Section B – TWO questions ONLY to be attempted
Pitlane Electronic Components (Pitlane) manufactures components for use in the electricity distribution network in Deeland. Demand from Pitlane’s biggest customer, to replace identical but worn out components, has been constant for many years. Pitlane has recently renewed an exclusive long-term supply agreement with this customer, who has always agreed to buy the components for their total standard cost plus a fixed profit margin of 15%. Variances between standard and actual costs of the components are negligible. Pitlane runs several production lines in two factories located in different areas of Deeland. The factories’ layout is poorly designed and the production process requires components to be transported around and between the factories.
The Deeland government wants to encourage renewable electricity generation. It is offering a three-year subsidy scheme, beginning in 2018, for consumers to have solar panels installed on the roofs of their homes. As an added incentive, businesses will be exempt from tax on profits made on the sale of solar panels and related components.
To take advantage of this scheme, Pitlane has built a prototype of a new electrical component, known as the ‘Booster’, which increases the output from domestic solar panels. The Booster will be sold to installers of solar panels and not directly to consumers. Pitlane’s marketing department has estimated market data for the duration of the scheme based on a similar scheme in Veeland (Appendix 1). As a result of its products being unchanged for many years, Pitlane has little recent experience of developing new products and estimating costs and potential revenues from them. It is expected that many competitor products will be launched during the scheme, at the end of which demand is expected to fall greatly, and production of the Booster will discontinue.
Pitlane’s shareholders insist that for the Booster project to go ahead, it must meet the financial performance objective of achieving a 15% net profit margin, after all costs, for the duration of the scheme.
The Booster’s total fixed costs during the scheme are estimated to be $10m, including $2·8m upfront development costs to enable the Booster to communicate the amount of solar energy generated directly to consumers’ smartphones via an app. The product development team at Pitlane believes this feature, and the use of highest quality packaging, will allow it to charge 10% more that the average price of its competitors. The marketing team, however, has questioned the overall value of these two features and whether customers would be prepared to pay extra for them, as most of the Deeland population do not yet own smartphones.
Pitlane has estimated the direct costs for the Booster (Appendix 2). The largest direct cost is for the four main sub-components. These are bought in bulk from six different suppliers in Deeland, though all are readily available from suppliers worldwide. The sub-components are fragile. During production of the Booster prototype, many sub-components were found to be damaged during the production process by workers incorrectly assembling them. This resulted in the completed prototype Boosters being scrapped after testing by the quality control department. The manufacturing director is concerned that the incorrect assembly of sub-components by workers may mean that it may not be profitable for Pitlane to start full scale production of Boosters. To counteract these quality problems, Pitlane will employ more highly skilled workers, who are paid around 30% more than most other workers in the business which is accounted for in the cost estimate given in Appendix 2. Pitlane staff have never been encouraged to suggest any ways to improve the manufacturing process.
Pitlane’s directors are concerned that the Booster project will not meet the shareholders’ financial performance objective. They have asked you, as a consultant experienced in target costing, Kaizen costing and other Japanese business practices, for your advice.
Appendix 1 – Estimated market data for Booster
Calculate the cost gap per unit in each of the three years of the Booster’s life, taking into account all estimated costs.
Advise on the extent to which target costing would help Pitlane to achieve the financial performance objective set by the shareholders.
Target costing
Target costing Pitlane currently operates a traditional cost plus pricing method, where customers pay a fixed mark up on Pitlane’s standard cost. This has been appropriate because the components currently produced have been manufactured in the same way for some time and their cost structure is well understood. Actual costs of production are very close to the standard costs. There is little competition in the market for Pitlane’s current products, as a long-term contract was recently renewed with its biggest customer.
In contrast, for the proposed Booster product, the market price is only estimated. To compete with similar products, the Booster will need to sell at a price reflecting that of competitors’ products, taking into account the different benefits and quality which each product has.
Target costing begins with taking the price which the market will pay for the product for a given market share. From that, the required profit margin is deducted to arrive at a target cost. The difference between the estimated cost for the product and the target cost is the cost gap. Where the estimated costs exceed the target cost, steps are taken to reduce the cost gap. The product can then be sold at a price which the market will accept, and which generates an acceptable profit margin.
Determining the market price
Pitlane’s marketing department has estimated the average market price of competitors’ products and the likely market share over the three years of the scheme. The estimates are based on the success of a similar scheme in Veeland, and the assumptions used could be incorrect. Electricity prices may already be higher in Veeland than in Deeland, meaning consumers there would reduce their energy costs more by installing solar panels. Similarly, consumers in Veeland could save more on energy costs if there is more sunshine there than in Deeland, enabling solar panels to generate more energy. Both factors would, in this case, reduce the take up of subsidies by consumers in Deeland and the amount they would be willing to pay for solar panels.
The domestic solar energy market is new in Deeland, and Pitlane has no experience in estimating market share or price for this type of product. Pitlane’s belief that consumers would be willing to pay a 10% premium for highest quality packaging, or for the Booster to communicate with consumers’ mobile phones, may be incorrect.
