05c AMP Investment Calculation Target Costing

5.
6 Static
Investment Calculation
or one-period method
innovativ & lebendig – Bildungsregion DonauWald

TECHNICAL UNIVERSITY DEGGENDORF
Classification of Investment Types
● Objects:
● real investment
● financial investment
● Immaterial investment
● Objective:
● construction investment
● replacement investment
● rationalization investment
● expansion investment
● Social / security investment
● Useful life:
● Short-term investment (up to 1 year)
● Medium-term investment (from 1 year to 5 years)
● Long-term investment (from 5 years)
● Time schedule :
● start-up investment
● Ongoing investment
Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e

Basic Structure of Investment Calculations
Definition of the task
Creative phase, technical planning with alternatives
Quantity Structure: Quantity determination and valuation
Check:
Cash outflows and cash
Costs and services
inflows
Cost, performance and profit

Discounting
comparison
Criteria: Profitability, liquidity, risk, social impact
Decision

Overview of the Investment Calculation Procedure
Investment calculation procedure
Static investment calculation Dynamic investment calculation
Classic Non classical

methods methods
net present Method of

profit comparison method
value method complete
financial plans
annuity-
cost comparison calculation
method
internal interest
average return method
rate
dynamic
amortization calculation
amortizationsr.

Static Method or Single-period Method
● The evaluation of the variant is always based on a period that can be

regarded as representative:
● Use of average values
● Comparison of investment alternatives only for the same useful lives
● No account is taken of the differences in payment dates, interest and
compound interest effects are not taken into account.
● Advantages: ● Disadvantages:
+Simple calculation logic, execution – Ignorance of temporal differences
+High transparency – Low accuracy
● Static investment calculation

● Cost minimization Cost comparison accounting
● Profit maximization Profit comparison calculation
● Return maximization Average return calculation
● Capital return optimization Static amortization calculation

Cost Comparison Calculation
● Comparison of the costs of two or more investment alternatives.

● Costs are calculated from the average costs per period and per unit of
activity produced. The investment amount is allocated to the period or
useful life using imputed depreciation and interest.
● Prerequisite:
The revenues of the investment alternatives must be the same.
Investment alternatives have the same term.
● Advantageousness:
The savings per period must be greater than the imputed costs
(depreciation and interest).
● Comparison of alternatives:
Alternative with the lowest costs, mostly by machine hourly rate or unit
cost calculation

Application of Cost Comparison Accounting
● Selection problem:
Cost comparison accounting is only applicable to selection problems if it
has been separately demonstrated that the revenue is sufficient to cover
the new costs.
● Rationalization investments:
The debt service of the investment amount (i.e. the total financial burden
of the investment, i.e. the purchase amount plus lost interest, etc.) can
be recovered through cost savings. If a calculation interest rate and an
economic useful life are known, a meaningful comparison is possible.
● Replacement investments:
As a general rule, only the value 0 may be estimated as the debt service
of an existing installation. Where an general maintenance is considered
as an alternative to replacement, the cost of the overhaul shall be
allocated over the remaining years.

Example: Cost Comparison Accounting
Milling machine Alpha Beta

Capacity (pcs. per year) 20.000 pcs./a 20.000 pcs./a
Fixed costs per year 110.000 €/a 132.000 €/a
Variable costs per piece 2,90 €/pcs. 1,70 €/pcs.
Costs per year at full capacity 168.000 € 166.000 €
Unit costs with full capacity 8,40 €/pce. 8,30 €/pce.
utilization

Profit Comparison Method
● Comparison of the profits of two or more investment alternatives.

● Profits result from the average profit per period.
Profit = Revenue – Costs
● Application: short-term investments and rough estimates
● Comparison of alternatives:
Alternative with the highest average profit
● Prerequisite:
Investment alternatives have the same useful lifetime.
All revenue payments without interest consideration (no discounting)
Thus prerequisites: the neglect of interest is permissible and income and
expenditure are fully correlated.

Profit Comparison Method
● Expansion investment:
The costs will be compared with the revenues made possible by the
investment. Only if the additional revenues exceed the fixed and variable
costs does it make sense to expand.
● Selection problems:
Application if the investment alternatives have different revenue effects.
This is the case if the alternatives have different production capacities or
can produce products of different value.

