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Economics of Product Development Projects: When to Use Economic Analysis
Go/no-go milestones:
‡Should we try to develop a product to meet this market need? ‡Should we proceed with the implementation of a selected concept? ‡Should we launch the product we have developed? Such decisions commonly arise at the end of each development phase.

Operational design and development decisions:
‡Should we spend $100,000 to hire an outside firm to develop this component In order to save two months of development time? ‡Should we launch the product in four months at a unit cost of $450 or Wait until six months when the cost can be reduced to $400?

Quantitative Analysis:
We must consider both cash inflows (revenues) and

cash outflows (costs)
In the life cycle of a new product.

‡Cash inflows are generated by product sales. ‡Cash outflows include spending on product and process development,
costs of production ramp-up such as equipment purchases & tooling, costs of marketing and supporting the product, and ongoing productions costs such as raw materials, components & labor.

Limitations of Quantitative Analysis
Detractors of quantitative analysis argue that it suffers as following: It focuses only on measurable quantities. Techniques such as NPV emphasize and rely on that which is measurable. Many critical factors are, however, difficult to measure. Quantitative techniques serve to encourage investment in measurable assets and discourage investment in intangible assets. It depends on validity of assumptions and data. Bureaucracy reduces productivity. Detractors of financial analysis assert that such activities provide a high level of planning and control at the expense of product development productivity. In their view, extensive planning and review assure that a brilliantly conceived, well-engineered product will reach the market after its market window has already closed. Detractors also argue that overzealously applied ³professional´ management techniques stifle the product development process. Potentially productive development time is devoted to preparation of analyses and meetings. The cumulative effect of this planning and review can be a ballooning development process.

It is often difficult for quantitative analysis to capture important characteristics of a dynamic and competitive environment. In qualitative analysis we will specifically consider interactions between: ‡the project and the firm. yet projects typically have both positive and adverse aspects that are difficult to quantify. ‡the project and the market. and ‡the project and the macroeconomic environment. .Qualitative Analysis: Quantitative analysis can capture only measurable factors. Thus quantitative analysis alone is often incomplete and must be augmented by qualitative analysis.

2. . Perform a sensitivity analysis to understand the relationships between financial success and the key assumptions and variables of the model. Build a base-case financial model. Consider the influence of the qualitative factors on project success. 3.Economic Analysis Methodology The following four-step economic analysis methodology is recommended for product development projects: 1. Use sensitivity analysis to understand trade-offs. 4.

Build a Base-Case Financial Model This consists of estimating the timing and magnitude of future cash flows and then computing the Net Present Value (NPV) of those cash flows. and service costs ‡ Inclusion of tax effects. The level of detail should be coarse enough to be convenient to work with. Estimating the timing and magnitude of future cash flows is done by merging the project schedule with the project budget. yet contain enough resolution to facilitate effective decision making. salvage costs. promotion costs.Step 1. sales volume forecasts. & refinement costs up to the production ramp-up) Ramp-up Cost Marketing & Support Cost Production Cost Sales Revenues. The most basic categories of cash flow for a typical new product development project are: Development Cost (all remaining design. . cannibalization (impact of the new product on existing product sales). testing. and opportunity costs. direct sales costs. including the depreciation tax shield and investment tax credits ‡ Inclusion of such miscellaneous inflows and outflows as working capital requirement. Refinements may include: ‡ Breakdown of production costs into direct costs & indirect costs (overheads) ‡ Breakdown of marketing and support costs into launch costs. and estimated production costs.

Key Factors Influencing INTERNAL FACTORS Development Program Expense Investigation Cost Development Cost Development Speed: Investigation Time Development Time Production Cost Product Performance Product Development Project EXTERNAL FACTORS Product Price Sales Volume Competitive Environment Net Present Value Product Development Profitability .

widely used in business.they are profitable. Build a Base-Case Financial Model Economically successful products generate more cumulative inflows than they do cumulative outflows ± that is . also. The QUANTITATIVE part of economic analysis estimates the NPV. but also in bringing a measure of structure and discipline to the product development process. Net Present Value . The value of quantitative analysis is not only in providing objective evaluations of projects and alternatives.Step 1. A measure of this sort of profitability is Net Present Value (NPV). This is easily understood and. NPV is the value in today¶s dollars of all expected future cash flows.

