<http://sloanreview.mit.

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Develop Profitable
New Products with
Target Costing
With the emergence of the lean enterprise and global competition, companies face ever-
increasing competition. To survive, companies must become experts at developing products
that deliver the quality and functionality that customers demand, while generating the
desired profits.1 One way to ensure that products are sufficiently profitable when launched
is to subject them to target costing.2
Target costing is primarily a technique to strategically manage a company’s future profits.
It achieves this objective by determining the life-cycle cost at which a company must
produce a proposed product with specified functionality and quality if the product is to be
profitable at its anticipated selling price. 3 Target costing makes cost an input to the
product development process, not an outcome of it. By estimating the anticipated selling
price of a proposed product and by subtracting the desired profit margin, a company can
establish its target cost. The key is then to design the product so that it satisfies customers
and can be manufactured at its target cost.
In Japan, lean enterprises have learned to view target costing not as a stand-alone program,
but as an integral part of the product development process. To document the “Japanese”
approach to target costing, we visited seven companies with mature and effective target
costing systems and documented their procedures in depth. The companies we studied
were Isuzu Motors Ltd., Komatsu Limited, Nissan Motor Corporation, Olympus Optical
Company Ltd., Toyota Motor Corporation, Sony Corporation, and Topcon Corporation.4
While the target costing practices at each company differed, we identified a common
underlying generic approach that we document here to give managers a road map for
implementing target costing systems.
Target costing, to be effective, must be a highly disciplined process. The process used at the
seven firms studied can be divided into three sections (see Figure 1). The discipline starts by
forcing alignment with the marketplace and requiring a new level of specificity about what
customers want and what price they are prepared to pay. Market analysis plays a critical
role in shaping the market-driven costing section of target costing by determining so-called
allowable costs. Target costing systems use these allowable costs to transmit the
competitive cost pressures that the company faces to the product designers. Product-level
target costing disciplines and focuses the product designers’ creativity on achieving the
cost aspect of this objective. Once a company establishes product-level target costs, it
decomposes them to the component level, thus transmitting its cost pressures to its
suppliers. Suppliers, in turn, must find ways to design and manufacture the company’s
externally sourced components so that they can make adequate returns when they sell
their components to the company. Thus, component-level target costing helps discipline
and focus suppliers’ creativity in ways beneficial to the buyer.
While market-driven costing is the first step and should be initiated early in the product
conceptualization process, the new product’s design must be sufficiently advanced so that
its functionality and quality can be defined adequately to the company’s customers.
Otherwise, the customers will not be able to specify a meaningful selling price. Even though
the product-level target costing process cannot begin in earnest until the company
establishes the allowable cost, the company can start some activities in parallel with the
market-driven costing section. For example, it can determine the current cost and initiate
some supplier feedback. Furthermore, the ability to fine-tune the functionality and quality
of products during product development means that the company has to return to the
market occasionally to ensure that design changes have not invalidated the target selling
price. Thus, there is iteration between market-driven costing and product-level target
costing.
Component-level target costing must begin early during the product-level target costing
process since the product-level target cost depends heavily on supplier estimates.
However, the formal decomposition process and the establishment of negotiated supplier
selling prices occur fairly late in the overall target costing process. The two processes are
again iterative, with the product-level target costing process establishing the level of cost
reduction that the company’s suppliers must achieve, but ameliorated by the suppliers’
early feedback.
Thus, while product-level target costing is the linchpin of the whole process, a company can
manage the three sections predominately in isolation of each other. The chief engineer is
responsible for resolving the tensions that are created by the market pressures on the one
hand and the suppliers on the other. Effective target costing allows a company to trade off
these pressures against each other so that it manufactures and sources products with the
required level of quality and functionality and it achieves an adequate return on its
investments.
Market-Driven Costing
Market-driven costing focuses on customer requirements and uses the concept of
allowable cost to transmit the competitive pressure of the marketplace to the company’s
product designers and suppliers. We can break market-driven costing into five steps (the
first two of these steps cover all the company’s products; the next three are performed for
each new product; see Figure 2):
Set the company’s long-term sales and profit objectives, highlighting the primary role of
target costing as a technique for profit management.

