Cost Based Decision Making

Dr. Nancy Mangold

California State University, East Bay
3 Managerial Use of Cost Information

Product and customer decisions:

 Whether to make or abandon a product
 Influence the nature of customer
relationships
Develop a cost basis for a price
Identify opportunities to improve
product or process design and process
operation
Product Life Cycle-
3 Broad Phases
The planning phase
The manufacturing phase
The service and abandonment phase
Life Cycle Costing
Used predominately in the planning
phase
It attempts to estimate the the
product’s cost over its lifetime
Exhibit 6-1
Target Costing
Used during the planning cycle.
Drives the process of choosing product
and process designs.
Will result in a product that can be
produced at a cost that will allow an
acceptable level of profit, given the
product’s estimated market price,
selling volume, and target functionality.
Kaizen Costing
Identify opportunities for cost
improvement during the manufacturing
cycle
A Widely Accepted Rule
80% of a product’s costs are committed
or locked in during the product design
stage
During the design stage, planners
choose the product design and design
the process that organization will use to
make the product
Exhibit 6-2
Effective Cost Control
During the product’s planning and design
phase
Not when the product and process have
already been designed and the product is
being made
During the product manufacturing phase,
most of the product costs have been
committed and the focus is cost containment
Target Costing
Cost management tool that planners
use during product and process design
to drive improvement efforts aimed at
reducing the product’s future
manufacturing costs.
Target Costing
Promotes and facilitates communication
among the members of the cross-
functional team that is responsible for
product design
Target Costing
Customer oriented
Begins with price, quality, and
functionality requirements defined by
customers
Price-led costing vs cost-led pricing
(cost plus approaches to pricing)
Two Critical Elements
Customer (market) defines the price that will
be paid for the product and its designated
functions.
To the extent that there is a market for the
same product with different functions (autos),
the market or consumer will choose a price
that reflects the set of product functions
supplied.
Target Costing Process
Driving force behind the product and
process design efforts.
Iterative process and continues until the
design team finds a product design with
a projected cost that meets the target
cost.
Market-Driven Costing
Starts by identifying the target selling price-
the product’s anticipated price when
launched.
The price must reflect.
 the perceived value of the product in the eyes of
the customer,
 the anticipated relative functionality.
 the selling price of competitive offering.
 the firm’s strategic objectives for the product.
Market-Driven Costing
Conduct extensive market analysis
procedures to identify what their
customers want and how much they are
willing to pay for it.
Market-Driven Costing
Setting a target profit margin.
 Historical profit margins for replacement of
existing products adjusted for unusual
costs at the front end (R&D) or back end
(salvage or disposal).
Calculate an allowable cost by
subtracting the target profit margin
from the target selling price.
Product-Level Target Costing
Starts with the current cost of the
proposed product.
The costs at which the firm could
launch the new product today without
undertaking any design changes or
introducing any process improvements
in existing manufacturing processes.
Product-Level Target Costing
The discrepancy between the current
cost and the allowable cost gives the
project team an estimate of the
magnitude of the cost reduction
opportunities it must identify to achieve
the allowable cost.
Product-Level Target Costing
Cost reduction objective.
Achievable.
Unachievable.
Product-Level Target Costing
Achievable.
Expend considerable effort during the
design process.
 Value engineering.
 Quality function deployment.
 Design for manufacture and assembly.
 Target costs set properly, should be
achieved 80% of time.
Product-Level Target Costing
Unachievable.
Strategic cost reduction challenge.
Identify how far the firm is from being
competitive.
Product-Level Target Costing
Setting product-level target costs that
are too aggressive will result in
unachievable target costs and eventual
failure of the target costing process.
Setting too high a strategic cost
reduction challenge leads to easily
achieved target costs but a loss of
competitive position.
Product-Level Target Costing
Cardinal rule - Target cost can never be
violated.
Rule implies that even if engineers find
a way to improve the functionality of a
product, they can incorporate the
improvement only if they can also
identify how to offset any additional
costs.
Component-Level Target
Costing
The design team establishes the target
cost for every component in the future
product.
These component-level target costs
establish the suppliers’ selling prices.
Target costing transmits the competitive
pressure faced by the firm to its
suppliers.
Component-Level Target
Costing
Products are broken down into major
functions (Engine, transmission, air condition,
audio systems).
The chief engineer sets the target cost for the
major functions.
The engineer decides the theme of the
product and that certain functions should be
emphasized (high-performance engine).
Component-Level Target
Costing
Once the major function target costs are
established, the design team for each major
function must find ways to design that
function so that it can be produced at its
target cost.
