10.8 Tool: Target Costing

Advanced costing also enables you to pursue target costing. You use target costing to reduce the cost of a product over its entire lifecycle. Imagine, for example, that your company has just developed a cool new product. However, when finance runs the numbers, you discover that the product concept will not provide a positive net present value (NPV). When this happens, you only have two options: 1) kill the concept or 2) change the cost equation so that the product is profitable. Target costing may give you your best chance of making Option #2 viable.

Let's look at the example that put target costing on leading companies' must-have tool list. When the finance guys at Honda calculated the profitability of its newly redesigned 1998 model Accord, to everyone's shock, the results showed that Honda would lose money on every Accord sold. Two findings riveted decision makers' attention:

  1. The new design really was what Honda needed to bring to market in order to compete.

  2. Rivals offered competing vehicles for 25% less than Honda's new design.

After carefully considering these two facts, the Honda team initiated a rigorous target-costing initiative. Figure 10.9 shows the six-step target costing process. Let's comment on each step.

Figure 10-9: The Target Costing Process

Step 1: Evaluate Product Characteristics

Product characteristics define the product; that is, both what it should do for the customer and how it will do it.

Step 2: Set Target Sales Price

The sales price is determined by "what the market will bear." To figure out what this price is, you need to evaluate three questions.

  1. What do competitors' offerings look like? If rivals offer highly desirable products, your price point will be lower.

  2. What do customers expect? Let's make a key point here: The Internet has increased pricing pressure. For example, customers can visit Best Buy, check out the products they are interested in, and then go home and look for a lower-priced equivalent on line. This practice is called . Similarly, you can download a manufacturer's invoice price from Edmunds.com before going to an auto dealership to negotiate the price of the new car you want to buy.

  3. How distinctive is your product? Few companies offer a distinct-enough product to be able to set their own price. Even Apple had to bring out a low-cost iPhone to stay competitive!

Step 3: Calculate Your Target Cost

Your target cost is simply the target sales price minus the target profit (i.e., how much you need to make from each product sold).

Step 4: Develop a Cost Breakdown

The cost breakdown is where target-costing's rigor comes into play. At this point in the analysis, you need to identify all of the components that make up your product. For a product as simple as a watch, you would want to consider the band, the case, the dial assembly, the timing mechanisms, the battery, et cetera. Imagine how long Honda's component list was.

Step 5: Execute the Target Costing Process

The target costing process takes place at the component level. Each component team goes back to the proverbial "drawing board" and asks a series of questions:

  • If we changed the design, could we reduce the costs?

  • If we changed the materials, could we reduce the costs?

  • If we changed specifications, could we reduce the costs?

  • If we work with suppliers to help them build better skills, could we reduce the costs?

  • What other cost trade-offs could we evaluate to take costs out of the product/process?

Step 6: Make the Decision—i.e., Roll Out or Redesign

If the target costing process is successful, you can proceed to launch. If not, you may need to kill—or radically redesign—the product.

You've probably already deduced the outcome of Honda's target-costing initiative for the 1998 Accord. Working closely with suppliers, the product team actually reduced the cost of the new design by 30%. The launch was successful and target costing became a standard tool in Honda's NPD process.

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