DOKUZ EYLL UNIVERSITY

GRADUATE SCHOOL OF NATURAL AND APPLIED

SCIENCES

TARGET COSTING
AND NEW PRODUCT DESIGN
IN A
MANUFACTURING COMPANY

by
Gnta KOCATRK

February, 2006
ZMR
 TARGET COSTING
AND NEW PRODUCT DESIGN
IN A
MANUFACTURING COMPANY

A Thesis Submitted to the

Graduate School of Natural and Applied Sciences of Dokuz Eyll University
In Partial Fulfillment of the Requirements for the Degree of Master of Science
in Industrial Engineering, Industrial Engineering Program

by
Gnta KOCATRK

February, 2006
ZMR
 M.Sc THESIS EXAMINATION RESULT FORM

We have read the thesis entitled THESIS TITLE completed by STUDENT

NAME under supervision of TITLE AND NAME OF THE SUPERVISOR and
we certify that in our opinion it is fully adequate, in scope and in quality, as a thesis
for the degree of Master of Science.

Prof. Dr. Edip TEKER

Supervisor

(Jury Member) (Jury Member)

Prof.Dr. Cahit HELVACI

Director
Graduate School of Natural and Applied Sciences

ii
 ACKNOWLEDGEMENTS

This thesis is by far the most significant accomplishment in my self-life and in my

business-life. It would be impossible without people who supported me.

Most of all I would like to thank my research advisor, Prof. Dr. Edip TEKER for
his valuable advice, encouragement and guidance of this thesis. His trust inspired me
in the most important moments of making right decisions and I am glad to work with
him. I would also like to express my special thanks again to him for giving me the
opportunity to share her experience and insights during this process that inspired
creativity and motivation.

I am grateful to all of the personnel of the manufacturing company DEKORPAN

who helped me to gather the data of the study.

I also want to express my special gratitude to Cengiz and Reyhan Baltac for their
encouragement. Without their help, I would not have finished the degree.

Special thanks to Gamze ztuzcu and Sezgi zen for their continuous support
and friendship.

Special thanks to Gl Ylmaz and Mehmet Kl for their professional supports.

Finally, I wish to express thanks to all my family. Therefore, I dedicate this thesis
to my family; Metin, Emine, Berna and Belma Kocatrk, who have provided me
constant support, endless love, patience and encouragement throughout my whole
life. I am particularly grateful to them.

Gnta KOCATRK

iii
 TARGET COSTING
AND NEW PRODUCT DESIGN
IN A
MANUFACTURING COMPANY

ABSTRACT

Increased competition and increased costs of designing made it important for the
firms to identify the right products and the right methods for manufacturing the
products. Firms should focus on customers and identify customer demands directly
to design the right products. Several management methods and techniques that are
currently available improve one or more functions or processes in an industry and do
not take the complete product life cycle into consideration.

On the other hand target costing is a method / philosophy that takes financial,
manufacturing and customer aspects into consideration during designing phase and
helps firms in making product design decisions to increase the profit / value of the
company. It uses various techniques to identify customer demands, to decrease costs
of manufacturing and finally to achieve strategic goals. Target Costing forms an
integral part of total product design / redesign based on strategic plans. The current
report details the process of target costing along with some associated techniques and
applies the process to the designing of the DEKORPAN Towel Radiators.

Keywords: Target Costing, Target Cost Management, Cost Management,

Activity Based Costing, New product design.

iv
 BR MALAT LETMESNDE
HEDEF MALYETLENDRME
VE
YEN RN TASARIMI

Ykselen rekabet ortam ve artan tasarm maliyetleri, rnn retilmesi iin doru
malzemelerin ve doru metodlarn kullanlmasn nemli hala getirdi. Firmalarn
mterilere odaklanmalar ve doru rn iin mteri taleplerini direct olarak rn
dizaynna yanstlmas nem kazmaktadr. ou ynetim metodlar ve teknikleri bir
endstrideki birka fonksiyon ya da sreci gelitirmeye yneliktir ve bunlar tm bir
rn oluum srecini gz nne almazlar.

Dier bir taraftan da; hedef maliyetlendirme; rnn tasarm aamasna, finansal,
imalat ve mteri taleplerini yanstan bir method/felsefedir ve firmalara, firma
kar/deer oranlarnn artmas iin rn tasarm gelitirmesinde yardmcdr. Hedef
Maliyetlendirme; mteri taleplerini tehis etmek, maliyetleri azaltmak ve sonu
olarak da stratejik hedefleri oluturmak iin birok teknik kullanr. Hedef
Maliyetlendirme tasarmlarn nemli bir paras olarak, stratejik planlara ait, tm
rn tasarmlarn ve/veya revize tasarmlarn ekillendirir. Bu tez; hedef
maliyetlendirmenin aamalarn, birok birletirilmi teknikle birlikte incelemi ve
DEKORPAN Havlu Radyatrleri Ltd ti de yeni bir tasarm zerinde
uygulanmtr.

Anahtar Szckler: Hedef Maliyetlendirme, Hedef maliyet Ynetimi, Maliyet

Ynetimi, Sre Tabanl Maliyetlendirme, Yeni rn Tasarm.

v
 ABBREVIATIONS

Activity Based Budgeting..ABB

Activity Based Costing..ABC
Activity Based Management ....ABM
Analytic Hierarchy Process....AHP
Balanced Scorecards ....BC
Component cost analysis ...CCA
Computer Aided Design .. CAD
Computer Aided Manufacturing . CAM
Computer Integrated Manufacturing CIM
Cost Management .. CM
Cost of Quality ..COQ
Customer voice analysis ...CVA
Design for Manufacture and Assembly .... DFMA
European Economic Commitee .EEC
Equipment Manufacturers Institute .. EMI
Functional Cost Analysis ..FCA
Functional Costing .. FC
Kaizen Costing ....KC
Life Cycle Budgeting LCB
Quality Function Deployment ...QFD
Process Costing ...PC
Relationship Matrix ...RM
Return on Investment ROI
Return on Sales .ROS
Standard Costing .SC
Strategic Investment Decisions ..SID
Strategic Management Accounting .SMA
Target Costing TC
Target Pricing ...YP
Target Cost Management TCM

vi
Theory Of Constraints ...TOC
Throughput Accounting ..TA
Total Quality Manegement ...TQM
Value Engineering ...VE
Variable Costing ..VC
Variance Analysis ....VA
Work In Process .WIP

vii
CONTENTS

Page

THESIS EXAMINATION RESULT FORM.............................................................. ii

ACKNOWLEDGEMENTS ........................................................................................iii
ABSTRACT................................................................................................................ iv
Z ................................................................................................................................ v
ABBREVIATIONS .................................................................................................... vi

CHAPTER ONE - INTRODUCTION ..................................................................... 1

1.1 Objectives........................................................................................................... 1
1.2 Thesis Outline .................................................................................................... 2

CHAPTER TWO COST MANAGEMENT ......................................................... 3

2.1 Cost management ............................................................................................... 3
2.2 Cost Management Tools .................................................................................... 4
2.2.1 Costing systems that follow the flow of costs............................................. 4
2.2.2 Overhead cost allocation methods .............................................................. 5
2.2.3 Budgeting .................................................................................................... 5
2.2.4 Target Costing / Target Pricing................................................................... 6
2.2.5 Value Engineering....................................................................................... 7
2.2.6 Standard Costing and Variance Analysis.................................................... 7
2.3 Modern Cost Management Techniques ............................................................. 8
2.3.1 Activity Based Costing (ABC) And Activity Based Management (ABM) 8
2.3.2 Cost of Quality Calculations in Support Of TQM .................................... 15
2.3.3 Target Costing........................................................................................... 17
2.3.4 Kaizen Costing .......................................................................................... 20
2.3.5 The Theory Of Constraints (TOC)............................................................ 21
2.3.6 Throughput Accounting ............................................................................ 23
2.3.7 Integrated Strategic Management Accounting.......................................... 24
2.3.8 Balanced Scorecards ................................................................................. 27

viii
CHAPTER THREE TARGET COSTING......................................................... 29
3.1 Introduction To Target Costing........................................................................ 29
3.2 Core Concept of Target Costing ...................................................................... 30
3.2.1 Definition .................................................................................................. 30
3.2.2 Process ...................................................................................................... 30
3.3 Literature Review............................................................................................. 34
3.4 Facts / Advantages of Target Costing .............................................................. 37

CHAPTER FOUR TC IN NEW PRODUCT DEVELEOPMENT .................. 39

4.1 Establishing Target Costing ............................................................................. 39
4.2 Product Design Stages ..................................................................................... 41
4.2.1 Product Strategy and Profit Planning........................................................ 44
4.2.2 Product Concept and Feasibility ............................................................... 45
4.2.3 Product Design and Development............................................................. 48
4.2.4 Production and Logistics........................................................................... 50

