Cost Analysis Through Life Cycle Analysis and Target Costing

INTRODUCTION
A major trend occurring at many firms is the early and continuing involvement with new products or services by teams comprised of engineers, management accountants, marketing professionals, and logistics personnel. Their involvement ensures that new products and services are launched in a timely manner and that costs are minimized and profits maximized throughout the products' or services' life cycle. Management accountants need to focus on every stage of the product cost life cycle, not just the production stage. Management accountants must be involved with the design of new products, assisting design engineers and others with cost estimates and target costs. They should also understand the activity value chain and help determine how costs can be reduced throughout this chain. This chapter presents a framework for estimating and managing costs and assessing the consequences of decisions made at different stages of the life cycle of a product or service. A key objective is to establish target costs throughout the life cycle of new products or services before they enter production. Two methods used to set target costs are functional analysis and activity-based costing systems. The parametric cost estimating method is helpful in estimating costs of new products or services.

LIFE CYCLE ANALYSIS

Understanding and analyzing both the product market life and cost life cycles are necessary for effective cost management. Analyzing the consequences of cost-reducing decisions over the life of a product or service can significantly increase a company's profits. Making the correct early decisions in market life and cost life cycles can dramatically affect later stages.

The Market Life Cycle

A product or service has a market life cycle, which includes five stages:
Pre-introductory stage in which the product concept is developed and all activities necessary to

produce, market, distribute, and service the product are poised for implementation.
Introduction stage in which the product is launched into the market. Growth stage, which is typified by consumer acceptance. Maturity stage, which is characterized by market saturation, strong brand loyalty, and stabilized

sales volume and profits.

Decline stage, which is the final stage of the market life cycle. It is marked by a continued decline in

sales and eventual abandonment of the product or service. At one time, the average market life cycle was about 15 years. Today, it can be less than 3 years, and in some cases less than 1 year. For example, new computer products are introduced at very frequent intervals. When market life cycles were 10 to 15 years or more, management accountants could report costs on an after-the-fact basis because there was sufficient time to make adjustments and improve productivity and profitability. With a market life cycle anywhere from one to three years, however, many factors that influence product or service profitability will he incurred prior to entering production. In today's competitive world, management's goal is to get new products to market on time at or less than the target cost. After-the-fact cost reporting is thus of little value in managing costs.1

INSIGHTS & APPLICATIONS

Product Development at Pharmaceutical Companies
New product development performance is a major factor in winning the race to market, positioning products successfully against competitors, and minimizing development resource requirements. Pharmaceutical companies have an opportunity to establish a stronger competitive position and superior financial returns by significantly improving product development performance. High pharmaceutical profit margins make delays in the product launch (i.e., from development to production and marketing) extremely costly. For example, a six-month delay can result in lost contributions of $40 million or more. Consequently, the reduction in profit potential that losing the race would entail considerably outweighs the incremental development resources required to meet target launch dates.2

Analyzing the Cost Life Cycle

The product cost life cycle presented in Exhibit 14-1 provides a total cost life cycle profile. It includes cost curves starting with product development, then production., and on into logistics and service support until the product or service market life cycle ends. These life cycle cost curves are particularly important to management accountants and others who are trying to achieve target costs and make their companies more competitive.

Product or Service Life Cycle

Traditionally, management accountants have not been concerned with costs in the development stage of a new product or service, nor with logistics, marketing, and service costs. Their primary concern was with production costs. The best time, however, to manage these costs is during development before the product or service goes into production. Many authorities observe that 80 to 90 percent of the life cycle costs of a new product or service are committed during development. Focusing on costs after the product or service enters production results in only 10 to 20 percent of costs being manageable3. Thus, the key to managing these life cycle costs is to focus attention on the development phase4. Decisions made during this phase will impact the enterprise's resources far into the future. As some authorities point out, one dollar spent on activities that occur prior to production, such as market research and product or service design based on target costing, can save from $8 to $10 in production, marketing and sales, logistics, and service costs5.

Commited versus Incurred Costs

Linear Approach versus Simultaneous Engineering

The linear approach is a sequential, uncoordinated design process in which each functional area of the enterprise focuses on its own needs and priorities. It is an over-the-wall approach to bringing a new product or service to market. The phrase over-the-wall refers to a department's (e.g., engineering) interest in completing its objectives while giving little consideration to how the work it produces impacts the work of other departments (e.g., production, logistics, marketing)6. In essence, a department completes its assigned work and then throws the work over-the-wall to the next department involved in the project. The over-the-wall process is symptomatic of linear project management in which departments do not work collaboratively. The result is a failure to satisfy all the functional needs of the company (i.e., marketing's need for a product with consumer appeal, service department's desire for a product that is easy to service, finance's goal to use the least expensive parts, and manufacturing's need to have a simple manufacturing process with few parts to assemble). By failing to design quality in and consider downstream life costs, this uncoordinated, expedient approach ultimately increases costs throughout the product's life cycle7.

INSIGHTS & APPLICATIONS

But manufacturing had to make the engine according to engineering design specifications. Clunker's vehicles are designed in a linear (or Throwing the New Car Design over the Wall serial) fashion with little or no co-operative involvement with those at the next step of the process. Such an approach does not support a meeting of the minds between design, manufacturing, marketing At Clunker Motors, the engineers designed a car and sales, and service. The linear approach to product or service with an engine that required many different holes to design not only causes problems with manufacturing, an internal be drilled and tapped at multiple angles. A simpler customer, but can result in dissatisfied external customers, as shown engine with fewer parts would have been less in the next Insights &Applications. expensive to produce and easier to service.

The over-the-wall approach is not only costly, but it lengthens the time it takes to get a product or service to market. Alternatively, simultaneous engineering (also called concurrent engineering) is a concurrent and collaborative design process, which strives to integrate and balance product or service development, from initiation of the concept to customer feedback. Simultaneous engineering reduces the time-to-market (i.e., the time it takes to convert a product idea into a marketable product) and involves all key players in the product team. Everyone receives the same information at the same time, so all team members can work together toward a common goal of doing it right the first time. According to the National Institute for Defense Analysis, there are tangible benefits to simultaneous engineering versus the linear approach. For example, simultaneous engineering is credited with reducing development time by 30 to 70 percent, reducing the number of engineering changes by 65 to 90 percent, improving overall quality by 200 to 600 percent, and increasing return on assets by 20 to 120 percent.

Collaboration by members of the cross-functional product team reduces the myopic focus by integrating the various people and activities required to develop, manufacture, market, distribute, and service high-quality, innovative products quickly and successfully. A key performance measurement of a product team is time-tomarket, which is a measure of the team's effectiveness at converting ideas into marketable and profitable products.
Some typical improvements from simultaneous engineering include the following: Reducing number of parts Reducing nonvalue-added activities Improving quality Increasing manufacturability Increasing flexibility

As can be readily seen, all these improvements are in concert with world-class manufacturing.
No I'm not kidding, says Scott, now frowning. To do a simple tune-up, we have to dismount the engine so we can reach two spark plugs that we otherwise can't get to. The engine is poorly designed and difficult to Throwing the New Car to the Customer service. And what's all this going to cost me? Winnie asks. Assuming it's a regular tune-up, it'll cost Scott Farley is manager of mechanics at Wilson Motors, a local you $250, Scott replies. What? Winnie exclaims. I car dealer that sells Clunker cars. Winnie Gorham, an owner of can't believe a simple tune-up will cost $250. It's the a Clunker, drives her new car into Wilson Motors' shop, gets out labor cost, Winnie, Scott explains. A mechanic has to of the car, and approaches Scott. Hi Scott, says Winnie. Good dismount the engine and move it away from the chassis to replace two of the spark plugs and make other morning, Winnie, Scott responds. What can I do for you? adjustments. Maybe Clunker Motors will redesign the The engine in my new Clunker is acting up. Maybe it needs a tune-up, new spark plugs. Can I have it done by noon? Maybe engine next time for easier service. There won't be a next time for me, says Winnie. I'll not buy another by noon day after tomorrow, Scott laughs. Clunker, ever! I can't say that I blame you, Scott You've got to be kidding, Winnie says, somewhat frustrated. responds.

INSIGHTS & APPLICATIONS

Chapter 12 emphasized how preventive measures can eliminate downstream costs of quality, especially final inspection, internal failure, and external failure costs. This prevention-based philosophy is important because the earlier in the product development process that prevention techniques (e.g., modular design, prototype testing, designing for manufacturability) can be applied, the lower the final inspection, internal failure, and external failure costs that will be incurred. Simultaneous engineering teams design quality in before the production stage begins. Some traditional companies, using the linear design approach, try to achieve quality during production, an inopportune time to be thinking about quality.

