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SYLLABUS - 2016
SYLLABUS - 2016

FINAL : PAPER -

15
15

STRATEGIC COST MANAGEMENT - DECISION MAKING

FINAL

PAPER - 15 STRATEGIC COST MANAGEMENT - DECISION MAKING FINAL STUDY NOTES The Institute of Cost
PAPER - 15 STRATEGIC COST MANAGEMENT - DECISION MAKING FINAL STUDY NOTES The Institute of Cost

STUDY NOTES

COST MANAGEMENT - DECISION MAKING FINAL STUDY NOTES The Institute of Cost Accountants of India CMA

The Institute of Cost Accountants of India

First Edition : August 2016 Reprint : January 2018

Published by :

Directorate of Studies The Institute of Cost Accountants of India (ICAI) CMA Bhawan, 12, Sudder Street, Kolkata - 700 016 www.icmai.in

Printed at :

Jauant Printery LLP 352/54, Girgaum Road Murlidhar Temple Compound Mumbai - 400 002.

Girgaum Road Murlidhar Temple Compound Mumbai - 400 002. Copyright of these Study Notes is reserved

Copyright of these Study Notes is reserved by the Institute of Cost Accountants of India and prior permission from the Institute is necessary for reproduction of the whole or any part thereof.

of India and prior permission from the Institute is necessary for reproduction of the whole or

Syllabus- 2016

Syllabus Structure

A

Cost Management

20%

B

Strategic Cost Management Tools and Techniques

50%

C

Strategic Cost Management - Application of Statistical Techniques in Business Decisions

30%

A 20% B 50% C 30%
A
20%
B
50%
C
30%

ASSESSMENT STRATEGY

There will be written examination paper of three hours

OBJECTIVES

On completion of this subject students should have developed skills of analysis, evaluation and synthesis in cost and management accounting and, in the process, created an awareness of current developments and issue in the area. The subject covers the complex modern industrial organizations within which the various facets of decision-making and controlling operations take place; the subject includes discussion of costing systems and activity based costing, activity management, and implementation issues in modern costing systems.

Learning Aims

The syllabus aims to test the student’s ability to:

Identify the conventions and doctrines of managerial and cost accounting and other generally accepted principles which may be applied in the contemporary cost management models

Identify major contemporary issues that have emerged in strategic cost management

Discuss a number of issues relating to the design and implementation of cost management models in modern firms

Application of Operation Research in Strategic Decision Making

Skill set required Level C : Requiring skill levels of knowledge, comprehension, application, analysis, synthesis and evaluation

Section A : Business Strategy

20%

1.

Business Strategy

 

Section B : Strategic Cost Management Tools and Techniques

50%

2.

Decisions Making Techniques

 

3.

Standard Costing in Profit Planning

 

4.

Activity Based Cost Management – JIT and ERP

 

5.

Cost of Quality and Total Quality Management

 

Section C : Strategic Cost Management – Application of Statistical Techniques in Business Decisions

30%

6.

Application of Operation Research and Statistical Tools in Strategic Decision Making

 

SECTION A: BUSINESS STRATEGY [20 MARKS]

1. Business Strategy

(a)

Developments in Cost Management:

(i)

Life Cycle costing

(ii)

Target costing

(iii)

Kaizen Costing

(iv)

Value Analysis and Value Engineering

(v)

Throughput Costing

(vi)

Business Process Re-engineering

(vii) Back-flush Accounting

(viii) Lean Accounting

(ix)

Socio Economic Costing

(b)

Cost Control and Cost Reduction – Basics, Process, Methods and Techniques of Cost Reduction programme.

SECTION B: STRATEGIC COST MANAGEMENT TOOLS AND TECHNIQUES [50 MARKS]

2.

Decision Making Techniques

 

(a)

Marginal Costing- Differential costing-CVP Analysis – Profit Volume Graphs – Contribution Approach

(b)

Decisions involving alternative choices – Optimum utilization of resources – Make or Buy –

 

Evaluation of Orders – Multiple scarce resource problems- Product sales pricing…

etc

 

(c)

Pricing Decisions and Strategies – New Product Pricing, Use of Costs in Pricing, Sensitivity Analysis in Pricing Decisions; Monopoly Pricing vs. Competitive Pricing; Bottom Line Pricing

(d)

Costing of Service Sector – methods, pricing, performance measurement

(e)

Transfer Pricing - Objectives, Methods ( Cost Based, Market Price Based, Negotiated Pricing), Advantages and Disadvantages, Criteria for setting Transfer Prices, Transfer Price in different situations, Situations causing Conflicts and resolving the Conflicts;

(f)

Relevant Cost Analysis : Relevant Cost, Irrelevant Costs - Sunk or Historical Cost, Committed Cost, Absorbed Cost, Situations where Fixed Costs become relevant for decision – making and its related implications

(g)

Profitability Analysis – Product wise / Segment Wise / Customer wise

3.

Standard Costing in Profit Planning

 

(a)

Variance Analysis - Investigation of Variances, Planning and Operating Variances, Controllable / Non-controllable Variances, Relevant Cost Approach to Variance Analysis; Variance analysis under marginal costing and absorption costing; Activity Ratios; Application of budgetary control and Standard Costing in Profit planning, Standard Costing Vs Budgetary Control, Reconciliation of Actual Profit with Standard Profit and /or Budgeted Profit.

(b)

Uniform Costing and Inter-firm comparison.

4.

Activity Based Cost Management – JIT and ERP

 

(a) Activity Based Cost Management - Concept , purpose, benefits, stages, relevance in decision- making and its application in Budgeting, Responsibility accounting, Traditional Vs. ABC System – comparative analysis

(b)

JIT – introduction, Benefits, Use of JIT in measuring the Performance

(c)

ERP and its applications in strategic cost management

(d)

Bench Marking

5. Cost of Quality and Total Quality Managment

(a)

TQM - Basics, Stages, Principles, Control, Corrective actions

(b)

PRAISE-Steps, Problems, implementation

(c)

PARETO Analysis

(d)

Quality Costs

SECTION C: STRATEGIC COST MANAGEMENT – APPLICATION OF STATISTICAL TECHNIQUES IN BUSINESS DECISIONS [30 MARKS]

6. Application of Operation Research and Statistical Tools in Strategic Decision Making

(a)

Learning Curve,

(b)

Linear Programming (Formulation only)

(c)

Assignment,

(d)

Transportation

(e)

Simulation

(f)

Network Analysis – CPM / PERT

Contents

SECTION A – COST MANAGEMENT

Study Note 1 : Cost Management

1.1

Life Cycle Costing

 

1

1.2

Target Costing

 

8

1.3

Kaizen Costing

14

1.4

Value Analysis and Value Engineering

 

15

1.5

Throughput Costing

 

21

1.6

Business Process Re-engineering

 

33

1.7

Back-flush Accounting

 

34

1.8

Lean Accounting

40

1.9

Socio Economic Costing

 

43

1.10

 

Cost Control and Cost Reduction – Basics, Process, Methods and Techniques of Cost Reduction Programme

47

SECTION B – STRATEGIC COST MANAGEMENT TOOLS AND TECHNIQUES

 

Study Note 2 : Decision Making Techniquesti

 

2.1

Marginal Costing

 

51

2.2

Transfer Pricing

 

145

 

Study Note 3 : Standard Costing in Profit Planning

 

3.1

Variance Analysis

 

165

3.2

Uniform Cosing and Inter-firm comparison

 

