Montclair Paper Mill-The Deep Color Grades the fact that an English translation of the Japanese

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Montclair Paper Mill

Teaching Commentary

OVERVIEW

Target Cost and Standard Cost. Much has been written in recent years that positions the concept of “target cost” as

very distinct from the concept of “standard cost.” Many authors are very emphatic that target cost is preferred over

standard cost as a cost management tool.

The Benefits of Target Costing? The benefits of “target costing” seem apparent at one level. And, in spite of

frequent misattribution, it is not a “Japanese” innovation. The concept can be traced back at least as far as eighty-five

• Canon in the personal copier

• FedEx in overnight mail

And, most of these instances did not start with a

“clean slate.” Target costing is sufficiently appealing at a

ANSWERS TO ASSIGNMENT QUESTIONS

Question 2

The Target Cost Methodology. Target cost is

an ex ante concept that starts at the end-user stage of the

value chain. Very broadly, the concept is “price–based

the target cost derives.

For products or services for which there is a

well-established substitute in the market, the “value price”

is just the selling price for that substitute item. This

concept is very simple to apply—the “value price” for a

product is the selling price of the competing product.

When there is not a well-established substitute product in

the market, the “value price” is much more difficult to

compute. Then, conceptually, it is equal to the “economic

value” that the product or service generates in the end–

price could be lowered substantially. But, how much

lower? They chose $60 as the price point, based on the

Dollar equivalent of the Yen value of the normal

here, the value price is the $2,200/T, which Reebok is

paying to its printer for Ajax’ competing deep green

is beyond the scope of this commentary. It is largely

irrelevant to Montclair anyway, as long as that price

prevails in the market.

The last step in netting back to an “allowable”

mill target cost is to deduct an allowance for a reasonable

return on the investment at the Montclair mill. This is the

beyond the scope of this commentary. For our purposes,

suffice it to say that we are estimating a capital charge of

$120T based on a fully allocated mill investment of

$800/T (valued at replacement cost with full capacity

utilization), and an earning rate of 15% based on a

factory–level proxy for the firm’s cost of capital.

Since the Montclair mill sells to merchants from

its distribution center (DC), we must further deduct the

costs to get the product to and through the DC, including

a capital charge on the investment in the DC, as follows:

* Target cost before capital charge is $1,220. The capital

charge is based on the final target cost. This is a classic

simple “simultaneous equation” problem as follows:

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cost inefficiencies at the mill, as we demonstrate next.

Question 3

It is possible to decompose any standard cost

into an “ideal” cost (which allows no waste, scrap, or

conversion inefficiency) and the “allowable variance.”

“Allowable Variance”

Materials lost 1,257 ($2,159 – $902)

Lost paper machine time 254 ($427 – $173)

Conversion time lost 36 ($303 – $267)

Ship to DC 11 (A non-value adding step)

Standard Cost $2,900

In this situation, the ideal cost for the mill is

$1,342/T versus a target cost of $1,162/T. That is, even if

operations were perfect, the cost would still be $180/T too

Target Costing in Action (Question 4). Once

management at Montclair accepted the fact that the

product cost of $2,900 was more than $1,700/T too high,

they decided to undertake “reengineering” of the

manufacturing process for that product. It took this

2. Paper machine yields (getting “on grade” faster)

3. Conversions cost (“make” vs. “buy”)

As we will show here, each of these areas

finished sheet if the scrap paper was used properly. In the

standard cost mindset, there was no incentive to

experiment with a dramatically different and supposedly

lower quality raw materials mix. Once the scrap usage

experiments began, the results were so impressive that the

scrap percent just kept growing. This is parallel to the

well-known story in other industries where standard set–

up times of several hours for stamping machines have

been reduced, over time, to a few minutes by steady

application of the “Kaizen” (continuous improvement)

philosophy.

allows sufficient volume to justify a long enough

production run to amortize the anticipated heavy

changeover costs. Montclair needed to schedule a four-

hour run to get even as high as only .46 yield (about two

hours “set–up” time to get “on shade” and about two hours

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the target cost study.

