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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

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


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.
As a totally new product and its industry develops, it starts to compete based on its new
technology, concept, and/or service. Competitors emerge and the basis for competition
evolves to other areas such as cycle time, quality, or reliability. As an industry becomes
mature, the basis of competition typically moves to price. Profit margins shrink.
Companies begin focusing on cost reduction. However, the cost structure for existing
products is largely locked in and cost reduction activities have limited impact. As
companies begin to realize that the majority of a product's costs are committed based on
decisions made during the development of a product, the focus shifts to actions that can
be taken during the product development phase.

Until recently, engineers have focused on satisfying a customer's requirements. Most

development personnel have viewed a product's cost as a dependent variable that is the
result of the decisions made about products functions, features and performance
capabilities. Because a product's costs are often not assessed until later in the
development cycle, it is common for product costs to be higher than desired. This process
is represented in Figure 1.

Target costing represents a fundamentally different approach. It is based on three

premises: 1.) orienting products to customer affordability or market-driven pricing, 2.)
treating product cost as an independent variable during the definition of a product's
requirements, and 3.) proactively working to achieve target cost during product and
process development. This target costing approach is represented in Figure 2.
Target costing builds upon a design-to-cost (DTC) approach with the focus on market-
driven target prices as a basis for establishing target costs. The target costing concept is
similar to the cost as an independent variable (CAIV) approach used by the U.S.
Department of Defense and to the price-to-win philosophy used by a number of
companies pursuing contracts involving development under contract.

The following ten steps are required to install a comprehensive target costing approach
within an organization.

1. Re-orient culture and attitudes. The first and most challenging step is re-orient thinking
toward market-driven pricing and prioritized customer needs rather than just technical
requirements as a basis for product development. This is a fundamental change from the
attitude in most organizations where cost is the result of the design rather than the
influencer of the design and that pricing is derived from building up a estimate of the cost
of manufacturing a product.
2. Establish a market-driven target price. A target price needs to be established based
upon market factors such as the company position in the market place (market share),
business and market penetration strategy, competition and competitive price response,
targeted market niche or price point, and elasticity of demand. If the company is
responding to a request for proposal/quotation, the target price is based on analysis of
the price to win considering customer affordability and competitive analysis.
3. Determine the target cost. Once the target price is established, a worksheet (see
example below) is used to calculate the target cost by subtracting the standard profit
margin, warranty reserves, and any uncontrollable corporate allocations. If a bid includes
non-recurring development costs, these are also subtracted. The target cost is allocated
down to lower level assemblies of subsystems in a manner consistent with the structure
of teams or individual designer responsibilities.
4. Balance target cost with requirements. Before the target cost is finalized, it must be
considered in conjunction with product requirements. The greatest opportunity to control
a product's costs is through proper setting of requirements or specifications. This requires
a careful understanding of the voice of the customer, use of conjoint analysis to
understand the value that customers place on particular product capabilities, and use of
techniques such as quality function deployment to help make these tradeoff's among
various product requirements including target cost.
5. Establish a target costing process and a team-based organization. A well-defined
process is required that integrates activities and tasks to support to support target
costing. This process needs to be based on early and proactive consideration of target
costs and incorporate tools and methodologies described subsequently. Further, a team-
based organization is required that integrates essential disciplines such as marketing,
engineering, manufacturing, purchasing, and finance. Responsibilities to support target
costing need to be clearly defined.
6. Brainstorm and analyze alternatives. The second most significant opportunity to
achieve cost reduction is through consideration of multiple concept and design
alternatives for both the product and its manufacturing and support processes at each
stage of the development cycle. These opportunities can be achieved when there is out-
of-the-box or creative consideration of alternatives coupled with structured analysis and
decision-making methods.
7. Establish product cost models to support decision-making. Product cost models and
cost tables provide the tools to evaluate the implications of concept and design
alternatives. In the early stages of development, these models are based on parametric
estimating or analogy techniques. Further on in the development cycle as the product
and process become more defined, these models are based on industrial engineering or
bottom-up estimating techniques. The models need to be comprehensive to address all
of the proposed materials, fabrication processes, and assembly process and need to be
validated to insure reasonable accuracy. A target cost worksheet can be used to capture
the various elements of product cost, compare alternatives, as well as track changing
estimates against target cost over the development cycle.
8. Use tools to reduce costs. Use of tools and methodologies related to design for
manufacturability and assembly, design for inspection and test, modularity and part
standardization, and value analysis or function analysis. These methodologies will consist
of guidelines, databases, training, procedures, and supporting analytic tools.
9. Reduce indirect cost application. Since a significant portion of a product's costs
(typically 30-50%) are indirect, these costs must also be addressed. The enterprise must
examine these costs, re-engineer indirect business processes, and minimize non-value-
added costs. But in addition to these steps, development personnel generally lack an
understanding of the relationship of these costs to the product and process design
decisions that they make. Use of activity-based costing and an understanding of the
organization's cost drivers can provide a basis for understanding how design decisions
impact indirect costs and, as a result, allow their avoidance.
10. Measure results and maintain management focus. Current estimated costs need to be
tracked against target cost throughout development and the rate of closure monitored.
Management needs to focus attention of target cost achievement during design reviews
and phase-gate reviews to communicate the importance of target costing to the
Meeting customer affordability requirements is critical to a successful product. Since
typically 80% of product costs are committed based a decisions during concept
development, target costing is key to a successful product. The concepts of target costing
that form the basis for our consulting process are described in a paper titled, Achieving
Target Cost / Design-to-Cost Objectives. DRM Associates, a leading consulting
organization specializing in product development, can help with the following eight-step