 Structure the product lines to achieve maximum profitability.

 Set the product’s target selling price, i.e., the price at which the product is expected
to sell when launched.
 Establish the target profit margin the company must earn on the product to achieve
its long-term profit objectives.
 Compute the allowable cost by subtracting the target profit margin from the target
selling price.
 Set Long-Term Sales and Profit Objectives
Target costing begins with the company’s long-term sales and profit objectives. Its primary
objective is to ensure that each product, over its life, contributes its planned share of
profits to the company’s long-term profit objectives. The credibility of the long-term plan is
paramount in establishing target costing discipline. Two factors help establish this
credibility. First, the company derives long-term sales and profit plans from careful analysis
of all relevant information. To achieve this objective, it spends considerable energy on
customer and competitor analysis. For example, Olympus Optical, a manufacturer of
cameras and other optical-based products, collects and integrates information from six
sources: the corporate plan, a technology review, an analysis of the general business
environment, quantitative information about camera sales, qualitative information about
consumer trends, and an analysis of the competitive environment.
Second, the company approves only realistic plans. Wishful thinking is not allowed to enter
the planning process. For example, at Toyota, Japan’s largest auto manufacturer, the sales
division proposes anticipated production volumes based on past sales levels, market trends,
and competitors’ product offerings. The sales division typically proposes a figure that is
considered achievable. Optimism is thus restrained in favor of realistic goals.

 Structure the Product Line

For product lines to be successful, they must be structured carefully to ensure that they
satisfy as many customers as possible but do not contain so many products that they
confuse customers. For that reason, structuring the product line typically is based on a
thorough analysis of how customer preferences change over time. For example, Nissan,
Japan’s second largest auto manufacturer, conceptualizes new models by identifying so-
called consumer mind-sets. Mind-sets capture how consumers view themselves in relation
to their cars. Nissan uses them to identify design attributes that consumers take into
account when purchasing a new car. Typical mind-sets include “value seeker,” “confident
and sophisticated,” “aggressive enthusiast,” and “budget/speed star.” By detecting clusters
of these mind-sets, Nissan can identify niches that contain a sufficient percentage of the
auto-purchasing public to warrant introducing a model tailored specifically for that niche.

 Set Target Selling Price

The target costing process requires that a company establish a specific target selling price.
At the heart of the price-setting process is the concept of perceived value. Customers can
be expected to pay more for a product than for its predecessor only if its perceived value
is higher. For example, at Toyota, the sales divisions usually propose retail prices and sales
targets. The fundamental guiding principle they use in setting retail prices is that the
vehicle price remains the same unless there is a change in function from the previous
model, and this change alters the perceived value of the vehicle in the customer’s eyes.
Therefore, increases in retail price are based primarily on the customer’s perception of
additional value from new functions, such as the introduction of four-wheel steering (for
increased maneuverability) and active suspension, or from better performance, such as
higher engine horsepower or better fuel efficiency.
The price increases associated with incremental perceived value are tempered by the
availability of competitive products and their perceived value. A company can raise selling
prices only if the perceived value of the new product exceeds not only that of the
product’s predecessor, but also that of competing products. For example, at Topcon, a
manufacturer of ophthalmic instruments and other advanced optics and precision
equipment, competitive forces determine the allowable range of market prices. Topcon sets
the price of its new products close to its competitors’ prices. However, if managers believe
the Topcon product has greater functionality than competitive products, then they will raise
the price of the Topcon product. In contrast, if the functionality is perceived to be lower, the
price will be correspondingly lower. Once the new product enters the market, competitors
usually react by repricing their own products, increasing their advertising levels, or
introducing a new model at a lower price.
Given the importance of the target selling price to the whole process, it is not surprising
that companies are very careful to ensure the most realistic possible target selling prices.
They set the prices by taking into account the market conditions expected when launching
the product. For example, Nissan determines the target selling price of a new model by
considering a number of internal and external factors. The internal factors include the
position of the model in the product matrix and the strategic and profitability objectives of
top management for that model. The external factors include the corporation’s image and
level of customer loyalty in the model’s niche, the model’s expected quality level and
functionality compared to competitive offerings, its expected market share, and the
expected prices of competitive models.