CHAPTER FIVE TARGET COSTING PROCESS.......................................... 51

5.1 Target Costing Process Steps ........................................................................... 51
5.1.1 Product Planing Phase............................................................................... 52
5.1.1.1 Establishing the Target Market Price................................................. 52
5.1.1.1.1 Quality Function Deployment..................................................... 53
5.1.1.1.2 Analytic Hierarchy Process......................................................... 58
5.1.1.1.3 Customer Voice Analysis ........................................................... 61
5.1.1.1.4 Relationship Matrix..................................................................... 63
5.1.1.2 Establishing the Target Profit Margin and Cost to Achieve .............. 66
5.1.1.2.1 Multi-Year Product/Profit Plan. .................................................. 68
5.1.1.3 Calculating the Probable Cost of Current and New Products and
Processes ........................................................................................................ 69
5.1.1.3.1 Process (Operational) Costing. ................................................... 70
5.1.1.3.2 Component Cost Analysis........................................................... 71
5.1.1.3.3 Cost Tables.................................................................................. 74
5.1.1.4 Establishing the Target Cost .............................................................. 77

ix
 5.1.1.4.1 Benchmarking. ............................................................................ 77
5.1.2 Product Design and Development Phase .................................................. 79
5.1.2.1 Attaining the Target Cost ................................................................... 79
5.1.2.1.1 Computing the Cost Gap............................................................. 79
5.1.2.1.2 Designing Costs Out of the Product............................................ 81
5.1.2.1.3 Releasing Design to Manufacturing and Undertaking Contin.
Improv. ....................................................................................................... 81
5.1.3 Pursuing Cost Reductions Once Production Has Started.......................... 86
5.1.3.1 ABC and ABM................................................................................... 87
5.2 The Factors Influencing TC Process ................................................................ 89
5.2.1 Factors Influencing Market-driven Costing .............................................. 89
5.2.1.1 Intensity of Competition ................................................................... 90
5.2.1.2 Nature of the Customer ...................................................................... 93
5.2.1.2.1 Degree of Customer Sophistication. .......................................... 94
5.2.1.2.2 The Rate at which Customer Requirements Change................... 95
5.2.1.2.3 The Degree to which Customers Understand their Future Product
Requirements.............................................................................................. 96
5.2.2 Factors Influencing Product-Level Target Costing.................................. 97
5.2.2.1 Product Strategy ................................................................................ 98
5.2.2.1.1 Number of Products in the Line. ................................................ 98
5.2.2.1.2 Frequency of Redesign............................................................... 99
5.2.2.1.3 Degree of Innovation................................................................. 100
5.2.2.2 Characteristics of the Product .......................................................... 101
5.2.2.2.1 Product Complexity. ................................................................ 102
5.2.2.2.2 Magnitude of Up-Front Investments......................................... 102
5.2.2.2.3 Duration of Product Development. .......................................... 103
5.2.3 Factors Influencing Component-Level Target Costing .......................... 104
5.2.3.1 Supplier-Base Strategy..................................................................... 104
5.2.3.1.1 Degree of Horizontal Integration. ............................................ 105
5.2.3.1.2 Power over Major Suppliers. .................................................... 106
5.2.3.1.3 Nature of Supplier Relations..................................................... 106

x
CHAPTER SIX CASE STUDY ......................................................................... 108
6.1 Objective of the Case Study........................................................................... 108
6.2 Introduction to DEKORPAN ......................................................................... 108
6.3 Problem Statement ......................................................................................... 110
6.4 Applying Target Costing in Product Design.................................................. 111
6.4.1 Product Strategy and Profit Planning...................................................... 111
6.4.2 Product Concept Development and Feasibility....................................... 111
6.4.3 Product Design and Development........................................................... 114
6.4.4 Recommendations for Cost reduction..................................................... 119
6.4.5 Production and Logistics......................................................................... 120
6.5 Case Study Results......................................................................................... 120

CHAPTER SEVEN - CONCLUSION ................................................................. 121

REFERENCES....................................................................................................... 123

APPENDIX A1 .................................................................................................... 126

xi
 CHAPTER ONE
INTRODUCTION

1.1 Objectives

Increased competition and vocal customers have made it imperative that every
company should upgrade its processes constantly to stay ahead of the competition.
This is achieved mainly through design and process designs and cost reductions. The
process of actual designing is product-dependent and it is more important to identify
the aspects of products that require designing than the process of designing. Target
costing is a strategic tool for planning that takes a holistic view of products and their
sub-assemblies and identifies the opportunities for cost reduction and product
improvement. Target costing also uses various techniques to set and achieve the
goals based on the strategic plans of a company.

The objective of the current report is to describe the process of target costing for
total product re-designing. This is achieved through the following steps.

The concept of target costing is explained along with the various tools that
are used. The managerial aspects that need to be considered are mentioned.
The concepts of designing and cost reduction are also considered in the
process.

The introduction of the DEKORPAN TOWEL FARMER is analyzed

retroactively with the help of target costing.

1
 2

1.2 Thesis Outline

This report shows the implementation of target costing and analyzes the
managerial aspects of target costing from the perspective of a manufacturing firm.
The cost management and cost management tools have been presented in Chapter 2.
Target costing concept and literature review is presented in Chapter 3. Chapter 4
deals with the role of target costing in product re-designing to be competitive, and
studies the aspects of implementation from the practitioners view. Chapter 4
illustrates the re-designing process stages. Also, target costing process steps and
factors influencing Target costing process are presented in Chapter 5. A case study
about implementing target costing and new product design in a manufacturing
company, DEKORPAN, presented in Chapter 6. And finally, a conclusion ,regarding
target costing and new product design based on the case study, is described in
Chapter 7.
 CHAPTER TWO
COST MANAGEMENT

2.1 Cost management

Cost management is currently one of the main topics of interest in the area of
project management. This is particularly true as high technology companies, which
until recently were mainly concerned with time-based competition, are being
increasingly subjected, especially under the highly competitive conditions that are
prevalent today, to cost-based competition. The need to improve project cost control
has been emphasized by Nixon (1998), Jorgensen and Stein (2000) and Kinsella
(2002), among others.

This chapter examines; project managers perceptions of the contribution of

various cost management tools to improvement of the organization's cost
management system.

Project cost management is concerned with ensuring that the project is completed
within the approved budget, and includes the processes of resource planning, cost
estimation, cost budgeting and cost control. The management accounting discipline
has developed various planning and control tools and concepts for these processes,
including: costing systems (such as Job Order Costing and Process Costing) to track
the flow of costs related to the project; overhead allocation methods, such as the
traditional method that allocates overhead costs to projects on the basis of hours or
months used, and Activity Based Costing (ABC) method that derives the cost of a
project as the sum of the costs of the activities undertaken to produce the project
while accounting for various levels of overhead; budgeting, as a central mean for
cost planning and cost control throughout the entire life cycle of projects; Target
Costing and Target Pricing aimed at ensuring the projects profitability; Value
Engineering which seeks to reduce non-value-added activities and hence non-value-
added costs, as well as Standard Costing and Variance Analysis as important
managerial control tools.

3
 4

Some of these cost management tools and techniques have been acknowledged in
the traditional industry sectors as highly successful in improving firms operating
results and performance (Horngren et al., 2003).

2.2 Cost Management Tools

Cost Management is the area in accounting that deals with methods of costing
products and services, and provides managers with information relevant to planning
and control of costs in the short run and in the long run (Horngren et al., 2003). Six
major cost management tools have been selected for inclusion in this study and will
be briefly introduced next.

2.2.1 Costing systems that follow the flow of costs.

There are two main costing systems that are being used by organizations - Job
Order Costing system and Process Costing system. In a Job Order Costing system the
cost object is a unit or multiple units of a distinct product or service called a job.
Costs are collected for each job separately, and the individual jobs are
identified as separate work units. The jobs have clear start and finish times, and
include units that are uniquely identifiable. In the context of projects, the Job Order
Costing system can be applied to activities or segments between milestones, to
specific work packages, or even to an entire project. Most organizations in the high-
technology sector use Job Order Costing systems due to the nature of their projects.
Conversely, in a Process Costing system the cost object consists of masses of
identical or similar units of a product or a service. In typical Process Costing
systems, conversion costs (labor and overhead costs) are accumulated uniformly
throughout the process, whereas material costs are added at discrete points of
completion in the process. Cooper and Kaplan 1999) claim that over the long run
projects with few milestones adopt the characteristics of Process Costing. Typically,
bothsystems are applied within Standard Costing, which establishes predetermined
standards for the cost of the inputs.
 5

2.2.2 Overhead cost allocation methods

Overhead allocation is required whenever the manufacturing of a product or the

delivery of a service involve costs that cannot be directly traced to these cost objects.
Traditional overhead allocation methods use a simplified approach, which amounts
to assignment of overhead to cost objects on the basis of a single allocation rate, say
on the basis of man/months that were used in a project. A relatively modern pproach,
called Activity Based Costing (ABC), has been attributed with success and with
providing insights to managers regarding their resource consumption. The basic
premise behind ABC is that overhead costs are incurred with relationship to more
than a single, volume-based, cost driver. The ABC method recognizes a hierarchy of
cost-drivers and overhead costs, and accumulates the costs at the product or service
level according to the amount of specific activities that were consumed by the
product or service. The original ABC hierarchy was developed in the manufacturing
environment, as described in Cooper and Kaplan (1999). Raz and Elnathan (1999)
adapt the ABC hierarchy and apply it to projects. They include cost drivers at the
work unit level, deliverable level, project-support level, and organizational-support
level. Kinsella (2002) offers an analysis of ABC, points out to its usefulness for
project cost management and concludes that its use may result in cost figures that in
many cases are significantly different from those obtained under traditional
accounting.

2.2.3 Budgeting

Horngren et al., (2003) define the budget as a quantitative expression of a

proposed plan of action by management for a specified period, and an aid to
coordinating what needs to be done to implement the plan. The budget describes in
financial terms the future activities of the organization during the period for which it
is prepared, and serves as a basis for comparison between plans and actual activities.
More specifically, in this context a distinction is made between a static budget, which
is based on the level of planned activities and a flexible budget, which takes into
 6

account the actual level of activity for the period, and is thus more useful. In
particular, in a dynamic environment, the flexible budget provides more informative
data and allows for a better Variance Analysis (see below). Frank (1998) notes that
many organizations use the flexible budget, which allows for budget changes when
economic conditions change. Jorgensen and Stein (2000) write about improvement in
project cost estimation when managerial flexibility is taken into account during the
planning of the budget.

Of particular interest for project managers is Life Cycle Budgeting, which span
the entire planned life cycle of the project and therefore extend beyond the short
term, operational budget. Life Cycle Budgeting is the process of estimating and
accumulating costs over a products entire life (Kaplan and Atkinson, 1998). It is
particularly important in environments in which there are larger planning and
development costs or large product abandonment costs. Kaplan and Atkinson (1998)
mention the three broad purposes of Life Cycle Budgeting: develop a sense of the
total costs associated with the product or project; identify the products
environmental cost consequences and spur action to reduce or eliminate these costs;
and identify the planning and decommissioning costs during the product and process
design phase in order to control and manage costs in this phase.

