What changes would you make to the company's current target costing system and strategy?

Olympus Optical Company, Ltd. (A): Cost Management for Short Life-Cycle Products Introduction Olympus, which consisted of Olympus Optical Company, Ltd. and its subsidiaries and affiliates, manufactured and sold opto-electronic equipment and other related products. The fim's major product lines included cameras, video camcorders, microscopes, endoscopes, and clinical analyzers. Olympus also produced microcassette tape recorders, laser-optical pickup systems, and industrial lenses. Olympus was founded in 1919 as Takaching. Seisakusho, a producer of microscopes. The brand name Olympus was first used in 1921 and became the firm's name in 1949. The first Olympus camera was developed in 1936, and by 1990 Olympus was the world's fourth-largest camera manufacturer. Olympus had six divisions plus a headquarters facility. Four divisions - consumer products, scientific equipment, endoscopes, and diagnostics - were responsible for generating revenues (Exhibit 1 shows 1995 financial results). The other two divisions were responsible for sopportagessarch and production engineering, respectively. Headquarters was responsible for corporate planning, general affairs, Bersorrel and accounting and finance. The consumer products division manufactured and sold 35mm cameras, video camcorders, and microcassette tape recorders. In 1995, the division employed 3,900 people (29% of the total Olympus work force) and generated revenues of #73 billion (29% of group revenues). Cameras were by far the firm's most important consumer product, accounting for #62.8 billion in revenues. Cameras were sold worldwide, with approximately 70% sold outside of Japan. The consumer products division consisted of six departments: division planning, quality asawance, marketing, product development, production, and overseas manufacturing. Responsibility for the division's production facilities was centered at the Tatsuna plant, which opened in 1981 and was the firm's main camera production facility. Tatsuno, was responsible for trial production of experimental products, introductory production of new products, and, to a limited degree, camera and lens production. Five other domestic manufacturing facilities reported to Tatsuna. These facilities were all located in Japan and were responsible This case was prepared by Professor Robin Cooper of the Peter F. Drucker School of Management at the Claremont Graduate School as the basis for class discussion rather than to illustrate either effective or ineffective Monaling of an. administrare situation. The assistance of Professor Ragnar Siguider of the University of Ghent and off. My Wada KPMG Peat Warwick is gratefully acknowledged Copyright 1994 by the President and Fellows of Harvard College To order copies or request permission to reproduce materials, call 1-800-545-7685 or write Harvard Business School Publishing, Boston, MA 02163. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means- electronic, mechanical, photocopying, recording, or otherwise without the permission of Harvard Business School 195-072 Olympus Optical Company, Ltd. (4): Cost Management for short Life-Cycle Products for plastic molded parts, lenses, camera assembly, and die casting. Overseas production facilities located in Hong Kong and China reported to the overseas manufacturing department. The 35mm Camera Market Five Japanese firms dominated the world's 35mm camera market: Asahi Pentax, Canon, Minolta, Nikon, and Olympus. Canon and Minolta were the largest of the five firms, each with approximately 17% of te market compared to Olympus' 10%. There were two major types of 35mm cameras: single lens reflex (SLR) and lens shutters (LS) or compact cameras. SLR cameras, first introduced in 1959, used a single optical path to form the images for both the film and the viewfinder, allowing the photographer to see exactly what a picture would look like before it was taken. This ability allowed SLR cameras to take advantage of interchangeable lenses. Because of this feature SLR cameras rapidly gained a dominant share of the professional photographic market. As their price fell, they also came to dominate the high-end amateur market The low-end amateur 35mm market continued to be dominated by cameras with two separate optical paths. This market was divided into two segments. One segment contained veinidempsesive cameras produced primarily by film manufacturers. The economics of this segment were driven predominantly by film, not camera, sales. The cameras in this segment primarily used the disc or 110mm film formats, though film producers had started to sell 35mm cameras that included new single-use versions. The other segment consisted of 35mm cameras that were less expensive than SLR cameras. This segment had undergone a dramatic change in the 1980s with the introduction of compact cameras. Compact cameras, as suggested by their name, were smaller than SLR cameras. The first compact camera, the "XA," was introduced by Olympus in 1978 when miniaturized electronic shutters allowed the size of non-SLR cameras to be significantly reduced. The size of SLR cameras could not be equivalently reduced because their single optical path required a retractable mirror. This mirror was positioned between the lens and the film when in the down position and reflected the image into the viewfinder. When the shutter was pressed, the mirror retracted up into the body of the camera, allowing the image to expose the film. The retractable mirror, which was approximately the same size as the image, required SLR cameras to remain relatively bulky. Cameras with two optical paths, however, did not require a retractable mirror and therefore could be reduced to quite small sizes. For example, the Olympus