Target Costing

Post Graduate Diploma in Management.

Institute Of Management Technology, Ghaziabad December, 2010

MANAGEMENT ACCOUNTING project on

TARGET COSTING as a STRATEGIC COST MANAGEMENT TOOL

Presented By

Saurabh Thadani[10FN-102] Srikanth Konduri[10FN-109] Srivatsan Rangarajan[10FN-110] Tushar Gupta[10FN-115] Varun Joshi[10FN-117] Nikhil Gupta[10FN-121]

Target Costing

Table of Contents
1. A Historical Perspective: ............................................................................................................................. 3 1.1 The Origin of Target Costing .................................................................................................................. 4 1.2 The Ford mistake and the importance of target costing ....................................................................... 4 2. Definition: .................................................................................................................................................... 5 2.1 Target costing v/s Traditional costing .................................................................................................... 5 2.2 Target costing principles ........................................................................................................................ 5 2.3 Target Costing Objectives ...................................................................................................................... 6 3. Approaches to target based costing: ........................................................................................................... 6 3.1 Price based targeting ............................................................................................................................. 6 3.2 Cost based targeting .............................................................................................................................. 6 3.3 Value based targeting ............................................................................................................................ 6 4. Target costing Implementation:................................................................................................................... 7 4.1 The Process of Implementation - Target Costing into a New Product .................................................. 7 4.1.1 Establishing a Selling Price for the Product..................................................................................... 7 4.1.2 Establishing a Target Profit for the Product.................................................................................... 7 4.1.3 Determine the Target Cost ............................................................................................................. 7 4.1.4 Perform Functional Cost Analysis and/or Value Engineering ......................................................... 8 4.1.5 Determine the Cost Estimate .......................................................................................................... 8 4.1.6 Decision: is the Cost Estimate on Target? ....................................................................................... 8 4.1.7 Make the Final Decision .................................................................................................................. 8 5. Benefits of target based costing: ................................................................................................................. 8 6. Disadvantages of target based costing: ....................................................................................................... 9 7. TOYOTA Implementation - Introduction: ..................................................................................................... 9 7.1 Toyotas target costing process ............................................................................................................. 9 7.2 Target Costing in the Design Stage ........................................................................................................ 9 7.3 Data required ....................................................................................................................................... 11 7.4 Reason that Toyota excels in target costing ........................................................................................ 11 8. Example Case Target Costing for SMARTCOM Modems......................................................................... 12 8.1 Findings of Market Research: .............................................................................................................. 12 8.2 Findings of Market Research: .............................................................................................................. 12 8.3 Quality Function Deployment for customer priority & feature correlation: ....................................... 13 8.4 Value quantification for the Component contributing to a feature: ................................................... 14 8.5 Actions Required: ................................................................................................................................. 15 9. Ways to achieve the Target Costs using Value Engineering/Innovation ................................................... 16 2

Target Costing 10. Conclusion ................................................................................................................................................ 16 10.1 Marketing costs.................................................................................................................................. 16 10.2 Installation costs ................................................................................................................................ 16 11. Key Learnings ........................................................................................................................................... 17 12. Bibliography ............................................................................................................................................. 17

List of Figures
Figure 1. Traditional cost Management Approach .......................................................................................... 4 Figure 2. Western & Japanese Cost Management........................................................................................... 5 Figure 3. Target Cost Concept .......................................................................................................................... 6 Figure 4. Cost Management System at Toyota .............................................................................................. 10 Figure 5. Procedure of Target Costing ........................................................................................................... 11 Figure 6. Value Engineering for Target Costing ............................................................................................. 16 Figure 7. Sources of Cost reduction ............................................................................................................... 16 Figure 8. Key Learnings .................................................................................................................................. 17

List of Tables
Table 1. Cost estimate for SmartCOM Modem.............................................................................................. 12 Table 2. Cost Gap Analysis ............................................................................................................................. 12 Table 3. Function-Feature Mapping for SmartCOMs Modem ...................................................................... 13 Table 4. Individual Component Value quantification .................................................................................... 14 Table 5. Actions Required .............................................................................................................................. 15 Table 6. Target Costs to be achieved ............................................................................................................. 15

Target Costing

1. A Historical Perspective:
1.1 The Origin of Target Costing
Target costing originated in Japan in the 1960s, though it remained a secret for years. The first use of value engineering in Japan known as genka kikakuoccurred at Toyota in 1963, though it wasnt 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. 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.

