STRATEGIC COST MANAGEMENT

CHAPTER 8

COST PLANNING FOR PRODUCT LIFE-CYCLE:

LIFE-CYCLE COSTING AND LONG-TERM PRICING; TARGET COSTING AND

THEORY OF CONSTRAINTS

At the introduction and into the growth phases, the primary need is for value chain
analysis, to guide the design of products in a cost-efficient manner. Master budgets
are also used in these early phases to manage cash flows; there are large
developmental Costs at a time when sales revenues are still relatively small.
Then, as the strategy shifts to cost leadership in the latter phases, the
goal of the cost management system is to provide the detailed budgets and activity-
based costing tools for accurate cost information.

Life-cycle costing

- considers the entire cost life cycle of the product and thus provides a more
complete perspective of product costs and product profitability. It is used to manage
the total costs of the product, across its entire life cycle. For example, design and
development costs may be increased in order to decrease manufacturing costs and
service costs later in the life cycle.
Life-cycle costing

- is most appropriate for firms which have high upstream costs (i.e.
design and/development) and downstream costs (i.e. Distribution and service
costs). Firms with high upstream and downstream costs need manage the entire
life cycle of costs, including the upstream and downstream costs as well as
manufacturing costs. Traditional cost management methods tend focus on
manufacturing costs only, and for these firms, this approach would ignore a
significant portion of the total costs.

The methods of product engineering and design in life-cycle costing are:

Basic engineering

- is the method in which product designer’s work independently from marketing

and manufacturing to develop a design from specific plans and specifications.
Prototyping

-is a method in which functional models of the product are developed and
tested by engineers and trial customers.

Templating

-is a design method in which an existing product is scaled up or down to fit the
specifications of the desired new product.

Concurrent engineering, or "simultaneous" engineering

- is an important new approach in which product design is integrated with

manufacturing and marketing and throughout the product's life cycle.

Sales Life Cycle

- refers to the phase of the product's sales in the market—from introduction of

the product to decline and withdrawal from the market. In contrast, the cost life cycle
refers to the activities and costs incurred in developing a product, designing it,
manufacturing it, selling it and servicing it.
Sales life-cycle analysis is used help a firm develop and implement its strategy for
success as its products and services mature in the market place. The
focus for new products is typically differentiation and there is a heavy
focus on research and development, while cost control becomes more
important as the product matures. In contrast, life-cycle costing is used to manage the
costs of the product over its entire cost life cycle—from research and
development and product testing to manufacturing and finally distribution and
customer service.

The phases of the sales life cycle are:

Phase One: Product Introduction. In the first phase there is little

competition, and sales rise slowly as customers become aware of the new product.
Costs are relatively high because of high R&D expenditures and capital costs for
setting up production facilities and marketing efforts. Prices are relatively high
because of product differentiation and the high costs at this phase.

Phase Two: Growth. Sales begin to grow rapidly and product variety
increases. The product continues to enjoy the benefits of differentiation. There is
increasing competition and prices begin to soften.

Phase Three: Maturity. Sales continue to increase but at a decreasing rate. There is a
reduction in the number of competitors and of product variety. Prices soften further,
and differentiation is no longer important. Competition is based on cost, given
competitive quality and functionality.

Phase Four: Decline. Sales begin to decline, as does the number of competitors. Prices
stabilize. Emphasis on differentiation returns. Survivors are able to
differentiate their product, control costs, and deliver quality and excellent
service. Control of costs and an effective distribution network are key to
continued survival.

The Strategic Pricing Approach

-changes over the sales life cycle of the product. In the first phase, pricing is
set relatively high to recover development costs and to take advantage of
product differentiation and the new demand for the product. In the second phase,
pricing is likely to stay relatively high as the firm attempts to build profitability in the
growing market.

Alternatively, to maintain or increase market share at this time, relatively low prices
("penetration pricing") might be used. In the latter phases, pricing becomes more
competitive, and target costing and life-cycle costing methods are used, as the firm
becomes more of a price taker rather than a price setter, and efforts are made to
reduce upstream (for product enhancements) and downstream costs.

Target costing

-is a method by which the firm determines the desired cost for the product,
given a competitive market price, so that the firm can earn a desired
profit. It is used by several manufacturing firms, particularly in the automotive
and consumer products industries, such as Honda, Toyota, Ford, Volkswagen, and
Kodak camera.
Target costing is most appropriate for firms that are in a very competitive industry,
so that the firms in the industry compete simultaneously on price, quality and product
functionality. In very competitive markets such as this, target costing is
used to determine the desired level of functionality the firm can offer for the
product while maintaining high quality and meeting the competitive price.

Value engineering

- is used in target costing to reduce product cost by analyzing the

tradeoffs between different types and levels of product functionality and total product
cost.

