chapter 8 solutions

Chapter 8: Measuring Life-Cycle Costs

Chapter 8Measuring Life-Cycle Costs

QUESTIONS

8-1 The total-life-cycle costing approach is acomprehensive way for managers to understand andmanage costs through a product’s design,development, manufacturing, marketing, distribution,maintenance, service, and disposal stages. It refersto the process of managing all costs along the valuechain. Using this approach can lead to substantialcost savings. By some estimates, 80-85% of aproduct’s total life costs are committed bydecisions made in the RD&E stage, underscoring theimportance of managing all costs along the valuechain.

8-2 The three major stages of the total-life-cyclecosting approach are (1) research, development andengineering (RD&E), (2) manufacturing, and (3)post-sale service and disposal.

8-3 Committed costs are those that the organizationagrees must be set aside (or committed) to coverproduct costs through the three major stages of thelife cycle. Costs incurred are the actual costs thatthe organization has paid out over the three majorstages of the product life cycle.

8-4 The three substages of the RD&E stage are (1) usingmarket research to assess emerging customer needsthat lead to idea generation for new products, (2)product design, during which scientists and

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Atkinson, Solution Manual t/a Management Accounting, 6E

engineers develop the technical aspects of theproduct, and (3) product development, during whichthe company creates the features critical tocustomer satisfaction and designs prototypes,production processes, and any special toolingrequired.

8-5 During the post-sale service and disposal stage,organizations have to consider both the costsinvolved in providing service to products as soonas they are in the hands of customers, as well asthe costs of ultimately disposing of the product.The following three substages typically occurduring this stage: (1) rapid growth from the firsttime the product is shipped through the growthstage of its sales, (2) transition from the peak ofsales to the peak in the service cycle, and (3)maturity from the peak in the service cycle to thetime of the last shipment made to a customer;disposal occurs at the end of a product’s life andlasts until the customer retires the final unit ofa product.

8-6 Target costing is a method of profit planning andcost reduction that focuses on reducing costs forproducts in the research, development andengineering (RD&E) stage of the total life cycle ofa product. It also considers all aspects of thevalue chain and explicitly recognizes total-life-cycle costs.

8-7 The two essential financial elements needed toarrive at a target cost are the target sellingprice and the target profit margin. The target costis the difference between the two.

8-8 For product development and target costingpurposes, customers’ needs or requirements must betranslated into product functions or components forengineering. A quality function deployment matrixrelates information about customer requirements(that is, features that customers require) to a

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product’s functions or components. The matrix mayalso include a competitive evaluation of theproduct. In this way, the matrix highlights therelationship among competitive offerings, customerrequirements, and a product’s design parameters.The matrix is used to compute functional(component) rankings of how important eachcomponent is to customers, and these rankings arein turn used to compute a value index (benefit/costratio) for each component. If the value index isless than one, the cost exceeds the benefit, andthe component is a likely candidate for costreduction in efforts to achieve the target cost.

8-9 Value engineering is a process in which eachcomponent of a product is scrutinized to determinewhether it is possible to reduce costs whilemaintaining functionality and performance. Statedanother way, value engineering is an organizedeffort directed at analyzing the functions of thevarious components for the purpose of achievingthese functions at the lowest overall cost withoutreductions in required performance, reliability,maintainability, quality, safety, recyclability,and usability.

8-10Target costing is most applicable during theresearch, development and engineering (RD&E) stageof the total life cycle of a product.

8-11Cross-functional teams guide the target costingprocess. These teams may include, for example,representatives from the organization’s designengineering, manufacturing, management accounting,and marketing areas, as well as representativesfrom among suppliers, customers, distributors, andwaste disposers. Supply chain management, whichinvolves developing cooperative, mutuallybeneficial long-term relations between buyers andsuppliers, plays a critical role in target costingwhen suppliers actively participate in resolvingcost reduction problems.

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8-12The break-even time (BET) metric for the productdevelopment process measures the length of timefrom the project’s beginning until the product hasbeen introduced and generated enough profit to payback the investment originally made in itsdevelopment.

8-13The break-even time (BET) metric brings together ina single measure three critical elements in aneffective and efficient product developmentprocess. First, for the company to break-even onits R&D process, its investment in the productdevelopment process must be recovered. So BETrequires tracking the entire cost of the design anddevelopment process. It provides incentives to makethe product development process faster and lesscostly. Second, BET stresses profitability. Itencourages marketing managers, manufacturingpersonnel, and design engineers to work together todevelop a product that meets real customer needs,including offering the product through an effectivesales channel at an attractive price, and at amanufacturing cost that enables the company to earnprofits that can repay the product developmentinvestment cost. And third, BET is denominated intime: it encourages the launch of new productsfaster than the competition so that higher salescan be earned sooner to repay the productdevelopment investment.

8-14Desirable behavioral consequences that are likelyas people focus on improving the break-even time(BET) metric include collaboration and integrationacross organizational functions. People fromdifferent disciplines come together at the start ofevery product development project to estimate thetime and money they require to perform their tasks,and the impact of their efforts on the success ofthe entire project. The BET metric promotesdiscussion and facilitates decision-making duringthe project among people from the multiple

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functions as more information about the project,customers, and competitors becomes available.

8-15Using percent of revenues from new products as a performancemetric may fail to stimulate highly innovativeproducts because this metric can lead productdevelopers to introduce new products that are smallvariations of existing products. With thisapproach, a company’s products run the risk ofbecoming stale or being copied by competitiveofferings, and prices and margins will consequentlydecline.

8-16Nonfinancial measures that a company might use inorder to motivate achieving the objective ofanticipating future customer needs include (1) timespent with key customers at targeted accountslearning about their future opportunities andneeds, and (2) the number of new projects launchedbased on customer input.

