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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.

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?

* Four aspects of a product's or service's value can be considered in the analysis: o Cost value: the cost of making and selling it.

* Exchange value: the price that customers are prepared to pay for it.

* Use value: the purpose it fulfils.

* Esteem value: the prestige that customers attach to it.

* For example, if some customers simply need something to sit on, they will be unwilling to pay for a reclining leather chair, since they simply require the product's use value. But other customers will be prepared to pay a premium price for a luxury item in return for its esteem value.

Cost reductions will result if the company adopts a systematic approach after conducting the value analysis. Usually the firm will establish a value analysis team that may then go through the following seven-step process, which is adapted from BPP Professional Education's P2 study text:

* Step one: choosing the product or service to be studied. The product should be one that accounts for a high proportion of the organisation's costs, since the biggest savings should be obtained from high-cost areas. The choice should also consider the life-cycle stage of the product, since an item reaching the end of its marketable life is unlikely to offer scope for substantial savings.

* Step two: obtaining and recording information. Questions to consider here will include: what is the product or service supposed to do? Is it succeeding? Are there alternative ways of providing it? How much would these other options cost?

* Step three: analysing the information and evaluating the product. Every aspect of the product or service should be included. Any cost savings must be achieved without losing either use value or esteem value. (Or at least the savings must exceed any loss in value suffered, so customers would then have to be compensated for the loss of use or esteem value in the form of a lower price.) Questions for the analysis stage might be: are all the parts necessary? Can the parts be obtained or made at a lower cost? Can standardised parts be used? Does the value provided by each feature justify its cost?

* Step four: considering alternatives. A range of options may be devised, including ideas for eliminating unnecessary parts or standardising certain components or features.

* Step five: comparing the costs (and other aspects of value) of each option, and choosing the lowest-cost alternative.

* Step six: recommending the preferred option for management approval.

* Step seven: implementing and reviewing the changes. The value analysis team should assess how its recommendations have been implemented and, where appropriate, modify the new product or production method in the light of its findings.

A company using the value analysis approach should reap huge benefits, including: [R] A reduction in cost, but not quality.

* An improvement in quality that may attract more customers or enable the company to increase the product's selling price.

* An increase in sales that may lead to economies of scale and either an increase in profit or a reduction in selling price.

* An increase in sales that may lead to economies of scale and either an increase in profit or a reduction in selling price.

There is no single approach to value analysis that fits all situations. Companies operate in dynamic environments and they need to be able to accommodate the emergence of new products, competitors and economic circumstances. Value analysis is simply one of the many tools available to companies seeking to balancing cost, price and profit.

Functional analysis

This approach has similarities to value engineering in that it's applied during the development stage of a product or service, but, as its name suggests, it uses the functions of the product as the basis for cost management. Functional analysis aims to increase profits by trying to reduce costs and/or by cost-effectively adding new features that are so attractive to customers that the product becomes more profitable. CIMA's official definition states that it is "an analysis of the relationship between product functions, their perceived value to the customer and their cost provision".

Consider an example of functional analysis from my time with a company at the forefront of designing, making and selling telephones. When a new phone was in development, the marketing team would conduct a pre-production target costing exercise to establish what consumers would be willing to pay for it. Working backwards, the firm could then establish a target cost. The next stage was a functional analysis that listed everything the product could do, followed by a more detailed investigation to establish the importance that consumers attached to each feature. It was pointless including functions that people didn't value, wouldn't use and weren't prepared to pay for. At the end of the exercise, its unnecessary features were removed and an overall target cost was calculated. In this way, the company was establishing a use value rather than simply catering for the few people who were ready to pay more for the phone's esteem value.

As with value analysis, functional analysis requires a systematic approach. The technique could involve the following nine steps, again adapted from the BPP study text for P2:

* Step one: choose what to analyse (product, service or overhead area). If it's not a new product, a high-volume product with a complex design and relatively large manufacturing cost is often an ideal candidate. Other selection criteria might include an apparently high cost, a low yield rate, a manufacturing problem or a need for a more compact design. The chosen product will determine the objective of the analysis exercise - eg, reduce weight by 25 per cent and reduce cost by 30 per cent while maintaining the same quality.