1.2 The Ford mistake and the importance of target costing

Wouldn't it be nice if you could prevent your company from making a $300 million mistake? In 1988, Ford would have appreciated knowing that production costs on its Thunderbird sped up to an additional $1,000 per car. The result? A $300 million loss drove off Ford's bottom line. How do you put the brakes on these exorbitant errors? The answer lies in the hands of accountants and engineers who need to work closely together in the design stage of product development. The numbers came too late at Ford - accountants were doing their jobs back then, which was to track what departments spend money on after they spend it. Today things are different. We are called on to predict costs, and critical to that process is being involved in design decisions that impact the bottom line, even to the tune of $300 million. Target costing is the name - increasing the bottom line is the game. Some people think target costing is straightforward: You start with the selling price of the product minus the profits you desire to determine the money you can spend to produce it. But arriving at the right numbers requires intense cooperation among all groups involved in product development. This is no easy task.

Figure 1. Traditional cost Management Approach

Target Costing

2. Definition:
In essence, it is a philosophy in which product development is based on what the market will pay for it, not on what it has cost to produce. In other words, market price becomes the determinant of cost and not the other way around, as is the practice with most organisations. Target costing is a strategic management tool that seeks to reduce a products cost over its lifetime. Therefore, the target cost is not necessarily the cost to currently build the product. Target costing presumes interaction between cost accounting and the rest of the firm; wellexecuted, long-range profit planning; and a commitment to continuous cost reduction.

2.1 Target costing v/s Traditional costing

The use of target costing did not pervade U.S. companies. In fact, the only example in the literature featured Xerox. Most of firms their used the traditional costing method. However there are several examples of Japanese companies from all different industries using target costing. In fact, Kobe University researchers discovered that 100% of Japanese car manufacturers use this target costing approach. Below is given a diagrammatic differentiation between the costing methods that were used in Japan and the west.

Figure 2. Western & Japanese Cost Management

2.2 Target costing principles

Price-Led costing Focus on customer Focus on design Cross-Functional involvement Value-Chain involvement A life-cycle orientation

Target Costing

2.3 Target Costing Objectives

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

3. Approaches to target based costing:

3.1 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

3.2 Cost based targeting

It sets the cost 1st, 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 itsnt good for the long run

3.3 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

Figure 3. Target Cost Concept

Target Costing

4. Target costing Implementation:

Price-led costing ~ market prices are used to determine target costs Focus on customers ~ value to the customer must be greater than the cost of the product itself Focus on design ~ cost control must occur before production Cross-functional involvement ~ interfunctional product and process teams Value-chain involvement ~ all members of the value chain included Life-cycle orientation ~ minimizing total life-cycle costs

4.1 The Process of Implementation - Target Costing into a New Product

The target costing approach brings the management accountant into the process at the early planning stage. The management accountant is contributing to the early decisionsshould the company be making this kind of product? What constraints need to be applied in the design stage? Is the market demand consistent with our projections? Can we achieve the determined return in this competitive of a market?

