Target Costing (#57)
/In this podcast episode, we discuss the nature of target costing and how the process functions. Key points made are noted below.
The Uselessness of Cost Variances
Remember in your accounting classes in college, where the professor droned on about price variances, and volume variances, and efficiency variances? Well, all of those variances involve the cost of a product after its already been designed. The trouble is that most of the cost structure of a product was built into it. And that means that all of those variances that you learned -- and may have been calculating since then -- don’t really help the product margin very much. Instead, variance analysis only helps you understand if extra costs are being incurred over and above the baseline cost of the product.
The Nature of Target Costing
But they don’t give you any insight into how to reduce the baseline cost. And that’s where target costing comes in. In brief, target costing is about figuring out in advance what price the market will bear, and then designing a product that has a predetermined margin, based on that price. If the design team can’t create a product with the right margin, then it stops the project.
That sounds pretty simple, but there’s a fair amount of iterative work involved. First of all, the marketing department needs to research what other products are in the market already, and the types of products that competitors sat they’re going to introduce. This also involves some estimates of the total market size, and the market share that the company thinks it can obtain. The end result should be some decent estimates of the price point and features that a new design should have before management allows it to be introduced into the market.
Now the cost accounting people get heavily involved in this work. They have to determine cost of all the key components, based on the estimated number of units to be produced. When they subtract these expenses from the per-unit price point, the result needs to be at least in the general range of the target gross margin.
At this point, the product project will very likely have too low a margin, because the design team has not yet put any effort into cutting costs out of the design. But that’s all right, because all we’re trying to do at this stage is to determine if it’s worth the effort to proceed.
So, let’s assume that management decides to continue with the project. If so, the company assembles a design team that includes marketing, engineering, and accounting staff. Under the target costing concept, the basic strategy of this group is to gradually reduce the designed-in cost of the product until it reaches the target margin. The marketing staff helps by figuring out which product features are the most important and valuable to customers. And the cost accounting staff continually re-runs cost estimates as the designers change the design.
And there is a lot of design work to be done. The engineers can interact with the marketing people to see if it’s acceptable to design the product with a reduced level of durability or reliability – and that’s because some products are seriously overbuilt. And for other products, customers don’t keep them long enough for there to be any concerns about durability.
But keep in mind that this is not just a design effort that reduces the cost of materials. You can also add industrial engineers to the group, to see if there’s a less expensive way to manufacture the product.
Also, you can add purchasing staff to the team, because they can figure out how to most cost-effectively source materials, or maybe it makes more sense to outsource some or all of the production. And they will certainly want to look at using substitute parts that are less expensive – but which may require some design changes so that they’ll work.
And it might also make sense to figure out a different distribution channel, such as Internet only, or through a distributor network.
Because of all these extra factors, the cost accountant might be running multiple costing scenarios at once, depending upon how the product is design, and sourced, and built, and sold.
To do all this, the cost accountant needs to compile a lot of costing information. This can include the cost of purchased parts and of entire subsystems of parts at different volume levels. This is really useful not only for more easily calculating the latest iteration of a design, but also for sensitivity analysis. For example, if the product sells a lot less than expected, the supplier price points for some materials might jump a lot, which triggers a massive profit drop.
The cost accountant should also quite definitely do an analysis of how much time the product will require through the company’s bottleneck operation – whatever that may be – to see how badly it might clog up the bottleneck. For more information about this topic, go back to my episodes 43 through 47, which are on throughput accounting.
So, getting back to the general process, during the early stages of the project, you can expect to have a swarm of costing models running concurrently, while the team works its way through a bunch of scenarios to see which one optimizes total profits.
But over time, all of these models need to be whittled down into a smaller cluster of options. The way the team manager does this is to set up a series of milestone reviews, perhaps once a month. At each review, the team has to be a little closer to the target margin. So for example, at the start, the target margin may be 40%, but the initial margin estimate is only 10%. So at the first milestone review, the team has to bring its margin estimate up to 15%, and to 20% at the next review, or else the project is scrapped.
By taking this forced improvement approach, design teams have to very quickly arrive at a competitive and profitable design within a fixed period of time – or else the project is cancelled.
Now, if a project is cancelled, this doesn’t in any way mean that the project team has a beer bash and a ritual burning in the parking lot of all its design paperwork. No, that would be bad. Instead, the team carefully assembles its files and stores them. The reason is that the market’s price point may change, and material costs may change.
And for that matter, the company may alter its target margin. So if these variables shift around enough, it’s possible that the project may become viable again. If so, you reassemble the team, pull their research materials out of the archives, and get them going again – but this time they have a head start, because they kept their original materials.
The Result of Target Costing
So what is the end result of target costing? It can lead to a massive improvement in profits, because companies don’t waste enormous amounts of time tinkering with products that realistically have no chance of becoming profitable.
And it certainly avoids the old technique of cost-plus pricing, where a company just builds what it thinks the market wants, tacks on a standard margin, and hopes the price point will be acceptable in the market. That approach almost always leads to excessively high prices, which usually results in poor market share numbers.
The Downside of Target Costing
But what is the downside of target costing? It requires the cooperation of a lot of departments on the same team – and that’s not easy to manage. And another problem is that the target costing process can winnow out products even if the company needs them for strategic purposes.
For example, a car company may feel that it needs a top of the line luxury car, which sometimes yields a trickle-down quality image on the entire product line. The target costing analysis on that particular car may result in a rejection of the product, because the margin is too low. But if you look at its impact on the entire product line, it may still make sense.
So, use target costing selectively, keeping in mind the company’s overall goals in the marketplace.