It is called this because it is the return forgone by investing in the project rather than other investments ± that is. To illustrate NPV concepts. hurdle rate) t = number of time periods Then: PV = Present Value = C/(1 + r)t NOTE: r is the opportunity cost of capital. the ³reward´ that investors demand for accepting delayed payment. let: C = monetary amount invested r = interest rate (e. . Thus NPV calculations estimate the value today (present value) of some future income or expense. A project with positive NPV must be earning more than the opportunity cost of capital. rate of return.g.Quantitative Analysis: Net Present Value Essentially this technique acknowledges that ± generally ± a monetary unit today is worth more than the same monetary unit tomorrow. discount factor.

2.06 invested at rate of return of .06 That is.38 + $73.Net Present Value ± Example Suppose C = 100 and r = .08)4 = $73.08)1 = $92. 3. then that 100 contribution (expense) in PRESENT monetary units is only $68.26 .06 = $399. 4.59 + $85.73 + $79.06.08)2 = $85. Consequently.73 PV3 = 100/(1+.08 with t = 1. $68.59 PV2 = 100/(1+. the sum of 100 unit contributions at the end of each five time Periods has a PRESENT VALUE of: $92.08 / unit time will be valued at 100 after 5 units of time.08)5 = $68.08)3 = $79. Similarly.38 PV4 = 100/(1+. if we estimate a contribution (expense) to inflow (outflow) 5 units of time in the future.50 + $68.50 PV5 = 100/(1+. 5 then PV1 = 100/(1+.

.Sunk Costs are Irrelevant to NPV Calculations: In the context of product development decision making. they cannot be affected by present or future decisions and should hence be ignored in NPV calculations. An illustration follows. costs that have already been incurred are sunk costs. Because these are past and are irreversible outflows.

then simple examination of NPV (in millions) indicates: CUT OUR LOSSES Additional investment: Profits from Product Sales: NPV of ³cut losses´ Total Invested Total Project Return $0 $0 $0 -$600 -$600 INVEST $90 MILLION MORE Additional Investment Profit from Product Sales: NPV of ³Invest´ Decision: Total Investment: Total Project Return: -$90 $350 $260 -$690 -$340 CONCLUSIONS??? .Example: Should We Cut our Losses? Suppose that we have spent $600 million and 9 years with no product.o. Suppose That: $90 million more will get the product to market and generate $350 million in product sales.g. Should we do this? Fact One: $600 million and 9 years are irrelevant ± except emotionally. We are asked to approve another $90 million. that all numbers given are present values. Assume w/o l. Fact Two: what is important is determination of what can be gained from investing the additional $90 million.

. Instead. Market risk stems from the fact that there are economy-wide perils that threaten all businesses and projects « market risk is USUALLY accounted for by inflating the discount rate. Sales forecasts depend on such information as when our competitors get their versions of the product or service to market. These are arbitrary and are usually used because of inadequate cash flow forecasting. These should be supplemented with CAREFUL sensitivity analysis to understand the impact of the full range of possible outcomes for the uncertain factors. project-specific risks should be considered only in the expected cash flows and not in the discount rate. Such uncertainties are called project-specific risks. LAST: A second type of risk is market risk which is not project-specific. Fudge factors are then applied uniformly to both certain and uncertain cash flows. Often fudge factors are used because project teams simply do not want to confront the true likelihood of adverse outcomes. Some project development teams add a fudge factor to r to offset such uncertainties. THAT IS.Dealing With Uncertainty in the Cash Inflow & Outflow Estimates Actual manufacturing or service delivery costs may be higher or lower than estimated. development teams should perform realistic cash flow forecasts.