For Montclair, a “root cause” analysis of the long

change–over time revealed that getting “on shade” for a

designer-created subtle color such as “Forest Green” is

market demand for green “broke” (scrap), the mill was

able to buy essentially unlimited quantities at very low

prices. Broke dealers were perplexed as to why anyone

would even want colored broke! The very thin demand

shade” in forty minutes instead of two hours if they could

start with green “broke.” The software they developed

(120 minutes ÷ (120 + 40)).

Dyes cost. A related advantage of starting with

up to 75% green fiber in the raw-materials mix is that

much less dye is needed to achieve the exact Forest Green

shade. In the standard cost, the $1,196 for “other

materials and dyes” was calculated as follows:

Perfect yields:

Dyes $500

Fillers 50 $550

Conversion cost. Another project team tackled

this problem by seriously considering the “make” versus

“buy” option. Based on a preliminary “best practices”

survey, a “world class” converting cost of $150/T was

Over a period of eighteen months, the $303/T

conversion cost for Forest Green Carnival Cover was

reduced to $240 (a 20% reduction) as shown in the

following table:

Interestingly, this dramatic reduction was not

seen as creating a new “standard,” but rather as just the

results were extremely encouraging to the management

team in the mill. Not all these new improvements were

being realized all the time, but the target cost mindset and

the Kaizen philosophy meant the lower numbers were

now well within reach. The new “standard” was now

lower by $1,738 ($1,162 versus $2900)—almost a 60%

reduction. This is a clear indication that, for this mill, the

concept of “attainable standard” was amenable to

continuous improvement in a dramatic way once it

incorporated a target cost framework.

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Machine conversion ($520 ÷ 3 ÷ .75) 230

$820

* Students will probably use $60/T here, per case Exhibit

Pack & Ship to DC 11

TOTAL $1,162

And, the new “standard,” $1,162, was $180

below that $1342 figure that had been considered the

Using the Value Chain to Rethink

Distribution Cost (Question 5). At about this stage of

the project, it was observed that the $1,162 manufacturing

target cost was based on a $83 deduction from sales price

for costs in Montclair’s distribution center ($25 + $58,

from Exhibit 1). This was based on the current

“standard” of three inventory turns for deep colors in the

DC. It was noted that this represented an excellent

opportunity for improved inventory management. Some

reduce the normal gross margins from the range of 25 to

35% to the range of 5 to 7%. With no inventory or

Actually, the following table shows that the

merchant should prefer mill direct versus stocking status

for items like this. They earn a much better ROA:

MONTCLAIR PAPER

Capital Paper Merchants

Assets

A/R (23 ÷ 6) = 4

Inventory (23 -5 =18 ÷ 6) = 3 ~$13M

Warehouse & Equip. = 6

P/S =

GM –OH =.5

23

=2%

S/A =

23

13

= 1.8X

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Much Better Than “Stocking.”

At this point in our analysis, compared to the

situation with no change in distribution cost, the mill has

$610/T of “slack” to “manage” ($1,772 – $1,162). The

mill could rely on the new “standard” and cut its price

$687 below the $2,310 competitive level [$610  1,048 ÷

.93]. Or, the mill could hold price and earn $610 more

Per ton to Mill 1466 1466 2047 1437

Freight to Merchant (30) (30) (30) (30)

Return & Allowance (60) (60) (60) (60)

Net to Montclair 1376 1376 1957 1347

DC Costs (94) (65) (65) (65)

Mill Margin (120) (120) (120) (120)

Mill Mfg. Target Cost 1162 1191 1772 1162

Summary of the Cost Analysis for Questions

2, 3, 4, and 5. The result of this project was a dramatic

turnaround. The project started with a standard cost of

$2,900 versus a target cost of $1,162 and an ideal cost of

$,1342—target cost $180/T lower than perfect! After

about eighteen months of price-based costing initiatives,

management tool in a situation where standard cost was

essentially useless to management. The mill management

team had no idea when the target cost project started that

the results could be so dramatic. In fact, the situation for

“deep colors” looked so bleak before the project teams

began working that the problem was seen then as more

likely a “make versus buy” choice.

