Reducing Production Costs

To bring its high production costs into line, Olympus developed an aggressive cost-reduction program

that focused on five objectives: to design products that could be manufactured at low cost, to reduce unnecessary expenditures, to improve production engineering, to adopt innovative manufacturing processes, and to shift a significant percentage of production overseas.

Designing High-Quality Products at Low Cost

At the heart of the program to design low-cost products was the firms target costing system. The first

step in setting target costs was to identify the price point at which a new camera model would sell. For most new products, the price point was already established. For example, in 1995 the simplest compact cameras were sold in the United States at the $80 price point, down from $100 in 1991. The actual selling prices for a given camera varied depending on the distribution channel (e.g., mass merchandiser versus specialty store). Thus, cameras at the $80 price point would sell for between approximately $70 and $100. The appropriate price point for a camera was determined by its distinctive feature (e.g., it might be magnification capability of the cameras zoom lens or the cameras small size). The relationship between distinctive features and price points was determined from the competitive analysis and technology review used in the development of the product plan. The product plan thus described cameras only in terms of their distinctive features. Other features were added as the camera design neared completion.

The price point at which a camera with given functionality was sold tended to decrease over time with

improvements in technology. Price points were typically held constant for as long as possible by adding functionality to the cameras offered. Typically, a given type of camera would be introduced at one price point, stay at that price point for several years but with increasing functionality, and then as the functionality of the next higher price point was reached, drop to the next lower price point. The natural outcome of this process was to generate new price points at the low end. For example, the price point for the simplest compact camera was $150 in 1987 and $80 in 1995. At the high end, technology also generated new price points. As the functional gap between the capabilities of compact and SLR cameras closed, it became possible to introduce compact cameras at higher prices. For example, Olympus created a new price point of $300 when it introduced the first compact camera with 3X zoom capability in 1988.

The growing number of price points required camera manufacturers to expand their product offerings

to maintain a full line. The decision to be full-line producers was based on two strongly held beliefs: that Japanese consumers trade up over time and that only by offering a full line could a firm obtain a balanced position in the entire market. A firm trying to compete in only the low end of the market would not have access to the high-end technology that would rapidly come to define the low-end market, and a firm selling only at the high end would not have the loyalty of consumers who were trading up.

The proliferation of products due to the increase in the number of price points was further aggravated

by Olympus decision to introduce multiple models for some price points. This change in strategy was prompted by the observation that market share associated with some price points was considerably larger than others. For high-volume price points, it was possible to identify different clusters of consumer preferences and profitably produce and market cameras designed specifically for those clusters. Under the new strategy, the

number of models introduced at each price point was roughly proportional to the size of the market. Thus, the expected market share of each camera model offered was approximately the same unless it was designed to satisfy a low-volume strategic price point.

Once the price point of a new camera was identified, the free on board (FOB) price was calculated by

subtracting the appropriate margin of the dealers and the U.S. subsidiary plus any import costs, such as freight and import duty. Target costs were established by subtracting the products target margin from its FOB price. The products target cost ratio was calculated by dividing the target cost by the FOB price. Every six months, the divisional manager set guidelines for acceptable cost ratios. These guidelines were developed in tandem with the divisions six-month profit plans. In 1996, the divisional manager had identified the acceptable cost ratios as 85% for Tatsuno manufactured products and 60% for products manufactured overseas.

The target ratio for a given camera was set based on the historical cost ratios of similar cameras, the

anticipated relative strength of competitive products, and the overall market conditions anticipated when the product was launched. Once the target cost ratio was established, it was converted into yen by multiplying it by the target FOB price. This yen-denominated target cost was used in all future comparisons with the estimated cost of production to ensure achievement of the target cost.