8-17Nonfinancial measures that a company might use inorder to motivate achieving the objective ofreducing product development cycle time across anarray of products include (1) number of projectsdelivered on time, (2) average time spent byprojects at the development, test, and launchstages of the development process, and (3) totalRD&E time from idea to market.

8-18Activities included in environmental costinginclude selecting suppliers whose philosophy andpractice in dealing with the environment matchthose of buyers, disposing of waste products duringthe production process, and incorporating postsaleservice and disposal issues into managementaccounting systems.

8-19Explicit environmental costs include the directcosts of modifying technology and processes, costsof cleanup and disposal, costs of permits tooperate a facility, fines levied by government

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agencies, and litigation fees. Implicitenvironmental costs often pertain to theinfrastructure required to monitor environmentalissues. Examples of implicit environmental costsinclude legal counsel, administration, employeeeducation and awareness, and the loss of goodwillif environmental disasters occur.

EXERCISES

8-20The total-life-cycle costing approach differs fromthe traditional product costing in that it includesthe research, development and engineering (RD&E),manufacturing, and post-sale service and disposalcycles. Traditional product costing is morenarrowly focused and is concerned only with costsincurred during the manufacturing stage of thetotal product life cycle.

8-21The benefits of using a total-life-cycle costingapproach to product costing include providingmanagers with the “big picture” of managing costsover the research development and engineering;manufacturing; and post-sale service and disposalcycles. Such a perspective allows managers theopportunity to see how decisions made in one stageaffect costs throughout the entire product lifecycle. This perspective is not possible under thetraditional product costing approach. The total-life-cycle costing approach should therefore leadto more cost-effective products and services.

8-22The traditional accounting focus in managing costsis on the manufacturing stage of the total lifecycle of a product. The most significant problemwith this focus is that the traditional methodignores product costs before manufacturing (in theresearch, development and engineering (RD&E) stage)as well as those that occur after manufacturing (inthe post-sale and disposal stage). The limitedfocus is especially problematic because it iscommon for 80-85% of a product’s life cycle costs

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to be committed by decisions made in the RD&Ecycle.

8-23Exhibit 8-2 illustrates the relationship betweencosts committed and costs incurred over the totallife cycle of a product. The top curve, “costcommitted,” shows how a very large percentage (80–85%) of product life cycle costs are assigned orcommitted to by an organization during the pre-manufacturing (research development andengineering) stage of the total product life cycle.Costs continue to be committed up through the endof the life cycle, but these costs level off duringthe manufacturing and post-sale service anddisposal stages. The bottom curve, “costsincurred,” illustrates the actual costs incurred bythe organization over the various stages of thelife cycle. Note that a small percentage of costsare incurred during the research, development andengineering stage, but these costs increasesignificantly during the manufacturing and post-sale service and disposal stages. The implicationsare: (1) managers need to manage costs at the RD&Estage, (2) all stages of the life cycle areimportant, and (3) the RD&E stage is the criticalstage in managing later costs.

8-24The disposal phase of the post-sale service anddisposal stage of a product begins when the firstunit of product is retired by the customer and endswhen the last unit of product is retired by thecustomer. Disposal costs are most relevant when anorganization has to eliminate any harmful effectsassociated with the end of a product’s life.

8-25Target costing differs from traditional costreduction methods through the process by whichcosts are determined. Under traditional costreduction, after market research to determinecustomer requirements and product specification,engineers and designers determine product design,then the cost to produce the product. If the

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estimated cost is too high, then it may benecessary to modify the product design. The desiredprofit margin is found by subtracting the estimatedcost from the expected selling price.

Target costing begins in approximately the same waywith market research to determine customerrequirements and product specification. From thispoint on, procedures are quite different. The nextstep under target costing is to determine thetarget selling price and target product volume.Then the target profit margin is determined. Thetarget cost is the difference between the targetselling price and target profit margin. Targetcosting focuses on achieving the target cost.Product cost is not important in product designunder traditional cost-reduction methods, whichfocus on cost reduction at the manufacturing stage.In contrast, target costing focuses on costreduction at the RD&E stage. Target costing usesthe total life cycle costing concept to focus oncost of ownership over the product’s life. Inaddition, target costing involves cross-functionalteams and close relationships with suppliers.Market research is not a single event as it isunder traditional cost methods. Under targetcosting, market research is customer driven, withcustomer input obtained continually throughout theprocess.

8-26The relationship between value engineering andtarget costing is as follows: Once a target costhas been set, the organization must determinetarget costs for each component in a product. Valueengineering is used to examine the design of eachcomponent of a product to determine whether it ispossible to reduce costs while maintainingfunctionality and performance.

8-27Return on sales (net income ÷ sales) is the mostwidely used profitability measure to develop thetarget profit margin under target costing.

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8-28Some of the potential problems in implementing atarget costing system from a behavioral point ofview are: (a) conflicts that arise between partiesinvolved in the target costing process, (e.g., theconflict that arises between suppliers and thetarget costing organization when too much pressureis placed on suppliers to cut their costs), (b)burnout among employees, and (c) some employees(such as senior executives) reject the idea and donot understand its value.

8-29A manager asked to benchmark another organization’starget costing system would want informationpertaining to the method by which target prices andtarget margins (and consequently, target costs) areset, supplier relations, how the organization usesvalue engineering to reduce costs, and theorganizational structure and culture needed tomanage the target costing process. While these arecritical variables on which to gather information,target costing always has to be studied andunderstood in relation to the specific organizationinvolved.

8-30The target costing relationship is expressed in thefollowing equation form: C S P , where C is thetarget cost, S is the target selling price, and Pis the target profit margin. This equation differsfrom the other two types of traditional equationsrelating to cost reduction in the following ways.The first traditional cost reduction method isexpressed as follows: P S C . The desired profitmargin, P, is found by subtracting the estimatedcost, C, from the expected selling price, S. Thesecond traditional approach, known as the cost-plusmethod, expresses the relationship among variablesas S C P . Under cost-plus, an expected profitmargin is added to the expected product cost. Priceis simply the result of the sum of these two

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variables. Unlike the traditional approaches, targetcosting focuses on achieving a particular costtarget.

