With 95% of total product costs being committed before production, and success being determined by business areas which often work independently, the key to controlling costs and managing profits is discipline. In their chapter on 'Target Costing for New Product Development' from the Handbook of Cost Management, INSEAD Associate Professor of Accounting and Control Regine Slagmulder, and Emory University's Robin Cooper, argue that effective implementation of cost-based planning can harmonize contributions, while providing ongoing benefit by clarifying goals for production efficiency and leading innovation going forward.
A proper framework for target costing, considers costs at three levels. Evaluation of market demand determines potential revenues and sales volume, while production and component level considerations reveal internal capabilities for bringing products to market as efficiently as possible. Through monitoring each contribution through a unified costing framework, a company can benefit from improved initial planning, as well as through an ongoing evaluation of cost reductions and profit margin maximization.
At the Market-Driven Costing level, initial profit planning and extensive market research are used to determine what price level the market will bear. Existing products, market position, estimates of sales volume and consumer perceptions of value are considered, with this information being used to determine an appropriate range of prices, while quantifying the upper limit, or 'allowable cost', products can be sold at.
Allowable cost is then used to set the sale price and assess what profit margins are available at that level. In short, market-driven costing captures the external pressure from customers and competitors, then allows this to be transformed into meaningful cost targets for product designers.
Internal capabilities are considered at the second level, Product-Level Costing, which focuses on production efficiencies through evaluating a firm's manufacturing costs. The key metric here is target cost, which is similar to allowable cost, but differs by focusing on firm capabilities rather than market demand.
The gap between target cost and allowable cost gives the strategic cost reduction challenge: a figure used to set targets for value engineering, motivate production goals and lead decisions whether re-design is beneficial or even necessary. In addition to indicating areas for future improvement, target cost also is a valuable tool for assessing bottom line viability of new products, through the cardinal rule: never launch a product above its target cost.
The third level, Component-Level Costing, focuses on setting budgets for raw materials and other inputs. Important aspects include fielding competitive bids, managing relationships with suppliers and encouraging innovation. Disaggregating purchase costs on a component basis allows a company to have a detailed understanding of where current costs are greatest, in order to help identify suppliers that should be provided with engineering assistance or replaced with lower cost providers, and areas where vertical integration makes sense.
Once costs are understood at all levels, this information can be combined to evaluate how specific costs impact margins, providing a more comprehensive understanding of areas of strength, while isolating where future gains are likely to be derived from through product or process re-design.
Target costing becomes an even more valuable tool in more sophisticated cases, involving multi-product considerations, as well as kaizen costing. Through unifying market demand, production and supply management into an integrated framework, a firm can quantify factors that determine margins, gain a better understanding of how efficiencies can be achieved at each stage of the product life cycle, and harmonize contributions between designers, production engineers and suppliers.
John Wiley & Sons, 2005