The Aspects of Target Costing

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The aspects of target costing

Executive Summary

Target Costing is a simple, straight forward process that can have significant impact on the health and profitability of many, if not most, businesses. It doesn’t require any specialists, large-scale software implementations, or complex management structures and procedures. It’s mostly logical, disciplined common sense that can be imbedded into a company’s existing procedures and processes that helps to:

· Assure that products are better matched to their customer’s needs.

· Align the costs of features with customers’ willingness to pay for them.

· Reduce the development cycle of a product.

· Reduce the costs of products significantly.

· Increase the teamwork among all internal organizations associated with conceiving, marketing, planning, developing, manufacturing, selling, distributing and installing a product.

· Engage customers and suppliers to design the right product and to more effectively integrate the entire supply chain.

Target Costing has been shown to consistently reduce product costs by up to 20-40%, depending on the product and market circumstances by what’s way that’s are shown below the report. Target Costing is a disciplined process that uses data and information in a logical series of steps to determine and achieve a target cost for the product. In addition, the price and cost are for specified product functionality, which is determined from understanding the needs of the customer and the willingness of the customer to pay for each function.

Another interesting aspect of Target Costing is its inherent recognition that there are important variables in the process that are essentially beyond the control of the design group or even the company. For example, the selling price is determined by the marketplace — the global collection of customers, competitors and the general economic conditions at the time the product is being sold. The desired profit is another variable that is beyond the control of the design organization. It may be set at the corporate level. It is influenced by the expectation of the stockholders and the financial markets. And, the desired profit is benchmarked against others in the same industry and against all businesses.

In this complicated environment, it is the role of Target Costing to balance these external variables and help develop a product at a cost that is within the constraints imposed. In short, traditional approaches, such as simple “cost-plus” is a recipe for market failure, and giving the customers more than they are willing to pay for is a recipe for insolvency.

Chapter 2 evaluates the various aspects of target costing and its implementation process for various industries. Chapter 3 discloses the target costing contribution to various global industries for attain their growth. Chapter 4 mentions that target use in various industries in Bangladesh and various industries satisfactory level for using target costing.

The findings indicate that target costing has its application in the construction sector. It also indicates that target costing is followed in the textile and tea industries in the country. Accordingly, the author can say, target costing is so widely followed in textile, telecom and banking sector. Target costing has its application in the pharmaceutical sector. It is followed, but not to a great extent in the sectors like hospital and insurance.

INTRODUCTION TO THE REPORT

1.1 Primary Knowledge of the Project Paper

This report is organized and developed to make a perfect measurement of my knowledge and to complete my BBA program (major in accounting) from Business Faculty of Stamford University Bangladesh.

1.2 Objectives:

Every work has some specific objective. The main objective of this report is to fulfill the academic requirement of BBA degree and gather practical knowledge in target costing. The other objectives of the report are:

• To get a clear idea about target costing
• To understand the international target costing system
• To understand techniques of target costing
• To identify how to minimize unit manufacturing cost
• To identify how to minimize total supply chain cost
• To identify the overall practice of target costing in the global arena.
• To identify the overall practice of target costing in Bangladesh.

1.3 Scope of the study:

• To gain the practical knowledge by doing such type of research works.
• The study was conducted by taking opinion from chartered accountant and cost and management accountant.
• From different sectors: like service sector, manufacturing sector; data was collected.
• Stages include procurement; production, assembly and test processes; distribution channels; and transportation modes
• Our solution determines the optimal mix of options to produce the lowest total supply chain cost

1.4 Methodology

Sources of Data:

Data has been collected from some of the existing companies, studies and from some case studies. Internet data have been used. Data was even collected by means of questioner.

Sample Size:

Sample size is twenty five. Among them; there are Fifteen Cost and Management Accountants, five Chartered Accountants, and five Executive and Management level persons.

Data collection:

To conduct the research, used both primary sources of data, and secondary sources of data. A primary source of data was collected from some people who are involved with this topic. The data collection took around more than two weeks. The survey was conducted over the face to face conversation. Some information from the user was gathered through informal discussion. In addition, I used some secondary data which I collected from different familiar web sites and some international articles.

1.5 Limitation

• Time limitation was there.
• Availability of Information– Information was not available so directly

OVERVIEW OF TARGET COSTING

2.1 The origin of target costing:

A retrograde approach for determining product costs, which is one of the most important features of target costing, can be found as early as the beginning of the last century at Ford in the United States and in the development of the Volkswagen Beetle in Germany in the 1930s. At Volkswagen, in order to meet the price goal of DM 990, alternative technical solutions were weighed on the basis of cost considerations (Rösler, 1996). yet a full-fledged target costing approach began during the period of scarce resources after World War II. During this time, Americans created a concept of maximizing desirable product attributes while at the same time minimizing product costs (Leahy, 1998).The technique became known as “value engineering” and was subsequently adopted by Japanese companies in order to withstand stiff competition within Japan. In the 1960s, value engineering was combined with the idea of influencing and reducing product costs as early as possible during the planning and development stages of a product (Buggert & Wielpütz, 1995).