Market Driven Selling Price - Desired Profit = Target Cost

In the target costing model and opposed to the traditional method of costing, costs are not the driver rather they are driven. The market sets the price, management sets the profit margin, and the difference becomes the allowable costcost defined and constrained by price realities and profit goals. New and increasingly necessary, target costing abides to the following logical flow and procedures:

4.1.1 Establishing a Selling Price for the Product

The target costing process begins by establishing a selling price, based on market research, for the new product. From this targetselling price, the desired (target) profit is subtracted to determine the target cost. In all likelihood, this target is below the companys current manufacturing cost. Teams from many departments then perform functional cost analysis in an attempt to reduce costs to a level in the acceptable range. If the current cost estimate is at the target, the firm must decide whether or not to introduce the new product. If the current cost estimate is above the target, functional cost analysis is used to make changes and prepare another cost estimate.

4.1.2 Establishing a Target Profit for the Product

Marketing plays a crucial role in the determination of the target cost. The starting point for a target cost is the estimated selling price for the product determined by market analysis. Sales volume is also estimated and, from the total estimated sales revenue, the desired profit is subtracted. Management determines this desired profit margin in reference to the companys long-term strategy. Retail prices and sales volumes are proposed by the marketing function based on its research and the companys desired market share. Total sales revenue for each new product over its life can now be estimated. The target profit, usually determined by using return on sales, is subtracted from the total sales revenue. The target cost is now determined.

4.1.3 Determine the Target Cost

The target profit is subtracted from the target price to arrive at the target cost. Management accounting can play an important role in effectively determining target profits and target costs. Accountants can supply the information required to support marketing analysis for a new product and relate it to existing products. After the target cost is determined by subtracting the target profit from the target price, functional cost analysis is used to achieve the target cost. Functional cost analysis is a group activity typically involving employees from different departments (such as marketing, design, engineering, production, purchasing, and accounting) and is aimed at proposing alternatives for reducing overall product cost. This team-oriented approach requires that the employees of different departments bring together their knowledge and experience in the organisation to contribute to the cost reduction process. Working with product designers, their motivation is not only to cut the number of parts but also to work toward the use of standard parts in designs that give products desired functions at a lower cost.

Target Costing 4.1.4 Perform Functional Cost Analysis and/or Value Engineering
Functional cost analysis requires the preparation of a logical diagram for each function of the product. It should be noted that this is not a diagram of each part of the product since it is the functions of a product that determine its success in the market. Each function and sub-function of the product is defined to show the various operations of the product. Functional analysis is closely linked to value engineering. Functional analysis is a cost management system that focuses on the various functions of each product. The individual functions of a product become the set of cost objectives and provide the basis for the costing system. Value Engineering (VE) involves designing a product from different angles at a lower cost by reviewing the functions needed by customers. VE is used for purchasing, planning, design, production, and other processes on a company-wide basis. There are a variety of methods for conducting value engineering. The process generally starts with performance checks on test parts. Designs are changed to give each part a specific degree of performance. Then discussion turns to ways to cut costs while maintaining performance. The aim is to use the information provided by the functional analysis to propose alternatives for improving costs.

4.1.5 Determine the Cost Estimate

Functional analysis requires information concerning engineering specifications and accounting data. The actual manufacturing and the target cost for each products functions are compared. Alternatives are identified to bring each functions actual cost estimate to its target cost. Management accountants provide information on the cost effects of the proposed functional modifications. When needed, they prepare very detailed sets of cost tables that include the costs of alternative materials, of using different types of manufacturing technologies, and so on.

4.1.6 Decision: is the Cost Estimate on Target?

After the team consisting of members from the various functions of the company have used value engineering (as discussed in the following section) and functional cost analysis to determine the new products estimated cost, the estimate is compared with the target cost. If the cost estimate exceeds the target cost, functional cost analysis is used again to reduce the estimated cost to the target cost. It must be understood that this is not always a yes/no decision model. Although functional analysis is performed to determine if the product can be produced for less than the target cost, often product introductions are accepted when the initial review has the actual cost exceeding the target. This subjective approach is taken when it can be determined that, over the life of the product, the firm will be able to produce it for less than currently possible, and less than the target cost.

