COST ESTIMATION FOR PRODUCT DESIGN

SIX SIGMA
IS A HIGHLY STRUCTURED STRATEGY FOR ACQUIRING,

ASSESSING, AND ACTIVATING CUSTOMER, COMPETITOR, AND ENTERPRISE INTELLIGENCE LEADING TO SUPERIOR PRODUCT, SYSTEM, OR ENTERPRISE INNOVATIONS AND DESIGNS THAT PROVIDE A SUSTAINABLE COMPETITIVE ADVANTAGE.

DEPARTMENT

OF STATISTICS

Economics of Product Development Projects: When to Use Economic Analysis

Go/no-go milestones:
Should we try to develop a product to meet this market need? Should we proceed with the implementation of a selected concept? Should we launch the product we have developed? Such decisions commonly arise at the end of each development phase.

Operational design and development decisions:

Should we spend $100,000 to hire an outside firm to develop this component In order to save two months of development time? Should we launch the product in four months at a unit cost of $450 or Wait until six months when the cost can be reduced to $400?

Quantitative Analysis:
We must consider both cash inflows (revenues) and

cash outflows (costs)

In the life cycle of a new product.

Cash inflows are generated by product sales. Cash outflows include spending on product and process development,
costs of production ramp-up such as equipment purchases & tooling, costs of marketing and supporting the product, and ongoing productions costs such as raw materials, components & labor.

Limitations of Quantitative Analysis

Detractors of quantitative analysis argue that it suffers as following: It focuses only on measurable quantities. Techniques such as NPV emphasize and rely on that which is measurable. Many critical factors are, however, difficult to me Quantitative techniques serve to encourage investment in measurable assets and discourage investment in intangible assets. It depends on validity of assumptions and data. Bureaucracy reduces productivity. Detractors of financial analysis assert that suc activities provide a high level of planning and control at the expense of product development productivity. In their view, extensive planning and review assure that brilliantly conceived, well-engineered product will reach the market after its market window has already closed. Detractors also argue that overzealously applied professional management techniques stifle the product development process. Potentially productive development time is devoted to preparation of analyses and meetings. The cumulative effect of this planning and review can be a ballooning development process.

Qualitative Analysis:
Quantitative analysis can capture only measurable factors, yet projects typically have both positive and adverse aspects that are difficult to quantify. It is often difficult for quantitative analysis to capture important characteristics of a dynamic and competitive environment. Thus quantitative analysis alone is often incomplete and must be augmented by qualitative analysis. In qualitative analysis we will specifically consider interactions between: the project and the firm; the project and the market; and the project and the macroeconomic environment.

Economic Analysis Methodology

The following four-step economic analysis methodology is recommended for product development projects:

1. Build a base-case financial model. 2. Perform a sensitivity analysis to understand the relationships between financial success and the key assumptions and variables of the model. 3. Use sensitivity analysis to understand trade-offs. 4. Consider the influence of the qualitative factors on project success.

Step 1. Build a Base-Case Financial Model

This consists of estimating the timing and magnitude of future cash flows and then computing the Net Present Value (NPV) of those cash flows. Estimating the timing and magnitude of future cash flows is done by merging the project schedule with th roject budget, sales volume forecasts, and estimated production costs. The level of detail should be coar nough to be convenient to work with, yet contain enough resolution to facilitate effective decision making

The most basic categories of cash flow for a typical new product development project are: Development Cost (all remaining design, testing, & refinement costs up to the production ramp-up) Ramp-up Cost Marketing & Support Cost Production Cost Sales Revenues. Refinements may include:
Breakdown of production costs into direct costs & indirect costs (overheads) Breakdown of marketing and support costs into launch costs, promotion costs, direct sales costs, and service costs Inclusion of tax effects, including the depreciation tax shield and investment tax credits Inclusion of such miscellaneous inflows and outflows as working capital requirement, annibalization (impact of the new product on existing product sales), salvage costs, and opportunity cos

Key Factors Influencing

INTERNAL FACTORS
Development Program Expense Investigation Cost Development Cost Development Speed: Investigation Time Development Time Production Cost Product Performance