Using Quality Function Deployment

Quality function deployment (QFD) is a method that assures quality while the product or service is still in the development stage8. The key focus of QFD is on determining customer requirements and then developing the product or service to meet or exceed those requirements. QFD reduces the need to redesign and make modifications after the product or service is launched into the market-place. One of the major ideas presented in Chapter 12 was designing quality in; QFD is the method that supports this idea. Most of the time, customer requirements are determined from ideas, complaints, characteristics, issues, and so forth expressed by customers. The development team is therefore faced with a great deal of verbal, qualitative data gathered from customer surveys and other market research methods. QFD helps the team organize and prioritize these data. With the data structured, the development team not only understands what the customers say they want but, possibly, what the customers want but are not expressing. These unexpressed wishes lead to what has been

called exciting quality and customer delight. The development team has to design in expected quality, or no one will buy the product or use the service. But today many companies are trying to look beyond expected quality to design in exciting quality. An example in the manufacturing sector was the addition of cup holders in cars. Ten or fifteen years ago, few cars except Japanese cars had cup holders.
to produce. In such cases they send blueprints back for revision. The process forces each group to turn out reams of corrections, consuming millions of hours a year. Boeing hopes to capture huge savings by enabling Simultaneous Engineering at Boeing groups to design new aircraft simultaneously rather than in sequence. When the group decides to alter the Boeing aimed to shrink the time needed to manufacture a plane design of a major part, it has the authority to make the from more than a year to just six months by 1998. Its traditional changes itself, rather than waiting months for approvals method for designing aircraft was a three-phase process with from higher-ups. Reengineering efforts, just-in-time each phase being completed in sequence. Worse, the three inventory management, and simultaneous engineering groups have little contact until their initial designs are are innovations that are expected to give Boeing the completed. As a result, tooling specialists often receive billions in savings that it needs. Says Grace Robertson, blueprints for parts that either can't be manufactured or are too program director, We expect a substantial reduction in expensive design, development, and manufacturing costs.9

INSIGHTS & APPLICATIONS

Customers did not look for this feature in a car, but they were pleased when they got it. Later, the cup holder, once a customer delight, became a customer requirement10. In the merchandising sector, Nordstrom Department Stores, located in the western United States, offers not only expected service, but a delightful and satisfying shopping experience. In Nordstrom's case, this kind of quality didn't just happen, it was designed in. As also seen in the Pacioli Bookstore case (later in the chapter), QFD is not just for manufacturing companies. Unlike a product, a service is not a measurable material object because it is often intangible and immediate. Nevertheless, the service industry (e.g., hospitals, retailers, hotels, restaurants) is finding it necessary to use QFD in developing a quality design for its services. QFD makes it possible to clarify, plan, and design a service to be offered and to conduct total quality management (TQM) throughout the service's life cycle.

Matching Capacity with Demand

Product or service cost life cycles can also be reduced by optimally matching production capability with product or service demand. This capacity matching is illustrated in Exhibit 14-3. The capacity line represents a step function because capacity is acquired in whole increments; that is, one cannot purchase part of a machine.

Resource Capacity Matched with Product or Service Demand

A company that is planning to introduce a new product or service is willing to invest in excess capacity because it anticipates growth in demand during the growth stage. With all else constant, this capacity ensures that the product or service is delivered to customers without delay. As soon as the product or service moves through the growth and maturity stages, decisions to add capacity are weighed carefully because excess capacity is very costly. If the company is introducing a new product or service or revitalizing the present one, then a proper level of capacity must be acquired to meet a new growth stage.

INSIGHTS & APPLICATIONS

No longer is a product tossed over-the-wall from vertical department to vertical department. Once the company decides it will build a new car platform of certain dimensions, functions, cost, and price,the platform team works to see that Chrysler's enterprisewide study led to its platform team these parameters are met. The Viper was the first car produced concept (i.e., the simultaneous engineering team under the new working arrangement. It was designed and built approach) composed of design engineers, manufacturing under the target cost in three and a half years instead of the personnel, management accountants, and vendors. With normal five. this new approach, departmental silos have gone the way of the K car.

Bashing Silos But Not Quality

SETTING TARGET COSTS WITH FUNCTIONAL ANALYSIS

A goal of management is to produce products or services that meet consumer needs and price and quality expectations over the product's or service's entire life cycle. For the product or service to be profitable, it must be designed within the established target cost. One method used to achieve the target cost is functional analysis.

What Is Target Costing and How Is It Used as a Cost Management Method?

Target costing is a cost management method for reducing the overall cost of a product or service over its entire life cycle by employing better specification and design procedures at the lowest possible cost. Target costing is not a method for day-to-day cost management. Rather, it is a cost planning method that focuses on controlling design specifications, production techniques, and logistics. Target costing contributes to the goal of delivering a competitive product or service to the marketplace. Target cost is computed as follows:

INSIGHTS & APPLICATIONS

Using QFD to Design the Bookstore for Professor

Why is that? Tom asked. Well, I have already signed a lease that will give me the space for a reading room, and now I discover that customers don't want that facility. That means I'll be spending about one-third more for rent than required. This is very unfortunate. I

Pacioli
Professor Marvin Pacioli has just retired. He plans to open a bookstore to supplement his rather meager retirement income. Before embarking on this entrepreneurial venture, he calls one of his previous students, Kristy Paton, for assistance. Following are parts of their conversation. Before I launch my bookstore, I want to make sure that I've covered all bases and don't spend money on things that are not important to my customers, said Professor Pacioli. I couldn't agree with you more, said Kristy. In fact, we are currently studying quality function deployment, or QFD, which helps people design quality into a product or service before it is introduced to the market. This method is certainly in line with your wish to do things right the first time. I think this is exactly what I'm looking for to help me design my bookstore from a quality viewpoint before opening it. Would you mind helping me apply the QFD method? said Professor Pacioli. Not at all, said Kristy. As a matter of fact, Tom Hardaway, Heidi Franz, and myself are looking for a project to do as part of the course requirement. Tom is an industrial engineering major and Heidi is a marketing major. I'll be the management accountant. We'll form a simultaneous engineering team. That sounds great, said Professor Pacioli excitedly. When can we get started? Let me coordinate with the team members. Then, I'll call you next Monday and we'll set up a definite schedule, said Kristy. After meeting with Professor Pacioli, Kristy's team performed a marketing survey to determine customer requirements and customer ratings. The team used the planning and design matrix shown in Exhibit 144. After conducting a session with Professor Pacioli and benchmarking the competition-the university bookstore-the matrix was completed. You know, this QFD method has really opened my eyes, said Professor Pacioli. However, I wish that we had done this three weeks earlier.

should have been more careful. I didn't practice what I preached; that is, doing it right the first time. Now, I'm committed to a 10-year lease with about 1,500 square feet of space that I don't need. All is not lost, said Heidi. While using QFD, the team is supposed to look for exciting quality or customer delight. I believe we've done a thorough job in analyzing what customer requirements are and relating them to the design parameters for your bookstore. If you invest in these design parameters, you will be providing quality that the customer expects. And you'll be performing better than your competitor. But there is that nagging problem of wasted space. Maybe we can use that space for an exciting quality or customer delight. What if you used the extra space as a place where your customers can sit, relax, and enjoy snacks while runners gather books, charge them, and deliver them to the customers? asked Kristy. The runners would be trained to know how to gather the books quickly for all subjects. On the customer delight side, customers wouldn't have to stand in line. This design would not only support, but go beyond fast service, high attentiveness, and quick book availability. Customers buying a few items and not needing runners would have ready access to an express checkout lane. Well, that sounds like a good idea, said Professor Pacioli. But I need to know what this would mean in terms of revenue and cost. The team conducted another customer survey to determine the value of Kristy's and Heidi's idea. Sixty percent of those surveyed said that they would buy books at the new bookstore if this design parameter was installed. An expected value for revenue was calculated, resulting in additional revenue of $5,000 per month. Expenses including the $900 rent for the extra space amounted to $4,300 per month. Therefore, the expected profit is $700 per month. I am really pleased with the work you people have done, said Professor Pacioli. I now have a clear vision of how I'm going to design quality into the bookstore before it is opened. To celebrate, you all are invited to my house Saturday for lasagna. I make a great lasagna! Then, after we eat, I'll show you a video of The History of Double Entry Bookkeeping!

Target cost = Target price - Target profit A product's or service's sales price is heavily influenced by prevailing market forces. Individual companies are rarely able to sell a product or service for a price higher than the market price unless they are able to differentiate their product or service from the competition. A company can differentiate its product or service in several ways:
Product enhancements, such as eliminating product defects and uncovering additional uses for the

product
Ancillary product enhancements, such as making product packaging more appealing and improving

customer service Additional product development, such as providing features not previously available11

Planning and Design Matix for a new Store

Book inventory Design parameters

customer information

customer service

facilities

competitiv e classif large good quick readin special evaluation JI knowledg databas y and energeti custome inventorie manner checkou g lightin [draw line T e e displa c r rating s s t rooms g to connect y all Cs and Ns 1 2 3 4 5 S S S S W S W S M W S S S W W W W S S c n M M M S c n c c M c c n n 5 4 n 5 c 2 n 5 n 5 n 5 c 1

customer requirements 1 fast service 2 high attentiveness 3 quick book S availability 4 friently and conversation al 5 wide S selection 6 easy access to books 7 answers to questions 8 additional facilities S = strong relationship M= moderate relationship W = weak relationship

key to competitive analysis c = what competition offers N = what new store will offer competitive ratings 1 = least desireable 2 = most desireable