2.2.4 Target Costing / Target Pricing.

Target Costing is a cost management tool that planners use during product and
process design to drive improvement efforts aimed at reducing the products future
manufacturing costs (Kaplan and Atkinson, 1998). Target Costing is price-led and
customer oriented - it begins with price, quality, and functionality requirements as
defined by the customers. This is in contrast to cost-plus pricing methods, which are
cost-led (Horngren et al., 2003). Cooper and Kaplan (1999) write: in the Target
Costing approach, the cost of a new product is no longer an outcome from the
product design process; it becomes an input into the process. Ansari and Bell (1996)
argue that Target Costing is better suited to meet the needs of organizations in
todays competitive environment.
 7

2.2.5 Value Engineering.

Value Engineering is the systematic evaluation of all aspects of the value-chain

business functions, with the objective of reducing costs while satisfying customers
needs (Horngren et al., 2003). Laszlo (1997) writes that the purpose of Value
Engineering is to improve quality, and reduce inefficiency and waste for the end user
- the customer. Value Engineering seeks to reduce non-value-added activities and
hence non-valueadded costs, on the one hand, and enhance greater efficiency in
value-added activities in order to reduce value-added costs, on the other. Value-
added costs are those that, when removed, reduce the value or the perceived benefits
that customers obtain from a particular product or service (Horngren et al., 2003).
Epstein and Young (1999) claim that using such management tools improves the
capital investment decisions.

2.2.6 Standard Costing and Variance Analysis.

Standard Costing is a method that relies on pre-established rates (standards) of

consumption for inputs. It traces direct costs to the produced output by multiplying
the standard prices or rates of direct cost items, such as materials and labor, by the
standard quantities of those inputs that were allowed for actual outputs produced. As
for the indirect costs (overhead) - those are allocated on the basis of the standard
indirect rates and the standard quantities of the allocation bases allowed, for the
actual output produced (Horngren et al., 2003).

Variance Analysis is a longstanding and widely used managerial control tool.

Variance is the difference between a target level of revenues or costs and the realized
level of that item. The variance is a signal that the assumptions underlying the
financial plans were not realized (Kaplan and Atkinson, 1998). Managers use
Variance Analysis in their planning and control decisions. In the planning process
they focus on areas where the variances are large - and thus where actual results
deviate most significantly from plans. By doing so, they use limited managerial
 8

resources more efficiently, directing them to areas of operations where they are
needed most and where they are more likely to yield the higher return. Variances are
then used in performance evaluation, a central control procedure. Managers are
expected to meet their targets (standards) and when they do, as indicated by low
variances, their evaluation and rewards reflect it favorably (Horngren et al., 2003).
Frank (1998) notes that in the project planning process, the costs are estimated for
each of the tasks that make up the entire project. The estimated costs then become
the projects standard costs. After each task has been completed, the standard costs
are compared with the actual costs to arrive at the variances.

2.3 Modern Cost Management Techniques

After decades relative stability in cost accounting, the increasingly competitive

environment through the 1980s and 1990s has been the prime stimulus for a range of
new developments in cost identification, cost management and, possibly to a lesser
extent, in broader aspects of financial control concerned with responsibility
accounting. These developments were mainly initiated in companies related to the
motor industry and high-tech companies in industries like computing and electronics
where the competitive threat from Japan in particular was severe, although changes
in cost accounting practice were by no means observable only within such industries.

These developments have not, however, spread widely to the civil engineering
industry. This section examines, outline the current state of the art in cost accounting
and cost management theory and practice in manufacturing industry.

2.3.1 Activity Based Costing (ABC) And Activity Based Management (ABM)

There are two traditional forms of product costing: full Absorption costing and
Variable (sometimes called marginal) costing. Under absorption costing the cost of
products is estimated to include all direct and indirect manufacturing costs
irrespective of whether they are variable or fixed in relation to changes in the level of
 9

output produced. Direct product cost is defined as those costs which can be easily
traced direct to the product. Hence, the cost of the material content of a finished
product and the cost of labour working directly on the production line are,
traditionally, the prime elements of direct product cost. Indirect manufacturing costs
are all other costs incurred in the manufacturing process.

The manufacturing costs of products under absorption costing are used to specify
inventory amounts in the balance sheet and trading account where the valuation rule
is to show stocks at the lower of their manufacturing cost or market value. For
internal management purposes, businesses may also wish to attribute a share of non
manufacturing costs to individual products or product groups in order to compare the
full cost with selling price and thereby determine the profitability of each product or
product group.

Variable costing differs from full absorption costing in only one key respect. Only
variable costs (i.e. those assumed to change in strict proportion to changes in the
level of output) are considered to be the costs of products. This will include both
direct and indirect variable costs. For balance sheet and trading account purposes this
will mean that the cost of stocks is based on only variable manufacturing costs. But,
for management purposes, businesses may attribute both manufacturing and non
manufacturing variable costs to products in order to estimate each products (or
product groups) contribution towards profits and fixed period costs. (The
contribution for a product is simply its selling price minus the variable cost per unit).
Under variable costing, fixed costs are simply treated as a cost of doing business in
the period and not a product cost.

It is important to recognise that under both absorption costing and variable

costing, product cost will be the sum of direct costs plus a share of indirect costs.
Under absorption costing both fixed and variable indirect costs are assigned to
products; under variable costing only variable indirect costs are assigned to products.
It is important to stress this because debates about cost accounting are often
 10

conducted as though the overhead cost allocation problem arises only in absorption
when it also arises in variable costing although to less extent.

Unless otherwise stated, the following description in this section of the paper
applies to absorption costing. In addition, the cost allocation in a manufacturing firm
will be described because that is where Activity Based Costing (ABC) originated.

Activity Based Costing concerns itself with the way in which indirect costs (all
indirect costs including both manufacturing and non-manufacturing indirect costs)
are best associated with the production of different products and product groups. It is
, therefore, necessary to consider the traditional method for doing this, before
considering what changes supporters of ABC propose. Of course, systems of cost
allocation will vary from firm to firm, but one can describe the traditional nature of
general practice.

Conventionally, the cost of products for balance sheet purposes was constructed
as follows:

Direct product cost (direct materials plus direct labour costs)

plus
Indirect manufacturing costs
equals
Total manufacturing cost

To obtain a full cost estimate, including non-manufacturing overheads, for

management purposes, it was often convention simply to add a percentage of Total
manufacturing cost to cover non-manufacturing costs.

Indirect manufacturing costs for each product (product group) were usually
assigned to products through a two stage process. First, one would separate out the
indirect costs incurred directly in the manufacturing processes (e.g. plant
depreciation, supervisors wages, factory cleaning, costs of utilities) from the costs
 11

incurred in service operations (e.g. personnel, buildings and grounds, machine

maintenance) which supported manufacturing. More sophisticated systems would
trace costs of support services to different production departments using factors
which seemed most appropriate. For example, one might use number of employees
in each production department to allocate personnel costs, square footage to allocate
buildings and ground costs or actual work tickets to charge out machine
maintenance. The support services costs would then be added to the indirect product
costs incurred in each production department and the sum of the two would be
allocated to products which used the processes in each production department. The
allocation of the indirect product costs to products was traditionally, and still is
widely, performed on a direct labour basis. That is the total indirect manufacturing
cost in each department forecast for the year would divided by the budgeted number
of products to be produced times the estimated labour hours required to produce each
one - this would yield an indirect cost per labour hour which would be multiplied by
the actual hours taken in that department by each product in order to work out its
share of indirect manufacturing costs. Figure 2.1 outlines the whole system.

Figure 2.1 shows costs of four Service Departments assigned and added to the
indirect product costs incurred in two Production Departments (PD1 and PD2) which
are then allocated to products at rates appropriate for each product as it passes
through each Production Department. Some systems also re-allocate costs between
Service Departments before assigning them to Production Departments. Some
systems do not differentiate between separate production departments, but use one
blanket rate for allocating overheads to products related to total labour hours used by
products in all stages of production.

Traditional systems do not necessarily use labour hour bases for overhead
allocation. Other bases used include a direct labour cost basis, a direct materials cost
basis or machine hours basis with a tendency towards a growth in the latter as
production becomes more dominated by technology in many industries. ABC
advocates usually claim, however, that the labour hour or labour cost basis is still the
most widely used basis.
 12

Buildings and Works

Personel Machine
grounds canteen

traced directly or assigned by suitable bases

PD1 PD2

SSC SHARE SSC SHARE

plus plus
PD1 indirect PD2 indirect
costs costs

allocated on direct labour hour basis

direct
product TOTAL
mfg PRODUCTS Manufactoring
costs costs

Figure 2.1 Allocation of manufacturing indirect costs to add to direct product costs to
determine total manufacturing costs. (Carr. C. and C. Tomkins 1997)

Having described a traditional cost allocation system, it will now be possible to

demonstrate the essential difference of that system from ABC.

ABC supporters argue primarily that costs in modern manufacturing firms, with
their reliance on CAD / CAM and CIM are less and less driven by the employment
of direct labour. Moreover, a large proportion of costs do not vary with other
measures of production volume either (e.g machine hours). The ABC position is that
if one wants to understand fully how costs change, one needs to establish exactly
what the determinants of costs are. This applies both to manufacturing and non-
manufacturing costs. One needs, in other words, to discover what drives costs. While
ABC supporters would agree that many costs may still vary according to the number of
direct labour hours or machine hours worked, a growing element of total costs have
different cost drivers. These might, for example, be the number of set-ups required for
 13

production or the number of orders placed to procure materials or the number of

deliveries to be made to customers. If different products, production batches or product
groups have a different call for numbers of production set-ups, etc., then it will only be
possible to estimate an accurate product (product batch, product group) cost by
reference to these cost drivers.

The difference between ABC and conventional absorption cost accounting is,
fundamentally, no more than that. In fact some have argued that it was always
possible for a variety of cost drivers to be made in traditional systems and so ABC
systems are not really significantly different. The principal advocates of ABC
respond that even if this is so, companies have not, in general, been operating that
way and they are concerned more with changing practice than debating the
appropriate terminology. Moreover, ABC eschews allocating costs first to
Production Departments if it is not necessary and it also applies the cost-driver logic
to all costs and not just manufacturing costs.

