PROBLEM 7.

29 Life-Cycle Cost Management and Target Costing

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. 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 pro t that the current (initial) design offers (including preproduction
costs).

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.

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

b. How much more cost reduction is needed?

c. What are the total life-cycle profits now projected for the new product?

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. 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. 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?
Requirements:
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).
Target cost = Target price - Target Profit

= $130 - $15 = $115 per unit 200,00

0x
25%
Projected Cost = $122 ---> [$120 + ($100,000/50,000 unit)]

Target is not met.

Projected total life-cycle profit is $400,000.

-----> ($130 - $122) x 50,000

2. Assume that two features that are apparently not valued by
consumers will be eliminated. Also assume that the selling price is
$125.

a. Calculate the target cost for the $125 price and 35% market share.
b. How much more cost reduction is needed?
c. What are the total life cycle profits now projected for the new
product?
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?
a. New target cost = $125 – $15 = $110 per unit

b. T h e c u r r e n t p r o j e c t e d c o s t i s $ 11 5 . 4 3
--->[$120 + ($100,000/70,000) – $6].

----> Cost reductions of $5.43 per unit still must be

achieved.
= ($115.43 - $110)

c. Total life-cycle profits = ($125 – $115.43) × 70,000 =

$669,900
d. Three general approaches to reduce costs in the
design stage:
1. Reverse Engineering - attempts to discover more design
features from competitors’ products
2. Value Analysis - attempts to assess the value placed on
product functions by customers.
3. Process Improvement - redesigning processes to improve
efficiency in producing and marketing the product.

Both Value Analysis and Process Improvement are likely to

reduce cost since this is a new product, not a redesign of an
existing product.
Requirements
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?
 DESIGN A

Sales ($125 × 70,000*) $ 8,750,000

Less life-cycle costs:
Production and logistics ($106** × 70,000) (7,420,000)
Preproduction activities*** (250,000)
Life-cycle income $ 1,080,000
Units / 70,000
Profit per unit $15.43
Total profits = $15.43 × 70,000 = $1,080,100

*SELLING PRICE IS $125, MARKET SHARE WOULD BE 35%

200,000 UNITS X 35% = 70,000 UNITS

**$120-$6-$8 =$106

***$100,000 + $150,000 = $250,000

 DESIGN B

Sales ($125 × 100,000*) $12,500,000

Less life-cycle costs:
Production and logistics ($106 × 100,000) (10,600,000)
Preproduction activities** (400,000)
Life-cycle income $ 1,500,000
Units / 100,000
Profit per unit $15
Total profits = $15.00 × 100,000 = $1,500,000

*POST-PURCHASE COSTS ARE LESS THAN $5 PER UNIT WHICH MEANS THE MARKET

SHARE WILL BE 50 PERCENT.

200,000 UNITS X 50%= 100,000 UNITS

**$100,000 + $300,000 = $400,000

• Design B should be chosen.

• It meets the target profit ($15 per unit)

• It provides the greatest life-cycle income.

DESIGN A DESIGN B

$ 1,080,000 $ 1,500,000

• If Design B costs an additional $500,000 instead of an

additional $300,000, then it would have produced a life-cycle
income of $1,300,000—still more than the Design A income of
$730,100. This illustrates that we need to be cautious about
using per-unit targets—particularly when the life cycle is short.
 DESIGN A

Sales ($125 × 70,000) $ 8,750,000

Less life-cycle costs:
Production and logistics ($106 × 70,000) (7,420,000)
Preproduction activities* (600,000)
Life-cycle income $ 730,000
Units / 70,000
Profit per unit $10.43
Total profits = $10.43 × 70,000 = $730,100
 DESIGN B

Sales ($125 × 100,000) $12,500,000

Less life-cycle costs:
Production and logistics ($106 × 100,000*) (10,600,000)
Preproduction activities** (600,000)
Life-cycle income $ 1,300,000
Units / 100,000
Profit per unit $13
Total profits = $13.00 × 100,000 = $1,300,000
Requirements
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?
 PROBLEM 7.30
Jolene Askew, manager of Feagan Company, has committed her company to a
strategically sound cost reduction program. Emphasizing life-cycle cost management is a
major part of this effort. Jolene is convinced that the production costs can be reduced by
paying more attention to the relationships between design and manufacturing. Design
engineers need to know what causes manufacturing costs. She instructed her controller
to develop manufacturing cost formula for a newly proposed product. Marketing had
already projected sales of 25,000 units for the new product. (The life cycle was estimated
to be 18 mo.) The company expected to have 50% of the market and priced its product to
achieve this goal. The projected selling price was $20 per unit. The following cost
formula was developed.

Y= $200,000 + $10X1

X1= Machine hours (The product is expected to use one

machine hour for every unit produced)
Upon seeing the cost formula, Jolene quickly calculated the projected gross profit to be $50,000. This produced a
gross profit of $2 per unit, well below the target of $4 per unit. Jolene then sent a memo to the engineering dept.
instructing them to search for a new design that would lower the costs of production by at least $50,000 so that
the target profit would be met.

