Best practices in target costing

Management Accounting Quarterly, Wntr, 2003 by Dan Swenson, Shahid Ansari, Jan Bell, Il-Woon Kim

HERE IS HOW FOUR "MODEL" COMPANIES--THE BOEING COMPANY, CATERPILLAR, DAIMLERCHRYSLER, AND CONTINENTAL TEVES--APPLY THIS COSTING TECHNIQUE.

The Consortium for Advanced Manufacturing--International (CAM-I), the American Institute of CPAs, and the University of Akron recently sponsored a major study to benchmark best practices in target costing. This study examined the ways in which target costing has been applied in a variety of industries, the level of success and measurable improvements achieved, and the factors that influenced the success of these applications.

The study began with a survey to collect information about target costing practices throughout the United States. After analyzing the survey results, conducting telephone interviews, and reviewing secondary research, the research team selected four companies as having best practices in target costing. The team then conducted site visits at each of the "best practice" companies, namely The Boeing Company, Caterpillar, DaimlerChrysler, and Continental Teves (a supplier of automotive brake systems). The results of the study are discussed here.

TARGET-COSTING PRINCIPLES

Target costing can best be described as a systematic process of cost management and profit planning. The six key principles of target costing are: (1)

1. Price-led costing. Market prices are used to determine allowable--or target--costs. Target costs are calculated using a formula similar to the following: market price - required profit margin = target cost.

2. Focus on customers. Customer requirements for quality, cost, and time are simultaneously incorporated in product and process decisions and guide cost analysis. The value (to the customer) of any features and functionality built into the product must be greater than the cost of providing those features and functionality.

3. Focus on design. Cost control is emphasized at the product and process design stage. Therefore, engineering changes must occur before production begins, resulting in lower costs and reduced "time-to-market" for new products.

4. Cross-functional involvement. Cross-functional product and process teams are responsible for the entire product from initial concept through final production.

5. Value-chain involvement. All members of the value chain--e.g., suppliers, distributors, service providers, and customers--are included in the target costing process.

6. A life-cycle orientation. Total life-cycle costs are minimized for both the producer and the customer. Life-cycle costs include purchase price, operating costs, maintenance, and distribution costs.

THE TARGET COSTING PROCESS

Essentially, companies use target costing to establish concrete and highly visible cost targets for their new products. To maximize cost control and enhance profit improvement, most companies set relatively aggressive targets. The process begins when top management establishes a target cost for a new product, for example, a Chrysler Neon or a Caterpillar Excavator. A cost estimating group will then decompose the target cost for the product as a whole into cost targets for subassemblies and individual component parts--engine, transmission, seats, and so on.

Frequently a "gap" exists between the target cost and cost projections for the new product based on current designs and manufacturing capabilities. Closing the gap through cost reduction is central to the target costing process. This is accomplished through cross-functional target costing teams, which analyze the product's design, raw material requirements, and manufacturing processes to search for cost savings opportunities. The cross-functional teams employ a variety of management tools and initiatives to help them achieve their objectives. The following section describes some of these tools and initiatives and other characteristics of successful target costing companies.

TARGET COSTING ENABLERS

The best practice companies demonstrated certain commonalities in their operations and the way in which they supported the target costing process. They all had very effective organizational structures, responded to the "voice of the customer," streamlined their product development process, and actively engaged their supply chain to achieve target costing objectives. To better understand these practices, we visited the four companies that had achieved the most success in each area. Our objective was to document "best practices" in deploying these key elements of target costing.

At each best practice company, target costing is supported by a matrix organizational structure where a vertical, functional organization combines with horizontal, cross-functional teams. For example, U.S. Operations for DaimlerChrysler has five platform teams that cover large cars, small cars, mini-vans, trucks, and jeeps. Each team is cross-functional and includes members from design engineering, manufacturing engineering, purchasing, production, and finance. The target costing system determines cost objectives and performance goals for each platform team, and meeting these goals is an important component of team members' annual performance reviews.