Chapter 10
Cost Planning for the Product Life Cycle: Target Costing,
Theory of Constraints, and Strategic Pricing
Teaching Notes for Cases
10-1. Strategy; the Theory of Constraints
1. What is the firm’s competitive strategy?
Information in the case suggests that CI is the high-cost producer that led the industry in quality,
which implies differentiation. What strategy are they pursuing now? Cost leadership, through
robotics, increasing batch sizes, reducing idle time, efforts to reduce overhead. There should be a
combined focus on customer satisfaction (differentiation) and plant reengineering (using TOC), to
improve the use of existing capacity, i.e., to improve throughput through the plant.
For example, why did they reject the Saudi offer, which would have been consistent with their
quality image? The Saudi deal should have been accepted; no reason to turn down low margin deals in a
depressed market.
Why the steep drop in price for AA knives? This simply intensified overall competition in the
industry and since competitors responded, made everyone in the industry less profitable. The steep drop
in price of AA knives is not consistent with CI’s quality image
2. What motivated the cost reduction strategy?
A depressed market for their product
Cash flow problems
Losses
Is the firm close to bankruptcy? In the actual case, the bank gave the firm 6 months or they would
enforce reorganization.
Did the cost reduction strategy work? Why?
The answer is no, because:
a. Efficiency through larger batches, less idle time, and reduced set-up time: the result was an
increase in WIP, difficulties in scheduling the large batches (less plant flexibility), and
increased overtime
b. Overhead reduction – hinged on increase in sales, which did not happen
c. The robotics did reduce labor costs of arc welding, but savings were not realized:
i.) the arc welders were not released but were reassigned
ii.) the robotics eventually caused additional labor costs necessary to manage them
3. How did the standard costs system affect the cost reduction strategy?
 The standard cost system rewarded keeping busy (i.e., no idle time) even though this was
wasteful of non-constraints resources
 The standard costing system rewarded output, i.e., build-up of inventory
4. What is the role of WIP in the cost reduction strategy?
 Insurance against machine or scheduling failure
 Makes scheduling easier
What are the costs of WIP?
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


Carrying cost: space, insurance, taxes, damage, pilferage, obsolescence
Cost of funds tied up
Allows downstream departments to pick up and choose among parts to increase their piece rates
5. Is the new Production Control/Inventory Control (PCIC) manager on the right track with the smaller
lot sizes?
Yes, this is the TOC concept; smaller lot sizes make it more likely that CI will be able to keep the
binding constraint busy.
6. What steps is the PCIC likely to take now?
The five steps of TOC are:
 The binding constraints: heat treating (due to excessive overtime) and hardfacing (due to underutilization of capacity)
 Maximize flow: weekly schedules from PCIC for the two bottlenecks. Meeting the schedules is
top priority of all shop floor managers
 Coordinate other resources: use of the drum-buffer-rope concept
 Increase capacity on the constraints: training and increased staffing in hardfacing; in heat treating,
off-load jobs that do not absolutely need heat treating
 On-going search for constraints
Results in the actual firm: WIP and overtime fell; unfortunately, the focus was only on the plant,
and marketing was not integrated into the effort.
7. What type of cost system should be used at CI?
Standard costing is an effective method for controlling costs in the manufacturing plant, and can
be useful to CI to manage costs. However, CI also needs ABC to help management better understand the
causal cost factors in the plant, as a way to identify activities that do not facilitate throughput.
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10-2 . Blue Ridge Manufacturing (B)
Note: This case uses information from Case 5-1: Blue Ridge Manufacturing (A)
Answers to Discussion Questions:
1. What is Blue Ridge Manufacturing’s strategy now that it has developed the new products and become
a global competitor? Has the strategy changed?
With the growing acceptance of the new ink and the upgraded quality throughout its product lines, one
could argue that Blue Ridge is moving from the cost leadership strategy to a differentiation strategy based
on quality and innovation. However, the case description also points out that Blue Ridge is encountering
significant new competition in these product lines. That is, as the firm’s reach has become more global,
so has the pressure from competing products. The new competition has forced Blue Ridge to drop prices,
indicating that cost leadership is still very important. An important point of the case is that the
simultaneous move into quality, innovation, and cost reduction is consistent with what Robin Cooper
describes as Lean Competition, or the Confrontation Strategy (HBS Press, 1995, When Lean Enterprises
Collide: Competing Through Confrontation). Firms that compete globally under this type of competition
often adopt target costing as a way to achieve the desired product enhancements at the minimum (i.e., the
“target”) cost
Note that before the introduction of the new ink, Blue Ridge’s strategy could best be described as cost
leadership based on their innovation in plant, the ABC-based costing of manufacturing cost to supply the
needed accuracy in product costs, and the “medium quality” of their product. Case (A) shows how the
ABC approach was extended to analyze more accurately the profit contribution of the three customer
groups. At this time the focus was on productivity and cost reduction. Now the firm has a broader
strategic focus, including innovation and quality. The firm’s cost management methods must also adapt,
as addressed in the following question.