Calculating the target cost using the required profit margin
Pitlane charges a 15% profit margin on its existing projects. The shareholders’ financial objective indicates that they require the same profit margin to be earned on Booster.
For its existing products, Pitlane can set a selling price based on its own costs, whereas the Booster’s price must reflect external market conditions more closely. Target costing will focus Pitlane on the external environment by considering prices and relative benefits of competitors’ products.
Estimating total costs of Booster
The total direct costs of Booster have been estimated at $134·00. The fixed overhead per unit relating to Booster for the three years of the scheme is $44·05, making total estimated costs per unit of $178·05. The cost estimates may be incorrect, especially as Booster is new, and different from Pitlane’s existing products. As Booster includes costs which are fixed, estimating sales volumes is also crucial in determining costs per unit.
Pitlane has no recent experience of developing new products or of estimating costs and sales volumes for them. This makes it more likely that the cost estimates for the Booster will be incorrect. Estimating the total costs is needed for the next stage in the target costing process, to identify the cost gap.
Reducing the cost gap
A big advantage for Pitlane of using target costing is that it is often easier to reduce costs of a product at the design stage rather than after it has entered production.
As Boosters are not sold directly to consumers, the buyers of the product, who are professional installers, may not see value in the highest quality packaging. This could be a significant yet unnecessary cost, to be eliminated at the design stage. In deciding what costs to eliminate, Pitlane will have to take into account the effect of these on the quality and perception of the final product.
The features where the Booster can communicate with consumers’ smartphones, and the use of highest quality packaging, are believed to enable Pitlane to charge 10% more than competitors’ products. The $3·8m (W1) of estimated additional total revenue from the packaging and smartphone features may not justify the $2·8m upfront development costs for the smartphone feature alone, especially if the time value of money were to be taken into account. Consumers may not value these two features or be prepared to pay more for them. Eliminating them would therefore have little effect on sales volumes and would enable Pitlane to charge a more competitive price, or obtain higher gross profit margins.
Due to damage of sub-components when assembling the prototype, the estimated assembly labour cost assumes highly skilled labour will be used. This is 30% more expensive than other labour. By providing additional training, lower paid labour could be used to produce the Booster, and hence reduce the cost gap.
Pitlane plans to purchase the four main sub-components in bulk from six different suppliers. Consolidating suppliers, or using suppliers in lower cost countries, could help reduce the cost gap by reducing purchase costs. Moving to a just-in-time production system, rather than buying supplies in bulk, would help reduce costs of holding inventory as suppliers would only deliver sub-components when needed. This may increase other costs such as by requiring investment in information technology. It would also take time to develop the close relationship required with suppliers.
Another source of waste is due to internal transport and handling, which forms over 5% of the total direct cost of the Booster. This will also increase production cycle times, and is an unnecessary process which does not add value. It could be eliminated by changing the layout of the factory, or reorganising production into teams and ensuring all production was done at a single factory, rather than in both of Pitlane’s factories.
W1 – Additional revenue from smartphone feature and highest quality packaging
Advise Pitlane how Kaizen costing may be used to help the Booster project achieve the financial performance objective set by the shareholders.
Kaizen costing
Unlike target costing, which occurs at the beginning of a product’s life, Kaizen costing is a process of long-term continuous improvement by cost reduction throughout the life of the product.
The Booster will be produced only for the three years during which the Deeland government offers subsidies and tax incentives. Generally, Kaizen costing is used over longer periods, and it is likely the full benefits of this approach will not be achieved in such a short timescale. The target cost is the starting point for Kaizen costing. After production begins, each period’s target is based on the previous period’s reduced costs.
Target costing can achieve large cost reductions at the design stage of the product, e.g. by choosing not to develop the smartphone feature. Kaizen costing, however, reduces costs in much smaller, incremental steps.
The need for continuous improvement
Even though Booster’s share of the market rises over the three years of the project, the market price falls, as does the size of the market. Which means that in order to achieve the shareholders’ financial targets, the direct costs of the Booster must fall over the three years. Continual incremental improvements using Kaizen costing, and measuring these improvements against targets from the previous period rather than the original estimated cost, could help to achieve this.
Ways to reduce waste using Kaizen costing
Traditional costing methods often see employees as the cause of high costs, whereas Kaizen costing sees the employees as a source of ideas on how to reduce costs. The manufacturing director’s comments, that the damage caused by employees to delicate sub-components may mean it may not be possible to produce the Booster, indicates that Pitlane is currently following the traditional approach. Employees are seen as the source of the waste.
To benefit from Kaizen costing, Pitlane must undergo a culture change to encourage employees to suggest ideas, perhaps using quality circles, to reduce costs. That way, improvements could be made in the way sub-components are assembled during production, which would shorten the production cycle and lead to a reduced cost of scrapped items.