1. Initiation of a Target Costing program begins with management understanding and

commitment. These objectives must then be communicated to the rest of the
organization. Our Target Costing training can provide an understanding of the concepts
and essential elements of a Target Costing approach. We can help in establishing metrics
and determining baseline performance.
2. A team-based organization needs to be established to support development. We can
help define roles and responsibilities to support Target Costing and provide Team-
Building training or Team Launch training as required. We can work with the team to
facilitate their use of Target Costing practices.
3. A Target Costing process needs to be defined and established. We can review the
current development process and define the changes and additional activities to establish
a Target Costing Process. We can then develop and conduct training to deploy this
process to the organization.
4. Target costs must be established based on analyzing market niches, assessing
customer affordability requirements, understanding cost drivers, considering trade-offs in
costs vs. other requirements, determining elasticity of demand, and analyzing volume-
cost relationships. We can help organize the data gathering, guide this analysis, and
facilitate the use of tools such as quality function deployment to support requirement
5. Product cost models and/or cost tables are required to evaluate concept and design
alternatives and support decision-making. Parametric cost models are needed in the
early stages of a development program to develop a proposal or establish a business
case, to support analysis of concept alternatives, and perform trade studies. More
detailed cost models based on analogy or industrial engineering build-up are needed in
the later stages to evaluate product and process design alternatives. We can help in
selecting, building, validating and establishing these cost models and cost tables and
define a process for their use.
6. Value analysis and design for manufacturability are two primary methods to provide
focus on functions of value to the customer, the associated costs, and the DFM principles
to reduce costs. We can provide value analysis training and design for manufacturability
training, help establish DFM guidelines, define a process for the application of value
analysis and DFM, and facilitate the use of these practices on a development project.
7. Supplier involvement in a Target Costing program is critical since typically 50-70% of
product costs are materials. We can work with the materials organization to help structure
a supplier involvement program based on Target Costing, provide Target Costing training
to suppliers, work with key suppliers to establish a Target Costing program, and develop
pricing programs.
8. Indirect costs are the second most significant cost element. We can assist with business
process reengineering indirect activities, eliminate non-value-added activities, and
establish an activity-based costing system to better support decision-making.
9. Monitoring of Target Costing results is key to a successful program. We can help
establish Target Costing tracking systems, develop design review guidelines, and insure
appropriate management focus to a Target Costing program.



A competitive product must address factors such as cost, performance, aesthetics,

schedule or time-to-market, and quality. The importance of these factors will vary from
product to product and market to market. And , over time, customers or users of a product
will demand more and more, e.g., more performance at less cost.

Cost will become a more important factor in the acquisition of a product in two
situations. First, as the technology or aesthetics of a product matures or stabilizes and the
competitive playing field levels, competition is increasingly based on cost or price.
Second, a customer's internal economics or financial resource limitations may shift the
acquisition decision toward affordability as a more dominant factor. In either case, a
successful product supplier must focus more attention on managing product cost.

The management of product cost begins with the conception of a new product. A large
percentage of the product's ultimate acquisition or life cycle costs, typically seventy to
eighty percent, is determined by decisions made from conception through product
development cycle. Once the design of the product has been established, relatively little
latitude exists to reduce the cost of a product. Decisions made after the product moves
into production account for another ten to fifteen percent of the product's costs. Similarly,
decisions made about general and administrative, sales and marketing, and product
distribution activities and policies account for another ten to fifteen percent of the
product's cost.

When a company faces a profitability problem and undertakes a cost reduction program,
it will typically reduce research and development expenditures and focus on post-
development activities such as production, sales, and general and administrative
expenditures. While not suggesting that these are inappropriate steps to take, the problem
is that it is too late and too little. Most of the cost structure in a company has been locked
into place with the design decisions made about the company's products. A cost reduction
or profitability program has to start with the design of the company's products at the very
beginning of the development cycle.


The following definition of terms will provide a common basis for discussion:
Recurring production cost = production labor + direct materials + process costs +
overhead + outside processing

Non-recurring costs = development costs + tooling

Product costs = Recurring production costs + allocated non-recurring costs

Product price or acquisition costs = Product costs + selling, general & administrative +
warranty costs + profit

Life cycle costs = Acquisition costs + other related capital costs + training costs +
operating costs + support costs + disposal costs


In many companies, product cost or life cycle cost considerations are an afterthought.
Costs are tallied up and used as the basis for determining the product's price. The primary
focus is on product performance, aesthetics, or technology. Companies may get by with
this approach in some markets and with some products in the short term, but ultimately
competition will catch up and the product will no longer be competitive.

In other companies, cost is a more important factor, but this emphasis is not acted upon
until late in the development cycle. Projected costs of production are estimated based on
drawings and accumulated from quotes and manufacturing estimates. If these projected
costs are too high relative to competitive conditions or customers requirements, design
changes are made to varying degrees to reduce costs. This may occur before or after the
product has been released to production. The result is extended development cycles and
added development cost with these design iterations.

In some organizations, development costs receive relatively little attention as well. There
may not be a rigorous planning and budgeting process for development projects. Budgets
are established without buy-in from development personnel resulting in budget overruns.