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8-31(a)

Percent Contribution of Each Component to CustomerRequirements

Component

Customer Requirements

BrewBasket

Carafe

Coffee

Warmer

Body/

Water

Well

Heating

Element

Display

Panel

Relative

Feature

Ranking

Tastes/smells like expresso

0.7 20% =14%

0.3 20% =6% 20%

Easy to clean

0.5 16% =8%

0.116%=

1.6%

0.416%=

6.4% 16%

Looks nice

0.1 8%=

0.8%

0.5 8%= 4%

0.4 8%=

3.2% 8%

Has 6+ cup capacity

0.512%= 6%

0.512%= 6% 12%

Starts auto- maticallyon time

1 16% =16% 16%

Has multiple grinder settings

0.1 4% =0.4%

0.9 4%=

3.6% 4%

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Keeps thecoffee warm

0.212%=

2.4%

0.8 12% =9.6% 12%

Automaticshutoff

1 12% =12% 12%

Convertedcomponentranking 22.4%

10.8% 9.6%

16.4% 6.0% 34.8% 100%

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(b) Value Index for Kitchenhelp’s Coffeemaker

(2) (3)(3) (2)

Component Componen

t Relative Value Action

or Function CostImportan

ce Index Implied

Brew Basket 18.0% 22.4% 1.24 Enhance Carafe 4.0% 10.8% 2.70 Enhance Coffee Warmer 6.0% 9.6% 1.60 Enhance Body/ Water Well 18.0% 16.4% 0.91

Reduce cost

Heating Element 8.0% 6.0% 0.75

Reduce cost

Display Panel 46.0% 34.8% 0.76

Reduce cost

The body/ water well, heating element, and displaypanel are candidates for cost reduction becausetheir value indexes are less than 1.

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8-32As shown below, Greyson’s new break-even timeoccurs during Quarter 3 of Year 4, approximately 15months later than the initial 30 months (Year 3,Quarter 2).

(000) Y1,Q1

Y1,Q2

Y1,Q3

Y1,Q4

Y2,Q1

Y2,Q2

Y2,Q3

Y2,Q4

Market Research

$(100)

$(50)

Product Development (80)

(150)(150

)(150

)(150

)(150

) (150)Selling PriceCost per unitMargin/unit Sales quantity Contribution MSDA expenses Product profit QuarterlyProfit/Loss

$(100)

$(130)

$(150)

$(150)

$(150)

$(150)

$(150)

$(150)

Cumulative Profit/Loss

$(100)

$(230)

$(380)

$(530)

$(680)

$(830)

$(980)

$(1,130)

(000)a Y3,Q1

Y3,Q2

Y3,Q3

Y3,Q4

Y4,Q1

Y4,Q2

Y4,Q3

Y4,Q4

Market Research

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Product Development

$(60)

Selling Price $19 $18 $18 $17 $17 $16 $15 $15Cost per unit 10 10 10 10 10 10 10 10Margin/unit $9 $8 $8 $7 $7 $6 $5 $5Sales quantity 25 35 45 50 50 50 40 30Contribution $225 $280 $360 $350 $350 $30

0$200

$150

MSDA expenses 120 120 120 120 120 120 120 120Product profit $105 $160 $240 $230 $230 $18

0$80 $30

Quarterly Profit/Loss

$45 $160 $240 $230 $230 $180

$80 $30


$(1,085)

$(925)

$(685)

$(455)$(225)

$(45) $35 $65

aAll amounts except selling price, cost per unit, and marginper unit are in 1,000s.

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8-33As shown below, Greyson will now never reach abreak-even time. Beginning with Y4, Q4, Greysonwill incur quarterly losses of $20,000 and willnever show a positive cumulative profit.

(000) Y1,Q1

Y1,Q2

Y1,Q3

Y1,Q4

Y2,Q1

Y2,Q2

Y2,Q3

Y2,Q4

Market Research

$(100)

$(50)

Product Development (80)

(150)(150

)(150

)(150

)(150

) (150)Selling PriceCost per unitMargin/unit Sales quantity Contribution MSDA expenses Product profit QuarterlyProfit/Loss

$(100)

$(130)

$(150)

$(150)

$(150)

$(150)

$(150)

$(150)


$(100)

$(230)

$(380)

$(530)

$(680)

$(830)

$(980)

$(1,130)

(000)a Y3,Q1

Y3,Q2

Y3,Q3

Y3,Q4

Y4,Q1

Y4,Q2

Y4,Q3

Y4,Q4

Market ResearchProduct $(60)

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DevelopmentSelling Price

$18 $17 $17 $16 $15 $15 $15 $15

Cost per unit

10 10 10 10 10 10 10 10

Margin/unit

$8 $7 $7 $6 $5 $5 $5 $5

Sales quantity

20 30 40 45 45 35 30 20

Contribution

$160 $210 $280 $270 $225 $175 $150 $100

MSDA expenses

120 120 120 120 120 120 120 120

Product profit

$40 $90 $160 $150 $105 $55 $30 $(20)

QuarterlyProfit/Loss

$(20) $90 $160 $150 $105 $55 $30 $(20)


$(1,150)

$(1,060)

$(900)$(750

)$(645

)$(590

)$(560)

$(580)

aAll amounts except selling price, cost per unit, and marginper unit are in 1,000s.

8-34To use activity-based costing to help control andreduce environmental costs, the activities thatcause environmental costs must be identified. Next,the costs associated with the activities must bedetermined. These costs must then be assigned to themost appropriate products, distribution channels andcustomers. As in all types of management accountingand control systems, it is only when managers andemployees become aware of how the activities inwhich they engage generate environmental costs thatthey can control and reduce them.