Product Development Project

EXTERNAL FACTORS
Product Price Sales Volume Competitive Environment

Net Present Value

Product Development Profitability

Step 1. Build a Base-Case Financial Model

Economically successful products generate more cumulative inflows than they do cumulative outflows that is - they are profitable. A measure of this sort of profitability is Net Present Value (NPV). NPV is the value in todays dollars of all expected future cash flows. The QUANTITATIVE part of economic analysis estimates the NPV. This is easily understood and, also, widely used in business. The value of quantitative analysis is not only in providing objective evaluations of projects and alternatives, but also in bringing a measure of structure and discipline to the product development process.

Net Present Value

Quantitative Analysis: Net Present Value

Essentially this technique acknowledges that generally a monetary unit today is worth more than the same monetary unit tomorrow. Thus NPV calculations estimate the value today (present value) of some future income or expense.

To illustrate NPV concepts, let: C = monetary amount invested r = interest rate (e.g. rate of return, discount factor, hurdle rate) t = number of time periods Then: PV = Present Value = C/(1 + r)t
NOTE: r is the opportunity cost of capital. It is called this because it is the return forgone by investing in the project rather than other investments that is, the reward that investors demand for accepting delayed payment. A project with positive NPV must be earning more than the opportunity cost of capital.

Net Present Value Example

Suppose C = 100 and r = .08 with t = 1, 2, 3, 4, 5 then PV1 = 100/(1+.08)1 = $92.59 PV2 = 100/(1+.08)2 = $85.73 PV3 = 100/(1+.08)3 = $79.38 PV4 = 100/(1+.08)4 = $73.50 PV5 = 100/(1+.08)5 = $68.06 That is, $68.06 invested at rate of return of .08 / unit time will be valued at 100 after 5 units of time. Consequently, if we estimate a contribution (expense) to inflow (outflow) 5 units of time in the future, then that 100 contribution (expense) in PRESENT monetary units is only $68.06. Similarly, the sum of 100 unit contributions at the end of each five time Periods has a PRESENT VALUE of:
$92.59

+ $85.73 + $79.38 + $73.50 + $68.06 = $399.26

Sunk Costs are Irrelevant to NPV Calculations:

In the context of product development decision making, costs that have already been incurred are sunk costs. Because these are past and are irreversible outflows, they cannot be affected by present or future decisions and should hence be ignored in NPV calculations.

An illustration follows.

Example: Should We Cut our Losses?

Suppose that we have spent $600 million and 9 years with no product. We are asked to approve another $90 million. Should we do this? Fact One: $600 million and 9 years are irrelevant except emotionally. Fact Two: what is important is determination of what can be gained from investing the additional $90 million. Suppose That: $90 million more will get the product to market and generate $350 million in product sales. Assume w/o l.o.g. that all numbers given are present values, then simple examination of NPV (in millions) indicates:
CUT OUR LOSSES Additional investment: Profits from Product Sales: NPV of cut losses Total Invested Total Project Return $0 $0 $0 -$600 -$600 INVEST $90 MILLION MORE Additional Investment Profit from Product Sales: NPV of Invest Decision: Total Investment: Total Project Return: -$90 $350 $260 -$690 -$340

CONCLUSIONS???

Dealing With Uncertainty in the Cash Inflow & Outflow Estimates

Actual manufacturing or service delivery costs may be higher or lower than estimated. Sales forecasts depend on such information as when our competitors get their versions of the product or service to market. Such uncertainties are called project-specific risks. Some project development teams add a fudge factor to r to offset such uncertainties. These are arbitrary and are usually used because of inadequate cash flow forecasting. Fudge factors are then applied uniformly to both certain and uncertain cash flows. Often fudge factors are used because project teams simply do not want to confront the true likelihood of adverse outcomes. Instead, development teams should perform realistic cash flow forecasts. These should be supplemented with CAREFUL sensitivity analysis to understand the impact of the full range of possible outcomes for the uncertain factors. THAT IS, project-specific risks should be considered only in the expected cash flows and not in the discount rate.