The first use of value engineering in Japan—known as “genka kikaku”—occurred at Toyota in 1963, though it wasn’t mentioned in Japanese literature until 1978 (Tani et al,1996). Later “genka kikaku” was translated into “target costing,” the term now used throughout the world. Rösler (1996) did etymological research to clarify the derivation of the term “target costing” from Japanese language, which is described in Figure 1. Even though Kato (1993) criticizes the use of “target costing” as a translation of “genka kikaku,” the term has been generally accepted in the Western world. At the annual meeting of the Japan Cost Society in 1995, the official name was made “target cost management” on the grounds that “target costing” was too vague and did not convey the true meaning of “genka kikaku.”

2.2 The background to target costing

According to the CIMA Official Terminology-2, a target cost is ‘a product cost estimate derived by subtracting a desired profit margin from a competitive market price.’

Target costing is a technique which developed in the early 1970s in Japan’s manufacturing industry as consumer demand for more diversified products and shorter product life cycles made the development and planning stages of new products more important. At the same time increased automation and decreased labor costs made standard costing less important as the main method of cost management within manufacturing companies. It was also recognized that the major part of product cost (around 80%) is determined at the design stage and that cost management needed to start earlier in the process. Sakurai (1989) defines target costing as a ‘cost management tool for reducing the overall cost of a product over its entire life cycle with the help of the production, engineering, R&D, marketing, and accounting departments’. The use of target costing spread as increased competition, and shorter life cycles, in global markets meant that companies needed to manage costs from the design stage forward, and launch products at prices to attract customers and forestall imitation. Target costing as a technique to achieve these aims spread into other countries and industries.

A review of the literature, however, reveals that target costing is not seen as a technique for cost control but a management process which involves all disciplines and brings a focus on the customer from the beginning of the design process. Cooper and Chew (1996)4 describe the value of target costing as its ‘ability to bring the challenge of the marketplace back through the chain of production to product designers.’

2.3 Definition of Target costing: – target costing is a pricing method used by various firms. It is defined as “a cost management tool for reducing the overall cost of a product over its entire life-cycle with the help of production, engineering, research and design”. A target cost is the maximum amount of cost that can be incurred on a product and with it the firm can still earn the required profit margin from that product at a particular selling price.

Target Costing is a disciplined process that uses data and information in a logical series of steps to determine and achieve a target cost for the product. In addition, the price and cost are for specified product functionality, which is determined from understanding the needs of the customer and the willingness of the customer to pay for each function.

Another interesting aspect of Target Costing is its inherent recognition that there are important variables in the process that are essentially beyond the control of the design group or even the company. For example, the selling price is determined by the marketplace — the global collection of customers, competitors and the general economic conditions at the time the product is being sold. The desired profit is another variable that is beyond the control of the design organization. It may be set at the corporate level. It is influenced by the expectation of the stockholders and the financial markets. And, the desired profit is benchmarked against others in the same industry and against all businesses. In this complicated environment, it is the role of Target Costing to balance these external variables and help develop a product at a cost that is within the constraints imposed. In short, traditional approaches, such as simple “cost-plus” is a recipe for market failure, and giving the customers more than they are willing to pay for is a recipe for insolvency.

According to coopers:-

Target Costing is a disciplined process for determining and realizing a total cost at which a proposed product with specified functionality must be produced to generate the desired profitability at its anticipated selling price in the future.

What is really Target Costing?

A set of management tools and practices bound to support organizational learning to support organizational learning, those tools and practices must have an actual impact on individual and collective behaviors about the economic performance product economic performance is the ratio between cost and customer value of a future product to optimize the economic performance of a product, it is necessary to take into account the whole value chain which will provide it.

Target Costing is a highly disciplined process having three main elements:

• Market Driven Costing
• Product Level Target Costing
• Component Level Target Costing

According to Maria Osipova:-

Target Costing is defined as a cost management tool for reducing the overall cost of a product over its entire life-cycle with the help of production, engineering, research and design.

2.4 Objective:

Objectives of Target Costing:

The fundamental objective of target costing is to enable management to use proactive cost planning, cost management and cost reduction practices whereby costs are planned and managed out of a product and business early in the design and development cycle, rather than during the latter stages of product development and production. It obviously applies to new products, but can also be applied to product modifications or succeeding generations of products. It might also be used for existing products, but costs are more difficult to reduce once a product is in production.

