Chapter 14: Strategic Management of Cos93
Strategic Management of Costs
Chapter 14 addresses the following objectives:
LO1 Explain how value chain analysis, supply chain and JIT are used to improve operations.
LO2 Explain target costing and calculate target costs.
LO3 Explain kaizen costing and compare it to target costing.
LO4 Explain life cycle costing.
LO5 Explain lean accounting and discuss how it is used.
These learning objectives (LO1 through LO5) are cross-referenced in the textbook to individual
exercises and problems.
© 2012 John Wiley and Sons Canada, Ltd. 94 Cost Management
14.1 Just-In-Time (JIT) is an inventory management and manufacturing system where
products are manufactured as demanded and raw materials are delivered just when they
are needed in the manufacturing cycle. Very little inventory is kept on hand; suppliers
deliver small amounts on a regular basis. Organizations adopt Just-In-Time systems to
keep inventory costs down and also to better manage quality because defects are often
monitored more closely with JIT systems. Systems such as JIT are known as demand-
pull systems, because demand pulls inventory through the system to the point of sales.
14.2 Similarities between target and kaizen costing:
• Rely on goal setting to achieve cost reduction
• Focus on product design and the manufacturing process to find ways to reduce
• Encourage organizations to work with suppliers to reduce costs
• Use functional teams to determine where costs can be cut
• Encourage employees to take an active part in the cost cutting decision making
• Take advantage of the trade-offs among price, functionality, and quality
• Focus on continuous improvements in products and processes
Differences between target and kaizen costing:
• Target costing occurs in the design and decision-making phase of product
• Kaizen costing occurs after the product has been manufactured for the first time,
and continues throughout the life of the product.
Similarities and difference among life cycle, target, and kaizen costing
• Life cycle costing (LCC) is similar to kaizen costing in that cost reductions over
time are expected. LCC is different because there is no goal setting for specific
targeted costs and the product is unprofitable in the beginning of the life cycle.
• In target costing, an unprofitable product is never manufactured, but under life
cycle costing the product is expected to make a profit at some time, although not
at the beginning of its life cycle.
14.3 Target and Kaizen costing are most appropriate in the following situations:
• Product development and design phases are long and complex.
• The production process is complex.
• The market is willing to pay for differences in quality or
• The manufacturer can push some cost reductions onto suppliers
• The manufacturer can influence the design of subparts.
© 2012 John Wiley and Sons Canada, Ltd. Chapter 14: Strategic Management of Costs 95
Students should draw from these characteristics in identifying products for which target
and kaizen costing would and would not be appropriate. For example, these methods
would be appropriate for automobile design and production, heavy equipment
manufacture, camera manufacture, computers, and electronics. Some service industries
use various forms of target costing practices. For example, hospitals in the United States
are reimbursed by Medicare with a flat-fee per patient by the diagnosis the patient is
given. Doctors agree on clinical pathways, that is, the steps taken to treat the average
patient with that diagnosis. The clinical pathway is designed to cost less than the
reimbursement amount. Similarly, a CA firm may use these methods to evaluate whether
services can be provided to achieve desired profits or whether the firm should continue
offering services to a client. Target and kaizen costing are not generally useful for simple
product manufacturing such as small toys or for food and beverages such as colas,
cereals, or pasta products.
14.4 The value chain cycle follows these processes in an organization, in a continuous
manner: research and development, product or service design, manufacturing process or
service delivery design, manufacture or service delivery, marketing, distribution,
customer service. Following are some of the benefits from value chain analysis:
enhanced efficiency, cost reduction, improvements in supplier and customer
relationships, the ability to identify and eliminate non-value-added activities, reductions
in rework, scrap, and waste, production cycle time reductions, and an increased ability to
negotiate lower prices with suppliers.
14.5 First determine the product’s target price, quality, and functionality. Then determine the
target cost. Design the product and manufacturing or delivery process to achieve the
target cost. A pilot project is set up to evaluate the feasibility of the product and process
design and operation. If the product meets the target criteria, it goes into full production.
At each stage decisions are made about whether the product will be able to meet the
price, quality, and functionality requirements. If these are not met, the product will not
be produced or the requirements will change in response to customer input.
