Target Costing

Robin Cooper and Regine Slagmulder Editors circular This article is an updated synthesis of in-depth explorations contained in posterior monetary revalueing and Value Engineering, by Robin Cooper and Regine Slagmulder (Portland, operating theatre Productivity Press, 1997). Part two of the series discusses fruit-level orchestrate greeting part lead, to be signd in an upcoming issue, entrust address component-level intent wooing. omers. Consequently, the objective of harvesting-level point personifying is to maturation the permissible come to of the harvest-home to a level that stack reasonably be expected to be achievable, given the capabilities of the riotous and its suppliers (see Exhibit 1). EXECUTIVE SUMMARY Product-level bum be works to increase the all(prenominal)owable embody of the w ar to a level that is both reasonable and achievable given the capabilities of the hard and its suppliers. Step one establishes the identify terms by incorporating the capability of the firm and its suppliers into the allowable represent so that an achievable harvest-festival-level target live is established. Step two uses value engineering to identify directions to digiting the harvest-festival so that it piece of ass be compeld at its target comprise. Step third applies the disciplining appliances to supporter ensure that the output-level target cost is passd. The target be assist contains three major sections market-driven cost, harvest-feast-level target cost, and component-level target costing.In part two of a three part series, this article discusses how ware-level target costing works to increase the allowable cost of the product to a level that is both reasonable and achievable given the capabilities of the firm and its suppliers, in a three graduation mould. Step one establishes the target cost by incorporating the capability of the firm and its suppliers into the allowable cost so that an achievable product-level target cost is established.Step two uses value engineering to identify ways to mark the product so that it can be manufactured at its target cost. Step three applies the disciplining mechanisms to cooperate ensure that the product-level target cost is achieved. PRODUCT-LEVEL set COSTING The objective of product-level target costing is to establish pugnacious but achievable product-level target cost. These target be should place considerable wring on the firms product engineers to fall out creative ways to reduce the manufacturing cost of the products that they ar designing.Target costs take issue from allowable costs, because they incorporate the capabilities of the firm and its suppliers into the target costing go. In practice, it is non always possible for the designers to find ways to achieve the allowable cost and still satisfy the firms cus1 Product-level target costing can be broken into three steps (see Exhibit 2). In the first step, the product-level target cost i s established. This step consists of incorporating the capability of the firm and its suppliers into the allowable cost so that an achievable product-level target cost is established.The secant step consists of using value engineering (and other similar techniques) to identify ways to design the product so that it can be manufactured at its target cost. In the third step, the disciplining mechanisms of target costing are applied to help ensure that the product-level target cost is achieved. The disciplining mecha- article 32. TARGET COSTING FOR NEW-PRODUCT information PRODUCT-LEVEL TARGET COSTING thereof require that the firm must reduce costs if it is to wield its in demand(p) level of profitability.The degree of cost reduction required to achieve the allowable cost is called the cost-reduction objective and is derived by subtracting the allowable cost from the current product cost Cost-Reduction Objective = Current CostAllowable Cost The current cost is the cost of a forward -looking product if it were manufactured today using exist components or variants thereof. No cost-reduction activities are assumed in computing the current cost of the product. For the current cost to be meaningful, the components used in its estimation must be very similar to those that chargetually depart be used in the sunrise(prenominal) product.If the existing shape uses a 1. 8-liter engine and the new model uses a 2. 0-liter one, for example, current cost would be estimated using the cost of the to the highest degree similar 2. 0-liter engine currently produced by the firm. Because the allowable cost is derived from external conditions without consideration of the firms internal design and output capabilities, there is a risk that the allowable cost give not be achievable. In this case, to maintain the content of target costing, the firm must identify the achievable and unachievable parts of the cost-reduction objective.Analyzing the ability of the product designers and suppliers to remove costs from the product (see Exhibit 3) derives the achievable or target cost-reduction objective. The regale by which costs are outside from the product is called value engineering, and it depends heavily on an interactive descent with the suppliers. The purpose of this relationship is to allow the suppliers to provide early estimates of the selling prices of their products and, when possible, insights into alternative design possibilities that would enable the firm to deliver the craved level of functionality and quality at reduced cost.The unachievable part of the cost-reduction objective (referred to in Exhibit 2) is called the strategical cost-reduction challenge. It identifies the profit shortfall that leave behind occur when the designers are unable to achieve the allowable costa signal that the firm falls short of the capabilities demanded by hawkish conditions. Typically, in a firm with a well-established target costing system, the strategic co st-reduction challenge will be small or nonexistent, and intense pressure will be brought on the design police squad to reduce it to zero.For the most capable firms, the achievable cost reduction for a product might exceed the cost-reduction objective. much(prenominal) firms do not face a strategic