STRATEGIC COST MANAGEMENT – Solutions Manual

CHAPTER 8
COST PLANNING FOR PRODUCT LIFE-CYCLE:
LIFE-CYCLE COSTING AND LONG-TERM PRICING;
TARGET COSTING AND THEORY OF CONSTRAINTS

Answer to Questions
1. Life-cycle costing considers the entire cost life cycle of the product and thus provides a more
complete perspective of product costs and product profitability. It is used to manage the total
costs of the product, across its entire life cycle. For example, design and development costs may
be increased in order to decrease manufacturing costs and service costs later in the life cycle.
2. At the introduction and into the growth phases, the primary need is for value chain analysis, to
guide the design of products in a cost-efficient manner. Master budgets are also used in these
early phases to manage cash flows; there are large developmental costs at a time when sales
revenues are still relatively small. Then, as the strategy shifts to cost leadership in the latter
phases, the goal of the cost management system is to provide the detailed budgets and
activity-based costing tools for accurate cost information.
3. Life-cycle costing is most appropriate for firms which have high upstream costs (i.e. design
and/development) and downstream costs (i.e. distribution and service costs). Firms with high
upstream and downstream costs need manage the entire life cycle of costs, including the upstream
and downstream costs as well as manufacturing costs. Traditional cost management methods tend
focus on manufacturing costs only, and for these firms, this approach would ignore a significant
portion of the total costs.
4. Sales life-cycle analysis is used help a firm develop and implement its strategy for success as its
products and services mature in the market place. The focus for new products is typically
differentiation and there is a heavy focus on research and development, while cost control
becomes more important as the product matures. In contrast, life-cycle costing is used to manage
the costs of the product over its entire cost life cycle—from research and development and
product testing to manufacturing and finally distribution and customer service.
5. The methods of product engineering and design in life-cycle costing are:
Basic engineering is the method in which product designers work independently from marketing
and manufacturing to develop a design from specific plans and specifications.
Prototyping is a method in which functional models of the product are developed and tested by
engineers and trial customers.
Templating is a design method in which an existing product is scaled up or down to fit the
specifications of the desired new product.
Concurrent engineering, or "simultaneous" engineering, is an important new approach in which
product design is integrated with manufacturing and marketing and throughout the product's life
cycle.
6. The sales life cycle refers to the phase of the product's sales in the market—from introduction of
the product to decline and withdrawal from the market. In contrast, the cost life cycle refers to the
activities and costs incurred in developing a product, designing it, manufacturing it, selling it and
servicing it. The phases of the sales life cycle are:
Phase One: Product Introduction. In the first phase there is little competition, and sales rise
slowly as customers become aware of the new product. Costs are relatively high because of high
R&D expenditures and capital costs for setting up production facilities and marketing efforts.
Prices are relatively high because of product differentiation and the high costs at this phase.
Product variety is limited.

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 Phase Two: Growth. Sales begin to grow rapidly and product variety increases. The product
continues to enjoy the benefits of differentiation. There is increasing competition and prices begin
to soften.
Phase Three: Maturity. Sales continue to increase but at a decreasing rate. There is a reduction in
the number of competitors and of product variety. Prices soften further, and differentiation is no
longer important. Competition is based on cost, given competitive quality and functionality.
Phase Four: Decline. Sales begin to decline, as does the number of competitors. Prices stabilize.
Emphasis on differentiation returns. Survivors are able to differentiate their product, control costs,
and deliver quality and excellent service. Control of costs and an effective distribution network
are key to continued survival.
7. The strategic pricing approach changes over the sales life cycle of the product. In the first phase,
pricing is set relatively high to recover development costs and to take advantage of product
differentiation and the new demand for the product. In the second phase, pricing is likely to stay
relatively high as the firm attempts to build profitability in the growing market. Alternatively, to
maintain or increase market share at this time, relatively low prices ("penetration pricing") might
be used. In the latter phases, pricing becomes more competitive, and target costing and life-cycle
costing methods are used, as the firm becomes more of a price taker rather than a price setter, and
efforts are made to reduce upstream (for product enhancements) and downstream costs.
8. Target costing is a method by which the firm determines the desired cost for the product, given a
competitive market price, so that the firm can earn a desired profit. It is used by several
manufacturing firms, particularly in the automotive and consumer products industries, such as
Honda, Toyota, Ford, Volkswagen, and Kodak camera.
9. Target costing is most appropriate for firms that are in a very competitive industry, so that the
firms in the industry compete simultaneously on price, quality and product functionality. In very
competitive markets such as this, target costing is used to determine the desired level of
functionality the firm can offer for the product while maintaining high quality and meeting the
competitive price.
10. Value engineering is used in target costing to reduce product cost by analyzing the tradeoffs
between different types and levels of product functionality and total product cost. Two common
forms of value engineering are:
● Design analysis is a process where the design team prepares several possible designs of the
product, each having similar features but different levels of performance on these features and
different costs.
● Functional analysis is a process where each major function or feature of the product is
examined in terms of its performance and cost.
11. The firm has two options for reducing costs to a target cost level:
a. Reduce costs to a target cost level by integrating new manufacturing technology, using
advanced cost management techniques such as activity-based costing, and seeking higher
productivity through improved organization and labor relations. This method of cost
reduction is common in specialized equipment manufacturing.
b. Reduce cost to a target cost level by redesigning a popular product. This method is the more
common of the two, because it recognizes that design decisions account for much of total
product life cycle costs. By careful attention to design, significant reductions in total cost
are possible. This approach to target costing is associated primarily with Japanese
manufacturers, especially Toyota, which is credited with developing the method in the mid
1960s. This method of cost reduction is common in consumer electronics.