Two common forms of value engineering are:

 Design analysis is a process where the design team prepares several possible
designs of the product, each having similar features but different levels of
performance on these features and different costs.
 Functional analysis is a process where each major function or
feature of the product is examined in terms of its performance and cost.

The firm has two options for reducing costs to a target cost level:

a. Reduce costs to a target cost level by integrating new manufacturing

technology, using advanced cost management techniques such as activity-based
costing, and seeking higher productivity through improved organization and
labor relations. This method of cost reduction is common in specialized
equipment manufacturing.

b. Reduce cost to a target cost level by redesigning a popular product. This

method is the more common of the two, because it recognizes that design decisions
account for much of total product life cycle costs. By careful attention to design,
significant reductions in total cost are possible. This approach to target
costing is associated primarily with Japanese manufacturers, especially Toyota,
which is credited with developing the method in the mid1960s. This method of cost
reduction is common in consumer electronics.
Activity-based costing (ABC)

- is used assess the profitability of products, just as TOC. The

difference is that TOC takes a short term approach profitability analysis, while ABC
develops a longer-term analysis.

The TOC analysis has a short-term focus because of its emphasis

on materials related costs only, while ABC includes all product costs. On the other
hand, unlike TOC, ABC does not explicitly include the resource constraints
and capacities of production operations. Thus, ABC cannot be used to determine
the short-term best product mix. ABC and TOC are thus complementary methods;
ABC provides a comprehensive analysis of cost driver sand accurate unit costs, as a
basis for strategic decisions about long-term pricing and product mix. In contrast,
TOC provides a useful method for improving the short-term profitability
of the manufacturing plant through short-term product mix adjustments
and through attention to production bottlenecks.

The purpose of the network diagram is to assist the management accountant in the
first step of TOC, to identify the binding and non-binding constraints.

TOC emphasizes the improvement of throughput by removing or reducing

the binding constraints, which are bottlenecks in the production process that slow
the rate of output. These are often identified as processes wherein relatively large
amounts of inventory are accumulating, or where there appear to be large lead times.

Using TOC the management accountant speeds the flow of product through the
binding constraint, and chooses the mix of product so as to maximize the profitability
of the product flow through the binding constraint. A non-binding constraint is the
opposite of a binding constraint, that means it is a process which does not result in
relatively large accumulation of inventory or where there are no large lead times.

There are five steps in TOC analysis:

Step One: Identify the Binding and Non-binding Constraints Use a network diagram.
The binding constraint is a resource that limits production to less than market
demand.
Step Two: Determine the Most Efficient Utilization of Each Binding Constraint
Product mix decision: based on capacity available at the binding constraint, find the
most profitable product mix. Maximize flow through the constraint: -reduce setups
-reduce lot sizes -focus on throughput rather than efficiency

Step Three: Manage the Flows through the Binding Constraint Drum-Buffer-Rope
concept: maintain a small amount of work-in-process (buffer) and insert materials
only when needed (drum) by the constraint, given lead times (rope). All resources are
coordinated to keep the constraint busy without a build-up of work.

Step Four: Increase capacity on the constrained resource Invest in additional capacity
if it will increase throughput greater than the cost of the investment. Do not move to
investment until steps two and three are complete, that is, maximize the productivity
of the process through the constraint with existing capacity.

Step Five: Redesign the Manufacturing Process for Flexibility and Fast Throughput
Consider a redesign of the product of production process, to achieve faster
throughput. One could argue that any step could be the most important; for example
step one can be considered to be the most important because of the analysis
undertaken is intended to improve the speed of product flow through the binding
constraint.

TOC is appropriate for many types of manufacturing, service and not-for-profit

firms. It is most useful where the product or service is prepared or
provided in a sequence of inter-related activities as can be described in a
network diagram. The most common users of TOC to date have been manufacturing
firms who use it to identify machines or steps in the production process which
are bottlenecks in the flow of product and profitability.

Multiple Choice:

1. The critical success factors for a business today are all:

a. Planning-oriented c. Sales-oriented
b. Production-oriented d. Customer-oriented
2. The Theory of Constraints (TOC) focuses on improving cycle time, the rate at
which raw materials are converted to finished product. This strategic
 management technique is primarily concerned with the critical success factor
of:
a. Energy c. Originality
b. Quality d. Speed

