Sol10 4e

CHAPTER 10
COST PLANNING FOR THE PRODUCT LIFE CYCLE: TARGET

COSTING, THEORY OF CONSTRAINTS,
AND STRATEGIC PRICING
QUESTIONS
10-1 A 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 (see Exhibit 10-3). 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 mid
1960s. This method of cost reduction is common in consumer electronics.
10-2 The sales life cycle refers to the phase of the products 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.
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. Product variety is limited.
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 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.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
10-1
The McGraw-Hill Companies, Inc., 2008
10-3 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 At least three factors that make sensitivity analysis prevalent
in decision making including the following price setter, and efforts are made to
reduce upstream (for product enhancements) and downstream costs.
10-4 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 (Chapter 8) 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.
10-5 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 Olympus camera.
10-6 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.
10-7 There are five steps in TOC analysis:
Step One: Identify the Constraint
Use a flow diagram. The constraint is a resource that limits production to less
than market demand.
Step Two: Determine the Most Efficient Utilization of Each Constraint
Product mix decision: based on capacity available at the 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: Maximize the Flow Through the Constraint
10-2
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 buildup 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 the analysis
undertaken is intended to improve the speed of product flow through the
constraint.
10-8 TOC emphasizes the improvement of throughput by removing or reducing the
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
constraint, and chooses the mix of product so as to maximize the profitability of
the product flow through the constraint.
10-9 The purpose of the flow diagram is to assist the management accountant in the
first step of TOC, to identify the constraints.
10-10 The methods of product engineering and design in life-cycle costing are:
Basic engineering is the method in which product designers 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 throughout the products life cycle.
10-11 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:
10-3
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.
10-12 Activity-based costing (ABC) is used to assess the profitability of products, just
as is TOC. The difference is that TOC takes a short-term approach to
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 drivers and 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.
10-13 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
such as shown in Exhibit 10-6. 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.
10-14 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.
10-15 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 to manage
the entire life cycle of costs, including the upstream and downstream costs as
well as manufacturing costs. Traditional cost management methods tend to focus
on manufacturing costs only, and for these firms, this approach would ignore a
significant portion of the total costs.
10-4
10-16 Strategic pricing is used to 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.
10-17 Takt time is the ratio of available manufacturing time for a period to the units of
customer demand for that period. Each unit must be produced within the Takt
time to satisfy customer demand. Takt time is computed for each manufacturing
operation, and those operations with longer Takt times are the constraints in the
manufacturing process.
10-18 Pricing based on the cost life cycle is a common form of pricing. It involves a
markup on full product cost or product life cycle cost. In contrast, pricing based
on the sales life cycle bases the product price on competitive factors, including
which phase of the sales life cycle (introduction, growth, maturity, or decline) the
product is currently in.
10-5
BRIEF EXERCISES
10-19
Current profit per unit = $50 - $ 38 - $8 = $4/unit

Target total cost = $45 - $4 = $41
Target manufacturing cost = $45 - $4 - $8 = $33
10-20 Price = 1.4 x ($38) = $53.20

10-21 Price = 1.10 x ($38 + $8) = $50.60
10-22 The introduction phase
10-23
Takt time = 6,000 x 4 weeks per month/200,000 units per month = .12 hour/unit
or 7.2 minutes per unit
10-24
20 - 1 = 19 days
10-25
2 days in production (May 20-May 21)

(21-1=20 days cycle time)
10-26
Kaizen, continuous improvement
= .1
10-27 $140 - $140 x (.25) = $105
10-6
EXERCISES
10-28 Target Costing (15 min)
1. The unit cost is currently $548.60 = $13,715,000/25,000
The current profit per item is $610 - $548.60 = $61.40
Thus, the target cost to meet the competitive price is:
$550 - $61.40 = $488.60
2. The target cost can probably be achieved by efforts in two areas:
a. The standard cost analysis shows an unfavorable materials
variance of $500,000 ($7,000,000 - $6,500,000) or $20 per unit, a very
significant variance. Efforts to reduce or eliminate this variance will
make the firm much more competitive. Notice that the labor usage
variance for indirect labor is favorable, and the direct labor variance is
unfavorable. It may be that additional work is needed setting the
standards.
b. The standard cost shows an unfavorable direct labor variance
of $125,000 ($2,625,000 - $2,500,000), or $5 per unit, an opportunity
for cost savings.
c. The remaining manufacturing costs can be considered nonvalue adding costs, since they do not add to the functionality or quality
of the product. Efforts can be made to reduce the total cost of these
manufacturing costs, which now total a significant $4,090,000 or
$163.60 per unit.
10-7
10-29 Manufacturing Cycle Efficiency (10 min)

MCE = total processing time/total cycle time
= 23/(23+3+6+3+1+5+2+6+2) = 23/51 = 45%
Note that new product development time and order taking time are not
considered part of the manufacturing cycle and are excluded from
cycle time.
The level of MCE is best interpreted by reference to the prior MCE
values for the firm or to an industry average. A number closer to one
is better. When comparing to an industry average, management
should make sure that the measures are calculated in the same
manner. In this case, Waymouth has improved significantly on its
MCE relative to the prior data, and is higher than the industry average.
10-8
10-30 Takt Time (10 min)

