Simplified Cost Accounting Chapter 12 – CONTEMPORARY DEVELOPMENTS IN COST

ACCOUNTING

Chapter 12

CONTEMPORARY DEVELOPMENTS IN COST ACCOUNTING

Learning Objectives:

After studying this chapter, you will be able to:

identify, enumerate, explain, compare and contrast key theories and concepts on
quality, cost of quality, benchmarking, ISO, product life cycle, kaizen and target
costing, theory of constraints and business process reengineering.
Prepare cost of quality reports

Introduction:
For over a hundred years, KODAK has
been everyone’s companion in capturing life’s
memory. At one time it captures 76% of the
market share of cameras sold in the USA yet
on January 2012, it filed for bankruptcy. What
happened?
Click.
Kodak did not invent photography, but
made it possible for everyone to own a camera
at the times when only wealthy can afford it.
Their downfall was ironically to a new
technology which they actually invented in
1975 – Digital Photography.
Click.
When Kodak discovered the Digital
photography they did not fully commit to this
new technology fearing that it would obsolete
their old technology which was generating a
ton of money. It was Sony who introduced
digital camera to the masses in 1981.
Click.
Kodak did not begin to seriously
market digital cameras when the market was
already fairly established and it was too late.
They move slowly in digital photography as
they invested heavily in chemicals, paper and
film. They fully understood that the new
technology would destroy their market.
Click.
Their first digital imaging offering in
1991 was not even a camera, it is a “Photo
CD”. During the infancy of digital
photography, Kodak choose to focus on digital
products like scanners and spent billions of
dollar in digital imaging research in 1993,
only to delegate it to 23 separate scanner
projects.
Click.
When they file for bankruptcy,
Bloomberg reported that the company intends
to shift its business towards printers and its
ink. However, Kodak holds 11,000 patents
which analyst value it around P1 billion yet
no one seems interested in buying its patents
as new technology are growing like
mushrooms nowadays.
Click.

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QUALITY

What is QUALITY?

Quality is difficult to define as individuals have different perception on its definition. Quality
depends on one’s taste, personality and standards. However an international organization
who sets standard, the ISO, adopted a unified and clear definition of the term. Quality is
something that can be determined by comparing a set of inherent characteristics with a set
of requirements. If those characteristics meet the established requirements then high
quality is achieved, if not then poor level of quality is attained.

If so, the question is whose requirements? This can be resolved by looking at two different
perspectives, the requirements and standards set by the one who made the product and the
one who used the product.

Production View of Quality

Productivity is the quality, state or fact of being able to generate, create, enhance, or bring
forth a good output during a period of time. Anything that either slows down or stops a
production process, or causes unnecessary work hinders the productivity. To measure the
productivity of a certain manufacturing concern an activity analysis must be made.

Activity analysis is identifying and describing different activities in an organization, usually

repetitive in nature, and evaluating their impact to the operations. The analysis may include
(1) what activities to be performed (2) the number of workers involved on each activity (3)
the length of time it was performed (4) resources consumed (5) and the value of the
activities in the organization.

Any activities that increases the time of production but does not increase the value of the
product or to the external customer are called non-value added activity and must be
eliminated, minimize or simplified. Those increases the worth of the product called value
added activities for which the customer is willing to pay must be the only one to be
retained. Typical examples of non-value added activities are inefficient employees,
reprocess and rework, repair, storing slow moving inventories, unnecessary material moves,
unscheduled production interruptions and the likes.

Aside from minimizing non-value added activities, other ways to increase the productivity of
the company are as follows:
 Reduce Variability – adoption of technology, worker skill and training programs and
any management control strategies like quality control, statistical process control
and control chart that may help monitor the production quality.
 Reduce Failure Rate – creating a thorough quality product design, using of high
standards for raw materials, employees monitoring etc.
 Increase good output from specific amount of input
 Conform to customer requirements.

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Consumer View of Quality

A consumer view of quality is the capacity of manufactured goods or service offered to

satisfy and meet all of the consumer needs. Notice that the meaning is not limited on the
delivery of a product or being free from any defects but it must met all or significant
number of characteristics required by the customer. Below is the list of basic characteristics
that are commonly included as consumer view of quality, either Product or Service Quality.

Characteristics
Aesthetics This refers to the design and appearance of the product.
Consumer no longer simply buy products for its functions and
usability, it also considers how an object is pleasing to them. It
maybe associated to products fashionability, novelty, appeal,
symbol of wealth or others and even its safety features.
Conformance This pertains to the ability of the product to conform to the
expectations of the consumers. This maybe either an
expectation made by the customer or the promised satisfaction
advertised by the manufacturer.
Durability The capacity of manufactured goods to exists for a relatively
Product

long continuous useful life without significant deterioration or

any unwarranted degree of maintenance.
Features Pertains to additional characteristics, traits, or a special
attraction that may be exclusive to the product offered.
Perceived Value A customer’s perception on the expected benefits gain from the
product or service. It may be tangible benefits or psychosocial
in nature like status enhancement.
Reliability The probability of the product to perform satisfactorily for its
intended function on demand and without degradation or failure
under all circumstance.
Serviceability and This refers to products features to be user friendly and the
Responsiveness ability of the company’s support group to quickly reply to the
needs, queries and consumers concerns.
Assurance The customer expects that the employees are knowledgeable,
trustworthy and courteous.
Tangibles Refers to customer’s expectation to quality physical equipment
Service

and facilities and appearance of personnel.

Empathy A high degree of attention, care and service from employees to
customers.

TOTAL QUALITY MANAGEMENT (TQM)

In an international market, competition is on a high level that quality becomes a significant

concept in an organization. As of the end of the 20 th century, Total Quality Management has

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become a key management model. It is about building quality from the beginning of the
process and making it as number one priority and responsibility of every employee.