If a company chooses not to differentiate its product or service (i.e., decides to compete on price), it must offer the product at a target price equal to or less than the market price in order to obtain its target profit. To compete on price, a company must thoroughly understand the pricing strategy of its competitors. If, for example, a competitor is using a price skimming strategy, which provides the opportunity for large marginal profits, a target costing strategy must take into account the possibility of a price war, which the low-cost producer most likely will win. On the other hand, if the competition is using a market penetration pricing strategy, which provides limited marginal profit, a target costing strategy may prove to be more effective because the competitors' low profit margins will allow little room for price reductions. In either case, any company using

target costing would be well advised to develop extensive and continuing knowledge of its industry so as not to become the victim of a price war. As an example, a company, after conducting extensive industry research, determines that the market sales price for a particular type of lawn mower is $500. Additionally, the company determines that its competitors have large profit margins and that, to be an effective competitor, it needs to have a target profit of $230 per unit. With this information, the company calculates its target cost for its new lawn mower at $270.This target cost information enables the company to influence the lawn mower design costs prior to going into production-this is when cost management can have its greatest impact. Designers design the lawn mower so that it can be produced at the target cost of $270. This approach is sometimes referred to as design to cost. A target cost is attainable, but only with considerable effort and analysis12.
our costs will be low enough to meet this price constraint and make a profit. By focusing on measuring departments, we may actually cause customers not to INSIGHTS & APPLICATIONS get what they want and to go to our competitors, said Edna. I still don't understand, stated Robert. Look, Costing at Masterson Industries we measure the engineering department's cost, and they introduce the product prematurely. They throw it overWhat is this target costing I keep hearing about? said Robert the-wall to the manufacturing people who try to produce it on the fly. They try to catch up with marketing's Cooper, a long-time cost accountant at Masterson Industries. schedule, and quality suffers. And the worst thing is that The focus is on the total cost of the product, said Edna we sell one of those son-of-a-guns. The key is the target Mallory, newly hired management accountant. I don't understand your point, Robert responded. In the past, we've cost. When we introduce a new product, we assign an engineer, a manufacturing person, a marketing person, focused on our departments. But customers don't buy our departments. They buy a product that performs a certain way a management accountant, and a logistics person to get that product to the customer at a fair cost. Everybody or a service that achieves a goal. Customers will pay a certain works together as a team, and the team is responsible price range for a particular product or service. We have to for achieving the target cost. And we have a pretty good make sure that idea of what the costs are going to be up and down the line before the product is introduced. No surprises.

Are Target Costs the Same as Standard Costs?

Target costs are conceptually different from standard costs. Standard costs are predetermined from internal analysis of the production process; that is, standard costs are production-driven. Target costs come from external sources, primarily the analysis of markets and competitors; that is, target costs are market-driven. Moreover, target costs are established for all activities of the product life cycle, as shown in Exhibit 14-5.

Target Costs for a New Lawn Mower

Clipper Lawn Mower Estimated market life cycle Estimated sales Target Sales price 4 years 1,000,000 units $500 per unit Development target cost Production target cost Marketing target cost Logistics target cost $10 200 20 30 Total 1,000.000 20,000,000 2,000,000 3,000,000

Service target cost Total unit target cost Total life cycle target cost

10 $270

1,000,000 $27,000,000

During the introduction and growth stages of a product life cycle, standard costing techniques are often used inappropriately. During these two stages of the product life cycle, standard costing techniques arc ineffective as a cost management tool because they provide after-the-fact cost information during a production phase that is changing rapidly as production is ramped up to meet market demand. Target costing, on the other hand, is a more valuable cost management tool during these stages because it provides proactive, before-the-fact information, rather than reactive, after-the-fact information. Additionally, target costs are dynamic. They are often revised in the pre-introductory stage and several times again during the introduction and growth stages of the product life cycle. As a result, the target cost for a product or service changes several times over its entire life cycle. In fact, world-class manufacturers expect the target cost to decrease over the product's or service's life cycle as a result of continuous improvement.

What Is Function Analysis and How Is It Used in Conjunction with Target Costing?
A function is an action or feature of a product or service. Functional analysis is a cost management technique that focuses on the various functions and design costs of a product or service. Functional analysis contributes to cost management by assisting in the identification of cost reduction possibilities by eliminating or modifying functions of the product or service. Alternatively, functional analysis can, on occasion, lead the designer to add new functions to the product or service if the target profit is greater than the target cost generated by the additional functions. It is important to remember that the objective of cost management is to generate a greater return on assets, not merely to reduce costs. In addition to providing a focus for cost management, functional analysis provides a way to discover how more (or less) investment in products or services may lead to increased profits13. For example, a large range of new materials or new parts may be considered, functions may be modified, or two or more functions may he combined into one function. When functions are eliminated or combined, certain direct labor and overhead costs may no longer be required. The elimination of a function (or the combining of functions) may also eliminate the need for a machine and labor to operate the machine, thus decreasing direct labor, depreciation, insurance, maintenance, and utility costs. Functional analysis can be applied to both products and services throughout their life cycles. It is particularly useful during the pre-introductory stage of a new product or service, however, because costs can normally be affected much more easily during this phase than after investment is made and production starts.
believe Harold Faig (project team manager) would hold us back for 5 percent. Now, I know better Faig's response to the news was: Unacceptable. If we don't make the 40 percent Achieving the Target target cost, we won't do it. The team returned to work and squeezed an additional 5 percent out of the machine in time to beat the deadline. When P-270, renamed Vista, hit the market, As the deadline approached to unveil a demonstration there was an agonizing lull. Then suddenly, whoosh, says model, Ethel Watson, the product design team's management accountant, discovered that the cost of the P- Bill Reinhart, one of the team members. Milacron won't release exact numbers, but in Vista's first full year of 270 was only 35 percent lower than its predecessors. I production, the company sold 2.5 times as many of the was the bean counter, she says, and there were too machines as it had in the best year of Vista's predecessor.14 many beans. I felt responsible, but I couldn't

INSIGHTS & APPLICATIONS

With functional analysis, costs are allocated to functional areas of the product or service under analysis. Production or service prototypes are assigned costs, based on their functions, to evaluate the product's or service's potential profitability15.

USING A SIMULTANEOUS ENGINEERING APPROACH. Generally, functional analysis is a team activity involving five areas of expertise:
Engineering and design Management accounting Production Marketing a Logistics

The goal of the functional analysis team is to perform functional cost analysis and propose alternative designs of the product or service for optimal cost management. At Toyota, the team meetings are chaired by the senior vice president in charge of accounting or finance.16 In some situations, several competing teams will be organized to tackle the same product or service. These teams will all have the same goals, such as:
Maintain the quality of the product, but reduce the cost by 30 percent Add two new specific functions to the product without increasing its cost or reducing its quality17

DEVELOPING A FUNCTIONAL FAMILY TREE. A functional family tree is the logical diagram of each function of the product or service, not each part of the product or service. A general model of a functional family tree is presented in Exhibit 14-6.

General Model of a Functional Family Tree

The functions (i.e., actions and features) help determine the success of a product or service in the market. For example, Exhibit 14-7 shows the functional family tree for a propelling ballpoint pen. Each function is defined in terms of a verb and a noun. The primary function of a propelling ballpoint pen is to make mark. To perform this primary function, subfunctions, such as put color and hold pen, are needed.18

Propelling Ballpoint Pen Functional Family Tree

To assign a target cost to the new product or service, the management accountant, as a member of the team, must perform the following steps:
1. Define and classify functions. 2. Evaluate the importance of functions. 3. Assign target costs to each function.

If target costs are not being met, the designers must make design changes. As stated before, this iterative process is based on the concept of design to cost, the main principle of cost management at the product's or service's design phase. DEVELOPING A PARTS-FUNCTIONS-COST MATRIX. Exhibit 14-8 is the parts-functions-cost matrix, which shows the links among the parts and functions of the propelling ballpoint pen, together with their associated costs. These costs will become the focus of assessing the pen's potential success.19

Parts-Functions-Cost Matrix for the Matrix for the Propelling Ballpoint

Pen

Part Number 1 2 3 4 5 6 7 8 9 10

Name of Parts Tip Barrel Cartridge Top Ink Cap Spring Stopper Clip Screw

Function Transitive Verb Flow Hold Store Store Put Pull in/out Pull in/out Fix Prevent Attach

Noun Ink Pen Ink Ink Color Tip Tip Spring Loss Clip

Cost $0.80 1.20 0.30 0.20 0.15 0.12 0.10 0.08 0.13 0.02 $3.10

Exhibit 14-9 is an alternative functional family tree of the original propelling ballpoint pen design. Here, the two functions of preventing stains and preventing loss are integrated. Exhibit 14-10 shows the parts-functionscost matrix for this new design. The number of parts required in the first design falls from ten to only six. The result is a cost reduction of over one-third (from $3.10 to only $2.00).20

Disposable Ballpoint pen functional family

If management's target cost is in the $2.00 range, then the propelling ballpoint pen design will be scrapped, and the disposable ballpoint pen design will become a strong candidate for a new product produced and sold by the company. Additional functional analysis, however, may result in another design alternative, which will give the ballpoint pen new functions, such as erase ink. This alternative design will probably increase costs, but it may also permit a larger incremental increase in the sales price of the ballpoint pen, resulting in higher profit margins. In any case, after the selected alternative design is implemented, the management accountant will review the results to verify the accuracy of the parts-functions-cost matrix data.