 Establish Target Profit Margin

The objective in establishing target profit margins is to ensure achievement of the
company’s long-term profit plan. Usually, the division in charge of the product line is
responsible for achieving the overall profit target. For example, Sony, Japan’s leading
manufacturer of consumer electronics, uses an iterative process to set the target profit
margin for each product. The starting point is the group profit margin identified by each
group’s profit plan. Once the annual group profit target is set, each group is responsible for
its own profitability. Two important considerations in setting target profit margins are to
ensure that the margins are realistic and that they are sufficient to offset the life-cycle
costs of the products.

 Set Realistic Profit Margins.

A company can set target profit margins in two ways. In the first method, it starts with the
actual profit margin of the predecessor product and then adjusts for changes in market
conditions. Nissan adopts this approach when it uses computer simulations to identify the
relationship between selling price and profits. From this historical relationship, it identifies
the target profit margins of new products, based predominantly on their target selling
prices. The aim of this careful analysis is to set realistic profit margins that will enable it to
achieve its long-term profit plans.
In the second method, the company starts with the target profit margin of the entire
profit line (or other grouping of products) and raises or lowers the target profit margin for
individual products, depending on the realities of the marketplace. Sony calculates the
first-cut target cost for a new product by subtracting the group target profit margin from the
product’s target selling price. It compares the resulting target cost to the estimated cost of
the new product. When it considers the target cost too low, it allows the target profit
margin to decrease, but only if it can increase another product’s target profit margin
sufficiently to offset the loss. The outcome for the product with the decreased target margin
is an increased target cost; the outcome for the product with the increased profit margin is a
decreased target cost. The objective is to maintain the group’s profit target. When all the
individual product decisions are complete, Sony runs a simulation of overall group
profitability to make sure the group’s profit target will indeed be met.

 Offset for Life-Cycle Costs.

If product launch or discontinuance requires high investments or if a product’s selling
prices or costs are expected to change significantly during its life, the company has to
adjust the target profit margin accordingly. The purpose of such adjustments is to ensure
that the company accounts for all costs and savings when determining the target profit
margin so that the expected profitability of the product across its life is adequate.
Without such adjustments, the company risks either launching products that do not earn an
adequate return or not launching products that will earn an adequate return over their lives.
Companies with products that require large up-front investments typically analyze their
life-cycle profitability. These analyses include a determination of the investment, both
capital and marketing related, required to bring the new product to market. The objective
of the analyses is to ensure that target profit margins are set large enough so that
products will earn an adequate profit margin over their lives (assuming all goes according
to plan). For example, when the conceptual design reaches the stage where Nissan can
make rough estimates of how many vehicles it is likely to sell and the costs associated with
the development of the new products, it undertakes a life-cycle contribution study to
estimate the overall profitability of the proposed model. The study compares the estimated
revenues generated by the new model to the expected cost of the product across its life.
Companies that can reduce product costs substantially during the manufacturing stage of
the product’s life cycle undertake a different life-cycle analysis that reflects any savings in
production costs expected during the manufacturing phase in the target costing profitability
analysis. For example, the joint impact of increased functionality and reduced prices places
severe pressure on Olympus Optical to reduce costs.
Only by continuously taking costs out of products can the company hope to remain
profitable. This intense cost reduction across the manufacturing life of the product often
reflects the fact that the target selling price already incorporates the anticipated cost
savings.

