Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
Chapter 13
Cost Planning for the Product Life Cycle: Target Costing, Theory of
Constraints, and Strategic Pricing
Learning Objectives
1. Explain how to use target costing to facilitate strategic management.
2. Apply the theory of constraints to strategic management.
3. Describe how life-cycle costing facilitates strategic management.
4. Outline the objectives and techniques of strategic pricing.
Teaching Suggestions
This chapter has a unique design to integrate the strategic cost management topics of target costing,
life-cycle costing, strategic pricing and the theory of constraints in a meaningful way. This is done by first
defining and distinguishing the concepts of the cost life-cycle and the sales life-cycle. The cost life-cycle
is for a particular product, and reflects the costs incurred in preparing the product for the customer, from
initial development and design through manufacturing to distribution and customer service. In contrast,
the sales life-cycle is the life of the product in the marketfrom introduction to maturity and eventual
withdrawal from the market. The concept of the value chain explained in Chapter 2 can be compared to
that of the cost life cycle. The cost life cycle refers to the development and sales of a single product by a
single firm only, while the value chain refers to the sequence of activities for any firm that is involved in
the production and sale of the product. The latter is often called the “industry-level” value chain, and has
been presented in the accounting literature by Shank and Govidarajan. The firm-specific value chain was
developed by Michael Porter.
The topics of target costing, life cycle costing, and the theory of constraints can be systematically
explained to the students as cost management methods which are intended for different phases of the cost
life cycle. Target costing, which focuses on costs at the front end of the cost life cycle design and
development, is employed early in the cost life cycle. This is followed by the theory of constraints, a
method for speeding the flow of product through the plant, by recognizing and managing production
constraints. Thus, the theory of constraints is applicable at the second, or middle phase of the product’s
cost life cycle. Finally, life cycle costing is a method which takes into account all the phases of the
product’s cost life cycle, so that the product’s full life cycle costs are managed.
Strategic pricing and the sales life cycle are covered at the end of the chapter. The key issues here are
to identify the strategies that are likely to be used in each of the phases of the sales life cycle and to
identify cost management methods that are likely to be appropriate at each phase.
New in this Edition
Two new and one updated “Real-World Focus” items
Four new or revised end-of-chapter problems
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Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
Assignment Matrix
Learning Objectives Text Features
7e
EOC
6e
EOC
Transition
6e to 7e Time
1.Using target costing
2.Theory of constraints
3.Life-cycle costing
4.Strategic pricing
Strategy
Service
International
Ethics
Sustainability
Brief Exercises
13-20 13-20 05 min X
13-21 13-26 05 min X
13-22 13-25 05 min X
13-23 13-23 05 min X
13-24 13-24 05 min X
13-25 13-21 05 min X
13-26 13-22 05 min X
13-27 13-27 05 min X
Exercises
13-28 13-28 15 min X
13-29 13-29 30 min X X
13-30 13-30 20 min X X
13-31 13-31 20 min X X
13-32 13-32 15 min X X
13-33 13-33 10 min X
13-34 13-34 20 min X
13-35 13-35 25 min X
13-36 13-36 10 min X X
13-37 13-37 20 min X X
Problems
13-38 13-38 20 min X X
13-39 13-39 20 min X X
13-40 13-40 Revised 20 min X X
13-41 13-41 20 min X
13-42 13-42 20 min X X X
13-43 13-43 Revised 30 min X
Continued on next page:
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Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
Learning Objectives Text Features
7e
EOC
6e
EOC
Transition
6e to 7e Time
1.Using target costing
2.Theory of constraints
3.Life-cycle costing
4.Strategic pricing
Strategy
Service
International
Ethics
Sustainability
13-44 13-44 20 min X X X
13-45 13-45 30 min X
13-46 13-46 30 min X
13-47 13-47 80 min X X
13-48 13-48 Revised 25 min X X
13-49 13-49 Revised 30 min X
13-50 13-50 60 min X X
13-51 13-51 40 min X X X
Lecture Notes
In this chapter, we discussed four different cost management methods: target costing, theory of
constraints, life-cycle costing, and strategic pricing. A common element of the methods is that each looks
at the product from the product life cycle point of view. There are, however, two different views of the
product life cycle. The cost life cycle is the sequence of activities within the firm that begins with R&D
followed by design, manufacturing, marketing, and customer service. It is the life cycle of the product or
service, from the viewpoint of costs incurred. The sales life cycle is the sequence of phases in the
product’s life in the market from introduction to growth in sales, followed by maturity and decline.
A. Target Costing. Target costing is used for determining profitable product designs early in the cost
life cycle. The firm determines the allowable (target) 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
The firm has two options for reducing cost to a target level: by integrating new manufacturing
technology and seeking higher productivity, or by redesigning the product or service. Target costing is a
useful way to measure the trade-off between functionality and cost. Implementing a target costing
approach involves five steps: determine the market price, determine the desired profit, calculate the target
cost, use value engineering to find ways to reduce cost, and use kaizen costing or operational control to
further reduce cost.