226

3.3

Inter Firm Comparison

 

228

 

Study Note 4 : Activity Based Cost Management - JIT and ERP

 

4.1

Activity Based Cost Management

 

231

4.2

Just-In-Time (JIT)

 

245

4.3

Enterprise Resource Planning (ERP)

 

251

4.4

Bench Marking

 

254

 

Study Note 5 : Cost of Quality and Total Quality Management.1

 

5.1

Total Quality Management (TQM)

 

259

5.3

Six Sigma

261

5.4

Pareto Analysis

264

5.5

Quality Costs

267

SECTION C – STRATEGIC COST MANAGEMENT – APPLICATION OF STATISTICAL TECHNIQUES IN BUSINESS DECISIONS

Study Note 6 : Application of Operation Research and Statistical Toolsin Strategic Decisions Making

6.1

Learning Curve

281

6.2

Linear Programming

289

6.3

Assignment

296

6.4

Transportation

307

6.5

Simulation

327

6.6

Network Analysis – CPM/PERT

342

Study Note - 1 COST MANAGEMENT This Study Note includes 1.1 Life Cycle Costing 1.2

Study Note - 1

COST MANAGEMENT

Study Note - 1 COST MANAGEMENT This Study Note includes 1.1 Life Cycle Costing 1.2 Target
Study Note - 1 COST MANAGEMENT This Study Note includes 1.1 Life Cycle Costing 1.2 Target

This Study Note includes

1.1

Life Cycle Costing

1.2

Target Costing

1.3

Kaizen Costing

1.4

Value Analysis and Value Engineering

1.5

Throughput Costing

1.6

Business Process Re-engineering

1.7

Back-flush Accounting

1.8

Lean Accounting

1.9

Socio Economic Costing

1.10

Cost Control and Cost Reduction – Basics, Process, Methods and Techniques of Cost Reduction Programme

1.1 LIFE CYCLE COSTING

Meaning of Life Cycle Costing

(a)

Life Cycle Costing; aims at cost ascertainment of a product, project etc. over its projected life.

(b)

It is a system that tracts and accumulates the actual costs snd revenues attributable to cost object (i.e.; product) from its inception to its abandonment.

(c)

Sometimes the terms; cradle-to-grave costing and womb-to-tomb costing convey the meaning of fully capturing all costs associated with the product from its initial to final stages.

Meaning of Product Life Cycle

(a)

Product Life Cycle is a pattern of expenditure, sale level, revenue and profit over the period from new idea generation to the deletion of product from product range.

(b)

Product Life Cycle spans the time from initial R&D on a product to when customer servicing and support is no longer offered for the product. For products like motor vehicles, this time-span may range from 5 to 7 years. For some basic pharmaceuticals, the time-span be 7 to 10 years.

Characteristic of PLCC

(a)

Involves tracing of costs and revenues of each product over several calendar periods throughout their entire life cycle.

(b)

Traces research, design and development costs and total magnitude of these costs for each individual product and compared with product revenue.

(c)

Assists report generation for costs and revenues.

Phases in Product Life Cycle:

The 4 identifiable phases in the product Life Cycle are — (a) Introduction (b) Growth (c) Maturity and (d) Decline. A comparative analysis of these phases is given below —

Cost Management

Particulars

Introduction

Growth

Maturity

Decline

Phase

1

II

III

IV

Sales

Initial stages, hence low.

Rise in sales levels at increasing rates.

Rise in sales levels at decreasing rates

Sales level off and then start decreasing

Volumes

Prices of

High levels to cover initial costs and promotional exps.

Retention of high level prices except in certain cases.

Prices fall closer to cost, due to effect of competition.

Gap between price and cost is further reduced.

products

Ratio of

Highest, due to effort needed to inform potential customers, launch products, distribute to customers etc.

Total expenses remain the same, while ratio of S&D OH to sales is reduced due to increase in sales.

Ratio reaches a normal

Reduced sales

promotion

A of sales. Such normal

promotional efforts as

expenses to

A becomes the industry

the product is no longer in demand.

sales

standard.

Competiti

Negligible and

Entry of a large number of competitors.

Fierce Competition

Starts disappearing due to withdrawal of products.

on

insignificant

Profits

Nil, due to heavy initial costs

Increase at a rapid pace

Normal rate of profits since costs and prices are normalized.

Decline profits due to price competition new products etc.

• in me growm stage, me rirm win maintain me prices at me nign levels, in oruer to realize maximum profits.

• Price reduction will not be undertaken unless (a) the low prices will lead to market penetration, (b) the Firm has sufficient production capacity to absorb the increased sales volume, and (c) Competitors enters the market.

Benefits of PLCC

`

Maturity Growth Sales Decline Introduction
Maturity
Growth
Sales
Decline
Introduction

Time

(a)

Results in earlier actions to generate revenue or to lower costs than otherwise might be considered.

(b)

Ensures better decision from a more accurate and realistic assessment of revenues and costs atleast within a particular life cycle stage.

(c)

Promotes long-term rewarding.

(d)

Provides an overall framework for considering total incremental costs over the life span of the product.

Importance of Product Life Cycle Costing: Product Life Cycle Costing is considered important due to

Importance of Product Life Cycle Costing:

Product Life Cycle Costing is considered important due to the following reasons —

(a)

Time based analysis: Life cycle costing involves tracing of costs and revenues of each product over several calendar periods throughout their life cycle. Costs and revenues can analysed by time periods. The total magnitude of costs for each individual product can be reported and compared with product revenues generated in various time periods.

(b)

Overall Cost Analysis: Production Costs are accounted and recognized by the routine accounting system. However non-production costs like R&D; design; marketing; distribution; customer service etc. are less visible on a product — by — product basis. Product Life Cycle Costing focuses on recognizing both production and non-production costs.

(c)

Pre-production costs analysis: The development period of R&D and design is long and costly. A high percentage of total product costs maybe incurred before commercial production begin. Hence; the Company needs accurate information on such costs for deciding whether to continue with the R&D or not.

(d)

Effective Pricing Decisions: Pricing Decisions; in order to be effective; should include market considerations on one hand and cost considerations on the other. Product Life Cycle Costing and Target Costing help analyze both these considerations and arrive at optimal price decisions.

(e)

Better Decision Making: Based on a more accurate and realistic assessment ot revenues and costs, at least within a particular life cycle stage, better decisions can be taken.

(f)

Long Run Holistic view: Product Life Cycle Costing can promote long-term rewarding in contrast to short-term profitability rewarding. It provides an overall framework for considering total incremental costs over the entire life span of a product, which in turn facilitates analysis of parts of the whole where cost effectiveness might be improved.

(g)

Life Cycle Budgeting: Life Cycle Budgeting, i.e., Life Cycle Costing with Target Costing principles, facilitates scope for cost reduction at the design stage itself. Since costs are avoided before they are committed or locked in the Company is benefited.

(h)

Review: Life Cycle Costing provides scope for analysis of long term picture of product line profitability, feedback on the effectiveness of life cycle planning and cost data to clarify the economic impact of alternatives chosen in the design, engineering phase etc.

Illustration 1.

Wipro is examining the profitability and pricing policies of its Software Division. The Software Division develops Software Packages for Engineers. It has collected data on three of its more recent packages - (a) ECE Package for Electronics and Communication Engineers, (b) CE Package for Computer Engineers, and (c) IE Package for Industrial Engineers.