 Compute Allowable Cost

Once it has established the target selling price and target profit margin, the company can
calculate the allowable cost by simply subtracting the target profit margin from the target
selling price:
Allowable cost = target selling price - target profit margin

Given the way in which target profit margins are set, there are two critical issues that a
company must understand. First, the allowable cost reflects the company’s relative
competitive position because it is based on its realistic, long-term profit objectives.
Consequently, the allowable cost is not a benchmark against which the company can
measure itself compared to its competitors. To make allowable costs act as benchmarks in
this way, target profit margins that reflect the capabilities of the most efficient competitor
would have to be set. Second, the allowable cost does not take into account the cost-
reduction capabilities of the company’s product designers or suppliers. Therefore, there is
no guarantee that the company can achieve the allowable cost. When a product’s allowable
cost is considered unachievable, the company must establish a higher cost in the product-
level target costing process.
Product-Level Target Costing
In the second part of the target costing process, product designers focus on finding ways
to develop products that satisfy the company’s customers at the allowable cost. In
practice, however, it is not always possible for the product designers to find ways to do
that. Therefore, the process of product-level target costing increases the product’s
allowable cost to a target cost that the company can reasonably expect to achieve, given
its capabilities and its suppliers (see Figure 3).
Product-level target costing can be broken into three steps:
1. Set the achievable product-level target cost.
2. Discipline the target costing process to ensure that the target cost is met where
feasible.
 3. Achieve the product’s cost to the target level without sacrificing functionality and
quality by using value engineering and other engineering-based cost reduction
techniques.

 Set Product-Level Target Cost

In highly competitive markets, customers expect each new generation of products to
improve, in terms of higher quality and functionality or reduced prices. Any of these
improvements, or a combination, requires that the company reduce the costs of new
products to maintain its profitability. The degree of cost reduction required to achieve the
allowable cost is the target cost-reduction objective, derived by subtracting the allowable
cost from the current product cost:
Cost-reduction objective = current cost - allowable cost

The current cost of the new product is determined by adding up the current
manufacturing costs of each major function of the new model, assuming no cost-reduction
activities are undertaken. For the current cost to be meaningful, the major functions that
the company uses in product construction have to be very similar to those that it will
eventually use in the new product. For example, if the existing model uses a 1.8 liter engine
and the new model uses a 2.0 liter one, the appropriate current cost is for the most similar
2.0 liter engine that the company produces or purchases.
Since the allowable cost is derived from external conditions and does not take into
account the company’s design and production capabilities and its suppliers, the risk is that
the allowable cost will not be achievable. In this case, to maintain the discipline of target
costing, the company has to identify achievable and unachievable parts of the cost-
reduction objective. The achievable or target cost-reduction objective is derived by
analyzing the ability of the product designers and suppliers to remove costs from the
proposed product. The purpose of the interactive relationships with the company’s
suppliers is to allow them to provide early estimates of their products’ selling prices and,
when possible, insights into alternative design possibilities that would enable the company
to deliver the desired level of functionality and quality at reduced cost. The product-level
target cost is then determined by subtracting the new product’s target cost-reduction
objective from its current cost:
Product-level target cost = current cost- target cost-reduction objective

Negotiations with the chief engineer and the product designers and major suppliers
establish the product-level target cost. All concerned should consider the target cost-
reduction objective achievable. It is the number to which the designers will be held
accountable for the rest of the project.
The unachievable part of the cost-reduction objective is called the strategic cost-reduction
challenge, which is the difference between the allowable cost and the target cost:
Strategic cost-reduction challenge = product-level target cost- allowable cost

