Strategic Cost Management in the Product Life Cycle

2. Chapter 10 Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Long-Term Pricing

3. Learning Objectives • Explain how to use target costing to facilitate strategic management • Apply the theory of constraints to strategic management • Describe how life-cycle costing facilitates strategic management • Outline the objectives and techniques of long-term pricing

4. Definitions Thecost life cycleis the sequence of activities within the firm that begins with research and development followed by design, manufacturing (or providing the service), marketing/distribution, and customer service. The sales life cycleis the sequence of phases in the product’s or service’s life in the market from the introduction of the product or service to the market, the growth in sales, and finally maturity, decline, and withdrawal from the market.

5. The Cost Life Cycle of a Product or Service R&D Design Manu- facturing Marketing and Distribution Customer Service Upstream Activities Downstream Activities

6. The Sales Life Cycle of aProduct or Service (Exhibit 10.2) Important strategic cost management issues arise in each activity of the life cycle. Sales Growth Maturity Decline Introduction Time

7. Learning Objective One Explain how to use target costing to facilitate strategic management

8. Target Costing Target cost = Competitive price – Desired profit A firm has two options for reducing costs to a target cost level: By integrate new manufacturing technology, using advanced cost management techniques such as activity-based costs, and seeking higher productivity. By redesigning the product or service.

9. Target Costing R&D Design Manu- facturing Marketing and Distribution Customer Service Lower cost design is a definite goal that appears to be achievable and often motivates employees. Target Costing

10. Five Steps in Implementing aTarget Costing Approach • Determine the market price. • Determine the desired profit. • Calculate a target cost at market price less desired profit. • Use value engineering to identify ways to reduce product cost. • Use kaizen costing and operational control to further reduce cost.

11. Definition Value engineeringis used in target costing to reduce product cost by analyzing the trade-offs between different types of product functionality (different types of product features) and total product costs.

12. Value Engineering Functional Analysis Examine each major function or feature for value/cost Design Analysis • Try and analyze different designs • Reduce the number of parts • Use standard parts • Increase modularity and subassemblies Cost Tables Are computer-based databases that include comprehensive information about the firm’s cost drivers

13. Value Engineering • Value engineering begins with consumer analysis performed during the design stage of the new or revised product. • Benchmarking is used to determine which features give the firm a competitive advantage.

14. Target Costing and Kaizen Costing • Kaizen, which means “continual improvement,” costing occurs at the manufacturing stage. • The role for cost reduction at this phase is to develop new manufacturing methods and to use new management techniques such as operations control, total quality management, and the theory of constraints.

15. Learning Objective Two Apply the theory of constraints to strategic management

16. Manufacturing Cycle Efficiency The ratio of processing timeto total cycle time The Theory of Constraints Constraints are those activities that slow a product’s total cycle time. The amount of time between the receipt of a customer order and the shipment of the order.

17. Steps in The Theory ofConstraints Analysis • Identify the constraints. • Determine the most profitable product mix given the constraint. • Maximize the flow through the constraint. • Add capacity to the constraint. • Redesign the manufacturing process for flexibility and fast cycle time.

18. Flow Diagram for HPI, Inc. (Exhibit 10.7) ElectronicComponents Price = $300 ComputerChip Price = $450 ElectronicComponents Price = $300 Test and Program 30 min. AssembleEarpiece 130 min. AssembleEarpiece 110 min. Install OtherElectronics 40 min. Install OtherElectronics 40 min. 1st Assemblyand Test 30 min. Last Assemblyand Test 60 min. Pack andShip 25 min. Pack andShip 25 min. HPI-2 HPI-3

19. Maximize Flow Through the Constraints • Simplify the operation: • simplify the product design • simplify the manufacturing process • Look for quality defects in raw materials that might be slowing things down. • Reduce set-up time. • Reduce other delays due to unscheduled and non-value-added activities, such as inspections, machine break-downs, etc. • Simplify the constraint by removing all activities from the constraint that will not reduce the function of the operation.