As part of the program to design low-cost products, target costs were set assuming aggressive cost

reduction and high quality levels. A target cost system existed prior to 1987, but it was not considered effective. As part of the three-year program to reduce costs, the target cost system was improved and more attention was paid to achieving the targets. Aggressive cost reduction was achieved by applying three rationalization objectives. First, the number of parts in each unit was targeted for reduction. For example, the shutter unit for one class of compact camera was reduced from 105 to 56 pieces, a 47% reduction that led to a 58% decrease in production costs. Second, expensive, labor-intensive, and mechanical adjustment processes were eliminated wherever possible. Finally, metal and glass components were replaced with cheaper plastic ones. For instance, replacing metal components that required milling in an SLR body with plastic ones that could be molded reduced the SLR body costs by 28%. Similarly, replacing three of the glass elements with plastic ones in an eight-element compact camera lens reduced the lens cost by 29%

During the design phase, the anticipated cost ratio of new products was monitored on a frequent

basis, typically two to three times before launch. The FOB price of a new product was sensitive to both market conditions and fluctuations in foreign exchange rates. Olympus sold 70% of its cameras overseas, and the FOB price of a product was the weighted average yen price. Since the FOB price for cameras sold overseas was designated in the appropriate foreign currency, fluctuations in the exchange rates caused the FOB price to change when measured in yen.

If the FOB priced changed sufficiently during the design phase to cause the anticipated cost ratio for

the camera to fall outside the acceptable range by about 10%, then the target cost of the camera was reviewed and usually revised to bring the anticipated cost ratio back into the acceptable range. If the FOB price was falling, the result was a lower target cost that was harder to achieve. If it was rising, the result was higher profits, which were used to increase promotions and advertising fees as well as reduce prices to overseas subsidiaries.

The target cost was based on the price point for the distinctive feature of the camera. Research and

development was responsible for identifying the other features of the camera (e.g., the type of flash and shutter units). Feature identification was an iterative process in which the cost of each new design was estimated and compared to the products target cost. Production engineering developed estimated costs of production in collaboration with production. Research and development reviewed these estimates and revised them as deemed appropriate. Most revisions resulted in lower estimated costs. The research and development group identified additional ways to reduce the cost of the product either through minor product redesign or a more efficient production process.

Approximately 20% of the time, the estimated cost was equal to or less than the target cost, and the

product design could be released for further analysis by the production group at Tatsuno. The other 80% of the

time, further analysis was required by the research and development group. First, marketing was asked if the price point could be increased sufficiently so that the target cost was equal to the estimated cost. If the price could be increased, the product was released to the production group. If the market price could not be increased sufficiently, then the effect of reducing the functionality of the product was explored. Reducing the products functionality decreased its estimated cost to produce. If these reductions were sufficient, the product was released to production.

If it was not possible to raise the price or reduce the production cost enough to reduce the estimated

cost below the target cost, then a life-cycle profitability analysis was performed. In this analysis, the effect of potential cost reductions over the production life of the product was included in the financial analysis of the products profitability. In 1990, Olympus expected to reduce production costs by about 35% across the production lifetime of its products. The product was released if these life-cycle savings were sufficient to make the products overall profitability acceptable. If the estimated costs were still too high, even with these additional cost savings included, the product was abandoned unless some strategic reason for keeping the product could be identified. Such considerations typically focused on maintaining a full product line or creating a flagship product that demonstrated technological leadership.

Once a new product had passed the research and development design review it was released to

Tatsuno production for evaluation. The Tatsuno design review consisted of evaluating the research and development design to determine where and how the new product would be produced. To make these decisions, a detailed production blueprint was developed. This blueprint identified both the technology required to produce the camera and the components it contained. Using this blueprint and cost estimates from suppliers and subsidiary plants, the production cost of the product was re-estimated. If this cost was less than or equal to the target cost, the product was submitted to the division manager for approval for release to production.

If the estimated production cost was too high, then the design was subjected to additional analysis.

Frequently, relatively minor changes in the products design were all that were required to reduce the cost estimate to the target cost level. As long as these changes did not change the products price point, then the functionality was changed and the product was submitted for approval. If the design changes would change the price point, the product was returned to the research and development group for redesign.

The estimated production cost used in the evaluation of the product was the expected cost of

production three months after it went into production. The initial cost of production was higher than this target cost due to the work forces lack of experience with producing the new camera. As the work force gained experience, production costs would fall below target costs. Thus, the cost system would report negative variances for the first three months. In subsequent months the variances were expected to be positive. After the product was in production for six months, the target cost was changed to reflect any expected savings in the next six months due to the firms cost-reduction programs.

Required:

1. Evaluate how the company's target costing system functions. What changes would you make to the company's current target costing system and strategy?

Please provide a detailed and in-depth analysis.