It identifies the profit shortfall that will occur when the product designers are unable to
achieve the allowable cost, and signals that the company is not as efficient as demanded by
competitive conditions. To maintain the discipline of target costing, the company must
manage the size of the strategic cost-reduction challenge carefully. The challenge should
reflect the company’s true inability to match its competitors’ efficiency. To ensure that this
requirement is met, the company must set the target cost-reduction objective so that it is
achievable only if the entire organization makes a significant effort to achieve it. If it sets the
target cost-reduction objective consistently too high, it will not only subject the workforce
to excessive cost-reduction objectives, risking burn-out, but also lose the discipline of target
costing as it frequently exceeds its target costs. On the other hand, if it sets the target cost-
reduction objective too low, the company will lose competitiveness because new products
will have excessively high target costs. Typically, in a company with a well-established
target costing system, the strategic cost-reduction challenge will be small or non-existent,
and intense pressure will be brought on the design team to reduce it to zero.
The company establishes the strategic cost-reduction challenge through negotiations
between the chief engineer and senior managers. Senior managers push for the smallest
number possible, while the chief engineer pushes for a number high enough to ensure that
the product-level target cost is achievable. Since the target cost-reduction objective and the
strategic cost-reduction challenge add up to the gap between the current cost and the
allowable cost, these negotiations maintain the pressure on the product designers to reduce
costs. The chief engineer must ensure that the pressure does not become excessive. Thus,
when a strategic cost-reduction challenge emerges, the process of setting product-level
target costs becomes iterative, with the chief engineer in the middle and senior
management and the product designers at the ends.
The emergence of a strategic cost-reduction challenge is a sign for all involved in the new
product development to create additional pressure on the product designers and the
company’s suppliers to reduce the challenge to zero for the product’s next generation.
Thus, the primary purpose of the strategic cost-reduction challenge is to give the company
breathing room, while maintaining the overall cost-reduction pressure. If the company
cannot reduce the challenge to zero for the next-generation product, it may no longer be
fully competitive.
The value of differentiating between the allowable cost and the target cost lies in the
discipline that it creates. Target costing systems derive their strength from the application
of the cardinal rule: “The target cost must never be exceeded.” If a company continuously
sets overaggressive target costs, it would commonly violate the cardinal rule and lose the
discipline of the whole process. Even worse, if a company knows the target cost is
unachievable, the design team might give up even trying to achieve it and never effectively
reduce costs. To avoid this, companies frequently set target costs higher than the
allowable costs that are achievable only with considerable effort.
Theoretically, the cardinal rule should relate to the allowable cost. However, companies
often have to launch products for strategic reasons, such as to maintain a complete product
line. If, early in the target costing process, the company determines that the allowable cost
is unachievable, setting a lower target cost allows the product to be launched while
maintaining intense pressure to reduce costs. The degree to which the allowable cost is
relaxed to produce an achievable target cost is the strategic cost-reduction challenge.

 Discipline the Product-Level Target Costing Process

Once the company has established the target cost-reduction objective, it can begin the
process of designing the product so that it can be manufactured at its target cost. The chief
engineer and his or her superiors must continuously monitor the design engineers’ progress
toward this objective. This monitoring ensures that the company can take corrective actions
as early as possible and that it doesn’t violate the cardinal rule.
Apply the Cardinal Rule.
The cardinal rule of target costing — “The target cost must never be exceeded” — is critical
to ensuring that the discipline of target costing is maintained throughout the design process.
The cardinal rule is enforced in three ways. First, whenever improvements in the design
result in increased costs, the company must find alternative, offsetting savings elsewhere
in the design. Second, the company does not launch products whose costs exceed the
target. Finally, the company carefully manages transition to manufacturing to ensure that
it achieves the target cost.
The cardinal rule ensures that all involved realize that failure to achieve the product-level
target cost will typically lead to cancellation of the project. In a well-disciplined target
costing program, few projects will be cancelled for failure to achieve the target cost.
However, as new product development by its very nature must push technologies and
manufacturing processes to their limits, occasional failures occur. These failures are very
different from those encountered in non-target–costing environments, where the product is
designed to have excessive functionality for its sustainable selling price and, hence, is
withdrawn before (or, even worse, after) launch.
Sometimes a company has to apply the cardinal rule in a more sophisticated way than the
conventional, single-product perspective. When a given product leads to increased sales of
other products, a company must adopt a multiproduct perspective; when it is expected to
lead to sales of future generations of products, the company must adopt a
multigenerational perspective. Only when getting the product to market on time is so critical
that cost is of secondary consideration should the cardinal rule be violated. For example, the
Walkman market is so competitive that failure to release a timely new model typically will
result in considerable lost sales. Sony believes it is imperative to release products on a
timely basis and does not allow product redesign to extend product launch dates, even if
profitability is below minimum. When such a product is launched, it undergoes two
analyses: a thorough review of the design process to identify why the target cost was not
achieved and an intense cost-reduction effort immediately after its launch so that the
violation of the cardinal rule is as short-lived as possible. The two analyses maintain the
discipline of target costing despite the temporary violation.

