Cost Based Decision Making Dr Nancy Mangold California

Cost Based Decision Making Dr. Nancy Mangold California State University, East Bay

3 Managerial Use of Cost Information Product and customer decisions: n n Whether to make or abandon a product Influence the nature of customer relationships Develop a cost basis for a price Identify opportunities to improve product or process design and process operation

Product Life Cycle 3 Broad Phases The planning phase The manufacturing phase The service and abandonment phase

Life Cycle Costing Used predominately in the planning phase It attempts to estimate the product’s cost over its lifetime Exhibit 6 -1

Target Costing Used during the planning cycle. Drives the process of choosing product and process designs. Will result in a product that can be produced at a cost that will allow an acceptable level of profit, given the product’s estimated market price, selling volume, and target functionality.

Kaizen Costing Identify opportunities for cost improvement during the manufacturing cycle

A Widely Accepted Rule 80% of a product’s costs are committed or locked in during the product design stage During the design stage, planners choose the product design and design the process that organization will use to make the product Exhibit 6 -2

Effective Cost Control During the product’s planning and design phase Not when the product and process have already been designed and the product is being made During the product manufacturing phase, most of the product costs have been committed and the focus is cost containment

Target Costing Cost management tool that planners use during product and process design to drive improvement efforts aimed at reducing the product’s future manufacturing costs.

Target Costing Promotes and facilitates communication among the members of the crossfunctional team that is responsible for product design

Target Costing Customer oriented Begins with price, quality, and functionality requirements defined by customers Price-led costing vs cost-led pricing (cost plus approaches to pricing)

Two Critical Elements Customer (market) defines the price that will be paid for the product and its designated functions. To the extent that there is a market for the same product with different functions (autos), the market or consumer will choose a price that reflects the set of product functions supplied.

Target Costing Process Driving force behind the product and process design efforts. Iterative process and continues until the design team finds a product design with a projected cost that meets the target cost.

Market-Driven Costing Starts by identifying the target selling pricethe product’s anticipated price when launched. The price must reflect. n n the the the perceived value of the product in the eyes of customer, anticipated relative functionality. selling price of competitive offering. firm’s strategic objectives for the product.

Market-Driven Costing Conduct extensive market analysis procedures to identify what their customers want and how much they are willing to pay for it.

Market-Driven Costing Setting a target profit margin. n Historical profit margins for replacement of existing products adjusted for unusual costs at the front end (R&D) or back end (salvage or disposal). Calculate an allowable cost by subtracting the target profit margin from the target selling price.

Product-Level Target Costing Starts with the current cost of the proposed product. The costs at which the firm could launch the new product today without undertaking any design changes or introducing any process improvements in existing manufacturing processes.

Product-Level Target Costing The discrepancy between the current cost and the allowable cost gives the project team an estimate of the magnitude of the cost reduction opportunities it must identify to achieve the allowable cost.

Product-Level Target Costing Cost reduction objective. Achievable. Unachievable.

Product-Level Target Costing Achievable. Expend considerable effort during the design process. n n Value engineering. Quality function deployment. Design for manufacture and assembly. Target costs set properly, should be achieved 80% of time.

Product-Level Target Costing Unachievable. Strategic cost reduction challenge. Identify how far the firm is from being competitive.

Product-Level Target Costing Setting product-level target costs that are too aggressive will result in unachievable target costs and eventual failure of the target costing process. Setting too high a strategic cost reduction challenge leads to easily achieved target costs but a loss of competitive position.

Product-Level Target Costing Cardinal rule - Target cost can never be violated. Rule implies that even if engineers find a way to improve the functionality of a product, they can incorporate the improvement only if they can also identify how to offset any additional costs.

Component-Level Target Costing The design team establishes the target cost for every component in the future product. These component-level target costs establish the suppliers’ selling prices. Target costing transmits the competitive pressure faced by the firm to its suppliers.

Component-Level Target Costing Products are broken down into major functions (Engine, transmission, air condition, audio systems). The chief engineer sets the target cost for the major functions. The engineer decides theme of the product and that certain functions should be emphasized (high-performance engine).