Environmental costs include explicit costs, such asthe direct costs of modifying technology andprocesses, costs of cleanup and disposal, costs forpermits to operate a facility, fines levied by

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government agencies and litigation fees. Implicitenvironmental costs are often more closely tied tothe infrastructure required to monitorenvironmental issues. These costs includeadministration and legal counsel, employeeeducation and awareness, and the loss of goodwillif environmental disasters occur. Using traditionalcost systems, environmental-related costs are oftenhard to pinpoint because they are usually hidden insupport cost pools.

PROBLEMS

8-35 (a) To prepare an exhibit similar to Exhibit8-9, first compute the relative cost percentsillustrated in Exhibit 8-6 and the relativerankings illustrated in Exhibit 8-7.

Function Group TargetCost

Percent of Cost

Chassis $1,400 20.0Transmission 280 4.0Air conditioner 100 1.4Electrical system 700

10.0

Other function groups 4,520

64.6

Total $7,000 100.0


Importance

RelativeRanking inPercent

Safety 140 28%Comfort and convenience 120 24%Economy 40 8%Styling 60 12%Performance 140 28%

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Total 500 100%

Function Group


Chassis

Trans-

mission

AirCondi-tioner

Electrical

System

OtherFunction

Groups

Relative

Feature

Ranking

Safety0.3 28% =8.4%

0.1 28%

=2.8%

0.1 28% =2.8%

0.5 28% =14% 28%

Comfort and convenience

0.3 24% =7.2%

0.1 24% =2.4%

0.1 24% =2.4%

0.5 24%= 12% 24%

Economy 0.2 8% =1.6%

0.2 8% =1.6%

0.1 8% =0.8%

0.1 8% =0.8%

0.4 8% =3.2% 8%

Styling 0.1 12% =1.2%

0.9 12% =10.8% 12%

Performance

0.3 28% =8.4%

0.2 28% =5.6%

0.1 28% =2.8%

0.4 28% =11.2% 28%

Converted component ranking 26.8% 10.0% 3.2% 8.8% 51.2% 100%

(b) The value index is a benefit/cost ratio,obtained by dividing the relative importance incolumn (3) by the associated relative costcolumn (2).

(2) (3)(3) (2)

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Function Relative Value Action

Group CostImportan

ce Index Implied

Chassis 20.0% 26.8% 1.34 Enhance Transmission 4.0% 10.0% 2.50 Enhance Air conditioner 1.4% 3.2% 2.29 Enhance Electrical system 10.0% 8.8% 0.88

Reduce cost

Other function groups 64.6% 51.2% 0.79

Reduce cost

(c) The electrical system and other functiongroups are candidates for cost reductionbecause their value indexes are less than 1.

8-36The traditional focus of cost management has beenonly on manufacturing processes. Under thisapproach, pre-manufacturing costs, such as researchand development, and post-manufacturing costs, suchas service, are considered period costs, andcompanies expense them in the period incurred.Thus, these costs are in no way linked toindividual products. Traditional accountingprocedures and the way that many organizations havebeen separated by department or function (e.g.,design engineering, manufacturing, marketing,logistics, installation and postal service), oftenlead managers to focus myopically on their owndepartment’s costs. In particular, for themanufacturing function, defining product costs asthose solely related to the manufacturing processignores many costs associated with the entire lifecycle cost of a product.

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Understanding the total life cycle costs (TLCC) ofa product or service, or the product costs incurredbefore, during, and after the manufacturing cycleis critical, as decision makers can more completelyanalyze and understand what creates product costs.For example, if a company can reduce a product’sdesign and development costs at the pre-manufacturing stage, it also is possible to reduceall other subsequent product-related (downstream)costs such as manufacturing and service-relatedcosts. A TLCC system provides information formanagers to understand and manage costs through aproduct’s design, development, manufacturing,marketing, distribution, maintenance, service, anddisposal stages. The total life approach is alsoknown as managing costs “from the cradle to thegrave.”

8-37Gregoire Grant is shortsighted. The manufacturingcycle of the total-life-cycle costing approach isonly one of three major stages of the product lifecycle concept. The other life cycle concepts areresearch, development and engineering, and post-sale service and disposal. While each concept isuseful within its respective functional area, froma total-life-cycle costing (TLCC) perspective, itis important to integrate the concepts and tounderstand them in their entirety. Such integrationallows managers to see the big picture and to managewhole-life product costs in a comprehensivefashion. For example, poor decisions in theresearch development and engineering stage may leadto much higher costs in the manufacturing and post-sale service stages. Thus, it is in Gregoire’s bestinterest to understand what is occurring in theresearch development and engineering stage.

In order for managers at Gregoire’s company tofully adopt the TLCC view, it will probably benecessary to break down what are called “functionalsilos.” Functional silos are traditional parts oforganizations that are often thought (by those in

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them) to be self-contained. Breaking these downoften means reorganizing the company into cross-functional teams who share a vision of integrationacross their previous functions. Another criticalaspect to understanding the importance of the TLCCperspective is management education. The companyshould consider educational programs in which theirmanagers can learn about the benefits of and gaincommitment to the TLCC perspective.

8-38The target cost for a Calcutron calculator iscomputed as follows:

Target sales (500,000 calculators $75)

$37,500,000

Less: Target profit (15% $75/calculator 500,000 calculators)

5,625,000

Target cost for 500,000 calculators $31,875,000

Unit target cost ($31,875,000/500,000 calculators)

$ 63.75

8-39To compute the return on sales (ROS) for Bill Mann,it is necessary to determine Bill’s profit margin:

Sales (300,000 units $500)$150,000,000Less: Expenses

90,000,000= Profit Margin (ROS Sales)

$60,000,000ROS $150,000,000 = $60,000,000, so ROS = 40%.