Parts-Functions-Cost Matrix for the Disposable Ballpoint Pen

Part Number 1 2 3 4 5 6

Name of part Tip Barrel Cartridge Top Ink Cap

Transitive Verb Flow Hold Store Store Put Prevent

Noun Ink Pen Ink Ink Color Stain/loss

Cost $0.50 1.00 0.20 0.10 0.12 0.08 $2.00

Increasing Flexibility through Functional Analysis

Reducing the number of different parts is a major goal of target costing. The greater the number of different parts required to make the product, the greater its complexity. Complexity drives up costs. Moreover, if complexity is high, flexibility will be low. Products should be designed not only with as few parts as possible, but also with as many standard parts as possible- Unique parts, even though they may he few in number, will drive up costs and reduce flexibility. Standard parts are readily available (probably from certified vendors) and can be obtained with short lead times, at less cost, and in smaller quantities21. One General Electric location provided its designers with an incentive to reduce part numbers in their products. As a result, 1,000 parts were eliminated in two months. This reduction in part numbers led to the elimination of 39,000 shop orders per year and 125,000 fewer parts being ordered, made, or stocked.22 The mushroom concept, discussed in Chapter 2, substantially increases a manufacturer's flexibility, because a large variety of finished products are obtained from a small number of parts and subassemblies. The manufacturer differentiates its products toward the end of the production process, as shown in Exhibit 14-11c. The closer to the end of the production process the manufacturer can differentiate its products, the more

flexible it will be in meeting the needs of its customers. Unlike the other two approaches in the exhibit, the mushroom approach gives customers a wide choice, provides flexibility of production mix, and has the added advantage of making it easier and quicker to introduce new products or make product enhancements.

Product Design Approaches

(a) Traditional-inflexible Many components going into one final product

(b) Inflexible Many components, many final products

(c) Flexible approach Many final products, few components, last-minute differentiation

SETTING TARGET COSTS WITH ACTIVITY-BASED COSTING AND MANAGEMENT SYSTEMS

Whereas functional analysis helps achieve a target cost for a product or service according to functions provided to customers, using activity-based costing (ABC) systems to set a target cost involves focusing on activities and their cost drivers used to produce a product or provide a service. A powerful way to go about setting a target cost is to use functional analysis and ABC in combination.

Cost Management during Design

According to Pete Dybsand, senior finance manager at Boeing, cost is a focal point for the design teams. We provide the cost-driver information to the teams, so engineering will know what area to simplify or eliminate, says Dybsand23. Product costs can be reduced by using designs that decrease the demand for high-cost activities. Activity-based costing enables design engineers to understand the impact of different designs on product costs and manufacturing flexibility. Creating designs that enable products to be produced easier and faster will reduce product costs and the need for activity resources.

Understanding the Activity Value Chain

An activity value chain is used to develop and support an enterprise's production and delivery of products and services throughout their life cycles24. An example of this value chain is shown in Exhibit 14-12. The

activities linked together represent strategic-level activities found in almost any enterprise. The items listed under each strategic-level activity are a sampling of specific activities performed to support the strategic-level activities. Management's aim is to develop an activity value chain that includes specific activities that add value to products and services throughout their life cycle. Virtually all of a company's activities exist to support the production, delivery, and servicing of products and services throughout their life cycles.

A Company's Activity Value Chain

Research and Development

Inbound Logistics

Production

Outbound Logistics

Marketing and Logistics

Service

Researching Performing simultaneous engineering Conducting quality function deployment (QFD) Prototyping and testing Target costing

Issuing purchase orders Receivinginspecting. Storing Materials handling

Setting up Cutting Drilling Lathing- Painting and buffing Engineering

Materials handling Storing Packaging Shipping Preparing shipping document Installing

Advertising Customer calls Travelling Processing sales orders Analysis of customer problems

Field repairs Recalls Customer inquiries

Analyzing and Managing the Activities

Analyzing and managing activities within the activity value chain can result in effective cost management. For example, just-in-time (JIT) and certified vendors can reduce inbound logistics costs. Computer-integrated manufacturing (CIM) and JIT can reduce production costs. Electronic data interchange (EDI) and JIT can reduce outbound logistics, marketing, and sales costs. Total quality management and modular design can reduce service costs. The analysis of the activity value chain should involve individuals from all activities, to ensure that the concerns of activities impacted by the product are given adequate consideration. Analyzing and managing activities can reduce costs in four ways25:
Activity reduction. Reduce the time or effort required to perform the activity. For example,

simultaneous engineering reduces time-to-market.

Activity elimination. Eliminate the activity entirely. For example, installing EDI and JIT can Activity selection. Select the low-cost alternative from a set of design alternatives. For example,

eliminate the need to prepare purchase orders and checks for invoice payments.

design A can be produced with 14 parts whereas design B requires 60 parts. The designs are equal in quality, functionality, and consumer acceptance, but design A will reduce inventory, production, and service costs. For another example, activity I inserts a part through a hole in a circuit board. Activity 2 attaches a part to the circuit board using surface-mount equipment. The two alternatives require different equipment, setups, and other resources and entail different costs. These differences should influence the designer's decision.

 Activity sharing. Make changes that permit activities to be shared with other products to yield

economies of scale. For example, the drilling machine that drills holes in components for other products is used to drill holes for components of the new product. The phrase managing the activities is not an idle exercise in semantics. Managing activities is at the crux of activity-based costing and activity-based management, as pointed out in Chapters 10 and 11. To focus on cost reduction alone, however, may result in wrong decisions being made. For example, a manager may focus on reducing setup costs by spreading them over as many units as possible. But, producing a large batch of units may generate output in excess of current demand and thus add to storage and materials handling costs. So, by focusing on reducing setup costs per unit of product, management has actually done nothing to reduce setup activity costs. In fact, management has increased the cost of storage and materials handling. Had the focus instead been on analyzing and managing setup, storage, and materials handling activities, all three activities could have been streamlined, reducing the resources they consume. A painting and buffing activity provides another example. The painting process requires huffing to remove blemishes in the product's finish. But the need to buff the paint can be eliminated if the cause of the poor finish is identifed and corrected26.

Eliminating Nonvalue-Added Costs and Reducing Value-Added Costs

Exhibit 14-13 illustrates the type of information that can be obtained through an activity-based costing (ABC) system. In this example, one of the strategic-level activities is customer service, which includes several specific activities in the enterprise's activity value chain, with an aggregate activity cost of $107,000. Almost 85 percent of this total is for value-added costs, while the remaining 15 percent is for nonvalue-added costs. The exhibit also shows that the target cost team, through an in-depth analysis of each specific activity, has identified an opportunity to reduce costs by $37,000, or 35 percent of the total, while providing the same, or a better level of customer service. The other activities are analyzed in the same manner with similar cost reductions. The results are a target cost of $775,000 and an improvement margin of $324,000 ($1,099,000 original cost - $775,000 target cost). The ABC system can be used to establish target cost savings opportunities and then determine the best means of realizing these opportunities for improvement.27

Value-Added and Target Cost Information through Activity-Based Costing28

Understanding the Value Chain of Vendors and Customers

Besides analyzing and managing the company's activity value chain, the target cost team must also understand the value chain of its vendors and customers. By understanding stakeholder value chains, it is sometimes possible to make changes that benefit all parties. For example, a large bakery was purchasing millions of eggs from vendors. A major activity the vendors performed was packaging and shipping eggs so they wouldn't break during transit. A major activity of the bakery was breaking eggs and disposing of shells. Both activities were wasteful to the parties performing them. Analysis of the activities resulted in changes. The egg vendors broke the eggs and shipped the yolks and whites in tank trucks and sold the shells. The bakery received eggs ready for immediate production. Value was added and waste was reduced, a win-win situation. Another way logistics costs can be reduced is to introduce interchangeable components as late in the activity value chain as possible; that is, application of the mushroom concept. For example, a manufacturer of telephones designed the product so that costly internal mechanisms could be fabricated and shipped without covers. The covers available included a wide variety of styles and colors. Specific covers were shipped separately and stocked by the retailers to meet the tastes of local customers. Products can be designed to reduce costs throughout the activity value chain. Products requiring fewer parts reduce inbound logistics costs. Products that are simple in design and easier to assemble increase manufacturability and reduce production costs. Products that are compact, lightweight, and easy to package and handle reduce outbound logistics costs. Products that are simple in design require less special training for marketing professionals. Moreover, less complex products are generally more appealing to customers. A product with quality designed and built in will reduce external failure costs, thereby reducing' he need for service activities.

Maintaining ABC Cost Information in Computerized Databases

A variety of database management systems (DBMS) are available from software vendors to store, maintain, and access activity cost tables, which show the cost effects of using different materials, production methods, and designs. These cost tables permit easy access and analysis of costs under various assumptions29. Such tables enable the development team to determine in advance how using different activities and product and service designs will affect product or service costs. Cost information generated by activity cost tables can

encourage the team to redesign products and services so they are simpler to produce, deliver, and use. Activity cost tables are supplementary to the conventional cost accounting system. Activity cost tables not only help estimate the cost of new products or services, they also provide a basis for lowering the costs of existing products or services. These tables show the cost of all the activities that will be affected by any of a wide range of cost drivers. Indeed, the analysis and reduction of even small costs can have a dramatic effect on a company's overall performance. This situation is especially applicable to companies that cannot easily increase their sales volume or sales price. Such companies must look inward for cost savings and productivity increases. For example, suppose that a company's net profit per sales dollar is 2 percent. In a simplified manner, a cost savings of $0.02 is equivalent to an increase of $1.00 in sales. At such a small scale, the numbers seem rather insignificant, but the ratio is the important factor30:
A Cost Savings Of Is Equivalent To A Sales Increase Of $0.02 $1.00 $2.00 $100.00 $200.00 $10,000.00 $2,000.00 $100,000.00 $20,000.00 $1,000,000.00

Indeed, when one realizes that a cost savings of $20,000 is equivalent to a sales increase of $1,000,000, the value of activity cost tables becomes apparent. Exhibit 14-14 illustrates the general structure of activity cost tables. This example involves production activities, specifically the drilling activity. But the same structure can be used for inbound logistics, outbound logistics, other production activities, marketing and sales, and service activities.