Effective product cost management requires a design to cost philosophy as its basis since
a substantial portion of the product's cost is dictated by decisions regarding its design.
Design to cost is a management strategy and supporting methodologies to achieve an
affordable product by treating target cost as an independent design parameter that needs
to be achieved during the development of a product. A design to cost approach consists of
the following elements:

• An understanding of customer affordability or competitive pricing requirements by the key

participants in the development process;
• Establishment and allocation of target costs down to a level of the hardware where costs
can be effectively managed;
• Commitment by development personnel to development budgets and target costs;
• Stability and management of requirements to balance requirements with affordability and
to avoid creeping elegance;
• An understanding of the product's cost drivers and consideration of cost drivers in
establishing product specifications and in focusing attention on cost reduction;
• Product cost models and life cycle cost models to project costs early in the development
cycle to support decision-making;
• Active consideration of costs during development as an important design parameter
appropriately weighted with other decision parameters;
• Creative exploration of concept and design alternatives as a basis for developing lower
cost design approaches;
• Access to cost data to support this process and empower development team members;
• Use of value analysis / function analysis and its derivatives (e.g., function analysis
system technique) to understand essential product functions and to identify functions with
a high cost to function ratio for further cost reduction;
• Application of design for manufacturability principles as a key cost reduction tactic;
• Meaningful cost accounting systems using cost techniques such as activity-based costing
(ABC) to provide improved cost data;
• Consistency of accounting methods between cost systems and product cost models as
well as periodic validation of product cost models; and
• Continuous improvement through value engineering to improve product value over the
longer term.


Executive management, marketing, program/product managers, and development team

personnel all need to have an understanding of customer affordability constraints or
competitive market place requirements. Everyday customers buy products with functions,
features and performance in excess of their needs and wonder how much is money is
wasted on these unneeded capabilities. A keener awareness of design to cost requirements
is needed. This happens when product development team members and executive
management have direct contact with customers to understand their true needs and hear
their sensitivity to costs directly, or when they are exposed to competitor's product pricing
in the market place.

Based on this awareness of customer affordability or design to cost requirements, cost

targets should be formally established. These targets should be developed based on
pricing formulas and strategies and consideration of price elasticity. Prices and target
costs will also have to consider projected production volumes and amortization of non-
recurring development costs. In a more complex product or system, the top-level target
cost will need to be allocated to lower level subsystems or modules. This will establish a
measurable objective for a product development team where multiple teams are involved
in a development project.

In an environment where development cost is significant relative to total recurring

production costs, more attention will need to be paid to managing these non-recurring
development costs. Non-recurring development cost will be a function of the extent of
new product and process technology and the extent of use of new materials, parts and
subsystems. If product is an evolutionary step with minimal development risk, non-
recurring development costs will be lower. The use of standard parts and modules from
other existing products will also lower non-recurring development costs. This suggests a
strategy of not letting product and process technology application get too far ahead of
customer affordability requirements.

Product development team members should buy-in to or commit to these product cost
targets and development budgets to improve the chances of meeting these objectives.
When empowered product development teams actually develop these budgets and targets,
a sense of commitment to these budgets or targets develops. If the budgets or targets are
established by someone outside the product development team (e.g., by a product or
program manager, a management team, a system integration team, or a project engineer),
the targets and budgets should be carefully reviewed with the team members to insure
they understand these cost objectives and the assumptions behind them. While
competition will generally dictate that stretch goals be established, these goals should be
accepted by the team as achievable.


Once a team has a set of requirements and a cost target established, they will begin
exploring alternatives as part of the design process. In the absence of other information,
they will tend to evaluate a product concept primarily based on its performance merits
and, at best, secondarily consider a subjective estimate of the relative costs of the design
alternatives. Ad-hoc cost studies or trade studies may be prepared for significant issues,
but tools to regularly support this process are lacking. Tools and information need to be
provided to a product development team so that they can more proactively and
objectively consider the cost implications of various design approaches on a regular
basis. A product cost model or life cycle cost model provides an objective basis for
evaluating design alternatives from a very early stage in the development cycle.

As the organization proceeds through the design of both product and process, the product
cost model is used to project and accumulate product costs to use as a factor in evaluating
design alternatives and to refine the design to meet cost targets. If it is determined after
extensive evaluation that the product requirements cannot be achieved at the target cost,
the requirements and targets will need to be re-evaluated and modified.

Early in the development cycle, the product cost model will be based primarily on
characteristics of the product design with relatively little consideration of the actual
manufacturing process. The model will be driven by general design parameters,
product/part characteristics, and critical parameter tolerances. The model will be
implicitly based on assumptions about existing processes and process relationships to
types of materials, sizes and tolerance requirements.

Later in the development cycle, a different type of product cost model will be used that
will consider the specific manufacturing processes. This type of model will be built
around existing processes where relatively good historical cost data should exist. On
occasion, new manufacturing processes will need to be considered. Data will need to be
gathered as a basis for creating or extending the product cost model for the new
process(es). Information to support this model development can be obtained from
equipment suppliers, other users of this manufacturing process, facility engineers, and
manufacturing engineers.

Cost data will also need to be obtained for many purchased parts and sub-assemblies.
This information may be available in the form of catalog prices or supplier quotations.
However, to support cost projections much earlier in the development cycle, a close
working relationship with the company's supplier base will allow preliminary cost
projections to be obtained without the formalized commitment of a quotation. The
supplier relationship and company information needs may even develop to the point that
the company works with the supplier to develop a supplier cost model based on the
supplier's process capabilities.

A company's initial attempt with a product cost model may utilize a spreadsheet program
or a bill of material cost roll-up capability. The focus is on accumulating and tracking
estimated material, part and assembly costs. This summarization capability may start with
cost estimates and update the estimates with quoted prices or catalog prices for purchased
items or manufacturing's estimates based on preliminary drawings for fabricated items
and assemblies.

