AirTech was established in 2000 to manufacture and distribute quality ventilation equipment targeted at original equipment manufacturers for industrial and commercial fans. Over the ensuing years AirTech has built its brand on a reputation for superior products, dependable service, competitive pricing, and engineering expertise focused on design of custom fans. By early 2008 AirTech had grown to US$20 million in revenues and launched an aggressive growth plan expanding plant and installing a state-of-the-art automated warehousing facility. Within a year the recession hit and sales stagnated for four years. In early 2013 in search of growth AirTech entered the residential ventilation market with standard fans and blowers for bathroom exhaust, kitchen range hoods and laundry ventilation. Instead of selling to original equipment manufacturers, these fans and blowers were sold to major wholesalers for distribution in Canada and the US. This initiative had limited success. But, as a result of their expansion into the residential sector and AirTech's reputation for quality ventilation solutions, a major US retailer in the home improvement and building market, Home Depot, recently approached AirTech to design a heavy duty yet attractive ceiling fan for use in basement renovations where air circulation is often poor. The fan would be sold by Home Depot in the US exclusively under its own brand. From an initial meeting with Home Depot's product category manager, Carlos Batista, AirTech's Marketing VP, Sam Carlyle, learned that the retail price for this ceiling fan should be about US$150 and that customers would expect the product to carry a one year warranty. Carlos explained Home Depot's approach to warranty claims to Sam, "We simply replace all products returned in the warranty period with new products -- from you at no cost to us -- without any question. We will dispose of the products, recycling as much as we can. If you'd like to have them back, we'll ship them to you, but you pick up the tab for that. Based on past experience with products in this line, you should expect a 3% warranty return rate." Batista revealed that their marketing group had surveyed customer requirements for the fan's features and functionality. The information from the survey is provided in Exhibit 1. Batista told Sam, "Home Depot requires a 30% gross profit margin. We expect you to pay for all transportation, customs and handling costs. We handle our own internal distribution, so that's not a worry to you in this contract. We've estimated demand and are willing to offer a contract AIRTECH-A 2 for 40,000 of these units over the next 2 years. We may need up to 15% more per year depending on how the economy improves. At the end of the two year contract, we'll both reevaluate the contract, but it's likely that redesign will be required because we'll attract competition. I think that we'll acquire the units in lots of 10,000, which should reduce your transportation, handling and customs costs. We'd like to receive delivery at the end of quarters one and three. Given that we're ordering half a year's requirements and have to carry the inventory, we'll pay you for our purchases 90 days after delivery. That way we're both sharing some of the carrying costs." Sam expressed interest in the opportunity and promised to get back to Carlos within the next two weeks. After returning from the meeting with Batista, Sam Carlyle shared Home Depot's requirements with AirTech's Product Development Director, Arjun Patel, stressing that the company had to meet customer requirements while not sacrificing AirTech's reputation for quality. Sam told Arjun, "Boy we have to worry about everyone's margins in this deal-- Home Depot has a 30% gross profit margin requirement and I'm held responsible for a 7% return on sales for the residential line. That 7% is after all the products in the line share marketing and administration costs. I expect the charge for marketing and administration cost in total to be the same as last year, about 20% of AirTech's selling price. Although this may sound like an arbitrary allocation we have, if fact, done research on recent new product releases and found that incremental spending for the initial marketing materials and then the follow-on sales initiatives over the life of the product are real. Also, we think that the 3% warranty return rate is a bit high given our focus on quality, but we do expect it be about $4 per unit. With all these complexities on this order do you think we can develop this product profitably? On one hand I am worried about diluting our brand with this Home Depot deal, but on the other it may be an opportunity to expand sales into a new market." Arjun took in Sam's information and requested a day or two to think about it and gather a little information. After a few days of investigation, Arjun and Sam met again to share what they had learned. Arjun told Sam, "After brainstorming with my team, we decided that this basement fan could use the same technology and production facilities that we use on our laundry and bath ventilation fans. That line is new and so far, competitors haven't gotten anything out there that is as good as our products. We feel that we've got another two years before that happens. But basement fans pose special problems and move lots more air than bath and laundry fans. So my group will need a US$200,000 budget for designing and testing for basement conditions." Sam acknowledged Arjun's budget and replied, "I've done a little digging into the cost of transportation, handling and customs; those costs should total US$50,000 per shipment. I've tested out the payment terms with Finance and found out that we're generating enough cash flow to manage the 90 days without difficulty, but my product group will be charged 1% of the product's sales revenue for carrying charges, so that increases my return on sales from 7 to 8% to cover it. My real question is whether we can design to customer specifications and give everyone the margin they need." AIRTECH-A 3 Arjun had recently attended an executive education program on financial analysis of entrepreneurial ideas and learned about a concept, target costing, that he thought might be tried on this new product. As he explained to Sam, "What I learned is that target costing is a product innovation and profit management process. It's based on the notion that both the selling price for a product and the required return on sales are determined by others and are not under our control. That's just like this new product proposed by Home Depot. Target costing manages what you can control, namely, the cost of the product. It has tools that help design products at costs that maintain margins, satisfy customers, and can be manufactured. If we apply target costing principles, hopefully we'll be able to sell this new fan to Home Depot." "Okay," Sam replied. "I'm game to try this target costing process if it's not going to slow us down. Do you have any material on it that you can share?" "Sure," Arjun replied, "I'll make you a copy of the reading I got in my training course." Arjun sent him a copy of the Target Costing Note.

