Target Costing: delighting Your Customers While Making a Profit
Target Costing is a simple, straightforward process that can have significant impact on the health and profitability of many, if not most, businesses. It doesn't require an army of specialists, large-scale software implementations, or complex management structures and procedures. It's mostly logical, disciplined common sense that can be imbedded into a company's existing procedures and processes.
We spent our recent professional careers applying Target Costing to a wide range of products, processes and procedures in a large manufacturing company. We quickly came to learn that Target Costing helps to:
* assure that products are better matched to their customer's needs.
* align the costs of features with customers willingness to pay for them.
* reduce the development cycle of a product.
* reduce the costs of products significantly.
* increase the teamwork among all internal organizations associated with conceiving, marketing, planning, developing, manufacturing, selling, distributing and installing a product.
* engage customers and suppliers to design the right product and to more effectively integrate the entire supply chain.
Target Costing has been shown to consistently reduce product costs by up to 20-40%, depending on the product and market circumstances.
What is Target Costing?
Our working definition, adapted from Cooper, is as follows:
Target Costing is a disciplined process for determining and realizing a total cost at which a proposed product with specified functionality must be produced to generate the desired profitability at its anticipated selling price in the future.
Target Costing is a disciplined process that uses data and information in a logical series of steps to determine and achieve a target cost for the product. In addition, the price and cost are for specified product functionality, which is determined from understanding the needs of the customer and the willingness of the customer to pay for each function.
Another interesting aspect of Target Costing is its inherent recognition that there are important variables in the process that are essentially beyond the control of the design group or even the company. For example, the selling price is determined by the marketplace -- the global collection of customers, competitors and the general economic conditions at the time the product is being sold. The desired profit is another variable that is beyond the control of the design organization. It may be set at the corporate level. It is influenced by the expectation of the stockholders and the financial markets. And, the desired profit is benchmarked against others in the same industry and against all businesses. In this complicated environment, it is the role of Target Costing to balance these external variables and help develop a product at a cost that is within the constraints imposed. In short, traditional approaches, such as simple cost-plus is a recipe for market failure, and giving the customers more than they are willing to pay for is a recipe for insolvency.
The Basic Process:
The stages are market-driven:
Define the Product answers the fundamental questions of What are you selling? To whom? What do they want it to do?
Set the Target addresses the issue of What will they pay for it? What should it cost to produce?
Achieve the Target is concerned with How can we get there? Are we getting there?
Maintain Competitive Cost deals with How can we stay ahead?
One of the key points is that the target cost is the dependent variable. The market-based Price must be determined first, then the desired Profitability. Finally, the Target Cost is simply the Price minus the Profit. This may seem elementary, but many firms still fall into the trap of first determining the cost of their design, adding a profit margin and letting the sum be the price.
When Are Costs Set? Target Costing recognizes that the costs of a product are established very early in the development cycle. We have seen that by the time a product reaches the manufacturing stage where traditional cost-reduction takes place -- most of the costs are locked in, and it is quite difficult to find substantial cost improvements. In fact, much of the cost of a product is determined in the early stages of defining the product concept and determining the customer requirements well before the detailed design is started. Target Costing should begin at the very beginning of the so-called "fuzzy front end" of the product-realization process. That is when it is most important to get the product and its functional architecture right the first time. We have found a strong correlation between the cost savings obtained and how early in the product-realization cycle Target Costing was initiated. The moral: start early!
A Quantitative Process.
Target Costing is a largely quantitative process. There are many tools and techniques that can be used. There is not space in this article to describe them, but some examples used in the various Target-Costing steps include:
Define the Product Conjoint Analysis, Quality Function Deployment, Market Analysis, Competitor Analysis, Product Roadmapping, Market-Feature Tables.
Set the Target Conjoint Analysis, Experience Curves, Price Roadmapping, Competitive Intelligence, Reverse Engineering.
Achieve the Target -- Value Engineering & Analysis, Component Roadmapping, Cost Analysis Tools, ABC Practices, Simulation Tools, Supply-Chain Analysis.
Maintain Competitive Cost Cost-Reduction Methodology.
Mapping the Product to the Market. While it is not as quantitative as some of the other tools, we have found the Market-Feature Table to be a simple but powerful way to focus on customer needs.