Over time, a more sophisticated product cost model should be developed that will project
costs based on the characteristics of parts and the overall product design. This type of
cost model might be based on commercially available design for manufacturability
(DFM) or design for assembly (DFA) software packages. These systems typically
generate an estimate of fabrication or assembly labor time and costs or machine cycle
time. and costs as part of their capabilities. In addition, there are commercially available
cost models that allow a company to develop a custom model of their manufacturing
processes and project even more exacting cost estimates based on their product or part
characteristics. These individual packages or modules will be oriented toward a limited
part or product domain, e.g., manual or automated assembly, printed circuit boards, sheet
metal, injection molding, casting, etc. Multiple modules will typically be needed to
support overall product cost modeling. In addition, a database reporting capability or
spreadsheet will be needed to accumulate the many individual elements of cost from
these various cost modeling system components so that effective overall trade-off's can
be made.

Over the course of the development cycle, several different costing tools may be used by
an organization. In the early stages of product development, an estimating system may be
used to respond to a customer request for quotation or request for proposal or to develop
an internal estimate to prepare a cost justification for the development project to
management. This cost model would be based on parametric or analogy techniques.
Parametric techniques would take general characteristics about the product such as size,
weight, number of functions, etc., and use these parameters to develop a general cost
estimate. Analogy techniques would take a similar product's cost and use a "same as
except for" approach to develop a cost estimate based on the cost of an existing item.

As the development cycle moves into the product design phase, cost models and
DFM/DFA tools as just described would be used. These estimates would be more refined
since more is known about the design of the product and its cost drivers. Once the
product design is essentially complete, tools and methods such as computer-aided and
manual process planning and tools to support the development of labor standards would
be used to develop even more refined cost estimates. Finally, as the product moves into
production, cost accounting systems would collect costs by product, assembly, part, and
operation. These costing tools are illustrated below.

These costing tools should have a consistent basis for accounting for costs and a
consistent set of rates. In addition, the organization should establish procedures to
periodically validate the cost models by comparing the projected costs with actual costs
and adjusting parameters in the model to yield projections closer to actual experience.

In some cases, life cycle costs may need to be considered as the basis for making design
decisions. This will add to the complexity of a cost model. Data will need to be gathered
on operating costs (e.g., facilities, training, manpower, fuel or energy consumption, etc.),
maintenance costs, and disposal costs. While these costs can be modeled, historical data
related to operations, reliability and maintenance often is needed. This means that a
customer will need to provide this data or that the company have close working
relationships with customers where this data is routinely gathered.

To support the operation of these cost models, cost data will need to be readily accessed.
Some companies try to restrict access to cost data to prevent this information leaking out
to competitors. This restricted access undermines a design to cost methodology and
empowerment of the product development teams. This data needs to be made available to
support cost modeling. Typical data required will be labor rates, overhead rates, learning
curves, efficiencies, historical and projected parts costs, and escalation projections for
labor and materials.

Traditional approaches to allocating overhead or burden costs generally based on direct

labor. However, direct labor is becoming an insignificant cost component in many
products. Further, there is frequently a lack of understanding of sunk costs and fixed
versus variable indirect costs. All of this has led to distortion of overhead cost allocations
and inappropriate design and sourcing decisions. As companies move toward activity-
based costing, the quality of the cost data will improve. Costs will be more closely based
on the consumption of resources and the aberrations associated with allocating indirect
costs will diminish.

In the absence of product cost models and product development teams, each functional
organization will make decisions from their own perspective, trying to manage the
elements of cost that they are responsible for. For example, decisions to minimize non-
recurring design engineering expenditures may result in a less producible product, driving
up material and labor costs in manufacturing. Decisions to minimize tooling capital
expenditures may also have the same effect in manufacturing costs. Test engineering may
try to minimize its non-recurring development budgets and capital expenditures resulting
in a less automated test process and higher recurring test costs for production verification.

Product development teams provide the organizational mechanism to bring the various
disciplines together to optimize product costs from an enterprise perspective. Cost models
provide the means for the team to objectively consider the implications of various
development decisions. A company operating philosophy that emphasizes cost as a factor
in the development decision-making process is a final requirement.

Access to product cost projections early in the development cycle will improve decision-
making about design alternatives and lead to refinement of the design to come closer to
the established cost targets. These costs projections will aid decisions about the design of
the manufacturing process as well, focusing attention of elements of the product costs
that do not meet the target and allowing consideration of alternative processes while it is
still early enough in the development cycle to introduce new processes. The key is to
emphasize management of product costs during development, not merely accumulating
costs as designs are completed.


Since the decisions made during the product development cycle account for seventy to
eighty percent of product costs, product cost management must begin with the start of
product development. Product development personnel must understand competitive
pricing or customer affordability requirements. Target costs must be established at the
start and used to guide decision-making. Development personnel must operate as
entrepreneurs in making hard decisions about the product and process design to achieve
target costs. Cost models must be provided to support decision-making early in the
development cycle. And the quality of information and the cost models must be
continually improved and refined. This increased focus on product or life cycle costs will
lead to significantly reduced costs and more satisfied customers.

Target cost management
CAM-I (Consortium for Advanced Manufacturing –
International) was established 1972 as an
international non-profit-organization to carry out
research and scholarship on management and
manufacturing technology systems. CAM-I has
launched an extensive study labeled as target
cost management (TCM). The CAM-I study group
made the following conclusions concerning the
major changes needed:

• An overall management system is required

to set the targets and to channel the
decisions of all those involved in product
definition and development towards wider
corporate goals.
• Product management must widen to
incorporate both physical and service
attributes measured in terms of customer
• Cost management must shift its focus from
accounting for the sake of accounting to
enable expenditures to be used as a
planning tool for creative product and
process design.
• Product profitability must be assessed and
planned in the context of a comprehensive
life cycle and the relationship of a broad
market value chain. (CAM-I TCM Study
Group statements 1994.)