Example: Profit Comparison Accounting
Lathe Alpha Beta

Acquisition of a milling machine 500.000 € 600.000 €
Useful life 8a 8a
Interest 8% 8%
Calculation of average profit
Average current income 230.000 € 230.000 €
Average current expenses - 70.000 € - 50.000 €
Average depreciation (500.000€ / 8a ) - 62.500 € - 75.000 €
Average interest expenses (250.000€ x 8%) - 20.000 € - 24.000 €
Average annual profit 77.500 € 81.000 €
Assumption: The acquisition sum flows back uniformly, on average, half the
purchase money is to be understood as fixed capital!

Average Return Method - Rate of Return Comparison
● Comparison of the rate of return of two or more investment alternatives.

● Return on investment (ROI) is the ratio of average profit per period to
capital employed.
● Advantageousness: Not possible
● Comparison of alternatives: Alternative with the highest rate of return
● Prerequisite:
● Investment alternatives have the same useful lifetime
● The comparative interest rate must be known
● It must be possible to allocate profits to the project
● The rate of return must be constant

● Rate of Return (RoR) is generally defined as the ratio of a measure of

success, such as profit, to capital employed:

● Profit can be recognized as profit before tax or after tax. The consideration
of the tax effect leads to more precise results, however, is often associated
with considerable effort.
● The concept of capital can be differentiated on the one hand by its scope
and on the other hand by its temporal aspect:
● Differentiation of the scope:
Acquisition price plus any incidental acquisition costs or total capital
● Differentiation of the temporal aspect:
Initial capital or average fixed capital.
In a comparative rate of return calculation, all investment alternatives must
be evaluated according to the same differentiation.

● The investment that provides the highest return should be chosen as the
decision criterion.
● In contrast to the profit comparison calculation, the imputed interest is
not taken into account in the rate of return calculation. Profits are
calculated before interest so that the rate on return indicator is
comparable to the investor's minimum return (the imputed interest rate).
● The rate of return calculation is mainly used for a rough profitability
calculation.

comparative
Rate of return profitability
comparison: calculation
Punching mach. A B
Purchase of a punching machine 500.000 € 640.000 €
Useful life 8a 8a
Interest 8% 8%
Calculation of the average return on investment
Average current income per year 230.000 €/a 300.000 €/a
Average current expenses per year - 70.000 €/a - 90.000 €/a
Average depreciation (A: 500,000€ / 8a ) - 62.500 €/a - 80.000 €/a
Average annual return on capital 97.500 €/a 130.000 €/a
Average capital employed 250.000 €/a 320.000 €/a
average return on investment 39% 40,6%
(A: 97.500 € / 250.000 € = 0,39)
● A project makes sense if the return on invest. is higher than the interest rate.
● The distribution of payments over periods is not taken into account in the
average profit (early payments are better than late payments, interest profit).

Static Amortization Calculation
● The static amortization calculation determines the capital reflux or

amortization period ta taking into account the acquisition payment A0 and
the average annual payment surplus ∅ St .
● The static amortization calculation is also referred to as the capital return
calculation, pay-back calculation or pay-off calculation.
● A short payback period corresponds to a low investment risk, as quite
reliable figures can still be forecast over the short period of time.
: Annual average values

∅
A0 : Acquisition expense
LT : liquidation revenue/ residual value
∅ R : Revenue
Ef : Fixed expense
Ev : Variable expense
T : Duration of the investment
i :
current calculatory calculatory
revenue Calculatory rate of interest
expense amortization interest

Example Amortization Calculation
Lathe Alpha Beta

Acquisition of a milling machine 500.000 € 600.000 €
Useful life 8a 8a
Interest 8% 8%
Calculation of the average surplus
Average current income 230.000 € 230.000 €
Average current expenses - 70.000 € - 50.000 €
Average depreciation (500,000€ / 8a ) - 62.500 € - 75.000 €
Average interest expenses (250,000€ x 8%) - 20.000 € - 24.000 €
Average annual surplus 77.500 € 81.000 €
Amortization time (500.000€ / 77.500€) 6,5 years 7,4 years
Assumption: The acquisition sum flows back uniformly, on average, half the purchase
money is to be understood as fixed capital!

Static Amortization Calculation
● Comparison of the payback times of two or more investment alternatives.