Stylus, which was ergonomically designed to fit the hand, was only 4.6" long by 2.5" wide by 1.5" deep and weighed 6.3 ounces. The early compact cameras were relatively unsophisticated and posed little challenge to the SLR market. However, as advances in electronic control systems allowed auto-focusing and automatic exposure features to be added relatively low prices, the compact camera began to be viewed as a serious alternative to SLR cameras. The introduction of zoom auto-focus compact camera in the mid-1980s removed the last major advantage of SLR cameras, that is, variable fa al langth lenses. Sales of SLB Asa plummeted. The shift in coneumer preference to compact cameras adversely affected Olympus in particular, because the firm historically had relied heavily on SLR sales and had failed to develop a leadership position in the compact camera arena. In the mid-1980s. Olympus' camera business began to lose money and by 1987 its losses were considerable. Top management ascribed these losses to a number of internal extemal causes. The major intemal causes were poor product planning, a lack of "hit" products, and some quality problems. While Olympus' overall quality levels were above average for the industry, certain products that relied on completely new technologies had rather high defect rates. These quality problems had caused Olympus reputation to suffer. Externally, two factors were identified as primary contributors to losses: the appreciation of the yen from over 200 to the dollar in 1985 to around 130 in 1990 and an extended low-growth period for the industry that had caused prices (hence profits) to drop. Olympus Optical Company. Ltd. (4): Cost Management for Short Life-Cycle Products 195-072 Strategic Change at Olympus In 1987, Olympus top management reacted to the losses by introducing an ambitious three-year program to "reconstruct the camera business. At the core of this program were three objectives: first, to recapture lost market share by introducing new products, second, to dramatically improve product quality, and third, to reduce production costs via an aggressive set of cost-reduction programs. Recapturing Market Share To recapture market share, Olympus developed a new strategy of rapidly introducing, producing, and marketing new 35mm SLR and compact cameras. The firm's strategy in the SLR market was to differentiate its products from competitors' by the innovative use of technology. For compact cameras, Olympus strategy was to develop full line of low-cost cameras with particular emphasis on zoom lens models. Rapid introduction was considered important because it would allow the firm to react in a timely fashion to changean in the competitive environment. One of the key elements in improving the firm's ability to react rapidly was a plan to reduce to 18 months the time required to bring new compact cameras to market. The equivalent benchmark when the OMIO SLR camera was developed in 1980 was 10 years. New products were introduced via the firm's extensive product planning process. At the heart of this process was the product plan, which identified the mix of cameras that the firm expected to sell over the next five years. The information required to develop this plan came from six sources: Olympus corporate plan, a technology review, an analysis of the general business environment, quantitative information about camera sales, qualitative information about consumer trends, and an analysis of the competitive environment. As part of the three-year reconstruction program, the information collected to support the product plan was extended considerably from pre-1987 levels. In particular, the amount of qualitative data captured was increased. To ensure that all this new information was appropriately incorporated into the product plan, more extensive reviews of the plan were introduced. The corporate plan, which was developed by Olympus' senior management, identified the future mix of business by major product line, the desired profitability of the corporation and each division, and the role of each major product line in establishing the overall image of the firm. provided division management with a charter by which to operate. The technology review had two sections. The first consisted of a survey of how current and future technological developments were likely to affect the camera business. For example, digital image processing was reaching the stage where electronic still cameras were rapidly becoming both technically and economically feasible replacements for conventional cameras that relied on chemical film for image capture. Olympus was in the forefront of electronic still image capture and in 1990 had introduced its first electronic camera. The second part of the review sought to determine whether Olympus had developed any proprietary technology that could be used for competitive advantage. For instance, Olympus had developed an advanced electronic shutter unit that combined auto-focus control and the lens system, which allowed the size of the camera to be smaller. This shutter unit allowed the firm to develop "small in size" as a distinctive feature of its cameras. The analysis of the general business environment consisted of estimates of how changes in the environment would affect camera sales and the profitability of the business. Factors included foreign exchange rates, how cameras were sold, and the role of other consumer products. How cameras were sold was especially critical, because during the 1980s the percentage f the firm's cameras sold via specialty stores had decreased steadily from 70% to 40%. This change in retail distribution demographics had reduced the average wholesale prices of cameras because the bulk of cameras was now sold through discount houses and mass merchandisers, where profit margins