Best practices in target costing

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

To encourage process improvements among its suppliers, DaimlerChrysler rates the performance of each supplier on a yearly basis. A major component of the rating system is the "SCORE" (Supplier COst Reduction Effort) program. Each supplier is asked to achieve the equivalent of a 5% annual cost reduction based on its total annual sales to DaimlerChrysler. This cost reduction goal includes any supplier suggestions that result in lower costs for DaimlerChrysler. For example, one supplier suggested changing a vehicle's front rail system from several pieces to one unit. While the new design did not reduce the supplier's cost, it did improve the unit's quality and reduce DaimlerChrysler's assembly costs. Under DaimlerChrysler's SCORE system, the supplier received credit for this innovation.

Continental Teves has developed a cost-modeling tool to determine target costs for the components it outsources. The cost targets are based on material costs, cycle times, labor rates, overhead, and other characteristics. The model is sophisticated, and it adjusts wage and occupancy rates to correspond with the appropriate rates for the region of the country in which the supplier operates. Furthermore, the model's overhead allocation rates differ based on the type of supplier. Full-service suppliers, responsible for product research and design, are allowed higher overhead allocation rates than suppliers that simply "build to print." If a supplier is unable to meet its target costs, Continental might ask to send a team there to view its operations. Continental will then analyze the supplier's manufacturing processes, tolerances, and material content and generally verify the assumptions in its cost-modeling tool. After negotiations, however, if Continental still believes the supplier's costs are too high, it might consider bids from other suppliers.

TARGET COSTING STEPS AT CATERPILLAR

Once companies have the tools and systems in place to support target costing, they often develop a standardized approach for achieving their target costing objectives. Caterpillar offers a good illustration to highlight the target costing process for one of its new products. For this particular vehicle, management set the target cost at 94.6% of a comparable model, creating an initial gap of 5.4%. The cost of the comparable model is based on current manufacturing capabilities. Therefore, to achieve the target, costs must be reduced by 5.4%.

Current costs for a comparable model     100.0%
Target cost for new product               94.6%
Cost gap                                   5.4%

A cost improvement team is then assembled from product design, manufacturing engineering, production, marketing, and purchasing to determine how to close the gap. Initially, the group evaluates component part substitutions that would reduce costs but still provide the product features and benefits necessary to satisfy customer requirements. The group also considers opportunities to reduce costs through efficiency improvements. Table 1 shows that the cost improvement team identified 4.6% in "known" savings through an initial evaluation of cost savings opportunities.