12. Activity-based costing (ABC) is used assess the profitability of products, just as TOC. The
difference is that TOC takes a short term approach profitability analysis, while ABC develops a

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 longer-term analysis. The TOC analysis has a short-term focus because of its emphasis on
materials related costs only, while ABC includes all product costs. On the other hand, unlike
TOC, ABC does not explicitly include the resource constraints and capacities of production
operations. Thus, ABC cannot be used to determine the short-term best product mix. ABC and
TOC are thus complementary methods; ABC provides a comprehensive analysis of cost drivers
and accurate unit costs, as a basis for strategic decisions about long-term pricing and product mix.
In contrast, TOC provides a useful method for improving the short-term profitability of the
manufacturing plant through short-term product mix adjustments and through attention to
production bottlenecks.
13. The purpose of the network diagram is to assist the management accountant in the first step of
TOC, to identify the binding and non-binding constraints.
14. TOC emphasizes the improvement of throughput by removing or reducing the binding
constraints, which are bottlenecks in the production process that slow the rate of output. These are
often identified as processes wherein relatively large amounts of inventory are accumulating, or
where there appear to be large lead times. Using TOC the management accountant speeds the
flow of product through the binding constraint, and chooses the mix of product so as to maximize
the profitability of the product flow through the binding constraint.
A non-binding constraint is the opposite of a binding constraint, that means it is a process which
does not result in relatively large accumulation of inventory or where there are no large lead
times.
15. There are five steps in TOC analysis:
Step One: Identify the Binding and Non-binding Constraints Use a network diagram. The binding
constraint is a resource that limits production to less than market demand.
Step Two: Determine the Most Efficient Utilization of Each Binding Constraint Product mix
decision: based on capacity available at the binding constraint, find the most profitable product
mix. Maximize flow through the constraint: -reduce setups -reduce lot sizes -focus on throughput
rather than efficiency
Step Three: Manage the Flows Through the Binding Constraint Drum-Buffer-Rope concept:
maintain a small amount of work-in-process (buffer) and insert materials only when needed
(drum) by the constraint, given lead times (rope). All resources are coordinated to keep the
constraint busy without a build-up of work.
Step Four: Increase capacity on the constrained resource Invest in additional capacity if it will
increase throughput greater than the cost of the investment. Do not move to investment until steps
two and three are complete, that is, maximize the productivity of the process through the
constraint with existing capacity.
Step Five: Redesign the Manufacturing Process for Flexibility and Fast Throughput Consider a
redesign of the product of production process, to achieve faster throughput.
One could argue that any step could be the most important; for example step one can be
considered to be the most important because of the analysis undertaken is intended to improve the
speed of product flow through the binding constraint.
16. TOC is appropriate for many types of manufacturing, service and not-for-profit firms. It is most
useful where the product or service is prepared or provided in a sequence of inter-related
activities as can be described in a network diagram. The most common users of TOC to date have
been manufacturing firms who use it to identify machines or steps in the production process
which are bottlenecks in the flow of product and profitability.

