Target Costing Is An Approach To Managing Product Costs


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This paper discusses the use and process of target costing for product development and cost management and why it should be used in product planning. To explain the target costing process, benefits, and problems with its use, the authors utilize a case study of a poultry processing company manufacturing home meal replacements for sale through supermarkets. Testing the efficiency and effectiveness of ABC models, using various methods, has been widely highlighted in early empirical studies. The study makes use of secondary data available from early empirical literature on implementation of ABC model in banking industry. Although, the model proved to be successful when implemented in the banking industry, number of problems still remain acute, which prevents from massive introduction of a new model within a sector. In response, some recommendations were drawn to design a method of overcoming or resolving many of the issues around ABC. The distribution of adoption over industries confirmed the expectation that assembling firms show a relatively high adoption of target casting. The adoption of these techniques appears to be related to an intense competitive and unpredictable environment. Similar to target casting studies in Japan and Germany, the main objective for adopting these techniques in the sample is to reduce costs. The product development and design departments appear to be leading in the target cost management process, while the accounting department is only moderately involved. Finally, the most frequently adopted organizational form for target cost management is team structures, in which multiple functions combine knowledge and capabilities in the product development process.


Target costing is an approach to managing product costs and gross margins that works backward from the price a customer will pay for a specific product with a specific feature set, sets product cost targets based on that product's expected gross margin and then manages the development process to achieve the targets. This is different from how many companies approach product costs, where the teams may set targets based on historical data and prediction, and then set the price by adding a specific percentage of margins. Target costing places customer value at the center of the financial decisions that a development team makes about a product. To do this effectively, a team needs to know such things as how much extra a customer will pay for a specific feature or level of performance, which areas of the product may be over-performing or especially difficult to manufacture, how to re-think a product design to make it easier and less expensive to produce, and how to partner with suppliers to drive down costs. The idea is to rethink our assumptions about a product and ask our customers directly to give us guidance on the elements of the product that create the most value for them - so that we can deliver them more effectively and eliminate everything else.

The main benefit of this approach is increased gross margins, primarily by reducing direct labor and material costs for the product. One design goal can be fewer parts, which leads to savings in inventory management throughout the supply chain. The same techniques usually lead to products that are easier to transition to manufacturing, more reliable and easier to maintain, which also drives down development, warranty, service and support costs. Surprisingly, this approach can make customers happier, too. By simplifying the products to reduce excess features and complexity, we can make the products easier to use and maintain from the customers' perspective. They also benefit from lower service and support costs, and higher reliability.

The target costing concept grew out of a need for manufacturers to improve product cost management and product development. The traditional cost management, cost accumulation and allocation methods used for decades and still predominant in the manufacturing and services sectors have failed as tools for product development, planning, and cost management. This is because they focus on the product's cost rather than on the expectations of customers and the product design itself. Furthermore, traditional cost systems inundate managers with accounting reports that routinely overstate the cost of high-volume, standardized products and understate the costs of low-volume, customized products. (Lockamy III and Smith, 2000).

In 1999, Cooper and Slagmulder defined three stages of target costing:

Setting the market price: In this phase, Marketing sets a target price for the product, and provides the development team with a prioritized list of features that will deliver a product that the customer will buy at the target price.

Managing the product cost: The development team sets a target cost for the product that will meet the organization's expectations for gross margin. They set up a process for monitoring product cost through the development cycle.

Managing subsystem and part level costs: Using existing products and competitive data as guides, the team creates a "budget" for each subsystem and major component. The team then develops a strategy for closing any gaps between the expected costs and the target cost and engineers the product to achieve the costs. Along the way, the team continuously monitors both subsystem and product level costs to assess progress towards closing the gap and address the issues that arise.

These three phases provide a comprehensive focus on product cost throughout the product lifecycle that pulls together the entire development team. In the beginning, Marketing is heavily involved in setting the target price and helping the development team understand relative value for features and performance parameters. Manufacturing people get involved early - in one case, as early as the concept phase, to provide early feedback on production process alternatives and their costs. Procurement and suppliers also get engaged to contribute ideas for closing the inevitable gaps between projected product costs and targeted costs.