The costs most typically emphasized in the target costing process are such things as: material and purchased parts, conversion costs (such as labor and identifiable overhead expenses), tooling costs, development expenses and depreciation.

Target costing is as much a significant business philosophy as it is a process to plan, manage and reduce costs. It emphasizes understanding the markets and competition; it focuses on customer requirements in terms of quality, functions and delivery, as well as price; it recognizes the necessity to balance the trade offs across the organization, and establishes teams to address them early in the development cycle; and it has, at its core, the fundamental objective to make money, to be able to reinvest, grow and increase value.

• To identify the cost at which the product must be manufactured if it’s to earn its target profit margin at its expected or target selling price.
• To decompose the production process and then to set cost targets for each product element.

Objectives broadly speaking, a target costing system has two objectives:

• To lower the costs of new products so that the required profit level can be ensured while the new products meet the levels of quality, delivery timing, and price required by the market.
• To motivate all company employees to achieve the target profit during new product development by making target costing a company wide profit management activity.

Any system that supports decision making in an organization must direct and motivate staff from many departments to use their creativity and reach set goals. The ideas of company employees must be brought together for the sake of achieving common goals and must not be left scattered and disorganized. In other words, the company needs to have a unified and rational system for consensus building and decision making. As such, its objectives include the following:

(a) Establish target costs for new products that enable the company to achieve its target profit, and also make this target more achievable by setting a goal of reducing costs to below the design stage’s cost estimates (the goal may be to reduce costs to eliminate any gap by which estimated costs exceed target costs; this is called setting goals and motivating staff).

(b) Create a set of steps that follow a schedule for a certain period, such as two years or four years (this is called successive decision-making scheduling).

(c) Use the creativity of people from various departments to devise alternative plans that enable further cost reductions (this is called brainstorming for alternative plans).

(d) Using the method that appeals to the most people, critically study the proposed alternative plans and select the best one (this is called evaluation and selection of alternative plans).

The key point is that a target costing system operates at the new product development stage as a highly efficient mechanism for reducing costs by enlisting the cooperation of many people throughout the organization. The essential ingredients for such a system are (1) the ability to enlist the cooperation of many employees and (2) the ability to raise efficiency by devising bigger cost savings with shorter lead times.

2.5 Characteristics:

• Contradicts the traditional approach: design product, determine cost, set price
• Intense customer focus
  • What do they want?
  • How much will they pay for it?

§ Can we make a profit on it?

§ Want answers to these questions before committing to the project

• Cost control from the beginning

§ 70-90% of costs are committed to at the design stage

§ Focus on product and process design to engineer out costs from the beginning

• Saves costly changes later on
• Product, manufacturing process, delivery process designed simultaneously

§ Ensures features customers demand, but within acceptable cost parameters

§ Eliminates the temptation to add costly features

• Customers may not value the added features

§ Forces consideration of manufacturability

• Reduces the need for subsequent changes
• Cost control at all phases of the product life cycle

· Design

· Production

· Delivery/setup

· Customer’s cost of ownership

• Emphasizes future sales instead of current cost savings

§ Service and repair

§ Disposal and recycling

2.5.1 Key characteristics of successful target costing

A) Focus on the customer:

Target costing focuses on the customer. Customer requirements for quality cost and time are incorporated into the product decisions and guide the analysis of costs. The process may also involve discussions with customers of different design options, making trade-offs between cost and value. This is a key difference from other cost management processes which tend to be disconnected from the value perceptions and requirements.

B) Emphasis on cost reduction at early stages in product development:

Target costing starts at the earliest stage in new product development, indeed is embedded in the development process, such that detailed financial analysis takes place from the outset and engineering changes are made before production begins. This often means initial designs are simplified before manufacture, resulting in lower costs and time-to-market once the design is finalized.

C) Consideration of the whole product life-cycle:

In order to ensure that total costs are minimized for both the producer and the customer, successful target costing examines the full life-cycle cost of the product. This includes consideration of the purchase price, operating costs, maintenance and distribution costs.

D) A multidisciplinary process:

A characteristic mentioned on target costing is the multidisciplinary nature of the process and the importance of the involvement of all functions in the analysis and decision-making. In a study of Toyota Australia’s target costing system, the International Federation of Accountants’ (IFAC) Financial and Management Accounting Committee highlighted the multi-disciplinary involvement in the cost management process and the vital roles played by different functions:

• Finance — a co-coordinating role, managing the assignment of cost targets for individual components and subsystems, performance reporting and monitoring performance achievements across the business, and promoting target achievement and highlighting the need for action when deviations occur.
• Sales planning &distribution-driving the formulation of the overall target cost.
• Purchasing – looking for cost savings through the analysis of parts and components to be used in the new product and working with suppliers to improve their cost base and to redesign parts.
• Engineering – using techniques such as value engineering to identify cost savings which can be made whilst maintaining the functionality of the product.
• Manufacturing – looking for cost savings through improvements in the manufacturing processes, either through continuous improvement or more long-term fundamental changes.

