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Jan 1994

Use target costing to improve your bottom-line. (CPA in Industry)

by Lee, John Yee

    Abstract- Target costing is a cost management concept that has been used very effectively by leading Japanese manufacturers. It is based on a long-term, market-driven perspective rather than on the short-term, profit-driven outlook of most US manufacturing companies. With its emphasis on market position and product leadership, target costing enables companies to attain low costs to ensure low prices that help maintain market share. It is similar to the emerging concept of activity-based costing in that it relates profit to return on sales as opposed to return on investment, thereby allowing the company greater flexibility in production management and in production development. It is also a very effective foundation for building long-term quality improvement initiatives.

Changing Product Life and Requirement

Product life cycles are getting shorter and shorter, quite often one or two years, sometimes to less than one year in high-tech industries. Consumers are demanding new and diversified products in short intervals. Due to factory automation, robots and computer-controlled manufacturing systems are replacing the conventional production lines. What all these changes mean is the traditional standard costing systems, which emphasize cost control in the manufacturing phase of the product life cycle, are no longer effective. With a one-year product life, controlling costs in the manufacturing phase simply doesn't accomplish much. Once the product is developed and designed, there is a limit to how much cost cutting companies can do in the manufacturing stage. U.S. manufacturers have learned cost management should start up front at the initial stage to be effective and measure up to their foreign counterparts.

A new cost management concept has been developed and practiced by worldclass Japanese manufacturers to deal with the needs in the product development and design phase. A case example illustrates the technique.

Control Costs Early

Target costing, although its concept is used throughout the product life cycle, is primarily used and most effective in the product development and design stage. Born out of the market-driven philosophy, target costing is based on the pricedown, cost-down strategy, which has allowed companies like Sony and Toyota to win a considerable share of their respective markets.

In U.S. companies, costs of designing, producing, marketing, and delivering products dictate the mode of competition. Accountants usually measure, based on allocation routines, the total cost of each product. Most popular cost accounting methodologies, including the emerging activity-based costing, focus on product profitability. No matter how effective the cost accounting methodology may be, managers and accountants must heed the shareholders' needs for satisfactory short- term profits, measured by ROI or ROE.

This focus on meeting the shareholders' short-term needs has been well documented, and easily understood if we look at the Big Three automakers' practice of raising prices whenever there is a restriction placed on Japanese imports. The practice is effective in achieving the desired ROI or ROE, but it hurts the carmakers' ability to increase market share in sales volume. An increased market share would give them a buffer in the future if they choose to sacrifice sales volume to increase revenue and longterm profit.

In companies where target costing is used, there seems to be a different culture and attitude. They place more emphasis on their relative position in the market and product leadership. Since more than 80% of product cost is already determined by the time product design and processing is complete, cost management must start (and done substantially) at the design stage.

Connect with Profit Planning

Target costing is very closely linked with the company's long-term profit and product planning process. This link allows the company to focus on profit and product in an integrated strategy, which does not discriminate against high-quality, high-price, high-margin products that require high costs.

This is in direct contrast to a typical U.S. manufacturer's practice, in which the question persists, "How much does the product cost?" This question follows a new product design into the cost accounting department, which estimates the new product costs based on the prices of purchased materials and parts, labor costs, and other manufacturing overhead costs under the current production standards. The marketing department then addresses the issue of whether they can sell the new product. This departmentalized policy formulation of a typical U.S. company, which focuses on cost, tends to discriminate against developing a new high-quality, high-price product. Target costing derives its bases from the company-wide profit plan. The target profit for each period is determined for each of the new and existing product portfolios. The profitability of each group of related products is the focus, rather than the profitability of individual products. The desired profit margins are traded between products in the same group, depending on what stage the product is in its life cycle and what leadership role the product can play in acquiring a new segment of the market.

Setting the Target Costs

The main theme in the entire target costing practice is, "What should the new product cost?" It is not, "What does it cost?" Wben the target sales price is established based on market research, the desired profit is subtracted to yield the allowable cost. This allowable cost is top management's dream. This is a target which is very hard to attain, usually impossible in the short run.

The desired profit is determined based on the company's desired return on sales (ROS), rather than ROI. There are two primary reasons for using ROS. The first is technical, the second is strategic:

* The Technical Reason. In the fastchanging market of today, manufacturers need a variety of products in low volumes to survive. Calculating the profitability of each of those products in ROI is well- nigh impossible.

* The Strategic Reason. In the implementation of long-term strategies, manufacturers need to focus on the profitability of portfolios of related products and the role each product plays for the product group. For this, ROS provides a better measure. The allowable cost is compared to the estimated cost, which is based on the current standards of materials, labor, and overhead. In the meantime, intensive studies of competitors' parts are done. After motivational considerations have been made, the gap between allowable cost and estimated cost is reviewed on various dimensions. The target cost is then established as an attainable target which will motivate all personnel to achieve. Now, the struggle begins.

Achieving The Target Costs

At this point, cost management people help engineering planners and designers decompose the target cost into each cost element according to their relations to detailed production functions. Production engineers determine standards for material and part usage, labor consumption, etc., which become the basic cost data for financial accounting purposes. These standards are also used as a database for material requirements planning (MRP).