Component-Level Target Costing Once the major function target costs are established, the design team for each major function must find ways to design that function so that it can be produced at its target cost. The team breaks the major function down into its components and then distributes the major function-level target costs to component-level costs.

Component-Level Target Costing The sum of the component-level target costs must equal that of the major function that contains them.

Component-Level Target Costing This establishes the allowable selling prices of suppliers. The assembly companies do not want to squeeze the profits of their component suppliers to zero. They bring their major suppliers into the product design process as early as possible.

Component-Level Target Costing The suppliers provide and receive inputs on how to reduce costs. The suppliers also estimate costs for each component. These estimates are imputed into the component-level target-costing process subject to the constraint of the cardinal rule.

Chained Target Costing In today’s highly competitive environments it is not enough to be the most efficient player. It is also necessary to be part of the most efficient supply chain. One of the ways to achieve increased supply chain efficiency is through the use of chained target-costing systems.

Chained Target Costing The output of the buyer’s target-costing system becomes the input to the supplier’s target-costing system. The buyer’s component-level target costs become the supplier’s target selling prices. The supplier’s target-costing system develops both product-level and component-level target costs, thus transmitting the buyer’s competitive pressure to the supplier’s product designers.

Chained Target Costing If the supplier’s suppliers also use target costing, the chaining continues down the supply chain. Thus, chained target-costing systems can transmit the competitive pressure from the buyer down the supply chain, making the entire chain more efficient.

Chained Target Costing The intense cost reduction pressure that is characteristic of target costing thus permeates the whole supply chain.

Major Strength One – Team Concurrent Design Team environment Cross functional team members: n n n Design engineer Process engineer Purchasing Manufacturing Marketing

Major Strength One – Team Concurrent Design Concurrent design Objective-to deliver a product with the target functionality, quality, and price to a specific market segment

Major Strength One – Team Concurrent Design No room for individual groups to specify product features that reflect a functional fixation Eliminate product functions or features that add cost but provide no market price increment (no value to customers)

Major Strength One – Team Concurrent Design Avoid Engineers may design a production process that uses the latest production technology without regard for its effects on cost or manufacturability Marketing group might specify many product features that customers would like to have but do not consider essential in the product and would not pay to have them included in the product design

Major Strength One – Team Concurrent Design Reduces product development time and cost by reducing required designed changes

Major Strength One – Team Concurrent Design Each subgroup within the team is assigned cost reduction targets that is expected to meet in order to achieve the team’s overall target cost objective. Assign individual responsibilities but within an overall structure of group objectives relating to product quality, functionality and price.

Major Strength Two – Deployed at Design Stage Deployed at the product and process design phase when design choices can have a maximum impact on a product’s cost.

Suppliers on Design Team Include suppliers as active members of the product design teams to elicit their expertise. This approach requires a sharing of ideas and information – requires trust.

Suppliers on Design Team Payback for suppliers are long-term contracts Participate in the cost savings they generate Reduce product costs but not by squeezing the suppliers Use lower-cost commodity components rather than custom-designed components Implementing process improvements Chrysler supplier recommended an exterior molding-cost less, offer same function

Suppliers on Design Team Japanese keiretsu, South Korean chaebols Affiliations of companies interrelated by supplier-purchaser relationships Does not always work Several large keiretsu were disbanded because the protected suppliers and had become inefficient and noncompetitive

Chrysler Approach Chrysler to avoid this by Drop poorly performing suppliers Performance based on cost savings resulting either from n n design proposals Manufacturing process improvements Quality On-time delivery

Design Team Huge pressure on the design team to meet target cost. Product will not be launched unless the team meets the target cost. Ultimately target cost reflects what the customer demands and what the suppliers of capital expect as a reasonable return on their returns.

Target Costing in Action. Toyota Motors seems to have invented the process of target costing during the 1960 s. Market group specifies the target price.

Target Costing in Action. Toyota Motors The market value of additional functions added to existing vehicles determines the increment of the price of the new model over the existing model. Planners multiply this price by the estimated production volume over the product’s life cycle to determine the total product revenue.

Target Costing in Action. Toyota Motors Estimate the cost of the new product. Estimated by adding. n n n The cost base of the existing product. The incremental costs of the design changes associated with the new product. Compares revenues and costs to compute an estimated margin.