1. The takt time for this product is the number of available hours / total
demand.
Total manufacturing time = 70hr x 60 min x 60 sec = 252,000 seconds
8,400
8,400
= 252,000
84,000
= 30 seconds per unit
2. The processing line is not properly balanced. Operation 2 exceeds takt

time by 4 sec. and Operation 3s time is somewhat less than takt time. To
balance the line, so that products can be expected to come off the line every
30 seconds as needed, the capacity of operation 2 should be increased so
that it could speed up its operation. Similarly, operation 3 could reduce
capacity and resources to save money; we do not need this operation to
move so fast.
3. The strategic role of takt time is to help operations managers to balance
the operations and to improve the speed of throughput and reduce cycle
time. The management accountants role is to provide information on the
costs of processing time and capacity, and the value of increasing
throughput. TOC analysis attempts to accomplish this by maximizing the
flow through the constraints/operations.
10-9
10-31. Target Costing (30 min)

1., 2.
Cost and Activity Usage for Each Product
Direct Materials
Number of parts
Machine hours
Inspecting time
Packing time
Set-ups
Current
A-10
A-25
143.76 $
66.44
121
92
6
4
1
0.6
0.7
0.4
2
1
Revised
A-10
A25
$
78.65 $
42.45
110
81
5
2
1
0.5
0.7
0.2
1
1
Activity-based Costs
Direct Materials
Materials Handling
Mfg Supervision
Assembly
Set-ups
Inspection and Test
Packaging
Total
$
$
$
$
$
$
$
$
143.76
272.25
141.00
308.55
89.20
35.00
10.50
1,000.26
$
$
$
$
$
$
$
$
66.44
207.00
94.00
234.60
44.60
21.00
6.00
673.64
$
$
$
$
$
$
$
$
78.65
247.50
117.50
280.50
44.60
35.00
10.50
814.25
$
$
$
$
$
$
$
$
42.45
182.25
47.00
206.55
44.60
17.50
3.00
543.35
Price
Margin
$
$
1,050.00
49.74
$
$
725.00
51.36
$
$
825.00
10.75
$
$
595.00
51.65
3. The solution uses Goal Seek or trials in the Excel sheet. The number of
parts must be reduced to 101 or fewer to get at least $50 margin.
Cost and Activity Usage for Each Product
Direct Materials
Current
A-10
A-25
143.76 $
66.44
Number of parts
Machine hours
Inspecting time
Packing time
Set-ups
121
6
1
0.7
2
Revised
A-10
A-25
$
78.65 $
42.45
101
92
4
0.6
0.4
1
81
2
0.5
0.2
1
5
1
0.7
1
Activity-based Costs
Direct Materials
Materials Handling
Mfg Supervision
Assembly
Set-ups
Inspection and Test
Packaging
Total
$
$
$
$
$
$
$
$
143.76
272.25
141.00
308.55
89.20
35.00
10.50
1,000.26
$
$
$
$
$
$
$
$
66.44
207.00
94.00
234.60
44.60
21.00
6.00
673.64
$
$
$
$
$
$
$
$
78.65
227.25
117.50
257.55
44.60
35.00
10.50
771.05
$
$
$
$
$
$
$
$
42.45
182.25
47.00
206.55
44.60
17.50
3.00
543.35
Price
Margin
$
$
1,050.00
49.74
$
$
725.00
51.36
$
$
825.00
53.95
$
$
595.00
51.65
10-10
Problem 10-31 (continued)

4. Target costing should be useful to BSI to assist the firm in meeting
the new competition by finding new ways to cut costs without reducing
product quality or functionality.
10-11
10-32 Travel Costs; Target Costing (20 min)

1.
Cancun
Package
Specifications
Oceanfront room;
number of nights
Meals:
Breakfasts
Lunches
Dinners
Scuba diving trips
Water skiing trips
Unit Cost
Jamaica
Quantity
Cost
Quantity
Cost
$30
$180
$120
$5
$7
$10
$15
$10
$200
(Cancun),
Airfare (round trip
$355 (Jamaica)
from Miami)
Transportation to $15 (Cancun),
and from airport $10 (Jamaica)
TOTALS
7
7
6
4
5
35
49
60
60
50
5
5
0
2
2
25
35
0
30
20
200
355
15
$649
10
$595
Cancun: ($750 - $649 total costs)/$ 750 = 13.47% profit margin

Jamaica: ($690 - $595)/$690 = 13.77% profit margin
2. Cancun ($710 - $649 total costs)/ $710 = 8.59% profit margin
Jamaica: ($650- $595)/$650= 8.46% profit margin
3. The airfare costs are the largest component of cost and this category
could have room for improvement. By further negotiating group discount
rates or searching for lower cost discount carriers, Take-a-Break could lower
its cost in this category.
Room costs also comprise a major portion of total package costs. While
Take-a-Break could negotiate deals with off-beachfront hotels or opt for nonoceanfront rooms, this might decrease the value of the trip in the eyes of its
customers. A better option would be to further negotiate group rates with its
current hotel providers.
10-12
10.33 Target Costing in A Service Firm (20 min)

1. cost per unit = ($4,500,000 + $1,750,000 + $750,000 + $5,000,000) /
8,000 = $1,500 per unit
profit per unit = ($3,000 price per unit - $1,500 cost per unit)
= $1,500 per unit
2. Machine setups do not add value to the golf carts.
$750,000 total cost / 8,000 units = $93.75 per unit of non-value added
costs
3. $2,850 price per unit - $1,500 profit per unit = $1,350 per unit target cost
4. Cost must be reduced by $3,000 - $2,850 = $150. First and foremost,
Weekend Golfer should focus on getting back on budget. Inefficiencies in
materials usage have led an extra $37.50/unit in cost ($4.500.000$4,200,000)/8,000). Also, getting labor on budget would save an additional
$43.75/unit ($1,750,000/125,000 = $14 per hour; 25,000 hours excess X
$14 = $350,000; $350,000/8,000 = $43.75).
Labor and materials costs should be reduced by $43.75 + $37.50 = $81.25.
Additional savings could come from reducing the non-value added costs
from machine setups. This could be done through product design and
manufacturing process reengineering. Also, a careful examination of
mechanical assembly might reveal cost saving opportunities because this
category currently comprises half of the cost per unit. Cutting hours off of
mechanical assembly through product innovation or a process change
would provide more savings.
10-13
10-34 Pricing (25 min)