The struggle to achieve the target costs takes place in and outside the company. As soon as the above-mentioned standards are established, purchasing people negotiate with outside suppliers as to the prices of purchased materials and parts. Negotiations also take place among design, engineering, marketing, and other departments in the company, and compromises are made in their efforts to get within the target cost range.

The fundamental mechanism Japanese manufacturers use to achieve target cost, nevertheless, is value engineering (VE).

Value Engineering

The idea behind VE is very similar to activity analysis which was first developed and used by General Electric. GE's activity analysis was not, however, and was not intended to be, linked to corporate profit planning, target profit, and target costs as they are practiced In Japan.

VE is a mechanism Japanese manufacturers use to enhance the value of products and services, which is measured by the relationship between the functions performed by products and services and the costs incurred. The functions are defined by different companies in different ways. Some are geared toward process improvement while others are focused on satisfying the needs of customers.

The process of VE consists of describing the functions of each product, part, and service, and quantifying the components of those functions. For example, a printed circuit board (PCB) manufacturer's VE activities for the drilling operation include panel size, number of images per panel, lot size and frequency, number of holes, hole size, stack height, laminate thickness, post plate drill, and fine line class. In the design phase, management science techniques are employed on the many aspects of the drilling operation to improve upon the current method.

Post-Audit of Target Costing Performance

The short life cycles of manufactured goods in today's market require manufacturers to recover investment in a short time. A short payback period is usually assumed in planning and evaluating target costs. Post- audit of target costing performance is done on a regular basis to examine the degree to which targets have been achieved. If targets have not been achieved, investigations follow.

A Case Example

The following short case example is used to illustrate the process of determining target costs using production and cost figures.

PCBM, a Silicon Valley PCB manufacturer, is offered $48 per unit for 10,000 units of a multi-layer panel product by an electronic product manufacturer. SInce PCBM's usual return on sales (ROS) rate is 25 percent, the desired return on this offer is $120,000, calculated as follows:

Amount of the offer: $48 x 10,000 units = $480,000. Desired return: 25% x $48 = $12 per unit. $12 x 10,000 = $120,000 for the offer. The allowable cost for this production of 10,000 units is $36 per unit, or $360,000 for the offer, since sales price, $48, - desired return, $12, = $36 per unit. $36 x 10,000 units = $360,000 for the offer.

The estimated cost is calculated by the cost management team as $40 per unit, or $400,000 for the offer. The cost was estimated based on four layers requested, board length, board-width, two solder mask sides requested, five images per panel, one component legend side, estimated yield rate of 86%, panel size, material cost per panel of $19, and no tab plate edge. The impact of accepting the offer on the production plan and the cost of total production for the period was also considered.

The gap between the allowable cost ($360,000) and the estimated cost ($400,000) for the offer is $40,000, which is adopted as the target cost reduction. The "struggle" to eliminate the gap of $40,000 started with VE activities. After long hours of careful evaluation by production supervisors, process and product engineers, and cost management people, it was decided that VE activities should be focused on reducing the defect rate and material handling and purchasing.

A series of studies and analyses of material scraps and other types of defects were performed. Suggestions of possible improvement in performance by 30%, which was estimated to reduce unit cost by $2, were made, most of which looked too ambitious at first. But, since the new target costing-induced management plan had been accepted by all supervisors and managers of the plant, the suggestions were aggressively implemented by the processes and areas involved.

Improvements on material handling were centered around reducing material moving distances between the point of receiving the deliveries and the point of usage. Various moves were analyzed to reduce the distances. At the same time, the purchasing group of PCBM entered a long negotiation process with the suppliers, in order to persuade them to lower their prices. The result of these improvement activities was the reduction of another $1 per unit cost.

The combined reduction in cost per unit of $3, a total of $30,000, brought the cost to $370,000.

Although this was still higher than the allowable cost of $360,000 by $10,000, top management thought the efforts of those who were involved in reducing costs were substantial.

Furthor Action

After the successful execution of the target costing project, management asked the marketing team to review the $48 selling price. Since the customer was satisfied with the quality of the product, they were responsive to the request by PCBM for a review of the $48 price.

The customer's representative tried to justify the fair level of the current price by pointing out that no tab plate edge was required, which would reduce manufacturing costs.

Since PCBM had already designed and implemented an activity-based costing (ABC) system, it was rather easy to demonstrate the cost impact of each component. PCBM's ABC system, which had five process centers indicated the following costs of options:

The cost of solder mask option: $1.80

The cost of component legend option: $0.75

Since the customer's PCB didn't require tab plating, the ABC system already reflected that. No cost was charged to their order for the tab plating option. This helped PCBM earn credibility from the customer regarding the price quotes. The customer finally agreed to consider a price increase in the near future.

The Real Weapon

The real power of target costing is that it allows companies to successfully motivate employees and enforce cost management action plans. It is a disciplined approach to managing costs and improving processes and products. Target costing, as briefly illustrated here, is also very compatible with the emerging ABC, which can provide necessary cost information for implementing target costing. And target costing can be as effective in U.S. industry, as it has been in Japan.

John Y. Lee, PhD, is the Robert M. Schaeberle Professor of Accounting at Pace University. He is a frequent contributor to professional journals and the author of several books. He is currently working on a research project that examines practices of world-class Japanese manufacturers.

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