E) Team members understand their role and how it impacts cost:

According to Gagne and Discenza (1995), the best team members are those who have rotated through several departments, including design, purchasing and marketing before being assigned to a cost-planning project, as broad backgrounds give team members a unique ability to spot and implement ways to improve costs.

F) Involvement of the whole value/supply chain:

This is particularly important where a high proportion of the total cost of a product is in purchased raw materials and components, and target costing goals would be impossible to achieve without supplier involvement. Amongst the methods used to achieve this are joint classes and team-building and promises of shared savings.

G) An iterative process:

Target costing is not an exact science and depends on credible data and sometimes difficult judgments. It is also an iterative process where targets evolve as teams seek to balance functionality, price, volumes, and capital investment and costs (Cooper and Chew)

H) Specific and real targets for improvement:

Although the cost targets for individual components or processes evolve, once they are set, they should not be changed. Also, as Cooper and Chew (1996) point out, targets must be more than hypothetical, so that managers have an imperative to meet them in order to ensure the launch of products. They should also be attainable, but require effort to meet them (Sakurai, 1989).

2.6 Advantages of target costing

Obviously a primary reason why companies use target costing is to plan or project the costs of products before they are introduced, and to ensure that low-margin products are not introduced which do not bring sufficient returns. A number of other reasons are given in the literature for the use of target costing, as outlined below:

A) To reduce costs before they are locked in:

It is being increasingly recognized that the major proportion of product costs, are effectively fixed during the design stage. Target costing provides a means to manage costs from the design stage to maximize the potential for cost reduction.

B) To control design specifications and production techniques:

Target costing is a tool which can be used to control decisions such as design specifications and production techniques. For this reason it tends to be oriented more towards management and engineering than accounting, and to be successful requires the use of cost engineering techniques such as value engineering.

C) As an analysis which highlights other problems:

The discipline of target costing and the detailed review of costs can reveal more general managerial problems. For example, A company which uncovered corrupt practices in the purchasing department as a result of the detailed examination of component prices.

D) As a driver for cost improvement:

The use of other tools such as JIT and TQC (total quality control) and promote their use.

E) To encourage a focus on the customer:

Target costing is, by nature, market-driven. It therefore stimulates behavior which is customer-focused and encourages all functions within the company to respond to market demand and competitive trends rather than internal performance indicators. In addition the marketing department is free to make product decisions without the costs being a given.

Some Benefits of Target costing:

• Increased overall profitability

• Reduced manufacturing costs

• Reduced the costs of new products before manufacturing

• Met or exceeded customer expectations for our products

• Reduced the cost of purchased materials

• Resulted in product features and functions that customers value

• Developed a more profitable product mix

• Decreased the number of design changes after production begins

• Reduced the time required for new product introduction

2.7 Limitations of Target Costing:

· Numerous factors to consider when choosing components:-

§ Functionality, price, quality, flexibility, etc

§ Many of these are difficult to quantify

§ Firm establishes minimum thresholds for each factor. Chooses minimum cost parts and processes among qualifying set

· Justification for current approach

· Other factors are difficult, if not impossible, to quantify

· UMC will dictate whether or not product’s business case is successful

· Design team is not the same team that has to live with the options selected

2.8 Target Costing Process Tools

A number of techniques and tools facilitate an effective and efficient costing process. Three externally oriented analyzes market assessment tools; industry and competitive analysis and reverse engineering provide a firm with a foundation for defining the proposed new product and establishing its price. Every firm has relationships between prices, volumes and revenues; costs, and investments, in the aggregate and for specific product lines and individual products.

A) Product-Focused Financial Systems

• Financial systems are designed to allow estimation of costs at the parts level, major assembly level, and product feature or function

• Financial systems are an integrated part of product development

• Financial systems are used for past reporting, future planning, benchmarking of potentials, and identifying opportunities

• Financial data systems are flexible, timely, and the access mechanisms are invisible to the user

• Business plans and resource requirements are based on the mission-driven detail statement of work

B) Value Engineering/Value Analysis

• Feature and function decisions are tied directly to customer value expectations

• A corps of experts in value engineering principles and methodology is involved in the team

• Value decisions are based on total life cycle cost

• Value decisions are supported by part cost detail and integration cost detail

• The Value Methodology is employed throughout the value chain

C) Voice of the Customer

• There is a rigorous tool for identifying and ranking product and process design characteristics based on customer requirements (e.g., QFD)

• Customer input is sought during the product design phase

• Customer and product data is collected using formal methods (e.g., surveys, focus groups, clinics, etc.)