Many companies in many industries have now experimented with or applied

ABC. Notable case studies exist which indicate that, where companies have
introduced ABC, it has radically changed their perception of the profitability of
different products compared to that held under previous costing systems dominated
more by labour cost / hour bases of overhead allocation. Some found that many
products that they were producing were, in fact, loss making and that they had
simply not realised this. Several notable companies have significantly changed their
long run product mix strategies as a consequence. It is also noticeable that the spur
for change for some of these companies was a realisation that past profitability was
disappearing in the face of increased competition and that a better understanding of
their product costs was vital to meet this threat. For such companies, ABC was a
vehicle for product pruning and downsizing which enabled them to refocus on
their profitable core business. Initially, therefore, one might have conceived of ABC
as a corporate turnaround tool. Something required when a company is in need of a
radical re-think of where it will operate in future if it is to remain profitable. The
implication is that, once profitability, returns, ABC does not become so critical. In
 14

addition, it may not be necessary to use a full-blown ABC system for regular cost
control at ,say ,monthly intervals where product mixes are not changed frequently
and total product costs do not change radically. Hence, ABC analyses, which can be
rather detailed, may only be needed when strategic reviews of product mix takes
place.

Other accountants have, however, stressed that is fundamental to know exactly

how costs are generated if one wants to try continually to manage costs down. A vital
part of continuing improvement is, therefore, up-to-date ABC based estimates of
costs. Only then can one see the cost consequences of changing the batch size
(number of set-ups) or numbers of orders placed or delivery times and frequencies or
other key cost drivers. Even a company not under threat may, therefore, need ABC
estimates in order to keep free from threats by remaining, for example, a cost leader
in the industry.

Activity Based Costing then becomes the basis of Activity Based Management.
Budgets can also be drawn up on such a basis integrating activity based cost savings
with budget targets (Activity Based Budgeting).

Once one moves in that direction, however, it is important to note that the type of
cost drivers discussed by advocates of ABC are usually only first level cost drivers.
While the number of set-ups may well determine the level of a significant part of
manufacturing overheads given the existing plant layout, the number of set-ups
themselves may be determined in part by the plant layout. The plant layout may in
turn be partly a function of the type of plant used or the factory space available of the
particular location of the plant. Hence, there is really a complete hierarchy of cost
drivers above the first level cost drivers used in ABC product costing which stretches
up, in theory, to the existence of the whole entity itself. Consequently, cost reduction
programmes should not just be confined to the use of conventional ABC data, but
should also consider re-engineering processes in more radical form. The
advantages of operating at this higher level of cost driver may swamp the benefits to
be derived from modifications to production and non-production processes derived
 15

from insights gained by ABC. But then they may not - and radical re-engineering is
not always feasible or necessary. The specific context in which cost reduction is
being sought will be important in determining the cost reduction approach to be
adopted.

2.3.2 Cost of Quality Calculations in Support Of TQM

Quite a different, and rather earlier, accounting development introduced the idea
of calculating the cost of not getting things right first time. This has been termed the
Cost of Quality (COQ) but should perhaps have been called the cost of poor quality
or the cost of non-compliance. This development grew out of TQM developments
and the Japanese pressures to reduce parts per million defects. It is sometimes stated
that the Japanese did not extend their development of TQM to link with accounting
in the form of COQ procedures and that these were a product of more Western
thinking. One argument for this is that, initially, the Japanese realised that they had to
get defect rates down in terms of delivered products to customers as a key plank of
their marketing strategy and that this then fed back through the total production
process and led to a focus on moving to zero defects as a physical process rather than
wanting to know the costs that could be saved. In the West, it is sometimes argued
that many senior company executives had to be convinced first that this was an
appropriate policy to adopt and COQ estimates were developed as a means of
convincing such executives that a move to radical defect reduction could have a
major impact on the bottom line.

It is important to realise what quality means in this context. Quality means

producing something or giving a service which complies with a pre-determined
specification and achieving that first time without the need for alterations or
amendment. The COQ is, however, more than just re-work costs, although that may
constitute a significant element of COQ.

Most applications of this concept have attempted to estimate costs in four

categories:
 16

Prevention costs
Inspection costs
Costs of errors discovered on the firms premises
Costs of errors only discovered once the goods have left the firm

Prevention costs are incurred by all those activities which are undertaken because
the firm cannot trust everything to be done right first time without those activities.
This might include training, planning, supplier assurance, analysis of data to prevent
future failure and, indeed the cost of COQ programmes themselves. Inspection costs
include the costs of all those activities that are undertaken to ensure that errors have
not occurred. These will include testing equipment, inspecting work-in-progress and
finished goods, inspecting goods received, inspecting stock levels and condition.
Costs of errors are usually divided, as above, into internal failures and external
failures. Internal failures might include the cost of scrap materials and scrapped
items, the cost of re-work, the cost of defect analysis, re-inspection and testing, sub-
contractor failures, etc. External failures will include penalties and warranty claims,
the costs of handling, examining and reworking returned goods, and, where possible,
should also include the cost of lost goodwill or future business.

By undertaking a COQ analysis, it is possible to see the total estimated costs of

not getting things right first time. Such costs are not visible in conventional
accounting statements and usually need some effort to obtain.

Studies in various industries have suggested that companies that have not
undertaken such exercises before often discover that something of the order of 20%
of total costs are incurred through failures. This does not mean that those companies
can immediately get rid of those costs. Management methods have to be found to
ensure that errors do not occur. Practices and organisational culture has to change.
Operatives have to accept responsibility for ensuring that errors are not made and
given the necessary support and training to do that. Often this leads to increases in
Prevention costs in the short run - especially relating to improved planning.
However, internal and external failure costs are usually heavier than prevention and
 17

inspection costs, especially if any errors still remaining are discovered earlier in the
production process, and so there will be net gains even in the short run. As the error
rate improves, it should then be possible to work on reducing prevention and
inspection costs.

There has been much debate over the value of COQ estimates. Some managers,
like the Japanese apparently, argue that there is no need to estimate COQ costs,
companies should just focus upon avoiding errors. Others see the value of having
COQ estimates to convince senior managers that quality control has huge potential
for increasing profits. Even a 10% savings in total costs will do wonders for the
bottom line. Some have argued that they agree with this, but feel that once the
improved quality consciousness is instilled into the organisation, one can dispense
with the COQ estimates. Others, especially in industries where products are regularly
redesigned and new ones, with relatively short life cycles, introduced, have linked up
the notion of COQ improvement with notions of the learning curve and monitor
production cell achievement against standard time-cost reduction curves (sometimes
referred to as half-life functions).

2.3.3 Target Costing

Target costing has been given much more attention in Japan, but is increasingly
being taken up in the West. It is linked with both Functional Cost Analysis and Value
Engineering in order to design products and services which have the attributes that
the market requires at the price that it is prepared to pay.

The initial step is to study the market place to identify the attributes that the next
generation of products must have and the maximum selling price. This does not
mean that the company simply provides what the market says it wants. The company
may have superior knowledge of what can be provided. Depending on the type of
market, there may well need to be considerable interaction between supplier and
customer at this stage to decide on the bundle of attributes that will best meet the
customers needs (this may extend to trying to understand the customers customers
 18

needs too). This will usually also involve a marketing analysis to identify market
segments and how product attributes fit with each segment. It will also involve
understanding the capacities of rival companies to deliver such attributes at the
relevant costs.

The next stage of the target costing process is to identify what activities the
company must embark upon in order to deliver those product attributes. These
activities are then costed and the total cost compared to the cost level likely to be
consistent with selling at the acceptable market price after deducting a desired profit.
In the event that the allowable cost exceeds the predicted cost, the company then
embarks upon Functional Costing and Value Engineering routines to identify where
costs can be reduced without destroying the required product attributes. This process
continues until the predicted cost has been reduced to a level which, with a profit
margin added, is consistent with the required market price. When this stage has been
achieved, the company is ready to go ahead with its plans for investment in order to
produce the product in question.

Functional Cost Analysis and Value Engineering both contribute to the search for
viable cost reductions within this process. In outline, Value Engineering employs
multidisciplinary or multi-functional teams to examine the specification of the
product and, through intensive and creative study, reconsider how that specification
can be delivered with alternate product designs or through different production
processes. This Value Engineering process usually has at least two main stages: the
first, early in the concept development stage, considers more radical design
alternatives in terms of changing major components provided that the service
required from the product can still be delivered. The second stage, coming after the
concept has been largely set, usually uses separate teams to address different parts of
the product design to see whether the functionality of those specific parts can be
increased at no extra cost or whether the part can be reduced in cost with no loss of
functionality.
 19

Functional Cost Analysis may be used at both levels to help to focus this search
by comparing the actual cost of incorporating different attributes into the product
with its value as perceived by the customer / market place. The value attached by
customers to particular and specific product features is not obvious from market data.
Customers buy products as bundles of attributes for an all-encompassing price. There
may be evidence of product variations and different market prices, but this is
unlikely to be sufficient to identify the separate values of all major attributes. One
approach to resolving this question is to ask customers (or company staff acting as if
they were customers) to give weights indicating the relative importance attached to
each of the main product attributes. The total product price is then allocated over the
components according to those weights and the product price allocation for each
attribute compared to its costs. Clearly one may question how rigorous such a
process is for arriving at the precise market value of each attribute, but that would be
to miss the point. The aim is to get an approximate idea of the monetary value of each
attribute. If such an estimate is far below the cost of incorporating it into the product,
this is taken as a signal that here is an area that should be subjected to cost reduction.

The distinguishing feature of target costing is its ex ante nature. Traditional

Western costing is usually described as a process of identifying costs of products as
they are being produced with prices fixed by adding a profit element to cost. Target
costing says more of the detailed costing should take place at the design stage, after
all most major cost elements of many manufactured products are committed at that
stage and there is limited scope for reduction thereafter. Target costing does not start
with product cost, but with market price; it then deducts the profit element to leave
allowable product cost as the residual. As used in Japan, this approach also seems to
have the advantage of enabling the enterprise to operate with less detailed costing
systems for ongoing operations. Where more detailed cost planning is taken in
advance in conjunction with marketing and engineering functions, it is more likely
that the products will be acceptable to the market and that they can be produced at
the appropriate cost. Hence, cost accounts can be kept in more aggregated form and
focus more upon whether more aggregated budgeted goals are being met, rather than
very detailed product costing of goods as they are produced.
 20

2.3.4 Kaizen Costing

Kaizen costing also has a Japanese heritage. Kaizen refers to the process of
seeking continuous improvement. Some Japanese companies link a target costing
planning process with a kaizen process once the products are in production. Other
companies, for example those with short to medium product life cycles, place more
focus upon target costing. Their approach to continuing improvement is to have
several generations of products at different stages of design and development (i.e.
different stages of target costing). Other companies, in more mature markets with
longer product life cycles, place more emphasis on kaizen during operations.