The team breaks the major function down
into its components and then distributes the
major function-level target costs to
component-level costs.
Component-Level Target
Costing
The sum of the component-level target
costs must equal that of the major
function that contains them.
Component-Level Target
Costing
This establishes the allowable selling
prices of suppliers.
The assembly companies do not want
to squeeze the profits of their
component suppliers to zero.
They bring their major suppliers into
the product design process as early as
possible.
Component-Level Target
Costing
The suppliers provide and receive
inputs on how to reduce costs.
The suppliers also estimate costs for
each component.
These estimates are imputed into the
component-level target-costing process
subject to the constraint of the cardinal
rule.
Chained Target Costing
In today’s highly competitive
environments it is not enough to be the
most efficient player.
It is also necessary to be part of the
most efficient supply chain.
One of the ways to achieve increased
supply chain efficiency is through the
use of chained target-costing systems.
Chained Target Costing
The output of the buyer’s target-costing
system becomes the input to the supplier’s
target-costing system.
The buyer’s component-level target costs
become the supplier’s target selling prices.
The supplier’s target-costing system develops
both product-level and component-level
target costs, thus transmitting the buyer’s
competitive pressure to the supplier’s product
designers.
Chained Target Costing
If the supplier’s suppliers also use
target costing, the chaining continues
down the supply chain.
Thus, chained target-costing systems
can transmit the competitive pressure
from the buyer down the supply chain,
making the entire chain more efficient.
Chained Target Costing
The intense cost reduction pressure
that is characteristic of target costing
thus permeates the whole supply chain.
Major Strength One –
Team Concurrent Design
Team environment
Cross functional team members:
 Design engineer
 Process engineer
 Purchasing
 Manufacturing
 Marketing
Major Strength One –
Team Concurrent Design
Concurrent design
Objective-to deliver a product with the
target functionality, quality, and price to
a specific market segment
Major Strength One –
Team Concurrent Design
No room for individual groups to specify
product features that reflect a
functional fixation
Eliminate product functions or features
that add cost but provide no market
price increment (no value to customers)
Major Strength One –
Team Concurrent Design
Avoid
Engineers may design a production process
that uses the latest production technology
without regard for its effects on cost or
manufacturability
Marketing group might specify many product
features that customers would like to have
but do not consider essential in the product
and would not pay to have them included in
the product design
Major Strength One –
Team Concurrent Design
Reduces product development time and
cost by reducing required designed
changes
Major Strength One –
Team Concurrent Design
Each subgroup within the team is
assigned cost reduction targets that is
expected to meet in order to achieve
the team’s overall target cost objective.
Assign individual responsibilities but
within an overall structure of group
objectives relating to product quality,
functionality and price.
Major Strength Two –
Deployed at Design Stage
Deployed at the product and process
design phase when design choices can
have a maximum impact on a product’s
cost.
Suppliers on Design Team
Include suppliers as active members of
the product design teams to elicit their
expertise.
This approach requires a sharing of
ideas and information – requires trust.
Suppliers on Design Team
Payback for suppliers are long-term contracts
Participate in the cost savings they generate
Reduce product costs but not by squeezing
the suppliers
Use lower-cost commodity components rather
than custom-designed components
Implementing process improvements
Chrysler supplier recommended an exterior
molding-cost less, offer same function
Suppliers on Design Team
Japanese keiretsu, South Korean chaebols
Affiliations of companies interrelated by
supplier-purchaser relationships
Does not always work
Several large keiretsu were disbanded
because the protected suppliers and had
become inefficient and noncompetitive
Chrysler Approach
Chrysler to avoid this by
Drop poorly performing suppliers
Performance based on cost savings
resulting either from
 design proposals
 Manufacturing process improvements
 Quality
 On-time delivery
Design Team
Huge pressure on the design team to
meet target cost.
Product will not be launched unless the
team meets the target cost.
Ultimately target cost reflects what the
customer demands and what the
suppliers of capital expect as a
reasonable return on their returns.
Target Costing in Action-
Toyota Motors
Toyota Motors seems to have invented
the process of target costing during the
1960s.
Market group specifies the target price.
Target Costing in Action-
Toyota Motors
The market value of additional functions
added to existing vehicles determines
the increment of the price of the new
model over the existing model.
Planners multiply this price by the
estimated production volume over the
product’s life cycle to determine the
total product revenue.
Target Costing in Action-
Toyota Motors
Estimate the cost of the new product.
Estimated by adding.
 The cost base of the existing product.
 The incremental costs of the design
changes associated with the new product.
 Compares revenues and costs to compute
an estimated margin.