The need to improve productivity and product quality resulted in many companies adopting new cost management methods, including activity-based cost management, kaizen costing, just-in-time inventory management, total quality management, and target costing. (Lockamy and Smith, 2000). Of the foregoing cost or management methods, target costing stands alone as the best means to enhance product development, pricing, and management of production and selling costs. This paper argues for greater use of target costing.

The first section of this paper gives an overview of empirical literature on ABC model, and in particular, an implementation of the model in financial services (mainly in banking) industry. The research supports an argument for a need to implement ABC model at service industry in order to be able to understand the behavior and causes of costs. The following section illustrates a practical aspect of ABC in banking industry. The study makes use of secondary data taken from academic sources. It details the stages of ABC methods and presents the benefits. Most importantly, the papers draws attention to the obstacles that many banks face while trying to implement the ABC in practice. Finally, the last section will conclude the ideas in this paper by drawing recommendations to the bank management that make it easy to overcome the problems in the process of implementing ABC.

Literature Review

Target costing has been defined by the Consortium for Advanced Manufacturing International as a set of management tools and methods designed to (1) direct design and planning activities for new products, (2) provide a basis for controlling subsequent operational phases, and (3) ensure that products achieve given profitability targets throughout their life cycle. (Cf. Shank, 1999). Cooper and Slagmulder describe it as a process for ensuring that a product launched with specified functionality, quality, and sales price can be produced at a life-cycle cost that generates a satisfactory level of profitability. (Cf. Lockamy and Smith, 2000).

The process is design-centered and has a market driven focus, which, unlike the conventional cost management techniques, allows firms to trade off quality and functionality to achieve target costs as a last resort. (Castellano et al, 2003)

It actually focuses less on costs and more on customer requirements. The question is not "How much will the product cost?" but "How much can the product cost?" Karo describes target costing as a complete cost-reduction program, not a simple cost-reduction technique, but a complete, strategic profit management system. Horvath describes it as a part of the cost-management function for a product throughout its life cycle. (Cf. Shank, 1999) The key elements of the process is that it is a planning tool where aspects of the product, cost and otherwise, are considered over the product's whole life cycle. Also, it is a cross-functional process, much like good strategic planning.

A subject that receives increasing attention in accounting literature is the use of cost in formation and cost management during product design (Anderson and Sedatole, 1998, Davila, 1999). The major argument for managing costs during product design is that after the product development stage most costs have been 'designed' into the product and cannot be influenced anymore. One important technique that can be used for managing product costs during the design stage is target casting (Kato, 1993; Ewert and Ernst, 1999). Target casting is essentially concerned with setting a target cost to be achieved in the product development process, such that a sufficient profit margin is realized when the product is brought to the market. In the literature, target casting is viewed as a strategic management accounting system, as it focuses on long-term cost management efforts (Chenhall and Langfield-Smith, 1998; Ewert and Ernst, 1999; Guilding et al., 2000; Tani, 1995).

Toyota developed the concept in the 1960s. It is used more in Japan than anywhere else in the world. Lockamy and Smith report that in the early 1990s over 80 percent of Japanese assembly manufacturing firms were using target costing, including all firms in the Japanese transportation equipment industry but none in the paper and pulp industry (Lockamy and Smith, 2000).

The rest of the world has not as readily adopted target costing, although many companies adopt certain aspects of it. It has been particularly slow to be adopted in the U.S. Banham reports that in the year 2000 only about 65 U.S. firms utilized target costing. Of these, 85 percent were discrete-parts and finished-product manufacturers. Some of these firms include Boeing, Eastman Kodak, Caterpillar, and Daimler-Chrysler. A survey of those U.S. firms reveals favorable, although not exceptional, results from utilizing target costing. (See the survey results in Banham, 2000.) Peter Zampino, director of research at Consortium for Advanced Manufacturing -- International (CAM-I), noted that U.S. firms tend to adopt target costing when they are in crisis mode. In his opinion, U.S. firms tend to have the opinion that in good economic times a company does not need target costing (Banham, 2000). U.S. firms like the concept of cost management, and many utilize the techniques described in this paper, but they do not follow the disciplined target costing process and the cross-functional participation in product, production, and supply chain planning activities (Banham, 2000).