The price, contribution, and profit information is as follows.
1. $176.183 = $3,410,000 X 1.55 / 30,000
2. $184.60 = $4,260,000 X 1.3 / 30,000
3. $189.444 = $113.67 / (1 - .4)
4. $189.333 = $142.00 / (1 - .25)
5. $202.00 = $142.00 X (! + .4225)
Where: .4225 = ($12,000,000X.15) / (30,000X$142)
Total Variable Costs
Total Fixed Costs
Total Manufacturing Cost
Total Selling and Administrative
Total Life Cycle Cost
Per unit Manufacturing Cost
Per unit Life Cycle Cost
Method:
Markup on full manufacturing cost
Markup on life cycle costs
Price to Achieve Desired GM %
Price to Achieve Desired LCC %
Price to Achieve Desired ROA of
$ 2,500,000
1,760,000
3,410,000
850,000
4,260,000
113.67
142.00
Desired Rate
for Markup
55%
30%
40.00%
25.00%
15%
42.25%
$
$
$
$
$
Price
176.183
184.600
189.444
189.333
202.000
ANSWER TO PART 6.
Contribution
Gross Operating
Margin
Margin
Profit
$ 2,785,500 $ 1,875,500 $ 1,025,500
3,038,000
2,128,000
1,278,000
3,183,333
2,273,333
1,423,333
3,180,000
2,270,000
1,420,000
3,560,000
2,650,000
1,800,000
6. The contribution margin, gross margin, and operating profit are shown in
the right-hand portion of the table above. For example,
$2,785,500 = $176.183 x 30,000 - $2,500,000
The pricing methods yield prices from $176.00 to $202.00 The
highest price, $202, has the advantage that it provides the desired return on
investment, a more precise statement of the firms goal than in the other
methods. On the other hand, the lower price might be an advantage if the
firm is trying to achieve sales growth and is concerned about maintaining or
improving market share during turns in the business cycle for its customers.
This latter concern is especially important given that the demand for the
firms product is a derived demand, and there is little that Johnson can do to
influence total auto sales.
10-14
10-35 Life Cycle Costing (20 min)

Total Fixed Costs
$ 2,300
3,000
5,400
6,920
6,000
21,000
$
44,620
Total variable costs $2.50 + .50 + .50 = $3.50
Life-Cycle Costs =
$ 21,000 for fleet of canoes
446,200 (annual fixed costs x 10 years)
224,000 ($3.50 var. costs x 6,400 rentals per yr x 10 years)
$691,200
Life-Cycle Revenues needed for 20% profit margin = $691,200 / 0.80
= $864,000
Price per Rental for 20% profit margin = $864,000 / 64,000 rentals in
ten years = $13.50
10-15
10-36 Sales Life-Cycle Analysis (5 min)
Activities and Market Characteristics

Decline in sales
Advertising
Boost in production
Stabilized profits
Competitors entrance into market
Market Research
Market Saturation
Start Production
Product Testing
Termination of Product
Large Increase in sales
10-16
Life Cycle Stage

Decline
Introduction
Growth
Maturity
Growth
Introduction
Maturity
Introduction
Introduction
Decline
Growth
10-37 Pricing Military Contracts (10 min)

This is a complex issue which Pentagon officers and congressional leaders
continue to squabble over. In this particular case, Senator McCain argued
that the contract should be re-written to reduce the fixed fee from 10% to 3%
and the incentive fee should be increased from 5% to 12%. This means that
the total potential fee of 15% would be retained, but that a much larger
portion of the fee would have to be earned on performance measures (the
incentive fee).
Source: The Right Stuff for the GIs of the Future, Business Week, August
15, 2005, pp 74-75.
10-17
10-38 Pricing Power (10 min)

This exercise is intended for a brief class discussion. The objective is to
identify the factors that are critical in allowing some firms to have more
pricing flexibility than others. The discussion should touch on the
importance of distinguishing cost leadership firms, for whom the market
price is set by low-cost global suppliers, and who therefore have little pricing
flexibility, versus differentiated firms, who will have more flexibility in setting
prices because of the innovation and features of their product or service.
Also, considering the sales life cycle can help. Firms in the introduction and
growth phases of their product or service life cycle will have more flexibility
about setting prices than those in the mature phase of the life cycle, where
there is more effective price competition.
Geoffrey Colvin, writing in Fortune, points out that many firms today have
less flexibility in setting prices. The factors that have traditionally provided
pricing power are brands, intellectual property, and high entry barriers:
Brands: Colvin points out that many brands, including Coke, Nike,
and McDonalds, are under attack from a number of sources, including
those who are opposed to what they see as the social ills caused by these
firms
Intellectual Property: Colvin points out that firms around the world are
having more success at copying, legally or illegally, the patented products
such as Viagra, or entertainment products music and movies
High Entry Barrier: As Michael Porter notes (chapter 2), high entry
barriers for an industry can protect it from competition, through high costs of
facilities, patents, government regulations, etc. However, Colvin notes that
many of these barriers can now be hurdled by companies that use new
technologies, including the Internet.
Source: Geoffrey Colvin, Pricing Power Aint What it Used to Be, Fortune,
September 15, 2003, p 52.
10-18
10-39 Target Costing Using QFD (20 min)