2. How should Blue Ridge Manufacturing adapt to the new competitive environment?
With the change to differentiation and/or confrontation (per Robin Cooper), the role of cost
management has changed. Previously, there was a focus on cost efficiency and accuracy of cost
information, to support the previous cost leadership strategy. Consistent with this approach, the firm had
adopted ABC costing in both manufacturing and in the costing of the three major customer groups.
Moreover, the firm was committed to advanced manufacturing techniques to support the needed
manufacturing efficiency.
Now, with global competition and the manufacture of new products, the firm’s competitive
challenges have also changed. The role of cost management has now broadened, to include more
attention to the design, or “upstream” phase of product costs. While a great deal of attention has been
given, using ABC costing to develop accurate manufacturing and “downstream” costs (the analysis of
downstream costs is developed in case A), the need now is to look to the early phases of the cost life
cycle. The reason is that, as noted in the case, the design work for the new products can be significant in
itself, and most importantly, can have a significant effect on downstream costs. For example, a poorly
designed product might be more difficult and costly to manufacture. These concerns mean that the idea
of a product development team is a very sound idea. The team should use cost management principles to
facilitate the development of low cost product design and manufacturing methods.
The changed competitive circumstances point to the need for Blue Ridge to adapt its cost management in
two ways. First, design costs should be carefully considered as part of the ABC costing system. Blue
Ridge needs to know how the design costs of different orders/customers affects the overall costs of the
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order and serving the customer. This is particularly true for customers that submit incomplete or poorlydeveloped designs which then leads to additional design work for Blue Ridge and possibly also to
additional manufacturing costs. That is, the poor design may be more difficult to manufacturer, leading to
long setup times and low productivity for these orders.
Second, Blue Ridge should adopt a target costing approach, to capture all the product costs from design to
customer service, as a means for improved competition with the new Asian competitors. Target costing
would allow the company to competitively price those customers who submit a well-developed design.
At the same time, target costing can help the firm know when to reject orders from customers with
poorly-developed designs, if price cannot be adjusted to cover the additional costs. For a useful
reference, John Brausch (“Target Costing for Profit Enhancement,” Management Accounting,
November 1994) explains how target costing can be used within a textile firm.
10-3 Nebraska Toaster
1. Calculate Product Target Cost: for the Toaster Company is $16.00
(Competitive Market Price $20 - Desired Profit $4 = Target Cost $16)
This $16.00 target cost is then compared to the company current/estimated cost, produce based
on the features wanted a toaster oven, of $19.70 to arrive at the cost gap of $3.70. This $3.70
cost gap then is broken down into the products life cycle and value chain activities as shown
in Table 1. The value chain includes both inside activities and outside outsourcing activities.
The life cycle has R & D, manufacturing, selling, shipping, and general administrative
activities.
2. Combine step 2 and step 3from the case, we derive the Table 5 amounts. The “Relative
Ranking” column percentages are from Table 3.
Table 5 Quality Function Deployment Analysis
Components
or Functions
Heating
Unit
Display
Light
Lever
Spring
Coil
Temp.
Control
& Timer
20% x
28% =
5.6%
20% x
28% =
5.6%
10% x
28% =
2.8%
Customer
Requirements
Toasts and grills
properly
Size
Speed of toasting
50% x
28% =
14%
50% x
17% =
8.5%
70% x
17%=
10% x
17%=
Body
Design
Crumb
Catcher
Relative
Ranking
28%
50% x
17%=
8.5%
20% x
17%=
Blocher, Stout, Cokins, Chen: Cost Management 4e 10-4 ©The McGraw-Hill Companies, Inc., 2008
17%
17%
11.9%
30 %x
11%=
3.3%
Bagel Capacity
Appearance
5% x
11%=
0.55%
20 %x
5%=
1%
Easy to Clean
Converted
Component
Ranking
1.7%
50 %x
22%=
11%5
48.7%
1%
6.15%
5.6%
4.5%
3.4%
60% x
11%=
6.6%
80% x
5%=
4%
45% x
22%=
9.9%
32.4%
5 %x
11%=
0.55%
11%
5%
5 %x
22%=
1.1%
22%
1.65%
100%
This gives the company the importance and value of each component relative to the features that
create value to the customer. For example, the customer requirement of toast and grill
properly results from 50% of the heating unit 20% for both the lever and the spring coil and
10% for the temperature control and timer.