There are many important gurus in the evolution of quality management from Crosby,
Deming, Feigenbaum, Ishikawa and Juran however their approaches are not the same. The
term “TQM” was given on the early 80s however the original concept can be traced in the
late 40s when the Union of Japanese Scientists and Engineers formed a committee of
scholars, engineers and government officials aimed to improve Japan’s productivity and
enhance their post-war quality of life.(Powell, T.C. 1995, Strategic Management Journal).

As of today, Total Quality Management (TQM) is a

“Management approach of an organization, centered on quality, based on

the participation of all its members and aiming at long-term success through
customer satisfaction, and benefits to all members of the organization and to
society”
– ISO 8402, Total Quality Management
(Geneva:ISO,1994), definition 3.7.

Summarizing the concept of TQM are the four important tenets:

1. The Quality System

 TQM must be geared towards a designed on the emphasis of prevention,
continuous improvement and building quality into every process and product
rather than an after response strategy. It should create an environment in
which managers can better plan, control, evaluate performance and make
decisions for enhancement. In other words, the quality system implemented
in the company must be proactive quality assurance and not generally a
reactive approach, wherein the actions are only implemented after
determining a high number of errors occurred through inspection.

2. Employee Involvement
 Under TQM, top management must develop an atmosphere conducive to
quality improvement. They should be a prime example and mover of quality
conscious individual through firm commitment of quality. Employees must be
encouraged to provide feedbacks and be made feel that they are part of the
process for success. Training everyone in the organization to be a multi-task
individual and empowering them to make quality suggestions will help
improve efficiency and quality.

3. Product/ Service Improvement

 TQM must bridge the gap between the internal production/service process
and the external customer. Management’s attention should focus on
identifying the Value Added Customers and understanding their concept of
quality, value and good service. This gathered information must be then the

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tools used by the industry concern as the basis to improve its internal quality
processes.

4. Long- Term Supplier Relationship

 The philosophy of TQM considers the importance of reviewing the complete
supply chain management. This is a network of interconnected businesses
which spans from the point of origin, the acquisition of raw materials to the
ultimate point of consumer consumption. Companies must review their
suppliers and must link up to business partners that will enhance product
quality and customer satisfaction. Furthermore, establishing a strong and
long-term relationship with these industry partners must also be worked
upon.

Benefits of TQM

Many companies already affirmed the benefits derived from adopting total quality
management. However a study conducted to quality award winning firms that, on average,
it takes ten years before its benefits are fully realized by the company. Benefits are not
only trickled down to internal environment but external partners as well.

Internal Benefits
 Reducing the number of errors
 Promotes innovation and build an openness to creative thinking
 Empowered employees and promotes teamwork
 Increased benchmarks for individuals performance evaluation
 Improved communication within the organization
 Increased profitability through cost reduction
 Decreased cost through elimination of repetitive and non value added activities
 Increased the competitiveness of the company
 Enhanced the response time to change

External Benefits
 Earning customer trust, loyalty and satisfaction
 Improved relationship between suppliers and having quality raw materials
 Decrease selling price due to low internal costs.
 Improved response time to customer needs and requests.

BENCHMARKING

Companies which separate itself from the norms of the industry and from its competitors
have a potential risk of stagnation. The dangers of being lagged behind results to struggles
in gaining more consumers. By comparing the company’s own production and performance
to other players helps in understanding their strengths and weaknesses. Furthermore it also
aids them in finding ways to utilize the opportunities they discovered and find solutions to
the threats they are facing. The concept of benchmarking is not only a helpful tool for
industry to stay in a stiff competition but also adhering to continuous quality improvement.

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Benchmarking is a process of investigating, comparing and evaluating the product, process

and services of the company against its own, competitors or to the best-in-class of that
particular industry. One criticism though about benchmarking is the promotion of imitation
or “copying” of ideas or processes from the best in the industry. However benchmarking
activities have codes of conduct that must be followed which addresses this issue. These
include equal share of information, strict use of learned ideas, avoidance of antitrust issues
and inter-organizational courtesy. Furthermore, benchmarking does not aim to imitate or
copy but to understand the existing best concept or process in the industry and to
improve the methods under study and upgrade it to develop more efficient and effective
service, product or process. It is a tough process that needs a lot of commitment to
succeed.

There are four basic types of benchmarking as follows:

 Internal Benchmarking
o The comparison focuses on how and why one organizational unit or
department is performing better than the other. However, the quality level
measurement is only internal specification which maybe at par or lower than
what is expected by the outside users, customers and competitors.
 Results Benchmarking
o It involves examining an end product or service through a process called
reverse engineering.
 Process Benchmarking
o Focuses on best practices and how the best-in-class companies achieved
distinction.
 Strategic Benchmarking
o A non-industry specific and focuses on the competition and strategies made
by the high performing companies on their specific market

BENEFITS OF BENCHMARKING

There are many benefits derived from benchmarking such as:

 becoming competitive as it increases awareness of competition and better understanding
of the competitor’s process and performance;
 establishing a clearer and effective business goals and objectives; hence, it aids in
defining a specific company mission, goal and objective;
 develops a comprehensible program for evaluating the company’s operation and
processes;
 encourages a conscious outlook of continuous improvement within the company;
 measuring true productivity;
 identifying and implementing best practice in business processes; and
 achieving better performance in meeting customer needs and requirements;

Benchmarking models are used to determine how well a business unit or segment is
performing compared with other similar segments. It involves SWOT (Strength,
Weaknesses, Opportunities, and Threats) analysis. A benchmark is often used for improving
communication, professionalizing the organization/processes or for budgetary reasons.
Traditionally, performance measures have been compared with previous measures from the
same organization at different times. Comparing performances and processes with “best in
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class” is important and should ideally be done on a continuous basis (the competition is
improving its processes also). Benchmarking needs to become a habit if you are serious
about improving your performance. Historically, benchmarking is based on Kaizen and
competitive advantage thinking.