1. The calculations are shown below:
2. The cost index for wait staff is somewhat less than the importance index,
which indicates that Hannah should consider increasing the resources
applied to wait staff more wait staff, higher pay etc. In contrast, customer
satisfaction does not appear to reward the level of expenditure for food
ingredients; perhaps savings could be made here.
10-19
PROBLEMS
10-40Target Costing in a Service Firm (20 min)
1.
ICU 100
Unit Cost Quantity Cost
Video camera $ 150
1
$150
Video monitor
75
1
75
Motion detector
15
5
75
Floodlight
8
3
24
Alarm
15
1
15
Wiring
.10/ft
700
70
Installation
20/hr
16
320
Total
$729
ICU 900
Quantity Cost
3
$450
1
75
8
120
7
56
2
30
1,100
110
26
520
$1,361
ICU 100: ($810 - $729 total costs)/$ 810 = 10% profit margin
ICU 900: ($1,520 - $1,361)/$1,520 = 10.46% profit margin
2. ICU 100: ($750 - $729 total costs)/ $750 = 2.8% profit margin
ICU 900: ($1,390 - $1,361)/$1,390 = 2.09% profit margin
3. The installation costs are the largest component of cost and this
category could have room for improvement. By redesigning the layout
of the systems or finding components that integrate more readily, the
installation times could then be reduced. Also, costs could be lowered
by contractual bargaining with electricians to reduce the per hour rates
for installation.
The video equipment and motion detectors are sources of
significant costs, but decreasing the quality or quantity of these items
would substantially change the effectiveness and value of the security
systems.
10-20
10-41 Target Costing, Strategy (15 min)

1. cost per unit =
($2,700,000 + $1,000,000 + $300,000 + $4,000,000) / 10,000
= $800 per unit
profit per unit = ($875 price per unit - $800 cost per unit) = $75
2. Machine setups do not add value to the tables.
$300,000 total cost / 10,000 units = $30 per unit of non-value added
costs
3. $800 price per unit - $75 profit per unit = $725 per unit target cost
4. Cost must be reduced by $800 - $725 = $75. First and foremost,
Benchmark should focus on getting back on budget. Inefficiencies in
materials usage have led to an extra $15.88/unit in cost
{ [(25,000/425,000) x $2,700,000]/10,000 = $15.88}.
Also, getting labor on budget would save an additional $15/unit
{ [$1,000,000 x (15,000/100,000)]/10,000 }. This would get costs down
to $769.12 per unit ($800 - $15 - $15.88). Part of the additional $44.12
($75 - $15 - $15.88) of savings needed to attain the $725 target cost
could come from reducing the non-value added costs from machine
setups. This could be done through product design and manufacturing
process reengineering. Also, a careful examination of mechanical
assembly might reveal cost saving opportunities because this category
currently comprises half of the cost per unit. Cutting 2 hours off of
mechanical assembly through product innovation or a process change
would provide more than $30 of savings (at $4,000,000/320,000 =
$12.50 per hour; savings of 2 hours per unit would save 2 x
$12.50 = $31.25 per unit)
10-21
10-42 Target Costing (20 min)

1. The target cost, at the price of $1,500 and the desired margin of 20%
would be
TC = $1,500 - .2 x $1,500 = $1,200
2.
Manufacturing
Cost
Marketing Cost
GSA Cost
Total Cost
Currently
$1,000
With Cost
Reductions
$835
Savings
$85-25+105 = $165
200
225
$1,425
200
175
$1,210
$50
$215
The cost savings of $215 are not sufficient to get the product total cost
($1,210) down to the desired target cost of $1,200. Given that National
might be willing to pay a higher price, and since the cost difference is
relatively small, it seems that Morrow should in fact pursue the order. Here
are some other considerations:
a. Morrow should consider the short versus the long term issues of taking
on the order. In the short term, as noted in chapter 3, the fixed costs of
manufacturing the order will not change and therefore can be considered
irrelevant for the order if it is a one time special order. Thus, for a short term
analysis, Morrow should determine that portion of manufacturing, marketing,
and GSA costs that are fixed and exclude them from the analysis. In
contrast, if Morrow expects this to be a regular customer, that Morrow will be
supplying National these parts for several months or years, then the total
costs including fixed costs are relevant, as in the calculations above. In the
longer term, Morrow must cover all costs of production and sale, while in the
short term only the variable costs are relevant.
10-22

b. Morrow appears to compete in what Robin Cooper calls the
confrontation strategy (When Lean Enterprises Collide, Harvard Business
School Press, 1995) wherein each competitor must simultaneously compete
on the basis of price, quality and functionality. In Morrrows case,
functionality refers not only to meeting product specifications but also to
delighting the customer with meeting delivery times, reducing lead times,
and minimizing billing and shipping errors, as Morrow has done. In a
confrontation type of competition, target costing is particularly valuable, as
Cooper points out, because it provides the firm a mechanism for balancing,
and choosing the proper bundle of the three aspects of competition: price,
quality and functionality. For example, to be most competitive, Morrow must
spend extra dollars to ensure that there are few if any billing and shipping
errors, while at the same time reducing the costs of manufacturing the
product, and maintaining or improving product quality.
c. The problem notes that the manufacturing costs are standard full costs.
Since the costs are given at standard, this means that there are no apparent
inefficiencies reflected in the reported $1,425. However, the question still
remains whether the standard costs are properly determined. Should the
standards be revised?
10-23
10-43 Target Costing; Health Care (20 min)

