An Overview Of Target Costing

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AN OVERVIEW OF TARGET COSTING

Introduction

Many managers often underestimate the power of target costing as a serious competitive tool. When general managers read the word “costing”, they naturally assume it is a topic for their finance or accounting staff. They miss the fact that target costing is really a systematic profit and cost management process.

What Is Target Costing?

CAM-I defines target costing as the maximum amount of cost that can be incurred on a product and still earn the required profit margin from that product. This is captured by the equation

Target Cost = Price вЂ" Profit

At first sight the equation appears to reverse the familiar cost plus price equal profit that many firms use. However, behind the inversion of the equation are two very powerful ideas; (1) market price and profit margins are exogenous variables beyond the control of an organization’s management; and (2) customer and financial markets drive cost planning and not the other way around. Target costing, therefore, is a market driven system in which the needs of the customer and the likely reaction of competitors drive product and profit planning.

Target costing has six key principles:1

1. Price-led costing. Market prices are used to determine allowable or target costs.

2. Focus on customers. Customer requirements for quality, cost, and time are simultaneously incorporated in product and process decisions and guide cost analysis. The value (to the customer) of any features and functionality built into the product must be greater than the cost of providing those features and functionality.

3. Focus on design. Cost control is emphasized at the product and process design stage. Therefore, engineering changes must occur before production begins, resulting in lower costs and reduced “time-to-market” for new products.

4. Cross-functional teams. Cross-functional product and process teams are responsible for the entire product from initial concept through final production.

5. Value-chain involvement. All members of the value chain, e.g., suppliers, distributors, service providers, and customers, are included in the target costing process.

6. Life cycle cost reduction. Total life-cycle costs are minimized for both the producer and

1 These principles are adopted from, S. Ansari, J. Bell, and the CAM-I Target Cost Core Group, Target Costing, The Next Frontier in Strategic Cost Management, (Irwin/McGraw-Hill, 1997).

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the customer. Life-cycle costs include purchase price, operating costs, maintenance, and distribution costs.

The Target Costing Process

To maximize cost control and enhance profit improvement, most companies set relatively aggressive targets. The process begins when top management establishes a target cost for a new product (e.g., a Chrysler Neon or a Caterpillar Excavator). A cost estimating group will then decompose the target cost for the product as a whole into cost targets for subassemblies and individual component parts (e.g., engine, transmission, seats, etc.).

Frequently a “gap” exists between the new product’s target cost and cost projections for the new product based on current designs and manufacturing capabilities. Closing the gap through cost reduction is central to the target costing process. This is accomplished through cross-functional target costing teams, which analyze the product’s design, raw material requirements, and manufacturing processes to search for cost savings opportunities. The cross-functional teams employ a variety of management tools and initiatives to help them achieve their objectives. The following section describes some of these tools and initiatives, and other characteristics of successful target costing companies.

Setting Target Costs

A target cost for a product is set by considering a firm’s basic product strategy and the competition it faces. Product strategy defines the customers that a firm wants to target, the features that these customers want in the product and the prices they are willing to pay for each feature and for the product as a whole. Evaluation of competitive factors is translated into a desired market share for the product. Together the two variables determine a market price for the product.

Setting prices for new models of existing products, such as this year’s model of a video cassette recorder (VCR), starts with the current prices. These prices are adjusted for the features added or dropped. For example, assume we add to the new VCR the ability to view tapes in different formats (NTSC, PAL and SECAM). Also assume that we delete an FM radio which was on the previous model since it is not popular. The revised price may be set by taking the current price, adding the price that customers are willing to pay for the multiple format feature and deleting from this price the value customers place on the radio.

Setting prices for new products is not easy since there is no existing base to start from. Market research becomes crucial for this type of product. Fanack, a Japanese company, uses a simple formula that sets the price at a level that gives them a five-year lead over their competitors. Another technique is to use the prices for substitute products to develop an initial prices. For example, fiber optic cable prices may form the basis for pricing satellite-based communication links.

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The profit target, the second variable in the target costing equation, is set relative to the financial rate of return that a firm needs to stay viable in its industry. Since return on sales is part of the return on investment formula, firms often use this to set profit targets. If asset turnover, the second half of the return on investment formula, is relatively stable, it can be ignored and only the return on sales is used for setting target profit margins. A common Japanese practice is to use the return on sales ratio for the industry and the firm’s past and future return on sales in a weighted average formula.

All of this requires several iterations. The target price and profit margins are refined and revised as new data is available. An important reminder to the reader, the price and margin setting activity is at the product concept and design development phases in the life of a product. Therefore, revisions are