TARGET  COSTING

Kenneth Crow
DRM Associates

As a totally new product and its industry develop, it starts to compete based on its new
technology, concept, and/or service. Competitors emerge and the basis for competition evolves
to other areas such as cycle time, quality, or reliability. As an industry becomes mature, the basis
of competition typically moves to price. Profit margins shrink. Companies begin focusing on
cost reduction. However, the cost structure for existing products is largely locked in and cost
reduction activities have limited impact. As companies begin to realize that the majority of a
product's costs are committed based on decisions made during the development of a product, the
focus shifts to actions that can be taken during the product development phase.

Until recently, engineers have focused on satisfying a customer's requirements. Most

development personnel have viewed a product's cost as a dependent variable that is the result of
the decisions made about a products functions, features and performance capabilities. Because a
product's costs are often not assessed until later in the development cycle, it is common for
product costs to be higher than desired. This process is represented in Figure 1.

Target costing represents a fundamentally different approach. It is based on three premises: 1.)
orienting products to customer affordability or market-driven pricing, 2.) treating product cost as
an independent variable during the definition of a product's requirements, and 3.) proactively
working to achieve target cost during product and process development. This target costing
approach is represented in Figure 2.
Target costing builds upon a design-to-cost (DTC) approach with the focus on market-driven
target prices as a basis for establishing target costs. The target costing concept is similar to the
cost as an independent variable (CAIV) approach used by the U.S. Department of Defense and to
the price-to-win philosophy used by a number of companies pursuing contracts involving
development under contract.

The following ten steps are required to install a comprehensive target costing approach within an
organization.

1. Re-orient culture and attitudes. The first and most challenging step is re-orient thinking
toward market-driven pricing and prioritized customer needs rather than just technical
requirements as a basis for product development. This is a fundamental change from the
attitude in most organizations where cost is the result of the design rather than the
influencer of the design and that pricing is derived from building up a estimate of the cost
of manufacturing a product.
2. Establish a market-driven target price. A target price needs to be established based
upon market factors such as the company position in the market place (market share),
business and market penetration strategy, competition and competitive price response,
targeted market niche or price point, and elasticity of demand. If the company is
responding to a request for proposal/quotation, the target price is based on analysis of the
price to win considering customer affordability and competitive analysis.
3. Determine the target cost. Once the target price is established, a worksheet (see
example below) is used to calculate the target cost by subtracting the standard profit
margin, warranty reserves, and any uncontrollable corporate allocations. If a bid includes
 non-recurring development costs, these are also subtracted. The target cost is allocated
down to lower level assemblies of subsystems in a manner consistent with the structure of
teams or individual designer responsibilities.

4. Balance target cost with requirements. Before the target cost is finalized, it must be
considered in conjunction with product requirements. The greatest opportunity to control
a product's costs is through proper setting of requirements or specifications. This requires
a careful understanding of the voice of the customer, use of conjoint analysis to
understand the value that customers place on particular product capabilities, and use of
techniques such as quality function deployment to help make these tradeoff's among
various product requirements including target cost.
5. Establish a target costing process and a team-based organization. A well-defined
process is required that integrates activities and tasks to support to support target costing.
This process needs to be based on early and proactive consideration of target costs and
incorporate tools and methodologies described subsequently. Further, a team-based
organization is required that integrates essential disciplines such as marketing,
engineering, manufacturing, purchasing, and finance. Responsibilities to support target
costing need to be clearly defined.
6. Brainstorm and analyze alternatives. The second most significant opportunity to
achieve cost reduction is through consideration of multiple concept and design
alternatives for both the product and its manufacturing and support processes at each
stage of the development cycle. These opportunities can be achieved when there is out-
of-the-box or creative consideration of alternatives coupled with structured analysis and
decision-making methods.
7. Establish product cost models to support decision-making. Product cost models and
cost tables provide the tools to evaluate the implications of concept and design
alternatives. In the early stages of development, these models are based on parametric
estimating or analogy techniques. Further on in the development cycle as the product and
process become more defined, these models are based on industrial engineering or
bottom-up estimating techniques. The models need to be comprehensive to address all of
the proposed materials, fabrication processes, and assembly process and need to be
validated to insure reasonable accuracy. A target cost worksheet can be used to capture
the various elements of product cost, compare alternatives, as well as track changing
estimates against target cost over the development cycle.
8. Use tools to reduce costs. Use of tools and methodologies related to design for
manufacturability and assembly, design for inspection and test, modularity and part
standardization, and value analysis or function analysis. These methodologies will consist
of guidelines, databases, training, procedures, and supporting analytic tools.
9. Reduce indirect cost application. Since a significant portion of a product's costs
(typically 30-50%) are indirect, these costs must also be addressed. The enterprise must
examine these costs, re-engineer indirect business processes, and minimize non-value-
added costs. But in addition to these steps, development personnel generally lack an
understanding of the relationship of these costs to the product and process design
decisions that they make. Use of activity-based costing and an understanding of the
organization's cost drivers can provide a basis for understanding how design decisions
impact indirect costs and, as a result, allow their avoidance.
10. Measure results and maintain management focus. Current estimated costs need to be
tracked against target cost throughout development and the rate of closure monitored.
Management needs to focus attention of target cost achievement during design reviews
and phase-gate reviews to communicate the importance of target costing to the
organization.
JASON PLC

Jason plc a cement manufacturer is operating in an industry where there is a tough competition that is no
enterprise could influence selling price. Currently Jason sets prices on cost plus basis. At present each 2kg
bag of cement is sold for $50. At this selling price the company is expecting to sell 10,000 bags.

The company orders in quantities of 500 kgs. Each order costs $64 and costs $4 to hold one kg for one
year. It takes five hours to produce one bag and labor is currently paid @ $5/hour.

Raw material is first received by the goods received section and then transferred to store department, the
only cost of this transferring process is the loading and unloading cost and each unit’s loading and
unloading cost is $0.5 (separately for loading and unloading).

The production manager is of the view that at this price and sales level the company could not achieve its
required return of $82,800 per annum (based on capital employed). He has suggested following cost
reduction techniques to achieve required return.

1. Order size quantity should be based on EOQ Model. Furthermore he has been told by the
procurement department that the company will get special bulk quantity discount on purchase of
800kg or above.
2. The worker should be given a 10% increment in their wage rate if they raise their productivity by
25% (he is confident that the workers have potential to do so if motivated)
3. Raw material should directly be unloaded in the store department.

Requirement:

i. Why is the production manager so much stressing on cost reduction rather than increasing the
selling price, increasing sales volume or sacrificing some part of the required profit.
ii. Suggest whether the production manager’s suggestions are worth taking or not (Your answer
should be supported by calculations)
iii. In what other ways the company could reduce its cost gap.
Solution iii

Other ways to reduce COST GAP

1. Delete non value adding activities

2. Use Economic batch quantity
3. Space Management
4. Make process as simple as possible (reduces handling cost)
5. Introduce “assemble your self” strategy
6. Make or buy decision
7. Reduce number of components
8. Product standardization (Learning Curve effect)
9. Human Resource outsourcing
10. JIT
11. Reduce number of accessories (if possible)
12. Value analysis