Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
13-1
Chapter 13
13-1. Strategy; the Theory of Constraints
1. What is the firm’s competitive strategy?
Information in the case suggests that CI is the high-cost producer that led the industry in quality,
which implies differentiation. What strategy are they pursuing now? Cost leadership, through
robotics, increasing batch sizes, reducing idle time, efforts to reduce overhead. There should be a
industry and since competitors responded, made everyone in the industry less profitable. The steep drop
in price of AA knives is not consistent with CI’s quality image
2. What motivated the cost reduction strategy?
A depressed market for their product
Cash flow problems
Losses
Is the firm close to bankruptcy? In the actual case, the bank gave the firm 6 months or they would
enforce reorganization.
Did the cost reduction strategy work? Why?
The answer is no, because:
a. Efficiency through larger batches, less idle time, and reduced set-up time: the result was an
i.) the arc welders were not released but were reassigned
ii.) the robotics eventually caused additional labor costs necessary to manage them
3. How did the standard costs system affect the cost reduction strategy?
Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
13-2
4. What is the role of WIP in the cost reduction strategy?
• Insurance against machine or scheduling failure
5. Is the new Production Control/Inventory Control (PCIC) manager on the right track with the smaller
lot sizes?
6. What steps is the PCIC likely to take now?
The five steps of TOC are:
• The binding constraints: heat treating (due to excessive overtime) and hardfacing (due to under–
• On-going search for constraints
Results in the actual firm: WIP and overtime fell; unfortunately, the focus was only on the plant,
and marketing was not integrated into the effort.
7. What type of cost system should be used at CI?
Standard costing is an effective method for controlling costs in the manufacturing plant, and can
causal cost factors in the plant, as a way to identify activities that do not facilitate throughput.
Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
13-3
13-2 Blue Ridge Manufacturing (B)
Note: This case uses information from Case 5-1: Blue Ridge Manufacturing (A)
Answers to Discussion Questions:
1. What is Blue Ridge Manufacturing’s strategy now that it has developed the new products and become
a global competitor? Has the strategy changed?
With the growing acceptance of the new ink and the upgraded quality throughout its product lines, one
could argue that Blue Ridge is moving from the cost leadership strategy to a differentiation strategy based
2. How should Blue Ridge Manufacturing adapt to the new competitive environment?
With the change to differentiation and/or confrontation (per Robin Cooper), the role of cost
management has changed. Previously, there was a focus on cost efficiency and accuracy of cost
information, to support the previous cost leadership strategy. Consistent with this approach, the firm had
adopted ABC costing in both manufacturing and in the costing of the three major customer groups.
cycle. The reason is that, as noted in the case, the design work for the new products can be significant in
itself, and most importantly, can have a significant effect on downstream costs. For example, a poorly
designed product might be more difficult and costly to manufacture. These concerns mean that the idea
of a product development team is a very sound idea. The team should use cost management principles to
facilitate the development of low cost product design and manufacturing methods.
Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
13-4
The changed competitive circumstances point to the need for Blue Ridge to adapt its cost management in
two ways. First, design costs should be carefully considered as part of the ABC costing system. Blue
Ridge needs to know how the design costs of different orders/customers affects the overall costs of the
order and serving the customer. This is particularly true for customers that submit incomplete or poorly-
developed designs which then leads to additional design work for Blue Ridge and possibly also to
additional manufacturing costs. That is, the poor design may be more difficult to manufacturer, leading to
long setup times and low productivity for these orders.
Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
13-5
13-3 Nebraska Toaster
1. Calculate Product Target Cost: for the Toaster Company is $16.00
(Competitive Market Price $20 – Desired Profit $4 = Target Cost $16)
This $16.00 target cost is then compared to the company current/estimated cost, produce based on the
features wanted a toaster oven, of $19.70 to arrive at the cost gap of $3.70. This $3.70 cost gap then
2. Combine step 2 and step 3from the case, we derive the Table 5 amounts. The “Relative Ranking”
column percentages are from Table 3.
Table 5 Quality Function Deployment Analysis
Components
or Functions
Customer
Requirements
Heating
Unit
Display
Light
Lever
Spring
Coil
Temp.
Control
& Timer
Body
Design
Crumb
Catcher
Relative
Rank-
ing
Toasts and grills
properly
50% x
28% =
14%
20% x
28% =
5.6%
20% x
28% =
5.6%
10% x
28% =
2.8%
28%
Size
50% x
17% =
8.5%
50% x
17%=
8.5%
17%
Speed of toasting
70% x
17%=
11.9%
10% x
17%=
1.7%
20% x
17%=
3.4%
17%
Bagel Capacity
30 %x
11%=
3.3%
5% x
11%=
0.55%
60% x
11%=
6.6%
5 %x
11%=
0.55%
11%
Appearance
20 %x
5%=
1%
80% x
5%=
4%
5%
Easy to Clean
50 %x
22%=
11%5
45% x
22%=
9.9%
5 %x
22%=
1.1%
22%
Converted
Component
Ranking
48.7%
1%
6.15%
5.6%
4.5%
32.4%
1.65%
100%
Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
13-6
This gives the company the importance and value of each component relative to the features that
create value to the customer. For example, the customer requirement of toast and grill properly
results from 50% of the heating unit 20% for both the lever and the spring coil and 10% for the
temperature control and timer.