Summary details on each package over their two year cradle to grave product lives are -

Package

Selling Price

Number of units sold

   

Year 1

Year 2

ECE

` 250

2,000

8,000

CE

` 300

2,000

3,000

IE

` 200

5,000

3,000

Assume that no inventory remains on hand at the end of year 2. Wipro is deciding which product lines to emphasize in its software division. In the past two years, the profitability of this division has been mediocre.

Wipro is particularly concerned with the increase in R & D costs in several of its divisions. An analyst at the Software Division pointed out that for one of its most recent packages (IE) major efforts had been made to reduce R&D costs.

Cost Management

Last week, Amit, the Software Division Manager, decides to use Life Cycle Costing in his own division. He collects the following Life Cycle Revenue and Cost information for the packages (in `)-

Particulars

Package ECE

Package CE

Package IE

 

Year 1

Year 2

Year 1

Year 2

Year 1

Year 2

Revenues

5,00,000

20,00,000

6,00,000

9,00,000

10,00,000

6,00,000

Costs

           

R&D

7,00,000

-

4,50,000

-

2,40,000

-

Design of Product

1,15,000

85,000

1,05,000

15,000

76,000

20,000

Manufacturing

25,000

2,75,000

1,10,000

1,00,000

1,65,000

43,000

Marketing

1,60,000

3,40,000

1,50,000

1,20,000

2,08,000

2,40,000

Distribution

15,000

60,000

24,000

36,000

60,000

36,000

Customer Service

50,000

3,25,000

45,000

1,05,000

2,20,000

3,88,000

Present a Product Life Cycle Income Statement for each Software Package. Which package is most profitable and which is the least profitable? How do the three packages differ in their cost structure (the percentage of total costs in each category)?

Answer:

Life cycle Income Statement (in ` 000s)

Particulars

 

Package ECE

   

Package CE

   

Package IE

 
 

Y1

Y2

Total

%

Y1

Y2

Total

%

Y1

Y2

Total

%

Revenues

500

2,000

2,500

100%

600

900

1,500

100%

1,000

600

1,600

100%

Costs

                       

R&D

700

-

700

28%

450

-

450

30%

240

-

240

15%

Design

115

85

200

8%

105

15

120

8%

76

20

96

6%

Manufacturing

25

275

300

12%

110

100

210

14%

165

43

208

13%

Marketing

160

340

500

20%

150

120

270

18%

208

240

448

28%

Distribution

15

60

75

3%

24

36

60

4%

60

36

96

6%

Cust. Service

50

325

375

15%

45

105

150

10%

220

388

608

38%

Total Costs

1065

1,085

2150

86%

884

376

1260

84%

969

727

1696

106%

Profit

   

350

14%

   

240

16%

   

(96)

-6%

Observation: Package ECE is most profitable, while package IE is least profitable.

Illustration 2.

A2Z p.l.c supports the concept of tero technology or life cycle costing for new investment decisions covering its engineering activities. The financial side of this philosophy is now well established and its principles extended to all other areas of decision making. The company is to replace a number of its machines and the Production Manager is torn between the Exe Machine, a more expensive machine with a life of 12 years, and the Wye machine with an estimated life of 6 years. If the Wye machine is chosen it is likely that it would be replaced at the end of 6 years by another Wye machine. The patter of maintenance and running costs differs between the two types of machine and relevant data are shown below:

  Exe Wye Purchase price ` 19,000 ` 13,000 Trade-in value/brakeup/scrap ` 3,000 ` 3,000
 

Exe

Wye

Purchase price

`19,000

` 13,000

Trade-in value/brakeup/scrap

` 3,000

` 3,000

Annual repair costs

` 2,000

` 2,600

Overhaul costs

(at year 8) ` 4,000

(at year 4) ` 2,000

Estimated financing costs averaged over machine life

10%p.a

-Exe;

10% p.a.

-Wye

You are required to: recommend with supporting figures, which machine to purchase, stating any assumptions made.

Solution:

Computation of present value of outflows and equivalent annual

   

Exe machine

 

WYE machine

Initial cost (`)

 

19,000.00

 

13,000.00

Less : Scrap at the end of the life (`)

(3000x0.32)

960.00

(3000X.56)

1,680.00

   

18,040.00

 

11,320.00

Present value of total annual cost (`)

(2000x6.81)

13,620.00

(2600x4.36)

11,336.00

Overhaul cost (`)

(4000X.47)

1,880.00

(2000X.68)

1,360.00

   

33,540.00

 

24,016.00

Capital recovery factor

(1/6.81)

0.15

(1/4.36)

0.23

Equivalent annual cost (`)

 

4,925.00

 

5,508.00

As the equivalent annual cost is less for exe machine, it is better to purchase the same.

Illustration 3.

Company X is forced to choose between two machines A and B. The two machines are designed differently, but have identical capacity and do exactly the same job. Machine A costs ` 1,50,000 and will last for 3 years. It costs `40,000 per year to run. Machine B is an ‘economy’ model costing only ` 1,00,000, but will last only for 2 years, and costs ` 60,000 per year to run. These are real cash flows. The costs are forecasted in rupees of constant purchasing power. Ignore tax. Opportunity cost of capital is 10%. Which machine Company X should buy?

Answer:

Compound present value of 3 years @ 10%

= 2.486

P.V. of running cost of Machine A for 3 years

= ` 40,000 x 2.486

= ` 99,440

Compound present value of 2 years @ 10%

= 1.735

P.V. of running cost of Machine B for 2 years

= ` 60,000 x 1.735

= ` 1,04,100

Statement Showing Evaluation of Machines A and B

(`)

Particulars

Machine A

Machine B

Cost of purchase

1,50,000

1,00,000

Add: P.V. of running cost for 3 years

99,440

1,04,100

P.V. of Cash outflow

2,49,440

2,04,100

2,49,440

2,04,100

Equivalent present value of annual cash outflow

2.486

1.735

= 1,00,338

= 1,17,637

Analysis: Since the annual cash outflow of Machine B is highest, Machine B can be purchased.

Cost Management

Illustration 4.

Computation of Equivalent Annual Cost and Identification of Year to Replace the Machine

A & Co. is contemplating whether to replace an existing machine or to spend money on overhauling it.

A & Co. currently pays no taxes. The replacement machine costs ` 90,000 now and requires maintenance of

` 10,000 at the end of every year for eight years. At the end of eight years it would have a salvage value of ` 20,000 and would be sold. The existing machine requires increasing amounts of maintenance each year and its salvage value falls each year as follows:

(`)

Year

Maintenance

Salvage

Present

0

40,000

1

10,000

25,000

2

20,000

15,000

3

30,000

10,000

4

40,000

0

The opportunity cost of capital for A & Co. is 15%.

Required : When should the company replace the machine?