including the competitive environment (e. . and product price. development speed. Regardless. Both internal and external factors influence project value. and product performance. Sensitivity Analysis Sensitivity analysis uses the financial model to answer ³what if´ questions by calculating the change in NPV corresponding to a change in the factors included in the model. While external factors are not directly controlled by product development teams..g. there is little disagreement that price is strongly influenced by the prices of competitive products and that it is linked to sales volume. External Factors are those that the team cannot arbitrarily change. including development program expense. sales volume. they are often influenced by the internal factors. production cost. Internal factors are those over which the development team has a large degree of influence. market response. Price There may be disagreement over whether price is an internal or external factor. actions of competitors).Step 2.

decreasing product development time may require an increase in development spending. rather than by a planned extension of the schedule. decreasing development time may lead to lower product performance. Increased product performance may require additional product cost. yet extending development time may also lead to an increase in cost if the extension is caused by a delay in a critical task. Some interactions are.Step 3. For example. for example. more complex in nature. however. Use Sensitivity Analysis to Understand Project Trade-Offs Six Potential Interactions Development teams attempt to manage six potential interactions between internally driven factors. Development Time Product Cost Product Performance Development Cost Often interactions can be thought of as trade-offs. .

Step 3. For example. Trade-off Rules: These rules take the form of the cost per unit change in the internal & external factors. Use Sensitivity Analysis to Understand Project Trade-Offs Interactions are important because of the linkage between internal & external factors. decreasing development time may allow the product to reach the market sooner and thus increase sales volume. increasing development cost or time may enhance product performance and therefore increase sales volume or allow higher prices. Examples might be ³what is the cost of a one-month delay in development time?´ or ³What is the cost of a 10% development budget overrun?´ or ³What is the cost of a $1 per unit increase in manufacturing cost?´ .

that external forces do not change the team¶s actions. . alternately. Consider issues such as ³will knowledge gained from this project spill over and be of benefit to other development projects?´ or ³How will competitors react to the introduction of our product?´ or ³Will competitors modify their own development efforts in response to ours?´ ³Will there be significant fluctuations in the dollar/yen exchange rate that will change the cost of component parts?´ Our model implicitly accounts for these and other issues with several broad comparisons. Consider the Influence of the Qualitative Factors on Project Success Qualitative factors are one that influence development projects that are difficult to quantify because they are complex or uncertain.Step 4. This assumption is common in financial models and is called the Ceteris paribus (other things being equal) assumption. It assumes that decisions made by the team do not affect actions of groups external to the project or.

Consider the Influence of the Qualitative Factors on Project Success Projects Interact with the Firm. Macro Environment Market Firm Project . the Market. for competitors and customers in the market. and even for the macroeconomic (macro) environment in which the market operates. Similarly. and the Macro Environment Decisions made within a project typically have important consequences for the firm as a whole. events and actions Outside of a development project can significantly impact its value.Step 4.

but is paid for by the first one. development decisions must be made in the context of the firm as a whole. EXAMPLE of a POSITIVE EXTERNALITY ± development learning on one project may benefit other current or future projects. BUT how should the other projects projects account for such benefits gained as not additional cost. How should the first project account for resources spent that benefit not only itself. costs are known as negative externalities and benefits as positive externalities. However. technology. but also other current or future projects. This does not mean these issues should be ignored ± rather ± they must be considered quantitatively. An externality is an ³unpriced´ cost or benefit imposed on one part of the firm by the actions of a second. . but also be consistent with the firm¶s technology and competitive strategies. For example. Strategic Fit: Team decisions must not only benefit the project.Step 4. how well does a proposed new product. or feature fit with the firm¶s resources and objectives? Is it compatible with the firm¶s emphasis on technical excellence? Is it compatible with the firm¶s emphasis on uniqueness? Because of their complexity and uncertainty. The two key interactions between the project & the firm are externalities and strategic fit. Consider the Influence of the Qualitative Factors on Project Success Interactions between the Project and the Firm as a Whole Assumption: Firm profit will be maximized if project profit is maximized. externalities and strategic fit are very difficult to quantify.