Four(4) Types of Benchmarking Methods:

1. Internal (benchmark within a corporation, for example between business units)
2. Competitive (benchmark performance or processes with competitors)
3. Functional (benchmark similar processes within an industry)
4. Generic (comparing operations between unrelated industries)

STEPS IN BENCHMARKING
1. Determine the specific area where improvement is needed.
2. Select the quality characteristics to be used as the basis of measuring quality.
3. Identify the best company bearing the quality characteristics already determined.
4. Ask the cooperation of the chosen company.
5. Involved the people who were directly affected of that specific characteristic to be
improved to gather the data needed.
6. Analyze the “gap” between the company and the benchmarked best-in-class firm.
7. Take action on the discovered gap and make necessary improvements that fit to the
company’s culture, structure and philosophy.
8. Always make necessary continuous improvement after implementation.

In the first step, you have to clearly establish what needs to be improved. Make sure it is
important to you and your customers and determine the data collection methodology to be
used including any Key Performance Indicators (KPIs). Gather the data and determine the
current performance gap - against a competitor, the industry or internally – and identify the
reasons for the difference. Develop and implement your plans for improvement. Monitor
your performance by comparing it against your established performance targets.

Benchmarking must be clearly understood before undertaking it. Don't try to benchmark on
too many things. Select two or three key areas, and then gradually add others over time.
Don't waste time benchmarking on things that are just "nice to know". Every benchmark
should aim to improve performance in an area that contributes to profits or customer
satisfaction. Be precise in defining what is to be measured. Lack of clarity can lead to
confusing inappropriate benchmarks. Test the benchmarks internally before consulting with
outside companies. Remember that your company's priorities may change with time, and
so your benchmarks should be regularly reviewed (and changed if necessary) to reflect this.

INTERNATIONAL ORGANIZATION FOR STANDARDIZATION (ISO)

In this chapter, we have already talked about the importance of quality within the company.
An effective, efficient and high quality product and process generally promotes lower cost
and such control cost may even be discharged if the benefits derived from maintaining it far
exceeds from the expectation. Quality can only be measured if we compare the actual
output or process to a set of standards set either by the company itself or its customers or

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even by the direct competitors within the industry. However, the market today is
complicated because it is expanding. The onset of globalization and world trading pushes
every manufacturing concern to drive their product and performance quality specified not
only to a limited environment but to broader needs of the society.

ISO (International Organization for Standardization) is the world’s largest developer and
publisher of international standards. It is a non-government organization that bridges the
public and private sectors. Before a product can be put on an international market, they
must be tested for conformity with specifications, compliance about safety and other
regulations and ISO issues guides and standards on this matter.

It checks whether the products, materials, services, systems, processes or people measure
up to the international consensus of best practices. This conformity assessment facilitates
trade from one country to another.

Applying for ISO Certification is not only limited to business related industry, any private
organization, government and non-government agencies and schools can also apply. There
are two important ISO series, ISO 9000 and ISO 14000 series. These two are generic
management system standards. Generic in a sense that the same standard can be applied
to any organization, large or small, whatever product or service, government, public
administration or a business enterprise. The rest of the ISO standards are highly specific to
a specific product, material or process.

ISO 9000

ISO 9000 is a series of standards designed to provide quality assurance. The ISO rules
specify that its standards be periodically revised every 5 years to adapt to technological and
market developments. The ISO 9000 series is actually a set of three standards as follows:

a. ISO 9000:2005, Quality Management Systems – Fundamentals and Vocabulary: It

describes the fundamentals of quality managements systems and definition of terms.

b. ISO 9001:2008, Quality Management Systems – Requirements; it integrates the old

standards, ISO 9001, 9002 and 9003 and provides a model for quality assurance
programs.

c. ISO 9004:2009, Managing for the Sustained Success of the Organization – A Quality
Management Approach; it provides guidance to organizations to support the
achievement of sustained success by a quality management approach.

To qualify for ISO 9000 certification, a company must produce a QMS (Quality Management
System). It typically includes items as follows: the company quality policy, the company
quality manual, organization structure, common company-wide procedures, each

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department’s mission and responsibilities and every department’s quality plans, operating
controls and training plans.

Proper and solid documentation that identifies all of this process must be made. The
documentation must show the interrelationship of each department through flowchart and
diagrams. A third party will conduct an audit, analyzing the documents, confirming its
adherence and interviewing employees. If there are noncompliance within the QMS, the
auditor will note them and a recheck will made if the correction has been made within a
limited time. If all errors has been corrected, the auditor will issue the certification to the
company.

ISO 14000

ISO 14000 is a series of standards which provides companies with guidelines with respect to
improving environmental management such as reducing the consumption of natural
resources, minimizing the harmful effects on the environment caused by the company’s
activities, and continuous improvement of their environmental performance such as using
less materials, energy, water & land, while minimizing air emissions, water discharges,
waste disposal & the dispersion of toxic substances. It is the same with ISO 9000 but is
concerned with environmental quality systems. The list of ISO 14000 series are as follows:
a. ISO 14001:2004, Environmental Management Systems – Requirements with
guidance for use.
b. ISO 14004: 2004, Environmental Management Systems – General Guidelines on
principles, systems and support techniques
c. ISO 14015:2001, Environmental Assessment of Sites and Organizations (EASO)
d. ISO 14020:2000, Environmental Labels and Declaration
e. ISO 14031:1999, Environmental Performance Evaluation – Guidelines
f. ISO 14040:2006, Environmental Management – Life Cycle assessment – Principles
and Framework.
g. ISO 14050:2009, Environmental Management – Vocabulary
h. ISO 14062:2002, Environmental Management – Integrating environmental aspects
into product design and development.
i. ISO 14063:2006, Environmental Communication – Guidelines and Examples

The same with the other series, the ISO 14000 will focus on the development of EMS
(Environmental Management Systems). ISO 14001 and 14004 provides requirements and
general framework in creating, implementing, maintaining and improving EMS. The EMS
should be designed to help the management to define and monitor the environmental
impact of its own product, continuously improve its own environmental performance and
employ methodical approach to established environmental objectives.