The following quotations have been taken from a

state-of-the-art review about target costing. Target
costing is a cost management concept that has
been developed and practiced in Japanese
companies since the 1970s and has been
described in English mainly by Japanese authors.
Target costing is built on a comprehensive set of
cost planning, cost management and cost control
instruments which are aimed primarily at the early
stages of product and process design in order to
influence product cost structures resulting from
the market-derived requirements. The target
costing process requires the cost orients
coordination of all product related functions.
(Horváth 1993.)

Japanese management accounting uses

classification of predetermined and actual costs.
Predetermined costs are the expected measures
of the cost before production, while actual costs
are calculated after production. Predetermined
costs are divided into standard costs and
estimated costs. Standard costs depend on
statistical data and are utilized as an index for
cost management. Estimated costs depend on the
managers’ past experience or intuition (Makido

Target costing, as it has been developed in Japan,

was invented by Toyota in 1965. Thus, the use of
target costing has a long tradition at Toyota. At
Toyota, they talk about cost planning and cost
control, i.e. influencing product costs during the
design phase and keeping the running costs as
low as possible. Reducing cost through
continuous improvement, “cost kaizen”, is
becoming relatively less important, because the
efforts made throughout the company will
inevitably lead to fewer opportunities to cut costs.
(Tanaka T 1993.)

For example, the lifetime target profit Ps of a new

model (e.g. Celica) is calculated as follows:

Ps = P% * Sa

where P% is the profit ratio of sales and

Sa is the target sales.

The sales target is calculated using the retail price

Sa = Us * Qs


Us is the target retail price and

Qs is the target production volume
over the product’s life.

Tanaka M (1989) claims that 80-90% of the life

cycle cost is determined at the design phase of
the product. Therefore, the present cost control
system is focused on the design phase. The
system consists of five stages: planning, concept
design, basic design and manufacturing
preparation. The phases are outlines below:

STEP1: Planning

Summarize the new product plan in a document that clarifies the

design requirements:

1. Outline the product’s concept and mission.

2. Generate primary specifications for the product’s
performance and design.
3. Schedule the product’s design, manufacturing and
4. Define product target cost, selling price and volume.

STEP2: Concept design

Formulate the basic concept of the new product based on the

design requirements mentioned in step 1.

1. Formulate the main functional areas.

2. Assign the target cost to the functional area of the new
3. Design the basic product concept under the target cost.
4. Use a rough cost estimate to ascertain whether the basic
product concept has been designed to fit the target cost.

STEP3: Basic design

Make a general drawing of the product based on the previous


1. Assign target cost to the top and middle functions of each

functional area or main component of the new product.
2. Frame a general drawing under the target cost.
3. Use a rough estimate to ascertain whether the general
drawing has been designed to fit the target cost.
STEP4: Detailed design

Write the product’s manufacturing specifications based on:

1. The detailed manufacturing specifications under the target

2. A detailed cost estimate to ascertain whether the product’s
manufacturing specifications have been designed to fit the
target cost.

STEP5: Manufacturing preparation

Write the product’s manufacturing specifications based on:

1. The design of the manufacturing process, type and jig under

the target cost.
2. The detailed cost estimate used to ascertain whether the
manufacturing preparations for the product are
accomplished within the target cost. (Tanaka M 1989.)

Boer and Ettlie (1999) report a case where a car

manufacturer could have prevented a $300 million
mistake by using proactive target costing. The
survey was conducted among the top-performing
US R&D units and resulted in 126 questionnaires,
of which 77 showed an orientation towards
market-driven cost control. Xerox is mentioned as
one the well-known practitioners of systematic
proactive cost planning. (Boer & Ettlie 1999.)

According to Shank & Fisher (1999), target

costing seems to be applied mostly at the early
stages of product development, but the case of
Montclair Paper Mill shows how the target costing
principle can be applied at a later stage of the
product life cycle. The situation of Montclair Mill
seemed gloomy: The mill was making $700 loss
per every ton of paper sold. The management
believed that the loss was related to the market
price rather than their own manufacturing. The
standard cost of $2900 per ton was thought to be
based on a solid analysis and was taken for

The implementation of target costing was

introduced with a new target of $1162 per ton,
which equals a 60% cost reduction. The
management accepted the challenge, and after ta
cost-driven analysis, four major reductions were

1. Fiber cost: 60% cost reduction.

2. Paper machine cost: Yield from 47% ->
3. Dye costs: material savings of $250 per ton
incorporated in the yield improvement at
the paper machine resulted in an amazing
$769 reduction per ton.
4. Conversion costs: Based on
benchmarking, a reduction from $303 to
$150 was challenged with the risk of
possible outsourcing. During 18 moths, the
cost dropped to $240, and the continuous
improvement seemed to gain even more.

Together, these produced the desired level of

costing and a dramatic turnaround in the mind set.
(Shank & Fisher 1999.)

Cooper & Slagmulder (1999) gives a

comprehensive review of the application of target
costing. He emphasizes the strategic value of
target costing in managing the company’s future
profits. According to their study of seven
Japanese companies, the target costing discipline
has been structured into three sections, as
illustrated in Fig. 17.
Figure 17. Three main elements of the target
costing process (Cooper & Slagmulder 1999).