were lower. The role of other consumer products was important because some of them competed for the same segment of the consumer's disposable income. For example, consumer research had shown that many consumers were trying to choose between buying a compact disc player or a compact camera. Therefore, Olympus viewed compact disc players as competitive products. Olympus Optical Company, Ltd. (Al Cost Management for Short Life-Cycle Products 195-072 Improving Product Quality Olympus quality improvement program focused on two areas: the introduction of new products and the manufacturing process in general. The aim of the quality improvement program was to enable the firm to produce the highest-quality products in the industry. Olympus cameras were historically above average in quality, but management felt that it was important to be the best. Highest quality was considered important because it would help the firm recapture its lost market share by improving the reliability of the firm's products from the customer's perspective. In addition, improved product quality was expected to reduce production costs through decreased disruptions to the production flow. 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 processer and to shift a significant percentage of production overseas. Designing High-Quality Products at Low Cost a At the heart of the program to design low-cost products was the firm's 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 candersin vera, sold in the United States at the $80 price point, down from $100 in 1991. The actual selling prices for given camera varied depending on the distribution channel (ez, 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 (eg, it might be magnification capability of the camera's zoom lens or the camera's 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 580 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 $300when 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 fimm 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 fimm selling only at the high would not hav 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 5 195-072 Olympus Optical Company, Ltd. (A): Coat Management for Short Life-Cycle Products 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 product's target margin from its FOB price. The product's 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 division's six-month profit plans. In 1996, the divisional manager had identified the acceptable cost ratios a: 85% for Tatoung 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 pr of a new product w25 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 product's target coat Production engineering developed estimated costs of production in collaboration with production Research and development reviewed these estimates and revised themes 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 Tateing. The other 80% of the Olympus Optical Company. Ltd. (A): Cost Management for Short Life-Cycle Products 195-072 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 product's 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 product's 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 product's 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 produche or creating a "flagship product that demonstrated technological leadership. Once a new product had passed the research and development design review it was released the Tatsuna, production for evaluation. The Tatsung design review consisted of evaluating the research and development design to determine where and how the new product would be produced. To make their 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 anxovalov 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 product's 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 product's 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 force's 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 firm's cost-reduction programs. Reducing Unnecessary Expenditures The program to reduce unnecessary expenditures contained four components: It analyzed fixed expenses and curtailed any innecessary expenditures. It analyzed and improved the procedures surrounding new product Launching to reduce launch costs. . . It lowered the cost of purchased parts by implementing strict controls to ensure that target costs were met, widening the sources of procurement to obtain lower costs, and identifying multiple suppliers for each component to create competitive pressures. It strengthened and integrated its existing cost-reduction programs. . 195-072 Olympus Optical Company, Ltd. (A): Coat Management for Short Life-Cycle Products The first program focused on production costs, the second on the costs of defects, the third or capacity utilization costs, and the fourth on overhead expenses. The production cost control and reduction program focused primarily on removing material, labor, and some overhead costs from products, the division's profit plan identified cost-reduction targets for these costs for each product. These targets were considered challenging though achievable. The standards were set every six months and included the anticipated reductions that would be achieved in the next six months. Progress toward achieving these cost-reduction targets was monitored using variance analysis. Material price, work improvement, and "budgetary other cost variances were computed veeld ad accumulated monthly The material price variance was computed for each product by comparing the aspurk mstarisl cost to the standard material monthly target. This target was the average of the material costs for the previous six months adjusted for any anticipated changes in material costs in the upcoming month. The work improvement variances were the difference between the actual labor hours and the standard