Chapter 5

Life Cycle Costing, Target Pricing And Theory of Constraints

Introduction:
This chapter focuses on the time dimension of cost management. Consideration is given both to
(1) the effect of the timeliness of operations on total costs and (2) the way in which costs change
over the life cycle of the product.

Specific Objectives:

At the end of the lesson, the students should be able to:

• Describe the concepts of cost life cycle and sales life cycle.
• Describe target costing and how it is applied in the cost life cycle.
• Describe the concept of Theory of Constraints

Duration: 4 hours (Lecture/Discussion/Problem Solving)

Lesson Proper

Product Life Cycle

A product life cycle is the length of time from a product first introduced to consumers until
it is removed from the market. It is usually broken down into four stages:
1) Introduction- when the product is introduced and struggles to gain brand recognition.

2) Growth-advertising and word of mouth helps to increase sales of the product

3) Maturity-when the product reaches peak market penetration

4) Decline- the product gets eclipsed by new products

Two Aspects of the Product Life Cycle

1) Cost Life Cycle- sequence of activities within the firm that begin with research and
development, followed by design, manufacturing, marketing/distribution and customer
service.

2) Sales life cycle – the sequence of phases in the product’s or service’s life in the market
(from the introduction of the product or service to growth in sales and finally maturity,
decline and withdrawal from the market).

Life Cycle Costing

It is a system that tracks and accumulates the actual costs and revenues attributable to cost
objects from its invention to to its abandonment. Life cycle costing involves tracing cost
and revenues on a product by product base over several calendar years.

Characteristics of Life Cycle Costing

 1) Product life cycle costing involves tracing of costs and revenues of a product over
several calendar periods throughout its life cycle.
2) Product life cycle costing traces research and design and development costs and total
magnitude of these costs for each individual product and compared with product
revenue.
3) Each phase of the product life cycle poses different threats and opportunities that may
require strategic actions.
4) Product life cycle may be extended by finding new uses or users or by increasing the
consumption of the present users.

Stages of Product Life Cycle Costing

1) Market research-
It will establish what product the customer wants, how much he is prepared to pay
for it and how many he will buy.

2) Specification-
It will give details such as required life, maximum permissible maintenance costs,
manufacturing costs, required delivery date, and expected performance of the
product.
3) Design-
Proper drawings and process schedules are to be defined.

4) Prototype Maintenance-
From the drawings, a small quantity of the product will be manufactured. These
prototypes will be used to develop the product.

5) Development-
Testing and changing to meet requirements after the initial run. When a product is
made for the first time, it rarely meets the requirements of the specification and
changes have to be made until it meets the requirement.

6) Tooling-
Tooling up for production can mean building a production line ( building jigs,
buying the necessary tools and equipment).

7) Manufacture-
The manufacture of a product involves the purchase of raw materials and
components, the use of labor and manufacturing expenses to make the product.

8) Selling
9) Distribution
10) Product support
11) Decommissioning-
When manufacture of a product comes to an end, the plant used to build the product
must be sold or scrapped.
 Note: Nos. 1 to 6- Upstream costs
Nos. 8-11- Downstream costs

Why Design is Important

Decision making at the design stage is critical. Although the costs involved at the design
stage may be vey small in relation to the total costs over the entire life cycle, the design stage
decisions are important because they lock in most of the remaining life cycle costs.

Common Design Models and their Characteristics

1) Basic engineering- this is a method wherein product designers work independently
from marketing and manufacturing to develop a design from specific plan and
specifications.

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

3) Templating- a method in which an existing product is scaled up or down to fit the

specifications of the desired new product.

4) Concurrent engineering-also called simultaneous engineering. It is a new approach in

which product design is integrated with manufacturing and marketing throughout the
product’s life.