The General Structure of Cost Tables

Assume that 500,000 components for a new product will require that a hole be drilled. The hole must be onehalf inch in diameter, but its depth has not been determined. Exhibit 14-15 shows activity cost tables for three hole depths: three inches, five inches, and seven inches, each one-half inch in diameter. Each activity cost table also contains three types of material: plastic, steel, and aluminum.

Drilling Activity Cost Tables

Activity: Drilling Depth of hole: 3in. Type of material Plastic Steel Aluminum

Direct Materials $6 8 10

Machine: Vulcan Power Drill Diameter of hole: .5in. Direct Labor Overhead Total $3 $5 $14 5 8 21 4 6 20

Activity: Drilling Machine. Vulcan Power Drill Depth of hole 5in. Diameter of hole: .5in. Overhead Total Type of material Direct Materials Direct Labor $8 $4 $6 $18 Plastic 11 6 9 26 Steel 13 5 7 25 Aluminum Activity: Drilling Machine: Vulcan Power Drill Depth of hole 7in. Diameter of hole: .5in. Overhead Total Type of material Direct Materials Direct Labor $9 $5 $7 $21 Plastic 13 8 11 32 Steel 15 6 9 30 Aluminum

The highest cost for the drilling activity is $16,000,000 (500,000 components X $32), based on the use of a steel component with a seven-inch hole depth. The lowest cost for the drilling activity is $7,000,000 (500,000 components X $14), based on a plastic component and a three-inch hole depth. If the design engineer can adjust the design of the product so that a plastic component with a hole three inches deep can be used, then considerable cost savi.As can be realized in just one small part of the new product. Of course, other design factors will have to be considered as well, such as reliability, functionality, and serviceability of the finished product. This illustration demonstrates how activity cost tables can serve as a useful management tool for identifying cost reduction opportunities. Activity cost tables that cover the entire activity value chain are stored and maintained in a database. The database also includes additional activity cost tables not used in current activity value chains. For example, the database includes information on all known alternative drilling machines on the market, even those not currently used by the company. In this way, a company's activity cost tables will include the most current information, even on technologies not employed by the company. Thus, one of the major tasks of management accountants in world-class environments is to understand the activity value chain and to stay up-to-date on new technologies that have the potential for reducing costs throughout the activity value chain. A primary goal of Japanese management accountants is to keep cost tables as up-to-date as possible and to incorporate the cost effects of the latest technological developments into the cost tables. This commitment means that Japanese management accountants must keep abreast of technological developments outside their own company. Japanese management accountants draw on their own experience, the experience of others within their company, such as engineers, and the expertise of specialists outside their company.

ANOTHER COST MANAGEMENT TOOL: PARAMETRIC COST ESTIMATING

Some form of cost estimating is needed during the early, conceptual design stages. Parametric cost estimating provides a set of methods that are used to help satisfy this need.

Parametric Cost Estimating: An Overview

A simple example of parametric cost estimating is the use of a parameter such as dollars per square foot in the construction industry, as discussed in Chapter 5. The cost of building a new home can be approximated by multiplying the number of square feet by a typical value of this parameter. An architect might be able to provide such an estimate for a client on the day of their first meeting, whereas a detailed estimate would not be possible until blueprints are finalized. Parametric cost estimating is prevalent in the aerospace industry and in ship-building. A first cut estimate for the development cost of a prototype airplane or manned spacecraft would probably be based on its weight. Hence, a parameter with units such as thousands of dollars per kilogram would be appropriate in this case31. Construction, mining, power plants, computers, and electronics also have characteristically long product development lead times; parametric cost estimating has, therefore, gained widespread application in these industries as well. in fact, many businesses can benefit from parametric cost estimating methods. But, perhaps more importantly, such methods provide increased visibility for planning and control activities at the inception of a project32.

Developing a Database to Provide Historical Data for Applicable Parameters

The success of parametric cost estimating methods hinges on whether applicable parameters and comparable values from previous projects are available to be used in estimating new projects33. These data are usually stored in tabular form, either on paper or within a computerized database management system. Advances in computer technology have greatly improved the accuracy and acceptance of parametric cost estimates. The data necessary for a parametric database can be obtained from a number of sources both within and outside the organization. Costs are certainly included, but so too are the project characteristics that have been found to drive those costs. Such characteristics can include weight, volume, capacity, number of circuits or voltages, horsepower, speed, service ceiling, seating capacity, thrust, or any other parameter that shows a high degree of correlation with cost34.

Three Project CERs Using Activities as Independent Variables

Parametric Cost Estimating Methods

Parametric cost estimating methods are becoming more sophisticated and wide-spread. Three methods are used to develop good parametric cost estimating models:
The activities focus The work elements focus The standards focus

FOCUSING ON ACTIVITIES. The activities focus method concentrates on the most identifiable or most influential activities of a project. Exhibit 14-16. shows three cost estimating relationships (CERs) derived from historical information for a particular kind of project. Of the three, activity 3 has the best CER. Activity 1 is not quite as good, because the cost varies little with large differences in activity 1 values. Most often, the historical CER data will fall within a narrow band, or a sleeve of experience, as shown in Exhibit 14-17The straight line of the CER represents a valid estimating relationship, but due to the concept of the learning curve, the lower boundary may be a more realistic estimate. Thus, some degree of professional judgment must be used when evaluating CERs. In this case, the CERs are similar to the cause-and-effect relationships discussed in Chapter 10.

A Generic Linear CER with Upper and Lower Boundaries

FOCUSING ON WORK ELEMENTS. The work elements focus method is best suited for estimating unusual programs or projects in co-operation with engineers and managers. It involves using a Gantt chart (see Chapter 24) to determine each work element's length in the overall project's life cycle. Typically, the manager or foreman responsible for each work element develops work element cost estimates based on CER data for materials, labor, and equipment required to complete similar work elements during previous projects. Finally, the work element estimates are summed to generate time period and project costs. FOCUSING ON STANDARDS. The standards focus method is commonly used in promoting estimating consistency between different cost estimators working on the same (or different) projects. The approach can either focus on standard work elements or standard modular subassemblies. If standard work elements are used, a project needs to be broken down into a work element structure at the appropriate level of detail. The cost estimator then uses standard costs or hourly standards to derive an estimated cost. If standard modular subassemblies are used, the design is broken down into an analogous set of subassemblies. The cost estimator would use time standards (often referred to as standard hours), obtained through time and motion studies, to derive an estimated cost.

INSIGHTS & APPLICATIONS

A Work Elements Focus Method Estimating Example
A comprehensive and well-defined organization of work items is essential to the preparation of an estimate for any project. A contractor and management accountant need a method to identify work elements contained in the project's written specifications. A builder is considering constructing a customized house and has used a work break down structure (WBS), as illustrated in Chapter 5, to specify each work element. Appropriate managers and foremen have estimated completion times for each work element needed to construct the house, as shown in the Gantt chart in Exhibit 14-18. Examination based on similar work elements performed in the past resulted in the estimated costs shown in Exhibit 14-19. Totalling up the values gives the complete estimate of $100,000 for the first month, $250,000 for the second month, and $50,000 for the third and final month.

Gantt Chart Showing Estimated Start and Completion Times for Work Elements of a Customized House

Work Elements Focus Example Cost Estimates

Manager Jones Jones Smith Caston Abrams Carey Harris Jones Harris Ogden

Work Elements Site work Foundation Rough framing Roof work Mechanical work interior carpentry Finish carpentry Exterior finishing Interior finishing Final inspection

Material and Equipment Costs $ 2,000 10,000 30,000 20,000 20,000 10,000 35,000 12,000 16,000 -0-

Labor Costs $ 3,000 25,000 30,000 15,000 50,000 50,000 15,000 23,000 32,000 2,000

Total Estimated Cost $ 5,000 35,000 60,000 35,000 70,000 60,000 50,000 35,000 48,000 2,000

Time standards can be maintained as parametric relationships; that is, the standard hours required to produce a gear might be represented by an equation having variables of diameter and number of teeth. The standards approach has the ability to generate quick, yet reliable estimates.

SUMMARY OF LEARNING OBJECTIVES

The major goals of this chapter were to enable you to achieve four learning objectives:

Learning objective 1. Define market life and cost life cycles, and describe how they are used in analyzing and managing costs over the entire life cycle of a product or service.
The market life cycle of a product or service generally includes these stages: pre-introductory, introduction, growth, maturity, and decline to abandonment. In some instances, a product or service may go directly from

introduction to abandonment. In other instances, a product or service may be revitalized so that it appears to possess an endless life. Cost life cycles represent the kinds of costs that products or services incur during their market life cycles. Before products or services are introduced into the marketplace, development costs are incurred, such as technical research, engineering and design, quality function deployment (QFD), and market research expenses. Once a product or service is introduced to the market, production, marketing, sales, logistics, and service costs will be incurred throughout the product's or service's cost life cycle. For effective cost management, management accountants need to understand both market and cost life cycles.