14.6 Supply chain analysis explores the flow of resources from the initial suppliers (inside or
outside the organization) to the delivery of products or services to customers or clients.
Often, prices of inputs are reduced through negotiations with suppliers and may entail
long-term contracts. To further reduce costs, the purchasing organization may provide
engineering or other kinds of assistance to the supplier.
• Use of goal setting encourages better performance
• Team approach motivates employee cooperation
• Allows a competitive price advantage for a short period of time
© 2012 John Wiley and Sons Canada, Ltd. 96 Cost Management
• Stress of cost reduction environment can impair employee wellbeing
• Encourages organizations to forego some products having long term profit
potential that are not profitable in the beginning
14.8 Accounting functions can be improved under a lean system by analyzing the various
accounting activities and streamlining them to the degree possible. For example, approval
processes can be streamlined while still retaining appropriate authorization processes,
basic accounting processes are computerized whenever possible, and inventory amounts
can be minimized to reduce effort in tracking and valuing it.
14.9 Value stream analysis is the process of analyzing business processes to identify the cost
individual value-added activities. This analysis is similar to value chain analysis, but with
more specific activity categories by functional roles. Processes may be broken down into
cost streams for various cost categories, such as production labour, production materials,
production support, machines and equipment, facilities and maintenance, and so on.
Processes are reconfigured to reduce both effort and cost. Value stream analysis is
undertaken to reduce cost, improve quality and enhance competitiveness, among other
14.10 Life cycle costing values the cash flows throughout a product’s life. Because product life
is usually more than one year, NPV is used to take into account the time value of money.
Target and kaizen costing are performed in the short term to increase a product’s
competitiveness in the market. Kaizen costing occurs on a regular basis in industries that
experience constant product improvement and/or price declines.
14.11 Lean accounting is a set of accounting principles and methods to support lean business
practices and motivate continuous improvement. For cellular manufacturing teams, lean
accounting provides performance measures to determine whether operations are in
control. These measures often include day-by-the-hour, first time through (FTT), work in
process compared to standard (WIP to SWIP) and operational equipment effectiveness
(OEE). These measures monitor throughput time and defect rate and help managers
adjust operations when necessary.
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14.12 How is Kaizen costing different from standard costing?
a) Kaizen costing puts more emphasis on cost reduction than cost control.
b) Kaizen costing puts more emphasis on cost control during the product design stage.
c) Kaizen costing puts more emphasis on cost reduction during the product design
d) Kaizen costing puts more emphasis on the life cycle of the product.
14.13 Which of the following statements concerning target costing is correct?
a) This approach is based on the observation that the firm should set its price so as to be
able to cover its costs.
b) The firm should devote resources to effectivelymarket the product to improve
c) The firm should not expect to significantlyimprove profitability through cost
reductionsafter the product has entered production.
d) The cost of the product cannot be calculateduntil it has been produced.
14.14 A company considers producing a new product andselling 20,000 units per year at a
selling price of $60per unit. It will cost $800,000 to design, develop,and produce the
units. If the company desires a 16%return on investment, what is the target cost per unit?
$800,000 * 16% = $128,000 target OI.
Target revenue = $60 * 20,000 units = 1,200,000
Target cost = $1,200,000 - $128,000 = 1,072,000 / 20,000 = $53.60 per unit
14.15 Which of the following items is a limitation tototal-life-cycle costing in a firm?
a) Committed cost decisions are made by researchand development people.
b) Managers place enormous pressure on employeesto reduce costs.
c) Overhead costs are much higher than primarycosts.
d) It is difficult to attach some types of costsdirectly to a specific product line.
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14.16 Which of the following statements concerning theapproach of target costing is correct?
a) This approach is based on the observation thatthe firm should set its price so as to be
able tocover its costs.
b) This approach is based on the principle thatthe firm should devote resources to
effectivelymarket the product to improve profitability.
c) This approach is based on the principle that the firm should first determine the
appropriate price for its product and then design and produce the product to
achieve the cost that would lead to the desired profit.
d) This approach is based on the observation thatthe cost of the product cannot be
calculateduntil it has been produced.