(Notes: Present value of an annuity of ` 1 per period for 8 years at interest rate of 15% : 4.4873; present value of ` 1

to be received after 8 years at interest rate of 15% : 0.3269)

Answer:

Calculation of Equivalent Annual Cost of New Machine

 

(`)

Cost of New Machine

 

90,000

Add: Present value of annual maintenance cost for 8 years

(` 10,000 × 4.4873)

44,873

   

1,34,873

Less: Present value of salvage value at the end of 8th year

(`20,000 × 0.3269)

6,538

Total present value of life cycle costs of new machine

 

1,28,335

Equivalent Annual cost

= ` 1,28,335/4.4873 = ` 28,600

Calculation of Equivalent Annual cost in continuing with Existing Machine

 

1 st Year

(`)

P.V. of salvage value at the beginning of 1st year

 

40,000

Add: P. V. of Maintenance cost

(10,00/1.15)

8,696

   

48,696

Less: P.V. of salvage value at the end of the year

(25,000/1.15)

21,739

   

26,957

Equivalent Annual cost at the end of 1st year

(26,957 × 1.15)

31,000

2nd Year

(`)

P.V. of salvage value at the beginning of 2nd year

 

25,000

Add: P. V. of Maintenance cost

(20,00/1.15)

17,391

   

42,391

Less: P.V. of salvage value at the end of the 2 nd year

(15,000/1.15)

13,043

    29,348 Equivalent Annual cost at the end of 2 n d year (29,348
   

29,348

Equivalent Annual cost at the end of 2 nd year

(29,348 × 1.15)

33,750

3 rd Year

(`)

P.V. of salvage value at the beginning of 3 rd year

 

15,000

Add: P. V. of Maintenance cost

(30,00/1.15)

26,087

   

41,087

Less: P.V. of salvage value at the end of the 3rd year

(10,000/1.15)

8,696

   

32,391

Equivalent Annual cost at the end of 3 rd year

(32,391 × 1.15)

37,250

4 th Year

(`)

P.V. of salvage value at the beginning of 4 th year

 

10,000

Add: P. V. of Maintenance cost

(40,00/1.15)

34,783

   

44,783

Less: P.V. of salvage value at the end of the 4 th year

 

Nil

   

44,783

Equivalent Annual cost at the end of 4 th year

(44,783 × 1.15)

51,500

Analysis: Since the equivalent annual cost of new machine is lesser than that of existing machine, it is suggested

to replace the existing machine with new machine. The equivalent annual cost of existing machine is higher in all

the four years as compared to new machine.

Illustration 5.

A company is considering the purchase of a machine for ` 3,50,000. It feels quite confident that it can sell the

goods produced by the machine as to yield an annual cash surplus of ` 1,00,000. There is however me uncertainly

as to the machine working life. A recently publish Trade Association Survey shows that members of the Association

have between them owned 250 of these machines and have found the lives of the machines vary as under:

No. of year of machine life

3

4

5

6

7

Total

No. of machines having given life

20

50

100

70

10

250

Assuming discount rate of 10% the net present value for each different machine life is follows:

Machine life

3

4

5

6

7

NPV (`)

(1,01,000)

(33,000)

29,000

86,000

1,37,000

You required to advice whether the company should purchase a machine or not.

Answer:

Computation of NPV of an asset considering the probability of life of machine.

Year

Probability

NPV

Expected value (a × b)

(a) `

(b) `

3

20/250

(1,01,000)

(8,080)

4

50/250

(33,000)

(6,600)

5

100/250

29,000

11,600

6

70/250

86,000

24,080

7

10/250

1,37,000

5,480

     

26,480

So, Assets should be purchased.

Cost Management

1.2 TARGET COSTING

Target Costing.

Target Costing: This technique has been developed in Japan. It aims at profit planning. It is a device to continuously control costs and manage profit over a product’s life cycle. In short, it is a part of a comprehensive strategic profit management system. For a decision to enter a market prices of the competitors’ products are given due consideration. Target Costing initiates cost management at the earliest stages of product development and applies it throughout the product life cycle by actively involving the entire value chain. In the product concept stage selling price and required profit are set after consideration of the medium term profit plans, which links the operational strategy to the long term strategic plans.

Target Cost = Planned Selling Price - Required Profit.

From this, the necessary target cost can be arrived at. Target cost, then, becomes the residual or allowable sum. If it is thought that the product cannot generate the required profit, it will not be produced as such and aspects of the product would be redesigned until the target is met. Value engineering and value analysis may be used to identify innovative and cost effective product features in the planning and concept stages. Throughout the product’s life target costing continues to be used to control costs. After the initial start up stage target costs will be set through short-period budget. Thus all costs including both variable and fixed overheads are expected to reduce on a regular (monthly) basis. Target profit is a commitment agreed by all the people in a firm, who have any part to play in achieving it.

Features of Target Costing

Target Costing is defined as “a structured approach in determining the cost at which a proposed product with specified functionality and quality must be produced, to generate a desired level of profitability at its anticipated selling price.” The main features or practices followed in Target Costing are

Step 1

Identify the market requirements as regards design, utility and need for a new product or improvements of existing product.

Step 2

Set Target Selling Price based on customer expectations and sales forecasts.

Step 3

Set Target Production Volumes based on relationships between price and volume.

Step 4

Establish Target Profit Margin for each product, based on the company’s long term profit objectives, projected volumes, and course of action, etc.

Step 5

Set Target Cost ( or Allowable cost) per unit, for each product. Target cost = Target selling price less Target profit margin

Step 6

Determine Current Cost of producing the new product, based on available resources and conditions.

Step 7

Set cost reduction Target in order to reduce the Current Cost to the Target Cost.

Step 8

Analyze the Cost Reduction Target into various components and identify cost reduction opportunities using Value Engineering (VE) and Value Analysis (VA) and Activity Based Costing (ABC)

Step 9

Achieve cost reduction and Target profit by Effective Implementation of Cost Reduction decisions

Step 10

Focus on further possibilities of cost reduction ie Continuous Improvement program.

Steps in Target Costing

Target Costing is viewed as integral part of the design and introduction of new products.

Profit Management Process, rather than simply a tool for cost Reduction and Cost Management.

It is part of an overall

Step 1: Customer product Design Specification:

(a)

The customer requirements as to the functionality and quality of the product is of prime importance

(b)

The design specification of the new product is based on customer’s tastes, expectations and requirements.

(c) Competitor’s products and the need to have extra features over competitor’s products are also

(c) Competitor’s products and the need to have extra features over competitor’s products are also considered. However the need to provide improved products, without significant increase in prices, should be recognized as charging a higher price may not be possible in competitive conditions.

Step 2 & Step 3: Market - Target Selling Price and Production Volume:

(a)

The Target Selling Price is determined using various sales forecasting techniques.

(b)

The price is also influenced by the offers of competitors, product utility, prices, volumes and margins.

(c)

In view of competition and elasticity of demand, the Firm has to forecast the price volume relationship with reasonable certainty. Hence the Target Selling Price is market driven and should encompass a realistic reflection of the competitive environment.

(d)

Establishment of Target Production Volumes is closely related to Target Selling price, given the relationship between price and volume.

(e)

Target Volumes are also significant in computation of unit costs particularly Capacity Related Costs and Fixed Costs. Product Costs are dependent upon the production levels over the life cycle of the product.

Step 4: Profitability - Target Profit Margin:

(a)

Since profitability is Critical for survival, a Target Profit Margin is established for all new products.

(b)

The Target Profit Margin is derived from the company’s long term business plan, objectives and strategies.

(c)

Each product or product line is required to earn atleast the Target Profit Margin.

Step 5: Setting Target Costs:

(a)

The difference between the Target Selling Price and Target Profit Margin indicates the “Allowable Cost” for the product.

(b)

Ideally, the Allowable Cost becomes the “Target Cost for the product”. However, the Target Cost may exceed the Allowable Cost, in light of the realities associated with existing capacities and capabilities.

Step 6: Computing Current Costs:

(a)

The “Current Costs” for producing the new product should be estimated.

(b)

The estimation of Current Cost is based on existing technologies and components, taking into account the functionalities and quality requirements of the new product.