• Customer needs analysis data is routinely disseminated throughout the organization (customer = war fighter)

D) Decision Analysis

• Formal decision support tools or processes are used in the formulation of program plans

• Business case analysis is used for product and process decisions

• Decision tools address the following six investment elements: cost, schedule, performance, effectiveness/value, risk, and profit

• Decision analysis tools complement other target costing tools and processes (e.g., Value Engineering, Quality Function Deployment, etc)

• Decision making is information based

E) Benchmarking/Cost Driver Analysis

• Cost information categorized by part attributes and organized by part/process families is utilized

• Cost information is calibrated to regional performance and industrial engineering standards

• Cost information is readily accessible and easy to understand

• Cost information is utilized in conjunction with component actual to identify opportunities

• Cost information guides the Design/Build effort

F)Product Estimating

• Program lessons learned are folded into estimate tools and processes

• Estimating routines and manufacturing rules of thumb are integrated into design tools

• Program and component estimates are consistent with design and manufacturing schedules

• Appropriate tools to provide cost insight are used to make decisions during product definition and production

• Cost estimates delineate between cost risk and the core cost estimate

G)Supplier Partnerships

• Suppliers share in cost reduction opportunities and benefits

• Suppliers are involved in design and build decisions

• Partnerships maintain supplier profit margins

• Suppliers and producers have common measures of customer satisfaction and long term success

• Cooperation, performance to commitment, and communication are fundamental to the supplier-producer relationship

2.9 Target Costing Steps

A) Determination target selling price – As the first step, the company determines what the market is willing to pay for a product. Three main players are taken into consideration: customers, competitors, and a company’s senior management. The company must understand the customer’s perceived value of a product as well as their attitude for purchasing products. The company must take into account competitors alternative and substitute products. This is because customers are shoppers and will shop around for the best price and value. Senior management must define and adjust strategies to meet the company’s objectives.

B) Determination target profit margin – Profit margins must be set to satisfy the expectations of both the company and its investors. Two approaches can be used to determine the desired profit margin: baseline experiences and capital budgeting using lifecycle analysis.

C) Calculate the allowable product cost – The maximum allowable product cost is calculated as the net difference between the target selling price and the target profit margin. In order for target costing to work, the maximum allowable product cost must not be exceeded. If the maximum allowable product cost is exceeded there will be undesirable outcomes. First, the company will increase the price of the product in order to maintain the desired profit margin. This will decrease sales volume and the optimal sales-price combination will not be achieved. Second, investors will be dissatisfied.

2.10 Target costing in process and service businesses

Target costing is as relevant to the service sector as the manufacturing sector. The ways in which target costing can be applied to service-oriented businesses, which is of particular interest when looking at its applicability to the service business.

The key issues are still relevant

For process businesses, the focus of target costing shifts from the product to the process, and for service businesses the focus is the service delivery system. Although, the key issues – understanding the needs of the market, customers and users, and ensuring satisfactory financial performance at a given cost or price which does not exceed the target cost – remain.

Focus on the impact of new services on the whole system

People-intensive, customer-responsive service-delivery systems, it is not only possible to add new services, it can be hard not to – for example menus are easy to extend and firms can enter new areas of practice. But a discipline is still needed which ensures that these service extensions are still profitable.

Target costing which focuses on the systemic impact of new services can help organizations resist the urge to create new services just because they can.

2.11 Target Costing, and Service Companies

Many companies use target costing together with an activity-based-costing (ABC) system. Target costing requires a company to first determine what a customer will pay for a product and then work backwards to design the product and production process that will generate a desired level of profit. ABC provides data on the costs of the various activities needed to produce the product. Knowing the costs of activities allows product and production process designers to be able to predict the effects of their designs on the product’s cost. Target costing essentially takes activity-based costs and uses them for strategic product decisions.

Target costing has generally been applied in manufacturing companies. However, its use in service and nonprofit companies is growing. For example, a process nearly identical to target costing is being used in some hospitals. Development of treatment protocols-the preferred treatment steps for a patient with a particular diagnosis-is the “product design” phase for a hospital Treatment protocols have short life cycles because of rapid advances in medical technology and knowledge. Therefore, with increased attention to cost containment in health care, it is important to consider the costs of the various activities in a treatment protocol at the time of designing the protocol.

Measuring the costs of a particular treatment protocol after it is in use was the best that could be done until recently, even in the most cost-conscious hospitals. But identifying cost overruns after the fact, although better than never measuring them, did not lead to good cost control. By using target costing techniques, that is, identifying the maximum amount that would be paid for a treatment, protocols can be designed to avoid

Potential cost overruns before a treatment begins. Cost containment is then focused on the patient level, where most decisions are made, not at the department level, where identifying the causes of cost overruns is more difficult.

