ABSTRACT
One of the key objectives of all product-producing organizations is to make money, unless the organization is a nonprofit or a government entity The costs of developing, producing, distributing, and maintaining the products are important to all organizations The goals of the organizations are thus to minimize the total costs during the entire life cycle of the product-from its conception to product disposal At the early stages, accurate estimates of the costs are required to develop a budget for the product program and to get it approved The actual expenditure of costs should be continuously compared with the budgeted costs to ensure that the project is meeting its budgetary requirements Differences between the budgeted costs and actual costs may signal over or under expenditures or errors in estimating the budgeted costs
The costs are estimated by breaking down a large product program into a series of manageable tasks Experienced cost estimators, based on the work content in each task and availability of cost information from previously conducted similar tasks and adjustments for the prevailing and future economic and technological conditions, usually develop time and cost estimates to complete the tasks The costs of all tasks are then added along with some allowances for errors, interest, inflation, and other unknown or unforeseen problems The project cost estimates are also refined several times in the program as some of the less predictable tasks and unknown issues (eg, technology development) are resolved or better understood
The costs are incurred over time The costs during early product development are nonrecurring; that is, they do not recur or are one-time type of costs associated with product concept development, product design, detailed engineering, testing, building tools, and facilities Once the production begins, the costs associated with purchasing raw materials, parts purchased from suppliers, plant running costs, direct labor costs, insurance costs, and so forth are generally proportional to the volume of products manufactured The cumulative monetary needs decrease as products are sold and the revenues are generated
The objective of this chapter is to understand different types of costs associated with the various tasks involved during the product life cycle
The costs are incurred throughout the life cycle of a product program The total life cycle costs of a product can be divided into (1) nonrecurring costs and (2) recurring costs
Nonrecurring Costs These costs represent expenses and investments that are made during the product development, creation of the production systems, and also to retire and dispose the systems after the product is terminated These costs are incurred before the beginning of production and at the end of production, that is, retirement (disposal) stages in the life cycle of a product The early costs incurred to reach operational status of the program include product design, development, and refinement costs The costs include personnel costs (salaries and benefits) of the design team as well as for the development of models, prototypes, market research, verification tests, tools and fixtures design and build, plant and facilities building, equipment/tooling installation, and prove-out These nonrecurring costs do not vary as a function of the quantity of products produced Thus, they are also referred as the “fixed costs”
Recurring Costs These costs continue to occur and recur throughout the production, sales, and service/maintenance of the products These costs include personnel costs of the production and distribution (direct and indirect labor), parts and materials purchases, plant and equipment maintenance, utilities, insurance, rents, taxes, licenses, marketing and sales costs, warranty costs, and so forth The recurring costs vary as a function of the quantity of products produced Thus, they are also referred to as the “variable costs”
Figure 81 shows two charts The top chart shows various costs (which have negative values, as they represent money spent or lost) as they incur as functions of time during various life cycle stages of a typical product program for a manufactured product Figure 81 also shows revenues The revenues have positive values as they represent income They are only generated after the products are sold (Note: Revenue = Units sold × Unit price) The lower chart in Figure 81 shows the systems engineering “V” model The time line of the “V” model is synchronized with the timeline of the upper cost chart
For the cost management purposes, all the costs (negative values) and revenues (positive values) are added and the cumulative cash flow is frequently reviewed and compared with the budgeted cash flow (ie, predicted revenue minus budgeted costs) Two cumulative cash flow curves are presented in Figure 82 Let us assume that the two cumulative cash flow curves are for two alternative product programs The alternative 1 incurs much more costs and also extends over longer duration in the negative cash flow condition than alternative 2 However, the product in the alternative 1 generates revenue at a much higher rate than alternative 2 Understanding of the cumulative cash flow curves (ie, their levels and timings) is very important before committing to an alternative
As the products are sold, the generated revenues (positive values) are tracked and added to the total costs (negative values) The revenues are also affected by a number of factors such as changes in product volumes due to obsolescence of older products and emergence of new trends in design and technologies,
introduction and availability of new products by the competitors, and changes in economic conditions (eg, state of economy, interest, inflation, and currency exchange rates)
Most product-producing organizations do not produce all the entities (ie, systems, subsystems, or components) of the product within their organization Many of the entities are purchased from other organizations (ie, suppliers) Typically,