(c)

Direct Costs are determined by reference to design specifications, materials prices, labour processing time and wage rates. Indirect Costs may be estimated using Activity Based Costing Principles.

Step 7: Setting Cost Reduction Targets:

(a)

The difference between Current Cost and Target Cost indicates the required cost reduction.

(b)

This amount may be divided into two constituents namely - a) Target Cost - Reduction Objective and b) Strategic Cost - Reduction Challenge.

(c)

The former is viewed as being achievable (yet still a very challenging target) while the latter acknowledges current inherent limitations.

(d)

After analyzing the Cost Reduction Objective, a Product-Level Target Cost is set which is the difference between the current cost and the target cost -reduction objective.

Step 8: Identifying Cost Reduction Opportunities:

(a)

After the Product-Level Target Cost is set, a series of analytical activities, commence to translate the cost challenge into reality.

(b)

These activities continue from the design stage until the point when the new product goes into production.

(c)

The total target is broken down into its various components, each component is studied and opportunities for cost reductions are identified.

(d)

These activities are referred to as a) Value Engineering (VE) and b) Value Analysis (VA).

Cost Management

Advantages of Target Costing

(a)

Innovation: It reinforces top-to-bottom commitment to process and product innovation, and is aimed at identifying issues to be resolved.

(b)

Competitive Advantage: It enables a Firm to achieve competitive advantage over other Firms in the industry. The firm which achieves cost reduction targets realistically stands to gain in the long run.

(c)

Market Driven Management: It helps to create a Company’s competitive future with market-driven management for designing and manufacturing products that meet the price required for market success.

(d)

Real Cost Reduction: It uses management control systems to support and reinforce manufacturing strategies, and to identify market opportunities that can be converted into real savings to achieve the best value rather than simply the lowest cost.

Illustration 6.

B manufacturing company sells its product at `1,000 per unit. Due to competition, its competitors are likely to reduce price by 15%. B wants to respond aggressively by cutting price by 20% and expects that the present volume of 1,50,000 units p.a. will increase to 2,00,000. B wants to earn a 10% target profit on sales. Based on

Particulars

Existing

Target

(`)

(`)

Direct material cost per unit

400

385

Direct manufacturing labour per unit

55

50

Direct machinery costs per unit

70

60

Direct manufacturing costs per unit

525

495

Manufacturing overheads :

   

No. of orders (`80 per order)

22,500

21,250

Testing hours (`2 per hour)

4,500,000

30,00,000

Units reworked (`100 per unit)

12,000

13,000

Manufacturing overheads are allocated using relevant cost drivers. Other operating costs per unit for the expected volume are estimated as follows:

Research and Design

`50

Marketing and customer service

`130

 

`180

Required:

(i)

Calculate target costs per unit and target costs for the proposed volume showing break up of different elements.

(ii)

Prepare target product profitability statement.

Solution:

(i)

Target selling price : `1,000 less 20%

` 800

Less: Target profit margin (10%)

` 80

Target costs per unit

` 720

The break-up of ` 720 per unit is as follows: Target Costs per unit Particulars

The break-up of ` 720 per unit is as follows:

Target Costs per unit

Particulars

 

Per unit (`)

Direct materials

 

385

Direct manufacturing labour

 

50

Direct machining costs

 

60

Direct manufacturing costs

 

495

Add: Manufacturing overheads:

   

Ordering and receiving

8.50

 

(21,250 x `80)÷2,00,000

   

Testing and inspection

30.00

 

(30,00,000 x `2) ÷ 2,00,000

   
 

Rework

6.50

 

(13,000 x `100) ÷2,00,000

 

45

Total manufacturing costs

 

540

Other operating costs:

   

Research and Design

50

 

Marketing and Customer service

130

180

Full Product Costs

 

720

(ii) Target Product Profitability

 

Particulars

Per unit

2,00,000 units

(`)

(`)

 

1. Sales

800

16,00,00,000

2.

Costs of goods sold:

   

Direct materials

385

7,70,00,000

Direct labour

50

1,00,00,000

Direct machining costs

60

1,20,00,000

 

495

9,90,00,000

Manufacturing overheads

45

90,00,000

 

540

10,80,00,000

3. Gross margin (1-2)

260

5,20,00,000

4. Operating costs:

   

Research and Design

50

1,00,00,000

Marketing and customer service

130

2,60,00,000

 

180

3,60,00,000

5. Operating profit (3-4)

80

1,60,00,000

Illustration 7.

Desktop Co. manufactures and sells 7,500 units of a product. The full Cost per unit is `100. The Company has fixed Its price so as to earn a 20% return on an Investment of ` 9,00,000.

Required:

(i)

Calculate the Selling Price per unit from the above. Also, calculate the rncrk-up % on the Full Cost per unit.

(ii)

If the Selling Price as calculated above represents a mork- up% of 40% on Variable Cost per unit. calculate the Variable Cost per unit.

Cost Management

(iii)

Calculate the Company’s Income if it had increased the Selling Price to `115. At this price, the Company would have sold 6,750 units. Should the company have increased the Selling price to ` 230?

(iv)

In response to competitive pressures, the Company must reduce the price to `105 next year, in order to achieve sales of 7,500 units. The company also plans to reduce its investment to ` 8,25,000. If a 20% return on Investment should be maintained, what is the Target Cost per unit for the next year?

Answer:

(i)

Computation of Selling Price and mark - up % on the Full Cost per unit

 

Target Sale Price per unit = Full Cost + Target Profit = `100 +

 

`124

 

So, Martk – up price is

24%

(ii)

Computation of Variable Cost per unit:

` 124

 

Above sale Price `124 = VC + 40% thereon, i.e. 140% on VC. So, Var. Cost =

140%

=

` 89

 

(iii)

Calculate the company’s Income if selling price are increased

Present Contribution at 7,500 units = (`124 – ` 89) × 7,500 units =

` 2,62,500

Revised Contribution at 6,750 units = (`115 – `89) × 6,750 units =

` 1,75,500

 

` 87,000

 

Hence, Increase in Sale Price is not beneficial. due to reduction in Contribution by ` 87,000

 

(iv)

Calculate the company’s Target Profit if selling price are reduced and Target cost if investment is ` 8,25,000

Target Profit for next year =

` 8,25,000

×

20%

6,750 units

= `24

Illustration 8.

ABC Enterprises has prepared a draft budget for the next year follows:

Quantity

10,000 units

Sales price per unit

30

Variable costs per unit:

 

Direct Materials

8

Direct Labour

6

Variable overhead (2 hrs × 0.50)

1

Contribution per unit

15

Budgeted Contribution

1,50,000

Budgeted Fixed costs

1,40,000

Budgeted Profit

10,000

The Board of Directors is dissatisfied with this budget, and asks working party to com up with alternate budget with higher target profit figures.

The working party reports back with he following suggestions that will lead to budgeted profit of ` 25,000. The company should spend ` 28,500 on advertising, & set the target sales price up to ` 32 per unit. It is expected that the sales volume will also rise, inspite of the price rise, to 12,000 units.

In order to achieve the extra production capacity, however, the workforce must be able to reduce the time taken to make each unit of the product. It is proposed to offer a pay and productivity deal in which the wage rate per hour in increased to ` 4. The hourly rate for variable overhead will be unaffected.

Ascertain the target labour time required to achieve the target profit.