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14.17 Value-Added and Non-Value-Added Activities
A. Inspection activities are non-value-added. Some organizations have very low defect
rates, making it unnecessary to inspect; that is, the product design and manufacturing
process insures high quality production. The concept of high quality is to “do it right the
first time.” Some firms may inspect incoming materials to guarantee high quality during
their manufacturing processes, but these costs could be eliminated through contractual
arrangements with suppliers that include high penalties for low quality material
B. Moving materials to work stations could also be either value-added or non-value-added,
depending on the circumstance. In organizations that use JIT systems, the amount of
materials handling is reduced to the minimum level necessary, which reduces costs.
C. Manufacturing extra inventory to keep employees busy is non-value added if there are no
sales for the inventory.
14.18 JIT Production - Big Bertram
A. It is a cellular or kanban system. An employee work team manufactures each item in a
small workstation using Just-In-Time inventory control methods.
B. Each employee inspects his own work, and so defects are caught very quickly. Inventory
is delivered to each cell just as it is needed and products are made only when they are
ordered so inventory costs are minimized. Usually there are space savings.
C. A cellular system succeeds when manufacturing is continuous and the defect rates are
low. If the supplier has any problems with the software and deliveries are slow, the line
cannot manufacture anything. If there are any problems with quality, it may take longer
to get these adjusted because the software has already released materials for delivery. In
addition, Big Bertram would want to emphasize the security aspects of the supplier’s
access to its inventory levels. Firewalls and strong security code systems would be
needed to protect the integrity of Bertram’s database and specialized software programs.
Organizations in competitive industries guard their production information to protect
their private information regarding areas of their competitive strengths.
© 2012 John Wiley and Sons Canada, Ltd. 100 Cost Management
14.19 Target Costing – A company
$60 per unit * 20,000 units = $ 1,200,000
0.222222 * $900,000= $200,000
$200,000 / 20,000 = $10 per unit
($1,200,000 – 200,000) / 20,000 = $50 per unit
or $60 - $10 = $50 per unit
14.20 Target Costing - Ford
A. If Ford had used target costing for the Ford Escape, the first step would have been to
determine a market price for the new model. Focus groups and customer surveys would
have been conducted. Once the market price had been established, the required profit
margin would be subtracted, leaving the target cost. At this point a team would be
assembled of engineers, accountants, and marketing people to design the product and the
manufacturing process. If the team is able to do this at the target cost, a pilot production
line is implemented. If costs come in at the target cost, the Ford Escapewould go into full
production. If the target cost cannot be met, at either the design or pilot stage, the whole
process is reiterated several times. If the Escape never came in at the target cost, the
marketing department could do more research to see if customers would respond to an
increased price or decreased quality or function. If the target cost is never met, the
product is dropped.
B. New products such as the Ford Escapemay be well received, or they may not be.
Consumers’ preferences vary across age groups, across geographical locations, across
income brackets, across gender lines, and many other characteristics. Because of this, the
survey and focus group information may not represent the population of consumers
needed. In addition, economic factors affect the success of a new product. None of these
can be known for certain ahead of time.
14.21 Kaizen Costing - Blade Runner
A. Current price is equal to the cost plus 10% of the cost = 110% x $150 = $165.
New price = $165 – (10% x $165) = $148.50
B. Because the company wants to achieve a 10% return on sales, the new contribution
margin = $148.50 x 10% = $14.85. The contribution margin takes into account both
fixed and variable product costs, because none of the costs will be incurred unless the
motor scooter is produced.
Therefore the new target cost is cost = $148.50 – $14.85 = $133.65
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C. Need to reduce each cost by ($150 – $133.65)/$150 = 10.9% (assumes proportional
Original Amount Target Cost
$ 45 $ 40.095 (45 * (1-0.109)
14.22 Kaizen Costing, Proposed Cost Reductions, Uncertainties - Blade Runner
Continued from Exercise 14.21
A. Following are the new costs:
Direct materials $ 41.00 (45.00-4.50+.50)
Direct labour 13.50 (15.00-1.50)
Machining 8.70 (10.00-1.30)
Engineering 16.00 (20.00-4.00)
Marketing 22.50 (25.00-2.50)
Costs need to be reduced further by $136.70 - $133.65 = $3.05
B. The next step will be to look for more cost savings so that the target cost can be met. No
savings were mentioned for inspection, so that is one area that could be explored. Other
departments may have to cut back further to meet the target cost of $133.65. After the
target cost has been met, a pilot project would be set up. If the scooter can be produced
for $133.65 in the pilot project, the product would be manufactured. If costs still were
too high, the target costing process would be reiterated.