In literature, target casting and target cost management are often associated with Japanese companies. Empirical research into the practices of target casting has mainly been performed by Japanese researchers for the Japanese situation (Kato, 1993, Tani et al, 1994).'Few efforts have been made to investigate whether these practices are also are relevant for and do occur in non-Japanese situations (some exceptions are Chenhall and Langfield-smith, 1998; Guilding et al., 2000; Horvath and Tani, 1997). One could expect that as the drivers for using such methods are not idiosyncratic to Japan (i.e., the desire to realize a profit margin on products, under certain market characteristics), they could also be used in a non-Japanese situation, even though the actual application of such practices may deviate from the 'typical' Japanese way.


2.1 Research Methodology and Data Collection

The ABC model follows a two stage methodology, first, by setting the relationship between resources and activities through the use of allocation bases and direct tracing. Then followed by an application of cost per unit of activity to the consumption of activities by specific cost objects, usually products or customers, for the purpose of measuring costs. In banking industry, the ABC provides an efficient way of organizing the collection, processing, and reporting of cost information for decision making and strategy formulation in a competitive economic environment.

The study is mainly based on empirical investigation of the efficiency of implementing ABC in banking industry. Hence, the research paper will make use of a secondary data on banking industry contained in early empirical studies. The banking industry of Uzbekistan could not serve as a research object, due to the fact that ABC has not been introduced in, yet. However, considering large benefits of having ABC in place, the paper urges policy makers and management to start its implementation. The secondary data is mainly drawn from interview and questionnaire results.

2.2 Target Costing in Process

The target costing process is composed of a number of discrete activities and decisions. It begins with a determination of the product, its characteristics and qualities, and its optimal selling price. This is probably the most important step in the process. The product itself will ultimately determine the costs necessary to produce and sell that product. Butscher and Laker describe this first step as including (1) definition of the target segments, (2) identification of the competitive advantages and disadvantages, (3) positioning of the new product within the target segments, (4) fine-tuning the product design and pricing, and (5) market simulations (Butscher et al, 2000).

Market research is an essential element of this first step. Whether done within or outside the firm, market research should focus on the desires and concerns of the customer. What does the customer want? What design features does the customer like or dislike, need or doesn't need. The customer's perceptions as to quality, price, and value are also important.

The marketing research is used to determine the price customers are willing to pay for the product, given its functionality, quality, and the substitute products offered by competing firms. (Lockamy and Smith, 2000) The information obtained from the customer will allow product designers to focus on those desired qualities and features. However, the product must be forward-looking and incorporate new features and salient product characteristics to assure product differentiation and a reasonable product life.

The target selling price is determined based on the market for the product as designed. Obviously, when a manufacturer sells its products in more than one market or through different channels, it may sell the same product at different prices. For example, pharmaceuticals manufactured in the U.S. are exported at lower prices to sellers in Canada and Mexico than they are sold for in the U.S. In such case an average selling price should be used (Cooper et al, 1999).

The second step in the process is the determination of the desired profit or target profit margin. Profits and profit margin should be reasonable and cover planned costs, additional required investment, and decommissioning or disposal costs over the product's life cycle. Similarly, the profit margin should be sufficient to support continuing product research and development. (Lockamy and Smith, 2000) Some companies, for example, Sony Corporation, build in more flexibility in establishing the desired profit or target profit margin. There, they allow for tradeoffs between different products, i.e., within the product group some products will have some profit margins higher and some lower. (Cooper et al, 1999) The desired profit margin should be based on, and meet, the company's objectives or policies.