Answer:   ` ` Target profit 25,000 Add: Fixed cost 1,40,000 Add: Additional Advertisement

Answer:

 

`

`

Target profit

25,000

Add: Fixed cost

1,40,000

Add: Additional Advertisement

28,500

Total contribution

1,93,500

Sales volume

12,000

Contribution per unit (` 1,93,500/12,000)

16.125

Target Selling price per unit

32.000

Less: Contribution per unit

16.125

Target variable cost p.u.

15.875

Less: Material cost p.u.

8.000

Labour + Variable overhead p.u.

7.875

(1) Labour cost per hour

= x hour x ` 4 per hour

 

=

` 4x

Variable overhead per hour

= hour

` 0.5 per hour

=

` 0.5x

(2) Time required to achieve the target profit

1.75 hours per unit

So, for 12,000 units

= 12,000 × 1.75 hour

 

=

21,000 hours

(3) Time/unit

1.75

Present

2.00

Time reduced

0.25 hr.

Illustration 9.

You the manager of a paper mill (M Ltd) and have recently come across a particular type of paper, which is being sold at substantially lower rate (by another company -ABC Ltd) than the price charged by your ow mill. The value chain for one of tonne of such paper for ABC Ltd is follows,

ABC Ltd. Merchant Printer Customer

ABC Ltd sells this particular paper to the merchant at the rate of ` 1,466 per tonne ABC Ltd pays for the freight which amounts to ` 30 per tonne

Average returns and allowances amount to 4% of sales and approximately equal ` 60 per tonne.

The value chain of your company, through which the paper reaches the ultimate customer is similar to the of ABC Ltd. However, your mill does not sell directly to the merchant, the latter receiving the paper from a huge distribution center maintained by your company at Haryana. Shipment costs from the mill to the Distribution Center amount to ` 11 per tonne while the operating costs in the Distribution Center have been estimated to be ` 25 per tonne. The return on investments required by the Distribution Center for the investments made amount to an estimated ` 58 per tonne.

You are required to compute the “Mill manufacturing Target Cost” for this particular paper for your company. You may assum that the return on the investment expected by your company equals Rs. 120 per tonne of such paper.

expected by your company equals Rs. 120 per tonne of such paper. STRATEGIC COST MANAGEMENT –
expected by your company equals Rs. 120 per tonne of such paper. STRATEGIC COST MANAGEMENT –
expected by your company equals Rs. 120 per tonne of such paper. STRATEGIC COST MANAGEMENT –

Cost Management

Answer:

Computation of Target Cost

Per tonne (in `)

ABC Ltd selling price to the merchant

 

1,466

Less: freight paid by ABC Ltd

30

 

Less normal sales returns and allowances

60

 

XYZ Ltds Capital charge

120

210

Target cost for XYZ Ltd

 

1256

Less: Shipment cost Distribution Centre

11

 

Operating cost in the Distribution Centre

25

36

Distribution centre capital charge

 

1220

Less: Target manufacturing cost of the Mill

 

58

   

1162

1.3 KAIZEN COSTING

Meaning of Kaizen Costing

Introduction: The initial VE review may not be complete and perfect in all cost aspects. There may be further chances of waste reduction, cost and time reduction and product improvement. Such continuous cost reduction technique is called as Kaizen Costing.

The review of product costs under the target costing methodology is not reserved just for the period up to the completion of design work on a new product. There are always opportunities to control costs after the design phase is completed, though these opportunities are fewer than during the design phase.

Meaning: Kaizen Costing refers to the ongoing continuous improvement program that focuses on the reduction of waste in the production process, thereby further lowering costs below the initial targets specified during the design phase. It is a Japanese term for a number of cost reduction steps that can be used subsequent to issuing a new product design to the factory floor.

Process of Kaizen Costing: Activities in Kaizen Costing include elimination of waste in production, assembly, and distribution processes, as well as the elimination of unnecessary work steps in any of these areas. Thus Kaizen Costing is intended to repeat many of the value engineering steps, continuously and constantly refining the process, thereby eliminating out extra costs at each stage.

Kaizen Costing Vs Value Engineering: Cost reductions resulting from Kaizen Costing are much smaller than those achieved with value engineering. But these are still significant since competitive pressures are likely to force down the price of a product over time, and any possible cost savings allow a Company to still attain its targeted profit margins.

Multiple Versions of Products - Continuous Kaizen Costing: Multiple improved versions of products can be introduced to meet the challenge of gradually reducing costs and prices. The market price of products continues to drop over time, which forces a Company to use both target and kaizen costing to reduce costs and retain its profit margin.

However, prices eventually drop to the point where margins are reduced, which forces the Company to develop a new product with lower initial costs and for which kaizen costing can again be used to further reduce costs. This pattern may be repeated many times as a Company forces its costs down through successive generations of products.

The exact timing of a switch to a new product is easy to determine well in advance since the returns from kaizen costing follow a trend line of gradually shrinking savings. Since prices also follow a predictable downward track, plotting these two trend lines into the future reveals when a new product version must be ready for production.

Experience of Kaizen Costing in Toyota. Toyota’s Experience of Kaizen Costing: Toyota aggressively pursued Kaizen

Experience of Kaizen Costing in Toyota.

Toyota’s Experience of Kaizen Costing: Toyota aggressively pursued Kaizen Costing to reduce costs in the manufacturing phase. In July and January, Plant Managers submit six months plan for attaining their kaizen goal. Methods for achieving these goals include cutting material costs per unit and improvement in standard operating procedures. These are pursued based on employee’s suggestions. For improvements involving industrial engineering and value engineering, employees often receive support from technical staff. To draw up a Kaizen plan after Kaizen goals have been set by top management, employees look for ways to contribute to Kaizen in their daily work. About two million suggestion were received from Toyota employees in t\one recent year alone roughly thirty-five per employee. Ninety-seven percent of them were adopted. This is really a prime example of concept of employee empowerment in which workers are encouraged to take their own initiatives to improve operations, reduce costs, and improve product quality and customer service.

Kaizen Costing and Standard Costing

Standard Costing is used in conjunction with management by exception (management’s attention is directed towards situations where actual results differ from expected results). The expected results are based on standards, which have been derived from the capability of current organizational processes. Standard costing, therefore, reflects current level of performance and fails to provide any motivation to improve. A table given below set out principal differences between Kaizen Costing and Standard Costing:

Basis of Difference

Standard Costing

 

Kaizen Costing

Concepts

It is used for cost control

 

It is used for cost reduction.

 

It

is

assumed

that current

It assumes continuous improvement.

manufacturing conditions remain unchanged.

 

The cost focus is on standard costs based on static conditions

The cost focus is on actual costs assuming dynamic conditions

 

The

aim

is

to

meet

cost

The aim is to achieve cost reduction targets.

performance standards

Techniques

Standards

are

set

every

six

or

Cost reduction targets are set and applied monthly

twelve months

 
 

Costs are controlled using variance analysis based on standard and actual costs.

Costs are reduced by implementing continuous improvement (kaizen) to attain the target profit or to reduce the gap between target and estimated profit.

 

Management should investigate and respond when standards are not met.

Management should investigate and respond when target kaizen amount are not attained.

Employees

They are often viewed as the cause of problems

They are viewed as the source of, and are empowered to find, the solutions.