3. The key concept in TOC is:

a. Benchmarking c. The bottleneck
b. Throughout d. Reengineering
4. Which of the following determines the desired cost for a product bases upon
given competitive price?
a. Benchmarking c. Reengineering
b. Target Costing d. Life-cycle costing
5. Target costing forces the firm to become more competitive, like:
a. Reengineering c. Activity-based costing
b. Life-cycle costing d. Benchmarking
6. Which of the following is not one of the steps in the life cycle of a product?
a. Manufacturing, inspecting, packaging and warehousing
b. Research and Development
c. Purchasing and receiving
d. Marketing, promotion and distribution
7. In comparison to the Cost Life Cycle of a product, the Sales Life Cycle of
product is:
a. Much shorter
b. Much longer
c. Exactly parallel, except that it is expressed in sales terms.
d. Different because it represents a sequence of phases relating to sales, not
production.
8. In each of the phases of a product’s sales life cycle, management’s focus will be:
a. Parallel
b. On the next phase as well as the current one.
c. Different
d. Undifferentiated
9. Generally, firms will price a product more competitively at which stage of the
products sales life cycle?
a. Product Introduction c. Maturity
b. Growth d. Decline

10.Because of the four stages of a product’s sales life cycle has a different
emphasis, the cost management system will be expected to provide data that is:
a. Different at each stage
b. Common to all stages
c. Lesser in amount in the later stages.
d. Lesser in amount in the early stages.
11.The sequence of activities within the firm which begins with the research and
development, followed by design, and manufacturing, marketing/distribution,
and customer service is the:
a. Sales life cycle c. Market life cycle
b. Target life cycle d. Critical life cycle
12.The sequence of phases in the production or service’s life in the market-from
the introduction of the product or service to the growth in sales and finally
maturity, decline, and withdrawal from the market is fine:
a. Sales life cycle c. Market life cycle
b. Target life cycle d. Cost life cycle
13.When a firm determines the desired cost for a product or service, given a
competitive market price, in order to earn a desired profit, the firm is exercising:
a. Target costing c. Variable costing
b. Life cycle costing d. Absorption costing
14.Which of the following is used in target costing to reduce product cost by
analyzing the tradeoffs between (1) different types and levels of product
functionality and (2) total product cost?
a. Benchmarking c. Productivity analysis
b. Functional analysis d. Value engineering
15.Which one of the following is a common type of value engineering in which each
major function or feature of the product is examined in terms of its performance
and cost?
a. Benchmarking c. Productivity analysis
b. Functional analysis d. Functional engineering

16.Which of the following is a common form of value engineering in which

designing team prepares several possible designs of the product?
a. Benchmarking c. Productivity analysis
b. Functional analysis d. Design analysis
17.Which one of the following is not one of the five steps in TQC analysis?
a. Identify the binding constraint(s)
b. Determine the most efficient utilization for each binding constraint.
c. Manage the flow through the binding constraints
d. Deduct capacity from the constraint.
18.Which one of the following is true concerning TQC?

Short-Term Focus Long-Term Focus Cost Drivers

a. No No Yes
b. No Yes No
c. Yes No No
d. No Yes Yes
19.Which of the following is a downstream cost?
a. Research and development c. Purchasing
b. Packaging d. Prototyping
20.Which one of the following industries has high upstream cost?
a. Retail c. Cosmetics
b. Perfumes d. Computer software
21.Which of the following is not a critical success factor at the design stage?
a. Improved ease-of-manufacture
b. Reduced time-to-market
c. Reduced expected services costs
d. Enhanced quality
 22.Which one of the following is not a common design method?
a. Concurrent engineering c. Templating
b. Design engineering d. Prototyping
23.Sales begin to grow rapidly and product variety increases in:
a. Phase three c. Phase five
b. Phase two d. Phase four

24.Sales continue to increase but a decreasing rate is:

a. Phase three c. Phase five
b. Phase two d. Phase four
25.Sales begin to decline, as does the number of competitors, in:
a. Phase three c. Phase five
b. Phase two d. Phase four

Answer to Multiple Choice Questions

1.D 2.D

3.B 4.B

5.D 6.C

7.D 8.C

9.C 10.A

11.D 12.A

13.A 14.D

15.B 16.D

17.D 18.C

19.B 20.D

21.D 22.B

23.B 24.A

25.D
References:

 https://www.scribd.com/document/416524582/639904R1
 https://www.accaglobal.com/hk/en/student/exam-support-
resources/fundamentals-exams-study-resources/f5/technical-
articles/target-lifestyle.html
 https://www.accountingnotes.net/cost-accounting/life-cycle-
costing/life-cycle-costing-meaning-characteristics-and-everything-
else/5783
 https://www.academia.edu/25717824/CHAPTER_10_COST_PLANNING_
FOR_THE_PRODUCT_LIFE_CYCLE_TARGET_COSTING_THEORY_OF_CO
NSTRAINTS_AND_STRATEGIC_PRICING
 https://pdfcoffee.com/chapter-08-cost-planning-for-product-life-cycle--
pdf-free.html