Kaizen essentially tries to ensure that everyone in the company continually

reconsiders how the task is undertaken and whether there is a better way of doing it.
It is not so much a costing routine as the outcome of developing an organisational
culture of collaborative learning at all levels of the company. There were precedents
in the West in terms of learning curves (which projected the extent to which direct
labour costs could be reduced through learning undertaken in a repetitive activity)
and experience curves (which traced how all costs could be reduced as a task was
undertaken more and more times). There is certainly some element of this in kaizen,
but the latter is even more encompassing than experience curves in so far as it does
not just depend upon experience to identify improvements, but encourages the use of
intelligent and shared thought and action through work-teams to search for
improvements.

It is clear that one approach to seeking continuous improvement would be through

following up Cost of Quality analyses as described earlier in order to trace root
causes of not getting things right first time and removing them. As indicated earlier,
some companies have borrowed from the learning/experience curve notions and
established cost curves which indicate the rate at which kaizen learning ought to take
place.
 21

Sometimes these are expressed in terms of half-lives, that is the time it takes
forcosts, or machine failures, etc. to fall to half of what they were at the beginning of
each period. Progress in continuing improvement is then monitored against these
half-life functions.

2.3.5 The Theory Of Constraints (TOC)

The Theory of Constraints is not a cost accounting method, but it has far reaching
implications for cost management. The theory was developed by Eli Goldratt who
subsequently established the Goldratt Institute to extend the practice of the theory.
The initial motivation for developing the theory was to seek an improved way of
production. It was designed to identify the most efficient way of increasing
production throughput. Goldratt and Cox argued that the pace of the slowest process
in the production run determined the pace at which production could function.
Hence, everything had to be geared to ensuring that there were no delays in that
slowest part of the process. Unlike JIT which has the goal of eliminating all
inventories, TOC allows for a minimum buffer of stock to be held immediately
before the process with the slowest pace so that unexpected interruptions in delivery
from the other processes will not delay this critical process.

It also follows from Goldratts analysis that, in order to improve throughput,

which is not the same as reducing cost, attention will be best focused on increasing
the rate at which that one constrained factor operates. TOC supports the notion of
continuing improvement and after some point by improving the rate of production on
the critical process, that process will itself cease to be the constraining resource.
Then attention should be shifted to the new critical process. In this way Goldratt
provides a logical path for more efficient continuing improvement of throughput
rates. This must not be confused with the most logical way of cost reduction, because
this could well be achieved by paying more attention to non-critical processes.
However, Goldratt argues that TOC would prefer to focus on improving throughput
first, then cutting out inventories in excess of the minimum buffer stocks and lastly in
cost reduction.
 22

Later developments of TOC have moved far beyond improving production. TOC
is now directed to improving everything. In the Goldratt Institutes view all
problems can be resolved by a process of identifying constraints and removing them.
In pursuing this goal, Goldratt also developed what he called his Thinking Process
which is essentially a set of logic trees for identifying what factors are causing the
constraints and how to remove them. A particularly interesting observation that he
makes is that after tracing back to root causes it is valuable to ask why these causes
have not been removed before. The answer he says often lies in different
assumptions held by different people about what they and others have to do to
optimise the system. Change these assumptions (mind sets) and removing constraints
can often become much easier.

Goldratt also suggested that his TOC should be supported with some new and
specific measures of performance. These are (I) Throughput Dollar Days and (II)
Inventory Dollar Days. These may be explained quite simply.

Throughput Dollar Days is a new measure of due date performance. If an order is

late, it is given a value equal to its throughput (sales less direct materials costs) times
the number of days that it is late. The department in which the work is currently
situated bears this charge as a cost. The objective is to make departments very aware
of the need to maintain throughput and deliver on time. It may be unfair to charge a
department with such a cost when the delay was caused by some earlier process in
another department, but Goldratt argues that this practice will create a hot potato
and induce all departments to pass it on quickly.

Inventory Dollar Days has a similar philosophy. A calculation will be made to

indicate how long it will take to reduce any excess inventories beyond the agreed
buffer level to that buffer level at the normal rate of usage. If, for example, there was
an excess above the buffer level of 40 units in stock and the normal rate of usage was
20 units per day, this would imply that it will take two days to remove the excess
inventory - an excess of 20 units will he held for one day and an excess of 20 for two
 23

days. The inventory day measure will then be 20 x 1 plus 20 x 2 = 50 inventory days.
The number of 50 will then be multiplied by the value of each unit of stock in order
to derive a measure of Inventory Dollar Days and departments will be held
accountable for any such dollar days. (This measure would not normally be used to
value stock in accounting reports). The intention once more is to have a measure of
undesirable performance which escalates rapidly as stock is held for an excessive
time, thereby highlighting the matter.

Even though a number of companies have adopted a Theory of Constraints

approach to managing their operations, very few seem to have adopted the Inventory
Dollar Days measure mainly because the implied cost of holding excess stock was
seen itself to be unrealistic. The cost of holding stock does not normally double
between day 1 and day 2.

2.3.6 Throughput Accounting

Throughput accounting arose from Goldratts thinking in developing his Theory

of Constraints. In developing his theory, Goldratt was initially trying to maximise the
profitability of the firm by maximising the amount that could be produced given
existing production configurations and constraints. He argued that plans will be
drawn up to maximise production (throughput) and that once these plans have been
established no section of the firm should depart from them or the co-ordinated plan
would be upset. It follows that each department could be seen as having a fixed
budget to spend to meet its target.

Under this form of operation, Goldratt argued that no benefit, and perhaps a lot of
harm, came from existing cost accounting practices which allocated indirect costs,
variable and fixed, over products and / or product groups. Given a clear co-ordinated
plan, all the firm needs to do is maximise throughput measured in aggregate financial
terms as sales less direct materials costs and see that the throughput measured in
financial terms exceeded the fixed operating expenses by as much as possible. In
other words, he defined all costs as fixed except direct materials costs. Subsequently, he
 24

has softened his stance, to allow that other costs may also be variable, but still stresses
that direct materials costs are the main variable costs.

Throughput accounting, as defined by Goldratt, is not really a new form of

accounting. It is merely an extreme form of variable costing. If the only costs which
are truly variable are direct materials costs, there will be no difference between
throughput accounting and variable costing. Moreover, if the focus of decision-
making is on maximising throughput in the short-term, given existing resources,
throughput accounting may well approximate the true variable costs. As one
lengthens the period of decision-making, however, such that excess labour may be
laid off or other indirect cost services varied, it is clear that throughput accounting
would not support appropriate decision-making. At the limit, if the firm is
contemplating severe product line pruning, ABC with its sophisticated approach to
cost allocation will provide the best guide to relevant costs. There ought not,
therefore, to be a controversy over whether TA or Variable Costing or ABC (full
costing basis) is best - they each serve different purposes. Of course, companies will
not run their routine costing systems in all three forms. As data base methods become
more widely available and applied to accounting, it should be possible to generate
accounting data with the appropriate form of cost variation assumption for the
decision at hand and use the concept most appropriate for measuring managers at
different levels according to their personal responsibilities and functions. The
accounting skill should be to provide relevant costs for the purpose for which they
are required - this has always been the case and TA offers nothing new to that basic
concept.

2.3.7 Integrated Strategic Management Accounting

Strategic Management Accounting is not a new costing system. It is a generic

term which covers the use of cost and management accounting to help inform an
organisation in making major strategic decisions. In this sense, all the methods
described above have a role to play. More recently, however, the term has been used
more precisely (see Carr and Tomkins, 1996) to describe how accounting needs to be
 25

integrated with strategic thinking in order to provide a comprehensive control

system. Essentially, Carr and Tomkins, draw up a framework for system design
which integrates all, or most, of the new developments described above and it does
so through a general target costing approach to strategic investment decisions - i.e.
those decisions concerning new markets, new products or the acquisition of new
attributes by the company in order to give it a better market standing.

The process will first involve a consideration of what customers need and what
rival companies can deliver in order to arrive at a project description in terms of
product / service attributes and a target price at which that bundle of attributes
which constitute the product or service will sell.

The firm must next test out whether it is capable of delivering that product at the
target price. In order to do that it must specify the exact value chain for providing
each of the product characteristics. This will involve specifying how the firms
inbound logistics, operating production procedures, outbound logistics, distribution
system and aftersales service all impact upon the proposed product attributes. If
current elements of the value chain cannot deliver the product attributes, the firm has to
decide whether it was being too ambitious and settle for a more easily attainable set of
product attributes (provided that it can still be sold) or set about improving the
relevant aspects of its value chain. If it takes the latter route, it will be necessary to
establish exactly what the value chain modification will cost and whether that it still
feasible within the target price. Of course, as explained above the target price itself is a
product attribute and the firm may discover that it can produce the non-price attributes
with its current practices and resources, but not within that price. Either way attention
will need to be focused upon cost reduction in order to achieve the non-price attributes
within the target price (cost) or a functional cost analysis in order to establish which
attributes can best be downgraded to produce the minimum reduction in market
attractiveness of the product for the maximum reduction in cost.

It is likely that several iterations around this process using Functional Cost
Analysis and Value Engineering will be needed before a desirable mix of product
 26

attributes and target price can be delivered, namely a mix which is attractive to the
buying market and the producer/seller. Once this desirable mix has been established
as a feasible proposition, the producer can ahead and invest or accept the contract.
The whole system is mapped out in Figure 2.2.