labor hour monthly target and between actual machine-hours and the standard machine-hour monthly target. Their target was calculated by 259uming that labor cost reductions would occur evenly over time. To these linear cost reductions were added any specific reductions due to planned changes in the production process. The actual "budgetary other" costs, which included general expenses of the factory, were compared to budgeted costs to determine the other budgetary variance. The second cost control and reduction program focused on the costs of defectos production. To give these costs high visibility, they were not included in the standard costs and hence were not covered by the production cost control and reduction program. The cost of defects program sogeisted of setting cost of defects targets for each production group every six months. Groups were responsible for segments of the production process (at Tatsuing there were 10 groups). Cost-reduction targets were identified for each product the group produced. Division management negotiated with the group leaders to set cost-reduction targets for each product the group produced. The group leaders recommended their cost-reduction targets, then divisional management reviewed these recommendations. If the overall reductions were sufficient to achieve the division's cost-reduction objectives, divisional management accepted the targets. If the overall savings were insufficient, the targets were renegotiated until the savings were acceptable. The team leader and foreman in each group met daily to discuss their progress at achieving their reduction targets. Group and team leaders held weekly meetings to report on progress. If a group did not meet its weekly objectives, the group leader was expected to explain why the group had failed and what corrective actions would be taken. A request to engineering for assistance might be included in these actions. Occasionally, if a group consistently failed to meet its objectives, management would send in engineeringa serious blow to the group's reputation. The third program focused on managing the costs associated with capacity utilisation. The division's long-range management plan included estimates on the amount of overtime, actual working hours, operation day's, and attendance rates. These estimates and the expected workload for each cost center were combined to give a capacity utilization cost budget for each center. This budget, which consisted of overall attendance rates and direct labor hours by cost center, was set every six months and updated each month. The updated monthly budget was used to compute a daily variance, which was reported to management Weekly and accumulated monthly. The variance captured the over- or under-utilization of direct labor capacity at the standard distribution rate of processing costs. The final program focused on overhead expenses. These expenses inchided items such as the pesomel expenses of support and administration depreciation of factory buildings, and computer costs. The long-term management plan contained targeted levels for these expenses. Monthly budgets for these expenses were prepared taking into account the production volume for the six- Olympus Optical Company, Ltd. (A): Cost Management for Short Life-Cycle Products 195-072 month period, the introduction of new products, and any planned cost-reduction actions by the groups. Division management approved the resulting budget after any necessary adjustments were made. Each month, the budget was compared to actual and multiple cost center variances. Costs subjected to separate variance analysis included machine repair costs, machine maintenance costs, expenses of repair and maintenance personnel, and miscellaneous expenses. These variances were computed monthly because management felt that these expenses could not be controlled in a shorter time frame. The four cost control and reduction programs each generated variances, which were combined in a monthly cost report. This report provided division management with important insights into the success of the cost control and reduction programs. Improving Production Engineering Olympus achieved the desired improvements to production engineering through a three- phase approach. This approach shortened production lead times by decreasing batch sizes. In the production area, for example, batches were halved and moved to a zero inventory system. Improving communications between sales and manufacturing reduced introduction times for new products and production lead times in general. For example, the MRP system was used to check inventory levels twice a day as opposed to once a week. Finally, office automation improved the level of general administrative support provided to both marketing and sales. Adopting Innovative Manufacturing Processes The program to introduce innovative production technologies focused on increasing the Jewel of automation in manufacturing, particularly in the assembly, lens production, electronics parts mounting, and molding processes. In all these processes, the level of automation was significantly increased. For example, in assembly four major processes were automated in the three-year period after the new strategy began: the assembly of the film winding and shutter units, the adjustment and inspection processes for the focusing unit, the alignment and related inspection processes, and the transportation system for assembled parts. Similarly, the molding, lens processing, and IC mounting stages of production underwent complex changes. All told, the program initiated some 23 different automation projects. Shifting to Overseas Production The cost reductions that the aggressive application of target costing and production cost reduction achieved were further augmented by shifting some of the