Amortization period is the period of time required to recover invested
capital through the reflows.
● Advantageousness: Suitable for absolute assessment of the inherent risk
of an investment
● Comparison of alternatives: Alternative with the shortest payback period

Payback time, not Always Applies: The faster, The better
● The amortization calculation enables the company to estimate the period

after which an investment will pay off.
● Frequently, the company opts for a variant with the quickest amortization
in order to minimize the risk of a bad investment.
● But an investment that takes a little more time can be more profitable in
the long run. If the total annual profits after the amortization period far
exceed the total profits of the faster variant, the slower variant is the
more profitable one.
● The amortization calculation should therefore not be used as the
exclusive decision calculation, but only as an addition.

5.7. Dynamic
Investment Calculation

Dynamic Methods
Dynamic Methods
Perfect capital market Imperfect capital market
• Net present value method • Final asset value method

• Annuity method • Debit interest rate method
• Dynamic amortization • Complete financial plan (VOFI)
calculation (Visualization of Financial Implications)
• Internal interest rate method
focus

Perfect Capital Market
● There are no restrictions on access to the capital market; anyone can

demand or offer unlimited amounts of capital.
● Capital is homogeneous, it is available in a single, consistent quality.
There is therefore no distinction between equity and debt capital.
● The capital market is completely transparent and there are no
information asymmetries.
● There is therefore only one uniform interest rate i, i.e. debit and credit
interest are identical: s=h=i.
● Because of these (very tight) conditions, there are no liquidity problems
in particular. Money is always available in sufficient amounts.

Net Present Value Method
The net present value method is one of the most comprehensive methods
of dynamic investment calculation.
Question:
What is the net present value of an investment at a given time?
Methods of capital value calculation:

1. Compound interest on today's payment
2. Discounting of a later payment
3. Discounting and accumulation of a payment series
4. Compound interest and accumulation of a payment series

1. Compound of Interest on a Current Payment
, , ∙ -. - ∙ … ∙ - .
compounding
, , ∙ -. mit 2 const.
C0 CT? C0 : present value (today's value)

CT : end value (later value)
0 1 2 3 T years i : const. year interest rate
Present value End value it : year interest rate
(present value) (later value) T : lifetime in years
● What value does something have after T years at an interest rate i ?
● 10.000 € will be charged at an interest rate of 2% and

for a period of 6 years:
CT = 10.000€ ∙ (1+0.02)6 = 11.261,62€
Present value Interest factor Final value

Estimation Functions for the Capital Doubling Time

4%
=>
Relative error of the doubling
Exactly: 89:;<
3% -?
2%
FG
Mod. 69 rule: @ABCDE H
. 0,35
1%
time [%]
0%
-1%
-2% LM
Rule of '72: @ABCDE H
-3%
Rule of '69: LN
Rule of the '70s: @ABCDE
-4%
FG
@ABCDE H
H
-5%
0% 10% 20% 30% 40% 50%
percentage p per year [% p.a.]

2. Discounting of a Later Payment

-
, , ∙
-. - ∙ … ∙ - .
discounting
-
, , ∙ mit 2 const.
-.
C0 ? CT C0 : present value (today's value)
CT : end value (later value)
0 1 2 3 T years i : const. year interest rate
Present value End value it : year Interest rate
● What cash value C0 , we theoretically have to invest today,

to obtain the final value CT in T years?
● In 3 years the sale of company shares with a value of 300.000 € is
planned, we expect an interest rate of 5%:
1
ON 300.000€ ∙ 259.151,28€
1 . 0,05 R

3. Discounting and Accumulation of a Payment Series

cumulative discount factor
-. -
, ∙
∙ -.
C0 ? p p p p
discounting
sum factor (DSF).
C0 : present value (today's value)

0 1 2 3 T years p : constant amount
Present value End value i : const. year interest rate
● What is the net present value (NPV) C0 of a payment series with a duration of
T years, if a constant amount p accrues at the end of the year.
● Discount sum factor (DSF) is also referred to as the present value annuity factor.
● A smoker spends €1.200 a year on cigarettes. What is the cash value for a period
of 40 years if the interest rate is 6%?
1 . 0,06 XN 1
CN 1.200€ ∙ 18.055,56€
0,06 ∙ 1 . 0,06 XN
4. Compounding and Summing a Series of Payments

final value factor
-. -
, ∙
CT?
p p p p
Final value factor (EVF)
C0 : present value (today's value)

0 1 2 3 T years p : constant amount
Present value End value i : const. year interest rate
● What is the final value CT for a duration of T years?