Calculating Value Index for Each Function
The next process is the value index that targets areas for value engineering. It considers the
toaster oven customer requirements at their level of importance to the amount of cost that are
involved with that component. The value index shown in Table 6 calculates a ratio that
shows the areas were cost reduction can be done. As a rule of thumb, the ratio indicates that
numbers below 1.0 should be targeted for cost reduction/value engineering, because the
importance of that component is less than its cost. Values above 1.25 are activities that need
to be enhanced given the importance placed on them by customers. Values between 1.0 and
1.25 are activities that are balance with customer importance and cost, and are areas not
requiring value engineering.
Column 2, the “Component % of Cost” column percentages are inputted from the last column of
Table 2. Column 3, the “Relative Importance %” column percentages are inputted from the
last row of Table 5.
Table 6 Value Index
(1) Component or
Function
Heating Unit
Display Light
Lever
Spring Coil
(2)
(3) Relative
Component % Importance %
of Cost
20
13
5
5
48.7
1
6.15
5.6
(4) Value
Index =
Col. 3 /
Col. 2
2.435
0.077
1.23
1.12
(5) Action
Implied
enhance
reduce cost
ok
ok
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Temperature Control Timer
Body Design
Crumb and Grease Catcher
TOTAL
5
43
9
100%
4.5
32.4
1.65
100%
0.90
0.753
0.183
reduce cost
reduce cost
reduce cost
Applying Value Engineering and Cost reduction Techniques
From the value index, Nebraska Toaster Company can see what areas to enhance and areas to
apply value engineering. At this point the entire company can generate ideas on how to
accomplish these steps of reducing costs and maintaining the level of functionality. For
example, they should enhance and spend more on the heating unit because of its importance to
the customer. The new bagel toaster can reduce value engineer by possibly eliminating the
display light. Redesign the Body Design and the Crumb Catcher with plastic instead of the
expensive stainless steel. Temperature Control Timer may be combined with the Display Light
reducing costs.
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10-4. Mercedes-Benz All Activity Vehicle (AAV)
The target costing case literature contains numerous examples of Japanese cost management practices;
however, few cases describe the use of target costing by large companies outside Japan. The purpose of
the Mercedes-Benz AAV case is to consider the competitive environment of a leading German
automotive manufacturer and the company's response to changing competitive conditions. The teaching
plan generally follows the suggested student assignment questions. In places, I recommend considering
additional material during the case discussion. These questions are identified by a check mark.
Student Assignment Questions
1. What is the competitive environment faced by MB?
Students will identify a number of changes, including significant market share lost to Japanese
companies such as Lexus. Stress the importance of a cultural change taking place within top management
at Mercedes. Reinforce that Mercedes is a company that had never lost money. They simply built the best
car their engineers could design and priced it above cost. Demand often exceeded supply. As a result, cost
had never been a primary consideration. Changes include:
 cost competition;
 product innovation.
2. How has MB reacted to the changing world market for luxury automobiles?
Students should identify the following changes implemented by management at Mercedes; try to
get them to explain how different these approaches were from traditional strategies at Mercedes:
 many new product introductions;
 partnering with suppliers;
 reduced system complexity;
 new emphasis on cost control;
 layers of management reduced;
 lead time from concept to introduction reduced.
3. Using Cooper's cost, quality, functionality chart, discuss the factors on which MB competes with other
automobile producers such as Jeep, Ford, and GM. If the instructor wishes to give a brief mini-lecture on
Robin Cooper's survival triplet and confrontation strategy, this is a good point in the case discussion to do
so. (Robin Cooper, When Lean Enterprises Collide, Boston: Harvard Business School Press, 1995.)
The factors are:
 price-at mid to upper range of zone;
 quality-at upper range of zone;
 functionality-at upper range of zone.
An interesting point to discuss is that Mercedes does not produce the most expensive sports utility
vehicle. This distinction is reserved for the Land Rover; however, they strategically placed themselves
toward the luxury end of the spectrum. Also, unlike many Japanese examples, Mercedes does not use
target costing as a strict cost control mechanism to produce the lowest priced product in its class.
