Chapter 11, Problem 29P

Nico Parts, Inc., produces electronic products with short life cycles (of less than two years). Development has to be rapid, and the profitability of the products is tied strongly to the ability to find designs that will keep production and logistics costs low. Recently, management has also decided that post-purchase costs are important in design decisions. Last month, a proposal for a new product was presented to management. The total market was projected at 200,000 units (for the two-year period). The proposed selling price was $130 per unit. At this price, market share was expected to be 25 percent. The manufacturing and logistics costs were estimated to be $120 per unit.

Upon reviewing the projected figures, Brian Metcalf, president of Nico, called in his chief design engineer, Mark Williams, and his marketing manager, Cathy McCourt. The following conversation was recorded:

BRIAN: Mark, as you know, we agreed that a profit of $15 per unit is needed for this new product. Also, as I look at the projected market share, 25 percent isn’t acceptable. Total profits need to be increased. Cathy, what suggestions do you have?

CATHY: Simple. Decrease the selling price to $125 and we expand our market share to 35 percent. To increase total profits, however, we need some cost reductions as well.

BRIAN: You’re right. However, keep in mind that I do not want to earn a profit that is less than $15 per unit.

MARK: Does that $15 per unit factor in preproduction costs? You know we have already spent $100,000 on developing this product. To lower costs will require more expenditure on development.

BRIAN: Good point. No, the projected cost of $120 does not include the $100,000 we have already spent. I do want a design that will provide a $15-per-unit profit, including consideration of preproduction costs.

CATHY: I might mention that post-purchase costs are important as well. The current design will impose about $10 per unit for using, maintaining, and disposing our product. That’s about the same as our competitors. If we can reduce that cost to about $5 per unit by designing a better product, we could probably capture about 50 percent of the market. I have just completed a marketing survey at Mark’s request and have found out that the current design has two features not valued by potential customers. These two features have a projected cost of $6 per unit. However, the price consumers are willing to pay for the product is the same with or without the features.

Required:

1. 1. Calculate the target cost associated with the initial 25 percent market share. Does the initial design meet this target? Now calculate the total life-cycle profit that the current (initial) design offers (including preproduction costs).
2. 2. Assume that the two features that are apparently not valued by consumers will be eliminated. Also assume that the selling price is lowered to $125.
   1. a. Calculate the target cost for the $125 price and 35 percent market share.
   2. b. How much more cost reduction is needed?
   3. c. What are the total life-cycle profits now projected for the new product?
   4. d. Describe the three general approaches that Nico can take to reduce the projected cost to this new target. Of the three approaches, which is likely to produce the most reduction?
3. 3. Suppose that the Engineering Department has two new designs: Design A and Design B. Both designs eliminate the two nonvalued features. Both designs also reduce production and logistics costs by an additional $8 per unit. Design A, however, leaves post-purchase costs at $10 per unit, while Design B reduces post-purchase costs to $4 per unit. Developing and testing Design A costs an additional $150,000, while Design B costs an additional $300,000. Assuming a price of $125, calculate the total life-cycle profits under each design. Which would you choose? Explain. What if the design you chose cost an additional $500,000 instead of $150,000 or $300,000? Would this have changed your decision?
4. 4. Refer to Requirement 3. For every extra dollar spent on preproduction activities, how much benefit was generated? What does this say about the importance of knowing the linkages between preproduction activities and later activities?

To determine

Calculate the target cost associated with the initial 25 percent market share, find out whether the initial design meet this target and compute the total life-cycle profit that the current design offers.

Explanation of Solution

Target costing: Target costing is a business procedure that targets at the earliest stages of new product and service development, before creating and designing of production techniques.

Life-cycle cost management: Life cycle cost management is an approach that creates a “conceptual framework” by facilitating the ability of the management to make use of “internal and external linkages”.

Calculate the amount of target cost:

$\begin{array}{c}\text{Target}\text{cost}\text{=}\text{Target}\text{price}-\text{Target}\text{profit}\\ \text{=}\text{\$130}-\text{\$15}\\ \text{=\$115}\text{per}\text{unit}\end{array}$

Therefore, the amount of target cost is $115 per unit.