if a constant amount p accrues at each end of the year?
● A sum of 1.500 euros is invested each year. At the end of each year, 6% interest
is credited and in the following year interest is added:
1 . 0,06 Z 1
OY 1.500€ ∙ 14.846,20€
0,06

Net Present Value Method

Net present value C0 :
Total of all payments discounted or compounded to a point in time that are caused by
an investment object in relation to the start of the planning period:
C0 = Present value
C0 : Net present value based on time t = 0
i : Constant calculation interest rate
Rt : Revenue in period t
Et : Expensive in period t
, .\ .
-. -. A0 : Acquisition expense at time t = 0
]-
LT : Liquidation revenue / residual value at time T
T : Consideration duration (in periods)
t : Period index
Net present value C0 for variable interest rate

i [1;T] : period, it : Calculation interest rate in period t
`a ba `M bM `R bR `Y bY . d Y
^N _N . . . . ⋯.
1 . 2a 1 . 2a 1 . 2M 1 . 2a 1 . 2M 1 . 2R 1 . 2a 1 . 2M ⋯ 1 . 2 Y

Advantages and Disadvantages of the Net Present Value Method

Assumptions:
● Perfect capital market
● Acceptance with regard to capital lockup/useful life:
Clearing of capital commitment and useful life differences at the costing interest rate
Advantage rules:
● Absolutely advantageous: net present value > 0
● Relatively advantageous: largest net present value of all available alternatives
Advantages: Disadvantages:
+ Calculation: low effort – Data determination: problematic
→ Forecast problem
+ Higher realism than static models → Determination of i

Comparison of Net Present Value Method and Annuity Method
Net present value method: Annuity method:

● The net present value method ● On the other hand, the annuity method
calculates the total value of the calculates the annual average income
various surpluses on the basis of the surplus, including the interest accruing
specified discount rate. on it.
● Result: Net profit for the period
● Result: Total success
● Annuity a :
The average annual capital return,
which is above the calculation interest
rate.
C0 ? C0
Capital
value
p p p p Capital
value a a a a
0 1 2 3 T years 0 1 2 3 T years

Annuity Method
● Annuity method a:
● Average, constant period surplus of the investment.
The annuity method is derived from the net present value method:
The actual cash flows are transformed into an equivalent (same present value),
equidistant (same payment intervals) and uniform (same payment amounts)
payment series.
A : Annuity: annual capital reflux
∙ -.
, ∙ C0 : Net present value based on time t = 0
-. -
i : Calculation interest rate
capital return T : Consideration duration (in periods)
extractive factor
Discount and total a payment series:

1.2 Y 1 1.2 Y 1 1
^N i∙ ^N j∙ j ^N ∙
2∙ 1.2 Y 2∙ 1.2 Y 1.2 Y 1
2∙ 1.2 Y
discounting
sum factor (DSF).
Assumptions and Advantageousness Rules of the Annuity Method

Assumptions:
● Assumption with regard to the capital commitment / useful life: Compensation of
capital commitment and useful life differences at the costing interest rate
● To determine the relative advantageousness: identical useful life
Advantage rules:
● a = 0 If the annuity equals 0, the appropriations used shall be recovered
and outstanding amounts are subject to interest at the fixed interest rate i.
● a > 0 If the annuity is greater than 0, the system calculates an additional
average surplus. The investment is therefore advantageous.
● a < 0 If the annuity is less than 0, the investment is uneconomical.
● relatively advantageous: largest net present value of all available alternatives
+ Higher realism than static models – Data determination: problematic
+ Good interpretability → Forecast problem
→ Determination of i

Dynamic Amortization Calculation

Amortization time TA :
The TA date at which the capital employed was recovered through discounted return flows.

: ,
!
i : Calculation interest rate
, .\ Rt : Revenue in period t
-. Et :
]- Expense in period t
A0 : Acquisition expense at time t = 0
Solution through spreadsheet and
TA : Amortization time (in periods)
subsequent linear interpolation
t : Period index
^N o∗
@l o∗ .
^N o ∗ ^N o ∗ . 1 t* : last period with negative net present value
Net present value C0 for variable interest rate period:

