Chapter 8 - Lecture notes 22 PDF

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MGT .ACCTG-COST PLANNING FOR PRODUCT LIFE CYCLERepublic of the Philippines BATANGAS STATE UNIVERSITYACC 206- STRATEGIC COST MANAGEMENT STRATEGIC MASTER BUDGET/ COST PLANNING LECTURE /FOCUS NOTESName :_________________________________________________ SR Code:__________________ Course/Year:___________...

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Republic of the Philippines BATANGAS STATE UNIVERSITY ACC 206- STRATEGIC COST MANAGEMENT STRATEGIC MASTER BUDGET/ COST PLANNING LECTURE /FOCUS NOTES Name :_________________________________________________ Code:__________________ Course/Year:______________________________ Date:__________________

SR

LE A R N IN G OB JE C TIV E S  

Decide the concepts of the cost life cycle and sales life concept Explain and apply the methods in analyzing strategic cost management issues of the cost-life cycle such as  Life-cycle costing  Target costing  Theory of constraints  Distinguish between upstream costs, manufacturing and downstream costs of a product’s life cycle  Realize the importance of decision making at the design stage of a product  Describe the characteristics of the common design models  Explain the strategic cost management over the product’s sales life cycle  Describe Target Costing and how it is applied in the cost-life cycle  Know the techniques in reducing costs to a target cost level  Explain the steps in implementing a target cost approach  Describe the concept of the theory of constraints and how it is applies to improve the speed in improving speed in the manufacturing process COST MANAGEMENT FOR PRODUCT LIFE CYCLE: LIFE-CYCLE COSTING AND LONG-TERM PRICING; TARGET COSTING AND THEORY OF CONSTRAINTS

COST MANAGEMENT FOR PRODUCT LIFE CYCLE Life Cycle Costing 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. Product life cycle is consideration in each of two aspects: a) The cost life cycle b) The sales life cycle Cost life cycle is the sequence of activities within firm that begins with research and development, followed by design, manufacturing, marketing/distribution and customer service. Sales life cycle is 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 withdrawal from the market. Important strategic cost management issues arise in each activity of the cost life cycle. The methods helpful in analyzing the cost life cycle are A. Life-Cycle Costing B. Target Costing and C. Theory of Constraints Life-Cycle Costing is used throughout the cost life cycle to minimize overall cost. Target Costing is used for managing costs primarily in the design activity.

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Theory of Constraints is a method for managing manufacturing costs. Two of the methods, target costing and theory of constraints are particularly applicable to manufacturing firms because they deal primarily with product design and manufacture. However, each method also can be applied to service firm, to improve the efficiency and speed of the processes involved in providing the service. A. COST MANAGEMENT FOR THE PRODUCT LIFE-CYCLE Life cycling costing is a management technique used to identify and monitor the costs of product or service throughout its life cycle. It provides a long-term perspective of product costs and product or service profitability. For instance, a product that is designed quickly and carelessly, with little investment in design costs, may have significantly higher marketing and service costs later in the life cycle. Managers are interested in the total cost, over the entire life cycle, and not manufacturing costs only. Total cost over the product’s life cycle often is broken down into three components-upstream costs, manufacturing cost and downstream costs. FIGURE 8-1 Life-Cycle Costing R&D

Design

Production

Upstream Activities

Marketing & Distribution

Customer Service

Downstream Activities

LIFE-CYCLE COSTING

The sub components of these costs follow: Upstream costs Research and development Design: prototyping, testing, concurrent engineering and quality development Industries with high upstream costs include computer software, specialized industrial and medical equipment 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 Industries with high downstream costs include pharmacratic, performer, cosmetics and toiletries Why Design is Important Decision making at the design stage is critical. Although the costs incurred at the design stage may be very small in relation to the total costs over the entire life cycle the decision stage decisions are important because they lock in most of the remaining life-cycle costs. The critical success factors at the design stage include: 1. Reduced time-to-market.

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2. Reduced expected service costs. 3. Improves ease-of-manufacture. 4. Process planning and design. Reduced time-to-market The speed of product development and the speed of delivery and efforts to reduce time-to-market are critical for a business firm to sustain its competitiveness. Reduced expected service costs By careful simple design and the use of interchangeable or modular components can reduce expected service costs. Improves ease-of-manufacture The design must be easy to manufacture in order to reduce production costs and speed production. Process planning and design The plan for the manufacturing process should be flexible, allowing for fast setups and product changeovers, using computer-integrated manufacturing computer assisted design and concurrent engineering. Common Design Models The four common design methods are: a. b. c. d.

Basic engineering Prototyping Templating and Concurrent engineering

Basic engineering This is a method in which product designer’s work independently from marketing and manufacturing to develop a design from specific plans and specifications. Prototyping This is a method in which functional models of the product are developed and tested by engineers and trial customers. Templating This 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 Concurrent engineering or simultaneous engineering is an important new approach in which product design is integrated with manufacturing and marketing throughout the product’s life cycle.