but three other groups: Competitors Competitors may provide products in direct competition or products that compete indirectly with substitutes. Customers Customers¶ expectations. indirectly throughout the value chain.g. impact the new product. The entrance of such a new competitor would change our expected price and volume and we may attempt to speed our own development efforts in response so that the competitor¶s actions may impact both our sales volume forecasts and our planned development schedule. e. The market environment is impacted by the actions of not only the team. These pressures may. Actions & reactions of these groups may impact expected price and volume. Changes may be driven by new conditions in markets for complementary or substitute products or may be independent. incomes. Suppliers Suppliers of inputs to the new product are subject to their own markets¶ competitive pressures. Consider the Influence of the Qualitative Factors on Project Success Interactions between the Project and the Market Accurate modeling of project value requires relaxation of the ceteris paribus assumption to recognize that a team¶s decisions impact the market and that market events impact the project.Step 4.. . or tastes may change. but can also have second-order effects. consider a new competitor that has rapid product development cycles and that seems to value market share rather than short-term profitability.

However. . Consider the Influence of the Qualitative Factors on Project Success Interactions between the Project and the Macro Environment The ceteris paribus assumption is again relaxed to consider key macro factors.Step 4. Government Regulations: New regulations can seriously impact a product development opportunity or can spawn entire new industries. Major Economic Shifts: examples of typical major economic shifts that impact the value of development projects are changes in currency exchange rates or in input prices. Social Trends: As with government regulations. new social concerns such as increased environmental awareness can destroy existing industries or create new ones. Macro factors can have important impacts on development project value. their effects are difficult to model quantitatively because of inherent complexity and uncertainty.

Can you think of successful products that would never have been developed if their creators had relied exclusively on a quantitative financial model to justify their efforts? Do these products share any characteristics? 2. One model of the impact of a delay in product introduction is that sales are simply shifted later in time.1. Another model is that some of the sales are pushed beyond the ³window of opportunity´ and are lost forever. Can you suggest other models for the implications of an extension of product development time? Is such an extension ever beneficial? 3. How would you use the quantitative analysis methodology to capture the economic performance of an entire line of products to be developed and introduced over several years? .

of primary importance because it directly addresses manufacturing costs. serviceability. robustness. . Profit margin is the difference between the manufacturer¶s selling price and the cost of making the product. Economically successful design is thus about ensuring high product quality while minimizing manufacturing costs and DFM is one method of achieving this. many teams practice Design for X (DFX) where ³X´ may represent any number of criteria such as reliability. during later activities teams often have difficulty linking needs and specifications to the specific design issue they face. In response.Generally customer needs and product specifications are useful for guiding the concept phase of product development. Manufacturing cost is a key determinant of the economic success of a product since such success depends on the profit margin earned on each sale of the product and on how many units of the product the firm can sell. HOWEVER. or manufacturability. Most common among these is design for manufacturability or DFM . environmental impact.

Reduce the costs of assembly. 3. Reduce the costs of supporting production. 5. 2. 4. Consider Impact of DFM Decisions on Other Factors Recompute the Manufacturing Costs Good Enough? No Yes Acceptable Design . Consider the impact of DFM decisions on other factors. Estimate manufacturing costs. Reduce the costs of components.Proposed Costs Estimate the Manufacturing Costs Reduce the Costs Of Components Reduce the Costs Of Assembly Reduce the Costs of Supporting Production DFM methodology consists of five parts: 1.

The SIPOC Model Inputs Suppliers Steps Process Outputs Customers Inform Loop .

. and are pushed back through the value chain as far. the model is a ³COPIS´ one in the sense that Six Sigma projects are customer-driven. begin with the customer. ultimately.The COPIS Model Outputs Customers Steps Process Inputs Suppliers SIPOC from a Six Sigma Perspective: From the Six Sigma Perspective. as the supplier.

Manufacturing cost is the sum of all the expenditures for the inputs of the system and for disposal of the wastes produced by the system. purchased components. energy and equipment. In practice this concept is complicated by several issues: ‡ What are the boundaries of the manufacturing system? Should the field service operations be included? What about product development activities? ‡ How do we ³charge´ the product for the use of expensive general-purpose equipment that lasts for several years? ‡ How are costs allocated among more than one product line in large. Similarly. The metric of costs for a product firms generally use is unit manufacturing cost. outputs include finished goods and waste. multi-product manufacturing systems? .The SIPOC model includes the manufacturing system (IPO) with inputs that include raw materials. employee¶s efforts. computed by dividing the total manufacturing costs for some period (usually a quarter or a year) by the number of units of the product manufactured during that period.