* Step two: assemble the functional analysis team. Six to eight members will typically be drawn from a range of departments - eg, accounting, production, purchasing, design and marketing.

* Step three: gather information. Include data from both inside the organisation - eg, design, manufacturing and marketing information - and outside it - eg, information about new technologies.

* Step four: define the product's features. Its various functions should be defined using a verb and a noun. For example, according to Contemporaiy Cost Management (Thomson Learning, 1994): "The major function of a propelling ballpoint pen can be described as 'make a mark', but supporting functions are also required, such as 'put colour', 'guide tip' and 'prevent loss'. These in turn may also require their own supporting functions." The features should be classified as basic or secondary in terms of their importance to the product.

* Step five: draw a functional family tree. The features identified in step four should be arranged in a logical order in a family-tree diagram. A table illustrating the relationship between the functions and the parts of the product, as well as relevant existing costs, should also be constructed.

* Step six: evaluate the functions. Estimate the rel ative value of each feature to a total target cost from the customer's point of view, either by using market research or by asking all members of the analysis team to give their values and reach a consensus for each one. This relative value provides a target cost for every function. Those functions for which the actual cost is greater than the assigned target cost should be highlighted as potential problem areas, although the absolute amount of money involved

should also be taken into consideration.

* Step seven: suggest alternatives and compare these with the target cost. Options might include the use of new materials or parts; a change of production method; the introduction of new features (or even products); the modification of functions; the combination of functions; or even the elimination of certain features.

* Step eight: select manufacturing options. Assess the alternatives and choose which to implement.

* Step nine: review the results. An audit of the changes implemented should be conducted promptly and its findings reported to the management team. This should prevent any overoptimistic assessments and provide feedback to inform any future func tional analysis.

A functional analysis will result in a cost-effective design and ultimately increase the firm's competitive advantage. Because 90 per cent of a product's life-cycle cost is determined at the decision stage, it is essential that the tightest control is exercised at the design phase. This can be achieved by subjecting new products to value engineering and functional analysis, and existing products to value analysis.

The three most important messages for companies providing products or services are:

* Do not provide a product or service that customers do not want,

* Do not include features that are not required.

* Do not produce in the hope that people will buy.

To read an unabridged version of this article, which contains further real-life case studies, visit,

Papers E3, F3 and P3

(Enterprise Strategy, Financial Strategy and Performance Strategy) p46

'Target costingis not only a cost-reduction technique; it's also part of a comprehensive strategic profit management system'

'Any cost savings must be achieved without losing either use value or esteem value '

'There is no single approach to value analysis that fits all situations'

'Because 90 per cent of a product's life-cycle cost is determined at the decision stage, it is essential that the tightest control is exercised at the design phase'

Further reading J Avis, Performance Management - CIMA Official Learning System, CIMA Publishing, 2009.


When Toyota developed the Lexus to compete with BMW, Jaguar and Mercedes-Benz in the luxury car market, it applied two key techniques to its product: reverse engineering and target costing. In essence, it sought to make a car with the features of a BMW 7 series at the lower price of a BMW 5 series. Cost was the dominant design parameter that shaped the development of the Lexus - as it was later with Nissan's Infiniti.

Mercedes-Benz, one of the competitors that lost market share as a result of Toyota's strategy, responded by acknowledging that its cars were over-engineered and too expensive, and by changing its product development process to determine target product costs from competitive market prices.

Source: J Innes, B Nixon and J Rabinowitz, "Management accounting for design". Management Accounting, September 1997.

By Norwood Whittle FCMA

CI MA course leader at the University of Northampton

and lead marker for 92
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Title Annotation:Study Notes
Author:Whittle, Norwood
Publication:Financial Management (UK)
Date:Jul 1, 2011
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