2.12 Target Costing and New Product Development

Based on the existing technology and related cost structure, the product has three parts, requires direct labor, and has four types of indirect costs. The first step in the target costing process is the determination of market price. The market sets this price.

Management sets the gross margin for the new product. The difference between the gross margin and the market price is the target cost for the new product. The existing cost structure for the product is determined by building up costs on an individual component level. This product has two components. Component 1 consists of parts A and B. Component 2 consists of part C. Direct labor is needed for both components and final assembly. The indirect costs are associated with activities necessary to plan and process the product.

Marketing department may have a limited role in target costing because the price is set by competitive market conditions. Actually, market research from the marketing department at the beginning of the target costing activity guides the whole product development process by supplying information on customer demands and requirements.

In fact, one of the key characteristics of successful target costing is a strong emphasis on understanding customer demands.

The accurate cost information is critical to these cost-reduction methods. Activity-Based Costing (ABC) provides this information. Activity-Based Management (ABM) is then used to identify and eliminate non-value-added activities, waste, and their related costs. ABM is applied throughout both the design and manufacturing stages of the product’s life.

Developing New Products

Product development has grown more and more important as a necessity to stay competitive, especially with global competition. Products must be profitable during their life cycle before the decision should be made to allow the product to come to market. Target costing can be an integral part of the product development process as it makes cost an input to the product development process rather than an outcome of it. Because target costing is forward-looking and is an integrated, cross-functional activity, it is most effective when it is implemented early in the product planning process. The authors’ case study will illustrate the importance of target costing in planning new products.

2.13 Approaches to target costing

A) Price-based targeting

B) Cost-based targeting

C) Value-based targeting

A) Price-based targeting

· Sets target cost for the product through comparison with that of competitors

· This means setting the price of the product by observing what the market will bear, then deducting the desired profit margin from the price, and thereby obtaining the target cost.

B) Cost-based targeting

· It sets the cost 1st, and then the desired profit margin is derived at the price of the product.

· This method requires the suppliers to reveal the very details of their cost structure and will sour the buyer-supplier relationships so isn’t good for the long run.

C) Value-based targeting

• It sets the price by what it thinks the market will ‘value’ the product
• After that, the producer sets the desired profit margin and then tries all ways to keep the cost below that of the target cost.

2.14 Target Costing Process

Historically, target costing has been developed and used in manufacturing companies. The following are setting process of target costing:

1. Establish a selling price for the new product and estimated sales volume from an analysis of the market, and a target profit.

2. Determine the target cost by subtracting the profit from the selling price.

3. Perform functional cost analysis for individual components and processes.

4. Determine the estimated cost for the product.

5. Compare estimate with target.

6. If estimated cost exceeds target cost, repeat cost analysis/value engineering to reduce estimated cost (an iterative process).

7. Make the final decision whether or not to introduce the product once cost estimate is on target.

8. Manage costs during production of the product.

The Factors Influencing the Target Costing Process

2.15.1 Factors Influencing Market-driven Costing

The factors that apparently help shape the market-driven costing portion of the target costing process include the intensity of competition and the nature of the customer.

These two factors help determine how difficult it will be to ensure that products are successful when launched and hence, the magnitude of the benefits derived from target costing. They also help determine the nature and extent of the information collected about customers and competitors in the market analysis portion of the target costing process. It is reasonable to suspect that the intensity of competition is a factor to consider since it has been shown in other environments to influence the energy expended on cost management

A) Intensity of Competition

The intensity of competition apparently influences how much attention the firm is paying to competitive offerings in the target costing process. All of the firms studied could identify four to six direct competitors who were fairly evenly technologically matched. These firms had adopted a confrontational strategy because they lacked the ability to develop sustainable competitive advantages over each other. Three product-related characteristics, referred to as the survival triplet, play a critical role in determining the success of firms. The survival triplet comprises the product price, quality and functionality. Quality is defined as conformance with product specification.

Functionality, which includes service, refers to the degree of success in designing the product to meet the specifications that customers require. There is in other words, a three-dimensional space within which a product can succeed that is bounded by the maxima and minima of price, quality and functionality.

In such a situation, the traditional approach of selecting whether to use a cost-leadership or differentiated product strategy is no longer available. If a firm wants to survive, there is no alternative but to compete head on in terms of cost, quality and functionality. When these conditions exist, certain realities are present:-

• Profit margins are low,
• Customer loyalty is low,
• First mover advantages are small,
• Product that are launched outside their survival zones fail dramatically.