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Thus, Bill Mann has not met the company-widereturn-on-sales target of 45%. Assuming Bill’sinitial target costs and target sales prices wereconsistent with the company-wide return-on-salestarget, Bill should explain the causes for below-target performance. Potential problem areas includemanufacturing costs and misestimation of customerdemand for the products’ functionality at thetarget prices. Evaluating whether Bill has done agood or poor job will involve determining theextent to which Bill could control cost, andevaluating Bill’s judgment in setting prices.

8-40Some studies of target costing in Japan indicatethat there are potential problems in implementingthe system, especially if focusing on meeting thetarget cost diverts attention away from otherelements of overall company goals. These potentialproblems include the following:

(1) Senior executives and workers may rejecttarget costing. Education about the benefits oftarget costing should be provided in order togain top management commitment to targetcosting, and top management commitment shouldbe communicated to employees involved in thetarget costing process.

(2) Conflicts can arise between variousparties involved in the target costing process.First, companies can put excessive pressure onsubcontractors/suppliers to conform to theschedule and to reduce their costs. This canlead to alienation and/or failure of thesubcontractor. Second, design engineers becomevery upset when other parts of the organizationare not as cost conscious as they are. Sincethey work very hard to squeeze pennies out ofthe cost of a product, they think that otherparts of the organization (administration,

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marketing, distribution) should also be as costconscious. Often this is not the case.

To overcome this problem, pressure can bereduced on subcontractors/suppliers by givingthem reasonable grace periods over which costreduction must occur. Simply demanding costreduction immediately will exacerbate theconflict. The issue of design engineers alsocan be addressed by making other parts of theorganization as cost conscious. Adopting atotal-life-cycle costing approach and usingcross-functional teams will help theorganization to this end.

(3) Employees in many Japanese companiesworking under target costing goals experienceburnout due to the pressure to meet the targetcost. Burnout is particularly evident fordesign engineers.

This issue can be addressed by makingtarget-costing goals tight, but attainable.Often organizations make the mistake of settingimpossible goals. Design engineers also oftenfear that if they make the target, in the nextperiod, the target will be “ratcheted up” andmade even more difficult to achieve. Thus, theymay consciously try to make sure that they donot achieve the target unless their jobs reston it. The organization has to be careful notto burn out employees, and design engineers inparticular, as they are extremely valuable tothe organization. Burnout is probably thebiggest issue related to the success or failureof target costing in Japan.

(4) While the target cost may be met, theremay be increased development time because ofrepeated value engineering cycles to reducecosts, which ultimately can lead to the productbeing late getting to market. For some types of

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products, being six months late to market maybe far more costly than having small costoverruns.

This is a very serious problem for the organization. Clearly, there is a tradeoff between continuing to reduce target costs and being very late to market. However, on average,many months of lost sales will have a much moredetrimental effect on the organization than whether target costs are met. Thus, the organization has to take a reasonable approach to target costing and not lose sight of the ultimate goal of selling the product and increasing market share. Time limits can be putin place for the length of time allowed to develop or introduce new products.

8-41 There are some similarities between traditional costreduction and target costing, but the differencesare more striking. Both the traditional costingmethod and target costing begin with market researchinto customer requirements followed by productspecification. Under traditional cost reduction,companies engage in product design and engineering,and obtain prices from suppliers. Product cost at

this stage is not a significant factor forproduct design. After the engineers and designershave determined product design, they estimateproduct cost and if the estimated cost is too high,then product design may have to change. The desiredprofit margin is found by subtracting the estimatedcost from the expected selling price. Profit marginis the result of the difference between the expectedselling price and the estimated production cost.Under another traditional method, cost-plus, theexpected profit margin is added to the expectedproduct cost and selling price is the result of thesum of these two variables.

Under target costing, after market research todetermine customer requirements and productspecification, the process is quite different. The

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next step, determining a target selling price andtarget product volume, depends on the company’sperceived value of the product to the customer. Thetarget profit margin results from a long-run profitanalysis, often based on return on sales (netincome/sales). The target cost is the differencebetween the target selling price and the targetprofit margin.

Once the target cost is set, the company mustdetermine target costs for each component. Thevalue engineering process includes examination ofeach component of a product to determine whether itis possible to reduce costs while maintainingfunctionality and performance. In some cases,product design might change, materials used inproduction might need replacing, or manufacturingprocesses might require being redesigned. Suppliersalso play a critical role in making target costingwork. If manufacturers with market power decidethat there is a need to reduce the cost of specificcomponents, they will pressure suppliers to findways to reduce costs.

8-42Bringing in outside consultants to implement atarget costing system can be effective, but costly.Consultants often have a great deal of knowledgethat they can bring to an organization and in thissense the organization does not have to “start fromscratch.” A downside of using consultants is that,in some instances, consultants want to use anexisting template for implementing a new method,such as target costing. The template is oftendesigned generically and is meant to besuperimposed on any organization. Someorganizations object to this and want a moretailored approach, especially if they are in anindustry in which the consultants have not workedat all. Consultants may agree to tailor theapproach, but the cost of implementation of atarget costing system will increase significantly.

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A second downside is that many organizationalmembers may not be involved with implementing thechanges. Thus, they may simply rely on what theconsultants do. If organizational members do notunderstand what the consultants have done or howthe system works, then the system will likely failafter the consultants leave.

A second approach is for organizational members todevelop a target costing system internally withlittle or no assistance from outside consultants.This approach can be satisfying, but it can becostly and time-consuming, especially if theorganization has little experience in implementingthese types of systems. The positive side of thisis that organizational members may get more of a“buy-in” to the new method because they have tounderstand it well to convince others of the needto implement it. Once organizational members knowthat they can develop these systems themselves,they may be more confident in the future regardingthe implementation of other organizationalinnovations.