FIGURE8-2 Characteristics of the Four Design Methods Design Method Basic engineering

Design Speed Fast

Prototyping

Slow

Templating

Fast

Design Cost

Effect on Downstream Costs

Depends on desired complexity and functionality; should be relatively low Significant; materials, labor and time Modest

Can be very high; as marketing and production are not integral to the design process Potentially a significant reduction in downstream costs Unknown; can have costly

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Concurrent engineering

Continuous

Significant; design is an integral, ongoing process

unexpected if the scaling does not work in the market or in production The best method for reducing downstream costs

ILLUSTRATIVE CASE I. Life Cycle- Costing and Pricing Star Communication Technologies Inc., has introduce a new phone so small that it can be carried in a wallet. Star invested P400,000 in research and development for the technology, and another P800,000 to design and test the prototypes. Star predicts a four-year life cycle for this model and gathered this cost data for the wallet phone: Monthly Fixed Cost Variable Cost Manufacturing Cost P25,000 P20 Marketing Cost 20,000 5 Customer Cost 3,000 8 Distribution Cost 5,000 15 Sales prediction: For price of P150 – average annual sales of P80,000 units For price of P180 – average annual sales of P60,000 units For price of P225 – average annual sales of P48,000 units If the price of a wallet phone is P225, Star will have to increase the research and development costs by P100,000 and the prototyping costs by P400,000 to improve the model for the higher price. Fixed customer service costs also would increase by P500 per month and variable distribution costs would increase by P5 per unit to improve the customer service and distribution at the P225 level. At the lowest price level of P150fixed marketing costs would be reduced by P5,000 per month because the low price would be the principal selling feature. Required: 1. Determine the life cycle costs for each pricing decision. 2. What price will produce the most profit for Star for the wallet phone’s life cycle? Solution to Illustrative Case 1: Life Cycle Costing and Pricing Requirement 1 : Life Cycle costs for each decision

Price Units Sold revenues

P150.00 80,000 P12,000,000

P180.00 P60,000 P10,800,000

P225.00 P48,000 P10,800,000

Costs R&D Prototypes

P400,000 P800,000

P400,000 P800,000

P500,000 P1,200,000

more at P225 More at P225

Manufacturing Fixed

P1,200,000

P1,200,000

P1,200,000

Variable

P1,600,000

P1,600,000

P960,000

=25,000 X 12 months x 4 years =20 per unit

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Marketing Fixed Variable Customer Service Fixed

P720,000

P960,000

P960,000

P400,000

P300,000

P240,000

P144,000

P144,000

P168,000

Variable Distribution Fixed Variable

P640,000

P480,000

P384,000

P240,000 P1,200,000

P240,000 P900,000

P240,000 P960,000

Total Costs

P7,344,000

P4,176,000

P3,988,000

=20,000 x 12 x 4 (15,000 at P150) = 5 per unit

=3,000 x 12 x 4 (3,500 at P225) =8 per unit =5,000 x 12 x 4 =15 per unit (20 at P225 price)

Requirement 2 The P150 price renders the highest expected profit. COST MANAGEMENT OVER THE SALES LIFE CYCLE The sales life cycle is 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. Sales are first small, then peak in the maturity phase and decline thereafter. FIGURE 8-3 THE SALES LIFE CYCLE OF A PRODUCT

Sales Growth

Maturity

Introduction Decline

Time Phases of The Sales Life Cycle Phase 1: Product introduction The first phase there is little competition, and sales rise slowly as customers become aware of the new product or service. Costs are relatively high because of high R&D expenditures and capital costs for setting up production facilities and marketing efforts. Process are relatively high because of product differentiation and the high costs at this phase. Product variety is limited. Phase 2: Growth Sales begin to grow rapidly and product variety increases. The product continues enjoy the benefits of differentiation. There is increasing competition and prices begin to soften. Phase 3: 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.

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Phase 4: Decline Sales begin to decline, as do 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. Management Focus In the first phase, the focus of management is on design, differentiation, and marketing. The focus shifts to new product development and pricing strategy as competition develops in the second phase. In the third and fourth phases, management’s attention turns to cost control, quality and service as the market continues to become more competitive. Thus, the firm’s strategy for the product or services changes over the sales life cycle, from differentiation in the early phases to cost leadership in the final phases. Strategic Pricing Strategy The strategic pricing approach changes over the life cycle of the product or service. 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 take rather than a price setter and makes efforts to reduce upstream (for product enhancement) and downstream costs. Cost Management System Together with the change in strategy and pricing, there is a change in the cost management system. 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 also are used in these early phases to manage cash flows; there are large development costs at a time when sales revenues are still relatively small. As the strategy shifts to cost leadership in the latter phases, the goal of the costing tools for accurate cost information. Illustrative Case II: Sales Life-Cycle Analysis The management accountant at the Aeron Manufacturing Company has collected these data in preparation for a sales life-cycle analysis on one of its products, a leaf blower: Item Annual Sales Unit sales price Unit profit

This Year

Change over Last Year

P2,000,000 P400 P180

Average Annual Change over the Last Four Years 1.5% 2.0 (0.8)

19.6% 6.9 2.5

Required: Determine what stage of the sales life cycle the leaf blower is in.