The idea is to map the features desired by different market segments onto a single page. This forces you to concentrate on the really important features or functionalities at a high level. The Market for the potential product is divided into natural market segments. These distinctions may be by geographic region, by customers type of business, by consumer-government-business, by relative customer affluence, etc. Then the features desired by each market segment are divided into three categories:
Basic features desired by all customers in the segment, that they are all willing to pay for.
Step-Up additional or optional features desired by some customers in the segment who are willing to pay a higher price to get them.
Premium further optional features that a few customers want, and that carry a premium price.
The size of the market in each category is also listed, in terms of number of potential units that can be sold, or by potential revenues.
It is very important to separate the optional features from the basic ones, because if you make an optional feature that only some customers want -- part of the basic product, you will either force all customers in that segment to pay for it, or you will be giving it away. It is also important to establish and achieve the target cost for the basic product, because that is where most of the sales or revenues will be and so that is where you have to capture market share while remaining profitable. Finally, we contend that a Market-Feature Table should play as great a role in determining the architecture of a product as do physical and engineering considerations.
First, Price.
Once you have established the high-level product requirements, the next step is to establish the market price for the time at which the product is going to be sold. We have found that Experience Curves (sometimes called Learning Curves) are very helpful. In this approach, the historical market price of the product is plotted as a function, not of calendar time, but of the industrys cumulative sales of the product. On a log-log plot, the result is usually a straight line that is a very reliable predictor of prices for some time into the future. Note that often you should not always use the quantities of the product as the sales, but some key parameter that represents the functionality that the customer is really buying and which is really driving the industrys experience.
For example, in the famous Moore Curve showing the decrease in price of semiconductor memory, the price per bit of memory is plotted against the cumulative bits that have been sold. (It is not a plot of price per memory chip vs. the cumulative number of chips the customers are really buying memory bits, not packaged ICs.) If the product were cellular telephone network equipment, you would plot the price of the equipment divided by the number of subscribers that it can serve vs. the cumulative number of cell-phone subscribers in the world.
There are other ways to help triangulate on likely prices. Conjoint Analysis is quite quantitative, and it gives insights about customers willingness to pay for various specific features and capabilities. Other methods include gleaning information from bids and proposals, competitors prices, reverse engineering, comparable technologies or products that do similar things, analysts reports, and so on.
Then, Cost.
When you have determined the price for the time when the product will be sold, you can set the target cost. It is important to first decide how much of the companys cost elements to include. Traditionally, people have looked only at cost of goods sold (COGS), the cost of the raw materials and purchased subsystems that go into a product plus the conversion costs (labor and manufacturing overheads). In that case, you only need to know the healthy gross margin rate required by the company in order to calculate the target cost ( = Price * [100% G.M.%]). However, we have found it better to try to capture as much of the companys costs as possible (e.g.: engineering, installation, transportation, tariffs & duties, R&D, marketing & sales, taxes, etc.) If you use the companys required net margin then you can establish a full-stream target cost. The benefit is that, as ways to reach the target cost are explored, it is possible that design and other choices can significantly reduce costs that lie beyond the area of COGS. It goes without saying that Activity-Based Costing (ABC), if the company uses it, makes this cost decomposition more meaningful and effective.
Once you have set the overall target cost, the next step is to set cost targets for each of the components, subsystems and elements that go into making up the set of full-stream costs that are being included. We have found that Value Engineering is a valuable tool to assist in this step. Space does not permit a detailed explanation here. But the basic concept is to create a matrix that relates different product features to the various elements that make up the product. The cells of the matrix are filled with the extent (percent) to which each of the elements contributes to each feature. Then, knowing the relative importance (to the customers) of each feature, and applying some matrix multiplication it is possible to get a suggestion of the cost target for each product element. Comparing those costs with current or projected costs (again, ABC helps substantially) you can discover which elements need the most attention in cost-reduction efforts based on an understanding of their relative importance to the customer. For example, if 35% of the value to the customer is derived from a single feature, this feature is allocated 35% of the cost of the product. Actual mapping of the product features to product cost if a bit more complicated in practice but this is the basic point.
Finding Paths to the Targets.
At this point, you have a clear idea of what the customers want and what they are willing to pay, a target for the price, and cost targets for the significant elements that are part of the products cost structure. Frequently it becomes evident that the cost of the product will be too high to sustain a healthy profit. In that case it is necessary to find ways to take cost out of the product without sacrificing capability or quality.