standardized components that are common across many similar products are made by different organizations Some examples of standardized components are fasteners (such as nuts, bolts, rivets, clips, and pins), electrical and electronic components (eg, switches, resistors, transistors, and microprocessors), plumbing supplies, and so on Some special components that require unique manufacturing processes and specialized systems, machines, or equipment are also purchased from suppliers with specialized capabilities For example, major automotive manufacturers typically purchase about 30%–70% of the components (or systems) in the automotive products from their suppliers The aircrafts companies also rely on suppliers to produce most of their components For example, none of the commercial aircraft manufacturing companies produce jet engines that contribute about 40%–50% of the cost of an airplane Similarly, specialized systems such as electronic and electrical systems with components such as microprocessors, sensors, actuators, printed circuit boards, and so forth in most complex products are produced by suppliers
The decision on whether to make or buy an entity depends on many considerations Some important considerations are given as follows:
1 Availability of in-house manufacturing capability and capacity (eg, specialized equipment and personnel with unique backgrounds and skills to produce the required product volume)
2 Availability of reliable and low-cost suppliers that can deliver needed volumes of the entities with the required quality requirements
3 Availability of capital required for internal production of the needed entities 4 Need to maintain confidentiality of the competitive information on future
product designs or specialized knowledge on some unique processes needed to produce certain entities within the organization to retain competitive advantage
Many organizations organize their total costs into two major categories, namely, fixed costs and variable costs The fixed costs do not increase or decrease with the output quantity (ie, production volumes) of products produced The variable costs are a direct function of the output quantities (ie, the variable costs increase with an increase in output quantity) The nonrecurring costs are generally treated as the fixed costs and the recurring costs are the variable costs The cost of any output is the sum of the fixed and the variable costs The manufacturers should seek to reduce both the fixed and variable costs However, decreasing the unit cost of an output through increasing product volumes is a much sought-after approach as it spreads the fixed costs over a larger volume Developing and/or using common components that can be shared across a larger number of products (or models and hence increasing their component volumes) can reduce the total cost of the components substantially Table 81 shows the effect of product volume on three products, namely, A, B, and C The product cost was computed by using the following simple formula:
Product cost Fixed costs
Product volume =
+ Variable cost per unit Table 81 shows that the unit cost of product A will decrease from $15,000 to
$500100 as the product volume is increased from 100 units to 1 million units Similarly, the unit cost of product B can decrease from $10500 to $501 for product volumes of 100 units to 1 million units, respectively This shows the importance and power of increasing the product volume in reducing the cost of products
TABLE 8.1 Effect of Product Volume on Product Cost
To ensure that the product being designed will meet the customer needs and satisfy the customers, the organization must perform a number of tasks such as conduct a number of checks, analyses, and evaluations; implement quality control process; honor warranty; and repair or replace failed components The costs incurred for such tasks can be grouped into the following four categories (Campanella, 1990):
1 Prevention costs: These costs are associated with the information gathered and analyses conducted to assure that right product is being designed and ensure that the product will meet its customer needs Some examples of the activities involved in this cost category are market research, benchmarking, product performance analyses, design reviews, supplier reviews and ratings, supplier quality planning, training, quality administration, and process validations Chapters 9 and 14 provide more information on quality issues and techniques
2 Appraisal costs: These costs are related to various appraisals or evaluations conducted to ensure that incoming components and materials and outgoing products will meet quality requirements Examples of the activities involved in this cost category are purchasing appraisals, maintenance of laboratories with calibrated state-of-the-art testing equipment and trained staff, measurements and tests, inspections, and plant quality audits
3 Internal failure costs: These costs are incurred at the manufacturer’s facilities due to product failures during manufacturing, defects observed during testing, troubleshooting and analyzing the failures, rejected and scrapped units (or components), rework, repairs, and so forth
4 External failure costs: These costs are incurred after the product leaves the manufacturer’s facilities and is sold to the customers The costs are due to handling customer complaints, managing returned products, sending replacements, repairing failed products, product recalls, product litigations and liabilities, penalties, lost sales, and so forth
The manufacturing costs can be categorized into the following four broad categories:
1 Costs of parts (components) and subassemblies purchased from the suppliers: These costs include expenses incurred in purchasing components, standard fasteners, subassemblies, and so on, from various suppliers
2 Costs of parts manufactured internally within the product manufacturer’s plants: These costs are associated with fixed costs for tooling, equipment, and facilities and variable costs associated with purchasing raw materials, expendable tools, processing and operating machines/equipment, inspection, direct labor, coolants, lubricants, utilities, and so on
3 Assembly costs: These include assembly and inspection related to fixed and variable costs of equipment operation (eg, fixed costs of fixtures and robots
needed for assembly; variable costs to program and run the assembly robots and/or equipment), direct labor costs, and associated employee benefits
4 Overhead costs: These costs include expenses related to indirect labor (eg, administrative and plant maintenance personnel and costs of their benefits), employee training, utilities, insurance, property taxes, equipment dismantling, and so on