Successful application of this process (Fig. 17)

requires a highly disciplined approach. Each of
the main phases must be balanced to avoid
unrealistic target setting. The process starts from
the left, by setting the company’s long-term sales
and profits objectives, and continues through the
product level targets to component level target
costing. The role of the product chief engineer is
remarkable in the fundamental decisions
concerning product and component target costing.
The senior management tends to push down the
product target costs as much as possible while
the chief engineer must find the realistic limits in
co-operation with the design teams and the
suppliers. Once these have been decided on, the
Cardinal Rule is applied to ensure that discipline
is maintained throughout the design process. The
Cardinal Rule of target costing is: “The target cost
must never be exceeded”. The Cardinal Rule
controls the process in three ways:

1. If the design does not reach the target

costs, the offsetting saving must be found
somewhere else.
2. The company does not launch any product
exceeding the target costs.
3. The design transfer to manufacturing must
be well controlled to achieve the target

As a conclusion, the early involvement of

proactive product cost management has been
highlighted as a major advantage of some leading
Japanese companies in highly competitive
Use target costing to improve your bottom-line.
(CPA in Industry)
by Lee, John Yee

Abstract- Target costing is a cost management concept that has been used very
effectively by leading Japanese manufacturers. It is based on a long-term, market-driven
perspective rather than on the short-term, profit-driven outlook of most US manufacturing
companies. With its emphasis on market position and product leadership, target costing
enables companies to attain low costs to ensure low prices that help maintain market
share. It is similar to the emerging concept of activity-based costing in that it relates profit
to return on sales as opposed to return on investment, thereby allowing the company
greater flexibility in production management and in production development. It is also a
very effective foundation for building long-term quality improvement initiatives.

Changing Product Life and Requirement

Product life cycles are getting shorter and shorter, quite often one or two years, sometimes to less
than one year in high-tech industries. Consumers are demanding new and diversified products in
short intervals. Due to factory automation, robots and computer-controlled manufacturing systems
are replacing the conventional production lines. What all these changes mean is the traditional
standard costing systems, which emphasize cost control in the manufacturing phase of the
product life cycle, are no longer effective. With a one-year product life, controlling costs in the
manufacturing phase simply doesn't accomplish much. Once the product is developed and
designed, there is a limit to how much cost cutting companies can do in the manufacturing stage.
U.S. manufacturers have learned cost management should start up front at the initial stage to be
effective and measure up to their foreign counterparts.

A new cost management concept has been developed and practiced by worldclass Japanese
manufacturers to deal with the needs in the product development and design phase. A case
example illustrates the technique.

Control Costs Early

Target costing, although its concept is used throughout the product life cycle, is primarily used
and most effective in the product development and design stage. Born out of the market-driven
philosophy, target costing is based on the pricedown, cost-down strategy, which has allowed
companies like Sony and Toyota to win a considerable share of their respective markets.

In U.S. companies, costs of designing, producing, marketing, and delivering products dictate the
mode of competition. Accountants usually measure, based on allocation routines, the total cost of
each product. Most popular cost accounting methodologies, including the emerging activity-based
costing, focus on product profitability. No matter how effective the cost accounting methodology
may be, managers and accountants must heed the shareholders' needs for satisfactory short-
term profits, measured by ROI or ROE.

This focus on meeting the shareholders' short-term needs has been well documented, and easily
understood if we look at the Big Three automakers' practice of raising prices whenever there is a
restriction placed on Japanese imports. The practice is effective in achieving the desired ROI or
ROE, but it hurts the carmakers' ability to increase market share in sales volume. An increased
market share would give them a buffer in the future if they choose to sacrifice sales volume to
increase revenue and longterm profit.

In companies where target costing is used, there seems to be a different culture and attitude.
They place more emphasis on their relative position in the market and product leadership. Since
more than 80% of product cost is already determined by the time product design and processing
is complete, cost management must start (and done substantially) at the design stage.

Connect with Profit Planning

Target costing is very closely linked with the company's long-term profit and product planning
process. This link allows the company to focus on profit and product in an integrated strategy,
which does not discriminate against high-quality, high-price, high-margin products that require
high costs.

This is in direct contrast to a typical U.S. manufacturer's practice, in which the question persists,
"How much does the product cost?" This question follows a new product design into the cost
accounting department, which estimates the new product costs based on the prices of purchased
materials and parts, labor costs, and other manufacturing overhead costs under the current
production standards. The marketing department then addresses the issue of whether they can
sell the new product. This departmentalized policy formulation of a typical U.S. company, which
focuses on cost, tends to discriminate against developing a new high-quality, high-price product.
Target costing derives its bases from the company-wide profit plan. The target profit for each
period is determined for each of the new and existing product portfolios. The profitability of each
group of related products is the focus, rather than the profitability of individual products. The
desired profit margins are traded between products in the same group, depending on what stage
the product is in its life cycle and what leadership role the product can play in acquiring a new
segment of the market.

Setting the Target Costs

The main theme in the entire target costing practice is, "What should the new product cost?" It is
not, "What does it cost?" Wben the target sales price is established based on market research,
the desired profit is subtracted to yield the allowable cost. This allowable cost is top
management's dream. This is a target which is very hard to attain, usually impossible in the short

The desired profit is determined based on the company's desired return on sales (ROS), rather
than ROI. There are two primary reasons for using ROS. The first is technical, the second is

* The Technical Reason. In the fastchanging market of today, manufacturers need a variety of
products in low volumes to survive. Calculating the profitability of each of those products in ROI is
well- nigh impossible.

