TARGET COSTING:

Delighting Your Customers While Making a Profit

Target Costing is a simple, straightforward process that can have significant

impact on the health and profitability of many, if not most, businesses. It
doesn't require an army of 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.

We spent our recent professional careers applying Target Costing to a wide

range of products, processes and procedures in a large manufacturing
company. We quickly came to learn that Target Costing 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.

What is Target Costing? Our working definition, adapted from Cooper, is as

follows:

Target Costing is a disciplined process for determining and realizing a total

cost at which a proposed product with specified functionality must be
produce to generate the desired profitability at its anticipated selling price in
the future.
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.
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 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.

Steps in Target Costing approach to pricing:

1. Setting of target selling price:
The setting of target selling price of a product which customers are prepared
to pay, depend on many factors like design specifications of the product,
competitive conditions,customers demand for increased functionality and
higher quality projected production volume, sales forecasts etc. A concern can
set its target selling price after taking into account all of the aforesaid factors.
2. Determination of target costs:
Target profit margin may be established after taking into account long-term
profit objectives and projected volume of sales. On deducing target profit
margin from target selling price, target cost is determined.
3. Estimate the actual cost of the product:
Actual cost of the product may be determined after taking into account the
design specifications, material cost and other costs required to produce the
product.
4. Comparison of estimated cost with actual cost:
In case the estimated cost of the product is higher than that of the target cost
of the product then the concern should resort to cost reduction methods
involving the use of