It should be noted that all of the preceding four categories have fixed and variable cost components
The safety-related costs can be categorized into the following four broad categories (also see Chapter 11):
1 Accident prevention costs: These costs represent amounts spent by the organization to avoid or prevent accidents and injuries (or adverse health effects) from occurring The accident prevention activities typically include safety analyses (eg, conducting hazard analysis, failure modes, and effects analyses); incorporating engineering changes (eg, process and equipment improvements to reduce probability of accidents, adding safety devices); conducting safety evaluations/tests and safety reviews; providing safety training to employees; providing/installing and maintaining protection devices (eg, hard hats, safety glasses, lockout devices, antislip walking surfaces, and providing lifting devices to reduce back injuries) Chapters 11 and 16 provide more information on the accident prevention issues and techniques
2 Costs due to accidents: These costs include losses that an organization incurs due to accidents The accidents can involve injuries (eg, medical costs, temporary disability-related costs until an injured person returns to his/her regular job, and costs due to permanent disability), loss of life, damage to facilities and equipment, and/or work stoppages It should be noted that accident costs are almost always underestimated due to many unreported or unaccounted costs (eg, loss of production or temporary work slowdowns due to accidents, retraining of replacement workers) In some cases, the incidental costs of accidents have been estimated to be four times as great as the directly accounted costs
3 Insurance costs: This category includes costs to insure (ie, insurance premiums and workers compensation costs) against losses due to accidents and injuries, fatalities, and property damage (ie, repairing or replacing damaged equipment)
4 Product liability costs: These are costs incurred in the product liability cases resulting from injuries caused by the product due to defects in the products These costs include costs to defend cases (eg, fees charged by lawyers and experts) and compensation or settlement charges paid to the plaintiff, penalties, and fines (See Chapter 11 for more information on product liability)
These costs are incurred after the decision is made to terminate the production of the product These costs include the following:
1 Costs of selling discontinued products at discounted prices or with sales incentives
2 Costs of lost sales of new products due to some customers purchasing the discontinued products at the discounted prices
3 Plant and equipment write-down costs 4 Plant shutdown, equipment removal, and disposal costs 5 Environmental cleanup and site restoration costs 6 Materials recycling costs 7 Continual service, production, and distribution of spare parts for products
in service until they are disposed
These costs include total of all the aforementioned costs from product conception to end of production and disposal (or recycling) of all products from service and facilities closing
As the costs are incurred over time, in determining all the aforementioned costs, the effect of time due to factors such as interest rate, inflation rate, and fluctuations in currency exchange rates (if applicable) must be taken into account Similarly, since the revenues are generated over the selling periods of the products and payments are received over time, the effects of changes in interest rates, inflation, and currency exchange rates should also be considered
Most complex product programs extend over many years Therefore, cost computations need to consider the effects of interest and inflation The computations can be made by using the following variables and the formula
Let P = value at a time assumed to be the present i = combined annual interest and inflation rate
= ir + if ir = annual interest rate if = annual inflation rate n = number of annual interest periods F = future value after n periods
With the annual compounding of the combined interest and inflation, the relationship between P and F is as follows (Blanchard and Fabrycky, 2011):
F 1 or
1 = + =
+
P i P F i
( ) ( )
Using the preceding formula, the value of $100 today will be $128 in 5 years at 5% combined annual interest and inflation rate (Note: 128 = 100 (1 + 005)5) This means that $128 spent 5 years from now will be equivalent to $100 today assuming 5% rate of combined interest and inflation
For a program extending over many periods, the present value of revenues minus the costs can be computed for each period and the values for each period can be summed over the entire duration of the program to obtain present value of the cumulative cash flow The present value is generally computed at the beginning of the product program to provide the management the estimate of cash flow over the life of the program
This section presents a simplified cash flow analysis of an automotive product program The analysis covers a 64-month period-from 40 months before Job #1 to 24 months after Job #1 In the automotive industry, Job #1 represents time at which first production vehicle rolls out of the assembly plant
The assumptions used for the costs and revenue computations were as follows: Program milestones:
1 Program kicks off at −40 months (−40 months represents 40 months before Job #1)
2 Product development team formation begins at −395 months 3 Strategic intent confirmation at −34 months 4 Hard-points freeze at −29 months 5 Feasibility sign-off at −275 months 6 Program approval at −26 months 7 Surface freeze at −24 months 8 Appearance approval at −19 months 9 Early prototype vehicles available for testing at −14 months 10 Early production prototype vehicles available for testing at −9 months 11 Final prototype vehicles available at −5 months 12 Final sign-off at −2 months 13 Job #1 at 0 month 14 Postproduction at 24 months after Job #1
The costs estimates used for the preceding illustration are provided in Table 81
Head count cost (ie, salary plus benefits) = $8000/month Manufacturing personnel cost = $30/h Manufacturing plant operation = 2 shifts/day, 25 days/month Purchased parts and plant overhead costs = $8000/vehicle Marketing cost = $2000/vehicle Vehicle sale price = $24,000