LAST: A second type of risk is market risk which is not project-specific. Market risk
stems from the fact that there are economy-wide perils that threaten all businesses and projects market risk is USUALLY accounted for by inflating the discount rate.

Step 2. Sensitivity Analysis

Internal factors are those over which the development team has a large degree of

Sensitivity analysis uses the financial model to answer what if questions by calculatin the change in NPV corresponding to a change in the factors included in the model. Both internal and external factors influence project value.

nfluence, including development program expense, development speed, production co and product performance.

External Factors are those that the team cannot arbitrarily change, including the
competitive environment (e.g., market response, actions of competitors), sales volume and product price.

Price There may be disagreement over whether price is an internal or external factor.
Regardless, there is little disagreement that price is strongly influenced by the prices o competitive products and that it is linked to sales volume. While external factors are not directly controlled by product development teams, they are often influenced by the internal factors.

Step 3. Use Sensitivity Analysis to Understand Project Trade-Offs

Six Potential Interactions
evelopment teams attempt to manage six potential interactions between internally driven facto

Development Time

Product Cost

Product Performance

Development Cost

Often interactions can be thought of as trade-offs, for example, decreasing development time may lead to lower product performance. Increased product performance may require additional product cost. Some interactions are, however, more complex in nature. For example decreasing product development time may require an increase in development spending, yet extending development time may also lead to an increase in cost if the extension is caused by delay in a critical task, rather than by a planned extension of the schedule.

Step 3. Use Sensitivity Analysis to Understand Project Trade-Offs

Interactions are important because of the linkage between internal & external factors. For example, increasing development cost or time may enhance product performance and therefore increase sales volume or allow higher prices. decreasing development time may allow the product to reach the market sooner and thus increase sales volume. Trade-off Rules: These rules take the form of the cost per unit change in the internal & external factors Examples might be what is the cost of a one-month delay in development time? or What is the cost of a 10% development budget overrun? or What is the cost of a $1 per unit increase in manufacturing cost?

Step 4. Consider the Influence of the Qualitative Factors on Project Success

Qualitative factors are one that influence development projects that are difficult to quantify because they are complex or uncertain. Consider issues such as will knowledge gained from this project spill over and be of benefit to other development projects? or How will competitors react to the introduction of our product? or Will competitors modify their own development efforts in response to ours? Will there be significant fluctuations in the dollar/yen exchange rate that will change the cost of component parts? Our model implicitly accounts for these and other issues with several broad comparisons. It assumes that decisions made by the team do not affect actions of groups external to the project or, alternately, that external forces do not change the teams actions. This assumption is common in financial models and is called the

Ceteris paribus
(other things being equal) assumption.

Step 4. Consider the Influence of the Qualitative Factors on Project Success

Projects Interact with the Firm, the Market, and the Macro Environment
Decisions made within a project typically have important consequences for the firm as a whole, for competitors and customers in the market, and even for the macroeconomic (macro) environment in which the market operates. Similarly, events and actions Outside of a development project can significantly impact its value.

Macro Environment

Market
Firm Project

Step 4. Consider the Influence of the Qualitative Factors on Project Success

Interactions between the Project and the Firm as a Whole
Assumption: Firm profit will be maximized if project profit is maximized. However, development decisions must be made in the context of the firm as a whole. The two key interactions between the project & the firm are externalities and strategic fit. An externality is an unpriced cost or benefit imposed on one part of the firm by the actions of a second; costs are known as negative externalities and benefits as positive externalities. EXAMPLE of a POSITIVE EXTERNALITY development learning on one project may benefit other current or future projects, but is paid for by the first one, BUT how should the other projects projects account for such benefits gained as not additional cost. How should the first project account for resources spent that benefit not only itself, but also other current or future projects. Strategic Fit: Team decisions must not only benefit the project, but also be consistent with the firms technology and competitive strategies. For example, how well does a proposed new product, technology, or feature fit with the firms resources and objectives? Is it compatible with the firms emphasis on technical excellence? Is it compatible with the firms emphasis on uniqueness? Because of their complexity and uncertainty, externalities and strategic fit are very difficult to quantify. This does not mean these issues should be ignored rather they must be considered quantitatively.