The key benefit of target costing here was that it

Cost Concepts as Cost Management Tools

“Ideal” Manufacturing Cost (A)

(No waste, no scrap, no inefficiency, no delays,

perfect formulations, and perfect plant layout)

At the beginning of the project described in this

case, too much management attention was focused on (C)

vs. (D). There was heavy pressure to move (C) toward

(D) in order to minimize unfavorable variances for public

financial reporting. Too little management attention was

focused on (A), which is often dismissed as having

dysfunctional motivational impact. No attention at all

was focused on (B). At the end of the project, the most

useful cost management tool focused on (A) vs. (B), in

relation to (D). The standard cost concept (C) essentially

dropped out of the picture.

TEACHING STRATEGY

We cover this case in one ninety-minute class period. We

use the case after we have discussed standard cost

systems and after we have introduced the value chain

concept. As noted above, we see the purpose of the

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discussion as reinforcement for the student on the

calculational aspects of target cost (using a value chain)

and ideal cost.

are brought out for discussion, we usually don’t have

much time left for Question 1. As noted earlier, probing

for an explicit managerial response is not as important, for

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OVERLAY #1 (Question 2)

EXHIBIT 1

Value Chain for One Use of One Ton of One Uncoated, “Deep Color” Grade

Customer (Reebok – for a sales promotion brochure, 20,000 copies; 2 pieces per 23“x35” sheet; the paper came from

Ajax Paper Company’s mill in Middletown, Ohio)

Finish (10 hrs.) 1,000 65 pound uncoated cover-deep green color(1)

Paper 2,310 2,200/T÷.952 yield

Plates/Ink/Misc. 600

Total 1,989 for stocking items) Value to Mill 1,195

Margin (14%) $321 —Mill Capital Charge (120)

Mill Target Cost $1,162

Mill (Ajax Paper Company)

Per Ton Basis

(1) For this job, the customer chose $2,200/T paper made by Ajax Paper Co. for which the merchant pays $1,466/T. For

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OVERLAY #2 (Question 3)

EXHIBIT 2

Standard Cost

Sixty-Five-Pound Carnival Cover (Uncoated) – Forest Green Color – Sheets Pack

Fiber

% Mix Market Price

IDEAL

Paper Machine (Yield = 46%) COST

Converting (Yield = 88%)

Manufacturing Cost Summary (Yielded)

Overall Cost Summary

OVERLAY #3

1. FIBER MIX

EXHIBIT 2

Standard Cost

Sixty-Five-Pound Carnival Cover (Uncoated) – Forest Green Color – Sheets Pack

Fiber

156

Paper Machine (Yield = 46%)

Converting (Yield = 88%)

Manufacturing Cost Summary (Yielded)

Overall Cost Summary

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2. USE COLORED SCRAP Reduce time to get “on shade” from

two hours to forty minutes

EXHIBIT 2

Standard Cost

Sixty-Five-Pound Carnival Cover (Uncoated) – Forest Green Color – Sheets Pack

Fiber

Paper Machine (Yield = 46% 75% for 2 hours of good paper)

Converting (Yield = 88%)

Manufacturing Cost Summary (Yielded)

Overall Cost Summary

Per Ton

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OVERLAY #5

3. CONVERTING COST

EXHIBIT 2

Standard Cost

Sixty-Five–Pound Carnival Cover (Uncoated) – Forest Green Color – Sheets Pack

Fiber

% Mix Market Price

Paper Machine (Yield = 46%)

$2,276/T

Converting (Yield = 88%) .9

$2,900/T 1,162

Manufacturing Cost Summary (Yielded)

4. INVENTORY MANAGEMENT

Overall Cost Summary

Per Ton

OVERLAY #6

EXHIBIT 2

Standard Cost

Sixty-Five-Pound Carnival Cover (Uncoated) – Forest Green Color – Sheets Pack

Fiber

% Mix Market Price

Virgin Hardwood (for opacity and smoothness) .63 $425/T

Paper Machine (Yield = 46%) IDEAL

$2,276/T

Converting (Yield = 88%)

Manufacturing Cost Summary (Yielded)

Materials $2,159 [(704 + 1,196) ÷ .88]

Overall Cost Summary

Per Ton