manufacturing processes to lower-cost areas of the world. Olympus was the last of the camera firms to open such overseas facilities. Other manufacturers had opened such facilities in the late 1970s and early 1980s. Cost analyses at Olympus had indicated that the potential savings from shifting production offshore was about 15%. In 1988, the firm opened production facilities in Taiwan, Hong Kong, and Korea, and in China in 1989. The firm anticipated offshore production to reach #10 billion by 1991 and to expand rapidly thereafter. The New Cost-Reduction Effort The 1987 program to reconstruct Olympus' camera business achieved most of its objectives. The program to introduce new products was relatively successful at recapturing lost market share. The firm increased camera sales volume by almost 70% to 50 billion from #30 billion and almost doubled its market share for compact cameras. Unfortunately, the program was not as successful for 9 195-072 Olympus Optical Company, Ltd. (A): Coat Management for Short Life-Cycle Products the SLR product line. The firm continued to lose market share from 1987 through 1990, but with the introduction of completely new camera, the IS-1, the firm hoped to turn the situation around. The combined results of the cost-reduction program were impressive. By the end of 1990 every measure of productivity at Tatung had improved. For example, overall production had increased by 50%, the production cost ratio had fallen by 20%, the production value per employee had risen 70%, and gross added value per person had increased over 125%. Simultaneously, the work-in-process inventory had not increased despite the higher activity level and the fact that lead time had almost halved. Despite the success of the 1987 plan, top management at Olympus determined that additional cost reductions would be necessary in the coming years. In particular, they were worried by three trends that together would place significant pressure on the firm's profitability These trends were an increased proliferation in products required to satisfy consumer demand in the domestic market, an additional shortening of the product life cycle to less than a year, and reduced selling prices. The decision to introduce a new program was driven in part by the observation that the savings from the 1987 plan had gone down in recent months. At the heart of the new plan were two important concepts. The first was innovations in technology, and the second was functional group management Irinovations in technology consisted of applying new production technology-primarily automation to all stages of production Separate automation projects were initiated for camera assembly, lenis processing, molding, and electrical components. The most ambitious of these projects was a fully automated robotic assembly line designed to assemble cameras. This line was undergoing evaluation at Tatsuna before being released to other assembly facilities. Functional group management consisted of dividing the production process into a qubervor autonomous groups. Ten such groups were identified at the Tatsuna plant. These groups were given full management responsibility for their area of responsibility or cost center and are expected to manage it as if it were a separate company. Thus each group would effectively become a separate profit center. Top management felt that holding the groups responsible for this profitability would promote greater pressure to reduce costs and hence increase profitability than would any conventional cost-reduction program. By 1990, senior management had yet to operationalize the function group management concept but believed that it was going to play a critical role in the firm's future. Appendix The Evolution of the Cost System From 1970 to 1990, the firm's cost system had undergone three major changes. Prior to 1976, there was only one overhead rate at the Tatsuna plant. The system directly traced some materialaspets to products, but all other costs were allocated. These allocated costs were divided into two categories: processing and overhead. Processing costs included the indirect material, direct and indirect labor, and direct expenses of the production process. Direct labor was allocated because the direct labor wage rates varied by individual, and it was considered too expensive to assign the cost directly to products. The overhead costs contained the indirect material, indirect laoar, and indirect expenses associated with support and administration. The processing Berdead coats were combined and divided by the number of direct labor hours to give an average allocation rate. The reported cost of a product was given by the sum of the direct material charge and the direct labor hours that the product consumed multiplied by the allocation rate. Such a simple system was 10 Olympus Optical Company, Ltd. (Al: Cost Management for Short Life-Cycle Products 195-072 considered adequate because there were only small differences in the cost structure of the products. In addition, the level of automation was small, as was depreciation. The stated objective of this system was to differentiate material cost from other expenses and provide mechanisms for total cost reduction. In 1977, the cost system was updated. The overhead costs were split into two categories: procurement costs and other costs. Procurement costs were those costs associated with obtaining raw material and purchased parts. They included the personnel expenses of the procurement section, transportation charges, car fares, and other miscellaneous expenses. A single allocation rate was determined for processing costs and some of the other costs. A separate rate was determined for procurement costs and the allocated expenses of the administration and production technical sections. The costs of these