Target Costing in Action. Toyota Motors A margin that fails to achieve the target return on costs needed to provide an appropriate return on investment triggers a redesign process.

Toyota Motors– Redesign Process Compute the required cost reduction. The leader of the design team then distributes this target cost reduction among the members of the design team. Assembly division. n n Redesign the assembly process. Reduce the number of parts by increasing the number of pre-assembled modules or components.

Tear Down Analysis Reverse engineering. A process of evaluating a competitor’s product to identify opportunities for product improvement. The competitor’s product is taken apart piece by piece to identify the product’s functionality and design and to make inferences about the process that made the product.

Tear Down Analysis Provides insights into the cost of the product. Suggests the relative advantages or disadvantages of the competitor’s approach to product design. Benchmarking-compare the tentative product design with the designs of competitors.

Quality Function Deployment QFD is a management tool developed during the 1970 in Japan’s Kobe’s shipyards. Provides a structure to identify customer requirements – a key input into the target costing process.

Quality Function Deployment Organizations use QFD to identify what customers want from a product before the product design is undertaken. The process then compares what the customer wants with how the design team proposes to satisfy those requirements. QFD supports the process of value engineering.

Value Engineering A team based, systematic value analysis. To evaluate a product’s design in order to identify alternatives that will improve the product’s value. n The ratio of functionality to cost.

Value Engineering Hold functionality constant and reduce cost. Hold cost constant and increase functionality. Looks at all of the product’s elements including. n n the raw materials. the manufacturing process. the type of labor and equipment used. the balance between purchased and selfmanufactured components.

Value Engineering. Two Alternatives Identify improved product designs that reduce component and manufacturing cost while not sacrificing functionality. Eliminating unnecessary functions that increase the product’s cost and complexity.

Value Engineering. Two Alternatives Identify improved product designs that reduce component and manufacturing cost while not sacrificing functionality. Eliminating unnecessary functions that increase the product’s cost and complexity.

Reengineering The tear-down and value-engineering approaches focus mainly on the product design. Another critical element in determining the cost of a product is the process. Reengineering is the activity of redesigning a planned or existing process. Is driven by the desire to improve a product’s cost or quality attributes.

Kaizen Costing Operating the process in the most efficient way. Focuses organization’s attention on things that managers or operators of an existing system can do to reduce costs.

Kaizen Costing Target costing. n n Planners use before the product is in production. Driven by customer consideration. Kaizen costing. n n Operations personnel use when the product is in production. Driven by periodic profitability targets set internally by senior management. Similar – targets drive both.

Kaizen Costing Incremental improvements to the current production process or product design. n n Developing improved setup processes. Improving machine performance to reduce waste. Increasing employee training and motivation to encourage employees to identify and implement the incremental daily changes that can improve cost and quality performance. Focus on process not the product itself.

ABC and Target Costing Japanese target-costing processes focus on saving in materials, labor, assembly, and machining costs, the unit level cost drivers in traditional cost systems.

ABC and Target Costing As the focus of target costing extends beyond direct manufacturing costs to include supplier, distribution and customer relationships, the capabilities of the total or ABC cost model should enable an integration between ABC and target costing.

ABC and Target Costing Integrating ABC and target costing designers can make trade-offs between direct and indirect costs that are impossible with only target costing or with a combination of target and traditional costing.

ABC and Target Costing Some western firms are already using ABC for target costing purposes. An electronic assembler of data communication devices incorporated its manufacturing ABC model into its target -costing process. n n Selection of electronic components. Packaging materials.

ABC and Target Costing In general, ABC works very compatibly with target costing. The ABC gives product designers and developers a model of manufacturing support costs that enables them to balance the functionality and quality of the final product with economics-based decisions about component selection and design characteristics.

Operational Activity-based Management Drives the process of reengineering. Maps out the steps or activities in an existing or proposed process. n n Process mapping. Flowcharting. Planners then look for opportunities to reduce cost by eliminating factors that cause delay or waste in the planned process design.

Operational Activity-based Management Activities that consume resources without adding functionality to the product that the customer values are called nonvalue-added activies. Moving, storing, and inspecting are all activities that cause delay or waste in the manufacturing process while consuming resources.