Calculation interest rate in period t
@l : ^N @l 0
!
`a ba `M bM `Ym bYm
^N @l _N . . . ⋯.
1 . 2a 1 . 2a 1 . 2M 1 . 2a 1 . 2M ⋯ 1 . 2 Ym
Dynamic Amortization Calculation Table Form
Inte
interest Discounted
period rest receipts outgoings surplus cash value
factor surplus
rate
Investment:
0 - -250.000€ -250.000€
1 2% 1,02 90.000€ -30.000€ 60.000€ 58.824€ -191.176€
2 4% 1,02 x 1,04 110.000€ -35.000€ 75.000€ 70.701€ -120.475€
1.02 x 1.04
3 3% x 1.03
100.000€ -25.000€ 75.000€ 68.642€ -51.833€
1,02 x 1,04
4 1% x 1,03 x 120.000€ -35.000€ 85.00€ 77.024€ +25.191€
1,01
Amortization between the 3 and 4 periods

51.833€
Linear interpolation: @l 3. @l 3,67
77.024€

Dynamic Amortization Calculation Graphically

cash
value
+25.191€
Investment: 250.000€
periods
77.024€
-51.833€
68.642€
-120.475€
Linear
interpolation
TA 51.833€
70.701€
@l 3.
77.024€
-191.176€
58.824€ @l 3,67
-250.000€
t 0 t 1 t 2 t 3 t 4

Dynamic Amortization Calculation Graphically

cash value
+31.502€
u . €
-, sv
Invest.:180.000€
Investment: 180.000€
65.816€ t
-34.314€
Interest rate: 5%. s . €
-, st
Cash flow: Rt Et -77.506€
43.191€
t=1: 60.000€ s . €
-, s
t=2: 50.000€
-122.857€
45.351€ TA
t=3: 50.000€
t=4: 80.000€ r . €
-, s-
57.149€
-180.000€
t 0 t 1 t 2 t 3 t 4
1,05a 1,05M 1,05R 1,05X
Advantage rules of the Dynamic Amortization Calculation
Advantage rules:
● Absolutely advantageous: the amortization time TA is less than
a limit value to be set by the company.
● Relatively advantageous: shortest payback time TA of all selectable alternatives
+ Very popular in practice - especially – Is only suitable as a supplementary
as a risk measure criterion, since the effect after the
+ Good interpretability amortization period TA is neglected!
– Liquidation revenues or demolition
costs are not considered!

Comparison of Net Present Value and Internal Interest Rate Method
Net present value method: Internal interest rate method:

● The net present value method ● With the internal rate of return method,
determines the total value of surpluses the interest rate (internal rate of return)
of various sizes on the basis of the that results from a net present value of 0
specified calculation interest rate. is determined.
● Result: Total success ● Result: Internal rate of return r on
an investment
: ,
!
, .\ . .\ .
-. -. -. -.
]- ]-
Here i given C0 searched. Here C0 0 given r searched.
i : Const. calculation interest rate
Rt : Revenue in period t ● Solution: Numerical!
Et : Expensive in period t Excel goal-seek / solver
A0 : Acquisition expense at time t = 0
LT : Liquidation proceeds/residual proceeds at time T
Newton's method
T : Consideration duration (in periods) Tables / Graphical
t : Period index

Internal Interest Rate Method

Internal rate of return r:
The interest rate (internal rate of return) at which the net present value is 0.

: ,
!
R : Internal rate of return
Et : Deposits in period t
.\ . At : Disbursements in period t
-. -. A0 : Acquisition expense at time t = 0
]-
LT : Liquidation revenue / residual value at time T
T : Consideration duration (in periods)
Solution: numerical! t : Period index
Excel goal-seek / solver
Newton's method
Tables / Graphical

Internal interest rate method Table form

Excel
Rate of Interest
Spendi Over- Interest Interest Interest
Income interest rate
ng shot rate 6% rate 6.5 rate 7%
5.5%. 6.604%
investment (No liquidation proceeds) -250.000€ -250.000€ -250.000€ -250.000€ -250.000€
Discounted surplus
period
90.000€ -30.000€ 60.000€ 56.872 € 56.604 € 56.338 € 56.075 € 56.283 €
1
period
110.000€ -35.000€ 75.000€ 67.384 € 66.750 € 66.124 € 65.508 € 65.995 €
2
period
100.000€ -25.000€ 75.000€ 63.871 € 62.971 € 62.089 € 61.222 € 61.907 €
3
period
120.000€ -35.000€ 85.00€ 68.613 € 67.328 € 66.072 € 64.846 € 65.815 €
4
Capital
6.740 € 3.653 € 624 € -2.349 € 0€
value ,
7% 6,5% Excel
Linear interpolation: x 6,5% . ∙ 624€ x 6,604%
2.349€ . 624€
Internal Interest Rate Method Graphic
€4.000
€3.000
0,5%
€2.000
net present value ,
€1.000
624€
€0
6,0% 6,5% 7,0%
Rate of
2.973€ interest i
(€1.000)
0,5%
(€2.000)
x 6,5 . ∙ 624€ r 6,6%
2.973€
(€3.000)