C. Any changes in suppliers would need to be carefully considered. The reliability of the
supplier, the timeliness of delivery and quality of products supplied, all need to be
explored. If suppliers do not meet required standards, new vendors must be found, and/or
the target cost may not be met. Productivity gains by labour could reduce quality. Any
trade-offs in quality or functionality to meet the target cost need to be explored and
discouraged. The new target cost assumes no reductions in quality or functionality. For
each category: is the cost reduction actually attainable without affecting quality or
functionality? For marketing, will the cost reduction affect sales volumes? Will cutting
inspection costs mean that more defective units are sold? Will direct labour workers feel
© 2012 John Wiley and Sons Canada, Ltd. 102 Cost Management
too much pressure to continually reduce costs and will turnover increase? Will the
machining department continue to be precise in their work while cutting costs?
D. Questions (i.e., uncertainties) about whether the company will be able to achieve its
planned cost reductions are listed below. Students may think of others.
Direct materials – How certain can managers be that the price set by vendors now will
continue over the next accounting period? How certain can they be that no changes in
the price of raw materials will occur?How certain can managers be that the reduced cost
will not result in reduced quality?
Direct labour – How certain can managers be that labour productivity will continue to
improve? Could labour demand a pay rate increase in the next year?
Machining – How certain can managers be that no new technology will be developed,
making their current machines obsolete?How certain can managers be that cutting batch
sizes will not affect set up costs?
Inspection – How certain can managers be that inspectors will not demand an increase in
salaries, or that they will continue to provide high quality inspections?
Engineering – How certain can engineers be that any changes will either improve quality
or reduce costs as they anticipate?
Marketing – How certain can managers be that the popular media will not increase prices
for advertising? How certain can they be that appropriate customers are targeted in the
Administration – How certain can managers be that administrative costs do not increase,
especially costs for computerized systems and software?
14.23 Kaizen Costing, Design Change Effects – Preeti Telang
A. Total actual costs last 6 months: $6,000 + $2,500 + $15,000 = $23,500
Total estimated costs next 6 months: $5,500 + $2,000 + $14,500 = $22,000
Estimated percent change: ($23,500 – $22,000)/$23,500 = $1,500/$23,500 = 6.383%,
which is lower than the kaizen cost reduction goal of 10%. The kaizen cost goal is not
likely to be met.
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B. Examples of possible quality problems are listed below. Students may think of others.
• The quality of printouts delivered by fax may be poor.
• The quality of outsourced photocopies may be lower than current quality.
• The outsource partner may fail to deliver photocopies when needed.
• Support staff may be unavailable when needed by the professional staff.
14.24 Value-Added and Non-Value-Added Costs – Rapid Routers Company
A. Direct materials and direct labour are value-added costs because they add value to the
products purchased by customers. The remaining costs (material handling, inspection and
rework, purchasing, maintenance, and repair) are all non-value added and should be
minimized. Although the classification of costs for this company seemed rather
straightforward, some doubt exists about whether all of the costs can be classified as only
value-added or non-value-added. For example, direct labour was classified as value-
added. However, if workers perform non-value-added tasks that are not tracked
separately such as rework or inspection, then some of this cost might be non-value-added.
B. Assuming that all of the costs are correctly classified in Part A, non-value-added costs
sum to $5,500 and value-added costs sum to $60,000. Non-value-added are 8.4% of total
C. Most of these non-value-added costs probably cannot be eliminated because they involve
activities that are necessary to support manufacturing and/or ensure product quality.
However, rework costs might be eliminated (or reduced) by improving production
processes to avoid production of defective units.
D. In addition to reduction of rework costs as discussed in Part C, it may be possible to
reduce other non-value-added activities such as material handling, inspection,
purchasing, maintenance, and repair. Some costs, such as maintenance, should not be
minimized but optimized. That is, trade-offs exist in the costs for repair (including
production down time) versus regular maintenance and service costs. Organizations
would like to optimize the costs of regular maintenance to minimize the cost of repairs.