Learning objective 2. Explain how functional analysis is used to achieve target costs.
The setting of target costs for new products and services can be a powerful tool for effective cost management. Functional analysis is performed as a way to achieve target costs. Functions of new products or services are analyzed and modified as necessary so that the products or services can be developed, produced, and supported at a target cost that will enable them to enjoy success in the marketplace at a particular sales price. Using target costing, a company can set goals for cost reduction and seek to achieve those goals through design changes.

Learning objective 3. Describe how activity-based costing and activity-based management are used to meet target costs.
Activity-based costing systems are used to set target costs by identifying activities that are performed by companies throughout their activity value chain. With ABM, each activity is systematically analyzed so that nonvalue-added activities can be eliminated and value-added activities can be strengthened and performed in the most efficient way possible, all in an effort to meet target costs.

Learning objective 4. Discuss how parametric cost estimating methods may be used in estimating costs.
One of the most difficult tasks in management accounting is estimating costs of new products or projects. The parametric cost estimating methods provide a structured, engineered way to come to grips with this difficult and important task. Methods used in parametric cost estimating include the following:
Focusing on the most identifiable or the most influential activities in new products or projects Focusing on work elements, especially when products or projects are unusual or customized Focusing on standard work elements or standard subassemblies of fairly common products or

projects

IMPORTANT TERMS
Activities focus method A parametric cost estimating method that estimates the total cost of a

project, product, or service by focusing on the most identifiable or influen-tial activities.

Activity cost tables Tables generally stored in a database management system (DBMS) that contain Activity value chain A linkage of strategic activities, including research and development, inbound

cost data for a wide variety of activities throughout the activity value chain.

logistics, production, outbound logistics, marketing and sales, and service. Each strategic activity is composed of specific activities and tasks. The aim of the activity value chain is to bring value to products and services throughout their life cycle. Cost estimating relationships (CERs) The relationship of cost to some other variable or variables.

 Cost life cycle A combination of curves that shows the behavior and magnitude of development,

production, marketing, logistics, and service costs of products and services over their market life cycles. Function An action or feature of a product or service. Functional analysis A cost management technique that focuses on and evaluates the various functions of a product or service design. It is used to achieve a target cost. Functional family tree A logical diagram of each function of a product or service. Linear approach A sequential, uncoordinated, over-the-wall process of designing new products or services. Market life cycle A concept that illustrates the limited life of a product or service. It uses a curve to profile the duration of a product or service from the time it is conceived until it is abandoned by the firm and its customers. Generally, a market life cycle includes several stages: pre-introductory, introduction, growth. maturity, and decline and abandonment. In some instances, a product or service may get a new lease on life through revitalization efforts or suffer early abandonment due to changes in the marketplace. Parametric cost estimating A set of methods that attempt to estimate the cost to produce and bring to market a product or service or to build a project or complete a job. Quality function deployment (QFD) A method to assure that quality is designed into a new product or service while it is in the development stage. Simultaneous engineering (concurrent engineering) A concurrent and collaborative design process in which all players work together toward a common product or service development goal. Standards focus method A parametric cost estimating method that uses standards as parameters for estimating costs of a project, product, or service. Target costing A cost management tool for optimizing the overall cost of a product or service over its entire cost life cycle. Target costing determines what the cost of a product or service should be, based on the selling price of the product or service less a target profit. Time-to-market The time it takes to convert an idea into a marketable product or service. Work elements focus method A parametric cost estimating method that estimates the cost of a project, product, or service by concentrating on the length of time and cost of individual work elements.

DEMONSTRATION PROBLEMS
DEMONSTRATION PROBLEM 1 Performing life cycle analysis. The management accountant at the Fillmore Company has collected the following data in preparation for a life cycle analysis of one of its products, a forklift truck:
Item This Year Change Over Last Year Average Annual Change Over The Last Four Years $40,000,000 +1.0% +18.2% $2,100 +1.9 + 6.4 $400 -0.6 + 2.6 $5,800,000 +1.2 +26.7

Annual sales Unit sales price Unit profit Total profit

Required: Determine what stage the forklift is in. SOLUTION TO DEMONSTRATION PROBLEM 1 Sales are stabilizing, having grown only 1% over the past year. Average annual growl was much higher during prior years, at 18.2%. Unit sales price growth has slowed, an unit profit margins are beginning to shrink. Total profit is also beginning to level of All these signs suggest the early maturity stage. DEMONSTRATION PROBLEM 2 Functional analysis.

The latest development at KeepSake Enterprises is a personal diary hook. The product will have a classical design with a lock and a flowered cover. Required: Draw a functional family tree for KeepSake's personal diary.

DEMONSTRATION PROBLEM 3 Target cost. Tour De Frame Manufacturing Company is considering the development of a new cross-training bicycle. Extensive industry research has determined that a market sales price of no more than $600 would be feasible. Since the competition has relatively small profit margins, the profit margin for this product would only need to be $150. Required: With the understanding that the service, logistics, and marketing activities of the product lite cycle will be relatively small compared to the other activities, develop a target cost table for each product life cycle activity for this cross-training bicycle. Use your best guess estimate of such costs. SOLUTION TO DEMONSTRATION PROBLEM 3
Product: Cross-training bicycle Target price: $600 Target profit: $150
Development target cost $150 200 Production target cost 50 Marketing target cost 30 Logistics target cost 20 Service target cost Total unit target costs $450

DEMONSTRATION PROBLEM 4 Normalized CER. HotMax Conditioner Company is considering building a new heating unit rated at 4,000 BTUs. Research into past heater development, both inside and outside HotMax, resulted in the following information:
MODEL. SIZE (BTU) DATE DEVELOPMENT COST 1,050 2000 $ 52,250 30A 1,500 2001 68,000 35A 1,360 2001 58,950 133D 2,550 2000 120,950 C2A 3,000 2002 143,300 106 3,200 2002 166,700 108 2,820 2003 145,000 3AD

Required: Develop a CFR, normalized to 2003, assuming 5% inflation, to determine an estimate of development costs for HotMax's new heating unit. Comment on the confidence of this estimate. SOLUTION TO DEMONSTRATION PROBLEM 4 To normalize the data, we calculate the 2003 value of the development costs based on an increase of 5% each year. Thus:
MODEL SIZE (BTU) DATE DEVELOPMENT COST ADJUSTED COST (2003) 1,050 2000 $ 52,250 $ 60,486 30A 1,500 2001 68,000 74,970 35A 1,360 2001 58,950 64,992 B3D 2,550 2000 120,950 140,015 C2A 3,000 2002 143,300 150,465 106 3,200 2002 166,700 175,035 108 2,820 2003 145,000 145,000 3AD

Plotting the BTUs versus the adjusted costs, we have:

To estimate the development costs for the new 4,000-BTU model, we read off the CER at $210,000. This CER looks good, with very little variation off the trend line. However, we are using part of the trend beyond the largest data point (at 3,200 BTUs); thus, there is the risk that the trend will be different past 3,200.

REVIEW QUESTIONS
14.1 What are the stages of the product or service life cycle? 14.2 A sign on the way to an abandoned mine reads: Choose your ruts carefully; you will be in

them for the next 15 miles. How does this sign apply to life cycle analysis, especially committed costs? 14.3 A manufacturer with little understanding of the differences between life cycle stages might assume that the best way to maximize profits is always to maximize revenues and minimize costs. However, maximizing revenues and minimizing costs at every stage of a product's life cycle does not necessarily lead to maximum profits over the entire life of a product. Discuss this statement. 14.4 How much of the costs of a product or service are committed during the development stage? 14.5 Decisions made from a life cycle perspective lead to better long-term results than decisions made without such a perspective. Comment on this statement. 14.6 Explain the difference between linear and simultaneous engineering. 14.7 What are some of the documented benefits of simultaneous engineering? 14.8 What is the over-the-wall approach? 14.9 How does simultaneous engineering differ from the over-the-wall approach? 14.10 What is the purpose of quality function deployment (QFD)? Give an example. 14.11 A product's sales (in millions) are as follows. What stage of the product life cycle is this product in as of the second quarter, 19X5?
19X4 19X5

First quarter Second quarter Third quarter Fourth quarter

$ 15 $21.0 2.5 3.0 6.0 15.0

14.12 Once a target cost is established for a product, will that cost remain stable? Explain why or

why not. 14.13 In some cases, target costing uses market price to set target costs and profits in the development of products and services. Yet, competing on price can be fraught with dangers. Explain the dangers of competing on market price. 14.14 Explain how target costing can reduce costs over the entire life cycle of a product or service. 14.15 What is a product's functional family tree? 14.16 What are three functions of a pocket knife? 14.17 If a company wants to produce a product to compete in an existing market but does not want to compete on price, how can the company differentiate the product? 14.18 As a management accountant, you are asked to review the cost of the parts used in the production of a product. What two principles should you follow to reduce parts costs? 14.19 What are some of the ways reducing the number of parts can reduce costs? 14.20 Explain how a new product design can affect activity cost drivers. Explain the impact on design engineering of cost estimates prepared by management accountants. Give an example of how activity-based costing can reveal potential areas of cost reduction by identifying opportunities for design changes. 14.21 Explain how activity sharing can reduce costs. 14.22 Explain how activity cost tables allow design engineers to test what-if target cost scenarios. 14.23 Give an example of how designing for each of the following activities will reduce costs over a product's life cycle: a. Production. b. Marketing. c. Logistics. d. Service. 14.24 Why would one want to know what product life cycle stage a product is in when setting up production facilities? 14.25 By the time products reach the maturity stage, decisions to add capacity should be weighed very carefully because excess capacity is costly and disadvantageous to companies that compete primarily on price. Discuss this comment. 14.26 A company can reduce product costs by successfully matching its capacity to the demand for its product. Discuss this comment. 14.27 Explain how the mushroom concept can increase flexibility and decrease the cost of a product over its entire life cycle. 14.28 For what purposes are activity cost tables used? 14.29 Chocolate Importers delivers bulk chocolate to Sweety-Pie Candy Company in 10-pound, wrapped, molded bars of chocolate. Sweety-Pie unpacks, unwraps, and melts the solid bars of chocolate for raw materials input in the candy-making process. Discuss how Chocolate Importers and Sweety-Pie can revise their activities to reduce costs for both companies. 14.30 Failure to adopt an activity value chain perspective can lead companies to make costly errors. On the other hand, beneficial linkages throughout the enterprise, including with suppliers and customers, can be achieved if management accountants understand the activity value chain. Discuss this statement. 14.31 Designing a product to reduce postpurchase costs of the customer can be a major weapon in capturing competitive advantage. Comment on this statement. 14.32 Assume that you are a manufacturer of heavy, bulky containers that you supply to two large manufacturers. Discuss how you would develop a linkage to your two major customers that would, in turn, reduce costs for all parties.