Step 4. Consider the Influence of the Qualitative Factors on Project Success

Interactions between the Project and the Market
Accurate modeling of project value requires relaxation of the ceteris paribus assumption to recognize that a teams decisions impact the market and that market events impact the project. The market environment is impacted by the actions of not only the team, but three other groups:

Competitors Competitors may provide products in direct competition or products that

compete indirectly with substitutes.

Customers Customers expectations, incomes, or tastes may change. Changes may be driven
by new conditions in markets for complementary or substitute products or may be independent.

Suppliers Suppliers of inputs to the new product are subject to their own markets competitive
pressures. These pressures may, indirectly throughout the value chain, impact the new product. Actions & reactions of these groups may impact expected price and volume, but can also have second-order effects. e.g., consider a new competitor that has rapid product development cycles and that seems to value market share rather than short-term profitability. The entrance of such a new competitor would change our expected price and volume and we may attempt to speed our own development efforts in response so that the competitors actions may impact both our sales volume forecasts and our planned development schedule.

Step 4. Consider the Influence of the Qualitative Factors on Project Success

Interactions between the Project and the Macro Environment
The ceteris paribus assumption is again relaxed to consider key macro factors. Major Economic Shifts: examples of typical major economic shifts that impact the value of development projects are changes in currency exchange rates or in input prices. Government Regulations: New regulations can seriously impact a product development opportunity or can spawn entire new industries. Social Trends: As with government regulations, new social concerns such as increased environmental awareness can destroy existing industries or create new ones.

Macro factors can have important impacts on development project value. However, their effects are difficult to model quantitatively because of inherent complexity and uncertainty.

1. Can you think of successful products that would never have been developed if their creators had relied exclusively on a quantitative financial model to justify their efforts? Do these products share any characteristics? 2. One model of the impact of a delay in product introduction is that sales are simply shifted later in time. Another model is that some of the sales are pushed beyond the window of opportunity and are lost forever. Can you suggest other models for the implications of an extension of product development time? Is such an extension ever beneficial? 3. How would you use the quantitative analysis methodology to capture the economic performance of an entire line of products to be developed and introduced over several years?

Generally customer needs and product specifications are useful for guiding the concept phase of product development. HOWEVER, during later activities teams often have difficulty linking needs and specifications to the specific design issue they face. In response, many teams practice Design for X (DFX) where X may represent any number of criteria such as reliability, robustness, serviceability, environmental impact, or manufacturability. Most common among these is design for manufacturability or DFM - of primary importance because it directly addresses manufacturing costs. Manufacturing cost is a key determinant of the economic success of a product since such success depends on the profit margin earned on each sale of the product and on how many units of the product the firm can sell. Profit margin is the difference between the manufacturers selling price and the cost of making the product. Economically successful design is thus about ensuring high product quality while minimizing manufacturing costs and DFM is one method of achieving this.

Proposed Costs
Estimate the Manufacturing Costs

Reduce the Costs Of Components

Reduce the Costs Of Assembly

Reduce the Costs of Supporting Production

DFM methodology consists of five parts:

1. 2. 3. 4. 5. Estimate manufacturing costs. Reduce the costs of components. Reduce the costs of assembly. Reduce the costs of supporting production. Consider the impact of DFM decisions on other factors.

Consider Impact of DFM Decisions on Other Factors

Recompute the Manufacturing Costs

Good Enough?

No

Yes

Acceptable Design

The SIPOC Model

Inputs Suppliers Steps Process Outputs Customers

Inform Loop

The COPIS Model

Outputs Customers Steps Process Inputs Suppliers

SIPOC from a Six Sigma Perspective:

From the Six Sigma Perspective, the model is a COPIS one in the sense that Six Sigma projects are customer-driven, begin with the customer, and are pushed back through the value chain as far, ultimately, as the supplier.