Within 2 days, the engineering dept. proposed a new design that would reduce unit variable cost from $10 per
machine hour to $8 per machine hour (Design Z). The chief engineer, upon reviewing the design, questioned the
validity of the controller’s cost formula. He suggested a more careful assessment of the proposed design’s effect
on activities other than machining. Based on this suggestion, the ff. revised cost formula was developed. This cost
formula reflected the cost relationships of the most recent design (Design Z).

Y= $140,000+ $8X1 +$5,000X2 + $2,000X3

X1 = Machine Hours
X2 = Number of batches
X3 = Number of engineering change orders

Based on scheduling and inventory considerations, the product would be produced in batches of 1,000; thus, 25
batches would be need over the product’s life cycle. Furthermore, based on past experience, the product would
likely generate about 20 engineering change orders.
This new insight into the linkage of the product with its underlying activities led to a different design (Design W). This
second design also lowered the unit-level cost by $2 per unit but decrease the number of design support requirements
from 20 orders to 10 orders. Attention was also given to the setup activity, and the design engineer assigned to the
product created a design that reduced setup time and lowered variable setup costs from $5,000 to $3000 per setup.
Furthermore Design W also creates excess activity capacity for the setup activity, and resource spending for setup
activity capacity can be released by $40,000, reducing the fixed cost component equation by this amount.

Design W was recommended and accepted. As prototype of the design were tested, an additional benefit emerged.
Based on test results, the post-purchase cost dropped from an estimated $0.70 per unit sold to $0.40 per unit sold.
Using this information, the marketing dept., revised the projected market share upward from 50% to 60% (with no
price decrease)
Required
1. Calculate the expected gross profit per unit for Design Z using the controller’s original cost formula. According
to this outcome, does Design Z reach the target unit profit? Repeat, using the engineer’s revised cost formula.
Explain why design Z failed to meet the targeted profit. What does this say about the use of unit-based costing for
life-cycle cost management?

2. Calculate the expected profit per unit using Design W. Comment on the value of activity information for life cycle
cost management.

3. The benefit of the post-purchase cost reduction of Design W was discovered in testing. What direct benefit did it
create for Feagan Company (in dollars)? Reducing post-purchase cost was not a specific design objective. Should it
have been? Are there any other design objectives that should have been considered?
 Given:

Characters Original Cost Formula:

John Askew
Design engineer Y= $200,000 + $10X1
Chief engineer
Controller X1= Machine hours (The product is expected to use one machine
hour for every unit produced)

Revised Cost Formula: Design W

Designs
● $3000 per setup/batches
● From 20 orders to 10 orders

Y= $140,000+ $8X1 +$5,000X2 + ● $40,000 is reduced from the fixed cost component

$2,000X3 Design Z
● in batches of 1,000: 25 batches
● 20 engineering change orders.
OR

X1 = Machine Hours Deceased variable cost of $2 per unit

X2 = Number of batches
X3 = Number of engineering change orders
 Requirement 1

Calculate the expected gross profit per unit for Design Z using the controller’s original cost formula. According to
this outcome, does Design Z reach the target unit profit? Repeat, using the engineer’s revised cost formula. Explain
why design Z failed to meet the targeted profit. What does this say about the use of unit-based costing for life-cycle
cost management?

● Total cost (original) = $200,000 + $10(25,000) = $450,000

● Total cost (Design Z ) = $200,000 + $8(25,000) = $400,000
● Unit cost =$400,000/25,000 = $16
● Unit gross profit = $20 – $16 = $4 (Targeted profit)

Engineer’s formula:
● Total cost = $140,000 + $8(25,000) + $5,000(25) + $2,000(20) = $505,000
● Unit cost = $505,000/25,000 = $20.20
● Unit gross p(l) = $20 – $20.20 = $(0.20)
 Requirement 2 and 3

Calculate the expected profit per unit using Design W. Comment on the value of activity information for life cycle
cost management.

Total cost = $100,000 + $8(30,000) + $3,000(30) + $2,000(10) = $450,000

Unit cost = $450,000/30,000 = $15
Unit gross profit = $20 – $15 = $5

The benefit of the post-purchase cost reduction of Design W was discovered in testing. What direct benefit did it
create for Feagan Company (in dollars)? Reducing post-purchase cost was not a specific design objective. Should it
have been? Are there any other design objectives that should have been considered?

Profit based on 25,000 units: 

● Total costs = $100,000 + $8(25,000) + $3,000(25) + $2,000(10) = $395,000
● Unit cost = $395,000/25,000 = $15.80
● Unit gross profit = $20.00 – $15.80 = $4.20
● Benefit (per unit) = $5.00 – $4.20 = $0.80
● Total benefit = $5(30,000) – $4.20(25,000) = $45,000 (over the life of the product)