Calculate the expected total life-cycle profit:

$\begin{array}{c}\begin{array}{l}\text{Expected total }\\ \text{life-cycle profit}\end{array}\}\text{=}\left[\begin{array}{l}\left(\begin{array}{l}\text{Proposed}\text{selling}\text{price}-\\ \text{Expected}\text{cost}\end{array}\right)\\ \text{×}\text{Number}\text{of}\text{market}\text{share}\text{units}\end{array}\right]\\ \text{=}\left[\begin{array}{l}\left(\text{\$130}-\text{\$122}\text{(1)}\right)\\ \text{×50,000}\text{Units}\end{array}\right]\\ \text{=\$400,000}\end{array}$

In this case, the expected cost is $122, therefore, the target cost is not met and the expected total life-cycle profit is $400,000.

Working note:

(1)Calculate the amount of expected cost:

$\begin{array}{c}\text{Expected}\text{cost}\text{=}\left[\begin{array}{l}\left(\begin{array}{l}\text{Estimated}\text{costs}\text{of}\\ \text{manufacturing}\text{and}\text{logistics}\end{array}\right)\\ \text{+}\frac{\text{Amount}\text{previously}\text{spent}}{\text{Number}\text{of}\text{market}\text{share}\text{units}}\end{array}\right]\\ \text{=}\left[\text{\$120}\text{+}\left(\frac{\text{\$100,000}}{\text{50,000}\text{units}}\right)\right]\\ \text{=}\text{\$122}\end{array}$

Note:$\text{50,000}\text{units}\text{=}\text{25\%}\text{of}\text{200,000}\text{units}$

To determine

Compute the target cost for the $125 price and 35 percent market share.

Explanation of Solution

Calculate the new target cost:

$\begin{array}{c}\text{New}\text{target}\text{cost}\text{=}\left(\begin{array}{l}\text{Decrease}\text{in}\text{amount}\text{of}\\ \text{selling}\text{price}-\text{profit}\text{per}\text{unit}\end{array}\right)\\ \text{=}\text{\$125}-\text{\$15}\\ \text{=\$110}\text{per}\text{unit}\end{array}$

Therefore, the amount of new target cost is $110 per unit.

To determine

Ascertain the amount of cost reduction needed.

Explanation of Solution

Cost reduction of $5.43 $\left(\text{\$115}\text{.43}\text{(2)}-\text{\$110}\right)$  per unit is required to meet the new target cost.

Working note:

(2)Calculate amount of current projected cost:

$\begin{array}{c}\text{Current}\text{projected}\text{cost}\text{=}\left[\begin{array}{l}\left(\begin{array}{l}\text{Cost}\text{estimated}\text{for}\\ \text{manufacturing}\text{and}\text{logistics}\end{array}\right)\text{+}\\ \left(\frac{\text{Amount}\text{previously}\text{spent}}{\text{Units}\text{of}\text{market}\text{share}}\right)\\ -\left(\text{Projected}\text{cost}\text{per}\text{unit}\right)\end{array}\right]\\ \left[\text{=}\text{\$120+}\left(\frac{\text{\$100,000}}{\text{70,000}\text{units}}\right)-\text{\$6}\right]\\ \text{=}\left[\left(\text{\$120}\text{+}\text{\$1}\text{.43}\right)-\text{\$6}\right]\\ \text{=\$115}\text{.43}\end{array}$

Note:$\text{70,000}\text{units}\text{=}\text{35}\text{\%}\text{of}\text{200,000}\text{units}$ and amount of $115.43 is rounded.

To determine

Calculate the total life-cycle profits projected for the new project.

Explanation of Solution

Calculate the total life-cycle profits:

$\begin{array}{c}\text{Total}\text{life-}\text{cycle}\text{profits}\text{=}\left[\begin{array}{l}\left(\begin{array}{l}\text{Decreasse}\text{in}\text{selling}\text{price}-\\ \text{The}\text{current}\text{projected}\text{cost}\end{array}\right)\text{×}\\ \text{Number}\text{of}\text{market}\text{share}\text{units}\end{array}\right]\\ \text{=}\left[\left(\text{\$125}-\text{\$115}\text{.43}\right)\text{×70,000}\text{units}\right]\\ \text{=}\text{\$669,900}\end{array}$

Therefore, the amount of total life cycle profits is $669,900.