Sam and Arjun created a target costing team to develop a first look VE analysis. To round out their team, they added members from manufacturing and finance. Sam volunteered to lead the team since he had primary product responsibility; he would interface with Carlos Batista from Home Depot to make sure that the voice of the customer was in the process at every critical juncture. Hayden Wayne, from Finance, would supply costing details and financially model ideas so the team would know where they were relative to their target. Depending on whether or not it looked like the product could be successfully designed, the team would later involve important suppliers. Learning that the fan was to be produced on the same production lines as the laundry and bath ventilation fans, Alina Baskov, the representative from manufacturing, checked for capacity. She reported, "We have excess capacity on two of our assembly lines plus a standby line as well as in the warehouse, so we have enough capacity to produce 20,000 units per year without investing in a new line or storage facilities. The only issue is that we have to work this product into our normal schedule rather than producing 10,000 units all at once, but I think I can find time in Quarter 1 and 3 to run these products. We might have to increase headcount for setup, inspection, and assembly, but the work can be done in our one shift operations. These jobs aren't that highly skilled, and there are lots of full and part time workers out there, so our existing cost structure should hold." Sam was relieved and left the meeting thinking, "It is helpful that this opportunity with require no investment." Alina and Arjun decided to work together to test the design for manufacturability and report to the group by the end of the week. Arjun supplied the first look fan design that his team created to Alina. "The fan isn't that complex," Arjun commented, "it's fairly normal; I've attached a bill of materials (see Exhibit 1.) Although we debated using three 52 inch, more expensive blades, we've settled on four, 44 inch blades each attached to a hub with a heavy duty blade mount. A set consisting of one blade, one hub mount and necessary screws should cost us around $3. The electric motor is important, and we've identified a model we think is appropriate. With our specifications, it should cost us about $16, but we also have to have a sleek housing and a sturdy hub that AIRTECH-B 2 should total about $2. Then there is a ceiling mount shaft subassembly and extension lever to adjust height of the fan which should cost about $6.50. What's important is that our suppliers produce these to our exact specifications, because that's what gives us quality parts to assemble. Then of course our assembly process has to be flawless, so I'm counting on you to create the quality that we're known for." Working with Arjun's preliminary design, the production budget for other products at their normal batch sizes of 60-100 units and the resulting excess capacity, Alina concluded that the fans could be assembled in smaller batches of 40 utilizing short idle time slots and shipped to arrive at the end of quarters 1 and 3. Studying the design and planning her production layout, Alina decided that each fan would follow a standard assembly process where the hub mounts are first attached to the blades which are then attached to the hub. The shaft and extension lever is then attached to this fan assembly and connected to the motor and housing. The one electrical test is done just prior to packaging the assembled unit for shipment. Arjun and Alina met with Hayden to gather cost data. Hayden supplied results from a recently completed activity based costing analysis for AirTech's manufacturing facility that produced the residential fan line. (See Exhibit 2.) As he told Arjun and Alina, "We've decided to cost five major activities, scheduling and setup for the production lines, assembling products, testing and inspecting products, managing materials, which includes purchasing, warehousing and moving materials, and managing plant operations. We've kept our analysis fairly simple. For instance, when tracing the occupancy costs to the activities you will notice that only assembly and the warehouse - manage materials activity - were charged. Yes, test & inspect did occupy some space but it was minimal so we ignored to simplify. We did much the same with the depreciation charges. We'll use the driver rates from this analysis along with the cost of materials that you've collected, Arjun, to estimate the cost of your design."