Components Assembly Overhead Standard Custom Labor Equipment and Tooling Support Indirect Allocation Raw Material Processing Tooling Elements of the Manufacturing Cost of a Product .

These are the support systems required to manufacture the product.g. Indirect allocations are the costs of manufacturing that cannot be linked to a particular project but which must be paid for to be in business (e. parts) of a product may include standard parts purchased from suppliers. Other components would be custom parts. Overhead Costs. The components (e. We find it useful to distinguish between two types of overhead: support costs and other indirect allocations.g.) Because indirect costs are not specifically linked to the design of the product. purchasing. facilities. even though they do contribute to the cost of the product.. and equipment / tooling maintenance (among others). .. quality assurance. The process of assembling almost always incurs labor costs and may also incur costs for equipment and tooling. receiving. Overhead is the category used to encompass all of the other costs. Assembly Costs.Component Costs. and these costs are often shared by more than one product line and are lumped together in the category of overhead. shipping. Support costs are the costs associated with materials handling. made according to the manufacturer¶s design from raw materials. they are not relevant to DFM. Discrete goods are generally assembled from parts. the salary of the security guard and the cost of maintenance to the building and grounds are indirect costs because these activities are shared among several different products and are difficult to allocate directly to a specific product.

. and technology acquisition.Importance of Cost Accounting Information ‡ Cost data provide a basis for important decisions on pricing. product mix. product design. ‡ Poor decisions in these areas can severely impair the ability of a company to compete. process improvement.

The fragility of the items handled. The number of different items handled. . Examples for the case of a warehouse that receives and stores material and supplies are: ± ± ± ± Total monetary value of inventory. The number of different orders received.Definitions ‡ Cost Behavior: this analysis tells us how the activities of an organization affect its costs. Cost drivers can be volume related or non-volume related. ‡ Cost Drivers: the activities that affect costs.

Typically the number of units of the product is the cost driver.Definitions ‡ Variable Cost: is a cost that varies in direct proportion to changes in the cost driver. There may be quantity discounts available. . ‡ This relationship holds for some relevant range. ‡ A 20% increase in the number of units produced will cause a 20% increase in the cost of raw material used.

‡ Cost-Volume-Profit Analysis: is the study of the effects of output volume on sales. the cost for which would be fixed over some new and. within the capacity of the warehouse. it may be necessary to rent a larger warehouse. costs. For example. Beyond this range. probably. .Definitions ‡ Fixed Cost: is a cost that is not affected by changes in the cost driver within some relevant range. and net profit. the rent paid for storage space (a warehouse) is not affected by the number of units of product stored. higher range.

. that is: ‡ (USP)*(N) = (UVC)*(N) + Fixed Expenses ‡ Break Even Point (units) = (Fixed Expenses)/ [USP ± UVC] ‡ Where: o USP = unit sale price o UVC = unit variable cost o N = Number of units.Break Even Point (BEP) ‡ This is the sales volume at which revenue equals expenses and net income is zero.

rent. Indirect labor costs (for storeroom personnel. components. These would include the cost of raw materials. ‡ ‡ . These would appear in ³factory overhead´. and subassemblies. janitorial staff. where labor and factory facilities are used to convert materials into other goods. insurance. e.g. THESE are also known as SUPPORT RESOURCES. Direct-labor costs: include the wages of all labor that can be traced to the manufactured goods at reasonable cost. supervision. THUS: Direct-material costs: include the acquisition costs of all materials that form part of the manufactured goods and can be traced at some reasonable cost. indirect labor. BUT NOT supplies and indirect materials such as lubricants and cleaning supplies. wages of machine operators and assemblers. security personnel) are included with factory overhead. depreciation.Categories of Manufacturing Costs ‡ ‡ In a manufacturing environment. products are frequently the cost objective. Factory-overhead costs: include all costs associated with the manufacturing process not classified as direct material or direct labor ± see above and supplies.