The SIPOC model includes the manufacturing system (IPO) with inputs that include raw materials, purchased components, employees efforts, energy and equipment. Similarly, outputs include finished goods and waste. Manufacturing cost is the sum of all the expenditures for the inputs of the system and for disposal of the wastes produced by the system. The metric of costs for a product firms generally use is unit manufacturing cost; computed by dividing the total manufacturing costs for some period (usually a quarter or a year) by the number of units of the product manufactured during that period. In practice this concept is complicated by several issues: What are the boundaries of the manufacturing system? Should the field service operations be included? What about product development activities? How do we charge the product for the use of expensive general-purpose equipment that lasts for several years? How are costs allocated among more than one product line in large, multi-product manufacturing systems?

Components

Assembly

Overhead

Standard

Custom

Labor

Equipment and Tooling

Support

Indirect Allocation

Raw Material

Processing

Tooling

Elements of the Manufacturing Cost of a Product

Component Costs. The components (e.g., parts) of a product may include standard parts purchased from suppliers. Other components would be custom parts, made according to the manufacturers design from raw materials. Assembly Costs. Discrete goods are generally assembled from parts. The process of assembling almost always incurs labor costs and may also incur costs for equipment and tooling. Overhead Costs. Overhead is the category used to encompass all of the other costs. We find it useful to distinguish between two types of overhead: support costs and other indirect allocations. Support costs are the costs associated with materials handling, quality assurance, purchasing, shipping, receiving, facilities, and equipment / tooling maintenance (among others). These are the support systems required to manufacture the product, and these costs are often shared by more than one product line and are lumped together in the category of overhead. Indirect allocations are the costs of manufacturing that cannot be linked to a particular project but which must be paid for to be in business (e.g., the salary of the security guard and the cost of maintenance to the building and grounds are indirect costs because these activities are shared among several different products and are difficult to allocate directly to a specific product.) Because indirect costs are not specifically linked to the design of the product, they are not relevant to DFM, even though they do contribute to the cost of the product.

Importance of Cost Accounting Information

Cost data provide a basis for important decisions on pricing, product mix, product design, process improvement, and technology acquisition. Poor decisions in these areas can severely impair the ability of a company to compete.

Definitions
Cost Behavior: this analysis tells us how the activities of an organization affect its costs. Cost Drivers: the activities that affect costs. Cost drivers can be volume related or non-volume related. Examples for the case of a warehouse that receives and stores material and supplies are:
Total monetary value of inventory; The number of different orders received; The number of different items handled; The fragility of the items handled.

Definitions
Variable Cost: is a cost that varies in direct proportion to changes in the cost driver. Typically the number of units of the product is the cost driver. A 20% increase in the number of units produced will cause a 20% increase in the cost of raw material used. This relationship holds for some relevant range. There may be quantity discounts available.

Definitions
Fixed Cost: is a cost that is not affected by changes in the cost driver within some relevant range. For example, the rent paid for storage space (a warehouse) is not affected by the number of units of product stored, within the capacity of the warehouse. Beyond this range, it may be necessary to rent a larger warehouse, the cost for which would be fixed over some new and, probably, higher range. Cost-Volume-Profit Analysis: is the study of the effects of output volume on sales, costs, and net profit.

Break Even Point (BEP)

This is the sales volume at which revenue equals expenses and net income is zero, that is: (USP)*(N) = (UVC)*(N) + Fixed Expenses Break Even Point (units) = (Fixed Expenses)/ [USP UVC]
Where:

o USP = unit sale price o UVC = unit variable cost o N = Number of units.

Categories of Manufacturing Costs

In a manufacturing environment, where labor and factory facilities are used to convert materials into other goods, products are frequently the cost objective. THUS: Direct-material costs: include the acquisition costs of all materials that form part of the manufactured goods and can be traced at some reasonable cost. These would include the cost of raw materials, components, and subassemblies, BUT NOT supplies and indirect materials such as lubricants and cleaning supplies. These would appear in factory overhead. Direct-labor costs: include the wages of all labor that can be traced to the manufactured goods at reasonable cost, e.g. wages of machine operators and assemblers. Indirect labor costs (for storeroom personnel, janitorial staff, security personnel) are included with factory overhead. Factory-overhead costs: include all costs associated with the manufacturing process not classified as direct material or direct labor see above and supplies, indirect labor, supervision, rent, insurance, depreciation. THESE are also known as SUPPORT RESOURCES.

