Cost Based Decision Making

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

2. 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

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

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

5. 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.

6. Kaizen Costing • Identify opportunities for cost improvement during the manufacturing cycle

7. 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

8. 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

9. 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.

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

11. 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)

12. 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.

13. 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.

14. Market-Driven Costing • Starts by identifying the target selling price- the product’s 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 firm’s strategic objectives for the product.

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

16. 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.

17. 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.

18. 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.

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

20. 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.

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

22. 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.

23. 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.

24. 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.

25. 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 (high-performance engine).

26. 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.

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

28. 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.

29. 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.

30. 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.

31. 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.

32. 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.

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

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

35. 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

36. 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)

37. 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

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

39. 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.

40. 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.

41. 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.

42. 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

43. 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

44. 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

45. 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.

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

47. 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.

48. Target Costing in Action-Toyota 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.

49. 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.

50. 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.