cost-reduction challenge. They can take advantage of their superior capabilities by reduce the selling price of the product to increase market share, by increasing product functionality while maintaining the targeted selling price, or by care both price and functionality at their targeted levels to earn higher profits. To maintain the discipline of target costing, the size of the strategic cost-reduction challenge must be managed carefully.A strategic cost-reduction challenge should reflect the true inability of the firm to check up on competitor capabilities. To ensure that the strategic cost-reduction challenge meets this requirement, the target cost-reduction objective must be set so that it is 2 nisms include take place monitoring and validation and the masking of the rudimentary normal of target costing products whose manufacturing costs are above their target costs should not be launched. The monitoring and validation process helps ensure that the savings identified through value engineering are actually achieved.The application of the cardinal triumph ensures that the discipline of target costing is hold. When designers know that target cost violations lead to serious consequences, they are subjected to a real pressure to achieve the target costs. SETTING THE PRODUCT-LEVEL TARGET COST In passing competitive markets, customers expect each generation of products to have higher value than that of their predecessors. Value can be increased by improving the quality or functionality of the firms products or by reducing their selling prices. Any of these improvements or some combinationANNUAL EDITIONS cost-reduction challenge, which creates a powerful pressure on the design team of the next generation of the product to be even more aggressive provided about cost reduction. In this way, the failure to achieve the allowable cost this time around is turned into a challenge for the future, not a permanent defeat. Second, allowable cost avoids weakening the cardinal rule, which applies only to target costs, not allowable costs. The process by which the strategic cost-reduction challenge is established must be highly disciplined.Otherwise it becomes a mechanism to reduce the effectiveness of target costing by setting target costs that are likewise easy to achieve. In most firms, pinnacle management approves the strategic cost-reduction challenge before the product-level target cost can be set. Technically, the target cost of a product is the target selling price little the target profit coast plus the strategic cost-reduction challenge. Many firms blur the distinction between the allowable cost and the target cost, however, by st ating that the target cost is find by subtracting the target profit margin from the target selling price.This simplification makes it easier for people to understand the spirit of target costing as cosmos price driven. Obviously, if the strategic cost-reduction challenge is zero, the allowable and target costs are identical. At some firms, even when the allowable cost is considered achievable, it is not referred to as a target cost until the process has reached the stage at which the major component target costs are established. The retention of the term allowable costs shows that top management is not willing to invoke the cardinal rule until it is convinced that the target cost is therefore achievable. chievable only if the blameless organization makes a significant effort to reach it. Consistently setting the target cost-reduction objective to a fault high can lead to workforce burnout and, ultimately, the discipline of target costing will be lost. Conversely, if the target c ost-reduction objective is consistently set too low, the firm will lose competitiveness, because new products will have excessively high target costs. Again referring to Exhibit 2, the product-level target cost is determined by subtracting the proposed product target costreduction objective from its current cost.That is Product-Level Target Cost = Current CostTarget Cost-Reduction Objective The strategic cost-reduction challenge is determined by subtracting the allowable cost from the target cost strategic Cost-Reduction Challenge = Target Cost Allowable Cost The value of differentiating between the allowable cost and the target cost in this manner lies in the discipline that it creates. In most firms, the allowable cost will sometimes be too low to achieve, given the relative capabilities of the firm and its suppliers compared to competitors and their suppliers.Target costing systems derive their military strength from the application of the cardinal rule, The target cost must nev er be exceeded. If a firm continuously sets over-aggressive target costs, violations of the cardinal rule would be common and the discipline of the target costing process would be lost. Even worse, if the allowable cost is known to be unachievable, the design team might give up even trying to achieve it, and effective cost reduction during product design would cease. To avoid this need problem, firms frequently set target costs higher than the allowable costs.These target costs are intentional to be achievable but only with considerable effort. They allow the cardinal rule to be maintained for almost every product. Consequently, the distinction between allowable and productlevel target costs plays two roles. First, it identifies the strategic 3 ACHIEVING THE PRODUCT-LEVEL TARGET COST Once planners have identified the target cost-reduction objective, the second stage of product-level target costing begins achieving it (see Exhibit 4). Several engineering techniques can help produ ct designers find ways to reduce the costs of products.They include value engineering, design for manufacture and assembly, and quality function deployment. Value engineering, the most important of the three techniques, has the primary objective of maximizing customer valueit tries to increase functionality and quality while at the aforementioned(prenominal) time reducing cost. In contrast, DFMA focuses on reducing costs by making products easier to assemble or manufacture, while holding functionality at specified levels. Finally, QFD provides