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Answer to Problems

Problem 1 (Sales Life-Cycle Analysis)

Characteristics Sales Life Cycle Stage

Decline in sales Decline
Heavy Advertising Introduction
Boost in production Growth
Stabilized profits Maturity
Competitor’s entrance into market Growth
Market Research Introduction
Market Saturation Maturity
Start Production Introduction
Product Testing Introduction
Termination of Product Decline
Large Increase in sales Growth

Problem 2 (Life-Cycle Costing)

Requirement 1. A product life-cycle statement would aggregate the three years into one show the
totals in each category for the “life” of the product. Since these products have expected ten year
lives, the product life cycle statement would need forecasts for the next seven years data.

Requirement 2. RM 200 appears be more profitable.

RM 200 RM 800
Revenue Costs: P5,000,000 P4,700,000
R&D 1,000,000 1,150,000
Prototypes 350,000 590,000
Marketing 855,000 584,000
Distribution 330,000 880,000
Manufacturing 1,820,000 1,385,000
Customer Svc. 145,000 30,000
Income P 500,000 P 81,000

Requirement 3
RM 200: Year 1 Year 2 Year 3
R&D 68.5% 0% 0%
Prototypes 20.5% 3.7% 0%
Marketing 4.1% 23.7% 28.1%
Distribution 5.5% 8.9% 7.7%
Manufacturing 1.4% 59.3% 59.2%
Customer Svc. 0% 4.4% 5%
Total Costs P1,460,000 P1,350,000 P1,690,000
RM 800: Year 1 Year 2 Year 3
R&D 55.3% 0% 0%
Prototypes 26.5% 2.6% .7%
Marketing 6% 17.4% 18.7%
Distribution 8.2% 26.1% 29.5%
Manufacturing 4% 52.2% 50.4%
Customer Svc. 0% 1.7% .7%
Total Costs P2,079,000 P1,150,000 P1,390,000

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The RM 200 had lower initial costs, but the customer service costs are much higher as a
percentage of total costs compared the RM 800 customer service cost percentages. Also, the RM
200 customer service costs increased compared a percentage drop for the RM 800 customer
service costs. This seems indicate that the RM 200’s lower initial costs in R&D and Prototypes
will be offset by increasing customer service costs. An accurate prediction can not be made based
on just this information, but the RM 800 may very well turn out be a more profitable product due
lower costs achieved through a heavier investment in R&D and Prototypes.

Problem 3 (Target Costing in a Service Firm)

Requirement 1
MCU 100 MCU 900
Unit Cost Quantity Cost Quantity Cost
Video camera P150 1 P150 3 P450
Video monitor 75 1 75 1 75
Motion detector 15 5 75 8 120
Floodlight 8 3 24 7 56
Alarm 15 1 15 2 30
Wiring .1/ft 700 70 1,100 110
Installation 20/hr 16 320 26 520
Total P729 P1,361

MCU 100: (P 810 – P 729 total costs) / P810 = 10% profit margin
MCU 900: (P1,520 – P1,361) / P1,520 = 10.46% profit margin

Requirement 2
MCU 100: (P 750 – P 729 total costs) / P750 = 2.8% profit margin
MCU 900: (P1,390 – P1,361) / P1,390 = 2.09% profit margin

Requirement 3
The installation costs are the largest component of cost and this category could have room for
improvement. By redesigning the layout of the systems or finding components that integrate more
readily, the installation times could then be reduced. Also, costs could be lowered by contractual
bargaining with electricians reduce the per hour rates for installation.
The video equipment and motion detectors are sources of significant costs, but decreasing the
quality or quantity of these items would substantially change the effectiveness and value of the
security systems.

Problem 4 (Target Costing, Strategy)

Requirement 1
Cost per unit = (P2,700,000 + P1,000,000 + P300,000 + P4,000,000) / 10,000 = P800 per unit
Profit per unit = (P875 price per unit – P800 cost per unit) = P75 per unit

Requirement 2. Machine setups do not add value to the table.

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300,000 total cost / 10,000 units = P30 per unit of non-value added costs
Requirement 3. P800 price per unit – P75 profit per unit = P275 per unit target cost

Requirement 4
First and foremost, Benchmark should focus on getting back on budget. Inefficiencies in materials
usage have led an extra P15.88/unit in cost. Also, getting labor on budget would save an
additional P15/unit. This would get costs down to P769.12 per unit. Part of the additional P44.12
of savings needed to attain the P725 target cost could come from reducing the non-value added
costs from machine setups. This could be done through product design and manufacturing process
reengineering. Also, a careful examination of mechanical assembly might reveal cost saving
opportunities because this category currently comprises half of the cost per unit. Cutting 2-2 ½
hours off of mechanical assembly through product innovation or a process change would provide
an extra P30 of savings.