We recommend a cross-functional team approach. It is best to use individuals from all the stakeholder organizations product management, marketing, sales, engineering, design, manufacturing, installation, etc. It is also very beneficial to include subject-matter experts from outside the organizations directly involved in the specific product they bring fresh ideas and outlooks to the table. Such individuals could even come from suppliers. Once the business needs and target-setting has been laid out before the team, we recommend that it use proper brainstorming techniques to generate cost-reducing ideas. We also recommend that sub-teams, each focused on a specific major product element, have separate brainstorming sessions.
At this point, for fairly complex products, we find that we typically have 100-150 cost-reducing ideas. Then the sub-teams must evaluate the ideas -- that is, eliminate redundant and clearly infeasible ones, determine the cost impact of the remainder, and estimate how much incremental effort (if any) it will take to implement them. This usually takes a few weeks. At the end of the evaluation phase, the teams should report to the management their target-cost goals, the ideas to close the cost gaps, and the plan to implement the ideas.
Maintaining Cost.
Through the rest of the product-development phase the cross-functional teams are responsible for implementing the cost-reduction ideas, and seeing that the product stays within its cost targets. It is especially important to resist feature creep the temptation to add incremental features to the product. It is one thing if a customer wants a new feature and is willing to pay for it. But if it is deemed necessary to add a feature without increasing the price, then the team has to accept the challenge of finding further cost reductions in order to still achieve the target cost.
After the product has been introduced, prices will continue to decline. In order to maintain necessary profit margins, the costs have to continue to be reduced. This activity is generally in the realm of traditional cost reduction kaizen (continuous improvement), so we will not discuss this area further.
Summary.
Target Costing is an effective method for ensuring a company has profitable products that are well-matched to its customers needs. The process is simple, logical, and easy to implement. We also find that it helps bring different parts of the company together and helps them focus on the key issues.
This article has given a brief overview of Target Costing, and it emphasized some aspects of the first steps in the process. For a more comprehensive treatment of the entire process, plus a more complete treatment of the tools and techniques, see the book by R.E. Albano,, H.M.B. Bird, M.B. Clifton & W.P. Townsend, Target Costing: Market Based Product Definition, Marcel-Dekker Publishing, 2003.
H.M.B. Bird, R.E. Albano, W.P. Townsend
We spent our recent professional careers applying Target Costing to a wide range of products, processes and procedures in a large manufacturing company. We quickly came to learn that Target Costing helps to:
* assure that products are better matched to their customer's needs.
* align the costs of features with customers willingness to pay for them.
* reduce the development cycle of a product.
* reduce the costs of products significantly.
* increase the teamwork among all internal organizations associated with conceiving, marketing, planning, developing, manufacturing, selling, distributing and installing a product.
* engage customers and suppliers to design the right product and to more effectively integrate the entire supply chain.
Target Costing has been shown to consistently reduce product costs by up to 20-40%, depending on the product and market circumstances.
What is Target Costing?
Our working definition, adapted from Cooper, is as follows:
Target Costing is a disciplined process for determining and realizing a total cost at which a proposed product with specified functionality must be produced to generate the desired profitability at its anticipated selling price in the future.
Target Costing is a disciplined process that uses data and information in a logical series of steps to determine and achieve a target cost for the product. In addition, the price and cost are for specified product functionality, which is determined from understanding the needs of the customer and the willingness of the customer to pay for each function.
Another interesting aspect of Target Costing is its inherent recognition that there are important variables in the process that are essentially beyond the control of the design group or even the company. For example, the selling price is determined by the marketplace -- the global collection of customers, competitors and the general economic conditions at the time the product is being sold. The desired profit is another variable that is beyond the control of the design organization. It may be set at the corporate level. It is influenced by the expectation of the stockholders and the financial markets. And, the desired profit is benchmarked against others in the same industry and against all businesses. In this complicated environment, it is the role of Target Costing to balance these external variables and help develop a product at a cost that is within the constraints imposed. In short, traditional approaches, such as simple cost-plus is a recipe for market failure, and giving the customers more than they are willing to pay for is a recipe for insolvency.
The Basic Process:
The stages are market-driven:
Define the Product answers the fundamental questions of What are you selling? To whom? What do they want it to do?
Set the Target addresses the issue of What will they pay for it? What should it cost to produce?