Computation of the allowable product cost is the third step in the process. The allowable product cost is the difference between the target selling price and the target profit margin. The objective is to meet the cost constraints placed on the company, or as Cooper and Slagmulder describe it, establishing the target cost reduction objective.

The fourth step in the target costing process is determining the nature and amount of the product manufacturing and marketing costs and actually assuring itself that it can attain those target costs. These costs cannot exceed the allowable product costs, unless extenuating circumstances, such as a targeted product release date, dictate proceeding with the product before sufficient costs reductions are obtained. This part of the target costing process ends when the firm discovers a way to satisfy the customer requirements at the target cost or when the product is abandoned (Lockamy and Smith, 2000).

What has been the company's past production and marketing costs? Will new cost savings be required? What will be the effect of product revisions? In what areas can one reasonably expect cost savings? How soon must the product be released? Will the allowable cost require modifications in the supply chain? These are just some issues that may arise in proceeding through the process. Because from time-to-time there are unexpected cost overruns due to design-related problems in the production process, a company may build in a "cushion" or "reserve for the production manager" of 5-10 percent to cover such costs.

In determining what costs are necessary and identifying ways to reduce costs, a company may use other cost management techniques like value engineering, benchmarking, design for manufacture and assembly, and quality function deployment. (Cooper et al, 1999) Also, continuous cost reduction may be available through kaizen costing. Integration of the various functions, such as accounting, purchasing, marketing, production, logistics, and engineering in planning activities will be necessary here to reduce unnecessary costs and work processes. As the target costing approach is a cross-functional team approach, initially it is time extensive but the payoff for the additional planning costs should come later in savings in production and the supply chain activities. Notwithstanding that cost reduction is usually favorable, in target costing cost rationalization, not cost minimization, is the goal. This is consistent with techniques like value engineering, which is performed to redesign the product, its manufacturing process, and its distribution and service systems. (Lockamy et all, 2000)

Cooper and Chew argue that a product's cost needs to be subjected to the scrutiny of the marketplace from the beginning of the development activity. (Cooper et al, 1996) Benchmarking helps avoid the arbitrariness in target costing in such situations as internal subassembly and can help to reduce costs, especially when value engineering is used early in the product/production development stage (Clausing, 1996). In addition, benchmarking provides a tool for measuring the effectiveness of target costing. For example, Eastman Kodak set a benchmark of a 10:1 return on the costs associated with implementing target costing. If it cost the company $100,000 to have an engineer work closely with customers in product design, the return on that activity would have to generate at least $ 1 million in cost reductions (Banham, 2000).

Cost reductions should be sought in the manufacturer's internal activities and external sourcing. Although a manufacturer has significant legal and ethical obligations in maintaining safety and health of its employees, customers, and users of its products, and legal and regulatory requirements become more and more onerous every year, companies must cut costs wherever possible. Sometimes, however, cost savings are just not possible, and the product characteristics must be scrutinized again to isolate cost savings.

The supply chain should be scrutinized and utilized for cost reduction opportunities. The supply chain is much more important for companies utilizing target costing. Ellram notes that supply management and the purchasing function is particularly critical at the initial stages of the target costing process when developing component-level target costs and when activities and modifications are occurring to achieve target costs. Furthermore, supply management can play a very important role in managing, monitoring and improving costs in the supply chain (Ellram, 2002).

When acquiring component parts or necessary services, supply management may find it necessary to work more closely with suppliers. Additional cost savings may be achievable by creating trading partner relationships with the suppliers. The manufacturer's chief engineer or product manager might try to assist or provide incentives for a supplier to redesign a part or production process to achieve cost savings. Moreover, the company and the supplier may collaborate to develop and improve products and enhance the value and satisfaction provided to customers. (Lockamy and Smith, 2000; Banham, 2000)

The trading partner relationship may create administrative cost savings through EDI, B-2-B (business-to-business) transactions, or by providing incentives or rewards for devising creative cost reduction measures (Cooper et al, 1999; Lockamy and Smith, 2000). In order to maintain the trading partner relationship, however, the company must allow the supplier-trading partner to receive a reasonable compensation making continuation as a trading partner worthwhile. The

trading partners, including the company utilizing target costing, must be assured of profitability and survivability. (Lockamy and Smith, 2000).