 Achieve the Target Cost

Once a company has established the target cost-reduction objective, it must find ways to
achieve it. Several engineering techniques can help product designers reduce product costs,
including value engineering (VE), design for manufacture and assembly (DFMA), and quality
function deployment (QFD). VE is a multidisciplinary approach to product design that
maximizes customer value; it increases functionality and quality while reducing cost. In
contrast, DFMA focuses on reducing costs by making products easier to assemble or
manufacture, while holding functionality at specified levels. QFD provides a structured
approach to ensure that customer requirements are not compromised during the design
process.
Component-Level Target Costing
Once a company has established a product’s target cost, it develops target costs for the
product’s components. This component-level target costing process enables the company to
achieve the second objective of target costing: transmitting the competitive cost pressure it
faces to its suppliers (see Figure 4). This objective is critical in lean enterprises, which are
horizontally rather than vertically integrated. Such companies purchase a significant portion
of their materials and parts from external instead of internal suppliers. For example, at
Toyota, third-party suppliers are responsible for approximately 70 percent of the parts and
materials required to produce the company’s cars. This high level of dependency on
externally supplied items makes supplier relations extremely important to Toyota’s success.
In particular, the cost and quality of third-party-supplied parts is considered critical.
Component-level target costing consists of three steps:
Decompose the product-level target cost to the major function level. Major functions are
the sub-assemblies that provide the functionality that enables the product to achieve its
purpose. For example, major functions for a vehicle include the engine, transmission,
cooling system, air conditioning system, and audio system.
Set component-level target costs.
Manage suppliers.
Decompose Target Costs of Major Functions
Identifying major functions allows the design process to be broken into multiple, somewhat
independent tasks. Typically, the design of each major function is the responsibility of a
dedicated team. Design teams usually include representatives from a number of disciplines,
such as product design, engineering, purchasing, production engineering, manufacturing,
and parts supply. The overall responsibility for coordinating the design of a new product
typically rests with the chief engineer or product manager, who selects the distinctive
theme of the new product and sets its functionality. At Toyota, more than 100 engineers
from various divisions work with a chief engineer on a typical project, but since they belong
to different divisions, not all team members are under his direct supervision. In this sense,
the chief engineer is more a project leader than a supervisor of product development.
The chief engineer is responsible for setting the target cost of each major function, usually
through an extended negotiation process with the design teams. The target costs typically
are based on historical cost- reduction rates. Some companies use relatively simple
heuristics to establish the cost-reduction objectives; for example, if the cost of a major
function historically has been decreasing by 5 percent a year, then this rate will usually be
used. Other companies, including Komatsu, have more sophisticated approaches, such as
functional analysis and productivity analysis.
However, not all companies rely solely on historical cost-reduction rates. Some use market
analyses to help set the target costs of new products. These market-based approaches are
particularly applicable when new forms of product functionality are being introduced. For
example, Isuzu uses monetary values or ratios to help set the target costs of major functions
and asks customers to estimate how much they are willing to pay for a given function. These
market-based estimates, tempered by other factors, such as technical, safety, and legal
considerations, often lead to adjustments to the prorated target costs. For example, if the
prorated target cost for a component is too low to allow a safe version to be produced, the
component’s target cost is increased, and the target cost of the other components is
decreased to compensate.
The chief engineer may modify the target costs derived from either historical rates or
market analysis for three major reasons. First, if the sum of all the historical rates does not
give the desired cost-reduction objective, the chief engineer will negotiate with the head of
the design teams of the major functions for higher rates of cost reduction. These