* The Strategic Reason. In the implementation of long-term strategies, manufacturers need to

focus on the profitability of portfolios of related products and the role each product plays for the
product group. For this, ROS provides a better measure. The allowable cost is compared to the
estimated cost, which is based on the current standards of materials, labor, and overhead. In the
meantime, intensive studies of competitors' parts are done. After motivational considerations have
been made, the gap between allowable cost and estimated cost is reviewed on various
dimensions. The target cost is then established as an attainable target which will motivate all
personnel to achieve. Now, the struggle begins.
Achieving The Target Costs

At this point, cost management people help engineering planners and designers decompose the
target cost into each cost element according to their relations to detailed production functions.
Production engineers determine standards for material and part usage, labor consumption, etc.,
which become the basic cost data for financial accounting purposes. These standards are also
used as a database for material requirements planning (MRP).

The struggle to achieve the target costs takes place in and outside the company. As soon as the
above-mentioned standards are established, purchasing people negotiate with outside suppliers
as to the prices of purchased materials and parts. Negotiations also take place among design,
engineering, marketing, and other departments in the company, and compromises are made in
their efforts to get within the target cost range.

The fundamental mechanism Japanese manufacturers use to achieve target cost, nevertheless,
is value engineering (VE).

Value Engineering

The idea behind VE is very similar to activity analysis which was first developed and used by
General Electric. GE's activity analysis was not, however, and was not intended to be, linked to
corporate profit planning, target profit, and target costs as they are practiced In Japan.

VE is a mechanism Japanese manufacturers use to enhance the value of products and services,
which is measured by the relationship between the functions performed by products and services
and the costs incurred. The functions are defined by different companies in different ways. Some
are geared toward process improvement while others are focused on satisfying the needs of

The process of VE consists of describing the functions of each product, part, and service, and
quantifying the components of those functions. For example, a printed circuit board (PCB)
manufacturer's VE activities for the drilling operation include panel size, number of images per
panel, lot size and frequency, number of holes, hole size, stack height, laminate thickness, post
plate drill, and fine line class. In the design phase, management science techniques are
employed on the many aspects of the drilling operation to improve upon the current method.

Post-Audit of Target Costing Performance

The short life cycles of manufactured goods in today's market require manufacturers to recover
investment in a short time. A short payback period is usually assumed in planning and evaluating
target costs. Post- audit of target costing performance is done on a regular basis to examine the
degree to which targets have been achieved. If targets have not been achieved, investigations

A Case Example

The following short case example is used to illustrate the process of determining target costs
using production and cost figures.

PCBM, a Silicon Valley PCB manufacturer, is offered $48 per unit for 10,000 units of a multi-layer
panel product by an electronic product manufacturer. SInce PCBM's usual return on sales (ROS)
rate is 25 percent, the desired return on this offer is $120,000, calculated as follows:
Amount of the offer: $48 x 10,000 units = $480,000. Desired return: 25% x $48 = $12 per unit.
$12 x 10,000 = $120,000 for the offer. The allowable cost for this production of 10,000 units is
$36 per unit, or $360,000 for the offer, since sales price, $48, - desired return, $12, = $36 per unit.
$36 x 10,000 units = $360,000 for the offer.

The estimated cost is calculated by the cost management team as $40 per unit, or $400,000 for
the offer. The cost was estimated based on four layers requested, board length, board-width, two
solder mask sides requested, five images per panel, one component legend side, estimated yield
rate of 86%, panel size, material cost per panel of $19, and no tab plate edge. The impact of
accepting the offer on the production plan and the cost of total production for the period was also

The gap between the allowable cost ($360,000) and the estimated cost ($400,000) for the offer is
$40,000, which is adopted as the target cost reduction. The "struggle" to eliminate the gap of
$40,000 started with VE activities. After long hours of careful evaluation by production
supervisors, process and product engineers, and cost management people, it was decided that
VE activities should be focused on reducing the defect rate and material handling and

A series of studies and analyses of material scraps and other types of defects were performed.
Suggestions of possible improvement in performance by 30%, which was estimated to reduce
unit cost by $2, were made, most of which looked too ambitious at first. But, since the new target
costing-induced management plan had been accepted by all supervisors and managers of the
plant, the suggestions were aggressively implemented by the processes and areas involved.

Improvements on material handling were centered around reducing material moving distances
between the point of receiving the deliveries and the point of usage. Various moves were
analyzed to reduce the distances. At the same time, the purchasing group of PCBM entered a
long negotiation process with the suppliers, in order to persuade them to lower their prices. The
result of these improvement activities was the reduction of another $1 per unit cost.

The combined reduction in cost per unit of $3, a total of $30,000, brought the cost to $370,000.

Although this was still higher than the allowable cost of $360,000 by $10,000, top management
thought the efforts of those who were involved in reducing costs were substantial.

Furthor Action

After the successful execution of the target costing project, management asked the marketing
team to review the $48 selling price. Since the customer was satisfied with the quality of the
product, they were responsive to the request by PCBM for a review of the $48 price.

The customer's representative tried to justify the fair level of the current price by pointing out that
no tab plate edge was required, which would reduce manufacturing costs.

Since PCBM had already designed and implemented an activity-based costing (ABC) system, it
was rather easy to demonstrate the cost impact of each component. PCBM's ABC system, which
had five process centers indicated the following costs of options:

The cost of solder mask option: $1.80

The cost of component legend option: $0.75

Since the customer's PCB didn't require tab plating, the ABC system already reflected that. No
cost was charged to their order for the tab plating option. This helped PCBM earn credibility from
the customer regarding the price quotes. The customer finally agreed to consider a price increase
in the near future.