© 2012 John Wiley and Sons Canada, Ltd. 104 Cost Management
14.25 Cumulative Exercise (Chapter 7) Target Costing, ABC – Fred’s Auto Components
[Note: This exercise requires application of knowledge of activity-based costing from Chapter
Calculations for Parts A and B:
Driver Costper Driver Costper
quantity unitof Totalcost quantity unitof Totalcost
Activity permonth driver permonth permonth driver permonth
Orderingparts 20 $ 40.00 $ 800 20 $ 40.00 $ 800
Receivingandinspectingparts 6,000 $ 0.10 $ 600 4,800 $ 0.10 $ 480
Materialshandling 6,000 $ 0.20 $ 1,200 4,800 $ 0.20 $ 960
Packagingseatsforshipping 1,200 $ 0.30 $ 360 1,200 $ 0.30 $ 360
Shippingcosts 18,000 $ 0.50 $ 9,000 18,000 $ 0.44 $ 7,920
Returnofdefectiveseats 20 $500.00 $ 10,000 20 $500.00 $ 10,000
Totalcostspermonth $ 21,960 $ 20,520
A. The current total cost of support activities this month is $21,960.
Reduce parts per seat by 1 part:
Reduction in number of parts = 1 part per seat × 1,200 seats = 1,200 parts
New number of parts = 6,000 – 1,200 = 4,800 parts
See revised cost for receiving and inspecting parts and for materials handling in
the schedule above.
Revised shipping cost per pound: $0.50– $0.06 = $0.44 per kilogram
See revised shipping costs in the schedule above.
Percent cost reduction = ($21,960 – $20,520)/$21,960 = 6.56% (does not meet goal of
14.26 Lean Accounting, Takt Time, Day-By-The-Hour, FTT – Sturdy Toy Company
A. Takt time = time available divided by units demanded from customers
Time available = 21 days × 7 hours per day × 10 cells = 1,470 hours
Units demanded by customers = 9,400 trucks
Takt time = 1,470 hours/9,400 trucks = 0.1564 hours per truck, or 9.4 minutes per truck
© 2012 John Wiley and Sons Canada, Ltd. Chapter 14: Strategic Management of Costs 105
B. 1. Day-by-the-hour = Number of units demanded per hour compared to number of units
Trucks demanded per hour = 60 minutes/9.4 minutes per truck= 6.4 trucks
Or, 9,400 trucks demanded / 1,470 hours = 6.4 trucks per hour
Trucks completed = 5
Variance = Trucks completed – Trucks demanded = 5 – 6.4 = –1.4 trucks
2. First time through (FTT) = Total good units completed / Total units completed
FTT = (5 – 1)/5 = 80%
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14.27 Cost Reduction, JIT, Value Chain Analysis - Budget Cupboards
[Note: An example is provided in the textbook for students to follow in answering Part A.]
A. Here are possible answers to this question; students may think of others.
Potential Area for Potential Cost Reduction
Manufacturing Reduce inventory by using a JIT Reduce inspection by using cellular
process system manufacturing (also increases
flexibility so that specialty items
can be manufactured to order more
Administration Outsource functions such as Explore software that would
payroll if it is cheaper to do so increase efficiency and reduce
number of employees needed
Changes in quality Identify specialty functions with Identify lower cost materials that
or functionality low volume sales and consider would not reduce current quality
B. To price more competitively, overall costs need to be reduced without affecting product
quality or functionality. Value chain analysis and JIT are methods that are used to reduce
costs. JIT manufacturing reduces inventory storage and insurance costs, and frees up
extra space in the manufacturing plant. If there are alternative uses for the space, the
overall contribution margin should increase. Value chain analysis enables managers to
categorize activities into value-added and non-value added. Then the non-value added
activities are eliminated or minimized to save costs. The supply chain can be analyzed to
determine whether vendors can reduce their costs or provide higher quality goods and
services at the same price.
14.28 Target and Kaizen Costing, Uncertainties, Manager Incentives - Sandy
A. Target and kaizen costing are both market-based pricing techniques. Once the market
price is established, both methods set cost goals for production. However, target costing
occurs at the decision-making phase of product development and kaizen costing occ