When it has been met and implemented, a third party auditor will provide a detailed report
on its compliance and certification will be issued after any errors has been corrected within
a limited time.

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Benefits of ISO

There are many positive reasons and benefits why one will acquire ISO certification.

Benefits received from specific sectors are mentioned below.

Business Adoption of the ISO assures management that the final output is with
international acceptance and products can compete to any market around
the world. It also promotes more efficient, safer and cleaner output.
Customers It provides customers a broad choice of offers and guarantees a quality,
safe and reliable product
Government It aids in the legislation with regards health, safety and environmental
issues.
Developing ISO equalizes the company towards an international market and important
Countries source of innovation and technological advances. By abiding the ISO third
world manufacturing companies can compete to first world consumers.
Everyone It contributes to quality of life by ensuring that transport, machinery, tools,
process we use are safe.
The Planet It preserves the environment as a whole

COST OF QUALITY

Every company manager has a clear purpose when dealing about COST – to minimize it.
However, the concept of cost is intricate and complex requiring the management to have a
deeper understanding of its nature. One of the major ways to minimize the company cost is
to adopt the concept of Quality. Yet, maintaining an efficient operation and high quality
standard on product is not an indication that cost is minimize, as adoption of technology,
retraining employees and monitoring activities also requires an additional cost.

To properly quantify and measure its financial effect, the Cost of Quality concept provides
cost accountant ideas on the different costs involved when adopting or not adopting quality
within the company. The table below illustrates the Four Quality Costs.

QUALITY CONTROL COSTS/ COST OF COMPLIANCE

PREVENTION COST
Quality Training, Quality Product Design,
Quality Technology, Quality Market
Research, Quality Participation, Quality
Training
APPRAISAL COST
Test equipment, Measurement Equipment,
Procedure Verification, Quality Inspection,
Product Testing, Performing Audits

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INTERNAL FAILURE COST EXTERNAL FAILURE COST

Reworking Products, Scrap and Waste, Customer reimbursement, Repair and
Rescheduling and Set ups, Storing and Replacing, Warranty Handling, Product
Disposing Wastes, Cost of Machine Returns, Litigations, Recalls
Downtime
QUALITY FAILURE COSTS/ COST OF NON-COMPLIANCE

Total Quality Costs is the sum of Cost of Compliance and Cost of Non-Compliance. The Cost
of Compliance or Control Cost is the sum of Prevention Cost and Appraisal Cost.

Prevention Costs are the costs to improve the quality by preventing product defects. On the
other hand, Appraisal Cost is the cost incurred in the process of uncovering the defects.

The cost of non-adoption of quality or Failure Cost is also composed of two, Internal Failure
Costs and External Failure Costs. Internal Failure Costs are those associated in discovering
poor quality products before it reaches to customer while External Failure Costs are those
quality problems at customer site.

These different costs of quality are incurred in different phase of production. Prevention and
Appraisal can be both found before and during the production, however appraisal costs can
still be extended until after production. Most of the internal failure cost is incurred during
the middle and after production process and external failure costs only incurred after the
sale. A feedback loop should be maintained linking after sales complaints to the control
measures during the production so that there will be a continuous improvement program. A
high external failure costs indicates a low prevention and appraisal costs and this should
alert managers and employees to discover the real causes and reasons behind
dissatisfaction of products. Below is a clearer illustration of Quality Cost Time Frame.

Before Production During Production After Production After Sale

Prevention Costs
Appraisal Costs
Internal Failure Costs
External Failure
Costs

Measuring Cost of Quality

Ideally, when company invested heavily on prevention and appraisal costs, failure costs
would become zero. However, even failure costs will be zero, total quality costs will never
be zero as prevention and appraisal costs will still be incurred. Nevertheless, when the
benefits from increased sales and greater efficiency exceeds the compliance cost
(prevention and appraisal), the total cost of quality will become free. Thus, in a simple
sense the money spent for the incurrence of cost of quality can only be practical and
favorable if the benefits derived exceeds from that particular costs.

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To understand more the relationships of the cost of quality, these are the different formulas
available to compute the total quality costs.

a. Profit Lost by Selling Defective Units = (Total Defective Units- No of units Reworked) x
(Profit For Good Units – Profit for Defective Units)

b. Internal Failure Costs (Rework Costs) = No. of Units Reworked x Cost to Reworked Defective
Units

c. External Failure Costs (Cost of

Processing Customer Returns)
d. Total Failure Cost
= No. of Defective Units Returned x Cost of Return
= Profit Lost by Selling Defective Units+ Rework Costs
+ Cost of Processing Customer Returns+ Cost of
Warranty Work + Cost of Product Recalls + cost of
Litigation related to Products + Opportunity cost of lost
customers

e. Total Compliance Cost = Prevention Cost + Appraisal Cost

f. Total Quality Cost = Total Failure Cost + Total Compliance Cost

Note: No formulas are available for Prevention and Appraisal costs as they are total estimated
amounts. Furthermore, when the prevention costs rises, the cost of appraisal and/or the number of
defective units should also decline. However, the decline of appraisal cost should never become zero.