Note:$\text{70,000}\text{units}\text{=}\text{35}\text{\%}\text{of}\text{200,000}\text{units}$ and amount of $115.43 is rounded.

To determine

Explain the three common approaches that Incorporation N can take to reduce the projected cost to this new target and find out the approach that is likely to produce the most reduction.

Explanation of Solution

Three common approaches used to decrease costs in the design stage are as follows:

1. 1. Reverse engineering is used to check whether several “efficiencies” can be learned from competitors;
2. 2. Value analysis is used to check whether the functional design can be enhanced; and
3. 3. Process improvement is used to check whether a more competent process design can be recognized.

Among the three approaches, the most potential approaches are the last two.

To determine

Compute the total life-cycle profits under each design, state the design that could be chosen, explain if the design chosen cost an additional of $500,000 instead of $150,000 or $300,000 and ascertain if this can change the decision.

Explanation of Solution

Compute the total life-cycle profits for design A:

$\begin{array}{c}\begin{array}{l}\text{The total life-cycle}\\ \text{ profits for design A}\end{array}\}\text{=}\text{Profit}\text{per}\text{unit}\text{×}\text{Number}\text{of}\text{market}\text{share}\text{units}\\ \text{=}\text{\$15}\text{.43}\text{(3)}\text{×}\text{70,000}\text{units}\\ \text{=}\text{\$1,080,000}\end{array}$

Therefore, the total life-cycle profit for design A is $1,080,000.

Note:$\text{70,000}\text{units}\text{=}\text{35}\text{\%}\text{of}\text{200,000}\text{units}$

Compute the total life-cycle profits for design B:

$\begin{array}{c}\begin{array}{l}\text{The total life-cycle}\\ \text{ profits for design B}\end{array}\}\text{=}\text{Profit}\text{per}\text{unit}\text{×}\text{Number}\text{of}\text{market}\text{share}\text{units}\\ \text{=}\text{\$15}\text{(7)×}10\text{0,000}\text{units}\\ \text{=}\text{\$1,500,000}\end{array}$

Therefore, the total life-cycle profit for design B is $1,500,000.

• Design B meets the target profit and gives the maximum life-cycle income. Therefore design B must be chosen.
• If Design B costs an extra of $500,000 instead of an additional $300,000, then it could have generated a life-cycle income of $1,300,000 which is still higher than the income generated by Design A ($730,100).
• This explains that, more precautious steps must be taken while using per-unit targets, mainly if the life cycle is short.

Working notes:

Design A:

(3)Compute profit per unit:

Design A	Amount
Sales	(4)$8,750,000
less life-cycle costs:
Production and logistics	(5)$7,420,000
Preproduction activities	(6)$250,000
Life-cycle income (a)	$1,080,000
Units (b)	70,000
Profit per unit $\left(\frac{\text{a}}{\text{b}}\right)$	$15.43

Table (1)

Note: The amount of $15.43 is rounded.

(4)Calculate the amount of sales:

$\begin{array}{c}\text{Sales}\text{=}\text{Price}\text{per}\text{unit}\text{×}\text{Number}\text{of}\text{market}\text{share}\text{units}\\ \text{=}\text{\$}\text{125}\text{×}\text{70,000}\text{units}\\ \text{=\$8,750,000}\end{array}$

Note:$\text{70,000}\text{units}\text{=}\text{35}\text{\%}\text{of}\text{200,000}\text{units}$

(5)Calculate the life-cycle costs of production and logistics:

$\begin{array}{c}\begin{array}{l}\text{Life-cycle costs of }\\ \text{production and logistics}\end{array}\}\text{=}\left(\begin{array}{l}\text{Per}\text{unit}\text{cost}\text{of}\text{production}\text{and}\text{logistics}\text{×}\\ \text{Number}\text{of}\text{market}\text{share}\text{units}\end{array}\right)\\ \text{=}\text{\$106}\text{×}\text{\$70,000}\\ \text{=\$7,420,000}\end{array}$

Note:$\text{70,000}\text{units}\text{=}\text{35}\text{\%}\text{of}\text{200,000}\text{units}$