Assumptions and Advantageousness rules of the Internal Interest Rate

Assumptions:
● Acceptance with regard to capital lockup/useful life:
Compensation of capital commitment and useful life differences at the internal
interest rate of the investment with the shorter useful life and/or capital expenditure
Advantage rules:
●r= i If the internal interest rate r is equal to the calculation interest rate i,
the funds used are recovered and the amounts are subject to interest at
exactly this fixed calculation interest rate.
●r> i An additional interest rate above the minimum interest rate of the capital
interest rate is calculated. The investment is therefore advantageous.
●r< i The minimum interest rate is not reached. The investment is uneconomical.
● Relatively advantageous: When comparing several investment objects, the object is
with the highest internal interest rate.

Advantages and Disadvantages of the Internal Interest Rate Method
+ Good interpretability – Not for non-normal investments,
+ Can be seen as a critical interest rate the period profit is called is
when considering the absolute not always positive.
advantage of an investment – Not suitable in pure form for assessing
alternative. relative advantageousness
+ Also enables comparison of financing
objects and loans
● The advantage of an investment strongly depends on the approach of the

calculation interest rate, which is considered necessary. As the calculation interest
rate rises, the comparison with the internal interest rate turns out to be worse.
● The comparability of several investment objects is only given if the initial
investment amount, the useful life and the payment surpluses are the same or if
difference amounts or remaining periods can be bridged with the internal interest
rate. Differential or supplementary investments must be included in the calculation.
However, this premise is mostly unrealistic and the internal rate of return method in
its pure form is therefore not suitable as a decision-making aid for comparing
several investment alternatives.

The Method of Differential Investment
If two or more investment objects with different acquisition values, cash

flows and maturities are to be compared, the differential investment
method is used.
{ {
z{ {
, .\ .
-. -.
]-
, |z{
Net present value of the differential investment related to time t = 0
i Constant calculation interest rate
{
, Revenue in period t for investment object A or B
{
, Expense in period t for investment object A or B
{
, Investment expenditure at time t = 0
{
, Liquidation revenue/residual value at time T
T Consideration duration (in periods)
t Period index

Interpretation of the Differential Investment
The differential investment A-B is defined as the payment consequences

resulting from the change from the implementation of project B to the
implementation of project A.
The same applies to the differential investment B-A:
The differential investment B-A is defined as the payment consequences
resulting from the change from the implementation of project A to the
implementation of project B.
z{
, can be interpreted like any other net present value:
1. So there , z{ to which increase in capital an investor is expected to

pay at the time t = 0 through the transition from the implementation of
project B to the implementation of project A.
2. Furthermore , z{ what price an investor would pay in t = 0 for the

possibility of carrying out project A instead of project B.

Internal Interest Rate Method with the Differential Investment Method
Internal rate of return r :

The interest rate (internal rate of return) at which the net present value is 0.
: ,
!
{ {
{
.\ .
-. -.
]-
The following guidelines apply when comparing payment series:

● If the internal rate of return of the differential investment is higher than
the costing interest rate, the project with the higher investment volume
should be chosen.
● If the internal rate of return of the differential investment is lower than
the costing interest rate, the project with the lower investment volume
should be chosen.

Example Method of Differential Investment

Period Investment Investment Differential investment
T A B A-B
Difference Discounted
Revenue Expense Revenue Expense
overplus overplus
0 -12.000€ -9.000€ -3.000€ -3.000€
1 8.000€ -1.000€ 3.000€ -500€ 4.500€ 4.286€
2 6.500€ -1.000€ 6.000€ -2.000€ 1.500€ 1.361€
3 5.500€ -1.500€ 7.000€ -1.000€ -2.000€ -1.728€
{ z{
Capital value , = 3.111€ , = 2.192€ , = 919€
Internal rate { z{
19,8% 15,8% 54,4%
of return
Calculation interest rate 5%

5.8 Target Cost Accounting /
Target Costing

Target Costing
● Target cost accounting / retrograde calc. / target costing / target pricing