Illustrative Problem:
Reiborn Company is a manufacturer of IPAD3.A. The following is a summary of quality costs
for the first quarter of operations:

Total Defective Units 3,750

Number of Units Reworked 2,000
Number of Customer Units Returned 500
Profit for a Good Unit P125
Profit for a Defective Unit P75
Cost to Rework a Defective Unit P30
Cost of a Returned Unit P50
Total Prevention Cost P43,750
Total Appraisal Cost P23,750

To compute the necessary requirements, the formula and solutions is as follows:

Profit Lost by Selling Defective Units = (3,750-2,000) x (P125 – P75)= P87,500

Rework Costs = 2,000 units x P30= P60,000
Cost of Processing Customer Returns = 500 units x P50= P25,000
Total Failure Cost = P60,000 + P25,000+P87,500= P172,500
Total Control Cost = P43,750 + P23,750= P67,500
Total Quality Cost = P172,500 + P67,500= P240,000

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Sample Quality Cost Report:

%
COST OF COST OF CHANGE CURRENT
%CHANGE
CURRENT PRIOR FROM PERIOD
FROM BUDGET
PERIOD PERIOD PRIOR BUDGET
PERIOD
Prevention costs
P 5800 P 5600 +4 P 6000 -3
-quality training
-quality participation 8200 8400 -2 8000 +4
-quality market research 9900 7700 +29 11000 -10
-quality technology 9600 10800 -11 15000 -36
-quality product design 16600 12200 +36 16500 +1
TOTAL P 50100 P 44700 +12 P 56500 -11

Appraisal Costs
P 3300 P 3500 -6 P 3000 +10
-quality inspections
-procedure qualifications 1200 1400 -14 1500 -20
-measurement equipment 2700 3000 -10 3200 -16
-Test Equipment 1500 1200 +25 1500 0
TOTAL P 8700 P 9100 -4 P 9200 -5

Internal Failure Cost

P 8500 P 8300 +0.2 N/A*
-reworking products
-scrap and waste 2200 2400 -8 N/A
-storing and disposing waste 4400 5700 -23 N/A
-reprocessing 1800 1600 +13 N/A
-rescheduling and setup 900 1200 -25 N/A
TOTAL P 17800 P 19200 -7

External Failure Costs

P 5800 P 6200 -6 N/A
-complaints handling
-warranty handling 10700 9300 +16 N/A
-repairing and replacing returns 27000 29200 -8 N/A
-customer reimbursement 12000 10700 +12 N/A
-expediting 1100 1300 -15
TOTAL P 56600 P 56700 +0
TOTAL QUALITY COSTS P 133200 P 129700 +3 P 65700 + 103

ENVIRONMENTAL COSTS

Environmental costs are incurred because poor environmental quality exists. Like quality
costs, they are also classified into the same broad categories. Environmental prevention

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costs are the costs of activities carried out to prevent the production of contaminants and/or
waste that could cause damage to the environment and include:
 Evaluating and selecting suppliers
 Evaluating and selecting pollution control equipments
 Designing processes and products
 Conducting environmental impact studies

Environmental detection costs are the costs of activities executed to determine whether
products, processes & other activities within the firm are in compliance with appropriate
environmental standards. Environmental detection costs will include:
 Auditing environmental activities
 Inspecting products & processes

 Developing environmental performance measures

 Testing for contamination
 Verifying supplier environmental performance
 Measuring contamination levels

Environmental internal failure costs are the costs of activities performed to eliminate and
manage contaminants and waste that have been produced but not discharged into the
environment. Examples include:
 Operating & maintaining pollution control equipment
 Treating & disposing of toxic waste
 Recycling scrap

Environmental external failure costs are the costs of activities performed after discharging
contaminants & waste into the environment. Examples include:
 Cleaning up contaminated water, soil and air
 Medical costs for employees & local community related to environmental
contamination
 Losing sales due to poor environmental reputation
 Losing employees due to concerns about working in a contaminated work
environment,breathing contaminated air, etc.
 Losing natural resources (forests, lakes, etc.) for recreational use.

Product Life Cycle (PLC)

All products pass through a “life cycle”. It depicts the stages through which a product class
passes from the time the idea is conceived until the production is discontinued. As products
passes through the different stages of its life cycle, the sales and profitability changes
reflecting its responsiveness to the changing environmental pressures. Understanding the
product’s life cycle will provide every company to enhance ways and strategies to manage
their sales and profitability.

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If we properly plot the product’s sales over its life in the market, the curve will look much
look like the “S” shape curve as illustrated above. The diagram also depicts that there are
five important stages of a product which will be discussed in details below:

Development Stage

A product starts from new ideas or possible inventions. It may come from a market research
which identifies the gap in the current market under study, monitoring the competitors, any
planned research and development or a creative and future thinking (determining what will
people wants/needs in 5, 10 or 20 years from now).

From this simple idea, high costs will be incurred through further research and
development. A market analysis is made to determine the potential profitability of the
product if introduced to the market and its likely target consumers. Product development
and refinement will also be made; test marketing and preparation for launching are some of
the major costs associated during this stage. Decisions made during this development
represent 80-90% of product total life – cycle costs.

Introduction Stage

This stage starts when the product is initially introduced to the commercial market for sale.
For 2012, so many new products will be introduced; leading the pack is Procter & Gamble
which will pitch in the Tide Pods, a three chambered laundry detergent; cleaning, stain-
fighting and brightening. These products eliminate the hassle of messy and time consuming
measuring of laundry powders or liquid to the wash. Apple is also expected to roll out Apple
iTV and iPAD Mini.

These new products are expectedly having relatively low and slow sales because it takes
time to introduce this to the multiple geographic markets, convincing wholesalers and
retailers to stock and sell their products and ultimately convincing and educating the
consumers for its existence and needs. This time also selling price will be usually match to
similar or substitute goods. Its lack of relative advantage will be a driving force for the
company to make the selling price at its minimum level.

On the other hand, cost during introduction stage are heavily channeled to established
distribution channels and generating a level of awareness, interests and trial by consumers.
Substantial costs may include engineering changes, market researches and advertising and

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promotion. Ultimately, profits are negative throughout a products life introduction stage.
These losses are a result of a very high costs combined with a low levels of sales during this
stage.

