Value Engineering, Cost Incurrence, and Locked-In Costs
Learning Objective 4 Apply the concepts of cost incurrence and locked-in costs
when resources are consumed
when resources are committed to be incurred in the future
To implement value engineering, managers distinguish value-added activities and costs from non-value-added activities and costs. A value-added cost is a cost that, if eliminated, would reduce the actual or perceived value or utility (usefulness) customers experience from using the product or service. In the Provalue example, value-added costs are specific product features and attributes desired by customers, such as reliability, adequate memory, preloaded software, and prompt customer service.
A non-value-added cost is a cost that, if eliminated, would not reduce the actual or perceived value or utility (usefulness) customers gain from using the product or service. Examples of non-value-added costs are the costs of defective products and machine breakdowns. Companies seek to minimize non-value-added costs because they do not provide benefits to customers.
Activities and costs do not always fall neatly into value-added or non-value-added categories, so managers often have to apply judgment to classify costs. Several costs, such as supervision and production control, have both value-added and non-value-added components. When in doubt, some managers prefer to classify costs as non-value-added to focus organizational attention on cost reduction. The risk with this approach is that an organization may cut some costs that are value-adding, leading to poor product quality and customer experiences.
Despite these difficult gray areas, managers find it useful to distinguish value-added from non-value-added costs for value engineering. In the Provalue example, direct materials, direct manufacturing labor, and direct machining costs are value-added costs; ordering, receiving, testing, and inspection costs have both value-added and non-value-added components; and rework costs are non-value-added costs.
Astel’s managers next distinguish cost incurrence from locked-in costs. Cost incurrence describes when a resource is consumed (or a benefit is forgone) to meet a specific objective. Costing systems measure cost incurrence. For example, Astel recognizes direct material costs of Provalue only when Provalue is assembled and sold. But Provalue’s direct material cost per unit is locked in, or designed in, much earlier, when product designers choose the specific components in Provalue. Locked-in costs, or designed-in costs, are costs that have not yet been incurred, but will be incurred in the future based on decisions that have already been made.
The best opportunity to manage costs is before they are locked in. Astel’s managers model the effect of different product design choices on non-value-added costs such as scrap and rework that will only be incurred later during manufacturing and try to minimize these costs by making wise design choices.
Exhibit 14-4 illustrates the locked-in cost curve and the cost-incurrence curve for Provalue. The bottom curve uses information from Exhibit 14-3 to plot the cumulative cost per unit incurred in different business functions of the value chain. The top curve plots cumulative locked-in costs. (The specific numbers underlying this curve are not presented.) Total cumulative cost per unit for both curves is $900, but there is wide divergence between locked-in costs and costs incurred. For example, product design decisions lock in more than of the unit cost of Provalue (including costs of direct materials, ordering, testing, rework, distribution, and customer service), whereas they only account for about of the unit cost incurred!
Exhibit 14-4
Pattern of Cost Incurrence and Locked-In Costs for Provalue
Y-axis shows the cumulative costs per unit ranging from $0 to $900 with an increment of $60 and X-axis shows various value-chain functions such as R and D and design, manufacturing, marketing, distribution, and customer service.
The details of cost-incurrence curve are as follows. All values are approximate here.
R and D and design: The cumulative costs per unit are $40
Manufacturing: The cumulative costs per unit are $680
Marketing, distribution, and customer service: The cumulative costs per unit are $180
The details of locked-in cost curve are as follows. All values are approximate here.
R and D and design: The cumulative costs per unit are $780
Manufacturing: The cumulative costs per unit are $90
Marketing, distribution, and customer service: The cumulative costs per unit are $30.
Value-Chain Analysis and Cross-Functional Teams
A cross-functional value-engineering team consisting of marketing managers, product designers, manufacturing engineers, purchasing managers, suppliers, dealers, and management accountants redesign Provalue—called Provalue II—to reduce costs while retaining features that customers value. Some of the team’s ideas are listed below:
Use a simpler, more reliable motherboard without complex features to reduce manufacturing and repair costs.
Snap-fit rather than solder parts together to decrease direct manufacturing labor-hours and related costs.
Use fewer components to decrease ordering, receiving, testing, and inspection costs.
Make Provalue lighter and smaller to reduce distribution and packaging costs.
Management accountants use their understanding of the value chain to estimate cost savings.
The team focuses on design decisions to reduce costs before costs get locked in. However, not all costs are locked in at the design stage. Managers also use kaizen, or continuous improvement techniques, to reduce the time it takes to complete a task, eliminate waste, and improve operating efficiency and productivity. To summarize, the key steps in value-engineering are as follows:
Understanding customer requirements and value-added and non-value-added costs.
Anticipating how costs are locked in before they are incurred.
Using cross-functional teams to redesign products and processes to reduce costs while meeting customer needs.