The third approach, known as benchmarking, requiresthat organizational members first understand theircurrent cost reduction methods and then lookexternally to the best target costing systems ofother organizations for guidance on change.Benchmarking is often highly cost-effective sinceorganizations can save time and money avoiding themistakes that other companies have made or byavoiding reinventing a process or method that othercompanies have already developed and tested.Benchmarking allows organizations to gain insightson target costing from others, but at the same timeto assume responsibility for the changes. In thisway, organizational members feel like they haveownership of the changes and this can lead todeveloping more confidence about future changes andimprovements to their management accounting system.

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8-43The answer to this question is very similar to thesolution for 8-41 but it is more detailed. Theprocess involved in traditional cost reduction aspracticed in the United States is significantlydifferent from target costing. The traditionalcosting method begins with market research intocustomer requirements followed by productspecification. Then, companies engage in productdesign and engineering, and they obtain prices fromsuppliers. Traditionally, at this stage, productcost is not a significant factor for productdesign. After the engineers and designers havedetermined product design, they estimate productcost Ct , where the t subscript indicates numbersderived under a traditional, sequential design anddevelopment process. If the estimated cost isconsidered to be too high, then it might benecessary to modify product design. In order tofind the desired profit margin Pt , it is necessaryto subtract the estimated cost from the expectedselling price St . The profit margin is the resultof the difference between the expected sellingprice and the estimated production cost. Thisrelationship in the traditional system is expressedas: P S Ct t t .

Another widely used traditional approach is thecost-plus method. Under cost-plus, an expectedprofit margin Pcp is added to the expected productcost Ccp where the subscript cp indicates numbersderived under cost-plus thinking. Selling price Scp,then, is simply the result of the sum of these twovariables. In equation form, this relationship forthe cost-plus approach is: S C Pcp cp cp . As in thefirst traditional method described above, product

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designers do not attempt to achieve a particularcost target.

Under target costing, both the sequence of stepsand way of thinking about determining product costsdiffer significantly from traditional costing. Thefirst two steps, market research to determinecustomer requirements and product specification,are similar to traditional costing. After theseinitial steps, the process is quite different. Thenext step, determining a target selling price Stc and target product volume, depends on the company’sperceived value of the product to the customer. Thetarget profit margin Ptc results from a long-runprofit analysis, often based on return on sales(net income/sales). Return on sales is the mostwidely used measure, as it can be linked mostclosely to profitability for each product. Thetarget cost Ctc is the difference between thetarget selling price and the target profit margin.Note that the tc subscript indicates numbersderived under the target costing approach. Thisrelationship for the target costing approach isshown in the following equation: C S Ptc tc tc .

Once the target cost is set, the company mustdetermine target costs for each component. The valueengineering process includes examination of eachcomponent of a product to determine whether it ispossible to reduce costs while maintainingfunctionality and performance. In some cases,product design might change, materials used inproduction might need replacing, or manufacturingprocesses might require redesign. For example, aproduct design change might involve using fewerparts or reducing specialty parts if the company canuse more common components. Several iterations ofvalue engineering usually are required before it is

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possible to determine the final target cost.Suppliers also play a critical role in making targetcosting work. If manufacturers with market powerdecide that there is a need to reduce the cost ofspecific components, they will pressure suppliers tofind ways to reduce costs. Companies such as Toyotaand Nissan might, in some cases, offer incentiveplans to suppliers who come up with the best costreduction ideas.

8-44In theory there is no reason to assume that targetcosting, or at least parts of it, cannot be appliedto service organizations. However, the method wasdeveloped for products requiring discretemanufacturing processes and short product lifecycles. In a bank, products (or services, dependingon how you look at it) would include checkingaccounts, savings accounts, all types of loans,etc. The bank could follow the steps outlined inExhibit 8-4 and do market research to determinecustomer requirements and product specification.Customer requirements would include the desiredinterest rate on a checking account, the level ofattention needed to open these accounts, thechoices for colors and designs on checks, etc.Next, the “target selling price” or the cost to thecustomer of opening and maintaining the checkingaccount would be determined as well as the targetvolume or the number of checking accounts that thecompany desires to service. The target profitmargin would have to be determined based oncalculations related to the amount of income earnedfrom customer accounts. The target cost then wouldbe the difference between the target selling priceand the target profit margin.

The following approach can be used. Using the five-stage benchmarking model below, the instructor maywish to select various approaches beginning withthe choices on the dimensions in Stage 3 andcontinuing into Stage 4 for different members ofthe class and then have them compare the plans that

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they devise. For instance, in Stage 3 you might asksome students to devise a plan for benchmarkingorganizations within the banking industry and forthose outside of banking. Some might be asked tobenchmark with many partners and some with few. ForStage 4 the methods of information gathering andsharing can be varied. Some students can beassigned the unilateral form of benchmarking, whileothers can be assigned one of the three forms ofcooperative benchmarking. What are the implicationsof each? Also, students need to determine theperformance measures that they will use and a timeframe over which the study will occur. This can bea very interesting and informative exercise forstudents.