Under such conditions, the benefits of target costing are potentially high. The low profit margins and customer loyalty mean that the firm can not afford to make too many mistakes when launching new products. By transmitting the competitive pressure faced by the firm to its product designers and suppliers, target costing increases the probability that new products are inside their survival zones when launched. In contrast, in environments where the intensity of competition is lower, non-confrontational strategies, such as cost leadership and differentiation, can be successful. Such strategies allow for higher profits and increased customer loyalty. Therefore, the benefits of target costing will be potentially lower in such environments.

.Consequently, it is postulated that target costing is particularly valuable for firms that have adopted confrontational strategies because failure to launch products that are in their survival zones typically leads to rapid and significant loss of market share. These losses are driven by the narrow survival zones that result from equivalent competitors chasing the same customers. In general, it is conjectured that as the intensity of competition increases, so does the value of target costing to the firm. For example, Sony has managed to differentiate its products based upon their superior functionality over those of the firm’s competitors. This lowered intensity of competition is thought to be one of the main reasons that Sony has a less well developed target costing process compared to the other firms in the sample. In contrast, all of the other firms are in confrontation and, with the exception of Topcon, have well developed and elaborate target costing systems.

B) Nature of the Customer

There are many characteristics of customers that can influence the intensity of consumer analysis that is undertaken by firms, but evidence suggests that three are particularly important in helping determine the benefits derived from target costing. The first is the degree of customer sophistication, the second is the rate at which future customer requirements are changing, and the final characteristic is the degree to which customers understand their future product requirements. These three characteristics appear to help determine the benefits that a firm can potentially derive from target costing because they deal with the width, rate of change of location, and ease of predicting the location of survival zones. Analysis of the practices observed in the six companies suggests that target costing is particularly valuable for firms that have to compete in environments that have narrow survival zones, whose locations are changing rapidly, but are relatively predictable.

1. Degree of Customer Sophistication

The degree of customer sophistication determines how good customers are at detecting differences between the price, quality, and functionality of competitive products.

Sophisticated customers are highly educated about the product offerings that are available, can detect minor differences, and will freely switch between manufacturers to buy the products that best satisfy their needs. Consequently, as customers become more sophisticated, the survival zones of products become narrower. When survival zones are narrow, it is easier to launch products that fall outside them and hence fail. To increase the probability that products are launched inside these narrow survival zones, firms expend considerable energy on consumer analysis trying to determine the location of survival zones when the product is launched.

2) The Rate at which Customer Requirements Change

The rate at which customer requirements change, defines how rapidly the location of survival zones moves over time. When survival zones are moving rapidly, it becomes more difficult for the firm to predict where a product’s survival zone will be when it is launched.

3) The Degree to which Customers Understand their Future Product Requirements

The degree to which customers understand their future requirements, in part, determines the amount of energy expended on customer analysis in the target costing process. As the degree of understanding increases, it becomes more beneficial to rely upon espoused customer preferences to determine the future location of survival zones. In contrast, when customers have little understanding of their future requirements, firms that pay too much attention to customers risk launching products that fail because they are outside their survival zones.

In the earth moving business, customers have a high degree of awareness of their future requirements. Consequently, product failures are more common because the critical attribute often only becomes apparent after the firm has launched a new product. Consequently, it is postulated that target costing is less beneficial in environments where the future locations of survival zones are hard to predict. In contrast, it is postulated that target costing will be more beneficial when the future locations are predictable.

2.15.2 Factors Influencing Product-Level Target Costing

These two factors help determine the nature and extent of the information collected about historical cost trends and customer requirements. The product strategy establishes the number of products in the line, the frequency of redesign, and the degree of innovation in each generation of products. The characteristics of the product include the complexity of the product, the magnitude of the up-front investments, and the duration of the product design process.

A) Product Strategy

The evidence suggests that the firm’s product strategy is a primary determinant of the degree of effort expended on target costing and where and how that effort is expended.

Therefore, it is postulated that firms with product strategies that create a lot of uncertainty about how the customer will react to new products will typically spend considerable efforts on target costing, while those whose product strategy creates only a small amount of uncertainty will typically expend less energy. There are three characteristics of a firm’s product strategy that analysis indicates help determine the benefits to be derived from target costing, these are the number of products in the line, the frequency of redesign, and the degree of innovation.

1) Number of Products in the Line

Customers have different requirements and these can be satisfied by developing products that are either vertically or horizontally differentiated. Vertically differentiated products differ by the degree of functionality they provide and their selling price. The higher the price, the higher the functionality (and perhaps quality) of the product. Horizontally differentiated products sell at the same price, but deliver a different bundle of quality and functionality. Relatively small variations in functionality and price are often achieved by developing optional features. The greater the number of different products1 that the firm supports, the higher the overall level of customer satisfaction. The evidence suggest that as the number of products in the line increases, so does the effort expended on target costing because new product launches occur more frequently. This observation is intuitively reasonable because target costing operates predominantly at the individual product level, hence the benefits must derive at that level.