Growth Stage

As the products become widely known and accepted by the consumers, the product will
enter to another stage – the Growth Stage. The World Wide Web component of the internet,
smartphones, Tablet PC (IPAD) is some of the most common example of products under the
growth stage. During this phase, sales will dramatically increased and the selling price will
be stable. Relatively, tremendous profits will be expected because of these probable cost
reduction reasons:
 Decrease in variable cost per unit, as quality may improve during this stage. The
reengineering process and continuous improvement of the product will result the
elimination or reduction of product waste and labor inefficiencies, rework and other
non-value added activities.
 Promotions, marketing expenses and other fixed costs will also decrease as the
expenses will spread over a larger sales production volume.

During the growth stage also, competitors begin to enter the market. As competition
intensifies,
POINTSadditional !
spending for strategies may incur and lowering slightly the market
TO PONDER
The first two stages of Product Life Cycle involve the initial establishment of
price. However,
Chainsuch additional (SCM).
expenses
It will
is abediscipline
offset by that
thoserefers
reasons to mentioned above,
Supply Management coordination the
increase in sales and decrease in manufacturing costs, providing still a net positive effect of
different managerial tasks to all supply activities of an organization from its suppliers
increase in profitability.
and partners to its customers. There are two important activities part in the SCM, the
Upstream and Downstream Activities:

Upstream Activities – these are supply chain activities that take place when the
product are still in development stage or when it is under further product refinement. It
can also be define as all activities maintained by external parties before a company
takes over with its value adding activities. Research, development and product design
cost are the most common costs incurred on these activities.

Downstream Activities – these are activities performed after product refinement and
within the borders of the company. In a larger sense, these are mostly activities
involving the distribution of goods to the market. Typical costs incurred are the
marketing, distribution and customer service costs.

UPSTREAM ACTIVITIES DOWNSTREAM ACTIVITIES

Organization Custome
Supplier
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Maturity Stage

The first indication of maturity stage is the slow growth rate of sales in comparison to
previous years until such time it will reach its peak. A product’s peak point varies in
duration. Automobiles, cigarettes and refrigerators hovered at maturity for decades. The
refrigerator for instance will continue to remain at mature stage until such time when new
technology will introduce to fill up the existing need. In general sense, maturity is the
longest phase of PLC, thus most of the products now in the market are under maturity
stage. In managerial perspective, this is one of the most important phases that need to be

considered. Most of the decisions made by marketing managers are relevant in managing
the product during this stage. Other characteristics of maturity stage includes high market
share, greater competition, lower level costs and sales stabilization or decline slowly.

Decline Stage

This phase starts when there is an introduction of new and better technology, a change in
fashion or the product outlive or outgrown its own value and usefulness. These significant
events will lead to a steady deterioration in sales and profits and culminates in the
withdrawal of the product in the market. Examples of products recently withdrawn from the
market are Friendster and Kodak.

At this stage, profits continue to decline until such time that it is not feasible to continue the
product. The continued pressure of competition in the market leads to oversaturation of the
industry, resulting to price cuts and increase spending on promotion. The buying pattern of
the consumers will also change and cost per unit increases as fixed costs are spread over
the fewer units.

Cycle
Attributes Development Introduction Growth Maturity Decline
Product Conceptualization Basic design, new Some Proliferation of Minimal changes,
models improvements, product lines, reduced number
expanding product extensive of product line
line differentiation
Learning High costs, much High costs, much Still strong, Stable production, No learning, labor
Effects learning, but little learning, but little learning begins to little to no learning as efficient can be

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pay off pay off reduce costs

Setups Only for testing and Few, but new and More, as new Many, as product Fewer, as only
trial runs unfamiliar models are differentiation occurs best selling lines
introduced are produced
Purchasing Minimal only for Maybe high as new Lower, reliable May be high, Fewer Suppliers
testing materials and suppliers found, depending on line and orders as
suppliers are sought few material changes existing
changes inventories are
liquidated
Cost High on Product High on Marketing Decline on unit Costs continue to Cost may continue
Research and cost and further manufacturing rise as competition to rise for
development. product cost and market competition and
development saturation will promotion will be
intensify intense to
promote customer
loyalty through
price concession
Sales None Low Rapid Growth Slow growth, peak Declining
sales
Profit None Negligible to loss Peak Levels Moderate to High Low

Cost Reduction System: Target and Kaizen Costing

Dr. Masayasu Tanaka, a target costing guru once said “A manager in Europe or the United
States generally expects to use cost information to make decisions about pricing or
investments, while a Japanese manager expects to use cost information to control costs.”
His comment provides us an insight of the two different approaches in setting up cost and
selling price in the company.

Under Traditional approach, the product is designed first and costing will be made for such
design. The desired markup is then added to get the selling price. In a general sense, the
cost was the driver and the selling price was driven. However, the Japanese viewed it
differently as it adopts a Target Costing approach. It is the reverse view of the traditional
perspective. It determines first the selling price and deducts the desired profit; and any
remaining amount will be the target cost and the basis of designing the product.

Target Costing = Anticipated Selling Price – Desired Profit

Target costing begins with the likely market price for the new product and subtracts an
acceptable profit margin to arrive at the manufacturing cost necessary to achieve the target
margin. Then, to achieve the target cost, the product may need to be redesigned and/or
re-engineered. Hence, Target Costing is an approach to estimate an allowable product cost
by applying market research to estimate how much the market will pay for a product with
specific characteristic. Its concept breaks the Western Corporate mindset as it was
developed in recognition of the two important ingredients – the market and the cost.

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Activity-based costing (ABC) can be used with target costing. It helps to focus on the
various activities required to manufacture a product and the costs of those activities. So
the end result is improved costing of goods and/or services. Activity-based costing can also
help focus attention on non-value-added activities that consume resources and increase a
product's cost. Reduction or elimination of these activities can help achieve the product's
target cost.