It should be clear how all the new developments described above could fit into
such an overall process. Careful cost behaviour analysis and cost driver identification
will be needed to cost out proposed changes in the value chain and the product
attributes derived from the Functional cost analysis and Value Engineering - this
suggests a role for world class finance functions using ABC principles. Cost
reduction may be pursued by trying to squeeze out waste using a COQ approach. The
TOC method might be used to identify constraints which prevent cost reduction
attribute improvement. The important point to note is that whatever mix of tools is
used in such a process, all the cost calculations will be made prior to the acceptance
of the project or investment decision. This implies that such an approach is best
employed where a firm is planning a succession of product developments. The next
generation of products to be launched should be nearing the end of this process, the
generation planned after that will still be in the earlier stages of this process.

Where this approach can be implemented successfully, it should be possible to

simplify the accounting processes required to monitor performance. The cost analysis
will have been conducted rigorously beforehand and operating control should be
attainable by reference to broader aggregates provided that managers keep to their
agreed planned way of operating. This has some similarity with the philosophy
behind Goldratts TOC although it is not identical to it.
 27

Analyse Analyse
Customer Requirements Provision by Competitors
Market &
Competitor Identify Identify
Analysis Desired Product/Service Attributes Desired Company
including Target Price Attributes

VALUE CHAIN ANALYSIS

Support Services
In-bound Internal Out-bound Distributi Marketing
Value Logistics Operations logistics on & selling
Chain
Analysis
Break Down into
ACTIVITIES

Identify Attribute (Including Cost) Drivers

YES
Can we deliver All the Required Attributes at desired Profit
Level? INVEST

NO
Cost &
Cost Reduction - Attribute Imrovement
Attribute
(Waste Removal, COQ , TQM , etc)
Driver
Analysis
Re-engineer the Value-Chain
(Higher Level Cost / Attribute Drivers)

Figure 2.2 A schematic formal Analysis for Strategic Investment Decisions (Carr. C. and C.
Tomkins 1997)

2.3.8 Balanced Scorecards

Another recent development has been balanced scorecards (see particularly

Kaplan and Norton, 1996). The thrust behind this development came from a
dissatisfaction with reliance on just financial statements, especially the Income
Statement and Balance Sheet, as the dominant means of checking a corporate group
or divisions position. Initially, in 1992, Kaplan and Norton proposed that was a need
 28

for balanced scorecards which reported performance along four different

dimensions: a financial perspective, a customer perspective, an internal business
perspective and an innovation and learning perspective.

This was a step forward in moving the focus of attention in performance

monitoring beyond financial analysis, but it could still be criticised in that it did not
offer a clear way to decide what was important to measure and what not. There
seemed to be no serious attempt to develop a clear theory of success for each
company or division which would serve as the basis for choosing between many
possible indicators and dimensions which could be measured. Without such a theory,
how could the performance monitoring be balanced - i.e how would one know what
weight to put on some factors compared to others? Perhaps it was always implicit
that these factors would be based on the key result areas and key success factors
appropriate to each corporate unit being monitored. It certainly has now been set out
very clearly in Kaplan and Norton (1996) where a whole book is devoted to linking
up these scorecards to the firms specific strategy and key success factors. In fact
Kaplan and Norton (1996) now say, up front:

A properly constructed Balanced Scorecard articulates the theory of the

business.

This scorecard will set out clearly the cause and effect relationships assumed to
underlay the firms strategy and be used in more innovative companies as the basis
for a complete management system and not just a measurement system.
 CHAPTER THREE
TARGET COSTING

3.1 Introduction To Target Costing

The most important feature of any company is its ability to stay ahead of the
competition. In the midst of a plethora of products and choices for the customer, it
becomes increasingly important for any company to make its products better, faster,
cheaper and more innovatively. Increasing the efficiency of products has the two
aspects of cost and functionality attached to it. An efficient designing technique takes
the cost and functionality aspects into consideration during the early stages of
product design. Such an approach provides us with the chance to concentrate our
design efforts on important features and at the same time reduce the costs incurred on
less important features. Target costing is like a planning tool that helps us to identify
the features to be improved and helps us in setting targets for designing and cost
reduction. It is generally known that challenging goals lead to better performance
than the general goal of doing ones best .Cooper R. and Slagmulder R. ,(1997).

Frequent innovations characteristic of todays market have decreased the life of

new or re-designed products and increased the costs of design. This made it essential
for every company to analyze its products feasibility and profit-making ability
before launching expensive design and manufacturing teams. Costs through the life
cycle of a product require more attention as the costs of recycling, distribution, etc.,
keep increasing. The following important features can be considered to summarize
the market condition for the last two decades.

Increased competition
Increased costs of design
Decreased product life
Increased non-manufacturing costs
Increased importance of customer needs and demands

29
 30

Less-forgiving customers

3.2 Core Concept of Target Costing

3.2.1 Definition

The core concept of target costing is very straightforward. It is based on the logic
that a company should manufacture the products that yield the desired profit. If the
product is not yielding the desired amount of profit, the design of the product should
be changed to obtain the desired profit or the product should be abandoned. A
comprehensive definition of target costing as given in ,Ansari S., and J. Bell,
(1996),is mentioned below:

The target costing process is a system of profit planning and cost management
that is price led, customer focused, design centered, and cross functional. Target
costing initiates cost management at the earliest stages of product development and
applies it through out the product life cycle by actively involving the entire value
chain.

3.2.2 Process

Target costing process consists of two phases known as establishment phase and
implementation phase. The establishment phase defines goals for product concepts
based on strategic plans and the implementation phase achieves the set goals. The
relation between target costing and product design is illustrated in Figure 3.1.
 31

Figure 3.1: Target costing and product development cycle.

Ansari S., and J. Bell, (1996)

The process of target costing is illustrated in Figure 3.2 and is based on the
cardinal rule, If we cannot make the desired profit we should not launch the
product.
 32

Figure 3.2: Target Costing Process (V. Amara 1998)

The illustrated process of target costing for product design (see Figure 3.2) can be
described in the following steps:
 33

1. Consider strategic and financial goals: Top management sets long-term goals
for the complete corporation and every product should be designed to help
the company to achieve these goals.
2. Determine the customer attributes or demands: This process involves
conducting thorough market analysis and customer surveys to determine what
the customers needs and demands are for a given product.
3. Consider costs and processes while designing: This step must result in the
design specification of the product. The major tools used to obtain the design
specification of a product are (a) Pugh Method and (b) QFD.
4. Determine the target price: Target price is the price a customer is willing to
pay for the new product. Thorough market analysis must be conducted to
determine the target price.
5. Determine the target cost: Target cost, also known as the allowable
manufacturing cost, is calculated by subtracting the profit required (ROS can
be used to determine the profit required from the new product) from the target
price.
Target Cost = Target Price - Desired Profit
6. Determine the drifting cost and product feasibility: fitting cost, also known as
the actual cost of manufacturing, is the present cost of manufacturing the new
product and this is calculated with the help of the engineering department. It
is also analyzed to see if all the desired functions can be provided in the new
product. A good costing system like ABC (Activity Based Costing) will
assist in determining accurate costs.
7. Process Improvements:f the designed product yields the required profit, the
new product can be manufactured. If the new product does not yield the
required profit, the product needs to be re-designed or the process of
manufacturing should be improved to yield the required profit. Some tools
like value engineering can be used to associate costs to components or
functions in order to determine their cost efficiency. The components or
functions that are cost inefficient should be re designed to reduce costs. If the
products are found not to meet the financial profit requirements, they should
be abandoned.
 34

8. Implementing / Evaluating long term effects:s essential to make sure that the
new product will yield the required profits through its complete life and the
product mix must be regularly adjusted to meet the strategic goals of the
company.

3.3 Literature Review

The literature about target costing deals more with the concepts of target costing
than with its practical application. Several companies where target costing is used are
mentioned, but specific details about product designing and cost reduction are not
available. Literature describing the concept of target costing and various techniques
used in target costing, along with some important definitions of target costing are
mentioned here.

The definitions of target costing are many, but they all focus on the same point of
cost reduction. However, definitions vary in the scope of cost reduction. Some
definitions take the overall product life cycle into consideration while some consider
particular functions or just product development. P. Horvath, (1994) take the product
life into consideration and define target costing as follows .

Target costing is a set of management methods and tools used to drive the cost
and activity goals in design and planning for new products, to supply a basis for
control in the subsequent operations phase, and to ensure that those products reach
given life cycle profitability targets.

Target costing has been defined in ,S. L. Ansari , M.D. Ferguson and P.A.
Zampino, (1997), by listing all stages of product life cycle, while Cooper R. and
Slagmulder R. ,(1997), defined target costing in Target Costing and Value
Engineering by placing emphasis on the aspects of cost, quality and functionality as
follows:
 35

Target costing is a structured approach to determine the life cycle cost at which a
proposed product with specified functionality and quality must be produced to
generate the desired level of profitability over its life cycle when sold at its
anticipated selling price.

Different aspects of target costing including those of interest to management are

detailed in S. L. Ansari , M.D. Ferguson and P.A. Zampino, (1997), The following
are the key messages sent by target costing according to there.

1. Target costing takes place within the strategic planning and product development
cycles of a firm. Product design goes through this development cycle in a
recursive, rather than in a linear fashion.
2. The first phase of target costing is the establishment phase. The focus here is on
defining a product concept and setting allowable cost targets for a product or a
family of products.
3. The second phase of target costing is the attainment phase. This phase transforms
the allowable target costs into achievable target costs.
4. The establishment and attainment phases of target costing occur at different
points in the product development cycle. Different organizational processes play
primary and secondary roles in these two phases.
5. Many other business processes support target costing, and the success of target
costing depends on these other processes being performed effectively within an
organization.

The process of target costing is explained in detail in Advanced Target Costing:

State of the Art Review [1] and Target costing: The next frontier in Strategic Cost
Management ,S. L. Ansari , M.D. Ferguson and P.A. Zampino, (1997), The
different steps of target costing and a guide for management have been laid out in S.
L. Ansari , M.D. Ferguson and P.A. Zampino, (1997), .These steps are detailed and
used in the current report.