Cost Accounting Systems ‡ COST ACCUMULATION: this collects costs by some classification such as materials or labor. The process of cost allocation is thus a two-stage process. . ‡ Costs are first allocated to departments (to evaluate performance) and then to products (to value inventory and judge product profitability). ‡ COST ALLOCATION: traces and reassigns costs to one or more activities of interest. such as departments or products.

which are consumed in direct proportion t the number of units produced. .Assigning Costs to Products ‡ The costs of two resources are typically charged directly ± material and labor (direct material and direct labor) Resources such as these. can be measured fairly and accurately.

engineering and support costs are high while production costs are low. Certain costs for current products ± such as warranty costs ± may be omitted. ‡ ‡ ‡ Many support resources are not consumed in proportion to their production volumes. . Life Cycle Costs: In the early stages of a product¶s life cycle. These costs get assigned to higher volume products that do not require similar levels of support.Assigning Costs to Products ‡ In a traditional cost accounting system. This can cause serious distortions in product costs for several reasons Timing: the R&D costs of future products are assigned to products currently being produced. the costs of all other resources are indirectly assigned to products using direct labor or some other unit-based measure.

Products that differ in volume. costs.Assigning Costs to Products The distortion from unit-based product cost systems is most severe in organizations producing a diverse product mix for the following reasons. and stage of life cycle increases levels of support consume support resources in activities and related indirect significantly different amounts. to be a larger proportion of total costs. the overhead costs are thus allocated incorrectly costs of support resources tend by measures such as direct labor or direct material. Increasing product diversity ‡ 2. ‡ The high proportion of overhead ‡ In other words. complexity. . ‡ 1.

the high support activity costs would be allocated incorrectly by unitbased measures to high volume models. Inc. plants . .000 and the designs of some of the lower volume models are subject to frequent changes. ‡ It is clear that Geronimo will have much higher levels of indirect costs due to larger costs for scheduling.000 units of a dozen different designs in volumes ranging from 1000 to 30.example ‡ Consider the case of two Tumbling Dice Electronics. but for Geronimo. inspections. ‡ The Geronimo Plant makes 100.Domino and Geronimo ± both producing CD Players.000 CD Players per year of a single model with a stable design. ‡ The traditional system would provide accurate costs for Domino. ‡ The Domino Plant makes 100. setups. design. materials management.Assigning Costs to Products . and engineering changes.

indirect costs are assumed to vary directly with volume of output.‡ Traditional product costing assumes that products cause indirect costs by consuming the driver(s). Indirect costs can. or are produced in different volumes. ‡ We have seen that this approach can cause cost distortions when products are in different stages of their life cycle. therefore. . ‡ That is. are not of the same complexity. be allocated through these unit-based measures.

. ‡ ABC attempts to trace as many of the indirect costs as possible directly to products. cause costs by consuming support resources such as the production planning and control dept. as is done with direct material and direct labor.... sale. Some examples are: (a) Engineering and hours of engineering services. . ‡ These activities.‡ ABC takes a different approach in assuming that products incur costs by the ACTIVITIES they require for design. setup dept. engineering dept. and so on. shipping dept. manufacture. in turn. (c ) Shipping and number of orders and (d) Production Setup and number of setups. (b) inspection and hours of testing. engineering. delivery and service. ‡ To implement an ABC system. a company must identify the major activities undertaken by support departments and select a cost driver for each.

‡ It allows cost analysis at the design stage. number of components) while designing the product. ‡ Improved insights into activities that lead to overheads.‡ ADVANTAGES: ‡ Improved decisions through more accurate cost data. as in the electronics and machinery industries where overhead accounts for 70%-75% of value added.g. Designers can keep in mind cost drivers (e. ‡ It recognizes the non-manufacturing costs of products through the activities that are linked to products. This becomes especially important when manufacturing overhead costs account for a large percentage of production costs ± e. It is therefore compatible with TQM efforts. By linking activities to financial costs. ABC provides cost information to complement nonfinancial indicators of performance.g. .