Cost Accounting Systems

COST ACCUMULATION: this collects costs by some classification such as materials or labor. COST ALLOCATION: traces and reassigns costs to one or more activities of interest, such as departments or products. Costs are first allocated to departments (to evaluate performance) and then to products (to value inventory and judge product profitability). The process of cost allocation is thus a two-stage process.

Assigning Costs to Products

The costs of two resources are typically charged directly material and labor (direct material and direct labor) Resources such as these, which are consumed in direct proportion t the number of units produced, can be measured fairly and accurately.

Assigning Costs to Products

In a traditional cost accounting system, the costs of all other resources are indirectly assigned to products using direct labor or some other unit-based measure. This can cause serious distortions in product costs for several reasons Timing: the R&D costs of future products are assigned to products currently being produced. Certain costs for current products such as warranty costs may be omitted. Life Cycle Costs: In the early stages of a products life cycle, engineering and support costs are high while production costs are low. These costs get assigned to higher volume products that do not require similar levels of support.

Many support resources are not consumed in proportion to their production volumes.

Assigning Costs to Products

The distortion from unit-based product cost systems is most severe in organizations producing a diverse product mix for the following reasons. Products that differ in volume, 1. Increasing product diversity 2. complexity, and stage of life increases levels of support cycle consume support activities and related indirect resources in significantly costs. different amounts. In other words, the overhead The high proportion of overhead costs of support resources costs are thus allocated incorrectly by measures such as tend to be a larger proportion direct labor or direct material. of total costs.

Assigning Costs to Products - example Consider the case of two Tumbling Dice Electronics, Inc. plants - Domino and Geronimo both producing CD Players. The Domino Plant makes 100,000 CD Players per year of a single model with a stable design. The Geronimo Plant makes 100,000 units of a dozen different designs in volumes ranging from 1000 to 30,000 and the designs of some of the lower volume models are subject to frequent changes. It is clear that Geronimo will have much higher levels of indirect costs due to larger costs for scheduling, setups, inspections, materials management, design, and engineering changes. The traditional system would provide accurate costs for Domino, but for Geronimo, the high support activity costs would be allocated incorrectly by unit-based measures to high volume models.

 Traditional product costing assumes that products cause indirect costs by consuming the driver(s). Indirect costs can, therefore, be allocated through these unit-based measures. That is, indirect costs are assumed to vary directly with volume of output. We have seen that this approach can cause cost distortions when products are in different stages of their life cycle, are not of the same complexity, or are produced in different volumes.

 ABC takes a different approach in assuming that products incur costs by the ACTIVITIES they require for design, engineering, manufacture, sale, delivery and service. These activities, in turn, cause costs by consuming support resources such as the production planning and control dept., setup dept., engineering dept., shipping dept., and so on. ABC attempts to trace as many of the indirect costs as possible directly to products, as is done with direct material and direct labor. To implement an ABC system, a company must identify the major activities undertaken by support departments and select a cost driver for each. Some examples are: (a) Engineering and hours of engineering services, (b) inspection and hours of testing, (c ) Shipping and number of orders and (d) Production Setup and number of setups.

 ADVANTAGES:
Improved decisions through more accurate cost data. This becomes especially important when manufacturing overhead costs account for a large percentage of production costs e.g. as in the electronics and machinery industries where overhead accounts for 70%-75% of value added. Improved insights into activities that lead to overheads. By linking activities to financial costs, ABC provides cost information to complement non-financial indicators of performance. It is therefore compatible with TQM efforts. It recognizes the non-manufacturing costs of products through the activities that are linked to products. It allows cost analysis at the design stage. Designers can keep in mind cost drivers (e.g. number of components) while designing the product.