two sections were allocated to the production and procurement sections based on head count. The procurement costs were allocated to products based on the sum of the direct material charge plus the allocated processing costs. The primary purpose of this system was to draw attention to the procurement costs, which had grown substantially over time. This increase was due both to an increase in production capacity, which was accompanied by a corresponding increase in the volume of procured parts, and by an increase in the ratio of procured to interally manufactured parts. The other important change in the system was its focus on the cost of quality. The cost of defects was isolated from the standard costs to give it more visibility. Separate variances were computed for standard production and defects. In 1983, the cost system was again updated. The general structure was maintained, but now multiple allocation rates were computed for processing costs. The production process was split into 10 different cost centers and different overhead rates were computed for each center. Examples of the cost centers included camera final assembly, electronic flexible board assembly, lens processing, and lens assembly. In addition, the firm had begun to enter into OEM contracts with other firms that would produce components for Olympus. The support and administration costs for the OEM production were significantly different from Tatsuno production. To capture this difference, the two overhead cost allocation rates were computed, one for general suppliers and the other for OEN suppliers. These two rates replaced the single procurement rate computed in the prior system The treatment of other costs as partially related to processing and partially related to procurement was suspended, and all other costs were allocated as part of the support and administration costs. The primary purpose of this system was to provide improved control over production and support and administration costs. 195-072 Olympus Optical Company, Ltd. (A): Cost Management for Short Life-Cycle Products Echibit 1 Olympus Optical 1995 Financial Results Millions Yen Thousands of US dollars 1995 1994 1993 1995 Net sales 252,097 299,551 267,718 2,801,078 Net income 3,101 556 3,805 34,456 Net income per share: Total assets 442,367 434, 704 439,716 4,915,189 Working capital 205,256 202,070 164,712 2,280,622 Shareholders' investment 182,418 183,039 145,775 2,026,287 Notes: 1. Net income per share is shown in yen and US dollars. 2. For the reader's convenience, US dollar amounts were translated from yen at the rate of 0090 = $1. 3. Fully diluted net income per share assuming full dilution is not presented because it is not significant. 4. The above figures were based on accounting principles generally accepted in Japan. Olympus Optical Company, Ltd. (A): Cost Management for Short Life-Cycle Products Introduction Olympus, which consisted of Olympus Optical Company, Ltd. and its subsidiaries and affiliates, manufactured and sold opto-electronic equipment and other related products. The fim's major product lines included cameras, video camcorders, microscopes, endoscopes, and clinical analyzers. Olympus also produced microcassette tape recorders, laser-optical pickup systems, and industrial lenses. Olympus was founded in 1919 as Takaching. Seisakusho, a producer of microscopes. The brand name Olympus was first used in 1921 and became the firm's name in 1949. The first Olympus camera was developed in 1936, and by 1990 Olympus was the world's fourth-largest camera manufacturer. Olympus had six divisions plus a headquarters facility. Four divisions - consumer products, scientific equipment, endoscopes, and diagnostics - were responsible for generating revenues (Exhibit 1 shows 1995 financial results). The other two divisions were responsible for sopportagessarch and production engineering, respectively. Headquarters was responsible for corporate planning, general affairs, Bersorrel and accounting and finance. The consumer products division manufactured and sold 35mm cameras, video camcorders, and microcassette tape recorders. In 1995, the division employed 3,900 people (29% of the total Olympus work force) and generated revenues of #73 billion (29% of group revenues). Cameras were by far the firm's most important consumer product, accounting for #62.8 billion in revenues. Cameras were sold worldwide, with approximately 70% sold outside of Japan. The consumer products division consisted of six departments: division planning, quality asawance, marketing, product development, production, and overseas manufacturing. Responsibility for the division's production facilities was centered at the Tatsuna plant, which opened in 1981 and was the firm's main camera production facility. Tatsuno, was responsible for trial production of experimental products, introductory production of new products, and, to a limited degree, camera and lens production. Five other domestic manufacturing facilities reported to Tatsuna. These facilities were all located in Japan and were responsible This case was prepared by Professor Robin Cooper of the Peter F. Drucker School of Management at the Claremont Graduate School as the basis for class discussion rather than to illustrate either effective or ineffective Monaling of an. administrare situation. The assistance of Professor Ragnar Siguider of the University of Ghent and off. My Wada KPMG Peat Warwick is gratefully acknowledged Copyright 1994 by the President and Fellows of Harvard College To order copies or request permission to reproduce materials, call 1-800-545-7685 or write Harvard Business School Publishing, Boston, MA 02163. