Target costing is a system under which a company plans in advance for the product price points, product costs, and margins that it wants to achieve. If it cannot manufacture a product at these planned levels, then it cancels the product entirely. With target costing, a management team has a powerful tool for continually monitoring products from the moment they enter the design phase and onward throughout their product life cycles. It is considered one of the most important tools for achieving consistent profitability.
The primary steps in the target costing process are:
- Conduct research. The first step is to review the marketplace in which the company wants to sell products. The team needs to determine the set of product features that customers are most likely to buy, and the amount they will pay for those features. The team must learn about the perceived value of individual features, in case they later need to determine what impact there will be on the product price if they drop one or more of them. It may be necessary to later drop a product feature if the team decides that it cannot provide the feature while still meeting its target cost. At the end of this process, the team has a good idea of the target price at which it can sell the proposed product with a certain set of features, and how it must alter the price if it drops some features from the product.
- Calculate maximum cost. The company provides the design team with a mandated gross margin that the proposed product must earn. By subtracting the mandated gross margin from the projected product price, the team can easily determine the maximum target cost that the product must achieve before it can be allowed into production.
- Engineer the product. The engineers and procurement personnel on the team now take the leading role in creating the product. The procurement staff is particularly important if the product has a high proportion of purchased parts; they must determine component pricing based on the necessary quality, delivery, and quantity levels expected for the product. They may also be involved in outsourcing parts, if this results in lower costs. The engineers must design the product to meet the cost target, which will likely include a number of design iterations to see which combination of revised features and design considerations results in the lowest cost.
- Ongoing activities. Once a product design is finalized and approved, the team is reconstituted to include fewer designers and more industrial engineers. The team now enters into a new phase of reducing production costs, which continues for the life of the product. For example, cost reductions may come from waste reductions in production (known as kaizen costing), or from planned supplier cost reductions. These ongoing cost reductions yield enough additional gross margin for the company to further reduce the price of the product over time, in response to increases in the level of competition.
The design team uses one of the following approaches to more tightly focus its cost reduction efforts:
- Tied to components. The design team allocates the cost reduction goal among the various product components. This approach tends to result in incremental cost reductions to the same components that were used in the last iteration of the product. This approach is commonly used when a company is simply trying to refresh an existing product with a new version, and wants to retain the same underlying product structure. The cost reductions achieved through this approach tend to be relatively low, but also result in a high rate of product success, as well as a fairly short design period.
- Tied to features. The product team allocates the cost reduction goal among various product features, which focuses attention away from any product designs that may have been inherited from the preceding model. This approach tends to achieve more radical cost reductions (and design changes), but also requires more time to design, and also runs a greater risk of product failure or at least greater warranty costs.
Of these methods, companies are more likely to use the first approach if they are looking for a routine upgrade to an existing product, and the second approach if they want to achieve a significant cost reduction or break away from the existing design.
What if the project team simply cannot meet the target cost? Rather than completing the design process and creating a product with a substandard profit margin, the correct response is to stop the development process and move on to other projects instead. This does not mean that management allows its project teams to struggle on for months or years before finally giving up. Instead, they must come within a set percentage of the cost target on various milestone dates, with each successive milestone requirement coming closer to the final target cost. Milestones may occur on specific dates, or when key completion steps are reached in the design process, such as at the end of each design iteration.
Though management may cancel a design project that cannot meet its cost goals, this does not mean that the project will be permanently shelved. Instead, management should review old projects at least once a year to see if the circumstances have changed sufficiently for them to possibly become viable again. A more precise review approach is to have each project team formulate a set of variables that should initiate a product review if a trigger point is reached (such as a decline in the price of a commodity that is used in the product design). If any of these trigger points are reached, the projects are immediately brought to the attention of management to see if they should be revived.
Target costing is most applicable to companies that compete by continually issuing a stream of new or upgraded products into the marketplace (such as consumer goods). For them, target costing is a key survival tool. Conversely, target costing is less necessary for those companies that have a small number of legacy products that require minimal updates, and for which long-term profitability is more closely associated with market penetration and geographical coverage (such as soft drinks).
The target costing concept has limited application in a services business where labor comprises the primary cost.
Target costing is an excellent tool for planning a suite of products that have high levels of profitability. This is opposed to the much more common approach of creating a product that is based on the engineering department’s view of what the product should be like, and then struggling with costs that are too high in comparison to the market price.