a structured near to ensure that customer requirements are not compromised during the design process.Target costing and value engineering can be viewed as concurrent activities, as can kaizen costing and VA. The application of value engineering begins with the innovationualization of the product and continues through the design process until the product is released to manufacturing. Even then the process continues, but under the name value analysis (VA). Article 32. TARGET COSTING FOR NEW-PRODUCT DEVELOPMENT PRODUCT-LEVEL TARGET COSTING The end between VA and VE is not in the cost taken or the tools used but the point at which they occur in the life circle of the product.VE is used during the product design and knowledge stages, and VA is used for the manufacturing stage and for purchasing parts. For this reason, target costing and value engineering can be viewed as concurrent activities, as can kaizen costing and VA. It would be violate to view VE as just another cost-reduction program. VE is primarily about product functions and only secondarily about cost. The motivating force behind VE is to ensure that the product achieves its basic function in a way that satisfies the customer at an acceptable cost.Consequently, VE programs are the domain of the product engineer, not the accountant. bility of the existing functions. Second-look VE is applied during the finish half of the planning stage and the first half of the development and product preparation stage. The objective of second-look VE, unalike that of zero- and first-look VE, is to improve the value and functionality of existing components, not create new ones. Consequently, the scale of changes is much smaller than for zero- and first-look VE. relative applications of VE consist of extracting down other products to identify new ways to reduce costs.We define tear down as a comparative VE method through visual observation of disassembled equipment, parts, and data coherent in a manner convenient for such observation. Numerous bettermentes to tear down exist. The six ascendent techniques are 1. 2. 3. 4. 5. 6. Dynamic. Cost. Material. Static. Process. Matrix tear down. VE Techniques The VE techniques can be broken into three major categories 1. Direct application of VE principles to the product. 2. Tear down approaches using comparative VE. 3. Miscellaneous VE. VE can be applied directly to proposed products at different stages of the product design process.These different approaches are known as looks. Zero-look VE is the application of VE principles at the c formerlypt proposal stage, the earliest stage in the design process. Its objective is to introduce new forms of functionality that did not antecedently exist. First-look VE focuses on the major elements of the product design and is defined as developing new products from concepts. The objective is to deepen functionality of the product by improving the capa4 The first three methods are designed to reduce a products direct manufacturing costs.The next three are intended to reduce the investment required to manufacture the product through increased productivity. There are at least four miscellaneous cost-reduction techniques 1. 2. 3. 4. The checklist method. The one-day cost-reduction meeting. mini VE. The VE reliability program. ANNUAL EDITIONS Checklists The checklist method is used to identify a products cost factors and to intimate ways to reduc e costs. The checklist consists of a number of questions designed to guide the firms cost-reduction activities by discovering cost-reduction opportunities.Checklists help ensure exploration of all possible avenues for cost reduction. One-day cost-reduction meetings are designed to improve the efficiency of the entire cost-reduction process, including VE and tear down methods. Participants from engineering, deed, cost, and sales are expected to come up with ideas for new costreduction possibilities. The meetings are a way to overcome limitations in the approval process used for most cost-reduction proposals. The approval process entails travel written proposals to all involved parties, who indicate acceptance by signing off on them.Unfortunately, this approach severely reduces the exchange of information and modification of ideas. At the oneday meetings, presentation of the results of various tear-down programs helps initiate discussions. production/sales-preparation stage, and the production/salespreparation stage. DISCIPLINING THE PRODUCT-LEVEL TARGET COSTING PROCESS Disciplining the product-level target costing process begins with monitoring and validating the progress of the design engineers toward reaching the cost-reduction objective.It is at this stage in the process that the cardinal rule of target costing is applied. nevertheless when getting the product to market is so imperative that cost is of secondary consideration should the cardinal rule be violated. Finally, when the product is released for mass production and its actual cost of manufacturing can be measured, steps sometimes have to be taken to reduce those costs to the target level. Once the target cost-reduction objective has been established, the process of designing the product so that it can be manufactured at its target cost can commence.The discipline of target costing requires that the chief engineer and his or her superiors continuously monitor and validate that the progress the des ign engineers are making toward this objective. This monitoring ensures that corrective actions can be taken as soft as possible and that the cardinal rule will not be broken. Some firms define an as-if cost at this point in the development process. The as-if cost reflects cost-reduction opportunities identified when the previous generation of the product was universe designed or manufactured. In most cases, the as-if cost is above the target cost of the new product but below its current cost.The additional cost that must be achieved is defined as the difference between the target cost and as-if cost. As the design process proceeds and costs are removed from the major functions, the estimated manufacturing cost gradually 5 Mini VE and VE Reliability Mini VE is a simplified approach to