negotiations continue until the sum of the target costs of the major functions equals the
target cost of the product. Second, if the relative importance of a given major function
changes from one generation to the next, the chief engineer will modify the target costs
accordingly. For example, if the chief engineer wants the new vehicle to be sportier, he or
she might increase the target cost of the corresponding major functions to make it easier for
the design teams to achieve both their functionality objective and target cost. However,
under the cardinal rule of target costing, these cost increases would have to be offset
elsewhere in the design. Third, when the technology on which a major function relies
changes, the historical cost-reduction rate of the old technology ceases to be meaningful.
Instead, the company should figure in the historical rate for the new technology, if it is
available. When entirely new technologies are used, the cost-estimation problem becomes
more difficult because no historical data on cost-reduction trends have been developed.
At some Japanese firms, a safety factor, often called “the reserve for the production
manager,” is built into the development of major function-level target costs. The purpose of
this reserve is to allow for any (minor) cost overruns due to design-related problems that
may occur during the production process. Experience has shown that minor overruns are
common in practice and cannot easily be avoided. By establishing an adequate reserve, a
company can significantly reduce the number of minor cardinal rule violations without
reducing the overall discipline of target costing. It creates the reserve by setting the
component target costs and assembly and indirect manufacturing target costs so that they
add up to an amount below the product-level target cost. The chief engineer is responsible
for creating a reserve that is sufficient to offset the anticipated overruns, but does not
introduce slack into the production process. The magnitude of the reserve is based on
experience from similar product development projects; it is typically quite small, ranging
from 5 percent to 10 percent of the product-level target cost.
Once a company has established the target costs of the major functions, it decomposes
them to the group component and parts level as appropriate. The objective is to set a
purchase price for every externally acquired component.
Set Target Costs of Components
Typically, the major function design teams decompose the target cost of the major function
to the component level. At Toyota, each design division is responsible for attaining its
respective cost-reduction goal. The specifics of parts, materials, and machining processes
are left to their discretion. The chief engineer will sometimes specify cost-reduction targets
for specific parts to the related divisions, especially for large, costly parts. These part-
specific targets are set at the same time as the divisional targets.
Manage Suppliers
Supplier management has two primary aspects that are particularly important in the
component-level target costing process:
Selecting suppliers.
Rewarding suppliers for finding creative ways to reduce costs of the components they
supply.
Select Suppliers.
A critical decision to be made during the component-level costing process is the sourcing of
components. The target costs for externally acquired components are typically set through
negotiation. This process starts with suppliers, both internal and external, providing
estimates of their selling prices to the company. At Nissan, the first step in the product
development stage is to prepare a detailed order sheet for the new model, which lists all the
components required. Nissan analyzes it to see which components are likely to be sourced
internally and which externally and gives both internal and external suppliers a description
of each component and its potential production volumes. Suppliers then provide price and
delivery-timing estimates.
The comparison of the target cost of each major function and the sum of the expected costs
of the components in that function after cost reduction indicates whether each major
function can be produced at its target cost. When the sum of the component costs is too
high, additional cost reductions are identified until the total target cost of the
representative variation, the one expected to sell the highest volume, is achieved. The
target costs for all components are compared to the suppliers’ quoted prices. If satisfactory,
the company accepts the quote. If the initial quote is too high, the company undertakes
further negotiations until reaching an agreement.
To maintain discipline, a company can relax target costs of components only under very
special circumstances and typically for a short period of time. The objective of this