1. The unit cost is $85 = $77,817,500/915,500
The current profit per item is $115 - $85 = $30
The target cost to meet the competitive price is $109 - $30 = $79.
2. The unit cost is $86.46 = $83,109,090/961,275
Note: $77,817,500 + ($77,817,500X6.8%) = $83,109,090
The current profit per item is $125 - $86.46 = $38.54
The target cost is $124 - $38.54 = $85.46
A critical success factor is the relationship with network providers.
Establishing a good working relationship with its providers improves
the likelihood that the clinicians will follow the HMOs protocols.
Customer satisfaction is essential, so MD Plus should measure and
monitor the satisfaction levels of their patients, employees, network
providers and referring physicians. Since quality of care is a critical
component of customer satisfaction, a continuous quality improvement
department could be established to monitor the organizations
effectiveness and efficiency.
3.
10-24
10-44 Target Cost; Warehousing (20 min)

Current Year Operating Income
Sales
$20 x 100,000 =
$2,000,000
Costs:
Purchase
$10 x 100,000 =
$1,000,000
Purchasing order $150 x 1,000 =
150,000
Warehousing $30 x 8,000 =
240,000
Distributing $80 x 500 =
40,000
Fixed operating cost
250,000 1,680,000
Operating income
$320,000
Target Cost
Sales $20.00 x 100,000 x .90 =
Desired profit
Total cost allowed
Total costs excluding warehousing:
Purchase
$1,000,000 x .98 =
Purchasing order
$150 x 700 =
Distributing
$75 x 500 =
Fixed operating cost
Maximum warehousing cost
$1,800,000
320,000
$1,480,000
$980,000
105,000
37,500
$250,000 1,372,500
$ 107,500
Warehousing costs must be reduced from $240,000 to $107,500, a

reduction of $132,500.
10-25
10-45
Target Costing; International (20 min)

1. Target manufacturing cost = Current manufacturing cost + U.S.
Differential
= $56 + Price differential - Cost differential
= $56 + $16 - $10 = $62
Or:
Target cost = target price differential advertising and shipping
desired US profit
$62 = $90 - $10 - $18
2. The cost differential is $62 - $56 = $6
Harpers cannot add the lighter weight feature, though it is the
most desired, as the cost of $6.75 is greater than the cost differential
of $6. The best approach might be to add the extra-soft insole ($3)
and the longer-wearing sole ($3).
3. Strategically, the decision to sell shoes in the United States makes
very good sense. To compete effectively in a competitive global
market such as shoes, a firm has to have an effective presence in all
the key markets, which would include the United States. The
experience of competing in the United States should bring profits (due
to the higher prices) and the knowledge obtained from dealing with the
different customers. This knowledge can be used to improve the
firms competitiveness in other markets.
10-26
10.46 Target Costing; Quality Function Deployment (QFD) (30 min)

1.
10-27

2. When the value index is compared to the target cost, the percentage
investment in hull & keel and standing rig looks too low
The value index for hull & keel is 35.5% while the cost index is 30%; the
value index for the standing rig is 20.1% while the cost is only 15%. Ranger
might benefit from additional design enhancement of features related to
these two components.
In contrast, the expenditures for electrical equipment are somewhat higher
than would be indicated by customer preferences. Overall, this suggests
that consideration be given to redesign of the boat to bring it more in line
with customer value.
10-28
10-47 Theory of constraints (25 min)

First, identify the constraint:
Receiving and
testing
Machining
Assembly
Final Assembly
Time Required
PEC-1
PEC-2
40x10 + 40 x 15x25=375
25=1,400
40x80=3,200
40x45=1,800 15x(45+30)
=1,125
40x60=2,400 15x40=600
Total
1,775
Time
Available
2,000
3,200
2,925
3,500
2,000
3,000
3,500
By inspection, the constraint is Assembly, where there are 2,000

minutes of time available, but 2,925 minutes required, a deficit of 925
minutes
Second: Determine the most profitable product mix
PEC-1
$200
110
90
45
$2.00
Price
Materials cost
Throughput margin
Constraint time (min)
Throughput/minute
PEC-2
$250
137.50
112.50
75
$1.50
Based on the profitability analysis, PEC-1 is the most profitable

product, given the constraint on Assembly time. So the most
profitable product mix is 40 units of PEC-1 and 2 units of PEC-2:
Demand
Production plan, PEC-1
Constraint time used,
remaining
Production plan, PEC-2
Total Throughput
PEC-1
40
40
40x45=1,800
2,000 -1,800=200
40 x $90 = $3,600
200/75=2.667; round to 2
2 x $112.50 = $225.00
10-29
PEC-2
15
10-48 Theory of Constraints (30 min)

First, summarize key information and obtain hours capacity in each process:
Second, identify the constraint. In this case the constraint is staining time,
where there is a need for 85 more hours of capacity
Next, determine the most profitable product, as determined by the

requirements of the staining operation. Since the sofa requires substantially
less staining time, and because it has higher throughput, it is the most
profitable product.
10-30
Finally, determine the most profitable product mix. Since sofas are the
most profitable through the staining constraint, we fill the sofa demand first,
and then with the remaining staining capacity, fill as much of the table
demand as possible. See below for calculations.
2. Part one above solves the first two steps of the TOC, to identify the
constraint and determine the most profitable product mix. The third step, to
maximize flow through the constraint, would require Colton to look for ways
to speed up the staining operation, by simplifying it, by training the operator,
or other means. In the fourth TOC step, Colton could consider adding a part
time employee to add capacity at the constraint, though it might be difficult
to find a skilled employee who wanted part time work. Adding a full time
employee would be unnecessary and wasteful, unless the motel contract
works out. In the final TOC step, Colton should consider the possibility of
re-design, by for example using a different type of stain that requires less
time and skill.
10-31
10-49 Theory of Constraints ( 30 min)