Solution to Illustrative Case II: Sales Life-Cycle Analysis It seems that sales are stabilizing since they only grew 1.5% over the past year and the average annual growth over the past four years was 19.6%. The unit sales price has also showed, and the unit profit its beginning decline. As a result, total profit is starting to level off. Because of these signs, it seems that the leaf blower is in the early maturity stage. Illustrative Case III: Strategic Costing and Pricing Optic Care Inc. (OCI) manufactures specialized equipment for polishing optical lenses. There are two models one principally used for fine eyewear (l-25) and another for lenses used in binoculars, cameras and similar equipment (BL-10).

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The manufacturing cost of each unit is calculated by activity-based costing*,using these manufacturing cost pools: Cost Pools 1.Materials handling 2.Manufacturing supervision 3.Assembly 4.Machine setup 5.Inspection and testing 6.Packaging

Allocation Base Number parts Hours machine time Number parts Each setup Logged hours Logged hours

Costing Rate P1.85 per part P11.40 per hour P2.55 per part P43.30 per setup P35 per hour P15per hour

OCI currently sells the BL-10 model for P1,050 and L-25 model for P725. Manufacturing costs and activity usage for two products are:

Bl-10 Direct materials Number parts Machine hours Inspection time Packing time Setups

126.50 121 6.1 1.3 0.7 2

L-25 58.19 88 3.2 0.6 0.4 1

Required: 1. Calculate the product cost and product margin for each product. 2. A new competitor has entered the market for lens polishing equipment with a superior product at significantly lower prices – P750 for the BL-10 model Ann P550 for the L—25 model. To try to compete, OCI Has made some radical improvements in the design and manufacturing of its two products. While the costing rates have stayed the same, the materials costs and activity usage rates have been decreased significantly : Bl-10 Direct materials Number parts Machine hours Inspection time Packing time Setups

111.50 96 5.7 10 0.7 1

L-25 48.30 77 2.9 0.5 0.4 1

Calculate the total product cost with the new activity usage data. Can OCI make a profit with the new costs, assuming that OCI must meet the price set by the competitor? 3. What cost management method might be useful to OCI at this time and why? Solution to Illustrative Case II: Strategic Costing Requirements 1 and 2

Cost Pool

Allocation Bas

Materials Handling Mfg. Supervision Assembly Set-ups Inspection and Test Packaging

Number of parts Machine hours Number of parts Hours Hours

Costing Rate 1.85 11.40 2.55 43.50 35.00 15.00

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new

Costs And Activity Usage for Each Product BL-10 126.50 121.00 6.10 1.30 0.70 2.00

Direct materials Number parts Machine hours Inspection time Packing time Setups

Current L-25 58.19 88.00 3.20 0.60 0.40 1.00

Received Bl-10 L-25 48.3 111.5 77.00 96.00 2.90 5.70 0.50 1.00 0.40 0.70 1.00 1.00

Activity-based costs Rate Materials Materials handling Mfg. supervision Assembly Set-ups Inspection & Test Packaging Price Margin

1.85 11.40 2.55 43.50 35.00

126.50 223.85 69.54 308.55 87.00 45.50 10.50 871.44 1050.00 178.56

Requirement 3.

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58.19 162.80 36.48 224.40 43.50 21.00 6.00 552.37 725.00 172.63

111.50 177.60 64.98 244.80 43.50 35.00 10.50 687.88 750.00 62.12

48.30 142.45 33.06 196.35 43.50 17.50 6.00 487.16 550.00 62.84

Target costing should be useful to OCI to assist the firm in meeting the new competition by finding new ways to cut costs without reducing product quality or functionality.

B. TARGET COSTING Target costing is a technique in which the firm determines the desired cost for the product or service, given a competitive market price so the firm can earn a desired profit. Target Cost = Competitive Price – Desired Profit Target costing is a very way manage the needed trade-off between increased functionality and higher cost.

FIGURE 8-4: TARGET COSTING IN THE COST LIFE CYCLE

R&D

Design

Manufacturing

Marketing & Distribution

Customer Service

TARGET COSTING With its positioning in the early, upstream phases of the cost life cycle. Target Costing can clearly help a firm educe total costs.

Steps in Implementing a Target Cost Approach 1. 2. 3. 4. 5.

Determine the market price. Determine the desired profit. Calculate the 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 costs. The first three steps do not require additional explanation. a. The role of value engineering b. Kaizen costing and operational control.

a. Role of Value Engineering Value engineering is used in target costing to reduce product cost by analyzing the trade-offs between (1) different types and levels of products functionality and (2) total product cost. An important first step in value engineering is a consumer analysi...