The Consortium for Advanced Manufacturing-International (CAM-I) made

concerted efforts to promote target costing. Horvath and CAM-I, P. Horvath,
 36

(1994)produced a comprehensive report detailing the basic technical concepts of

target costing. CAM-I later worked with its core group to generate L. Ansari ,(1997),
to include all the aspects to be considered during the implementation of target
costing.

The contribution of various techniques to target costing is different. Some

techniques like the Pugh Method, Quality Function Deployment (QFD) and Value
Engineering (VE) should be studied in more detail as these tools help in designing
the products and processes. The Pugh Method helps in identifying customer
requirements and is explained by Stuart Pugh in Pugh S. ,(1991), .This technique is
used in the current report to identify customer attributes. QFD relates product
functions to customer requirements in order to establish goals for product design.
Bob King explains this method in Kng B. ,(1989), .QFD is used in the current report
to correlate the customer attributes to components or product attributes to establish
their relative importance. The candidates for improvement are the product attributes
with high relative importance. Value engineering helps us in reducing costs incurred
by a product and is detailed by Cooper and Slagmulder in Cooper R. and Slagmulder
R. ,(1997), .This process is used to identify product attributes that are not cost
efficient.

P. Horvath, (1994) ,describes target costing and relates it with Activity-Based

Costing (ABC), product life cycle management costs, and Value Engineering. Target
costing along with supporting tools, techniques and means of deployment is detailed
in Ansari S., and J. Bell, (1996). Cooper R. and Slagmulder R. ,(1997), explain how
value engineering can be used along with target costing to increase the value of a
firms products. Kaizen costing, the process of continuous cost reduction after a
product is launched, is explained along with its relationship to target costing by
Monden Y. and Hamada K., (1991) .Effects of Return on Investment (ROI) and
Return on Sales (ROS) on target costing are analyzed by Sakurai in Measures of
Organizational Improvement Sakurai M. ,(1995).
 37

Effect of target costing in many large companies like Nissan, Toyota, and NEC,
are discussed in some papers. Sakurai M. ,(1992), mentions the reasons for the use of
target costing in Japan. He mentions that increased consumer demand for product
variety and shortening of life cycle prompted Japanese industries to adopt target
costing. Worthy F. S. ,(1991), shows how target costing helped several industries in
Japan. He mentions the way Japanese industries take calculated risks after using
management techniques like target costing. Schmelze G. Geier R. and Buttross T. E.
,(1996), show how target costing is applied at ITT Automotive and how it created
cost savings before the product reached the production stage. Cooper R. and Chew
W.B., (1996) , illustrate that target costing lets the customer and not the product set
the price with reference to Olympus and Komatsu. Brausch J.M. (1994)
demonstrates the implementation of target costing in the textile industry to reduce the
costs before they are incurred.

The literature review of target costing shows us that the concept of target costing
and the tools used for its implementation are described in detail. The companies that
have implemented target costing are multi-billion international companies, and the
literature illustrating the use of it in small-scale industries is sparse. The current
report explains target costing and discusses the issues of implementation from the
perspective of a company by conducting a retroactive analysis of a real life decision
taken by the DEKORPAN Company .

3.4 Facts / Advantages of Target Costing

The major characteristics or advantages of target costing as mentioned in ,P.

Horvath, (1994) ,are listed below.

Target costing will provide management methods and analytical techniques for
developing products and services whose costs support strategic objectives for market
position and profit.
Product costs will be defined from the customers viewpoint; they will include
functionality, cost of ownership and manner of delivery.
 38

Target costing is a critical component of product development teams and

concurrent engineering.
Target costing will incorporate as wide a range of costs and life cycle phases for
the product or service as can be logically assigned and organizationally managed.
Target costing will provide analytical techniques to indicate where cost
reduction efforts on parts and processes will have most impact, and where
commonality and simplification can be increased.
The quality of cost data will be consistent with the responsiveness and level of
detail required at various development phases: The system will use the logic and
benefits of activity-based costing.
The achievement of market-driven product attributes will be protected from cost
reduction ambitions.
Targets for product cost will be set for various life cycle phases in development
and production.
Target costing will aim for appropriate simplicity, relevance and ease of use by
product development teams; it avoids unnecessary complexity of language and time
consumption in cost assessments.

The process of target costing creates a team based, proactive atmosphere, where
representatives from different departments get together to make decisions. This leads
to a reduction in the information gap between different departments and makes the
departments more responsive as they realize the importance of their activities .
Ansari S., and J. Bell, (1996),

Another significant advantage of target costing is its inherent flexibility as

mentioned by Sakurai M. ,(1989). He mentions that target costing was used by
Atsugi to reduce the current level of standard costs by autonomous efforts, while
Daihatsu Motor used target costing to establish a new plant to maximize profits
through controlling costs by the use of automation and flexible manufacturing
systems. These factors are some of the many reasons that establish target costing as a
good technique.
 CHAPTER FOUR
TARGET COSTING IN NEW PRODUCT DEVELOPMENT

4.1 Establishing Target Costing

The first and the most important step of target costing is the critical decision of
management to implement target costing. The importance of this step cannot be
overstated, as target costing is a dynamic process based on managements strategic
plans. Some major reasons for implementing target costing can be increased
competition, expansion of business, or introduction of new products.

Once the decision to implement target costing is taken, the target costing team
needs to be established. Small manufacturing firms do not have the luxury of having
multiple target costing teams for different phases or for different functions of a
product.

The effectiveness of target costing is usually expected to increase with an increase

in the number of involved personnel. A target costing team has the advantages listed
below:

Association with the complete cycle of product development facilitates future

revisions.
No information gap occurs between different stages of product design or target
costing.

The target costing team should consist of personnel from different functions and
departments. It is very important to note that the members of the target costing team
should not be completely dedicated to target costing. The personnel must still have
significant functional responsibility, as this keeps them updated in their functional
areas. The target costing team should consist of personnel from marketing,
information systems, cost planning, operations, research and development and all

39
 40

functional areas. A top management executive, who has a good knowledge of the
companys strategic plans, must lead the target costing team. However, costing,
production and designing are more important and the product designing process can
be carried by frequent inputs from the remaining departments in a firm.

The members of a target costing team should be trained in target costing

implementation. A complete proper working knowledge of target costing is
necessary for its success. However, the most important factor is practice. Every firm
is different from another and it is very important to start implementing target costing
and it should be refined to meet the requirements.

For the successful implementation of target costing, the team should be provided
with the information required for conducting the analysis. The type and the amount
of data required vary depending on the type of the product, but typical categories of
data required are mentioned below.

Customer needs and demands

Pricing data
Costing data
Information system to track and evaluate the target costs and manufacturing
costs

For a firm without a big marketing department, there are several ways to collect
the required data. Customer surveys can be used to gather information about what the
customer currently needs. Operations personnel taking customer orders can collect
valuable information about customer demands. It is very important to store customer
demands historically as they can indicate trends in the market. The Internet and
organizations like Equipment Manufacturers Institute (EMI), Engineering
Information Inc., etc. can provide valuable historical information. Pricing data
consists of the customers willingness to pay, which can be determined from
customer surveys.
 41

The most efficient way to collect this pricing data is by function. Let us consider
an eraser; the basic function of an eraser is to erase. But additional functions and
features include softness, shape, scent, pen and pencil eraser in one, longevity, and
color. Pricing data must indicate how much a customer is willing to pay for each
function or feature.

An efficient method is to start from a current product and conduct surveys to

identify the price paid for features based on customer surveys. Costing data should
be obtained from the current costing system and cost bases for distributing
administrative, design and marketing costs must be established. Last but not the least,
systems and databases must be established so as to collect this information and the
data must be very accessible to the target costing team.

The duration of the target costing project depends on the type of the product being
studied. But, the preliminary analysis to reject or accept a product is suggested not to
take more than a couple of months for a manufacturing firm. The total time for
launching a product should be proportional to the product life.

4.2 Product Design Stages

Implementation of target costing in a firm is achieved through the establishment

phase and the implementation phase as mentioned before. These two phases happen
within the four major phases of product design, which are :

1. Product Strategy and Profit Planning

2. Product Concept and Feasibility
3. Product design and Development
4. Production and Logistics

The phases are classified based on critical decision points in product designing /
redesigning rather than being based on time or function. The process and the
decisions to be taken at the end of each step are explained in the Section 4.2.1.
 42

Each phase corresponds to one or more steps illustrated in Figure 2. Product

strategy and profit planning obviously includes the first step of setting strategic and
financial goals. The second phase includes the next four steps of considering
customer attributes and costs for designing the new product. It also includes
determining target price, target cost and drifting cost for new concepts. This phase
will validate the feasibility of various product concepts. The third phase involves
process improvements based on the results of phase two and finalizes the design and
manufacturing methods for the selected concept in phase two. Phase four involves
implementing the manufacturing processes and evaluating long term effects to make
sure that the product helps in achieving the corporate goals. The association between
the various phases and the steps in Figure 3.2 is illustrated in Figure 4.1.
 43

Figure 4.1 Target Costing Process along with Product Design phases (V. Amara 1998)

The various phases and the main tools used in each phase are illustrated in
Table4.1.
 44

Table 4.1: Product design phases and tools used . (V. Amara 1998)

4.2.1 Product Strategy and Profit Planning

The objective of this step is to define long term strategies and goals of a firm. The
strategic plan of a company must include the planned rate of return and market
expansion plans. There is no fixed method for determining the desired rate of return.
But it is indirectly determined by the expectations of stockholders and the price set
by competitors.

Marketing information about the trends in customer demands must help us in

establishing market expansion plans. Market expansion plans can include particular
product definitions or a general description of the market to be reached. For example,
an encapsulation firm for a pharmaceutical client can have market expansion for
solid tablet manufacturing, packaging and distribution or to enter paint-ball
manufacturing.
 45

The type of marketing information required depends mainly on the position of the
industry in a supply chain. Industries in the lower levels of the supply chain can
obtain most of the information from their direct upper level customers. The
interaction with suppliers is very important in large assembly industries and the
suppliers strategic goals and profit margin calculations should coincide with ones
own firms strategic plans. For the previously cited example, the marketing
information and strategic plans should consider the pharmaceutical clients supplying
the material to be encapsulated along with the end user.