1. Value Engineering. Value engineering is used in target costing to reduce product cost by analyzing
the trade-offs between different types of product functionality and total product cost. It is important to do
a customer analysis before starting value engineering, since the customer analysis will indicate critical
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Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
customer preferences that define the desired product functionality. Two different types of value
engineering are: either adding on/taking off features, or by redesigning the product based on the new
functionality. An example of target costing used for products on the first group is functional analysis,
which examines the performance and cost of each major feature of the product, with the goal being to find
a desired balance between performance and cost. Benchmarking is also used, in order to determine which
features give the firm a competitive advantage.
Design analysis is the common form of target costing for products in the second group. In design
analysis, product developers create several different product designs, and then, through benchmarking and
value chain analysis, a final design is chosen. Other cost-reduction approaches include cost tables and
group technology. Cost tables are computer databases that include information about the product’s cost
drivers. Group technology is a method of identifying similarities in the parts of products a firm
manufactures so the same parts can be used in two or more products, thus reducing costs.
2. Target Costing and Kaizen. Kaizen means continual improvement, an ongoing search for new
ways to reduce costs in the manufacturing process. Since kaizen occurs during manufacturing, keep in
mind that the effects of value engineering and improved design are already in place. The role for cost
reduction at this phase is to develop new manufacturing methods and use techniques like management
control, total quality management, and the theory of constraints to further reduce costs. Kaizen is used
periodically throughout the product’s life cycle; as competition reduces prices, firms implement kaizen to
keep costs down.
3. Quality Functional Deployment (QFD). QFD is the integration of value engineering, marketing
analysis, and target costing to assist in determining which components of the product should be targeted
for redesign or cost reduction. It helps designers and managers break down the total product target cost
into the components that make up the product. There are four steps in QFD:.
1. Determine the customer’s purchasing criteria for this product and how these criteria are ranked.
2. Identify the components of the product and the manufacturing cost of each component.
3. Determine how each component contributes to customer satisfaction.
4. The final step is to determine the importance index of each component, by combining the
information in steps one and three and then comparing this to the cost information in step 2.
B. The Theory of Constraints (TOC). TOC is a technique used to improve the speed of the
manufacturing process, giving firms an edge over slower competitors. There are several different ways to
measure the speed of a manufacturing process, two being cycle time and manufacturing cycle efficiency
(MCE):
Cycle time = Amount of time between the receipt of a customer’s order and the shipment of the order
MCE = Processing time/Total cycle time
TOC was developed to help managers reduce cycle time and operating costs. Prior to it, managers tried to
improve process efficiency throughout the process; instead, TOC trains managers to spend most of their
time eliminating constraints. Constraints are activities that slow down a product’s total cycle time.
Instead of trying to boost the efficiency of the most efficient process, managers use TOC to improve the
efficiency of the slowest part of the process, thereby speeding up the entire process.
1. Steps in the Theory of Constraints Analysis.
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Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
a. Identify the constraint. The management accountant works with manufacturing managers to
identify any constraint on then process by developing a flow diagram. The diagram shows the
sequence of processes and the amount of time each requires.
b. Determine the most profitable product mix given the constraint. To determine the most profitable
product mix, we first determine the most profitable product, given the constraint. TOC measures
product profitability using the throughput margin, which is the product price less materials cost
(includes the costs of all materials used, purchased components, and materials-handling costs).
c. Maximize the flow through the constraint. Management looks for ways to speed the flow through
the constraint by simplifying the process or improving the product design. An important tool for
managing product flow is the drum-buffer-rope (DBR) system, which is a system for balancing the
flow of production through a constraint. In a DBR system, all productions flows are synchronized to
the drum (the constraint). The rope is the sequence of processes prior to and including the constraint.
The objective is to balance the flow of production through the rope by carefully timing and
scheduling activities. The buffer is a minimum amount of work-in-process input to the constraint to
ensure it is kept busy.
d. Add capacity to the constraint. As a longer-term measure to relieve the constraint and improve
cycle time, management should consider adding capacity to the constraints by adding new or
improved machines and/or additional labor.
e. Redesign the manufacturing process for flexibility and fast cycle time. The most complete
strategic response to the constraint is to redesign the manufacturing process, including the
introduction of new manufacturing technology, deletion of difficult-to-manufacture products, and
redesign some products for greater ease of manufacturing.
2. Theory of Constraints Reports. When a firm focuses on improving cycle time, eliminating
constraints, and improving speed of delivery, the performance evaluation measures also focus on these
CSFs. A common approach is to report throughput margin as well as selected data in a theory of
constraints report. TOC reports are useful for identifying the most profitable product and for monitoring
success in achieving the CSFs.