4. How does the AAV project link with MB strategy in terms of market coverage?
The new introductions expand the product line of the traditionally luxury-oriented manufacturer. Recent
product introductions include the following:
 A class;
 C class;
 SLK;
 E class;
 M class.
These new introductions include new sports cars and off-road vehicles. The C-class is a mid-sized
vehicle sometimes referred to as the baby-Benz.
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Let's discuss the elements of the target costing model and how these elements are developed.
At this point in the discussion I usually write the target costing formula on the board and ask students to
consider sources of various inputs:
 selling price;
 margin;
 target cost.
What are the sources of input for the projected selling price?
Students will most likely identify the following sources of information:
 customer focus groups
 comparable products:
- existing;
- potential.
Stress the broad, cross-functional aspects of acquiring consumer information. To compare products, the
company had to evaluate existing competitive vehicles as well as vehicles under development.
What factors are considered when developing the required margin?
This question provides a link to finance classes. Most students have studied the concepts of weightedaverage cost of capital. I recommend spending a few minutes reviewing these concepts and linking cost of
capital to net present value (NPV) analysis. Because of the capital-intensive structure of automobile
manufacturing, production volume is a critical factor in determining each model's NPV. Students may
identify the following points for determining a required margin.
 long-run profitability;
 cost of capital;
 profitability across the entire product mix (classes of vehicles);
 sales volume by class.
The MB case suggests the target cost is "alive." Is this consistent with the ideals of target costing?
I generally emphasize that Mercedes did not consider the target cost to be locked in. It was a
moving target. As engineering changes became necessary, the target cost was allowed to move. However,
before making a change, market forces were considered. For example, changes included the addition of
side airbags. In addition, the European press was critical of a simulated wood-grain part. Management
decided the part would remain plastic because costs could not be passed on to the consumer. The main
point to emphasize is the design of the vehicle is dynamic; thus costs must evolve to reflect the changing
design characteristics.
5. Explain the process of developing a component importance index. How can such an index guide
managers in making cost reduction decisions?
The index development process has five steps, as follows:
 consumer importance category rankings;
 target cost percentage by function group;
 category: function group matrix;
 importance index;
 target cost index;
I recommend making slides of Tables 1-5 to facilitate discussion. Index development is an important
element in the early conceptualization phase of the AAV. The indexes help to quantify some very abstract
concepts.
Table 1. From conversations with potential consumer groups, a list of key categories was
developed. Next, potential customers were asked to rate the importance of each category. Their responses
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were computed as a percentage. Thus, safety and comfort of the AAV were viewed as significantly more
important than economy and styling.
Table 2 represents a rough estimate of the cost by function group and the relative percentage. The
information is used later to create a target cost index.
Table 3 is best understood by reading each category as a column. The rows explain the relative
importance of each function group to satisfying each category defined by customers. An interesting aspect
of this table is that the link between consumer preferences and engineering components is made explicit.
Table 4 builds on Table 3 by weighting the percentages computed in Table 3 by the importance
percentage calculated in Table 1. The key point is to understand which function groups contribute the
most (least) to important (less important) consumer categories.
Table 5 results in a target cost index that attempts to capture cost and benefit trade-offs. As
discussed in the case, this index may indicate a cost in excess of the perceived value of a function group.
Thus, opportunities for cost reduction (aligned with customer requirements) may be identified.
6. How does MB approach cost reduction to achieve target costs?
At this point, ask students to identify various value-engineering strategies. At Mercedes, reducing
the cost of each function group was accomplished by reducing costs of various components that make up
the function group. Stress the importance of this approach over an “across-the-board" cut.
7. How do suppliers factor into the target costing process? Why are they so critically important to the
success of the MB AAV?
From the conceptual phase through the production phase, the suppliers of systems for the AAV
truly were partners. Suppliers attended regular meetings with the cost planners throughout the entire
process. Thus, suppliers were design and development partners from very early stages of development,
responsible for meeting cost targets.
Why is the relationship with suppliers a crucial element in the success of the AAV?
Suppliers provide entire systems for the AAV.
The facility uses a JIT production system. In fact, many suppliers deliver directly to the assembly
line, rather than to a small warehouse.
The Black Warrior River separated Mercedes and a major system supplier. This supplier built a
new production facility on the same side of the river as the Mercedes Benz plant to avoid possible delays
associated with accidents on a major bridge.
