Introduction
Defining Target Costing
Objectives of Target Costing
Target Costing Process Tools
Introduction
The long term financial success of any business depends on whether its prices exceed its costs by enough to finance growth, provide for reinvestment, and yield a satisfactory return to its stakeholders. As competition increases, and supply exceeds demand, market forces influence prices significantly more. To achieve a sufficient margin over its costs, a company must manage those costs relative to the prices the market allows or the price the firm sets to achieve certain market penetration objectives. In the context of these characteristics, the practice of target costing has evolved.
Following World War II, many North American companies grew quickly because of pent up demand, the reconstruction of Europe and the Pacific Rim, and rapid population growth. Strong demand and few competitors permitted companies to remain profitable and grow by offsetting cost increases with price increases. Unfortunately, cost based pricing does not foster strong cost management. Today, many North American companies, accustomed to strong demand, little competition, and the ability to mark up costs to yield good profits, are experiencing a very different and more hostile marketplace.
Target costing is a fundamentally different way to look at the relationship of prices and costs. The basic target g equation of "Price Profit Margin = Cost" means that prices are driven and set either by competitive market forces or by the firm as it aggressively lowers its prices to increase market penetration; that profit margins are established such that the firm can make money; and that allowable costs are derived from price and margin.
For leaders in the use of target costing, this idea is much more than a shift in mechanics. It is a mind set change that permeates the whole organization, is highly disciplined, and integrates the marketplace with design and production. The idea that prices drive allowable costs has a marked behavioral and business impact. It is a key to long term business survival, growth and prosperity in a competitive and rapidly changing environment.
Because the idea of target costing has resulted from the highly competitive environment to which most Japanese companies have been subjected for a number of years, each company has its own unique approach. Definitions range from relatively narrow to broad. However, common to most definitions is a process founded on competitive market environment; market prices driving cost and investment decisions; cost planning, management and reduction occurring early in the design and development process; and cross functional team involvement.
In markets where there are a limited number of sellers, and demand exceeds supply, sellers can mark up their costs to achieve prices that result in profits; that is, they may use a "cost plus" approach to pricing. In competitive markets, prices are driven by market forces. Sellers must take greater account of the presence of strong competitors, alternative products and services, and their prices. One of the benefits of target costing is that it forces an increased understanding of markets, competition and customer needs in terms of products, quality, timeliness and price. When prices are set by market forces, or by a management decision to be a price leader, costs must be lower than prices to make money. Viewing costs as a derivative of prices and profit margin, rather than the other way around, requires a major shift in mind set. It should be pointed out, too, that margins cannot be arbitrarily set, but are influenced by one's potential cost position. Not all companies can be the lowest cost producer. Setting an unattainable margin could lead to an unattainable cost objective. Since target costing is usually applied to new product planning, which frequently requires investment in tooling, equipment and other assets influencing costs, it can legitimately be said that price drives both costs and investments.
Most costs are determined by early product and process design decisions. Trying to reduce costs once a product reaches production is very difficult. Therefore, focusing on costs during the early design stages to ensure that the target profit and cost can be realized is critical. That means product designs, material choices, specifications and tolerances, buy versus make decisions, process designs and investment decisions need to be thought through before product design and development decisions are finalized.
Achieving the necessary degree of agreement and compromise between any of the functions (marketing, design and development, procurement, process engineering, manufacturing and accounting) involved with the product delivery cycle requires the establishment of cross functional teams specifically charged with addressing the inevitable tradeoffs that will arise. Done well, this team effort can turn out new and modified products that are developed and produced quickly, satisfy the marketplace and yield the desired profits. A set of different views brought together early in the design process can be more efficient and effective than the typical sequential process.
Objectives of Target Costing
The fundamental objective of target costing is to enable management to use proactive cost planning, cost management and cost reduction practices whereby costs are planned and managed out of a product and business early in the design and development cycle, rather than during the latter stages of product development and production. It obviously applies to new products, but can also be applied to product modifications or succeeding generations of products. It might also be used for existing products, but costs are more difficult to reduce once a product is in production.
The costs most typically emphasized in the target costing process are such things as: material and purchased parts, conversion costs (such as labor and identifiable overhead expenses), tooling costs, development expenses and depreciation. However, all costs and assets that may be affected by early product planning decisions should be considered. This would include more indirect overhead expenses through the production stage, and beyond, such as service costs, and assets like inventory. Target costing is intended to get managers thinking ahead and comprehensively about the cost and other implications of the decisions they made.
Target costing is as much a significant business philosophy as it is a process to plan, manage and reduce costs. It emphasizes understanding the markets and competition; it focuses on customer requirements in terms of quality, functions and delivery, as well as price; it recognizes the necessity to balance the trade offs across the organization, and establishes teams to address them early in the development cycle; and it has, at its core, the fundamental objective to make money, to be able to reinvest, grow and increase value.
The Target Costing Process
Just as there is no single definition of target costing, there is no single target costing process. Nevertheless, all companies share a series of general steps:
· establishing the target price in the context of market needs and competition;
· establishing the target profit margin;
· determining the allowable cost that must be achieved;
· calculating the probable cost of current products and processes; and finally,
· establishing the target cost the amount by which current costs must be reduced.
Once the target cost has been calculated, companies take the following steps to achieving it:
· establishing a cross functional team, which is involved in the implementation process from the earliest design stages;
· using tools such as value engineering in the design process; and
· pursuing cost reductions using "kaizen costing" once production has started.