3. ABC and the Theory of Constraints. ABC is also used to assess the profitability of products.
However, TOC takes a short-term approach to profitability analysis, while ABC costing develops a long-
term analysis. TOC analysis is short term because of its emphasis only on materials-related costs, but
ABC includes all product costs. ABC and TOC are 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 profitability analysis. 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 constraints.
C. Life-Cycle Costing. Life-cycle costing provides a long-term perspective because it considers the
entire cost life cycle of the product or service. Therefore, it provides a more complete view of product
costs and profitability. Total costs over a product’s life cycle are often broken down into three
components: upstream costs (R&D, testing, engineering); manufacturing costs (purchasing, direct and
indirect manufacturing costs); and downstream costs (marketing, distribution, service, and warranty).
Upstream and downstream costs are managed in a number of ways including improved relationships with
suppliers and distributors; the most crucial way is the design of the product and the manufacturing
process.
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Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
D. Strategic Pricing for Phases of the Sales Life Cycle. Strategic pricing depends on the position of
the product or service in the sale life cycle. Overall, the firm’s general strategy shifts from differentiation
to cost leadership.
1. Introduction. The first phase involves little competition, and sales rise slowly. Costs are relatively
high due to R&D expenditures and capital costs. Prices are relatively high because of product
differentiation and high costs. Management focus is on differentiation, design, and marketing.
2. Growth. Sales begin to increase rapidly, as does product variety. Competition rises and prices
begin to fall. Management focus shifts to product development and pricing strategy.
3. Maturity. Sales continue to grow, but at a decreasing rate. Competitors and product variety begin
to decline. Prices continue to fall, as competition becomes based on cost. Management’s focus changes
cost control, quality, and service.
4. Decline. Sales, competitors, and prices continue to decline. Controlling costs becomes key to
survival. Management’s focus remains the same as in the maturity stage.
E. Pricing Using the Cost Life Cycle
There are four key methods that are used to determine product or service price based on manufacturing
cost or full life cycle costs:
1. Full manufacturing cost plus markup
2. Life cycle cost plus markup
3. Full manufacturing cost and desired gross margin percent
4. Full life cycle cost and desired return on assets
F. Analytical and Peak Pricing
A strategic approach to pricing which determines price based on the customer’s willingness to pay. An
example is the various prices charged by airlines for flights between the same two destinations.
Example of the Importance of Speed and Efficiency in the Fashion Industry
Burberry Group PLC is a London-based fashion retailer with several hundred retail stores worldwide,
providing its famous trench coats, and a variety of women’s and men’s fashion clothing. Burberry CEO,
Angela Ahrendts, upon taking the position in July 2006, noticed that the company was making “way too
much stuff.” There were too many product lines, for example, 20 different versions of men’s and
women’s polo shirts. The complexity of the large number of products resulted in delay throughout the
value chain – design, manufacturing, and distribution.
The Five Steps of Strategic Decision Making for Burberry, the Fashion Retailer
1. Determine the Strategic Issues Surrounding the Problem.
Burberry, as a fashion retailer, competes on the basis of design and fashion innovation, a
differentiation strategy.
2. Identify the Alternative Actions:
The company can continue to focus on product development, design and innovation, with the
expectation that the delays will not affect customer satisfaction or profitability. Alternatively, the
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Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
company could review its product lines and look for efficiency throughout the value chain, and expect
to maintain the unique designs that have satisfied Burberry customers in the past.
3. Obtain Information and Conduct Analyses of the Alternatives
Ahrendts directed the CFO to prepare a report showing what amount each product contributed to
overall sales. The findings were that 20% of the products produced 80% of total sales. In order to
determine product profitability, Ahrendts directed the CFO to develop appropriate computer-based
accounting and operating systems. The enterprise system, SAP, was introduced in 2007.
4. Based on Strategy and Analysis, Choose and Implement the Desired Alternative
Based on the CFO’s information and her understanding that the firm’s strategy required
comprehensive, coherent, product development, Ahrendts decided to reduce the number of Burberry’s
products by one third and to switch from two large collections of fashion per year to five smaller
collections. At the same time, she coordinated product development from London, so that all Burberry
lines provided the “…one brand and one message.” The changes allowed the company to design and
produce its fashions much more quickly, to adjust much more rapidly to changes in customer
expectations, and to reduce costs through more efficient processes – design through retail sales.
5. Provide an On-going Evaluation of the Effectiveness of implementation in Step 4.
The changes made by the new CEO have made the company more profitable and better able to meet its
customer expectations — a more competitive company. However, since design and innovation are the
hallmarks of the fashion industry and for Burberry, the company must maintain a priority on these
facets of the business as well.
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