Target Costing in Action-
Toyota Motors
A margin that fails to achieve the target
return on costs needed to provide an
appropriate return on investment
triggers a redesign process.
Toyota Motors– Redesign Process
Compute the required cost reduction.
The leader of the design team then
distributes this target cost reduction among
the members of the design team.
Assembly division.
 Redesign the assembly process.
 Reduce the number of parts by increasing the
number of pre-assembled modules or
components.
Tear Down Analysis
Reverse engineering.
A process of evaluating a competitor’s
product to identify opportunities for product
improvement.
The competitor’s product is taken apart piece
by piece to identify the product’s functionality
and design and to make inferences about the
process that made the product.
Tear Down Analysis
Provides insights into the cost of the
product.
Suggests the relative advantages or
disadvantages of the competitor’s
approach to product design.
Benchmarking-compare the tentative
product design with the designs of
competitors.
Quality Function Deployment
QFD is a management tool developed
during the 1970 in Japan’s Kobe’s
shipyards.
Provides a structure to identify
customer requirements – a key input
into the target costing process.
Quality Function Deployment
Organizations use QFD to identify what
customers want from a product before the
product design is undertaken.
The process then compares what the
customer wants with how the design team
proposes to satisfy those requirements.
QFD supports the process of value
engineering.
Value Engineering
A team based, systematic value
analysis.
To evaluate a product’s design in order
to identify alternatives that will improve
the product’s value.
 The ratio of functionality to cost.
Value Engineering
Hold functionality constant and reduce cost.
Hold cost constant and increase functionality.
Looks at all of the product’s elements
including.
 the raw materials.
 the manufacturing process.
 the type of labor and equipment used.
 the balance between purchased and self-
manufactured components.
Value Engineering-
Two Alternatives
Identify improved product designs that
reduce component and manufacturing
cost while not sacrificing functionality.
Eliminating unnecessary functions that
increase the product’s cost and
complexity.
Value Engineering-
Two Alternatives
Identify improved product designs that
reduce component and manufacturing
cost while not sacrificing functionality.
Eliminating unnecessary functions that
increase the product’s cost and
complexity.
Reengineering
The tear-down and value-engineering
approaches focus mainly on the product
design.
Another critical element in determining the
cost of a product is the the process.
Reengineering is the activity of redesigning a
planned or existing process.
Is driven by the desire to improve a product’s
cost or quality attributes.
Kaizen Costing
Operating the process in the most
efficient way.
Focuses organization’s attention on
things that managers or operators of an
existing system can do to reduce costs.
Kaizen Costing
Target costing.
 Planners use before the product is in production.
 Driven by customer consideration.
Kaizen costing.
 Operations personnel use when the product is in
production.
 Driven by periodic profitability targets set
internally by senior management.
Similar – targets drive both.
Kaizen Costing
Incremental improvements to the current
production process or product design.
 Developing improved setup processes.
 Improving machine performance to reduce waste.
 Increasing employee training and motivation to
encourage employees to identify and implement
the incremental daily changes that can improve
cost and quality performance.
 Focus on process not the product itself.
ABC and Target Costing
Japanese target-costing processes focus
on saving in materials, labor, assembly,
and machining costs, the unit level cost
drivers in traditional cost systems.
ABC and Target Costing
As the focus of target costing extends
beyond direct manufacturing costs to
include supplier, distribution and
customer relationships, the capabilities
of the total or ABC cost model should
enable an integration between ABC and
target costing.
ABC and Target Costing
Integrating ABC and target costing
designers can make trade-offs between
direct and indirect costs that are
impossible with only target costing or
with a combination of target and
traditional costing.
ABC and Target Costing
Some western firms are already using
ABC for target costing purposes.
An electronic assembler of data
communication devices incorporated its
manufacturing ABC model into its
target-costing process.
 Selection of electronic components.
 Packaging materials.
ABC and Target Costing
In general, ABC works very compatibly with
target costing.
The ABC gives product designers and
developers a model of manufacturing support
costs that enables them to balance the
functionality and quality of the final product
with economics-based decisions about
component selection and design
characteristics.
Operational Activity-based
Management
Drives the process of reengineering.
Maps out the steps or activities in an existing
or proposed process.
 Process mapping.
 Flowcharting.
Planners then look for opportunities to reduce
cost by eliminating factors that cause delay or
waste in the planned process design.
Operational Activity-based
Management
Activities that consume resources
without adding functionality to the
product that the customer values are
called nonvalue-added activies.
Moving, storing, and inspecting are all
activities that cause delay or waste in
the manufacturing process while
consuming resources.