Exhibit 1 - Summary of Customer Survey Results Feature Survey Score (10 point scale with 10 high and 1 low importance) Silent operation 9 Variable speed 7 Low maintenance 6 Appearance 5Air TechA S Estimate % Unit base for 9 Per unit Amount Retail Price 150.00 less Home Depot margin 30% Retail price 45.00 Annual Vol Amual rev AirTech Selling Price S 105.00 20000 $ 2, 100,000 price x volume Design cost $ 200,000 40,000 $ 5.00 5.00 Warranty cost S 4.00 4.00 4.00 Mkt& Seling 20% Air Tech Price $ 21.00 21.00 Freight $ 50,000 10,000 $ 5.00 5.00 Interest 1% Air Tech Price $ 1.05 1.05 NBT Required profit (ROS) 7% Air Tech Price $ 7.35 7.35 5 147,000 Amual revenuex target ROS Target Manufacturing Cost 61.60Step 7: Compute the projected cost of a fan Activity Cost Count Cost Total annual cost: Batches S 300.00 500 $ 150,000 Assembly S 0.386 700,000 270,233 Test S 5.000 20,000 100,000 Manage materials S 20.988 5,000 104,938 Manage plant operations S 0.140 80,000 11,200 Total indirect costs 636,371 Indirect cost per unit (divide by 20,000 units per year) S 31.82 Add Direct material costs from BOM S 37.50 Estimated total cost S 69.32 Target cost 61.60 Gap 7.72 Required reduction 11.1%Exhibit 1 - Bill of Materials (10 unique parts) Description Part Part Unit Total Number Count Cost per Fan Blades FB44AC 4 $2.00 $8.00 Blade Hub Attachments HA 33 4 $0.40 $1.60 Screw/washer set ( 3 sets for SWS5 12 $0. 10 $1.20 each blade to attach Blade to Blade Hub Attachment) Screw/washer set (2 sets for each SWS3 8 $0.15 $1.20 blade to attach each blade hub attachment to hub) Mount/shaft/wire assembly SM15 1 $5.00 $5.00 Shaft extension lever SE30 1 $1.50 $1.50 Motor MOT8 1 $15.50 $15.50 Screw/washer set (set of 2 to SWS1 2 $0.25 $0.50 attach assembly to electrical box) Hub & Housing HUB5 1 $2.00 $2.00 Packing materials PKG12 1 $1.00 $1.00 Total 35 $37.50Exhibit 2 - Activities & Driver Rates Activity Cost Driver Rate (rounded) Scheduling/ setup of # batches produced $300 per batch production lines Assembly # parts $.40 per part Test/inspect subcomponents # of inspections/tests $5.00 per inspection/test & product Manage materials (purchase, # unique parts times number $21.00 per driver warehouse & move) of batches Manage plant operations # unique production steps $.14 per unique stepExhibit 2 (continued) - Activity Cost Detail Step 1: Identify the activities Scheduling/Set-up of production line Assembly Test/Inspect Manage Materials Manage Plant Operations Step 2: Identify Resource Data Amount (000s) DL $ 5,100 Supplies 800 Depreciation 3,000 Occupancy 2,000 Supervision 56 Total 10,956 Step 3 & 4: Select resource drivers & cost the activities Manage Schedule/ Test/ Manage Plant Cost (000s) Set-up Assembly Inspect Materials Operations DL Direct $ 5,100 300 4,300 300 200 Supplies Direct 800 0 500 300 Depreciation Direct 3,000 2,000 0 1,000 Occupancy Sq Ft 2,000 1.500 0 500 0 Supervision H/C 56 56 Total 10,956 $300 $8,300 $600 $1,700 $56 Manage Schedule/ Test/ Manage Plant Step 5: Identify Activity Cost Drivers (000s) Set-up Assembly Inspect Materials Operations # of Batches # of individual parts/components 21,500 # of inspections 120 # of unique parts x # of batches 81 # of unique production steps 400 Step 6: Compute activity cost driver rates $ 300.00 $ 0.386 $ 5.000 $ 20.988 $ 0.140