A target cost is the allowable amount of cost that can be incurred on a product and still earn the required profit from that product. It is a market driven cost that is computed before a product is produced. Around 80% of the costs of many products are committed at the design stage. Therefore, the best opportunity to reduce costs is during design and not after a product is being manufactured. Target costing occurs within the product development cycle. This means it starts when a product is in its concept stages and ends when a product has been released for manufacturing. Target costing has its origin in Japan. It is used widely by most of automobile assembly units.
Target costing method works backward from the traditional cost plus method of costing. Unlike traditional cost based pricing methods, it begins with the price that the customer is willing to pay. It also considers not only the preferred current selling price but also the later life cycle pattern of prices. It is not just about the cost reduction technique or the cost control framework, but part of a strategic profit management system, which includes Analysis and Value Engineering.
To a customer a product such as a mobile phone is a set of features such as clarity of signal reception, touch screen, camera, sound and battery life, aesthetic looks, and other features. To an engineer, the mobile phone is a set of parts such as chassis, circuit board, a display panel, and so on. For a product to meet customer expectations, we must map how each function relates to a feature and set a target cost for that function that an engineer can design to.
In emerging markets like India, target pricing is what all marketers and businesses must keep in mind if they want to succeed. The best Example In emerging markets target pricing is seen across categories, i.e. shampoos, face creams, refrigerators, air-conditioners, cars, trucks, motorcycles.
Implementing target costing within the organization requires lot of efforts and discipline and all the supply chain partners must find ways to reduce costs as they design, manufacture and distribute the components.
To ensure satisfactory profit margins, many companies use what it calls ‘reverse engineering.’ Rather than create an item, and then assign a price to it, as in most developed markets, they first consider what consumers can afford. From there, it adjusts the features and manufacturing processes to meet various pricing targets. i.e. NANO by TATA Motors for Rs.1 Lakh, Desktops by HCL for Rs.9,999/-etc.
Achieving the Target Cost
Determine the cost gap between current cost and allowable cost: Generally current cost is based on currently used components, current suppliers, current manufacturing processes, current distribution network etc.
Decompose the cost gap: Cost reduction goals are divided among the functions in the product’s life cycle, design/engineering, manufacturing, sales/distribution, service/support, general administration etc.
Value chain decomposition: Cost reduction targets are divided among internal and external activities. Internal costs include labor, overhead, selling and administrative costs, etc. External costs i.e. components and services acquired from suppliers, etc. often represent a large proportion of total cost.
Perform value engineering to design out costs without sacrificing needed features. Perform cost analysis of major components and activities, list components or activities and their functions, determine the current cost of each component or activity and convert it to percentage of the total cost.
Relate the components to customer requirements: Develop Quality-Function-Deployment matrix. Develop a functional ranking, by Indicating the importance of each component to the customer.
Identify components for cost reduction: Calculate a value index for each major component, Component cost as a percentage of total cost divided by the component’s relative importance to the customer. If the index is greater than 1, it indicates disproportionately high cost in relation to its importance. Implies cost reduction should be considered.
Generate cost reduction ideas: Eliminate over engineering, Eliminate, replace, combine, rearrange. Seek ways to accomplish the goal at less cost, Consider the process as well as the product, More efficient manufacturing processes, better logistics, etc.
Test the ideas: To check if they will be effective, technologically feasible, for a domino effect, construct a component interaction matrix to check if the activities interact.
Estimate the achievable costs: Use activity based costing, cost tables, etc.
Barriers in target costing
There are a lot of barriers for implementing target costing, i.e. lack of understanding among the cross functional teams, fear of after effects of the cost reduction if the same cannot be maintained over a period of time, production cost details, MIS and cost data limitations, too much of pressure to achieve targets, longer development time etc.
Adapted and rewritten for Hyderabad Circuit by CMA Sanjay Prasad Kedia