Operational Activity-based
Management
A product or process redesign that
eliminate the need for non-value-added
activities will reduce costs and cycle
time and often will increase product
quality.
Operational Activity-based
Management - Steps
1. Chart the process to identify each activity.
2. Identify the cost of each activity.
3. Identify opportunities for improvement.
Reengineering to eliminate the need for non
value-added activities and.
Continuous improvement to improve the
performance of value-added activities.
Operational Activity-based
Management - Steps
4. Set priorities for improvement.
5. Provide the financial justification (business
plan) for reengineering efforts.
6. Identify what need to be done to eliminate
or otherwise reduce the activity’s cost.
7. Make the required changes.
8. Track the benefits to compare them with
the costs.
Life Cycle Costing
Process of estimating and accumulating
costs over a product’s entire life.
Important in environments in which
there are.
 large planning and development costs
(developing a new jetliner).
 Large product abandonment costs
(decommissioning a nuclear generating
facility).
Life Cycle Costing- 3 Purposes
1. Helps to develop a sense of the toal
costs associated with a product in
order to identify whether the profits
earned during the active,
manufacturing phase will cover the
costs in the development and
decommissioning phase.
Life Cycle Costing- 3 Purposes
It will identifies products that are no
longer profitable when their
decommissioning costs are factored
into the product evaluation process.
Life Cycle Costing- 3 Purposes
2. Because of its comprehensive
consideration of costs, it will identify a
product’s environmental cost
consequences and will spur action to
reduce or eliminate those costs.
Life Cycle Costing- 3 Purposes
3. It helps to identify the planning and
decommission costs during the
product and process design phase in
order to control and manage costs in
that phase.
Life Cycle Costing
A comprehensive accounting of a product’s
costs,
 both manufacturing and environment.
 From cradle to grave.
To help decision makers understand the
cost consequences of making that product
and to identify areas in which cost reduction
efforts are both desirable and effective.
Quality Cost
Approaches to monitor and control the
cost of quality.
Four types of quality costs.
Quality Cost –Prevention Costs
Prevention costs – the costs of
preventing quality problems.
 Cost of designing improved processes that
reduce quality failure.
 Employee training.
 Supplier training.
Quality Cost – Appraisal Costs
Appraisal costs – the costs of finding
quality problems.
 The cost of the equipment and personnel
who perform quality checks on work in
process.
Quality Cost –
Internal Failure Costs
Internal failure costs
The costs of fixing quality problems that
are found when the product is still in
the manufacturer’s hands
 Out of pocket and opportunity
 Personnel and materials and machine time
used to rework the product into a saleable
condition
Quality Cost –
External Failure Costs
External failure costs.
The costs of fixing quality problems that are
found when the product is in the hands of the
consumer.
 Warranty-related costs.
 Profits on sales lost when the organization’s image
is damaged by quality problems.
 Costs of lawsuits prompted by product failure.
Quality Cost
To manage the total cost of quality
Percentage of sales
To provide a shifting standard as sales level
rise or fall
To invest in preventing and finding quality
problems as long as the cost incurred is less
than the cost of fixing quality problems that
would other wise occur.
Taguchi Cost
Japanese academic approach.
Output failing to meet the target value
of the characteristic creates quality
losses.
Quality losses increase quadratically
with the deviation from the target
characteristic.
Prefers choice with smaller variance.
Environmental, Salvage and
Disposal Costs
Rapid rise in environmental costs.
Chemical industry- normal for a firm to
spend greater than a billion on
environmental costs.
Old emphasis- Accept environmental
costs as an inevitable part of doing
business
Environmental, Salvage and
Disposal Costs
Old emphasis-.
Accept environmental costs as an
inevitable part of doing business.
New emphasis-.
With appropriate management to
reduce business-related environmental
costs.
Managing Environmental
Costs
Develop detailed cost records that
attribute environmental costs to
activities and ultimately to products.
In order to identify the processes and
products that create environmental
costs.
Managing Environmental
Costs
Reduce or eliminate the drivers of
environmental costs.
Base part of incentive compensation on
steps employees have taken to reduce
environmental costs.
 Bonuses based on measures of
environmental performance (level of waste
discharged).
Managing Environmental
Costs
Effects of recognizing and accounting
for environmental costs are to
Provide an accurate picture of product
profitability
 Currently charged to corporate overhead,
obscuring the nature and source of these
costs.
Managing Environmental
Costs
Focus attention on developing products
that have lower decommissioning and
take-back costs.
 By identifying the magnitude of these
costs.
Increase efforts to recycle or otherwise
remanufacture existing product waste.