second-look VE. It is applied to specific areas of a part or to very small, inexpensive parts. Mini VE is applied during the development and product preparation stages, the development and production- sales preparation stage, and the production-sales preparation stage.A VE reliability program is designed to ensure that the most appropriate form of VE is applied to each problem. Essentially, it is a quality of VE program. If a completely new product design is required, for example, applying second-look VE is not appropriate. Like mini VE, the program is applied during the development and product-preparation stages, the development and Article 32. TARGET COSTING FOR NEW-PRODUCT DEVELOPMENT PRODUCT-LEVEL TARGET COSTING falls toward the target cost. Many firms call the updated estimate the travel cost (see Exhibit 5).Thus, the product design process starts with an as-if cost higher than the target cost and crosswise the design process reduces the expected or drifting cost until it reaches the target cost. At most firms, once the drifting cost equals the target cost, cost-reduction activities cease. There is no reward for achieving greater savings than those required to achieve the t arget cost. The engineers time is better spent on getting the drifting cost of other products to equal their target costs. estrictive, because the product under review causes additional revenues to be generated beyond those generated by the product itself. Such products include flagship products that create high visibility for the firm, products that introduce the next generation of technology, or products that fill a critical gap in the product line. For such products, the target cost is often relaxed to allow for the underground revenues. However typically, cost reduction pressures are still applied during the early stages of manufacturing until the target cost is achieved.For the products that feature a variety of options, the final fine-tuning of the target cost is often achieved by specifying the features that the banner product will contain. If the manufacturing cost is too high, for example, one or more standard features might be converted to options that the customer now h as to pay an additional amount to obtain. Converting features to options both reduces the cost of manufacturing the standard product, allowing the target cost to be achieved, and increases the selling price of the originally specified product, allowing the target profit to be achieved.Obviously, the reduction in the functionality of the standard variant must be subjected to market analysis to ensure that it is acceptable in the eyes of the customer at the target selling price. An example might include the conversion of side air bags from a standard feature to an optional one. This reduction in functionality will be acceptable only if competitive offerings treat side air bags in the same way. This fine-tuning process gives firms more leeway to achieve target costs set several years earlier. Similarly, the actual selling price is not fixed until just before the product is launched.Delaying these two critical decisions significantly reduces the uncertainty that a firm, in a multiyear p roduct development process, faces with respect to achieving target costs. At most firms, once the drifting cost equals the target cost, cost-reduction activities cease. The process of comparing the drifting cost to the target cost continues throughout the design process. Often when the product is fast to be released to production, for example, planners undertake a final review of the feasibility of the target cost.If the estimated production cost is too high, the design is subjected to additional analysis. Frequently, relatively minor changes in the products design are all that is needed to reduce the cost estimate to the target cost level. As long as these changes do not alter the products price point, the products functionality is reduced and the product is submitted for approval. If the design changes will reduce the price point, the product is typically returned to the research and development group for design.The cardinal rule of target costing plays an important role in maint aining the discipline of target costing. Great care is taken to ensure that the sum of the component target costs does not exceed the target cost of the product. Often, an increase in the cost of one component causes the engineers to explore ways to reduce the costs of other components by an equivalent amount. In addition, to help ensure enforcement of the cardinal rule, most firms have a policy against incoming unprofitable or sub-profitable products.When the product design phase is over, the product moves to manufacturing. As part of this transition phase, the target cost is compared to the standard cost of production. If the standard cost is higher, usually the firm takes steps to reduce manufacturing costs to the target level. Often, if the standard cost is at or below the target cost, the design of the product is rimed for the rest of its life, and no further actions, other than general kaizen, are taken to reduce the cost of the new product.As with any rule, the cardinal rul e occasionally is broken. It is violated when a broader analysis indicates that breaking it will be beneficial for the firm. Target costing, by its nature, takes a single-product orientation. Sometimes, this view is too NEXT STEPS One of the backbone constituents of the product-level target cost is the target costs of all of the outsourced components. These costs are the focus of the next step in the target costing process, component-level target costing.It is in this portion of the target costing process that the discipline of target costing is extended to the supplier base of the firm. Journal of Cost Management board part ROBIN COOPER is a professor in the practice of cost management at Roberto C. Goizueta barter School at Emory University and can be reached at (404) 7276679. REGINE SLAGMULDER is associate professor of accounting and control at INSEAD France. She can be reached at regine. slagmulder insead. edu. From Journal of Cost Management, July/August 2002, pp. 5-12. 200 2 by the Journal of Cost Management. 6