Problem 5 (Target Costing; Warehousing)

Current Year Operating Income

Sales P 10 x 100,000 = P1,000,000

Costs:
Purchase P 5 x 100,000 = P500,000
Purchasing order P100 x 1,000 = 100,000
Warehousing P 20 x 8,000 = 160,000
Distributing P 80 x 500 = 40,000
Fixed operating cost 100,000 900,000
Operating income P 100,000

Target Cost

Sales P9.50 x 100,000 x .95 P 950,000

Desired profit 100,000
Total cost allowed P 850,000
Total costs excluding warehousing:
Purchase P500,000 x .96 = P480,000
Purchasing order P 100 x 800 = 80,000
Distributing P 75 x 500 = 37,500
Fixed operating cost 100,000 697,500
Maximum warehousing cost P 152,500

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Problem 6 (Theory of Constraints, Throughput Contribution, Relevant Costs)

Requirement 1
Finishing is a bottleneck operation. Hence, producing 1,000 more units will generate additional
throughput contribution and operating income.

Increase in throughput contribution (P72 – P32) x 1,000 P40,000

Incremental costs of the jigs and tools 30,000
Net benefit of investing in jigs and tools P10,000

Zashi should invest in the modern jigs and tools because the benefit of higher throughput contribution
of P40,000 exceeds the cost of P30,000.

Requirement 2
The Machining Department has excess capacity and is not a bottleneck operation. Increasing its
capacity further will not increase throughput contribution. There is, therefore, no benefit from
spending P5,000 to increase the Machining Department’s capacity by 10,000 units. Zashi should not
implement the change to do setups faster.

Problem 7 (Theory of Constraints, Throughput Contribution, Relevant Costs)

Requirement 1
Finishing is a bottleneck operation. Hence, getting an outside contractor to produce 12,000 units will
increase throughput contribution.

Increase in throughput contribution (P72 – P32) x 12,000 P480,000

Incremental contracting costs P10 x 12,000 120,000
Net benefit of contracting 12,000 units of finishing P360,000

Zashi should contract with an outside contractor to do 12,000 units of finishing at P10 per unit
because the benefit of higher throughput contribution of P480,000 exceeds the cost of P120,000. The
fact that the costs of P10 are double Zashi’s finishing cost of P5 per unit are irrelevant.

Requirement 2
Operating costs in the Machining Department of P640,00, or P8 per unit, are fixed costs. Zashi will
not save any of these costs by subcontracting machining of 4,000 units to Rainee Corporation. Total
costs will be greater by P16,000 (P4 per unit x 4,000 units) under the subcontracting alternative.
Machining more filing cabinets will not increase throughput contribution, which is constrained by the
finishing capacity. Zashi should not accept Rainee’s offer. The fact that Rainee’s costs of machining
per unit are half of what it costs Zashi in-house is irrelevant.

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 Problem 8 (Theory of Constraints, Throughput Contribution, Quality)

Requirement 1
Cost of defective unit at machining operation which is not a bottleneck operation is the loss in direct
materials (variable costs) of P32 per unit. Producing 2,000 units of defectives does not result in loss
of throughput contribution. Despite the defective production, machining can produce and transfer
80,000 units to finishing. Therefore, cost of 2,000 defective units at the machining operation is P32 x
2,000 = P64,000.

Requirement 2
A defective unit produced at the bottleneck finishing operation costs Zashi materials costs plus the
opportunity cost of lost throughput contribution. Bottleneck capacity not wasted in producing
defective units could be used to generate additional sales and throughput contribution. Cost of 2,000
defective units at the finishing operation is:

Lost of direct materials P32 x 2,000 P 64,000

Forgone throughput contribution (P72 – P32) x 2,000 80,000
Total cost of 2,000 defective units P144,000

Alternatively, the cost of 2,000 defective units at the finishing operation can be calculated as the lost
revenue of P72 x 2,000 = P144,000. This line of reasoning takes the position that direct materials
costs of P32 x 2,000 = P64,000 and all fixed operating costs in the machining and finishing operations
would be incurred anyway whether a defective or good unit is produced. The cost of producing a
defective unit is the revenue lost of P144,000.

Answer to Multiple Choice Questions

1. D 11. D 21. D

2. D 12. A 22. B
3. B 13. A 23. B
4. B 14. D 24. A
5. D 15. B 25. D
6. C 16. D
7. D 17. D
8. C 18. C
9. D 19. B
10. A 20. D

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