(6)Calculate the life-cycle costs of preproduction activities:

$\begin{array}{c}\begin{array}{l}\text{Life-cycle costs of }\\ \text{preproduction}\text{activities}\end{array}\}\text{=}\left(\begin{array}{l}\text{Cost}\text{of}\text{developing}\text{and}\text{testing}\text{design}\text{A}\text{+}\\ \text{Amount}\text{previously}\text{spent}\end{array}\right)\\ \text{=}\text{\$150,000+\$100,000}\\ \text{=\$250,000}\end{array}$

Design B:

(7)Compute profit per unit:

Design B	Amount
Sales	(8)$12,500,000
less life-cycle costs:
Production and logistics	(9)$10,600,000
Preproduction activities	(10)$400,000
Life-cycle income (a)	$1,500,000
Units (b)	100,000
Profit per unit $\left(\frac{\text{a}}{\text{b}}\right)$	$15

Table (2)

(8)Calculate the amount of sales:

$\begin{array}{c}\text{Sales}\text{=}\text{Price}\text{per}\text{unit}\text{×}\text{Number}\text{of}\text{market}\text{share}\text{units}\\ \text{=}\text{\$}\text{125}\text{×}10\text{0,000}\text{units}\\ \text{=\$12,500,000}\end{array}$

Note 1:$\text{100,000}\text{units}\text{=}50\text{\%}\text{of}\text{200,000}\text{units}$

Note 2: In the case of design B, the post purchase cost is less than $5, that is $4. Therefore, the percent of market share will be 50%.

(9)Calculate the life-cycle costs of production and logistics:

$\begin{array}{c}\begin{array}{l}\text{Life-cycle costs of }\\ \text{production and logistics}\end{array}\}\text{=}\left(\begin{array}{l}\text{Per}\text{unit}\text{cost}\text{of}\text{production}\text{and}\text{logistics}\text{×}\\ \text{Number}\text{of}\text{market}\text{share}\text{units}\end{array}\right)\\ \text{=}\text{\$106}\text{×}\text{\$100,000}\\ \text{=\$10,600,000}\end{array}$

Note:$\text{100,000}\text{units}\text{=}50\text{\%}\text{of}\text{200,000}\text{units}$

(10)Calculate the life-cycle costs of preproduction activities:

$\begin{array}{c}\begin{array}{l}\text{Life-cycle costs of }\\ \text{preproduction}\text{activities}\end{array}\}\text{=}\left(\begin{array}{l}\text{Cost}\text{of}\text{developing}\text{and}\text{testing}\text{design}\text{B}\text{+}\\ \text{Amount}\text{previously}\text{spent}\end{array}\right)\\ \text{=}\text{\$300,000+\$100,000}\\ \text{=\$400,000}\end{array}$

To determine

Calculate the amount of benefit generated for every extra dollar spent on preproduction activities and state the importance of knowing the linkages between preproduction activities and later activities.

Explanation of Solution

Calculate the amount of benefit generated for every extra spent on preproduction activities:

$\begin{array}{c}\begin{array}{l}\text{The amount of benefit generated }\\ \text{for everyextra spent on }\\ \text{preproduction activities}\end{array}\}\text{=}\frac{\text{Increase}\text{in}\text{benefits}}{\text{Developing}\text{and}\text{testing}\text{costs}\text{of}\text{design}\text{B}}\\ \text{=}\frac{\text{\$800,000}\text{(11)}}{\text{\$300,000}}\\ \text{=}\text{\$2}\text{.67}\left(\text{Rounded}\right)\end{array}$

• Therefore, $2.67 of benefits will be recognized for every extra dollar spent on “preproduction activities”.
• The profitability of a firm can be increased in long-run by making use of the linkages among “preproduction activities and other activities” taking place in the later phases of the “production and consumer life-cycle stages”.

Working note:

(11)Calculate the amount of increase in benefits:

Cost Analysis	Amount
Life-cycle profits, Design B	$1,500,000
Less: Life-cycle profits, initial design	$400,000
Increase in profits	$1,100,000
Additional development cost	$300,000
Increase in benefits	$800,000

Table (3)