Stage 1:· Internal study and preliminary competitive

analyses· Preliminary internal and externalcompetitive analyses· Determining key areas for study· Determining scope and significance of thestudy

Stage 2:· Developing long-term commitment to the

benchmarking project Gaining senior management

support Developing a clear set of

objectives Empowering employees to

make change · Coalescing the benchmarking

team

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Using an experienced coordinator

Training employees

Stage 3:· Identifying benchmarking partners· Size of partners· Number of partners· Relative position within and acrossindustries· Degree of trust among partners

Stage 4:· Information gathering and sharing methods· Type of benchmarking information:

Product Functional (Process) Strategic (includes

management accounting methods)· Method of information collection:

Unilateral Cooperative:

Database Indirect/third party Group

· Determining performance measures· Determining the benchmarking performance

gap in relation to performance measures

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Stage 5:· Taking action to meet or exceed thebenchmark· Making comparisons of performance measures

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CASES

8-45 (a) Product X ProductY

Total

Direct costs (material plus labor)

$9,000,000

$4,000,000

Environmental support

14,000,000

Nonenvironmental support

22,000,000

29,000,000

Total support $22,000,000

$43,000,000

$65,000,000

Total machine hours

10,000,000

6,000,00016,000,0

00

Current cost driver rate

Total support machine hours

$4.0625

Costs using current cost driver rateDirect costs (material plus labor)

$9,000,000

$4,000,00

0Applied support:$4.0625 per machine hour

40,625,000

24,375,000

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Total costs $49,625,000

$28,375,000

Number of units 100,000,000

40,000,000

Cost per unit $0.50 $0.71

(b) Per unitProduct

XProduct

YX Y

Direct costs (material plus labor)

$9,000,00

0

$4,000,00

0

$0.09

$0.10

Environmental support

14,000,000

0.35

Nonenvironmental support

22,000,000

29,000,000

0.22 0.73

Total support $22,000,000

$43,000,000

$0.22

$1.08

Total costs $31,000,000

$47,000,000

Number of units 100,000,000

40,000,000

Cost per unit using ABC

$0.31 $1.18

(c) Different methods are used to allocate supportcosts in part (a) and part (b). In part (a),environmental support costs are allocated toboth products even though Product X does notgenerate any environmental costs. In part (b),environmental support costs are assigned only toProduct Y.

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(d) ProductX

ProductY

Cost per unit using current cost driver rate

$0.50 $0.71

Price, 1.5 cost $0.75 $1.07Cost per unit using ABC $0.31 $1.18Price, 1.5 cost $0.47 $1.77

Of the two costing systems here, theactivity-based costing system more accuratelyassigns costs of resource usage to the twoproducts. The cost system based on a plantwiderate results in product X essentiallysubsidizing product Y. Product Y’s price underthis system does not even cover the product’sspecific environmental costs as identified bythe activity-based costing approach..Consequently, the company should evaluate aprice increase for product Y or ways to decreaseproduct-related costs for product Y. The companymay be able to reduce product Y’s costs by usinga process that reduces or eliminates hazardouswastes.

Product X’s price could be reduced andstill generate a profit. In making such adecision, the company would evaluate expectedchanges in demand (if any) if product X’s pricewere reduced.

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8-46 (a) Pat Polley has listed or expressed concernabout a number of explicit and implicitenvironmental costs.

Explicit environmental costs include:

· The net cost of purchasing and installingthe new equipment

· Cost of removing the old equipment· Insurance for the equipment and the

workers due to hazardous materials· Storage and disposal costs for hazardous

wastes· Legal fees related to handling

paperwork for hazardous waste liabilities· Risk of OSHA fines· Risk of liability due to accidental

leakage· Labor cost of removing hazardous

wastes

Implicit environmental costs include:

· Negative media coverage that willreduce demand

(b) Other environmental costs include:

· Training workers on handling hazardouswastes

· Monitoring hazardous wastes· Filing reports on hazardous wastes

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· Possible productivity problems because ofpoor worker morale due to hazardous workenvironment· Poor worker health or increasedabsenteeism because of exposure tohazardous wastes· Risk of liability due to increasingly

stringent laws· Cost for permits related to hazardous

wasteLegal counselEmployee education and awareness Loss of goodwill if environmental

disasters occur

(c) Kwik Clean faces a variety ofenvironmental costs, including storage anddisposal costs for hazardous wastes, legalfees, training costs, insurance, permit costs,and monitoring costs. Using traditional costsystems, environmental-related costs are oftenhard to pinpoint because they are usuallyhidden in support cost pools, often one generalsupport cost pool. Activity-based costing canhelp control and reduce environmental costsbecause it identifies process activities,including activities that cause environmentalcosts. Next, the costs associated with theactivities are determined. These costs are thenassigned to the most appropriate products orservices. Awareness of how Kwik Clean’sactivities generate environmental costs, aswell as awareness of the magnitude of the

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costs, establish a starting point forcontrolling and reducing them.

8-47 (a) Mercedes-Benz All Activity Vehicle (AAV)1

[Note: Additional information can be found inthe following references:

Albright, T. “The Use of Target Costing inDeveloping the Mercedes Benz M-Class,” International Journal of Strategic Cost Management (Autumn 1998): 13-23.

Albright, T. and S. Davis. “The Elements of Supply Chain Management,” InternationalJournal of Strategic Cost Management (Autumn 1999): 49-65.]

The target costing case literature containsnumerous examples of Japanese cost managementpractices; however, few cases describe the useof target costing by large companies outsideJapan. The purpose of the Mercedes-Benz AAVcase is to consider the competitive environmentof a leading German automotive manufacturer andthe company’s response to changing competitiveconditions. The teaching plan generally followsthe suggested student assignment questions.Additional material that can be introducedduring the case discussion is indicated by acheck mark.

Student Assignment Questions

1 Source: Institute of Management Accountants, Cases from Management Accounting Practice, Instructor’s Manual, Volume 15. Adapted with permission.

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(a) What is the competitive environment faced by MB?

Students may identify a number of changes, includingsignificant market share lost to Japanese companiessuch as Lexus. Stress the importance of a culturalchange taking place within top management atMercedes. Reinforce that Mercedes is a company thathad never lost money until 1993. They simply builtthe best car their engineers could design and pricedit above cost. Demand often exceeded supply. As aresult, cost had never been a primary consideration.Changes include:

• cost competition;• product innovation;• new segments (sports utility vehicle);• new market niches.