‡ Any scheme for allocation of indirect costs can be considered arbitrary because another consultant or expert could design an alternate scheme. ‡ Many fixed costs are treated as variable costs. . Using only one of these drivers will not reflect costs accurately. the weight. ‡ The use of single cost drivers is naïve. with many cost pools and cost drivers. shipping and handling costs are likely to depend on the number of orders shipped. ‡ The cost of implementing an ABC System. This could lead a company to mistakenly use the per unit cost obtained from an activity-based costing system as a marginal cost. volume and special packaging needs of products. can be high. For example.

stages of life cycle. and losing bids that you considered low.‡ Diversity in the product mix in terms of complexity of products. . requirement for engineering and quality related activities. ‡ Profitability of products and competitors prices are hard to explain. Common symptoms of this problem are winning bids that you considered high. number of batches produced. The higher the cost of such measurement errors. the more important it is to get more accurate product costs. etc. volumes.

coordinate the different elements of the system. Scheduling and sequencing of products ± 3. Design of products and process routes so that production can be assigned to CNC equipment with minimum human intervention. . allows many different products to be produced simultaneously in small batches and in random order. the highly automated and computer controlled nature of the production process means that direct labor costs tend to be a very small component of the total cost. direct the material handling system. At the same time. Development of the computer programs that run the machines. and provide feedback to supervisors. ± a Flexible Manufacturing System (FMS).‡ CIM provides a good example of an environment where support activities generate high percentage of the costs: ± 1. and ± 4. Increased levels of preventive maintenance. ± 2. Any overhead cost allocation based on direct labor will provide distorted product costs. This makes the prior tasks even more complicated.g. The flexibility of CIM systems ± e.

‡ The setup cost is considered as a given. it becomes necessary to hold inventory ‡ However. This improved quality and allowed Toyota to be more responsive to the market. if any. A good example is provided by the Economic Production Quantity formula which is used to calculate the ³optimal´ batch size to minimize the sum of setup and inventory costs. COST. THAT IS ± THEY SIMULTANEOUSLY IMPROVED QUALITY. and generally reflects setup time. ‡ Given batch production. value to customers and are considered to be ³waste´. ‡ Toyota started a system (the ³Toyota Production System´) that reduced setup time and costs which in turn allowed smaller batch sizes and reduced inventory.Managing Activities Instead of Costs ‡ ABC highlights activities that incur costs and these activities can then be analyzed and improved. and FLEXIBILITY !!! . setups and storage add little.

Component 89 consumes $22. the product costs would be: COMPONENT 89 : $1.5 minutes each. Two of these.100) = $47.00 + $35. the company has decided to try the ABC approach.Example of Activity-Based Costing ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ The Buzz! Company assembles electronic components for use in medical instruments.05 + $230*(. Using a traditional costing system with all overhead costs allocated at a rate of $230 per direct labor hour. components 89 and 93. which costs $16/hour.60 + $22.00 COMPONENT 93 : $2.125) = $65.05 of direct material.40 + $230*(.80 In an attempt to get a more accurate estimate of costs. require 6 minutes and 7.40 of direct materials and component 93 consumes $35. respectively. . They have identified SIX activities in their system. of direct labor.

of Engineering Services Number of Setups Number of Components Hours of Testing Number of Orders RATE $0.Table 1: Activities & Cost Drivers ACTIVITY Materials Handling Engineering Production Setup Assembly (Automated) Inspection Packaging & Shipping COST DRIVER Number of Components Hrs.00 / hour $2.00 / hour $100.15 / component $60.05 / component $40.00 / order .00 / setup $0.

05 200 0.5 0.02 2.05 2 .Table 2: Cost-Driver Activity Component 89 Number of Components 36 Hours of Engineering Services Production Batch Size Hours of Testing Units Demanded Per Order Component 93 12 0.10 50 0.

80 $49.00 $58.40 $5.80 $3.00 $0.80 $0.00 $18.05 $1.00 $22.60 $2.00 $2.40 $35.00 $2.Table 3: Activity-Based Costing of the Two Components Direct Labor Direct Materials Materials Handling Engineering Production Setup Assembly Testing Packaging & Shipping TOTAL COST Component 89 Component 93 $1.40 $6.50 $6.95 .00 $0.00 $1.


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