 14.33 In the late 1980s, Sealtite Envelope Company lost profits and went bankrupt because it was

caught unawares by a significant change from sheet-fed machines to roll-fed machines. With sheetfed machines, an envelope company buys large rolls of paper 40-60 inches wide, which are cut into sheets, cut into blanks in die-cutting machines, and finally fed by hand into folding-and-gluing machines. With roll-fed machines, the envelope company buys narrow rolls of paper 5-11 inches wide, which are converted directly into envelopes in one combined operation. Discuss how a database containing activity cost tables about the new roll-fed technology might have prevented Sealtite from going bankrupt. 14.34 When setting up a parametric database, what should one look for when selecting a cost parameter?

CHAPTER-SPECIFIC PROBLEMS
These problems require responses based directly on concepts and techniques presented in the text. 14.15 Analyzing the market life cycle and its relationship to the cost life cycle. Different types of costs are incurred at different stages of the product or service market life cycle. Required: Identify the market life cycle stage or stages at which the maximum level of the following costs will occur:
Development Production Marketing Sales Logistics Service

14.36 Determining the life cycle stages. The Marlin Company makes and sells two fishing.' tackle products, Deepsea and Angler. Tommy Hogan, management accountant, is conducting a life cycle analysis to identify the current stage of each product in its life cycle. The profiles for the two products are as follows:
Product Item This Year's Performance Changeover Last year Average Annual Change Over The Last 3 Years $ 5,200,000 - 2.9% + 1.1% 450 + 0.3 + 0.6 60 - 2.8 - 0.7 780,000 - 8.1 + 0.3 10,300,000 +80.9 +41.5 160 +10.6 + 9.4 80 +14.7 +19.2 6,800,000 +87.3 +41.5

Deepsea Annual sales Unit sales price Unit profit Total profit Angler Annual sales Unit sales price Unit profit Total profit

Required: Determine which stage of its life cycle each product is in and explain your answer. 14.37 Matching market characteristics with life cycle stages. Following is a list of various 'activities and market characteristics:
A new product concept Entrance of competitors Shrinking sales Stable sales Strong brand loyalty

 Product dropped Rapid sales increases Rapid ramp up of production Product design Market research Build prototype Test prototype Initiate production

Required: Identify the appropriate life cycle stage-- pre-introductory, introduction, growth, maturity, or decline and abandonment--in the space provided after each activity or characteristic. 14.38 Preparing and costing a bill of materials (BOM). AlarmSys Company produces an alarm system for use in automobiles. These systems are offered as original equipment by most automakers. The alarm system consists of four modules. The alert module is composed of a siren and a headlight-flashing driver. The control module consists of a keypad, a valet override switch, and two remote controls. The brain module is composed of a CPU chip and 16 memory chips on one circuit board. Finally, the sensor module includes six door switches, three tip switches, and a motion detector. The cost for one unit of each component is as follows:
Component Cost (Each) $15.00 Siren 4.00 Headlight driver 5.00 Keypad 1.00 Valet switch 6.00 Remote control 6.00 CPU chip 2.00 Memory chip 3.00 Circuit board 0.50 Door switch 0.75 Tip switch 9.00 Motion detector

Required: Construct a bill of materials (BOM) for the car alarm system. In your BOM diagram, show how the product is broken down into modules and further into components. Then calculate the total cost of the product. 14 39 Analyzing and managing activities. Management at Jones and Company is trying to reduce costs in an effort to improve overall profitability. Tom, the new manage-ment accountant, suggests that they analyze the corporate activities and search for cost reduction opportunities among those activities. Required: Explain how Jones and Company can reduce costs by analyzing activities. 14.40 Determining the cost impact of using different parts. Jacob and Son produces housings for three computer manufacturers. To produce these housings, the company uses the following parts:
Part Cost Assembly Time In Minutes T51 $ 1.00 1 A19 1.50 1 A97 2.00 1 R78 0.50 2 S71 0.75 1

S53 S32 V15 V18 V92 P8 P3

0.50 0.75 1.00 5.00 2.00 2.75 4.25 $22.00

1 1 3 6 1 3 l 22 minutes

The parts purchasing storage, and auditing charges are $0.05 per part. The hourly wage costs average $15.00 per hour. Management accountant, Dee Kendrix, must determine whether she should recommend to management that parts A97, S53, and P8 be replaced by part A3 and parts V15 and P3 be replaced by part T15. The costs and assembly times associated with parts A3 and T15 are $5.00 at 6 minutes and $5.25 at 5 minutes, respectively. Required: Determine what Dee should recommend to management about parts A3 and T15. 14.41 Estimating the bid price of a house. As a custom home builder, you have deter-mined that the cost of the type of houses you build can be estimated with a high degree of accuracy using the following parameters, plus the cost of the land:
Cost per square foot of house =$69.75 Cost per square foot of glass = 4.50

Required: Given that a potential customer wants a 1,650-square-foot house with the equivalent of 20% of the floor space in windows and glass doors and that the cost of the land on which the house will be built is $38,250, calculate the bid price. You expect to make a 32% profit based on the total estimated cost, including the land. 14.,42 Determining cost estimating relationships (CERs). Biltmore is a major custom housing construction contractor. Susan Liggett, owner, has asked you, the management accountant, to determine the best CER for use in the early, conceptual design phase of each of Biltmore's future projects. Information from last year's Biltmore work is summarized as follows:
House Number Final Total Cost Interior (Square Feet) Number Of Rooms Lot (Square Feet) $110,000 2,500 9 35,000 1 65,000 1,300 6 19,500 2 96,000 2,200 6 25,500 3 160,000 4,200 10 25,000 4 132,000 3,500 10 20,000 5 67,000 1,500 7 19,000 6 112,000 2,700 9 22,000 7 89,000 2,000 9 23,500 8 81,000 1,900 8 26,000 9 139,000 3,500 9 24,500 10

Required: Determine which cost estimating relationship (CER) should be used in the future. Briefly comment on how comfortable Susan should be with this decision. 14.43 parts-functions-cost matrix. OpenAll manufactures small kitchen tools and appliances. Its latest potential product is a hand-crank can opener. The can opener is designed to he hand-held, open cans, and hold the lid. Following are the major parts of the product:

Part Upper handle Lower handle Handle grips Cutting wheel Gear assembly Magnet Magnet arm

Cost Part Number $0.26 631 0.24 632 0-13 630 0.31 11 0.18 33 0.08 940 0.11 941

Required: Develop a parts-functions-cost matrix for this product. 14.44 Normalization of database. A major manufacturer of electric generators is developing a cost database from historical data, both internal and external to the company. The following information was obtained from various sources:
Internal External Model Horsepower Date Cost Model Horsepower Date Cost 110 10 1976 $114 A-32 11 1985 $188 113 13 1978 128 A-43 22 1987 272 220 20 1982 200 D-103 15 1981 180 215 15 1983 195 D-104 17 1988 259 330 30 2000 360 D-106 23 2002 347 335 35 2003 434 Q-A5 30 1989 352 A-A3 28 1988 322

Required: Develop a parts-functions-cost matrix for this product. 14.45 Parametric cost estimating approaches. The following are different project estimating situations:
A large construction project with three different cost estimators. A long duration project comprising six different departments. A bridge construction of unique design. An airport runway construction project where historical runway length CER information is known. A new computer system composed of off-the-shelf modularized subassemblies.

Required: In the space provided, insert the type of basic approach (i.e., work elements focus, activities focus, standards focus) that is most appropriate for each situation.

