Cost Based Decision

Making
Dr. Nancy Mangold
California State University, East
Bay

3 Managerial Use of Cost

Information
Product and customer decisions:

Whether to make or abandon a product

Influence the nature of customer
relationships

Develop a cost basis for a price

Identify opportunities to improve
product or process design and
process operation

Product Life Cycle3 Broad

Phases
The planning
phase
The manufacturing phase
The service and abandonment
phase

Life Cycle Costing

Used predominately in the
planning phase
It attempts to estimate the the
products 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
products 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 products 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 products 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 products future
manufacturing costs.

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

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

Two Critical Elements

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

Target Costing Process

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

Market-Driven Costing
Starts by identifying the target selling
price- the products anticipated price
when launched.
The price must reflect.

the perceived value of the product in the eyes

of the customer,
the anticipated relative functionality.
the selling price of competitive offering.
the firms strategic objectives for the product.

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

Market-Driven Costing
Setting a target profit margin.

Historical profit margins for replacement

of existing products adjusted for unusual
costs at the front end (R&D) or back end
(salvage or disposal).

Calculate an allowable cost by

subtracting the target profit margin
from the target selling price.

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

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

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

Product-Level Target
Costing
Achievable.
Expend considerable effort during
the design process.

Value engineering.
Quality function deployment.
Design for manufacture and assembly.
Target costs set properly, should be
achieved 80% of time.

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

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

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

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

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

Chained Target Costing

The output of the buyers target-costing
system becomes the input to the suppliers
target-costing system.
The buyers component-level target costs
become the suppliers target selling prices.
The suppliers target-costing system
develops both product-level and componentlevel target costs, thus transmitting the
buyers competitive pressure to the
suppliers product designers.

Chained Target Costing

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

Chained Target Costing

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

Major Strength One

Team Concurrent Design
Team environment
Cross functional team members:

Design engineer
Process engineer
Purchasing
Manufacturing
Marketing

Major Strength One

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

Major Strength One

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

Major Strength One

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

Major Strength One

Team Concurrent Design
Reduces product development
time and cost by reducing required
designed changes

Major Strength One

Team Concurrent Design
Each subgroup within the team is
assigned cost reduction targets that is
expected to meet in order to achieve
the teams 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 products cost.

Suppliers on Design Team

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

Suppliers on Design Team

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

Suppliers on Design Team

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

Chrysler Approach
Chrysler to avoid this by
Drop poorly performing suppliers
Performance based on cost savings
resulting either from

design proposals
Manufacturing process improvements
Quality
On-time delivery

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

Target Costing in ActionToyota Motors

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

Target Costing in ActionToyota 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
products life cycle to determine the
total product revenue.

Target Costing in ActionToyota Motors

Estimate the cost of the new product.
Estimated by adding.

The cost base of the existing product.

The incremental costs of the design
changes associated with the new
product.
Compares revenues and costs to
compute an estimated margin.

Target Costing in ActionToyota Motors

A margin that fails to achieve the
target return on costs needed to
provide an appropriate return on
investment triggers a redesign
process.

Toyota Motors Redesign

Process
Compute the required cost reduction.
The leader of the design team then
distributes this target cost reduction
among the members of the design team.
Assembly division.

Redesign the assembly process.

Reduce the number of parts by increasing
the number of pre-assembled modules or
components.

Tear Down Analysis

Reverse engineering.
A process of evaluating a competitors
product to identify opportunities for
product improvement.
The competitors product is taken apart
piece by piece to identify the products
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 competitors
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
Japans Kobes 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 products design in
order to identify alternatives that
will improve the products value.

The ratio of functionality to cost.

Value Engineering
Hold functionality constant and reduce cost.
Hold cost constant and increase functionality.
Looks at all of the products elements
including.

the raw materials.

the manufacturing process.
the type of labor and equipment used.
the balance between purchased and selfmanufactured components.

Value EngineeringTwo Alternatives

Identify improved product designs
that reduce component and
manufacturing cost while not
sacrificing functionality.
Eliminating unnecessary functions
that increase the products cost
and complexity.

Value EngineeringTwo Alternatives

Identify improved product designs
that reduce component and
manufacturing cost while not
sacrificing functionality.
Eliminating unnecessary functions
that increase the products cost
and complexity.

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

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

Kaizen Costing
Target costing.

Planners use before the product is in production.

Driven by customer consideration.

Kaizen costing.

Operations personnel use when the product is in

production.
Driven by periodic profitability targets set
internally by senior management.

Similar targets drive both.

Kaizen Costing
Incremental improvements to the current
production process or product design.

Developing improved setup processes.

Improving machine performance to reduce
waste.
Increasing employee training and motivation
to encourage employees to identify and
implement the incremental daily changes that
can improve cost and quality performance.
Focus on process not the product itself.

ABC and Target Costing

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

ABC and Target Costing

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

ABC and Target Costing

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

ABC and Target Costing

Some western firms are already using
ABC for target costing purposes.
An electronic assembler of data
communication devices incorporated
its manufacturing ABC model into its
target-costing process.

Selection of electronic components.

Packaging materials.

ABC and Target Costing

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

Operational Activity-based
Management
Drives the process of reengineering.
Maps out the steps or activities in an
existing or proposed process.

Process mapping.
Flowcharting.

Planners then look for opportunities to

reduce cost by eliminating factors that
cause delay or waste in the planned
process design.

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

Operational Activity-based
Management
A product or process redesign that
eliminate the need for non-valueadded 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
activitys 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 products
entire life.
Important in environments in which
there are.

large planning and development costs

(developing a new jetliner).
Large product abandonment costs
(decommissioning a nuclear generating
facility).

Life Cycle Costing- 3

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

Life Cycle Costing- 3

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

Life Cycle Costing- 3

Purposes
2. Because of its comprehensive
consideration of costs, it will
identify a products
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
products costs,

both manufacturing and environment.

From cradle to grave.

To help decision makers understand

the cost consequences of making that
product and to identify areas in which
cost reduction efforts are both
desirable and effective.

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

Quality Cost Prevention

Costs
Prevention costs the costs of
preventing quality problems.

Cost of designing improved processes

that reduce quality failure.
Employee training.
Supplier training.

Quality Cost Appraisal

Costs
Appraisal costs the costs of
finding quality problems.

The cost of the equipment and

personnel who perform quality checks
on work in process.

Quality Cost
Internal Failure Costs
Internal failure costs
The costs of fixing quality problems
that are found when the product is
still in the manufacturers hands

Out of pocket and opportunity

Personnel and materials and machine
time used to rework the product into a
saleable condition

Quality Cost
External Failure Costs
External failure costs.
The costs of fixing quality problems that
are found when the product is in the
hands of the consumer.

Warranty-related costs.
Profits on sales lost when the organizations
image is damaged by quality problems.
Costs of lawsuits prompted by product
failure.

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

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

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

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

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

Managing Environmental
Costs
Reduce or eliminate the drivers of
environmental costs.
Base part of incentive compensation
on steps employees have taken to
reduce environmental costs.

Bonuses based on measures of

environmental performance (level of
waste discharged).

Managing Environmental
Costs
Effects of recognizing and
accounting for environmental costs
are to
Provide an accurate picture of
product profitability

Currently charged to corporate

overhead, obscuring the nature and
source of these costs.

Managing Environmental
Costs
Focus attention on developing
products that have lower
decommissioning and take-back costs.

By identifying the magnitude of these

costs.

Increase efforts to recycle or otherwise

remanufacture existing product waste.