With the information available Don can complete the first two steps of
TOC as shown below. The analysis shows that the reactor process is
the constraint, and that in the short run, Polymer 1 is the most
profitable product. The most profitable product mix is 60 units of
Polymer 1 and 35 units Polymer 2. Until the production delays can be
dealt with (TOC steps 3-5), Don should advise IPC to meet all the
sales demand of Polymer 1 and to advise customers of Polymer 2
there would be some delays in the shortterm. Then, IPC should work
quickly to relieve the constraint, reactor time, by applying the third,
fourth and fifth TOC steps. Without specialized technical knowledge
of the manufacturing processes in this industry, one can only
speculate about what these steps might be.
First: Identify the Constraint
Total Time Required for Each activity for Given Demand
Time Required for
Total
Polymer 1
Polymer 2
Time
Filtering
60x2= 120
Stripper 60x(1+1)= 120
Reactor
60x3= 180
Final Filter 60x2= 120
Mixing
60x3= 180
40x(2+2)= 160
40x(2+1)= 120
40x5 = 200
40x 1 = 40
40x3 = 120
280
240
380
160
300
Time Slack
Available Time
320
320
320
160
320
The reactor is the constraint , since there is a demand of

380 hours but only 320 hours available.
10-32
40
80
-60
0
20

Second: Identify the most profitable product
Third, Identify the most profitable product mix

Since Polymer 1 is the most profitable product, its total demand of 60
is filled first. The remaining time on the reactor is used to complete as many
units of Polymer 2 as possible:
Capacity of reactor available for Polymer 2 = 320 60 x 3 = 140
140/4 = 35 units of Polymer 2
10-33
10-50 Theory of Constraints (30 min)

1. Bakker will not be able to meet the demand. Department 1 is a
constraint, based on machine time. We do not consider labor time
because Bakker is able to hire and retain all the labor it needs.
1
Machine Hours needed
611
613
615
Total hours needed
Hours Available
Excess (deficiency)
2
1,000=
500x2
400=
400x1
2,000=
1,000x2
3,400
3,000
(400)
Departments
3
500=
500x1
400=
400x1
2,000=
1,000x2
2,900
3,100
200
1,000=
500x2
0
1,000=
500x2
800=
400x2
1,000=
1,000x1
2,800
3,300
500
1,000=
1,000x1
2,000
2,700
700
2. The best product mix is 400 units of Product 613, 500 units of product 611, and 800 units of product
615.
611
613
615
Price
$196
$123
Variable Cost*
103
73
Throughput/unit
$93
$50
Machine hours in Dept 1
2
1
Throughput/hour
$46.50
$50.00
* For example, variable cost for 611 = $(7+12+21+24+9+27+3)
Production/sales Plan
First:
Second:
Total hours available in Dept 1

400 units of 613; 400x1 hours
500 units of 611; 500x2 hours
Hours remaining
$167
97
$70
2
$35.00
3,000
400
1,000
1,600
Third: 800 units of 615; 1,600/2 hours per unit = 800
All 3,000 hours used
10-34
10-51
Life-Cycle Costing; Ethics (25 min)

1. Waters analysis based on the prepared report fails to consider the
very significant amount of research and development and selling
costs. It is unlikely that the two products consumed equal shares of
these costs. As the calculations in part 2 below illustrate, the
determination of profitability can be significantly affected by the tracing
of these non-manufacturing costs each product. The idea is that lifecycle costing, including upstream and downstream costs (research
and development, and selling costs, respectively) as well as the
manufacturing costs, is necessary to get an accurate picture of each
products overall profitability.
2.
Sales
Cost of goods sold
Gross profit
Research and dev.
Selling expenses
Profit before taxes
Xderm
$3,000,000
1,900,000
$1,100,000
(720,000)
(80,000)
$300,000
Yderm
$2,000,000
1,600,000
$ 400,000
(180,000)
(20,000)
$ 200,000
Total
$5,000,000
3,500,000
$1,500,000
(900,000)
(100,000)
$ 500,000
The life-cycle product line profitability analysis shows a much different

result.
3.Now, the two products have the same return on sales. This
illustrates that including the upstream and downstream costs can be
very important in getting a useful analysis of product profitability.
Failing to include these non-manufacturing costs, as Waters did at
first, may lead to incorrect marketing and management decision
making, as the firm may have a biased and incorrect idea of the most
profitable product(s). Calculation return on sales (not required) shows
that each product has the same return under life cycle costing.
Return on Sales
$300,000
$3,000,000
=
10%
$ 200,000
$2,000,000
= 10%
10-35
$ 500,000
$ 5,000,000
=10%
10-52 Life Cycle Costing (25 min)