An exception to the above observation occurs when customers demand a greater variety of products than the firm can afford to support. When this condition exists, the market analysis the firm undertakes must include procedures to identify the products that are going to be launched. Such procedures are necessary if the firm’s overall profit objective is to be met. As the number of products has to be rationed, the role of the target costing system shifts away from helping ensure individual product profitability towards helping identify the most profitable mix of products.

2) Frequency of Redesign

At the heart of the product strategies of the sample firms is the objective to increase product functionality as rapidly as possible. This objective is achieved via the rapid introduction of new products with each new generation incorporating the latest technology and hence providing increased functionality. In all of the firms, product development times have been reduced to enable more frequent product introduction to occur. Thus, intense competition has forced the firm to become expert at developing and launching products at a rapid rate.

However, this ability has a downside. First, the duration of the manufacturing phase is short, therefore the time available to generate an adequate return on the up-front investment is limited and it leads to lower sales volumes of each product. To remain profitable, the firm must launch a high percentage of profitable as opposed to unprofitable products. Second, due to the short product life cycles, there is inadequate time to correct any errors. If an unprofitable product is launched, it will often remain unprofitable until it is withdrawn. Therefore, it becomes critical to design new products so that they are profitable.

Consequently, it is postulated that the higher the rate of new product introduction, the greater the benefits derived from target costing. Therefore, such firms are expected to have well developed target costing systems that subject the product design process of all new products to systematic cost reduction pressures. In contrast, it is hypothesized that firms that rarely introduce new products will not require formal target costing systems, but will probably apply target costing principles on an ad hoc basis as required.

3) Degree of Innovation

The degree of innovation in each new product generation helps determine how much historical cost information can be used to estimate future costs. As the degree of innovation increases, information about past products becomes less valuable. Especially, for revolutionary products that rely upon completely new technologies, historical cost information about earlier products will have little value. Similarly, customer, competition, and supplier information can be invalidated by significant innovations in product design. In contrast, for products that are similar to the ones that they are replacing, the past is often highly predictive of the future and value engineering techniques such as functional analysis, which depend upon the use of the same technology, can be applied.

Target costing is most difficult to apply to revolutionary products. First, target selling prices are often difficult to establish because the value to the customer of the new product is difficult to estimate. Second, because the firm has never applied the technology in its products, historical cost information is not available and third, a higher percentage of new suppliers are typically involved. When the new model does not rely upon existing designs, the target costing system is of less value as more intuition as opposed to hard facts is required.

When the degree of innovation is low, then the target costing process becomes relatively straightforward. First, the selling price of the new product is primarily determined by the selling price of the product it replaces and second, historical cost information is highly predictive of the costs of the new products. Third, the suppliers are typically unchanged.

It is postulated that target costing has increased benefits in environments where the degree of innovation is relatively low and decreased benefits when high. Furthermore, in environments where the degree of innovation is low, the target costing system will rely more heavily upon historical information than in environments were the rate of innovation is higher.

B) Characteristics of the Product

There are three characteristics of the product that apparently have a particularly strong influence on the benefits derived from target costing and the way it is practiced. These characteristics are the product complexity, the magnitude of up-front investments, and the duration of the product development process. The complexity of the product captures how difficult it is to manage the product design process. The magnitude of up-front investments captures the amount of capital consumed in the research and development process, getting ready for production, and actually launching the product. The duration of the product development process captures the time it takes to go from product conception to release to production.

1) Product Complexity

Product complexity captures the number of components in the product, the number of distinct production steps required to manufacture it, the difficulty of manufacturing the components it contains, and the range of technologies required to produce them. As the complexity of the product grows, there are two major reasons that the benefits of target costing increase. First, the degree to which costs can be influenced in the product design stage versus the manufacturing stage increases. Second, it becomes more difficult to manage the product design process and ensure that component-level target costs sum to the product-level target cost. Therefore, the benefits of target costing are expected to increase with the complexity of the product. However, as the complexity increases, so does the cost of applying target costing at the component level? Fortunately, there are ways to simplify the target costing process to reduce the effect of product complexity by only performing detailed target costing on two or three representative variations, as opposed to all of them.

Consequently, as product complexity increases, it is postulated that target costing becomes more beneficial and ways to reduce the costs of performing target costing emerge.

Toyota, Nissan, and Komatsu manufacture products that are considerably more complex than the other firms. Their target costing processes reflect this increased complexity by being more formalized. This formalization helps the firms cope with the large number of components that have to be subjected to target costing.

2) Magnitude of Up-Front Investments

As the magnitude of the up-front investment increases, the number of products that a firm is willing