Calculating Value Index for Each Function
The next process is the value index that targets areas for value engineering. It considers the toaster
oven customer requirements at their level of importance to the amount of cost that are involved with
that component. The value index shown in Table 6 calculates a ratio that shows the areas were cost
importance and cost, and are areas not requiring value engineering.
Column 2, the “Component % of Cost” column percentages are inputted from the last column of
Table 2. Column 3, the “Relative Importance %” column percentages are inputted from the last row
of Table 5.
Table 6 Value Index
(1) Component or
Function
(2)
Component %
of Cost
(3) Relative
Importance %
(4) Value
Index =
Col. 3 /
Col. 2
(5) Action
Implied
Heating Unit
20
48.7
2.435
enhance
Display Light
13
1
0.077
reduce cost
Lever
5
6.15
1.23
ok
Spring Coil
5
5.6
1.12
ok
Temperature Control Timer
5
4.5
0.90
reduce cost
Body Design
43
32.4
0.753
reduce cost
Crumb and Grease Catcher
9
1.65
0.183
reduce cost
TOTAL
100%
100%
Applying Value Engineering and Cost reduction Techniques
From the value index, Nebraska Toaster Company can see what areas to enhance and areas to apply
value engineering. At this point the entire company can generate ideas on how to accomplish these steps
of reducing costs and maintaining the level of functionality. For example, they should enhance and spend
Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
13-7
13-4. Mercedes-Benz All Activity Vehicle (AAV)
The target costing case literature contains numerous examples of Japanese cost management practices;
however, few cases describe the use of target costing by large companies outside Japan. The purpose of
the Mercedes-Benz AAV case is to consider the competitive environment of a leading German
automotive manufacturer and the company’s response to changing competitive conditions. The teaching
plan generally follows the suggested student assignment questions. In places, I recommend considering
additional material during the case discussion. These questions are identified by a check mark.
Student Assignment Questions
1. What is the competitive environment faced by MB?
Students will identify a number of changes, including significant market share lost to Japanese
companies such as Lexus. Stress the importance of a cultural change taking place within top management
at Mercedes. Reinforce that Mercedes is a company that had never lost money. They simply built the best
car their engineers could design and priced it above cost. Demand often exceeded supply. As a result, cost
had never been a primary consideration. Changes include:
2. How has MB reacted to the changing world market for luxury automobiles?
Students should identify the following changes implemented by management at Mercedes; try to
get them to explain how different these approaches were from traditional strategies at Mercedes:
• many new product introductions;
• partnering with suppliers;
• lead time from concept to introduction reduced.
3. Using Cooper’s cost, quality, functionality chart, discuss the factors on which MB competes with other
automobile producers such as Jeep, Ford, and GM. If the instructor wishes to give a brief mini-lecture on
Robin Cooper’s survival triplet and confrontation strategy, this is a good point in the case discussion to do
so. (Robin Cooper, When Lean Enterprises Collide, Boston: Harvard Business School Press, 1995.)
The factors are:
toward the luxury end of the spectrum. Also, unlike many Japanese examples, Mercedes does not use
target costing as a strict cost control mechanism to produce the lowest priced product in its class.
4. How does the AAV project link with MB strategy in terms of market coverage?
The new introductions expand the product line of the traditionally luxury-oriented manufacturer. Recent
product introductions include the following:
• A class;
Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
13-8
These new introductions include new sports cars and off-road vehicles. The C-class is a mid-sized
vehicle sometimes referred to as the baby-Benz.
Let’s discuss the elements of the target costing model and how these elements are developed.
At this point in the discussion I usually write the target costing formula on the board and ask students to
consider sources of various inputs:
What are the sources of input for the projected selling price?
Students will most likely identify the following sources of information:
Stress the broad, cross-functional aspects of acquiring consumer information. To compare products, the
company had to evaluate existing competitive vehicles as well as vehicles under development.
What factors are considered when developing the required margin?
This question provides a link to finance classes. Most students have studied the concepts of weighted–
average cost of capital. I recommend spending a few minutes reviewing these concepts and linking cost of
capital to net present value (NPV) analysis. Because of the capital-intensive structure of automobile
• sales volume by class.
The MB case suggests the target cost is “alive.” Is this consistent with the ideals of target costing?
I generally emphasize that Mercedes did not consider the target cost to be locked in. It was a
moving target. As engineering changes became necessary, the target cost was allowed to move. However,
5. Explain the process of developing a component importance index. How can such an index guide
managers in making cost reduction decisions?
The index development process has five steps, as follows:
• consumer importance category rankings;
• target cost index;
Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
13-9
I recommend making slides of Tables 1-5 to facilitate discussion. Index development is an important
element in the early conceptualization phase of the AAV. The indexes help to quantify some very abstract
concepts.
