

"b$

6ther environmental costs include

Training workers on handling hazardous wastes Nonitoring hazardous wastes 2iling reports on hazardous wastes

9ossible productivity problems because of poor worker morale due to hazardous work environment 9oor worker health or increased absenteeism because of e4posure to hazardous wastes

%isk of liability due to increasingly stringent laws 1ost for permits related to hazardous waste

Iegal counsel (mployee education and awareness Ioss of goodwill if environmental disasters occur "c$ Lwik 1lean faces a variety of environmental costs, including storage and disposal costs for hazardous wastes, legal fees, training costs, insurance, permit costs, and monitoring costs. /sing 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. 3ctivity-based costing can help control and reduce environmental costs because it identifies process activities, including activities that cause environmental costs. ;e4t, the costs associated with the activities are determined. These costs are then assigned to the most appropriate products or services. 3wareness of how Lwik 1leans activities generate environmental costs, as well as awareness of the magnitude of the costs, establish a starting point for controlling and reducing them. 8-4 "a$ Nercedes-7enz 3ll 3ctivity Cehicle "33C$# T;ote- 3dditional information can be found in the following references3lbright, T. <The /se of Target 1osting in &eveloping the Nercedes 7enz N-1lass,= International Qournal of 8trategic 1ost Nanagement "3utumn #KK>$- #*-)*.

8ource- Institute of Nanagement 3ccountants, Cases from Management Accounting Practice, *nstructor+s Manual, ,olume %). 3dapted with permission.
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Atkinson, Solution Manual t/a Management Accounting, 6E

3lbright, T. and 8. &avis. <The (lements of 8upply 1hain Nanagement,= International Qournal of 8trategic 1ost Nanagement "3utumn #KKK$- ,K-E@.U The target costing case literature contains numerous e4amples of Qapanese cost management practices. however, few cases describe the use of target costing by large companies outside Qapan. The purpose of the Nercedes-7enz 33C case is to consider the competitive environment of a leading Derman automotive manufacturer and the companys response to changing competitive conditions. The teaching plan generally follows the suggested student assignment questions. 3dditional material that can be introduced during the case discussion is indicated by a check mark. 8tudent 3ssignment Fuestions "a$ :hat is the competitive environment faced by N7R 8tudents may identify a number of changes, including significant market share lost to Qapanese companies such as Ie4us. 8tress the importance of a cultural change taking place within top management at Nercedes. %einforce that Nercedes is a company that had never lost money until #KK*. They simply built the best car their engineers could design and priced it above cost. &emand often e4ceeded supply. 3s a result, cost had never been a primary consideration. 1hanges includeB cost competition. B product innovation. B new segments "sports utility vehicle$. B new market niches.

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"b$ How has N7 reacted to the changing world market for lu4ury automobilesR 8tudents should identify the following changes implemented by management at Nercedes. try to get them to e4plain how different these approaches were from traditional strategies at NercedesB many new product introductions. B partnering with suppliers. B reduced parts and system comple4ity. B new emphasis on cost control. B layers of management reduced. B lead time from concept to introduction reduced. "c$ /sing 1oopers cost, quality, functionality chart, discuss the factors on which N7 competes with other automobile producers such as Qeep, 2ord, and DN. "If the instructor wishes to give a brief mini-lecture on %obin 1oopers survival triplet and confrontation strategy,) this is a good point in the case discussion to do so.$ The factors areB priceVat mid to upper range of zone. B qualityVat upper range of zone. B functionalityVat upper range of zone. 3n interesting point to discuss is that Nercedes does not produce the most e4pensive sports utility vehicle. This distinction is reserved for the Iand %over. however, they strategically placed themselves toward the lu4ury end of the spectrum. 3lso, unlike many Qapanese e4amples, Nercedes does not use target costing as a strict cost control mechanism to produce the lowest priced product in its class.

%obin 1ooper, -hen Lean Enterprises Colli#e, 7oston- Harvard 7usiness 8chool 9ress, #KK@.
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Atkinson, Solution Manual t/a Management Accounting, 6E

