NEW COST MANAGEMENT

SYSTEMS

TARGET COSTING

DEFINITION

Target costing is the process of determining the

maximum allowable cost for a new product and then

developing a prototype that can be profitably made for

that maximum target cost figure.

The target cost for a product is calculated by starting

with the product's anticipated selling price and then

deducting the desired profit. TARGET COST = ANTICIPATED SELLING PRICE – DESIRED

PROFIT

PROCESS

MA

NUF

ACT

URE

R

VALUE ENGINEERING

Value engineering is used in target costing to reduce

product cost by analyzing the tradeoffs between

different types of product functionality and total

product cost.

An important first step in value engineering is to

perform a consumer analysis during the design stage

of the new or revised product.R&D DESIGN Manufacturin

g

Marketing and

Distribution

Customer Service

TARGET COSTIN

G

VALUE ENGINEERING The type of value engineering used depends on the

product's functionality.

GR

OU

P

1• Changes are made to features.

• Frequent new models or updates to the product.

• E.g. automobiles, computer software, cameras audio/video equipment.

GR

OU

P

2• Changes are made to product.

• Functionality must be designed into the product.

• E.g.construction equipment(truck), specialized medical equipment

TYPES OF VALUE ENGINEERING

Functional analysis a process of examining the

performance and cost of each major function or

feature of the product.

Objective: An overall desired level of performance

achievement for each function is obtained while

keeping the cost of all functions below the target cost.

Benchmarking is often used at this step to determine

which features give the firm a competitive advantage.

Design analysis - The design team prepares several

possible designs of the product each having similar features

with different levels of performance and different costs.

Benchmarking and value chain analysis help guide the

design team in preparing designs that are both low cost

and competitive.

The design team works with cost management personnel to

select the one design that best meets customer preferences

while not exceeding the target cost.

TYPES OF VALUE ENGINEERING

A comparison of different target costing and cost-reduction strategies in three Japanese firms based on the field research of Robin Cooper

FIRM/

INDUSTRY

FUNCTIONALI

TYCOST REDUCTION APPROACH STRATEGY

Olympus/

Cameras

Increasing

rapidly; is

designed in.

Target costing using value

engineering; the concept of

distinctive functionality for the price

point, plus supportive functionality.

Heavy focus on

managing

functionality

Nissan/Auto Increasing

rapidly; easy to

add or delete

functionality.

Value engineering by product and by

each component of each product;

then increase price or reduce

functionality

Prices are set by

desired customer’s

expectations about

functionality; the

target cost is used to

find savings,

especially from

suppliers.

Komatsu/

Construction

Equipment

Static; must be

designed in.

Design analysis to determine

alternative designs. Functional

analysis to develop

cost/functionality trade-offs.

Productivity programs to reduce the

remaining costs.

Primary focus is on

cost control rather

than redesign or

functionality analysis.

TYPES OF VALUE ENGINEERING

Group technology is a method of identifying similarities in

the parts of products a firm manufactures so the same parts

can be used in two or more products thereby reducing costs.

Large manufacturers of diverse product lines e.g.

automobile industry, use group technology in this way.

ABC is particularly useful for helping product designers

purchasing managers manufacturing managers and

marketing managers work together with a common

understanding of the costs of different features and options.

RATIONALE FOR USING TARGET COSTING

TECHNIQUE Target costing was developed in recognition

of two important characteristics of markets

and costs .

MARKETS:

• Companies have less control over price than they

would like to think.

• The market (i.e., supply and demand) determines

prices.

• So, anticipated market price is taken in target

costing .

COST:

• Most of the cost of a product is determined in the design

stage (not during production).

• The opportunities to reduce cost come from designing the

product so that it is

Simple to make,

Uses inexpensive parts, and

Is robust and reliable.

The difference between target costing and other

approaches to product development is profound. Instead

of designing the product and then finding out how much

it costs, the target cost is set first and then the product

is designed so that the target cost is attained.

R&D DESIGN Manufacturing

Marketing and

Distribution

Customer Service

TARGET COSTIN

G

ILLUSTRATION

Handy Appliance Co. feels that there is a market niche

for a hand mixer with certain new features.

The marketing department believes that a price of $30

would be about right for the new mixer.

At that price, it is estimated that 40,000 of new mixers

could be sold annually.

An investment of $2,000,000 would be required to

design, develop, and produce.

The company desires a 15% return on investment (ROI).

CALCULATION of TARGET COST

Projected sales

(40,000 mixers*$30 per mixer )$1,200,000

Less desired profit

(15%*$2,000,000)$300,000

Target cost for 40,000 mixers $9,00,000

Target cost per mixer

($9,00,000 / 40,000 mixers)$22.50

Given these data, the target cost to manufacture, sell,

distribute, and service one mixer is $22.50 as calculated

hereafter

ILLUSTRATION: TARGET COSTING IN HEALTH PRODUCT MANUFACTURING

Health Products International Inc. (HPI) is conducting a value

engineering project by making a target costing analysis of a

major product - a hearing aid.

Second-generation hearing aid (HPI – 2) for $ 750 (cost of $ 650)

Has obtained 30 percent of this market worldwide at a profit of

$100 per aid.

Competitor recently introduced a new third generation hearing

aid @ the price to $1200.

HPI must meet the new lower price and maintain its current rate

of profit ($100 per unit) by redesigning the hearing aid and/or

the manufacturing process.