Table 1. From conversations with potential consumer groups, a list of key categories was
developed. Next, potential customers were asked to rate the importance of each category. Their responses
were computed as a percentage. Thus, safety and comfort of the AAV were viewed as significantly more
Table 4 builds on Table 3 by weighting the percentages computed in Table 3 by the importance
percentage calculated in Table 1. The key point is to understand which function groups contribute the
most (least) to important (less important) consumer categories.
Table 5 results in a target cost index that attempts to capture cost and benefit trade-offs. As
discussed in the case, this index may indicate a cost in excess of the perceived value of a function group.
Thus, opportunities for cost reduction (aligned with customer requirements) may be identified.
6. How does MB approach cost reduction to achieve target costs?
At this point, ask students to identify various value-engineering strategies. At Mercedes, reducing
7. How do suppliers factor into the target costing process? Why are they so critically important to the
success of the MB AAV?
From the conceptual phase through the production phase, the suppliers of systems for the AAV
truly were partners. Suppliers attended regular meetings with the cost planners throughout the entire
process. Thus, suppliers were design and development partners from very early stages of development,
responsible for meeting cost targets.
Why is the relationship with suppliers a crucial element in the success of the AAV?
Suppliers provide entire systems for the AAV.
associated with accidents on a major bridge.
8. What role does the accounting department play in the target costing process?
Stress the fact that accountants were watchdogs in the target costing process. Their primary
responsibility was to ensure costs did not exceed targets during the production phase. Thus, the
accountants’ role was as follows:
• cost control;
Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
13–10
What are some of the organizational barriers that may challenge managers attempting to introduce TC
systems?
Try to get students to identify various impediments to target costing systems in the United States.
Examples may include:
Teaching Strategies for Readings
13-1: “Target Costing at a Consumer Products Company”
This article looks at target costing, a process driven by the market. It goes through the five main steps in
target costing and then applies these steps through a consumer products example. Target costing works
best when fully integrated into the pre-existing product development process.
Discussion Questions:
1. How does target costing differ from cost plus pricing and what key elements does it incorporate?
It differs from cost-plus pricing in that it’s a way of managing the product-development process. The
2. Explain how fixed costs are handled in the calculation of a target cost.
The fixed costs include not only fixed manufacturing costs, but also selling, general, and administrative
3. Where do opportunities to reduce costs occur?
Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
13–11
13-2 “Integrating Activity-Based Costing and The Theory of Constraints”
The authors of this article show how ABC costing and the Theory of Constraints (TOC) methods
can be compared and used in a complementary fashion.
Discussion Question: Explain how ABC and TOC can be viewed as complementary methods.
The ABC costing approach provides accurate information for product costing and evaluating
the relative profitability of different products, especially when the mix of required
manufacturing activities differs significantly between products. However, as the authors
point out, the ABC method takes a “resource usage” approach to determining product
equivalence of resource supply and resource usage, provides a useful long-term measure of
product profitability, one wherein the short-term availabilities and limitations of supply are
not considered.
In contrast, the theory of constraints enables the manager to consider the short-term
fluctuations in supply. Bottlenecks are identified and short-term profitability measures are
determined to help the manager choose the most profitable product mix, given the current
supply limitations.
Overall, the methods are complementary because the ABC method allows accurate
assessment of the longer-term profitability of the firm’s products, while the TOC method
allows effective short-term decision making when resource supplies and bottlenecks are
Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
13–12
13-3: “Is TOC for You?”
This article gives a good introduction to the objectives and techniques of the theory of constraints (TOC).
There is also a discussion of key performance measures related to to the application of TOC in
management accounting.
Discussion Questions:
1. What is meant by throughput?
Throughput equals sales less direct materials cost.
2. What are the five steps of TOC?
The five steps of TOC are:
• Identify the system’s constraint(s), and prioritize them according to importance.
3. List some ways to increase the capacity on a constraint.
• Performing regular maintenance on the constraint to prevent breakdowns.
4. What are the five management accounting truths related to TOC?
• Management Accounting Truth #1: Process improvements work together to speed up the whole operation..
• Management Accounting Truth #2: You have to spend money to make money.
• Management Accounting Truth #3: Operations can be made more efficient by improving labor efficiency
contribution margin.
Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
13–13
13-4: “Environmental Considerations in Product Mix”
With pressures from stakeholders, government and the public, companies often feel the pressure to
balance making profits with achieving environmental responsibility as well. This article looks at two
different methods to account for environmental costs: ABC costing method and TOC. It shows
calculations of both while also offering the positives and negatives to each method.
Discussion Questions:
1. What are some of the main differences between TOC and ABC?
ABC recognizes that different products use resources based on complexity rather than volume. Around
the same time, Eliyahu M. Goldratt promulgated TOC to prioritize scheduling of products over limited
resources in order to maximize profit.
2. What are the common internal environmental costs companies face, according to the article?
Internal environmental costs when regulations are imposed may include record keeping, reporting,
Chapter 13 – Cost Planning for the Product Life Cycle: Target Costing, Theory of Constraints, and Strategic Pricing
13–14
3. Explain several scenarios where using TOC is always the best choice.
TOC is always the best choice given the following conditions:
1. Products use shared resources.
5. When capacity increases are made, the constrained
resource is the first resource purchased.
6. The market dictates the price of the competing