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(b) How has MB reacted to the changing world market forluxury automobiles?

Students should identify the following changesimplemented by management at Mercedes; try to getthem to explain how different these approaches werefrom traditional strategies at Mercedes:

• many new product introductions;• partnering with suppliers;• reduced parts and system complexity;• new emphasis on cost control;• layers of management reduced;• lead time from concept to introduction reduced.

(c) Using Cooper’s cost, quality, functionality chart,discuss the factors on which MB competes with otherautomobile producers such as Jeep, Ford, and GM. (Ifthe instructor wishes to give a brief mini-lectureon Robin Cooper’s survival triplet and confrontationstrategy,2 this is a good point in the casediscussion to do so.) 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 themselvestoward the luxury end of the spectrum. Also, unlike many Japanese examples, Mercedes does not use target

2 Robin Cooper, When Lean Enterprises Collide, Boston: Harvard Business School Press, 1995.

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costing as a strict cost control mechanism to produce the lowest priced product in its class.

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(d)How does the AAV project link with MB strategy in terms of market coverage?

The new introductions expand the product line of thetraditionally luxury-oriented manufacturer. Recentproduct introductions include the following:

• A Class;• C Class;• SLK;• E Class;• M Class.

These new introductions include new sports cars andoff-road vehicles. The C Class is a mid-sizedvehicle sometimes referred to as the baby-Benz.

Let’s discuss the elements of the target costing model and how theseelements are developed.At this point in the discussion I usually writethe target costing formula on the board and askstudents to consider sources of various inputs:

• target selling price;• target profit margin;• target cost.

What are the sources of input for the projected target selling price?Students will most likely identify the followingsources of information:

• customer focus groups;• comparable products:- existing,- potential.

Stress the broad, cross-functional aspects ofacquiring consumer information. To compare

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products, the company had to evaluate existingcompetitive vehicles as well as vehicles underdevelopment.

What factors are considered when developing the required target profit margin?

This question provides a link to finance classes.Most students have studied the concepts ofweighted-average cost of capital. I recommendspending a few minutes reviewing these conceptsand linking cost of capital to net present value(NPV) analysis. Because of the capital-intensivestructure of automobile manufacturing, productionvolume is a critical factor in determining eachmodel’s NPV. Students may identify the followingpoints for determining a required target profitmargin.

• 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 withthe ideals of target costing?

I generally emphasize that Mercedes did notconsider the target cost to be locked in. It was amoving target. As engineering changes becamenecessary, the target cost was allowed to move.However, before making a change, market forceswere considered. For example, changes included theaddition of side airbags. In addition, theEuropean press was critical of a simulated wood-grain part. Management decided the part would

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remain plastic because costs could not be passedon to the consumer. The main point to emphasize isthe design of the vehicle is dynamic, thus costsmust evolve to reflect the changing designcharacteristics.

(e)Explain the process of developing an importance index for a function group or component. 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 and percentage by function group;• category vs. function group matrix (function group contribution to customer requirements); • importance index of the various function groups;• target cost index.

The instructor can make slides of Tables 1-5 tofacilitate discussion. Index development is animportant element in the early conceptualizationphase of the AAV. The indexes help to quantify somevery abstract concepts.

Table 1. From conversations with potential consumergroups, a list of key categories was developed.Next, potential customers were asked to rate theimportance of each category. Their responses werecomputed as a percentage. Thus, safety and comfortof the AAV were viewed as significantly moreimportant than economy and styling.

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Table 2 represents a rough estimate of the targetcost by function group and the relative percentageof each group of total target costs. The informationis used later to create a target cost index.

Table 3 is best understood by reading each categoryas a column. The rows explain the relativeimportance of each function group to satisfying eachcategory defined by customers. An interesting aspectof this table is that the link between consumerpreferences and engineering components is madeexplicit.

Table 4 builds on Table 3 by weighting thepercentages computed in Table 3 by the importancepercentages calculated in Table 1. The key point isto understand which function groups contribute themost (least) to important (less important) consumercategories.

Table 5 results in a target cost index for eachfunction group that attempts to capture cost andbenefit trade-offs. As discussed in the case, thisindex may indicate a cost in excess of the perceivedvalue of a function group. Thus, opportunities forcost reduction (aligned with customer requirements)may be identified.

(f) How does MB approach cost reduction to achievetarget costs?

At this point, ask students to identify variousvalue-engineering strategies. At Mercedes, reducingthe cost of each function group was accomplished byreducing costs of various components that make up

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the function group. Stress the importance of thisapproach over an “across-the-board” cut.

(g) How do suppliers factor into the target costingprocess? Why are they so critically important to thesuccess of the MB AAV?

From the conceptual phase through the productionphase, the suppliers of systems for the AAV trulywere partners. Suppliers attended regular meetingswith the cost planners throughout the entireprocess. Thus, suppliers were:

• design and development partners from very earlystages of development,

• responsible for meeting cost targets.

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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. Infact, many suppliers deliver directly to theassembly line, rather than to a small warehouse.The Black Warrior River separated Mercedes and amajor system supplier. This supplier built a newproduction facility on the same side of the riveras the Mercedes Benz plant to avoid possibledelays associated with accidents on a majorbridge.

(h)What role does the accounting department play in thetarget costing process?

Stress the fact that accountants were watchdogs inthe target costing process. Their primaryresponsibility was to ensure costs did not exceedtargets during the production phase. Thus, theaccountants’ role was as follows:

• cost control;• actual costs versus target costs:

- development stage,- production stage.

What are some of the organizational barriers that may challengemanagers attempting to introduce target costing systems?

Try to get students to identify variousimpediments to target costing systems in theUnited States. Examples may include:

• willingness to share cost data with– 319 –


suppliers;• suppliers treated as adversaries;• government regulations affecting exchange of

information.

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chapter 8 solutions

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