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means- electronic, mechanical, photocopying, recording, or otherwise without the permission of Harvard Business School 195-072 Olympus Optical Company, Ltd. (4): Cost Management for short Life-Cycle Products for plastic molded parts, lenses, camera assembly, and die casting. Overseas production facilities located in Hong Kong and China reported to the overseas manufacturing department. The 35mm Camera Market Five Japanese firms dominated the world's 35mm camera market: Asahi Pentax, Canon, Minolta, Nikon, and Olympus. Canon and Minolta were the largest of the five firms, each with approximately 17% of te market compared to Olympus' 10%. There were two major types of 35mm cameras: single lens reflex (SLR) and lens shutters (LS) or compact cameras. SLR cameras, first introduced in 1959, used a single optical path to form the images for both the film and the viewfinder, allowing the photographer to see exactly what a picture would look like before it was taken. This ability allowed SLR cameras to take advantage of interchangeable lenses. Because of this feature SLR cameras rapidly gained a dominant share of the professional photographic market. As their price fell, they also came to dominate the high-end amateur market The low-end amateur 35mm market continued to be dominated by cameras with two separate optical paths. This market was divided into two segments. One segment contained veinidempsesive cameras produced primarily by film manufacturers. The economics of this segment were driven predominantly by film, not camera, sales. The cameras in this segment primarily used the disc or 110mm film formats, though film producers had started to sell 35mm cameras that included new single-use versions. The other segment consisted of 35mm cameras that were less expensive than SLR cameras. This segment had undergone a dramatic change in the 1980s with the introduction of compact cameras. Compact cameras, as suggested by their name, were smaller than SLR cameras. The first compact camera, the "XA," was introduced by Olympus in 1978 when miniaturized electronic shutters allowed the size of non-SLR cameras to be significantly reduced. The size of SLR cameras could not be equivalently reduced because their single optical path required a retractable mirror. This mirror was positioned between the lens and the film when in the down position and reflected the image into the viewfinder. When the shutter was pressed, the mirror retracted up into the body of the camera, allowing the image to expose the film. The retractable mirror, which was approximately the same size as the image, required SLR cameras to remain relatively bulky. Cameras with two optical paths, however, did not require a retractable mirror and therefore could be reduced to quite small sizes. For example, the Olympus Stylus, which was ergonomically designed to fit the hand, was only 4.6" long by 2.5" wide by 1.5" deep and weighed 6.3 ounces. The early compact cameras were relatively unsophisticated and posed little challenge to the SLR market. However, as advances in electronic control systems allowed auto-focusing and automatic exposure features to be added relatively low prices, the compact camera began to be viewed as a serious alternative to SLR cameras. The introduction of zoom auto-focus compact camera in the mid-1980s removed the last major advantage of SLR cameras, that is, variable fa al langth lenses. Sales of SLB Asa plummeted. The shift in coneumer preference to compact cameras adversely affected Olympus in particular, because the firm historically had relied heavily on SLR sales and had failed to develop a leadership position in the compact camera arena. In the mid-1980s. Olympus' camera business began to lose money and by 1987 its losses were considerable. Top management ascribed these losses to a number of internal extemal causes. The major intemal causes were poor product planning, a lack of "hit" products, and some quality problems. While Olympus' overall quality levels were above average for the industry, certain products that relied on completely new technologies had rather high defect rates. These quality problems had caused Olympus reputation to suffer. Externally, two factors were identified as primary contributors to losses: the appreciation of the yen from over 200 to the dollar in 1985 to around 130 in 1990 and an extended low-growth period for the industry that had caused prices (hence profits) to drop. Olympus Optical Company. Ltd. (4): Cost Management for Short Life-Cycle Products 195-072 Strategic Change at Olympus In 1987, Olympus top management reacted to the losses by introducing an ambitious three-year program to "reconstruct the camera business. At the core of this program were three objectives: first, to recapture lost market share by introducing new products, second, to dramatically improve product quality, and third, to reduce production costs via an aggressive set of cost-reduction programs. Recapturing Market Share To recapture market share, Olympus developed a new strategy of rapidly introducing, producing, and marketing new 35mm SLR and compact cameras. The firm's strategy in the SLR market was to differentiate its products from competitors' by the innovative use of technology. For compact cameras, Olympus strategy was to develop full line of low-cost cameras with particular emphasis on zoom lens models. Rapid introduction was considered important because it would allow the firm to react in a timely fashion to changean in the competitive environment. One of the key elements in improving the firm's ability to react rapidly was a plan to reduce to 18 months the time required to bring new compact cameras to market. The equivalent benchmark when the OMIO SLR camera was developed in 1980 was 10 years. New products were introduced via the firm's extensive product planning process. At the heart of this process was the product plan, which identified