Instruments for Operational Enterprise Management

Target Costing

The traditional product development path consists – in very simplified form – of the following stages:

1. Design

2. Calculation of costs

3. Determination of price as a function of costs

Unlike this forward-thinking approach, target costing employs “backward thinking.” The starting point is the decision to position a product in a given market segment, for instance a coupe version of a sedan. The market prices of the competition’s similar (neighboring) products are known, so management has a basis for determining the price segment in which the new product will be positioned.

In the second step, the company determines what customers want regarding the attributes of the product, particularly its features. Depending on the industry, this could encompass not only the attributes of the product in the most narrow sense,but also such things as the expectations placed on customer service or financing terms (financial engineering). Collecting this data demands professional field research, since imprecise and amateurish questions give potential customers too much leeway for expressing impossible wishes: “The car should combine the performance of a Ferrari, the interior space of a large Mercedes, the passive safety potential of a tank, the noise level of a sewing machine, and the fuel consumption of a lawn mower.” It is also extremely important to estimate the customers’ willingness to pay for above-average performance and quality features, as well as for additional equipment. Conjoint analysis is a method that determines the level of consumers’ willingness to pay for certain product attributes.

All of this information contributes to the decision regarding the target price, which usually involves intense participation of corporate management or area management. Now you subtract the desired profit from the target price. The amount of desired profit is also dependent on the strategic ideas of the company, as reflected in value-based management (see section 2.2). The result is the target value for the costs.

The responsibility then shifts to the functional area for product and process development. This is where the particular transformation problem of target costing arises. Revenue normally depends on the functionality of the product. Costs, on the other hand, are determined by the parts needed to build the product. Therefore, it is important to specify what part of the manufacturing costs can be assigned to the design engineers in the different assembly groups (bodywork, chassis, drive chain, and so on) as a kind of budget. Within these areas, it is possible to break down the budgets even further, having a separate cost budget for seats and one for upholstery, for instance. The design engineers now have to try to keep their designs within the cost budget.

Complications arise through technical interactions, but an elegant target cost system takes these into account, similarly to a product configurator. For example, when the total power requirements of optional equipment exceeds a threshold value for the electrical system, the next-largest generator or the next-largest wiring harness is selected. The reverse effect occurs if the level of optional equipment is reduced.

The procedure described up to this point is referred to as the top-down approach. If the product is a variant or successor of a known product, then a bottom-up approach can be applied: the construction elements of the existing product are changed one after the other. For example, you replace old materials with new ones or mechanical elements with electronic ones, and calculate whether these variations meet certain cost limits. Generally, these phases have to be repeated more than once.

One of the challenges for the method is to output not only average prices and average costs, but also changes over time. For example, in the automobile industry, development and warranty costs usually fall in an early phase of the product lifecycle (see section 3.3.5); revenues from repairs and sales of replacement parts, however, are usually earned in later phases. The present value of the decision is affected accordingly, similar to a dynamic investment analysis.

Another interpretation of target costing is to set allowable costs as a new, lower maximum limit. The current actual costs are compared to this limit. If the actual costs are above a level based on the market price, the firm has to take cost reduction measures. In making these decisions, the customer benefit related to individual parts of the product, as determined by market research institutes, serves as a criterion for distributing the cost reduction burden.

An even less methodically influenced development in target cost calculation correlates the expected additional benefits of modern features with the increased costs. You then try to find the optimal point in this correlation. In doing so, it has to be considered that the benefit curve for the customer declines slightly if a product is weighed down with extras. For example, the operating instructions become too long and complicated which makes it difficult to learn all the functions, or the optica signals (such as from the onboard electronics of an automobile) are more than the customer can handle. However, the costs function increases progressively due to the more expensive chips required by the electronics, for instance.