The company will be in peril if it has a lesser control over the price and ignore the extent of
buyer’s willingness to purchase the product. The second observation is that the cost of the
product is determined at the design stage. Once the design is approved and the production
started, major cost reduction measures will be difficult. The target costing approach
provides awareness to the management of these two ingredients and led them to effectively
design and develop products within those limits; however, traditional costing perceives
selling price and cost dependent to product’s design.

Primary Reason for Adopting Target Costing

The primary reason is to reduce costs. Its unique approach is to design costs out of
products during the design stage in the product life cycle. Many firms adopt this approach
when they cannot reduce costs further using traditional costing methods which focus on cost
reductions in manufacturing. Target Costing is used during the development and design
stage of new products. It focuses on the development rather than the production stage
since most production costs are determined during the design stage but incurred only in the
production stage. It is also applicable throughout the product life cycle. Cross-functional
teams usually do the work, and sometimes include customers and suppliers.

There are many benefits derived from using Target Costing and these are as follows:
 Introduce the organization towards customers.
 It reduces time to market the product.
 It minimizes non-value added activities as it encourages selection of lower costs
 It enhances partnership with suppliers.
 The implementation improves employee awareness and empowerment.
 It promotes proactive view to cost management.

However, there are also disadvantages of using this approach as it primarily reduces the
quality of the product due to cost constraints, thus resulting to inferior quality. The
implementation requires willingness to cooperate and the need for a detailed cost data. It is
time consuming as it requires numerous meetings for coordination.

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Problems may also arise during the process, one of which is when the estimated cost to
make is more than the target costs. When this dilemma happens, the company can change
the product design or production process and can use value engineering approach.

Techniques Used to Achieve Target Costing Goals

Techniques used to achieve target-costing goals include value engineering, cross-functional

teams, and supply-chain management.

Value engineering refers to designing and redesigning products so that they will cost less
while delivering quality and functionality hence focuses on customer value. It is a discipline
used to search for various feasible combination of resources and methods that will increase
product functionality and reduce costs. It includes the elimination of nonessential activities
or using cost table to find the impact on product costs of different inputs, process and
specification.

If changing the process and design is too complicated, management can reduce the desired
profit margin to equalize the cost to make and the target cost. Ultimately, if the two
solutions mentioned above are not feasible, it is wise not to enter the market as it is not
profitable.

Kaizen Costing

Kaizen is a JapanesePOINTS term TOfor

PONDER!
continuous improvement. Thus, kaizen costing refers to
Target Costing Kaizen Costing
continuous reduction of costs throughout the entire product life. Its main objective is to
WHAT? A procedural approach to determining A mandate to reduce costs, increase product
reduce the actual cost below the standard costs. Elimination of waste, quality control, just in
a maximum allowable cost for an quality, and/or improve production processes
time delivery, standardized work and
identifiable, proposed process one some
product throughof its key philosophies.
continuous improvement efforts.
assuming a given target profit margin
USED FOR? New products Existing products
WHEN? Development stage (includes design) Primary production stages (introduction and
growth; possibly, but not probably, maturity)
HOW? Works best by aiming at a specified Works best by aiming at a specified cost
cost reduction objective: used to set reduction objective: reductions are integrated
original production standards. into original production standards to sustain
improvements and providenew challenges.
WHY? Extremely large potential for cost Limited potential for reducing cost of existing
reduction because 80% and 90% of a products, but may provide useful information
product’s lifelong costs are embedded for future target costing efforts
in the product during the design and
development stages
FOCUS? All product inputs (material, labor and Depends on where efforts will be most effective
overhead) as well as production in reducing production costs; generally begins
processes and supplier components. with the most costly component and (in more
mature companies) ends with overhead
components.

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Sample Problem:

Barato Appliance Company plans to introduce new product to the market. They conducted a
survey and determine that P75 will be the average acceptable price of the new item. At that
price, marketing department estimates that 40,000 will be sold annually. To design, develop
and produce these items, an investment of P5,000,000 will be required. The company
desires 15% return on investment. Compute the target cost per item on this product.

Projected Sales (40,000 x P75) P3,000,000

Less: Profit (P5,000,000 x 15%) (750,000)
Target Cost P2,250,000

Target Cost per Unit (P2,250,000/40,000 units) P56.25/unit

Theory of Constraints (TOC)

Theory of Constraints is a management approach that emphasizes the importance of

managing bottlenecks (constraints) that keep a system from achieving higher performance.
A constraint or bottleneck is anything that prevents you from getting more of what you
want. This theory was introduced by Dr. Eliyahu Goldratt. TOC is both descriptive and
prescriptive in nature. It does not describe only the cause of system constraints but also
provides guidance on how to resolve them. Its philosophy states that the flow of goods
through a production process cannot be at a faster rate than the slowest bottleneck in the
process.

To understand better the TOC, there are five (5) focusing steps:

STEP 1: Identify the system constraint and determine whether it is a physical

constraint or a policy-related issue.

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A company is a system of interrelated, independent process that work together to convert inputs into
products. Every department, division, process, employees are part of that system. And any of those
that will slow or hinders the process are considered weakest link and must be cut off.

The weakest link can be called constraints or bottlenecks. Constraints are anything that limits the
ability to perform a function while bottlenecks are those object or facilities whose processing level is
sufficiently slow that causes an idle time.

Constraints can be human, material or machine. Thus, even a fully automated company, optimum
production time and flow cannot be attained as all machines cannot operate at the same speed nor
handle the same capacity.

STEP 2: Decide how to exploit the constraints.

Exploiting the constraints is creating a plan on how to eliminate the limitations to promote faster and
efficient operation. However, any changes and upgrades should not be potentially expensive and
disruptive to the ongoing operation.

STEP 3: Subordinate everything else.

With the plan in place to exploit the constraint, the company will adjust the rest of the system to
enable the constraint to operate at a maximum effectiveness.