4.1.7 Make the Final Decision

Once the cost estimates are on target, management makes the final decision to introduce the product based on manufacturing feasibility, market needs and consumer acceptability. If the decision is to go ahead with the product, manufacturing is instructed to proceed with production. Once the decision has been made to manufacture the new product, there are other considerations necessary for successful implementation of the process. Since the target cost is often below the actual cost based on the current production technology, a team effort is required to enable the organisation to achieve the target cost. Teams of people from marketing, engineering, purchasing, manufacturing, and accounting work together to assure that a cost position on the product is such that the company can sell the product at its required market price to insure the desired target return on the product. Finally, target costing does not end once the decision has been made to move the product into the production stage. The standard manufacturing cost of the product depends on specific production line conditions. For example, production on lines below capacity pushes costs up, while production on lines near full capacity leads to the best-cost performance. Often during the planning stage, it is difficult to visualise the line conditions and thus reflect accurately these conditions in cost estimates. Therefore, once the initial target cost has been calculated, the manufacturing division then initiates an effort to improve on the standard cost, in order to get it down to the target cost.

5. Benefits of target based costing:

Delivering the optimal value proposition to end customers Minimizing product-line complexity

Target Costing
Selecting appropriate product and process technologies Lowering product design late in the innovation process Eliminating cost overruns

6. Disadvantages of target based costing:

Possible misuse of the technique. Producers might make use of cost-based target costing to squeeze the profit margins of suppliers, thereby getting materials at the lowest cost possible. The stress on the design team of companies using target costing Disadvantage to the company.

Product development time might be lengthen as product is repeatedly designed to bring cost below that of target.

7. TOYOTA Implementation - Introduction:

Toyota Motor Corporation commonly known simply as Toyota and abbreviated as TMC is a multinational corporation headquartered in Japan. In 2009, Toyota Motor Corporation employed 71,116 people worldwide (total Toyota 320,808).TMC is the world's largest automobile manufacturer by sales and production. The company was founded by Kiichiro Toyoda in 1937 as a spinoff from his father's company Toyota Industries to create automobiles. Three years earlier, in 1934, while still a department of Toyota Industries, it created its first product, the Type A engine, and, in 1936, its first passenger car, the Toyota AA. Toyota Motor Corporation group companies are Toyota (including the Scion brand), Lexus, Daihatsu and Hino Motors, along with several "non-automotive" companies.TMC is part of the Toyota Group, one of the largest conglomerates in the world. Toyota Motor Corporation is headquartered in Toyota City, Aichi and in Tokyo. In addition to manufacturing automobiles, Toyota provides financial services through its Toyota Financial Services division and also builds robots.

7.1 Toyotas target costing process

Normalize the costs to the existing conditions: Incorporate the changes in prices due to inflation etc. Select the price for your base product, the volumes expected to sell and the profits commanded Identify the cost reductions that need to be made to achieve the profit targets Allocate the cost reductions to different departments suitably

7.2 Target Costing in the Design Stage

Toyota's product design done by a product manager or a chief engineer (Shusa) who organizes the design engineers who in turn belong to Product Engineering Design Sections in his/her team in order to realize his/her concept of anew or revised car. As is well known, this type of organization is called a matrix organization. Moreover, it is also called concurrent engineering or simultaneous engineering because first-tier suppliers, production engineers and Production Division already take part in this design phase. Though the matrix organization has-been replaced by four Product Development Centers regime at the beginning of1990s, and development term (lead time) has been shorten by using 3D-CAD and virtual production system, no changes were observed in the target costing in the design stage. When a development of a new or revised vehicle is decided, its sales price and target (or desired) profit per vehicle are fixed by the top management that takes into consideration of the market price and new cars features that the Sales Division proposed based upon marketing and consumer analysis. As a result, the desired cost per vehicle is given automatically. This cost is called the target cost, because it haste be attained firstly in the product design phase and then in the production process where this model and its parts will be produced. After setting the target cost, the target costing is launched under the control of Cost Management Council (or Target Costing Council).