This part of the target costing process is iterative. Costs are estimated determined for the product as designed. It may be necessary to reconsider certain of the design features given the cost factors. A determination would then have to be made to delete the product feature or to revise it, which would require another review of the production and supply chain processes and costs.

Finally, the target costing process requires monitoring to make sure the process has been effective. Products must be changed from time-to-time and new products added to existing product lines, and these activities will require product and cost planning as well.

2.3 Defining Target Costing Methods in Selected Industry


3.1 Research Analysis

Referring to the current study Target casting was defined as consisting of a casting method calculating the maximum allowable cost price by subtracting a required profit margin from the expected selling price. Most of the enterprises in industry, especially the electronics, textile and precision equipment industries make relatively high use of these techniques. This confirms to expectations, as assembly industries are considered the most feasible industries for the use of target costing. This diversity of names used implies that many firms have developed a system based on similar principles as target casting, without being familiar with the concept and its principles. Therefore, in empirical research into these types of systems it seems sensible to focus on the characteristics of the system used, and not on its theoretical name. An explanation for the insignificance of the number of competitors is that this measure may include little information about the in tens of the competitive environment, which is theoretically most important. During the product development process several goals have to be realized simultaneously, for which purpose target casting systems can be supportive. Different goals to be realized are high product quality, customer satisfaction by developing functional products that fulfill their needs, fast product introduction (time to market) and low costs. Based on the literature we expected cost reduction to be the most important reason for adopting a target casting practice, as its main purpose is to introduce only profitable products to the market by attaining adequate cost levels. The questions about the organization of target casting in the survey were related more to the TCM process. They measured the involvement of different functional departments in the application of target casting, and the organizational form used for the target casting practices. (shown in table 2) TCM team membership is also a measure of involvement, although it is only informative about the presence of the department in the team, and not about the degree of involvement.

3.2 Conclusion

This exploratory survey study suggests Dutch listed manufacturing companies make relatively high use of casting techniques similar to the concept of target casting, although these systems come by in a diversity of names. These techniques are adopted across industries, of which the assembling industries are the major users. The findings suggest that these techniques are relatively more often adopted under circumstances of intense competition and high environmental uncertainty, for which conditions, according to the literature; the use of target casting is beneficial. The results suggest that the main objective for adopting these techniques was to reduce costs. This goal seems to have been achieved by respondents, as the major benefit derived from the target casting practices was cost reduction. The departments Product Development and Product Design are most heavily involved in the application of target casting, while the Accounting department seems to be least involved. The firm's target casting efforts are mainly organized in team structures, in which knowledge and capabilities of different organizational functions are combined to work on the target cost.

Wijewardena and De Zoysa (1999), for instance, provide an overview of some specific characteristics of Japanese companies under which the management accounting systems operate, consisting of collective decision making, unique company philosophies, subcontracting strategies and the firm-specific education and training of management accountants. It wil1 be clear that in this exploratory analysis it wil1 be difficult to touch upon these issues. Qualitative research may be a preferred research methodology to extend the analysis to these issues.

From this research we can conclude that Dutch listed manufacturing firms use casting techniques that are similar to the concept of target casting; the casting method identifies a target cost by subtracting a required profit margin from an expected selling price. However, this study provides little insight into the actual organizational processes and actions that proceed, and are initiated by these target costs. In addition, the role and importance of the target casting system in relation to the use of other management accounting systems wil1 be worthwhile studying, as the recent survey research by Chenhall and Langfield-Smith (1998) and by Guilding et al. (2000) has shown only modest appreciation for target casting systems by Western firms.

As banking products become increasingly complex, as shared services become more widespread, and as indirect costs consume more budgets, the ABC model can serve as an excellent analytical tool for the financial services sector.

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