THINK-TANK PROBLEMS
Although these problems are based on chapter material, reading extra material, reviewing previous chapters, and using creativity may be required to develop workable solutions. 14.46; Deciding what to do in the pre-introductory stage. When Iowa Beef Processors was being formed, its strategy was to be the low-cost producer of beef. Following are two alternatives facing Iowa Beef Processors during its pre-introductory (or formative) stage:
Alternative 1 Alternative 2 Automate Use manual methods Ship cattle to rail centers and then to plants Build plants next to large feedlots Cleave carcasses into various pieces and box the pieces at the plant Ship whole carcasses

Required: Choose the alternative that you believe would generate the most cost savings I for Iowa Beef Processors. Explain your choice. 14.47 Identifying nonvalue-added activities. Exhibit 14-12 presents an activity value chain and a list of activity cost drivers. Required: Making any assumptions you deem necessary:
a. Explain which activities are nonvalue-added and which are value-added. b. Give an example of how a company can reduce total costs by developing beneficial linkages in

the activity value chain and thereby reduce, if not eliminate, nonvalue-added activities. 14.48 Analyzing a comparative activity value chain. The following are the activity value /chains and costs of two competing airlines:
Activity Value Chain People Mover Cost Per 10,000 Seat-miles Air Bus Cost Per 10,000 Seat-miles $ 1,200 $ 1,800 Advertising 2,600 3,200 Ticketing offices 2,300 2,900 Ticket counter 3,700 4,100 Gate operations 3,100 4,000 Baggage facilities 5,600 7,200 Fleets 15,000 20,000 Aircraft operations 2,000 6,500 On-board service $35,500 $49,700 total

Required:
a. Study the comparative activity value chains and recommend how Air Bus may be able to close the

$14,200 cost gap between it and People Mover.

b. Discuss how a comparative activity value chain analysis can help a company (e.g., Air Bus)

manage costs. 14.49 Choosing between two options. Fredrik Manufacturing produces valves for waste treatment plants. The market for these valves is saturated. Ron Fredrik, CEO, is trying to decide how to allocate $100,000 in available budget-the funds have been requested by both the sales manager for market expansion activities and by the finance manager for use in reducing costs. The sales manager assures Ron that he can increase sales by $5,500,000 while the finance manager assures him that she can reduce the cost of goods sold by 3.5%. The cost of goods sold is $160 per unit, and the sales price is $200 per unit. Last year, Fredrik Manufacturing had sales of $50,000,000. Required: Determine which of the two options provides the greater increase in profit. 14.50 Functional analysis. Northwestern Electric Company manufactures electronic communication products. One of their most popular products is Model 1010, a combination phone, FAX, and answering machine. Due to increased competition from foreign manufacturers, the profit margin on Model 1010 is dropping and nearing zero. Required: Perform a functional analysis to determine the possibility of eliminating or modi-fying a function of Model 1010 for cost reduction. Make any assumptions necessary. 14.51 Parametric cost estimating. You are the new management accountant at FitRite Model Company, a manufacturer of plastic airplane and car models. FitRite's organization includes design, production, and

marketing departments. A new model of the latest stealth airplane is being considered, which will be part of FitRite's High-Tech Aircraft line. Required: As the management accountant, you have been instructed to lead a cost estimating team for this model concept. Describe the cost estimating technique you will use to ensure proper cost management for the new product. Also, what approaches would you use to ensure that quality is designed in and that time-tomarket is reduced? 14.52 Linear versus simultaneous engineering. PerfectPerk Appliance Company has determined that a new drip coffee maker might be profitable if developed within the year. The product would be a new venture for PerfectPerk, as it has only developed percolator coffee makers in the past. Required: For this product, comment on the potential problems and benefits of the traditional linear, simultaneous engineering, and quality function deployment (QFD) approaches in ultimately satisfying marketing, service, finance, and manufacturing department needs. Make any assumptions you deem necessary.

1. James A. Brimson, CAM-I Cost Management Systems Project, in Cost Accounting, Robotics, and the New Manufacturing Environment, ed. Robert Capettini and Donald K. Clancy (Sarasota, Fla.: American Accounting Association, 1988), p. 5.8.
2. Adapted front Charles Beever and Mary Jo Veverka, A Winning Approach to New Product Development (New York: Booz, Allen & Hamilton, 1988). With permission.

3. James R. Anderson, Unit Manufacturing Cost Tracking Systems at Xerox, in Cost Accounting for the 90s: Responding to Technological Change (Montvale, N.J.: Institute of Management Accountants, formerly the National Association of Accountants, 1988), p. 187. With permission. 4. Michael D. Shields and S. Mark Young, Managing Product Life Cycle Costs: An Organizational Model, in Emerging Practices in Cost Management, ed. Barry J. Drinker (Boston: Warren Gorham Lamont, 1992), p. G3-1. With permission. 5. Richard L. Engwall, Cost Management Systems for Defense Contractors, in Cost Accounting for the 90s: Responding to Technological Changes (Montvale, N.J.: Institute of Management Accountants, formerly the National Association of Accountants, 1988), pp., 205-225. With permission. 6. Peter Drucker, The Corning of the New Organization, Harvard Business Review, January-February 1988, pp. 4553. 7. Shields and Young, op. cit, p. G3-3. 8. For a full treatment of QFD, see James L. Bossert, Quality Function Deployment: .4 Practitioner's Approach (Milwaukee, Wis.; ASQC Quality Press, 1991); R. John Aalbregtse, Target Costing, in Handbook of Cost Management, ed. Barry J. Brinker (Boston: Warren Gorliani Lamont, 1992); and Yoji Akao, ed., Quality Function Deployment. Integrating Customer Requirements into Product Design (Cambridge, Mass.: Productivity Press, 1990).
9. Adapted from Shawn Tully, Can Boeing Reinvent Itself? Fortune, March 8, 1993, pp. 66 -73. 1993 Time Inc. All rights reserved.

10. Bossert, op cit., pp. 18-19. 11. Chester R. Wasson, Dynamic Competitive Strategy & Product Life Cycles (St. Charles, Ill.: Challenge Rooks, 19741, p. 174. 12. Michiharu Sakurai, Target Costing and How to Use It, in Emerging Practices in Cost Management, ed. Barry 3. Brinker (Boston: Warren Gorham Lamont, 1990), p. 255. With permission. 13. Takeo Yoshikawa, John Innes, and Falconer Mitchell, Cost Management through Functional Analysis, in Emerging Practices in Cost Management, ed. Barry J. Brinker (Boston: Warren Gorharn Lamont, 1990), p. 243. With permission.
14. Adapted from Peter Nulty, The Soul of an Old Machine, Fortune, May 21, 1990, p. 19. 1993 Time Inc. All rights reserved.

15. Masayasu Tanaka, "Cost Planning and Control Systems in the Design Phase of a New Product," in Japanese Management Accounting, ed. Yasuhiro Monden and Michiharu Sakurai (Cambridge, Mass,: Productivity Press, 1989), p. 53. With permission. 16. Takao Tanaka, "Target Costing of Toyota," Journal of Cost Management, Spring 1993, p. 7. 17. Takeo Yoshikawa, John Inns, and Falconer Mitchell, "Japanese Cost Management Practices," in Handbook of Cost Management, ed. Barry J. Brinker (Boston: Warren Gorham Lamont, 1992), p. F3-14. With permission. 18. Takeo Yoshikawa, John limes, and Falconer Mitchell, Cost Management Through Functional Analysis, in Emerging Practices in Cost Management, ed. Barry J. Brinker (Boston: Warren Gorham Lamont, 1992), p. 02-2. With permission.

19. Ibid., p. 02-3. 20. Ibid., p. 02-4. 21. Brian H. Maskel, Performance Measurement for World Class Manufacturing (Cambridge, Mass.: Productivity Press, 1991), p. 178. With permission. 22. Hat Mather, Competitive Manufacturing (Englewood Cliffs, N.J.: Prentice-Hall, 1988). Ibid., pp. 186-187. 23. Adopted from Esther I. Hayrnan, A Meeting of the Minds at Boeing Management Accounting, April 1993, pp. 30-32. Reprinted from Management Accounting. Copyright by Institute of Management Accountants, Montvale, N.J. 24. Adapted from Michael E. Porter, Competitive Advantage. Creating and Sustaining Superior Performance (New York: Free Press, 1985). 25. Peter B. B. Turney, How Activity-Based Costing Helps Reduce Costs, in Emerging Practices in Cost Management, ed. Barry J. Brinker (Boston: Warren Gorham Lamont, 1992), p. D5-3. With permission. 26. lbid., p. D5-1. 27. Lawrence S. Maisel and Eileen Morrissey, Using Activity-Based Costing to Improve Performance, in Handbook of Cost Management, ed. Barry J. Brinker (Boston: Warren Gorham Lamont, 1992), pp. B4-18 to B4-20. With permission.
28. Source- Lawrence S. Maisel and Eileen Morrissey, Using Activity-Based Costing to Improve Performance, in Handbook of Cost Management, ed. Barry J. Brinker (Boston: Warren Gorham Lamont, 1992), p. B4-19. With permission.

29. Takeo Yoshikawa, John limes, and Falconer Mitchell, Cost Tables: A Foundation of Japanese Cost Management, in Emerging Practices in Cost Management, ed. Barry J. Brinker (Boston: Warren Gorham Lamont, 1990), p. 262. With permission. 30. Bernard J. LaLonde, John R. Grabner, and James F. Roheson, Integrated Distribution Systems: A Management Perspective, International Journal of Physical Distribution Management, October 1970, p. 46. 31. D. M. Ashford and P. Q. Collins, The Prospects for European Aerospace Transporters Part 1: The Derivation of a First Order Parametric Method for Estimating the Development Cost of Aerospace Transporters, The Aeronautical Journal, 1989, pp. 1-10. 32. Paul F, Gallagher, Parametric Estimating for Executive and Estimators (New York: Van Nostrand Reinhold, 1982). 33. Ibid., P. 8. 34. Ibid., p. 9.