relaxation is to allow the supplier to make a reasonable return, while finding ways to reduce
costs to the target levels.
Reward Supplier Creativity.
Many companies use incentive plans to encourage their suppliers, both to reward
innovation and to signal where additional cost reduction should occur. These plans reward
the supplier with all or part of the order for a given component. For example, under its
incentive plan, if Nissan accepts a cost-reduction idea, it awards the supplier that suggested
it a significant percentage of the contract for that component for a specified time, say 50
percent for twelve months. This incentive scheme is particularly important because even if a
cost-reduction objective cannot be achieved for this model, it signals to the suppliers that
when the next model is developed, this component will be subject to cost-reduction
pressures.
Even with the discipline of target costing, the lowest-cost or highest-value supplier does not
always win the bid. Companies actively manage their suppliers to ensure that they remain
both efficient and innovative. Isuzu, although it generally gives the order to the supplier
rated as having the highest value, often awards companies with a reputation for being good
suppliers at least part of the order, even if their products do not have the highest value.
Isuzu awards partial contracts to maintain relationships with these companies.
Conclusion
Given a highly competitive environment, companies must manage costs aggressively if they
are to survive. Cost management must start at the earliest stages of a product’s life because
the ability to change the product significantly increases the degree to which costs can be
reduced. Three target-costing processes together discipline the product development
process to help ensure that only profitable products are launched (see Figure 5).
Leading Japanese manufacturers have used target costing systems to their advantage, and
western companies are introducing this proactive cost management technique to discipline
their product development processes. Target costing and value engineering provide
considerable payoffs to early adopters. The company that can most rapidly reduce costs of
new products without having to compromise on quality and functionality will gain market
share and experience economic success.
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About the Authors
Robin Cooper is professor of management, Peter F. Drucker Graduate School of
Management, Claremont Graduate University, and visiting professor, Goizueta Business
School, Emory University.Regine Slagmulder is associate professor, Department of Business
Administration, Tilburg University, and visiting professor, University of Ghent.
References (12)
1. R. Cooper, When Lean Enterprises Collide: Competing Through Confrontation (Boston:
Harvard Business School Press, 1995), p. 7.
2. R. Cooper and R. Slagmulder, Target Costing and Value Engineering (Portland, Oregon:
Productivity Press, 1997).
3. Target costs should include any costs that are driven by the number of units sold. For
example, if the company accepts responsibility for disposing of a product at the end of its
useful life, these costs are included in the target cost. See:
R. Cooper and B. Chew, “Control Tomorrow’s Costs through Today’s Designs,” Harvard
Business Review,volume 74, January–February 1996, pp. 88–97.
4. R. Cooper and T. Yoshikawa, “Isuzu Motors, Ltd.: Cost Creation Program” (Boston:
Harvard Business School, case study 9-195-054);
R. Cooper, “Komatsu, Ltd. (A): Target Costing System” (Boston: Harvard Business School,
case study 9-194-037);
R. Cooper, “Nissan Motor Company, Ltd.” (Boston: Harvard Business School, case study 9-
194-040);
R. Cooper, “Olympus Optical Company, Ltd. (A): Cost Management for Short Life-Cycle
Products” (Boston: Harvard Business School, case study 9-195-072);
R. Cooper, “Toyota Motor Corporation” (Boston: Harvard Business School, case study 9-197-
031);
R. Cooper, “Sony Corporation: The Walkman Line”(Boston: Harvard Business School, case
study 9-195-076); and
R. Cooper, “Topcon Corporation: Production Control System” (Boston: Harvard Business
School, case study 9-195-082).
5. When firms sell the same product at different prices, for example, in different countries
or through different channels, an average selling price is used.
Show All References
Tags: Innovation Strategy, Product Development, Product Strategy, Profitability Reprint #:
4042
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About the Authors
Robin Cooper is professor of management, Peter F. Drucker Graduate School of
Management, Claremont Graduate University, and visiting professor, Goizueta Business
School, Emory University.Regine Slagmulder is associate professor, Department of Business
Administration, Tilburg University, and visiting professor, University of Ghent.