 Any scheme for allocation of indirect costs can be considered arbitrary because another consultant or expert could design an alternate scheme. The use of single cost drivers is nave. For example, shipping and handling costs are likely to depend on the number of orders shipped, the weight, volume and special packaging needs of products. Using only one of these drivers will not reflect costs accurately. Many fixed costs are treated as variable costs. This could lead a company to mistakenly use the per unit cost obtained from an activity-based costing system as a marginal cost. The cost of implementing an ABC System, with many cost pools and cost drivers, can be high.

 Diversity in the product mix in terms of complexity of products, stages of life cycle, volumes, number of batches produced, requirement for engineering and quality related activities, etc. Profitability of products and competitors prices are hard to explain. Common symptoms of this problem are winning bids that you considered high, and losing bids that you considered low. The higher the cost of such measurement errors, the more important it is to get more accurate product costs.

CIM provides a good example of an environment where support activities generate high percentage of the costs: 1. Development of the computer programs that run the machines, direct the material handling system, coordinate the different elements of the system, and provide feedback to supervisors. 2. Scheduling and sequencing of products 3. Design of products and process routes so that production can be assigned to CNC equipment with minimum human intervention; and 4. Increased levels of preventive maintenance. The flexibility of CIM systems e.g. a Flexible Manufacturing System (FMS), allows many different products to be produced simultaneously in small batches and in random order. This makes the prior tasks even more complicated. At the same time, the highly automated and computer controlled nature of the production process means that direct labor costs tend to be a very small component of the total cost. Any overhead cost allocation based on direct labor will provide distorted product costs.

Managing Activities Instead of Costs

ABC highlights activities that incur costs and these activities can then be analyzed and improved. A good example is provided by the Economic Production Quantity formula which is used to calculate the optimal batch size to minimize the sum of setup and inventory costs. The setup cost is considered as a given, and generally reflects setup time. Given batch production, it becomes necessary to hold inventory However, setups and storage add little, if any, value to customers and are considered to be waste. Toyota started a system (the Toyota Production System) that reduced setup time and costs which in turn allowed smaller batch sizes and reduced inventory. This improved quality and allowed Toyota to be more responsive to the market. THAT IS THEY SIMULTANEOUSLY IMPROVED QUALITY, COST, and FLEXIBILITY !!!

Example of Activity-Based Costing

The Buzz! Company assembles electronic components for use in medical instruments. Two of these, components 89 and 93, require 6 minutes and 7.5 minutes each, respectively, of direct labor, which costs $16/hour. Component 89 consumes $22.40 of direct materials and component 93 consumes $35.05 of direct material. Using a traditional costing system with all overhead costs allocated at a rate of $230 per direct labor hour, the product costs would be: COMPONENT 89 : $1.60 + $22.40 + $230*(.100) = $47.00 COMPONENT 93 : $2.00 + $35.05 + $230*(.125) = $65.80 In an attempt to get a more accurate estimate of costs, the company has decided to try the ABC approach. They have identified SIX activities in their system.

Table 1: Activities & Cost Drivers

ACTIVITY
Materials Handling Engineering Production Setup Assembly (Automated) Inspection Packaging & Shipping

COST DRIVER
Number of Components Hrs. of Engineering Services Number of Setups Number of Components Hours of Testing Number of Orders

RATE
$0.15 / component $60.00 / hour $100.00 / setup $0.05 / component $40.00 / hour $2.00 / order

Table 2: Cost-Driver Activity

Component 89
Number of Components Hours of Engineering Services

Component 93 12 0.05 200 0.02 2.5

36 0.10

Production Batch Size 50 Hours of Testing Units Demanded Per Order

0.05 2

Table 3: Activity-Based Costing of the Two Components

Direct Labor Direct Materials Materials Handling Engineering Production Setup Assembly Testing Packaging & Shipping TOTAL COST Component 89 Component 93 $1.60 $2.00 $22.40 $5.40 $6.00 $2.00 $18.00 $2.00 $1.00 $58.40 $35.05 $1.80 $3.00 $0.50 $6.00 $0.80 $0.80 $49.95

COST ESTIMATION FOR PRODUCT DESIGN

End of Session