1. A product life cycle statement would aggregate the three years into
one that shows the totals in each category for the life of the
product.
2. L50 appears to be more profitable; 771 vs 670 life cycle profits.
L40
Revenues
Costs
Research and Development
Prototypes
Marketing
Distribution
Manufacturing
Customer Serivce
Total Cost
Operating Profit
1,400
350
60
60
20
1,890
Operating Profit
L50
Revenues
Costs
Prototypes
Marketing
Distribution
Manufacturing
Customer Serivce
Total Cost
2005
800
(1,090)
2005
900
650
300
124
170
85
1,329
(429)
10-36
2006
2,300
2007
3,100
Total
6,200
50
600
120
770
60
1,600
475
130
1,350
85
2,040
1,400
400
1,135
310
2,140
145
5,530
700
1,060
670
2006
1,900
2007
2,200
Total
5,000
30
200
200
700
20
1,150
10
260
410
770
300
1,750
650
340
584
780
1,555
320
4,229
750
450
771

3.
L40
Revenues
Costs
Prototypes
Marketing
Distribution
Manufacturing
Customer Serivce
Total Cost
Operating Profit
L50
Revenues
Costs
Prototypes
Marketing
Distribution
Manufacturing
Customer Serivce
Total Cost
Operating Profit
2005
800
0
1,400
350
60
60
20
1,890
$
74.1%
18.5%
3.2%
3.2%
1.1%
0.0%
(1,090)
$
0.0%
3.1%
37.5%
7.5%
48.1%
3.8%
700
2005
900
650
300
124
170
85
1,329
2006
2,300 %
0
50
600
120
770
60
1,600
$
48.9%
22.6%
9.3%
12.8%
6.4%
0.0%
(429)
2006
1,900
0
30
200
200
700
20
1,150
750
2007
3,100 %
0
0.0%
0.0%
475
23.3%
130
6.4%
1,350
66.2%
85
4.2%
2,040
1,060
$
0.0%
2.6%
17.4%
17.4%
60.9%
1.7%
2007
2,200
0
10
260
410
770
300
1,750
0.0%
0.6%
14.9%
23.4%
44.0%
17.1%
450
The analysis shows how the distribution of costs for both products shifts
from research and development in the first year to manufacturing and
customer service in the last year. The shift is most pronounced for L40
which has high development costs.
10-37
10-53 Life Cycle Costing; Health Care; Discounting (30 min)

If Cure-all were to manufacture the drug themselves, at a sales price
of $235, the life-cycle costs would be the following:
Price
$235
Units Sold
3,000,000
Revenues
$705,000,000
Costs
R&D
Clinical Trials
Manufacturing
Fixed
Variable
Packaging
Fixed
Variable
Distribution
Fixed
Variable
Advertising
Fixed
Variable
Total Cost
$1,000,000
$2,108,000
$5,000,000 x 5 = $25,000,000
$68x3,000,000 = $204,000,000
$380,000 x 5 =$1,900,000
$20 x 3,000,000 = $60,000,000
$1,125,000 x 5 = $5,625,000
$6.50 x 3,000,000= $19,500,000
$2,280,000 x 5 = $11,400,000
$12 x 3,000,000= $36,000,000
$366,533,000
Operating Income
$338,467,000
10-38

Outsourcing the manufacturing would result in the following life cycle
costs assuming the cost as $235 per unit and the changes in the
manufacturing costs:
Price
Units Sold
Revenues
Costs
R&D
Clinical Trials
Manufacturing
Fixed
Variable
Packaging
Fixed
Variable
Distribution
Fixed
Variable
Advertising
Fixed
Variable
Total Cost
$235
3,000,000
$705,000,000
$1,000,000
$2,108,000
$1,500,000 x 5 =$7,500,000
$80 x 3,000,000= $240,000,000
$380,000 x 5 = $1,900,000
$60,000,000
$1,125,000 x 5 =$5,625,000
$19,500,000
$2,280,000 x 5 =$11,400,000
$36,000,000
$385,033,000
Operating Income
$319,967,000
Outsourcing the manufacturing results in a lower operating income

than manufacturing the drug themselves.
10-39

It appears that selling the drug patent is the best alternative since
receiving $425,000,000 ($300,000,000 + $25,000,000 x 5) over the
five year period is greater than the operating incomes of both the other
options. However, in order to determine the real value of selling the
patent one needs to consider the present value of the annuity stream,
the $25,000,000 at the end of every year for the next 5 years. Assume
a discount rate of 10%, and the present value of the five-year annuity
(an annuity factor of 3.791 at 10%) is $25,000,000 x 3.791 =
$94,775,000. Thus the total value of the sale of the patent is
$94,775,000 + $300,000,000 = $394,775,000. The best alternative is
selling the patent.
10-40
10-54Constraint Analysis; Flow Diagram (Appendix) (60 min)

1. Grace Vanders accelerated delivery schedule is unsatisfactory in
cutting 10 days from the total project schedule because not all of her
crashed activities are included on the critical path. In order to reduce
the completion time for a project, activities along the critical path need
to be chosen to be crashed or reduced. Vanders selection of
activities FJ, EF, and BG, which are on the critical path ABGEFJK, will
reduce total project completion time only by three days but her
selection of activities HJ, GH, CD, and DE have no impact on the
critical path and thus will not reduce project time.
2. Below is a revised accelerated delivery schedule that meets both
objectives: (1) delivery of the first plane two weeks (10 working days)
ahead of schedule, and (2) at least incremental cost to Coastal. All
the paths need to be evaluated when reducing a projects completion
time. However, the selection of activities to crash should be taken
from the critical path first and then the activities should be selected in
order according to the smallest crash cost. The critical path now
becomes ABCDEFJK and will take 57 days, having only reduced the
total project completion date by eight days. Therefore, the activity CD
(the next least costly available activity) needs to be crashed two days
which will then bring all paths to 55 days or less. This analysis is
shown in the tables below.
The first path, ABGEFJK, crashed 10 days would cost $10,200, as
shown below.
Activity
Crashed
Days
Reduced
Incremental
Cost per
day
Incremental
Cost
START
FJ
EF
JK
BG
AB
GE
Total
1
1
1
2
4
1
$ 400
800
900
1,000
1,200
1,300
$ 400
800
900
2,000
4,800
1,300
$10,200
10-41
ABGEFJK
65
64
63
62
60
56
55
The second path, ABCDEFJK, which crashes less expensive