the mix of cameras that the firm expected to sell over the next five years. The information required to develop this plan came from six sources: Olympus corporate plan, a technology review, an analysis of the general business environment, quantitative information about camera sales, qualitative information about consumer trends, and an analysis of the competitive environment. As part of the three-year reconstruction program, the information collected to support the product plan was extended considerably from pre-1987 levels. In particular, the amount of qualitative data captured was increased. To ensure that all this new information was appropriately incorporated into the product plan, more extensive reviews of the plan were introduced. The corporate plan, which was developed by Olympus' senior management, identified the future mix of business by major product line, the desired profitability of the corporation and each division, and the role of each major product line in establishing the overall image of the firm. provided division management with a charter by which to operate. The technology review had two sections. The first consisted of a survey of how current and future technological developments were likely to affect the camera business. For example, digital image processing was reaching the stage where electronic still cameras were rapidly becoming both technically and economically feasible replacements for conventional cameras that relied on chemical film for image capture. Olympus was in the forefront of electronic still image capture and in 1990 had introduced its first electronic camera. The second part of the review sought to determine whether Olympus had developed any proprietary technology that could be used for competitive advantage. For instance, Olympus had developed an advanced electronic shutter unit that combined auto-focus control and the lens system, which allowed the size of the camera to be smaller. This shutter unit allowed the firm to develop "small in size" as a distinctive feature of its cameras. The analysis of the general business environment consisted of estimates of how changes in the environment would affect camera sales and the profitability of the business. Factors included foreign exchange rates, how cameras were sold, and the role of other consumer products. How cameras were sold was especially critical, because during the 1980s the percentage f the firm's cameras sold via specialty stores had decreased steadily from 70% to 40%. This change in retail distribution demographics had reduced the average wholesale prices of cameras because the bulk of cameras was now sold through discount houses and mass merchandisers, where profit margins were lower. The role of other consumer products was important because some of them competed for the same segment of the consumer's disposable income. For example, consumer research had shown that many consumers were trying to choose between buying a compact disc player or a compact camera. Therefore, Olympus viewed compact disc players as competitive products. Olympus Optical Company, Ltd. (Al Cost Management for Short Life-Cycle Products 195-072 Improving Product Quality Olympus quality improvement program focused on two areas: the introduction of new products and the manufacturing process in general. The aim of the quality improvement program was to enable the firm to produce the highest-quality products in the industry. Olympus cameras were historically above average in quality, but management felt that it was important to be the best. Highest quality was considered important because it would help the firm recapture its lost market share by improving the reliability of the firm's products from the customer's perspective. In addition, improved product quality was expected to reduce production costs through decreased disruptions to the production flow. 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 processer and to shift a significant percentage of production overseas. Designing High-Quality Products at Low Cost a At the heart of the program to design low-cost products was the firm's 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 candersin vera, sold in the United States at the $80 price point, down from $100 in 1991. The actual selling prices for given camera varied depending on the distribution channel (ez, 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 (eg, it might be magnification capability of the camera's zoom lens or the camera's 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 580 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 $300when 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 fimm 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 fimm selling only at the high would not hav 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 5 195-072 Olympus Optical Company, Ltd. (A): Coat Management for Short Life-Cycle Products 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 product's target margin from its FOB price. The product's 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 division's six-month profit plans. In 1996, the divisional manager had identified the acceptable cost ratios a: 85% for Tatoung 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 pr of a new product w25 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 product's target coat Production engineering developed estimated costs of production in collaboration with production Research and development reviewed these estimates and revised themes 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 Tateing. The other 80% of the Olympus Optical Company. Ltd. (A): Cost Management for Short Life-Cycle Products 195-072 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 product's 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