"d$ How does the 33C pro!ect link with N7 strategy in terms of market coverageR The new introductions e4pand the product line of the traditionally lu4uryoriented manufacturer. %ecent product introductions include the followingB 3 1lass. B 1 1lass. B 8IL. B ( 1lass. B N 1lass. These new introductions include new sports cars and off-road vehicles. The 1 1lass is a mid-sized vehicle sometimes referred to as the baby-7enz. Let+s #iscuss the elements of the target costing mo#el an# ho" these elements are #e!elope#. 3t this point in the discussion I usually write the target costing formula on the board and ask students to consider sources of various inputsB target selling price. B target profit margin. B target cost. -hat are the sources of input for the pro/ecte# target selling price0 8tudents will most likely identify the following sources of informationB customer focus groups. B comparable productse4isting, potential. 8tress the broad, cross-functional aspects of acquiring consumer information. To compare products, the company had to evaluate e4isting competitive vehicles as well as vehicles under development. -hat factors are consi#ere# "hen #e!eloping the re1uire# target profit margin0 This question provides a link to finance classes. Nost students have studied the concepts of weighted-average cost of capital. I recommend spending a few minutes reviewing these concepts and linking cost of capital to net present value ";9C$ analysis. 7ecause of the capital-intensive structure of automobile manufacturing, production volume is a critical factor in determining each models ;9C. 8tudents may identify the following points for determining a required target profit margin.
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Chapter 8: Measuring Life-C cle Costs

B B B B

long-run profitability. cost of capital. profitability across the entire product mi4 "classes of vehicles$. sales volume by class.

2he M3 case suggests the target cost is 4ali!e.5 *s this consistent "ith the i#eals of target costing0 I generally emphasize that Nercedes did not consider the target cost to be locked in. It was a moving target. 3s engineering changes became necessary, the target cost was allowed to move. However, before making a change, market forces were considered. 2or e4ample, changes included the addition of side airbags. In addition, the (uropean press was critical of a simulated wood-grain part. Nanagement 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$ (4plain the process of developing an importance inde4 for a function group or component. How can such an inde4 guide managers in making cost reduction decisionsR The inde4 development process has five steps, as followsB consumer importance category rankings. B target cost and percentage by function group. B category vs. function group matri4 "function group contribution to customer requirements$. B importance inde4 of the various function groups. B target cost inde4. The instructor can make slides of Tables #-@ to facilitate discussion. Inde4 development is an important element in the early conceptualization phase of the 33C. The inde4es help to quantify some very abstract concepts. Table #. 2rom conversations with potential consumer groups, a list of key categories was developed. ;e4t, potential customers were asked to rate the importance of each category. Their responses were computed as a percentage. Thus, safety and comfort of the 33C were viewed as significantly more important than economy and styling. Table ) 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 inde4.
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Atkinson, Solution Manual t/a Management Accounting, 6E

Table * is best understood by reading each category as a column. The rows e4plain the relative importance of each function group to satisfying each category defined by customers. 3n interesting aspect of this table is that the link between consumer preferences and engineering components is made e4plicit. Table , builds on Table * by weighting the percentages computed in Table * by the importance percentages calculated in Table #. The key point is to understand which function groups contribute the most "least$ to important "less important$ consumer categories. Table @ results in a target cost inde4 for each function group that attempts to capture cost and benefit trade-offs. 3s discussed in the case, this inde4 may indicate a cost in e4cess of the perceived value of a function group. Thus, opportunities for cost reduction "aligned with customer requirements$ may be identified. "f$ How does N7 approach cost reduction to achieve target costsR 3t this point, ask students to identify various value-engineering strategies. 3t Nercedes, reducing the cost of each function group was accomplished by reducing costs of various components that make up the function group. 8tress the importance of this approach over an <across-the-board= cut. "g$ How do suppliers factor into the target costing processR :hy are they so critically important to the success of the N7 33CR 2rom the conceptual phase through the production phase, the suppliers of systems for the 33C truly were partners. 8uppliers attended regular meetings with the cost planners throughout the entire process. Thus, suppliers wereB design and development partners from very early stages of development, B responsible for meeting cost targets.

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-h is the relationship "ith suppliers a crucial element in the success of the AA,0 8uppliers provide entire systems for the 33C. The facility uses a QIT production system. In fact, many suppliers deliver directly to the assembly line, rather than to a small warehouse. The 7lack :arrior %iver separated Nercedes and a ma!or system supplier. This supplier built a new production facility on the same side of the river as the Nercedes 7enz plant to avoid possible delays associated with accidents on a ma!or bridge. "h$ :hat role does the accounting department play in the target costing processR 8tress the fact that accountants were watchdogs in the target costing process. Their primary responsibility was to ensure costs did not e4ceed targets during the production phase. Thus, the accountants role was as followsB cost control. B actual costs versus target costs- development stage, - production stage. -hat are some of the organi6ational $arriers that ma managers attempting to intro#uce target costing s stems0 challenge

Try to get students to identify various impediments to target costing systems in the /nited 8tates. (4amples may includeB willingness to share cost data with suppliers. B suppliers treated as adversaries. B government regulations affecting e4change of information.

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