Design Method Design Speed Design Cost Effect on

Downstream Costs
Basic engineering Fast Depends on desired Can be very high, as
complexity and marketing and
functionality; should production are not
be relatively low. integral to the design
process.
Prototyping Slow Significant; labor, Potentially a
materials and time significant reduction
in downstream costs
Templating Fast Modest Unknown; can have
costly unexpected
results if the scaling
does not work in the
market or in
production
Concurrent Continuous Significant; design is The best method for
engineering an integral, ongoing reducing
process downstream costs.

TARGET COSTING-
It is an approach to determine to determine a product’s life cycle cost which should be
sufficient to develop a specified functionality and quality, while ensuring its desired profit. It
involves setting a target cost by subtracting a desired profit from a competitive market price.

Target Cost= Competitive Price- Desired Profit

Steps in Implementing a Target Cost Approach

1) Determine the market price.
2) Determine the desired profit.
3) Calculate the target cost at market price less desired profit.
4) Use value engineering to identify ways to reduce product cost.
In an article published by the Chartered Institute of Management Accountants,
lecturer Norwood Whittle claims that value engineering allows a company to
reduce costs, improve quality and increase sales. Lower costs in turn give a
company additional operational flexibility, such as the ability to lower selling prices
during downturns or to absorb higher labor and material costs. Controlling costs at
all stages of the production process helps a business achieve its target cost and gain
a competitive advantage.

5) Use Kaizen costing and operational control to further reduce costs.

Target costing is a market driven system of cost reduction, focused on managing
costs at the development and design stages of a product. Kaizen costing relies on
setting cost reduction targets and attaining the targets through continuous
improvement activities in the manufacturing phase.

Theory of Constraints (TOC)

As discussed in Chapter 2, TOC is a methodology for identifying the most
important limiting factor (i.e. , constraint) that stands in the way of achieving a
goal, and then systematically improving that constraint until it is no longer the
limiting factor. In manufacturing, the constraint is often referred to as bottleneck.

In contrast to target costing which focuses on the early stages of product life cycle,
the TOC focuses on manufacturing activity. This theory focuses the manager’s
attention on the bottlenecks that slow the production process.

Manufacturing and distribution processes that do not affect throughput (the

number of units that pass through a process during a period of time) are non
binding constraints that less receive less attention than bottlenecks or binding
constraints.

Steps in the TOC Analysis

1) Identify– identify the single part of the process that limits the rate at which the goal is
achieved.

2) Exploit – make quick improvements to the throughput of the constraint using existing
resources (i.e., making the most of what you have).
 3) Subordinate- review all other activities in the process to ensure that they are aligned
with and truly support the needs of the constraint. An important tool for managing
product flow in this context is the drum-buffer-rope (DBR)* system, which balances
the flow of production through the binding constraint.

4) Elevate- if the constraint still exists (i.e. it has not moved), consider what further
actions can be taken to eliminate it from being the constraint. Normally, actions are
continued at this step until the constraint has been “broken” (until it has moved
somewhere else). In some cases, capital investment may be required.

5) Repeat – the five focusing steps are a continuous improvement cycle. Therefore, once
a constraint is resolved, the next constraint should immediately be addressed. This step
is a reminder to never become complacent – aggressively remove the current
constraint-, and then immediately move on to the next constraint.

*Drum-buffer-role system- a method of synchronizing production to the constraint while

minimizing inventory and work in process.

The “Drum” is the constraint. The speed at which the constraint runs sets the “beat” for the
process and determines total throughput.

The “Buffer” is the level of inventory needed to maintain consistent production. Buffer
represents time, the amount of time (usually in hours) what WIP should arrive in advance
of being used to ensure steady production.

The “Rope” is a signal generated by the constraint indicating that some amount of
inventory has been consumed. This in turn triggers an identically sized release of inventory
into the process. The role of the rope is to maintain throughput without creating an
accumulation of excess inventory.

Activity
Discussion of exercises/problems in Ch. 8, Strategic Cost Management, 2021 edition, Ma. Elenita
B.Cabrera.