Figure 83 presents the cumulative cash flow curve for the vehicle program The cumulative cash curve was obtained by summing all the costs (negative values)
and revenues from product sales (positive values) The spreadsheet used to compute the costs can be downloaded from the website of this book (see: https://www crcpresscom/search/results/1/?kw=bhise&category=ENG&x=12&y=9 for file called “Program Cost Flow by Months”) Table 82 provides an output of the program It should be noted that the cost and the revenue values in Figure 83 and Table 82 were considered without any effects of interest and inflation
Table 82 shows that the point of maximum cumulative expenditure occurred at Job #1 (at month 0) The maximum cumulative expenditure in the program was $164 billion The maximum cash flow at 24 months after Job #1 was $616 billion
Another useful Excel spreadsheet for computation of program costs and revenues by quarters is also provided in the website of this book
The cost curve presented in Figure 83 when converted into present value at the beginning of the program at 10% combined annual interest and inflation rate will be lower Figure 84 shows both curves, first curve (the curve in Figure 83) that assumes zero interest and zero inflation and the second curve with 10% combined annual effects of interest and inflation The second curve was obtained by summing the present value of revenue minus the costs for each month (period) from the beginning of the program The website of this book (https://wwwcrcpresscom/ search/results/1/?kw=bhise&category=ENG&x=12&y=9) contains a downloadable Excel spreadsheet illustrating a “V” model of an automotive product development It shows a Gantt chart with various activities and cost estimates by month (shown in Figures 83 and 84)
Figure 84 thus shows that depending on the magnitude of the interest and inflection rates, their effects can introduce very significant differences in the estimated costs and revenues of the program The effect will be different at different base period at which the present value of the program will be computed
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The traditional approach in determining the product price is to add all the costs per unit (of product) and required profit per unit to come up with the price for the unit This approach generally does not provide strong incentives to reduce costs as the profits for the manufacturer are assured The approach also assumes that customers are willing to pay the price (ie, it is the producer’s market-the producer sets the price without regard to the customers) This approach has worked well in the past when the customers had a very limited number of choices in the market for selecting a product
In this approach, the producer determines the lowest price based on the prices of other similar products sold in the markets, then subtracts his dealer margin and expected profit, and the balance is considered as the target cost for producing the product The target cost is then divided and assigned to each entity in the product And all internal and external suppliers are asked to meet their respective target costs by improving the product design, manufacturing processes, and operations For example, in determining the price of a low-cost vehicle for the US market, Hussain and Randive (2011) surveyed the prices of low-cost vehicles sold in the US market They found that the lowest price of small economy vehicles sold in the US market during 2010-2011 was about $10,000 Thus, they set the target manufacturer’s retail price of $8000 (20% below the lowest priced sold in the US market) Assuming the dealer margin of 10% ($800) and the manufacturer’s profit of $200 (278% of factory cost), they set the target cost at $7000 per vehicle and then proceeded to develop
target cost for each vehicle system (see Figure 85) This assumes that they challenged their suppliers to deliver the systems at the target costs This approach was also used during the development of the Tata Nano, the lowest cost vehicle sold for about INR 100,000 (USD 2000) in India (Hussain and Randive, 2011)
Many different software applications are available to perform product life cycle costing and to create various reports (eg, by systems, program phases, months; comparisons with budgeted costs) Many of the applications are integrated with other functions such as management information systems, product planning, and supply chain management The software systems are used for production scheduling, component ordering, inventory control, product control, shop floor management, cost accounting, and so forth Some examples of such software systems are manufacturing resource planning (MRP) and enterprise resource planning (ERP) The software systems are available from a number of developers (eg, SAP, Oracle, Microsoft, EPICOR, and Sage)
Programs and projects involving development of complex products encounter a number of developmental problems and challenges Many problems involve trade-offs between different attribute requirements and trade-offs between a number of design and manufacturing issues The costs and timings are directly affected by how the
trade-off issues are resolved (see Chapter 3) The design teams deal with these issues constantly during various design stages Many of these problems are not sufficiently known in the early stages and hence the budgets prepared during the early stages need to be constantly reviewed and some changes in target costs and timings may need to be incorporated in subsequent budgets and milestones in the program
Bringing the product to the market at the right time and right price are both very important Therefore, costs and timings are important parameters used by the program and project managers to evaluate and control their progress Both these parameters affect profitability of the organization and its competitive position in the market Since the initial estimates of these parameters made during the early planning stages are usually not very accurate, they need to be adjusted to account for problems and challenges encountered during the program Costs and time overruns are universally hated by the management On the contrary, completions of the program before its planned end-date and under its budget are reasons for celebrations of the great accomplishments and deserve special recognition of the program teams