1.4 VALUE ANALYSIS AND VALUE ENGINEERING

Value Analysis

The Value Analysis (VA) technique was developed after the Second World War in America at General Electric during the late 1940s. Since this time the basic VA approach has evolved and been supplemented with new techniques that have become available and have been integrated with the formal VA process. Today, VA is enjoying a renewed popularity as competitive pressures are forcing companies to re-examine their product ranges in an attempt to offer higher levels of customization without incurring high cost penalties. In parallel, many major corporations are using the VA process with their suppliers to extend the benefits of the approach throughout the supply chain. Businesses, big and small, will therefore benefit from understanding and applying the VA process.

Cost Management

It is likely that those companies that do not take the time to develop this capability will face an uncertain future as the lessons and problems of the past are redesigned into the products of the future.

Definition of Value Analysis

Value Analysis (VA) or Value Engineering (VE) is a function-oriented, structured, multi-disciplinary team approach to solving problems or identifying improvements. The goal of any VA Study is to:

-Improve value by sustaining or improving performance attributes

(of the project, product, and/or service being studied)

-while at the same time reducing overall cost

(including lifecycle operations and maintenance expenses).

Value Analysis can be defined as a process of systematic review that is applied to existing product designs in order to compare the function of the product required by a customer to meet their requirements at the lowest cost consistent with the specified performance and reliability needed.

This is a rather complicated definition and it is worth reducing the definition to key points and elements:

(i)

Value Analysis (and Value Engineering) is a systematic, formal and organized process of analysis and evaluation. It is not haphazard or informal and it is a management activity that requires planning, control and co-ordination.

(ii)

The analysis concerns the function of a product to meet the demands or application needed by a customer. To meet this functional requirement the review process must include an understanding of the purpose to which the product is used.

(iii)

Understanding the use of a product implies that specifications can be established to assess the level of fit between the product and the value derived by the customer or consumer.

(iv)

To succeed, the formal management process must meet these functional specification and performance criteria consistently in order to give value to the customer.

(v)

In order to yield a benefit to the company, the formal review process must result in a process of design improvements that serve to lower the production costs of that product whilst maintaining this level of value through function.

Defining Cost and Value

Any attempt to improve the value of a product must consider two elements, the first concerns the use of the product (known as Use value) and the second source of value comes from ownership (Esteem value). This can be shown as the difference between a luxury car and a basic small car that each has the same engine. From a use point of view both cars conduct the same function – they both offer safe economical travel (Use value) – but the luxury car has a greater esteem value. The difference between a gold-plated ball pen and a disposable pen is another example. However, use value and the price paid for a product are rarely the same, the difference is actually the esteem value, so even though the disposable pen is priced at X the use value may be far less.

It is important for all managers to understand the nature of costs in the factory and for any given product. Whilst there is no direct relationship between ‘Cost’ (for the factory) and customer ‘Value’ in use and esteem, this education process is important. A shocking figure, that is often used as a general measure, is that typically 80% of the manufacturing costs of a product will be determined once the design drawing has been released for manufacturing.

The costs of production are therefore ‘frozen’ and determined at this point. These costs include the materials used, the technology employed, the time required to manufacture the product and such like. Therefore, the design process creates many constraints for the business and fixes a high degree of the total product cost. It is therefore a process that demands periodic review in order to recover any ‘avoidable’ costs that can be removed throughout

the life of the product (by correcting weaknesses or exploiting new processes, materials or methods)

the life of the product (by correcting weaknesses or exploiting new processes, materials or methods) and lowering the costs of production whilst maintaining its Use value to the customer.

Basically, there are three key costs of a product:

Cost of the parts purchased: These are costs associated with the supply of parts and materials.

Cost of direct labour used to convert products.

Cost of factory overheads that recover the expenses of production.

Although there are three elements of total cost accumulation it is traditionally the case that cost reduction activities have focused on the labour element of a product. Activities such as work-study, incentive payments and automation have compressed labour costs and as a result there is little to be gained, for most companies, in attempting to reduce this further. Instead, comparatively greater gains and opportunities lie in the redesign and review of the products themselves to remove unnecessary materials and overhead costs. This approach to the ‘total costs’ of a product involves taking a much broader look at the way costs in the factory accumulate and the relationship between costs and value generation. These new sources of costs and evaluations would therefore include such sources as:

Cost of manufacture

Cost of assembly

Cost of poor quality

Cost of warranty

A detailed understanding of how costs are rapidly accumulated throughout the process of design to the despatch

of the product is key to exploiting the process of VA. All VA activities are aimed at the reduction of avoidable and unnecessary costs, without compromising customer value, and therefore the VA process should target the largest sources of potential cost reduction rather being and indiscriminate or unsystematic process (such as focusing on labour alone). It is therefore preferable to take the holistic approach to understanding costs and losses in the ‘entire system’ of design and conversion of value in order to determine how to achieve customer service ‘functionality’ at a minimal cost per unit.

The Focus of Value Analysis

The key focus of the VA approach is therefore the management of ‘functionality’ to yield value for the customer. Let us emphasize this point a little. Not that long ago, consumers of electric kettles were offered a variety of different types of metal-based boiling device. The value of a kettle is derived through heating water and therefore its functionality can be determined (temperature, capacity, reliability, safety etc.). Now faced with the same functionality (to boil water), designers would probably look towards a kettle made of plastic.

Plastic has the same functionality as metal in terms of containing and boiling water. The action to boil water is conducted by the same part - known as the element. However the switch from metal to plastic does not impair this value and functionality with the customer – they still want to boil water - but it does result in a cost saving for the manufacturing company. If a company that traditionally made metal kettles did not review its design process then it would be severely disadvantaged when attempting to compete against the lower cost plastic alternative. This is a simple example used only to provide an illustration of the VA concept but it does demonstrate the point of maintaining value whilst reducing costs.

If a company seeks to reduce the costs of producing a product then it must seek out costs that are unnecessary

or items of the product that provide no functional value to the customer. If you adopt this approach then the VA process is concerned with removing a specific type of cost. This cost is one that can be removed without negatively affecting the function, quality, reliability, maintainability or benefit required by the customer. As such, the target for all VA activities is to find these costs as opposed to simply re-engineering a product design with no real purpose to the re-engineering exercise. The VA approach is therefore formal and systematic because it is directed towards highlighting and dealing with these ‘recoverable costs’ of production. The objective is to create

Cost Management

value for money as opposed to creating new products that do not provide customer satisfaction but are relatively inexpensive.

The rules governing the application of the VA approach are therefore simple:

No cost can be removed if it compromises the quality of the product or its reliability, as this would lower customer value, create complaints and inevitably lead to the withdrawal of the product or lost sales.

Saleability is another issue that cannot be compromised, as this is an aspect of the product that makes it attractive to the market and gives it appeal value.

Any activity that reduces the maintainability of the product increases the cost of ownership to the customer and can lower the value attached to the product.

Types of Value Analysis Exercises

VA for Existing Products

One of the best approaches to VA is simply to select an existing product that is sold in relatively large volumes. This product, or product family, will tend to have a great deal of the basic information, and documented history, which can be used quickly as opposed to a newly introduced product where such a history is not available. An existing product unites all the different managers in a business, each with an opinion and list of complaints concerning the ability to convert the design into a ‘saleable’ product. Therefore any team that is created for the purpose of VA will understand their own problems but not necessarily the cause of these problems across the entire business. These opinions regarding poor performance (and documented evidence of failures) are vital to the discussions and understanding of how the product attracts costs as it is converted from a drawing to a finished product. These discussions therefore allow learning to take place and allow all managers to understand the limitations to the scope of product redesign and re-engineering activities. These issues include:

• The inability to change existing product designs due to the need to redesign tooling and the expense of such an initiative.