20. Drum-Buffer-Rope Systemfor Production Flow Management Electronic Components and Computer Chips Process 1: Assemble the Earpiece Process 2: Test and Program Computer Chips Process 3: Install Other Electronics Rope Small amount of Work in Process Inventory Buffer Drum Process 4: Final Assembly and Test Process 5: Packing and Labeling the Shipment Finished Goods

21. Comparison of the TOC &Costing Methods Main Objective TOCABC Short-term focus; throughput margin analysis based on materials and materials-related costs Long-term focus; analysis of all product costs; including materials, labor and overhead

22. Comparison of the TOC & Costing Methods (continued) Comparison of the TOC &Costing Methods Resource Constraints and Capacities TOCABC Included explicitly; a principal focus of TOC Not included explicitly

23. Comparison of the TOC & Costing Methods (continued) Comparison of the TOC &Costing Methods Cost Drivers TOCABC No direct utilization of cost drivers. Develop an understanding of cost drivers at the unit, batch, product and facility levels

24. Comparison of the TOC & Costing Methods (continued) Comparison of the TOC &Costing Methods Major Use TOCABC Optimization of production flow and short-term product mix Strategic pricing and profit planning

25. Learning Objective Three Describe how life-cycle costing facilitates strategic management

26. Life-Cycle Costing R&D Design Manu- facturing Marketing and Distribution Customer Service Upstream Activities Downstream Activities LIFE CYCLE COSTING

27. Life-Cycle Costing Upstream Costs: Research and development Design: prototyping, testing, concurrent engineering, quality development Manufacturing Costs: Purchasing Direct manufacturing costs Indirect manufacturing costs Downstream Costs: Marketing and distribution-- packaging, shipping, samples. promotion, advertising Service and warranty--recalls, service product liability, customer support

28. Critical Success Factors atthe Design Stage • Reduce time-to-market • Reduce expected service costs • Improve ease-of-manufacture • Process planning and design

29. Value Chain Showing Upstream and Downstream Linkages (Exhibit 10.13) Design Not Easy to Manufacture Poor Design Marketing & Distribution Manufacturing Poor Quality Rush, Small Orders Improper Training, Installation Poor Quality Service & Warranty

30. Characteristics of the Four Design Methods (Exhibit 10.14)

31. ADI-1Appears More Profitable Incomplete Analysis Life-Cycle Costing in a Software Firm (Exhibit 10.15)

32. Complete Analysis Life-Cycle Costing in a Software Firm (Exhibit 10.16)

33. Learning Objective Four Outline the objectives and techniques of long-term pricing

34. Sales Life Cycle and Strategic Pricing There is little competition, and sales rise slowing as customers become aware of the new product or service. R&D and capital costs are high and product variety is limited. Introduction Sales Time

35. Sales Life Cycle and Strategic Pricing Sales begin to grow rapidly and product variety increases. There is increasing competition and prices begin to soften. Growth Sales Time

36. Sales Life Cycle and Strategic Pricing Sales increase but at a decreasing rate. Prices soften further, and differentiation is no longer important. Maturity Sales Time

37. Sales Life Cycle and Strategic Pricing Sales decline, as do the number of competitors. Cost control and effective distribution are keys to survival. Decline Sales Time

38. Pricing Example Manufacturing Cost: Materials $ 40 Labor 50 Batch level costs 20 Other plant overhead 40 Total manufacturing costs $150 Selling and administrative costs $ 25

39. Full Manufacturing Cost Plus Markup Suppose a firm uses a markup rate of 40 percent on full manufacturing costs. Price = $150 x (100% + 40%) = $210

40. Life-Cycle Cost plus Markup Suppose a firm uses a markup rate of 25 percent on life cycle costs. Price = ($150 + $25) x (100% + 25%) = $218.75

41. Full Manufacturing Costs & Desired Gross Margin Percentage Suppose a firm wants the desired gross margin to be 30 percent of sales. Price = Full Manufacturing Costs / (1 - Desired GM%) = $150 / (1.00 - 0.3) = $214.29

42. Life Cycle Costs & Desired Gross Margin Percentage Suppose a firm wants the desired percentage return on life-cycle costs to be 15 percent. Price = Full life-cycle costs / (1 - Desired life-cycle margin%) = $175 / (1.00 - 0.15) = $205.88

43. The Sales Life Cycle for a Manufacturer of Computer Processors

44. End of Chapter Ten