● Less an instrument of often enterprise-centered controlling.
● More a integrated management method that has proven itself as a strategic
decision-making aid in highly competitive orientated markets.
● Strength of target costing:

● Further development, differentiation and diversification of complex products and
systems manufactured in medium batch sizes.
● High customer orientation with regard to both price and customer-specific product
properties and functions.
● Weakness of target costing:

● Little effective in completely redesigning products
● Little effective in managing simple products in mass production
● Origin:
The concept was founded in the Japanese economy in the 1970s and was given a
broad theoretical foundation in western business administration especially in the
1990s.
Origin of target cost accounting
● The basic idea of target costing can be traced back to the 1930s to the
design of the Beetle by Volkswagen.
● Genka kikaku (原価企画) was developed by Toyota in 1965 and has been
used in Japanese companies since the 1970s.
● Theoretically, the concept was first thematized under the term Target
Costing in the 1970s by the Japanese scientists Michiharu Sakurai,
Toshiro Hiromoto and Masayasu Tanaka.
● The first German business economists to deal with this topic were Werner
Seidenschwarz (1991; Target Costing - a Japanese approach to cost
management) and Péter Horváth (1993; Target Costing).
● A further development of the concept is Kaizen Costing.

Target Costing
● Company focused view:

Traditional cost consideration: costs + profit surcharge = net price (bid price)
● Market focused view:
Question: Target costing: "What may a product cost?
Therefore: retrograde costing
● Target costing:
Market research measure: "What is the competitive market price?"
and "What are customers willing to spend money on?" (product preferences)

Target Cost Accounting / Target Costing
What can the new What would the product cost under
product cost? current conditions?
Market side: Company side:

• market situation • design factors
• competitors behavior • manufacturing factors
• buying behavior • existing production possibility.
target target allowable

– = drifting costs
price profit cost
target gap
target costs


Need for cost reduction in
product development
target
profit
Cost reduction achievable with
target
gap
current organizational design and
target price
technology
drifting costs
allowable cost
Gap to be closed by further
target costs
cost-cutting measures
Consequences:
• Guarantee of a customer-oriented price/performance ratio
• Cost-optimized implementation of customer requirements
• Early identification of possible cost reduction potentials
• Cost control
• Price leadership in competition
• Increasing the intensity of innovation
Target Costing: Allowable Costs
● Allowable Costs = Target Price – Target Profit

Allowed costs = customer or target price – target profit margin
● Drifting Costs:
Forecasted standard costs for production
● Target Gap = Allowable Costs – Drifting Costs
● The resulting target gap must be closed.
● It is advantageous that at the beginning of the product development

phase employees have binding cost specifications of a controlling nature
that can be significantly influenced.
● By determining the preferences, a weighting of the costs in relation to
the importance of the different product characteristics is carried out and
thus determines whether a product component or product function is
overdeveloped or whether there is still a need to increase value.

Target Costing Phase
● Phases of target costing (mostly):

Target cost determination Target cost splitting Target cost achievement phase
● Target cost determination phase:

● Objective: to determine the total cost of a product,
which may be caused within the company.
● Approaches to target cost determination:

● Market into company: to equate target costs with allowed costs
(i.e. to draw the market into the company)
Problem: With high-grade product innovations, customers can‘t
give for the benefits of the product a monetary values.
● Out-of-Company: Determine the target costs based on the technical and
business potential of the company.
Problem: The target costs are based on the standard costs.
● Into-and-out-of-Company: combine Market into company and Out of Comp.
● Out-of-standard costs: reduces the standard costs by a certain amount.
● Out-of-Competitor: Derive target costs from competitor costs.
(e.g. through benchmarking).

Target Cost Splitting Phase
● The total target costs are broken down to a certain level in order to be able to
effectively coordinate and achieve the target costs in the subsequent phase of
target cost achievement.
● The target cost split provides a realistic picture of the use of resources in the
company's functional areas.
● The target cost splitting enables a market-based allocation of resources and at the
same time ensures product functionality that is in line with customer
requirements.
● Cost splitting can take place at component and function level. The results can be
displayed graphically using a target cost control diagram. This compares the
customer-valued benefits with the standard costs of each individual component.
● Work steps for target cost splitting:
1. Define functions from the customer's point of view. The car always starts.
2. Determine customer value for function 100 € per month
3. Determine core component for function Starter + battery
4. Determine costs for core component 150 €