The target cost for the new aid is

A reduction in cost of $150 ($650-$500) from the

current model.

$600 – $100=$500

OLD ($) NEW ($)

S.P. 750 600

Profit 100 100

TARGET COST 650 500

ALTERNATIVES

Alternative A(-)Reduce R&D: $50

Replace – (-) The microphone unit

with one of nearly equivalent sensitivity:

$30(-)Toggle power switch with slide switch: $30(-)Current inspection

procedure with an integrated quality

review process at each assemble station: $40

Alternative BReplace –

(-)Amplifier unit with one having slightly less power, not expected to

be a noticeable difference:$ 50

(-) Microphone unit: $30

(-) Toggle power switch with slide switch: $ 30(-) Current inspection

procedure : $ 40

Alternative C(+)Increase R&D to

3G: $40Replace –

(-)Amplifier unit: : $ 50 (-)Microphone unit:

$30(-)Toggle power switch with slide switch: $ 30(-)Current inspection

procedure : $ 40(-)Plastic earpiece

material with material of lower quality: $20

(-)Renegotiate contract with supplier of plastic

casing:$ 20

$150 $150 $150

COMPANIES THAT USE TARGET COSTING

The U.S. Auto Companies – General Motors, Ford,

and Daimler Chrysler

The Japanese Auto Companies - Toyota, Nissan,

Honda, Mitsubishi etc.

General Electric

Motorola

NASA

Sony

The U.S. Military

COST ACCOUNTANT’s ROLE IN TARGET COSTING ENVIRONMENT

Provide for the members of the design team a running series of

cost estimates based on

• Initial design sketch,

• Activities based costing reviews of production process, and

• Best guess costing information from suppliers based on estimated

production volumes.

Take responsibility for any capital budgeting requests generated by

the design team.

Answer to any questions from finance staff regarding issues or

uncertainties in the capital budgeting approach.

Bridging the gap between the current cost of product development

and design and the target cost .

ADVANTAGES

Proactive approach to cost management.

Orients organizations towards customers.

Breaks down barriers between departments.

Minimize non value-added activities.

Reduced time to market.

Encourages selection of lowest cost value added activities.

Implementation enhances employee awareness and Foster

partnerships with suppliers.

LIMITATIONS

Requires many meetings for coordination.

Its implementation requires willingness to

cooperate.

Effective implementation and use requires the

development of detailed cost data.

May reduce the quality of products due to the use

of cheep components which may be of inferior

quality.

MANAGERIAL IMPLICATIONS

OF TARGET COSTINGAuthor(s): Marilyn M. Helms, Lawrence P. Ettkin,

Joe T. Baxter, and Matthew W. Gordon

INTRODUCTION Target costing may serve as a solution when developing new

products, minimizing costs through the optimal use of all

resources along the entire supply chain .

Originating in Japan, target costing is used in over 80

percent of Japanese assembly companies (Kroli, 1997) and by

100 percent of Japanese car manufacturers (Boer and Ettiie,

1999).

Target costing involves :Selecting and Involving Suppliers

Design Modifications

Outsourcing

Involvement and Continuous Improvement

RESEARCH INDUSTRY COMPANIES FINDINGS

Cooper and Slagmulder, 1997; Knott, 1996; and Tanaka, 1993

Automotive sector

Toyota, Nissan, Sony, Matsushia, Daihatsu, Canon, Olympus Optical, and Komatsu Non-Japanese companies – Mercedes, Goodyear, Rockwell, Texas Instrument, DaimlerChrysier, and the North Sea oil industry

-

Nicolini, Tomkins, Holti, Oldman, and Smalley (2000)

Construction sector -

Value engineering or analysis,

Design for manufacturing, Effective organizational

structures, Streamlined development

processes, Actively engaging the

supply chain

Ellram (2000)

Semiconductor, automotive, and electronic equipment industry , computer peripheral, consumer products, and aerospace original equipment

-

Reducing costs, Understanding the

supplier's cost structures, Improving internal cost

management. Improving cost monitoring,

and increasing cost accountability.

RESEARCH INDUSTRY COMPANIES FINDINGS

Swenson, Ansari, Dell, and Kim(2003)

Airlines

Boeing, Caterpillar, DaimlerChrysier, and Continental Teves

Shared target costingprinciples included: Price-led costing, A customer design

focus, Cross functional &

value-chain involvement and

Life-cycle orientation to price and costs.

Banham, 2000 Transportation and heavy equipment industries, theEntire auto industry, electronics, oil, Pharmaceuticals

Eastman-Kodak, Micrus Semiconductors, Honda of America, and Boeing

Cross-functionalinvolvement of design, marketing, procurement,logistics, and finance on talking with the customerChen and

Chung, 2002

IBM's Information Product Division spin off of Lexmark International

BARRIERS

Lack of Understand

ing or Relevance

Team and Cross-

Functional Barriers

Irrelevance or Fear of the Effects

Production Detail

MIS and Accounting Cost Data

Limitations

IMPLICATIONS FOR MANAGEMENT

Research at the University of Birmingham (UK) found that if

the design team has difficulty meeting a target cost, a

systematic approach can be taken.

• First, it may be important to review the target cost to determine if

the cost can be raised or if margins can be reduced.

• The next step is to review the manufacturing process for a

possible modification or relaxation of product functionality

requirements.

• It may be useful to make improvements in the machinery

tooling to meet target costs.

• Another avenue is to reduce supplier costs.

• The last alterative may be abandoning the project.