Paper P2 Performance Management: Value Analysis, Value Engineering and Functional Analysis Are Cost-Reduction Techniques That Are Closely Related to Target Costing. They Have Similar Characteristics, Yet Differ in Fundamental Ways

By Whittle, Norwood | Financial Management (UK), July-August 2011 | Go to article overview

Paper P2 Performance Management: Value Analysis, Value Engineering and Functional Analysis Are Cost-Reduction Techniques That Are Closely Related to Target Costing. They Have Similar Characteristics, Yet Differ in Fundamental Ways


Whittle, Norwood, Financial Management (UK)


As I explained in my April article, target costing is designed to reduce the life-cycle costs of a new product - while also ensuring that it satisfies quality, reliability and other consumer require-ments - by examining all possible ideas for cutting costs at the planning, R&D and prototyping phases of its production. But target costing is not only a cost-reduction technique; it's also part of a comprehensive strategic profit management system. It's an important starting point, too, because it opens the door to other techniques, particularly value analysis, value engineering and functional analysis.

The target cost is calculated by deducting the target profit from a selling price based on customers' views. Value analysis, value engineering and functional analysis are used to change production methods and/or reduce expected costs so that this target is met.

The traditional approach to pricing is based on developing a product, determining its expected cost based on the expected volume and then setting a selling price that would recover all indirect costs and generate enough profit to satisfy business objectives. With target costing, on the other hand, the company develops a product and then determines the price that customers are willing to pay. The desired profit margin is deducted from the price, leaving a figure that represents the maximum total cost. The company then has to ensure that it can make the product for this amount. If it cannot achieve that figure, it won't make the product. But life is not this simple, of course, so the following factors also need to be considered:

* The effects of Kaizen costing techniques could gradually reduce the product's cost, meaning that the selling price could be reduced over time.

* Conventional cost-reduction techniques should have an effect.

* Cost reductions and efficiencies would naturally result from an increase in volumes.

* Learning-curve effects could apply.

A company may press ahead with production for such reasons, even though the target cost is below the current estimated attainable cost. In this case the firm would be confident that cost reductions would accrue as a result of the factors listed above, and it might introduce better recruitment and training methods, use lower-cost labour, buy some components rather than make them, and so on.

Value analysis and value engineering

Such cost reductions will not take place without a systematic approach to achieving them, one of which is value analysis. This is a technique that reviews the material composition of a product and production design so that modifications can be made that do not reduce the product's value to consumers. CIMA's official definition is that value analysis is a "systematic interdisciplinary examination of factors affecting the cost of a product or service, in order to devise means of achieving the specified purpose most economically at the required standard of quality and reliability". So the value and quality of the product must be retained or improved at a reduced cost.

Value engineering is closely related to target costing, because it's about avoiding or reducing costs before the production phase. Value analysis is concerned with cost avoidance or cost reduction du ring production, but both adopt the same approach in undertaking a complete audit of the product. CIMA's official definition of value engineering is that it is the "redesign of an activity, product or service so that value to the customer is enhanced while costs are reduced (or at least increased by less than the resulting price increase)".

A value analysis exercise might involve considering a series of questions, including: could a different (cheaper) material be used that is better than the material currently in use? Could a different (cheaper) grade of labour complete the manual tasks? Could the use of material components be standardised to facilitate longer production runs if manufactured internally, or to provide bulk-buying benefits if purchased? …

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