Kano Model (Dr. Kano University Tokyo)

high customer performance
☺ satisfaction requirements
● articulated
enthusiasm requirements
● specific
● unarticulated
● measurable
● mostly unconscious
● technical
● impressly
time realized quality
characteristics
few many
basic requirements
● implicit
● self-evident
Main categories: ● unarticulated
● basic functions ● obviously
● performance features low customer
● enthusiasm functions satisfaction

Visualization through target cost diagram

Components too expensive
30
Cost reduction For products with high cost
pressure, q should be as small
25 as possible.
.~
Cost share of the function [%].
20 ● modulator ~
● SAT Tuner ● video
q 15 ● power supply
module Components too
cheap checking
Target cost ● remote control functionality
10 zone
● connector ● audio module
plug
5
● instruction manual
● cord
0
0 5 10 q 15 20 25 30
Customer benefits (technical weighting) [%]
Target Cost Splitting Phase
● The aim is to tailor products or services as closely as possible to

customer requirements before making investment decisions that are
difficult or impossible to revise and can lead to sunk costs.

process cost
profit analysis
overheads (product
target price remote costs)
target benchmarking
costs
product-related
costs
(influenceable)
weighted
market functional
customer
analysis target costs
benefit
component target
costs
benchmarking system
(best practice) analysis
divergences actions
current cost component
structure analysis

Target Cost Achievement Phase
● The success of target cost accounting lies particularly in the phase of

target cost achievement, in which a rounded and balanced, market-
oriented and innovative concept is generated, with which the Japanese
economy and ultimately target costing were successful.
● This success presupposes that those responsible in the target cost
accounting process have the necessary instruments and methods at their
disposal to achieve the cost targets.
● This requires cost information tools that provide meaningful information
based on low input information in early phases of the product innovation
process.

Advantages and Disadvantages of Target Costing
+ Early influence in the product life cycle – Application not possible with radical
The need for cost management from product innovations
the outset results from the realization How the market price for highly
that significant portions (about 85%) innovative products can be determined
of the total costs over the life cycle in advance has not yet been clarified.
are already determined by decisions – No exact scientific delimitation
in the early phases.
– High planning costs
+ High quality with decreasing average
costs – For complex products, the effort required
to determine the target cost portions can
be very time-consuming.
± Employee effect: ± Employee effect:

+ Resources are exposed by cost – Competitive pressure on employees is
pressure built up.

05c AMP Investment Calculation Target Costing

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5.

innovativ & lebendig – Bildungsregion DonauWald

Classification of Investment Types

Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e

Basic Structure of Investment Calculations

Definition of the task

Creative phase, technical planning with alternatives

Quantity Structure: Quantity determination and valuation

Cost, performance and profit

Criteria: Profitability, liquidity, risk, social impact

Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e

Overview of the Investment Calculation Procedure

Investment calculation procedure

Static investment calculation Dynamic investment calculation

Classic Non classical

net present Method of

Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e

Static Method or Single-period Method

● The evaluation of the variant is always based on a period that can be

● Static investment calculation

Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e

Cost Comparison Calculation

● Comparison of the costs of two or more investment alternatives.

Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e

Application of Cost Comparison Accounting

Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e

Example: Cost Comparison Accounting

Milling machine Alpha Beta

Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e

Profit Comparison Method

● Comparison of the profits of two or more investment alternatives.

Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e

Profit Comparison Method

Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e

Example: Profit Comparison Accounting

Lathe Alpha Beta

Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e

Average Return Method - Rate of Return Comparison

● Comparison of the rate of return of two or more investment alternatives.

Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e

Average Return Method - Rate of Return Comparison

● Rate of Return (RoR) is generally defined as the ratio of a measure of

Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e

Average Return Method - Rate of Return Comparison

Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e

Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e

Static Amortization Calculation

● The static amortization calculation determines the capital reflux or

: Annual average values

Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e

Example Amortization Calculation

Lathe Alpha Beta

Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e

Static Amortization Calculation

● Comparison of the payback times of two or more investment alternatives.

Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e

Payback time, not Always Applies: The faster, The better

● The amortization calculation enables the company to estimate the period

Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e

innovativ & lebendig – Bildungsregion DonauWald

Perfect capital market Imperfect capital market

• Net present value method • Final asset value method

Prof. Dr.-Ing. Stefan Scherbarth www. t h - d e g . d e