The Real Weapon

The real power of target costing is that it allows companies to successfully motivate employees
and enforce cost management action plans. It is a disciplined approach to managing costs and
improving processes and products. Target costing, as briefly illustrated here, is also very
compatible with the emerging ABC, which can provide necessary cost information for
implementing target costing. And target costing can be as effective in U.S. industry, as it has been
in Japan.
Avoiding the Pitfalls

What are the obstacles in target costing? It takes time and money to bring sweeping
changes into an organization. There's also the problem of changing workers' behavior.
Why rock the boat if things are going well? The answer, target costing proponents say, is
simple: In the long run your company will be better positioned to compete in the
marketplace with target costing than without target costing.

"Most American companies are working in silos," says Keith Hallin, senior manager of
finance in the Boeing Commercial Airplane Group in Seattle, who has introduced pilot
programs in target costing at his company. "For instance, engineers focus on the
specifications of the product. Target costing requires them to think beyond those
traditional tasks and factor in the cost of the engineering, to perform cross-functionally."

American companies tend to build something and discover after it's produced that the
price they need to charge to make a profit is too expensive for their customers. Then they
try to find piecemeal solutions for reducing the cost. The target costing process requires
that the desired cost to manufacture a product be spelled out ahead of time.

Since target costing is customer-driven, it can improve customer satisfaction. It also

allows more people in the company to understand the company's objectives and how they
are going to be achieved, because it encourages people with different functions to work
on the same team to meet the collective target costing goals. Target costing, ideally,
arrives at a price that works for the company as well as the customer. That makes it a
more effective way to do business, and companies that have used target costing have
indeed found that they reach their profit goals more effectively.

Controllers who introduce target costing successfully into their organization may change
how co-workers perceive financial types, from a policeman or someone with a big stick
to a valued partner working on everyone's behalf. Workers can understand that the
reasons behind your cost objectives are directly related to gaining a competitive
advantage, not merely a dictum from senior management.
PRODUCT AND CONSUMER INFLUENCESoduct and Customer Influences

A number of factors influence target costing, including senior management's objectives

and your company's long-term profit objectives. But while every company uses target
costing differently, there are some things that will influence your target costing efforts no
matter what type of business you're in or what your corporate culture is. They are the type
of customer you sell to and the type of product you make or service you offer.
10 Advantages of
Target Costing
If you are successful in
implementing and maintaining an
effective target costing system,
you may be able to:

1. Determine an expected
cost of manufacturing a
product or providing a
2. Achieve greater cost
3. Spend money where it
will have the greatest
4. Identify customers' real
5. Match your firm's
activities to your
customers' requirements.
6. Increase customer
7. Give co-workers a better
understanding of cost
8. Allow co-workers to
participate in setting
quality, cost and time
9. Transform your image of
"policeman" into that of
a valued partner working
on everyone's behalf.

10. Become more

competitive globally.
It may seem obvious to tie the
cost of your product or service
to the needs of your customers.
But target costing makes more
of a defined effort to achieve
this objective than traditional
costing methods. That effort
extends to researching
customer needs, something
Boeing takes very seriously.

"In research-gathering
seminars, I ask how many
people own one of our
products, and no one raises
their hand," says Boeing's
Hallin. "Then I ask how many
people have ever flown in one
of our planes, and everyone's
hand goes up. Although ours is
a business-to-business
company, we want to
understand not only how our
immediate customers [airplane
purchasers and lessors] use our
product, but how their
customers, the passengers, use
it as well."

Target costing says you need to

match your firm's activities to
your customer's requirements.
Dr. Judith E. Hennessey,
professor and chairwoman of
the marketing department in
the College of Business
Administration and Economics
at California State University,
Northridge, Calif., offers an

"Suppose you're an automaker

and you've determined your
customers want comfort," says
Hennessey. "Evaluate your
product as it relates to
enhancing customer comfort,
perhaps by looking at the
springs in the seat, the
upholstery, the angle of the
seat, the car's suspension.
Enhance those things and
reduce costs in areas that aren't
as important to the customer."

Uncovering customers' real

needs can occasionally be
difficult even with a simple
product, and even for the best
of companies. "When Procter
& Gamble developed their
Pringle's potato chip, they
asked people what they wanted
from a potato chip, and the
answer uniformly was
freshness," Hennessey says.
"The product was launched in
a vacuum-sealed can to
maximize freshness, and
initially, it was successful. But
then customers found out that
the product didn't taste very
good. Procter & Gamble had
missed taste as a customer

If in creating product functions

that reflect what the customer
wants your costs become too
high to hit your target, don't
give up. Find other areas less
important for customer
satisfaction and try to reduce
those costs. If the process
doesn't work the first time
around, try again. "Sometimes,
target costing needs many
iterations to carry it through,"
says Hennessey.

How does your product

influence target cost?
Generally, the longer your
product development cycle
from the design stage to the
production stage, the more
difficult it may be to establish
firm target costs early on. For
instance, if your cycle is up to
four years, which is how long
it typically takes at Boeing
according to Hallin, the target
cost you establish may need to
be revised over the years.

Some companies with a long

product development cycle
take the process in incremental
steps. They have an allowable
cost for each component
function, then the total
allowable costs of all the
functions for making the
product are added to arrive at
an expected cost of
manufacturing the product. It's
usually impractical for a
company with hundreds of
design and production
components to evaluate all of
them, so a representative
sample of allowable costs is
taken and applied to all
components. From these costs
comes an updated target cost.
Companies with shorter
product development cycles
may find they can stick to their
initial target cost more easily
because they are not as
susceptible to the changes that
time can impose.

"The simpler and more

straightforward your product,
the easier it is to implement
target costing," says George
Millush, program director for
project redesign on all
financial processes at Chrysler
Corp. in Auburn Hills, Mich.
"We're very interested in target
costing, but it takes time to put
the pieces in motion, and we're
just in the infant stages here."