Target Costing
In the design stage, begun after the product manager fixes his product planning, the target costing is organized so that the design engineers draw the parts and components of this vehicle so as to meet the target cost, ensuring of course their required quality. Following Toyota conventions, the cycle of drawing parts and production trials is repeated three times (but only one time from the end of the 1990s) before the definitive designs that satisfy the target cost and quality criteria are fixed (this process is called value engineering). Each time they draw the parts in this process, cost management personnel calculates the cost of the parts, in order to verify whether or not the target cost is achieved. Then the cost realized by definitive drawing becomes the referential cost of the product. Meanwhile, the Production Engineering Division, which conceives and prepares the production lines of parts and the final assembly line subject to investment budget constraints, fixes the standard time for producing parts and a whole vehicle. In other words, every production line has its own referential cost and standard time.

Figure 4. Cost Management System at Toyota

10

Target Costing

Figure 5. Procedure of Target Costing

7.3 Data required

Price target for the base car Price elasticity of the car Cost structure for every part of the car Price sensitivity related to the adding of various features to the base car Costs that can be reasonably removed Fixed costs that include moulds and other equipment

7.4 Reason that Toyota excels in target costing

Strong costing department Lots of historical data available and an excellent information network with customers and suppliers Competitive data Flexible architecture i.e. they can change features to accommodate the cost model Strong cross functional interactions Part sharing for reduced cost

11

Target Costing

8. Example Case Target Costing for SMARTCOM Modems

8.1 Findings of Market Research:
The Converter, Fax, Voice & Processor modules are the significant aggregated components leading to the overall cost of the modem.

Table 1. Cost estimate for SmartCOM Modem

8.2 Findings of Market Research:

Selling price which the customers are willing to pay for the Modem is $110, with a 10% margin of PC Maker, Installation & Assembling cost of $25 along with a 15% margin for SmartCom manufacturer.

Table 2. Cost Gap Analysis

12

Target Costing

8.3 Quality Function Deployment for customer priority & feature correlation:

4 Correlations 2 How (Technical Response)

1 What (Customer Wants)

3 Relationships

5 Planning Matrix

6 Technical Matrix
Below Table shows the features which mattered most for the customers and their relative priorities

Table 3. Function-Feature Mapping for SmartCOMs Modem

13

Target Costing

8.4 Value quantification for the Component contributing to a feature:

Table 4. Individual Component Value quantification

14

Target Costing

8.5 Actions Required:

Table 5. Actions Required

The above table shows the actions required in terms of costing of an individual component (either to enhance/reduce or do nothing), based on which the below changes have to be achieved:

Table 6. Target Costs to be achieved

15

Target Costing

9. Ways to achieve the Target Costs using Value Engineering/Innovation

Figure 6. Value Engineering for Target Costing

Figure 7. Sources of Cost reduction

10. Conclusion
10.1 Marketing costs
Decrease number of orders processed and deliveries made by encouraging larger orders through discounts.

10.2 Installation costs

1. Work with PC maker to reduce $25 installation charge by altering product design so that testing and installation will take less time and manpower than originally estimated. 2. Product design should incorporate the "plug and play" technology to minimize user involvement during installation and engineer the modem so that it can automatically configure itself with the right software.

16

Target Costing
3.Design product to include self-checking and diagnostic capabilities into the modem so that the modem can automatically test itself during operations.

11. Key Learnings

Figure 8. Key Learnings

12. Bibliography
Accenture Outlook Newsletter February 2010 Target Costing by Chrysler Strategy for Business Survival in 21st Century Ingersoll Rand Journal of Business & Economics Research February 2006 CAM-I Target Costing Interest Group Statements on Management Accounting Practices and Techniques June 1999 Japanese Target Costing A Historical Perspective Target Costing in Automobile Sector

17