• The project team may have a finite duration before the project is concluded and therefore time will dictate what can be achieved.

• The high levels of purchased costs may imply a need to engage with suppliers in the VA process. This initiative will be constrained by a number of issues such as the timing of the project, the availability of resources from the supplier, the location of the suppliers, and other constraints.

VA for New Products – Value Engineering

For new products, the team will need to modify the VA approach and will operate in an environment that is less certain and has poor levels of available information upon which to make decisions. In this case, the analysis and systematic process of review for new products is known as Value Engineering (VE). The VE approach is similar to that of Value Analysis but requires a much greater level of investment by the organization in terms of the skilled, experienced and proficient human resources seconded to the group.

VA for Product Families- Horizontal Deployment

The final form of VA is results when there is scope for the ‘horizontal deployment’ of the results of a VA exercise with a single product or family of products. Under conditions where the value analysis project team finds commonalties with many products manufactured by the company, then it is possible to extend the benefits to all these other products concurrently. In this manner, all affected products can be changed quickly to bring major commercial benefits and to introduce the improvement on a ‘factory-wide basis’. This is particularly the case when supplying companies offer improvements that affect all the products to which their materials or parts are used. The horizontal deployment activity has many advantages both in terms of financial savings and also the relatively short amount of time required to introduce the required changes to the product design.

Competitive VA VA techniques are not simply the prerogative of the business that designed the

Competitive VA

VA techniques are not simply the prerogative of the business that designed the product. Instead VA is often used as a competitive weapon and applied to the analysis of competitor products in order to calculate the costs of other company’s products. This is often termed ‘strip down’ but is effectively the reverse value analysis. Here the VA team are applied to understanding the design and conversion costs of a competitor product. The results of the analysis is to understand how competitor products are made, what weaknesses exist, and at what costs of production together with an understanding of what innovations have been incorporated by the competitor company.

It is recommended that the best initial approach, for companies with no real experience of VA, is to select a single product that is currently in production and has a long life ahead. This approach offers the ability to gain experience, to learn as a team, and to test the tools and techniques with a product that has known characteristics and failings. In the short term it is most important to develop the skills of VA, including understanding the right questions to ask, and finally to develop a skeleton but formal process for all VA groups to follow and refine.

How to use Value Analysis

Keys to Success

There are many keys to the success of a VA programme and it is wise to consider these issues before commencing the project, as errors in the project plan are difficult to correct, without causing frustration, once the VA project has started. One of the most important initial steps in developing the VA process is to create a formal team of individuals to conduct the exercise. These individuals must be drawn from different parts of the business that affect the costs associated with design, manufacturing, supply and other relevant functions. In addition, the team must be focused on a product or product family in order to begin the exercise. Further key success factors include:

Gain approval of senior management to conduct a Value Analysis exercise. Senior management support, endorsement and mandate for the VA project provides legitimacy and importance to the project within the business. This approval process also removes many of the obstacles that can prevent progress from being made by the team.

Enlist a senior manager as a champion of the project to report back directly to the board of directors and also to act as the programme leader.

• Once a programme team has been developed it is important to select an operational leader to co-ordinate the efforts, monitor progress and to support the project champion.

This leader will remain with the VA team throughout the life of the project and will be the central linking pin between the team and the senior management champion.

Establish the reporting procedure for the team and the timing of the project. This project plan needs to be formal and displayed as a means of controlling and evaluating achievements against time.

Present the VA concept and objectives of the team to all the middle and senior managers in the business. Widespread communication of the VA project is important so that other employees, particularly managers (who may not be involved directly with the process) understand the need to support the project either directly by assigning staff or indirectly through the provision of data.

• Maintain a list of those business functions that should receive a regular communication of progress even though they may not be directly involved with the project. This process allows other individuals in the business to be informed about the progress and findings of the group. This form of promotion is important as it maintains a momentum and communicates the findings of the team as widely as possible.

Provide an office space and co-locate the team members where practical and possible to do so. The ability to locate a VA improvement group in one area of the business is important and assists the communication within the group. A convenient area can also be used to dismantle the product and also the walls of the area can be used to record, on paper charts, the issues that have been discovered by the team (and the associated actions that must be undertaken).

Cost Management

Select the product for the first study. Ideally the existing product, or family of products, will be one that is established, sells in volume and has a relatively long life expectancy.

As such any improvement in the cost performance of the product will provide a large financial saving to the business.

• Write down the objectives of the project and the key project review points. Estimate the targets to be achieved by the project. These objectives provide a reference point and framework for the exercise. The objectives also focus attention on the outputs and achievements required by the company.

Select and inform any personnel who will act in a part time or temporary role during the project. This process

is used to schedule the availability of key specialist human resources to support the team throughout the duration of the project.

Train the team in both the process of VA and also in basic team building activities. It is important that all

members understand the nature of the project and its importance. The initial team building exercises are also

a good way of understanding the attitude of all members to the project – especially those with reservations

or a negative attitude to what can be achieved. As with most team exercises there is a requirement to allow the team to build and bond as a unit. It is often difficult for individuals, drawn from throughout the factory, to understand the language that is used throughout the business and also to understand the ‘design to market’ process when their own role impacts on a small section of this large and complex process.

Value Engineering

Value Engineering is an organized/systematic approach directed at analyzing the function of systems, equipment, facilities, services, and supplies for the purpose of achieving their essential functions at the lowest life-cycle cost consistent with required performance, reliability, quality, and safety. Society of Japanese Value Engineering defines VE as:

“A systematic approach to analyzing functional requirements of products or services for the purposes of achieving the essential functions at the lowest total cost”.

Value Engineering is an effective problem solving technique. Value engineering is essentially a process which uses function analysis, team- work and creativity to improve value. Value Engineering is not just “good engineering.” It is not a suggestion program and it is not routine project or plan review. It is not typical cost reduction in that it doesn’t “cheapen” the product or service, nor does it “cut corners.”

Value Engineering simply answers the question “what else will accomplish the purpose of the product, service, or process we are studying?”. VE technique is applicable to all type of sectors. Initially, VE technique was introduced in manufacturing industries. This technique is then expanded to all type of business or economic sector, which includes construction, service, government, agriculture, education and healthcare.

Aadarsh Instruments, located in Ambala, is a medical instrument manufacturing company considered to apply Value Engineering in to the Focus Adjustment Knob in one of their model SL 250 for Slit Lamp in microscope. This microscope has found application in the field of eye inspection. The value engineering analysis may help company in running its export business of medical microscope. This firm is producing different types of microscopes which they export to various countries around the globe. All of the products manufactured here are conforming to the international standards. It is an ISO certified company.

The total savings after the implementation of value engineering are as given below:

• Cost before analysis — ` 29.99

• Total Cost of Nylon Knob — ` 18.40

• Saving per product — ` 11.59

• Percentage saving per product — 38.64%

• Annual Demand of the product — 8,000

• Total Annual Saving — ` 92,720 • Value Improvement — ` 62.98% What are

• Total Annual Saving — ` 92,720

• Value Improvement — ` 62.98%

What are the steps to be followed for doing Value Engineering? How can you conclude the decision on the basis of the above Value Engineering?

Answer:

The following are the steps to be used for carrying out the Value Engineering exercise by Aadarsh Instruments in their model SL 250 for Slit Lamp in Microscope for the Focus Adjustment Knob:

(i)

Selection of the Product Plan.