Operational Activity-based Management A product or process redesign that eliminate the need for non-value-added activities will reduce costs and cycle time and often will increase product quality.

Operational Activity-based Management - Steps 1. Chart the process to identify each activity. 2. Identify the cost of each activity. 3. Identify opportunities for improvement. Reengineering to eliminate the need for non value-added activities and. Continuous improvement to improve the performance of value-added activities.

Operational Activity-based Management - Steps 4. Set priorities for improvement. 5. Provide the financial justification (business plan) for reengineering efforts. 6. Identify what need to be done to eliminate or otherwise reduce the activity’s cost. 7. Make the required changes. 8. Track the benefits to compare them with the costs.

Life Cycle Costing Process of estimating and accumulating costs over a product’s entire life. Important in environments in which there are. n n large planning and development costs (developing a new jetliner). Large product abandonment costs (decommissioning a nuclear generating facility).

Life Cycle Costing- 3 Purposes 1. Helps to develop a sense of the toal costs associated with a product in order to identify whether the profits earned during the active, manufacturing phase will cover the costs in the development and decommissioning phase.

Life Cycle Costing- 3 Purposes It will identifies products that are no longer profitable when their decommissioning costs are factored into the product evaluation process.

Life Cycle Costing- 3 Purposes 2. Because of its comprehensive consideration of costs, it will identify a product’s environmental cost consequences and will spur action to reduce or eliminate those costs.

Life Cycle Costing- 3 Purposes 3. It helps to identify the planning and decommission costs during the product and process design phase in order to control and manage costs in that phase.

Life Cycle Costing A comprehensive accounting of a product’s costs, n n both manufacturing and environment. From cradle to grave. To help decision makers understand the cost consequences of making that product and to identify areas in which cost reduction efforts are both desirable and effective.

Quality Cost Approaches to monitor and control the cost of quality. Four types of quality costs.

Quality Cost –Prevention Costs Prevention costs – the costs of preventing quality problems. n n n Cost of designing improved processes that reduce quality failure. Employee training. Supplier training.

Quality Cost – Appraisal Costs Appraisal costs – the costs of finding quality problems. n The cost of the equipment and personnel who perform quality checks on work in process.

Quality Cost – Internal Failure Costs Internal failure costs The costs of fixing quality problems that are found when the product is still in the manufacturer’s hands n n Out of pocket and opportunity Personnel and materials and machine time used to rework the product into a saleable condition

Quality Cost – External Failure Costs External failure costs. The costs of fixing quality problems that are found when the product is in the hands of the consumer. n n n Warranty-related costs. Profits on sales lost when the organization’s image is damaged by quality problems. Costs of lawsuits prompted by product failure.

Quality Cost To manage the total cost of quality Percentage of sales To provide a shifting standard as sales level rise or fall To invest in preventing and finding quality problems as long as the cost incurred is less than the cost of fixing quality problems that would other wise occur.

Taguchi Cost Japanese academic approach. Output failing to meet the target value of the characteristic creates quality losses. Quality losses increase quadratically with the deviation from the target characteristic. Prefers choice with smaller variance.

Environmental, Salvage and Disposal Costs Rapid rise in environmental costs. Chemical industry- normal for a firm to spend greater than a billion on environmental costs. Old emphasis- Accept environmental costs as an inevitable part of doing business

Environmental, Salvage and Disposal Costs Old emphasis-. Accept environmental costs as an inevitable part of doing business. New emphasis-. With appropriate management to reduce business-related environmental costs.

Managing Environmental Costs Develop detailed cost records that attribute environmental costs to activities and ultimately to products. In order to identify the processes and products that create environmental costs.

Managing Environmental Costs Reduce or eliminate the drivers of environmental costs. Base part of incentive compensation on steps employees have taken to reduce environmental costs. n Bonuses based on measures of environmental performance (level of waste discharged).

Managing Environmental Costs Effects of recognizing and accounting for environmental costs are to Provide an accurate picture of product profitability n Currently charged to corporate overhead, obscuring the nature and source of these costs.

Managing Environmental Costs Focus attention on developing products that have lower decommissioning and take-back costs. n By identifying the magnitude of these costs. Increase efforts to recycle or otherwise remanufacture existing product waste.