13-26 (30 min.) Value engineering, target pricing, and target costs. 1. Product
ID: 2455134 • Letter: 1
Question
13-26 (30 min.) Value engineering, target pricing, and target costs. 1. Product design and licensing $1,000,000 Direct materials 1,800,000 Direct manufacturing labor 1,200,000 Variable manufacturing overhead 600,000 Fixed manufacturing overhead 2,000,000 Fixed marketing 3,000,000 Total cost $9,600,000 Cost per unit ($9,600,000 ÷ 400,000) $24.00 Target cost per unit ($38 × 0.60) $22.80 The original cost estimate of $9,600,000 does not meet the company’s requirements. Value engineering will be needed to reduce the cost per unit to the target cost. Tiffany’s operating income will be $5,600,000 ($38 × 400,000 – $9,600,000) 2. Total cost $9,600,000 Less: Reduction in material costs ($1,800,000 × 45%) (810,000) Add: Increase in design costs 300,000 Total costs of redesigned table $9,090,000 Revised cost per unit ($9,090,000 ÷ 400,000 units) $22.73 Target cost per unit ($38 × 0.60) $22.80 The design change allows the table to meet its goal of target costs less than 60% of revenue and target operating income greater than 40% of revenue. The cost of materials is a locked-in cost because they are designed into the product formula. 3. Total cost $ 9,600,000 Add: Increase in marketing costs 400,000 Total costs of redesigned table $10,000,000 Revised cost per unit ($10,000,000 ÷ 400,000 units) $25 Target cost per unit ($42 × 0.60) $25.20 Yes, this proposal does allow the company to meet its goal of target costs less than 60% of revenue and target operating income greater than 40% of revenue. 2. The company has many considerations, both quantitative and qualitative, when deciding between the preceding requirements 2 and 3 . Although both options meet the target costing objectives, they will provide different amounts of income in both the short and potentially long term. In the short term, the alternative in requirement 2 will result in income of ($38 × 400,000) – $9,090,000 = $6,110,000. The alternative in requirement 3 will provide a higher income of ($42 × 400,000) – $10,000,000 = $6,800,000 and will be preferred. In the long run, however, there are other considerations that might favor the alternative in requirement 2 and using the chemical equivalent of the nectar obtained from the plant in South America. For example, will the nectar become more expensive in future periods? If so, could the product be reengineered at a later time or are the materials locked-in with the design for the full product life cycle. If the company chemically engineers the material, will this tarnish the quality of the product or more importantly, the company’s brand image? How might this affect the price in future periods and/or the sales of other products within the company?
Explanation / Answer
Scenario 1
Product Design Cost= 10,00,000
Direct Material Cost= 18,00,000
Direct Labour= 12,00,000
Variable Overhead= 6,00,000
Fixed Overhead= 20,00,000
Fixed Marketing= 30,00,000
Total Cost= 96,00,000
Unit= 400000
Cost/Unit= 96,00,000/400000= 24 Dollars
Target cost per unit= 38 Dollars
Target income per unit is 60 percent of target cost per unit= 38*.60=22.8 Dollars
Operating Income= (38*400000 )- 9600000= 5600000
Scenario 2:
Total Cost: 96,00,000
Subtract Reduction in Material Cost= 8,10,000
Add increase in design cost= 3,00,000
New total cost: 96,00,000- 8,10,000+ 3,00,000= 90,90,000 Dollars
Cost per unit= 90,90,000/400000= 22.73 Dollar
Target Cost per unit same as scenario 1= 22.8 Dollar
This is better than our expectations:
operating income: (38*400000)- 90,90,000= 61,10,000 Dollars
Scenario 3:
Total Cost: 96,00,000
Add increase in marketing cost: 400000
Total cost= 9600000+400000= 100,00,000
Cost per unit= 100,00,000/400000= 25 dollars
Target Cost per unit= 42*.60= 25.20 dollars
This is beyond our expectations.
operating income: (42*400000)- 100,00,000= 68,00,000 Dollars
Short term:
Scenario 3 is better. Short term is always bottom line (Profits).
Long term:
Scenario 3 is better. There are too many risks associated with scenario 2.
1) Raw material Nectar price variability.
2) Product Quality
3) Brand image
4) Loose out customers
So not a good approach to go with scenario 2. Scenario 3 provides stability and higher profits both in long term and short term.
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