8. What role does the accounting department play in the target costing process?
Stress the fact that accountants were watchdogs in the target costing process. Their primary
responsibility was to ensure costs did not exceed targets during the production phase. Thus, the
accountants' role was as follows:
 cost control;
 actual vs. target:
- development stage;
- production stage.
What are some of the organizational barriers that may challenge managers attempting to introduce TC
systems?
Try to get students to identify various impediments to target costing systems in the United States.
Examples may include:
 willingness to share cost data with suppliers;
 suppliers treated as adversaries;
 government regulations affecting exchange of information.
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Teaching Strategies for Articles
10-1 “Target Costing at ITT Automotive”
This article provides a good example of an actual application of target costing. The example is of
the production and sale of brake systems, an intensely competitive industry. The article explains how
value engineering is used. Two important concepts of the article are (1) that target costing is a moving
target, that as prices are expected to continue to fall in the industry, target costs and manufacturing costs
must continually fall as well, and (2) target costing is a bottom-up, team-oriented process that requires
cross-functional teams. Also, the article explains how ITT uses “tracking sheets” to manage the life-cycle
costs of the product.
Discussion Questions:
1. How are prices set at ITT Automotive?
Prices are set by market conditions.
2. How does ITT Automotive obtain information about a competitor’s costs?
Information on competitors is obtained from “tear down” analyses (also called reverse
engineering) of competing products.
3. What are the target costing tools used at ITT Automotive?
The techniques used by ITT include cross-functional teams, value engineering, and forming
strategic partnerships with suppliers.
4. How is the tracking sheet used in ITT Automotive’s target costing system?
The tracking sheet tracks the cost of the product throughout the product’s life cycle. The cost
tracking sheet is illustrated in Figure 2 in the article.
10-2 “Integrating Activity-Based Costing and The Theory of Constraints”
The authors of this article show how ABC costing and the Theory of Constraints (TOC) methods
can be compared and used in a complementary fashion.
Discussion Question: Explain how ABC and TOC can be viewed as complementary methods.
The ABC costing approach provides accurate information for product costing and evaluating
the relative profitability of different products, especially when the mix of required
manufacturing activities differs significantly between products. However, as the authors
point out, the ABC method takes a “resource usage” approach to determining product
profitability. This approach says that resources are available as needed. In contrast, if the
manufacturing context involves resource supply that does not equal resource usage (i.e.,
resource supply remains unchanged until a capacity limit is reached, and then resource
supply will change, but not necessarily by the amount required for usage), then the ABC
method will fail to be useful for assessing the profitability of products that require different
amounts of the supplied capacity. In essence, the ABC method, by assuming the
equivalence of resource supply and resource usage, provides a useful long-term measure of
product profitability, one wherein the short-term availabilities and limitations of supply are
not considered.
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©The McGraw-Hill Companies, Inc., 2008
In contrast, the theory of constraints enables the manager to consider the short-term
fluctuations in supply. Bottlenecks are identified and short-term profitability measures are
determined to help the manager choose the most profitable product mix, given the current
supply limitations.
Overall, the methods are complementary because the ABC method allows accurate
assessment of the longer-term profitability of the firm’s products, while the TOC method
allows effective short-term decision making when resource supplies and bottlenecks are
present.
10-3: “Is TOC for You?”
This article gives a good introduction to the objectives and techniques of the theory of constraints (TOC).
There is also a discussion of key performance measures related to to the application of TOC in
management accounting.
Discussion Questions:
1. What is meant by throughput?
Throughput equals sales less direct materials cost.
2. What are the five steps of TOC?
The five steps of TOC are:
 Identify the system’s constraint(s), and prioritize them according to importance.
 Exploit the system’s most critical constraint.
 Subordinate everything else to the action taken in Step 2.
 Elevate the system’s constraint(s).
 Repeat Steps 1-4, focusing on the new constraint.
3. List some ways to increase the capacity on a constraint.



Performing regular maintenance on the constraint to prevent breakdowns.
Running the constraint for extra shifts.
Automating the constraint.
4. What are the five management accounting truths related to TOC?





Management Accounting Truth #1: Process improvements work together to speed up the whole operation..
Management Accounting Truth #2: You have to spend money to make money.
Management Accounting Truth #3: Operations can be made more efficient by improving labor efficiency
variances.
Management Accounting Truth #4: Large production runs are desirable because they are an efficient use of
setup time and fixed costs. Moreover, large production runs reduce per-unit costs, which will increase
profit.
Management Accounting Truth #5: Product mix should be determined based on maximizing total
contribution margin.
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