STEP 4: Elevate the Constraints.

If the constraints still exists, the organization will take any action to eliminate it. Either it may involve
major changes in the existing system, reorganization or any capital improvements.

STEP 5: Go back to STEP 1.

After the limitations or bottleneck is resolve, the organization will repeat the steps looking again for
another constraints.

To illustrate how Theory of Constraints will be applicable in a company, below is the

illustration of typical processing unit in a manufacturing firm.

A manufacturing concern has three processes. Upon inspecting those units, the weakest link
will be process B as it produces only 6 units/day. Process B then is considered constraints
and the rest are called nonconstraints.

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Upon determination of this limitation, the company will create a plan to “exploit” the
constraints and improve its operation. Example if the company, can increase the production
in Process B to 20 units/ day the limitation has been eliminated. And once it has been
reduced or eliminated the company will go back again to Step 1 and determine again the
weakest link. In this case, Process C now becomes the constraints and the rest are
nonconstraints.

The whole process of TOC should be repeated until the market demand of 15 units/day will
be catered. The theory of constraints is geared towards fixing problems in the company by
part, by department or by segment with a big potential of immediate system improvement.
This is rather advantageous compared to spending time, energy, and limited resources of
improving the entire system at once which may or may not result into tangible results.

Business Process Reengineering (BPR)

There are three (3) major business trends that had caused an increasing use of BPR today:
technology advancement, pursuit of quality, and the stiff price competition brought about by
globalization. To be able to successfully compete on all of these, firms must determined
ways to become more efficient, effective and reduce costs.

Every organization has two foundation, people and process. If every employee is highly
motivated and efficient but process is tedious, cumbersome, complicated and nonvalue
added activities are still present, the total organizational performance will still be poor.

Business Process Reengineering or commonly called BPR helps transforms organization in

ways that directly affect performance. It is a method of examining processes to identify,
and then eliminate, reduce, or replace functions and processes that add little customer
value to products or services. It helps the company become more efficient and modernize

materials, issuance TO packaging,

of check, !
through redesigning the execution of a particular business function (like handling or storing
POINTS PONDER recording journal entries, payroll, etc).

Continuous Improvement Process is different to Business Process

Reengineering. Continuous Improvement only provides gradual, incremental
improvements in business process however the three key factors of the business
trends today (mentioned above), major changes are required to stay even. BPR is
looking on the future and assumes the current process is irrelevant. To understand
more the difference, refer to the illustration below:

Continuous Process Improvement Model

Document as Establish Follow Measure Identify and

- is Process measures Process performance implement
improvements

Business Process Reengineering Model

Scope Project Learn From Create to be Plan Implement

Others Process Transition
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Based on the illustration, Continuous Process Improvement is focusing on the improvement

of the current process however BPR is starting a clean slate and design a new business
process that caters to customer and the changes business trends. It starts in defining the
scope and objectives of the reengineered process, and then going through learning process
(with customers, employees, suppliers, competitors and other technology levers). Given
with this knowledge, they will begin to redesign the core process. Then creating a plan on
how to adopt the new process, technologies and structures on the current system and
produce key performance measures to track progress, then lastly implementation of the
reengineered process.

When BPR is adopted in the organization, it requires a massive amount of information about
the process, data and system. Failure to find excellent tool to support the BPR, it will be a
daunting task for management to implement it. The following are recommendations to a
successful BPR implementation:

 Make “stretch” goals for the reengineered process and express them in appropriate
performance measure, such as financial, time or defective production.
 Ascertain that there is a “champion” in the reengineering process and must be
supported by the top management.
 Involve as much as possible everyone, especially outside partners (suppliers and
customers) in the project.
 Assign authority and responsibility to specific person.
 Use a pilot project to identify problems that might arise during the implementation.

TERMINOLOGIES

Activity analysis: is identifying and describing different activities in an organization,

usually repetitive in nature, and evaluating their impact to the operations.

Appraisal Cost: is the cost incurred in the process of uncovering the defects.

Benchmarking: is a process of investigating, comparing and evaluating the product,

process and services of the company against its own, competitors or to the best-in-class of
that particular industry.

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Business Process Reengineering: is a method of examining processes to identify, and

then eliminate, reduce, replace functions and processes that add little customer value to
products or services.

Downstream Activities: these are activities performed after product refinement and
within the borders of the company. In a larger sense, these are mostly activities involving
the distribution of goods to the market.

External Failure Costs: are those costs incurred resulting to quality problems at customer
site.

Internal Failure Costs: are those costs associated in discovering poor quality products
before it reaches to customer.

Kaizen costing: refers to continuous reduction of costs throughout the entire product life

Non-Value Added Activity: Any activities that increases the time of production but does
not increase the value of the product or to the external customer.

Prevention Costs: are the costs to improve the quality by preventing product defects.

Product Life Cycle: It depicts the stages through which a product class passes from the
time the idea is conceived until the production is discontinued.

Productivity: is the quality, state or fact of being able to generate, create, enhance, or
bring forth a good output during a period of time.

Quality: is something that can be determined by comparing a set of inherent characteristics

with a set of requirements.

Target costing: then is an approach to estimate an allowable product cost by applying

market research to estimate how much the market will pay for a product with specific
characteristic.

Theory of Constraints: is a method of analyzing the bottlenecks (constraints) that keep a

system from achieving higher performance.

Total Quality Management: Management approach of an organization, centered on

quality, based on the participation of all its members and aiming at long-term success
through customer satisfaction, and benefits to all members of the organization and to
society.

Upstream Activities: define as all activities maintained by external parties before a

company takes over with its value adding activities.

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Value Added Activity: Those increases the worth of the product for which the customer is
willing to pay must be the only one to be retained.

Value engineering: is a discipline use to search for various feasible combinations of

resources and methods that will increase product functionality and reduce costs.

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