Target Costing
As a totally new product and its industry develops, 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.