activities, is less expensive overall, and thus a better crash schedule.
The ABCDEFJK path, before crash, has a time of 64, so that the table
begins with 64.
Activity
Crashed
Days
Reduced
Incremental
Cost per
day
Incremental
Cost
START
FJ
EF
JK
AB
CD
Total
1
1
1
4
2
$ 400
800
900
1,200
700
$ 400
800
900
4,800
1,400
$8,300
ABCDEFJK
64
63
62
61
57
55
Note that the activities BG and GE are not crashed in the final solution
because they are not on the critical path. Reducing time on these
activities will not reduce the overall project time.
3. The total incremental costs Bob Peterson will have to pay for this
revised accelerated delivery schedule amount to $8,300, or a new
total project cost of $73,400 from the original $65,100, and a saving of
10 days.
10-42
10-55 Production Planning and Control (30 min)

There may be a happy ending to this story if Kristen and Bryan
change the focus in the plant from productivity at each work station
and meeting budgets to a focus on speed and throughput. The
current emphasis on productivity at each work station has the effect
that each employee has the incentive to work very hard to meet their
productivity targets, without a consideration of the overall productivity
of the entire plant. This is why work-in-process inventory builds up in
places. Some operators are keen on moving the product through their
work stations, and not concerned about what happens to it
downstream.
Also, the emphasis on meeting cost budgets (as in the case of
the purchasing department manager), creates incentives to reduce
costs in ways which can cause delays and defective products. The
purchase of discounted material which apparently led to product
defects is an example.
The emphasis on individual productivity has other effects. Since
it creates a focus only on moving product through individual
processes, inadequate attention appears to be given to equipment
maintenance or to the prevention of defects. There is insufficient
attention to preventing quality defects. In contrast, there is excessive
attention to correcting defects (re-work). To speed up the process, the
rate of defects has to be reduced. The emphasis on correcting
defects merely slows things down. Six-sigma firms such as Toyota
and GE have learned it is less costly as well as faster to prevent
defects rather than to spend time on inspection and re-work.
Inspection and re-work are non-value adding processes that should be
eliminated.
Another unfortunate result of the cost allocation method in the
plant is that department managers apparently have the incentive to
reduce the amount of space in which they operate in order to reduce
the overhead costs allocated to them. This means that some work
stations, for example Eds, are possibly too small for efficient
processing, leading to lower productivity and increased defects.
Again, the focus of the accounting system has set things awry, and
provided a dysfunctional incentive.
10-43

To repair the situation, Kirsten and Bryan should refocus the
plant on throughput and use a system like the theory of constraints.
With the theory of constraints, managers and employees are rewarded
for moving total product through the plant, not just through their
individual work stations. Everyone in the plant has the incentive to
look for bottlenecks and to find ways to reduce the effect of these
bottlenecks. Moreover, employees have the incentive to work together
to reduce the bottlenecks and improve throughput, since the focus is
no longer on individual productivity, but on overall productivity, which
is the plants ultimate goal.
Summary Presentation of Problem on Chalk Board:

Problem Areas Manufacturing Outcomes
Materials quality
down
Defects up
Profit Outcomes
Costs up
Cramped space
Focus on speed
everywhere
(no concern for
downtime or
throughput..)
Reduced
Throughput
WIP up
Increased
holding cost
Orders delayed, some

orders and profits
lost
10-44

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CHAPTER 10

COST PLANNING FOR THE PRODUCT LIFE CYCLE: TARGET

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Drum-Buffer-Rope concept: maintain a small amount of work-in-process (buffer)

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Current profit per unit = $50 - $ 38 - $8 = $4/unit

10-20 Price = 1.4 x ($38) = $53.20

2 days in production (May 20-May 21)

Kaizen, continuous improvement

10-27 $140 - $140 x (.25) = $105

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10-29 Manufacturing Cycle Efficiency (10 min)

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10-30 Takt Time (10 min)

= 30 seconds per unit

2. The processing line is not properly balanced. Operation 2 exceeds takt

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10-31. Target Costing (30 min)

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Problem 10-31 (continued)

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10-32 Travel Costs; Target Costing (20 min)

Cancun: ($750 - $649 total costs)/$ 750 = 13.47% profit margin

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10.33 Target Costing in A Service Firm (20 min)

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10-34 Pricing (25 min)

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10-35 Life Cycle Costing (20 min)

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10-36 Sales Life-Cycle Analysis (5 min)

Activities and Market Characteristics

Life Cycle Stage

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10-37 Pricing Military Contracts (10 min)

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10-38 Pricing Power (10 min)

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10-39 Target Costing Using QFD (20 min)

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10-41 Target Costing, Strategy (15 min)

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10-42 Target Costing (20 min)

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Problem 10-42 (continued)

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10-43 Target Costing; Health Care (20 min)

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10-44 Target Cost; Warehousing (20 min)

Warehousing costs must be reduced from $240,000 to $107,500, a

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Target Costing; International (20 min)

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10.46 Target Costing; Quality Function Deployment (QFD) (30 min)

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Problem 10-46 (continued)

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