Achieve the Target is concerned with How can we get there? Are we getting there?
Maintain Competitive Cost deals with How can we stay ahead?
One of the key points is that the target cost is the dependent variable. The market-based Price must be determined first, then the desired Profitability. Finally, the Target Cost is simply the Price minus the Profit. This may seem elementary, but many firms still fall into the trap of first determining the cost of their design, adding a profit margin and letting the sum be the price.
When Are Costs Set? Target Costing recognizes that the costs of a product are established very early in the development cycle. We have seen that by the time a product reaches the manufacturing stage where traditional cost-reduction takes place -- most of the costs are locked in, and it is quite difficult to find substantial cost improvements. In fact, much of the cost of a product is determined in the early stages of defining the product concept and determining the customer requirements well before the detailed design is started. Target Costing should begin at the very beginning of the so-called "fuzzy front end" of the product-realization process. That is when it is most important to get the product and its functional architecture right the first time. We have found a strong correlation between the cost savings obtained and how early in the product-realization cycle Target Costing was initiated. The moral: start early!
A Quantitative Process.
Target Costing is a largely quantitative process. There are many tools and techniques that can be used. There is not space in this article to describe them, but some examples used in the various Target-Costing steps include:
Define the Product Conjoint Analysis, Quality Function Deployment, Market Analysis, Competitor Analysis, Product Roadmapping, Market-Feature Tables.
Set the Target Conjoint Analysis, Experience Curves, Price Roadmapping, Competitive Intelligence, Reverse Engineering.
Achieve the Target -- Value Engineering & Analysis, Component Roadmapping, Cost Analysis Tools, ABC Practices, Simulation Tools, Supply-Chain Analysis.
Maintain Competitive Cost Cost-Reduction Methodology.
Mapping the Product to the Market. While it is not as quantitative as some of the other tools, we have found the Market-Feature Table to be a simple but powerful way to focus on customer needs.
The idea is to map the features desired by different market segments onto a single page. This forces you to concentrate on the really important features or functionalities at a high level. The Market for the potential product is divided into natural market segments. These distinctions may be by geographic region, by customers type of business, by consumer-government-business, by relative customer affluence, etc. Then the features desired by each market segment are divided into three categories:
Basic features desired by all customers in the segment, that they are all willing to pay for.
Step-Up additional or optional features desired by some customers in the segment who are willing to pay a higher price to get them.
Premium further optional features that a few customers want, and that carry a premium price.
The size of the market in each category is also listed, in terms of number of potential units that can be sold, or by potential revenues.
It is very important to separate the optional features from the basic ones, because if you make an optional feature that only some customers want -- part of the basic product, you will either force all customers in that segment to pay for it, or you will be giving it away. It is also important to establish and achieve the target cost for the basic product, because that is where most of the sales or revenues will be and so that is where you have to capture market share while remaining profitable. Finally, we contend that a Market-Feature Table should play as great a role in determining the architecture of a product as do physical and engineering considerations.
First, Price.
Once you have established the high-level product requirements, the next step is to establish the market price for the time at which the product is going to be sold. We have found that Experience Curves (sometimes called Learning Curves) are very helpful. In this approach, the historical market price of the product is plotted as a function, not of calendar time, but of the industrys cumulative sales of the product. On a log-log plot, the result is usually a straight line that is a very reliable predictor of prices for some time into the future. Note that often you should not always use the quantities of the product as the sales, but some key parameter that represents the functionality that the customer is really buying and which is really driving the industrys experience.
For example, in the famous Moore Curve showing the decrease in price of semiconductor memory, the price per bit of memory is plotted against the cumulative bits that have been sold. (It is not a plot of price per memory chip vs. the cumulative number of chips the customers are really buying memory bits, not packaged ICs.) If the product were cellular telephone network equipment, you would plot the price of the equipment divided by the number of subscribers that it can serve vs. the cumulative number of cell-phone subscribers in the world.
There are other ways to help triangulate on likely prices. Conjoint Analysis is quite quantitative, and it gives insights about customers willingness to pay for various specific features and capabilities. Other methods include gleaning information from bids and proposals, competitors prices, reverse engineering, comparable technologies or products that do similar things, analysts reports, and so on.
Then, Cost.
When you have determined the price for the time when the product will be sold, you can set the target cost. It is important to first decide how much of the companys cost elements to include. Traditionally, people have looked only at cost of goods sold (COGS), the cost of the raw materials and purchased subsystems that go into a product plus the conversion costs (labor and manufacturing overheads). In that case, you only need to know the healthy gross margin rate required by the company in order to calculate the target cost ( = Price * [100% G.M.%]). However, we have found it better to try to capture as much of the companys costs as possible (e.g.: engineering, installation, transportation, tariffs & duties, R&D, marketing & sales, taxes, etc.) If you use the companys required net margin then you can establish a full-stream target cost. The benefit is that, as ways to reach the target cost are explored, it is possible that design and other choices can significantly reduce costs that lie beyond the area of COGS. It goes without saying that Activity-Based Costing (ABC), if the company uses it, makes this cost decomposition more meaningful and effective.
Once you have set the overall target cost, the next step is to set cost targets for each of the components, subsystems and elements that go into making up the set of full-stream costs that are being included. We have found that Value Engineering is a valuable tool to assist in this step. Space does not permit a detailed explanation here. But the basic concept is to create a matrix that relates different product features to the various elements that make up the product. The cells of the matrix are filled with the extent (percent) to which each of the elements contributes to each feature. Then, knowing the relative importance (to the customers) of each feature, and applying some matrix multiplication it is possible to get a suggestion of the cost target for each product element. Comparing those costs with current or projected costs (again, ABC helps substantially) you can discover which elements need the most attention in cost-reduction efforts based on an understanding of their relative importance to the customer. For example, if 35% of the value to the customer is derived from a single feature, this feature is allocated 35% of the cost of the product. Actual mapping of the product features to product cost if a bit more complicated in practice but this is the basic point.
Finding Paths to the Targets.
At this point, you have a clear idea of what the customers want and what they are willing to pay, a target for the price, and cost targets for the significant elements that are part of the products cost structure. Frequently it becomes evident that the cost of the product will be too high to sustain a healthy profit. In that case it is necessary to find ways to take cost out of the product without sacrificing capability or quality.
We recommend a cross-functional team approach. It is best to use individuals from all the stakeholder organizations product management, marketing, sales, engineering, design, manufacturing, installation, etc. It is also very beneficial to include subject-matter experts from outside the organizations directly involved in the specific product they bring fresh ideas and outlooks to the table. Such individuals could even come from suppliers. Once the business needs and target-setting has been laid out before the team, we recommend that it use proper brainstorming techniques to generate cost-reducing ideas. We also recommend that sub-teams, each focused on a specific major product element, have separate brainstorming sessions.
At this point, for fairly complex products, we find that we typically have 100-150 cost-reducing ideas. Then the sub-teams must evaluate the ideas -- that is, eliminate redundant and clearly infeasible ones, determine the cost impact of the remainder, and estimate how much incremental effort (if any) it will take to implement them. This usually takes a few weeks. At the end of the evaluation phase, the teams should report to the management their target-cost goals, the ideas to close the cost gaps, and the plan to implement the ideas.
Maintaining Cost.
Through the rest of the product-development phase the cross-functional teams are responsible for implementing the cost-reduction ideas, and seeing that the product stays within its cost targets. It is especially important to resist feature creep the temptation to add incremental features to the product. It is one thing if a customer wants a new feature and is willing to pay for it. But if it is deemed necessary to add a feature without increasing the price, then the team has to accept the challenge of finding further cost reductions in order to still achieve the target cost.
After the product has been introduced, prices will continue to decline. In order to maintain necessary profit margins, the costs have to continue to be reduced. This activity is generally in the realm of traditional cost reduction kaizen (continuous improvement), so we will not discuss this area further.
Summary.
Target Costing is an effective method for ensuring a company has profitable products that are well-matched to its customers needs. The process is simple, logical, and easy to implement. We also find that it helps bring different parts of the company together and helps them focus on the key issues.
This article has given a brief overview of Target Costing, and it emphasized some aspects of the first steps in the process. For a more comprehensive treatment of the entire process, plus a more complete treatment of the tools and techniques, see the book by R.E. Albano,, H.M.B. Bird, M.B. Clifton & W.P. Townsend, Target Costing: Market Based Product Definition, Marcel-Dekker Publishing, 2003.
H.M.B. Bird, R.E. Albano, W.P. Townsend
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