Established costing systems should provide the top management with the
information required for setting strategic goals for profit margins. Long term
planning needs to consider many factors and a few important ones are listed below:

Financial
Establishing new customers
Increasing market reach
Establishment of brand name

4.2.2 Product Concept and Feasibility

The objective of this step is to determine feasible product concepts. It is not

essential to determine precisely the manufacturing process at this stage. But, this is
the phase where several concepts are analyzed to determine the best concept.

The process of establishing product concept feasibility consists of the following

steps:

1. Determining if the product meets customer demands

2. Establishing the method of manufacturing
3. Verifying that the product generates the desired profit margin
 46

The product concepts are analyzed to determine if they at least satisfy the
customer needs. A product concept is considered to meet the requirement if it
satisfies the customer needs. The costs and manufacturability of concepts is later
considered to determine the best concept. But, at this preliminary stage all concepts
that satisfy the customer needs are considered.

The Pugh Method , Pugh S. ,(1991), focuses on the total life cycle of the product
to determine the complete list of customer needs and wants for total design. The
Pugh Method defines total design as a systematic activity, from the identification of
the market/user, to the selling of the successful product to satisfy that need. The
customer needs can be defined by analyzing the complete product life cycle, and the
customer demands must be classified into needs and demands. It is important to
apply the Pugh Method in the early phases to make sure that all customer
requirements are considered. It is also important at this stage to determine the price a
customer is willing to pay for each requirement/function (also known as target price
of the requirement/function). The different aspects that need to be considered during
designing according to the Pugh Method are listed in Table 4.2.

Table 4.2: Different aspects to be considered during product design

After establishing that a product concept meets customer requirements, its

functions must be analyzed to verify their manufacturability. Personnel from all
 47

positions and departments should apply their functional knowledge to determine the
manufacturability of products.

Once the manufacturability of a product concept is established, the target price

should be established by adding the target prices of all functions. The financial
feasibility of a product can be verified by using the equation mentioned in the
Section 3.2.2.

Target Cost = Target Price Desired Profit

The profit desired from a product is determined based on the strategic goals set by
the top management. If the actual cost of manufacturing is less than the target cost,
the product concept can be considered economically feasible. If the actual cost of
manufacturing is greater than the target cost, the target costing team needs to decide
if the manufacturing process can be improved to reduce the cost. The last step is to
compare different product concepts to determine the best concept for further
analysis.

A few other factors that need consideration for cost-effective design and decision
making are listed below:

1. Actual cost of manufacturing must include total life cycle costs, i.e. it must
include costs of designing, marketing, recycling, distribution, etc.
2. Product concepts must be analyzed along with suppliers in order to ascertain
their feasibility.
3. Trends in customer demands should be identified and considered during
designing.

4.2.3 Product Design and Development

An established product concept is refined to include more functions and to reduce

costs of manufacturing to achieve target costs. The final output of this step is a
 48

complete and comprehensive definition of the product along with the process of
manufacturing.

Quality Function Deployment (QFD) uses various charts and helps the designer
by establishing relative weights for various quality characteristics and customer
demands. A QFD chart compares the left section of the chart with the top section and
identifies strong, moderate and possible correlations. Processes are analyzed to see if
additional customer wants can be provided without adding significant costs. It is very
important to consider the features provided by competitors at this stage.

QFD (Quality Function Deployment), a process that originated in Japan, helps us

in designing products efficiently. Bob King defined QFD in Kng B. ,(1989), as:

Narrowly defined, QFD refers to the organization that makes the design
improvement effort possible. Broadly defined, QFD also includes the charts that
document the design process.

QFD is explained in detail in Kng B. ,(1989), and the major QFD charts (or
tables) taken into consideration are:

1. Quality-table relates customers demands to quality characteristics and

compares our current performance to competitors performance. This helps
the designer to come up with the initial plan of design ,Kng B. ,(1989),
2. Functions / Quality Characteristics table is used to identify functions of the
product that might not be known to the customer Kng B. ,(1989), by
establishing correlations between quality characteristics and the functions of
a product.

Quality characteristics not correlated to any customer function should be replaced

by appropriate functions to capture customer demands.
 49

The next step after establishing designing goals is to achieve them. The actual
process of designing depends on the product and is not considered in the current
report. But, the process of cost reduction using value engineering is described in this
report. The basic concept of value engineering is to determine candidates for cost
reduction by primarily focusing on product functions and only secondarily on cost
Cooper R. and Slagmulder R. ,(1997), .Value engineering compares the relative
degree of importance of each component or function to the percentage of total cost
the component or function takes. Dividing the percentage degree of importance by
the percentage of cost for that component gives the value index for that component.
A component/function with a value index of 1 or more is cost inefficient and needs to
be made cost efficient. The method of cost reduction depends on the type of the
product and the process of manufacturing. Some common cost reduction methods
include conducting staffing analysis to reduce staffing levels, compromising the
quality of a function in a product if it is not very important, decreasing the inventory
level, improving yield, etc. This process must be continued so as to add value to
important components and to reduce the costs of less important components until the
target cost is reached.

If the actual cost of manufacturing exceeds target cost, the product concept should
be discarded. This should not happen at this stage, as the second stage of product
concept testing must determine if the target costs are achievable or not. But, if it ever
happens, the target costings cardinal rule must be followed and the product should
not be launched except for marketing reasons.

Cost reduction can be achieved by identifying when and where the costs occur.
Reference ,Ansari S., and J. Bell, (1996), allocates the total costs based on:

1. Value chain perspective

2. Life cycle perspective
3. Customer perspective
4. Engineering perspective
5. Accounting perspective
 50

Each perspective provides a unique way of looking at the product and helps us to
identify where excess costs occur and to reduce them. Cost reduction should start as
soon as possible and should concentrate on functions that are easy to improve and
further cost reduction must be achieved.

4.2.4 Production and Logistics

Actual production should not be started until the target cost is considered
achievable. This is just the beginning of cost reduction and constant endeavors must
be made to reduce costs as much as possible. Frequent customer surveys should be
conducted to determine the changes in customer wants, and the products must be
modified accordingly.

Kaizen Costing is the process of continuous cost reduction. Economies of scale,

setup improvements, work methods, etc. must be analyzed to increase the
productivity of the bottleneck operation. This will help us in increasing the
throughput of the line without adding costs, thereby increasing the profit margin.
Root cause analysis must be conducted to identify the reasons for downtime and idle
time and process improvements must be made. A simple method of conducting root
cause analysis is to conduct time studies identifying the amount of non-productive
time. The total non-productive time can be classified into various categories like
waiting time for operator, waiting time for work in process (WIP), waiting time for
maintenance, setups, etc. The major causes can be further investigated for
improvement. For further details about Kaizen Costing refer to Monden Y. and
Hamada K., (1991), and Sakurai M. ,(1996).
 CHAPTER FIVE
TARGET COSTING PROCESS

5.1 Target Costing Process Steps

The target costing process has six key steps. These steps, along with the pre-
project preparation, represent a standard work plan, a framework for training, and
implementation. While each target costing initiative is unique, an organizations
actual implementation will likely include most or all six steps outlined in Figure 5.1,
although not necessarily in the order presented.

Keeping this in mind, the six basic steps involved in implementing target costing
are:
establishing the target market price;
establishing the target profit margin and cost to achieve;
calculating the probable cost of current and new products and processes;
establishing the target cost;
attaining the target cost; and
pursuing cost reductions once production has started.

51
 52

Establishing Establishing Calculating

the target target profit the probable Establishing
market margins and cost of current target cost
price cost to achieve and new
products and
processes

Product planning
phase

Pursuing
Attaining cost reductions
the targe once production
cost has started

Product design phase Production

phase

Figure 5.1. Target Costing Process Steps , (Andersen A. ,1998)

While organizations can modify these core activities to meet a particular situation,
they are recommended as a guide for structuring the implementation of target costing
initiatives.

5.1.1 Product Planing Phase

5.1.1.1 Establishing the Target Market Price

Cost considerations play a minor role, at best, in determining the target price
under target costing. Instead, target costing uses product or service features1 to
identify a target market price. Driven by the market, and by expected relationships
between supply, demand, and price sensitivity for the product, the determination of
the target market price incorporates several objectives, including:
 53

identifying market and customer wants and needs;

determining how much customers are willing to pay for alternative features;
transforming the desires of the customer/user into the language required to
implement a product; and
assessing what the competitive offerings are.

At the heart of the target-price-setting process is the concept of perceived value.

Customers can be expected to pay more for a new product than its predecessor, but
only if its perceived value is greater. Understanding what attributes lead to specific
value, and therefore price, is an essential part of setting a market price that yields
optimal return for the organizations efforts. These objectives can be achieved by
applying several tools and techniques including:

quality function deployment;

analytic hierarchy process;
customer voice analysis; and
relationship matrix.

5.1.1.1.1 Quality Function Deployment. Since customers often make fairly subjective
statements when evaluating a product, quality function deployment (QFD) is a
methodology useful for translating customer preferences systematically into a
number of objective design requirements.These requirements can then be
communicated to the design and production teams to ensure that everyone is working
toward the same objectives and outcomes.

QFD brings together the relationships between competitive offerings, customer

requirements, and design parameters, through a set of matrices. These matrices are
used iteratively throughout the target costing process. In the product planning phase,
these matrices help determine exactly what the customer desires, how well
competitors are satisfying the customer, and where unfulfilled niches exist in the
 54

marketplace. A QFD matrix developed for the product planning phase of a fax
machine is shown in Table 5.1.

Table 5.1. QFD Matrix in Product Planning of a Fax Machine , (Andersen A. ,1998)
Design Parameters Competitor
Display Print Modem Paper Memory Interface Ranking Customer
Customer Requirements Panel Engine Speed Tray Board Card 1 2 3 4 5 Ranking
Ease of setup S M O C 5
Memory S M S C O 3
Receive/send speed S S C O 4
Printing speed S W C O 4
Copy settings M S C O 3
Handset S W C O 2
Paper supply M S O C 3
PC interface W M S O C 2

Correlation of design parameters and rankings Comparative competitive rankings

S : Strong Correlation C : Competitor Ranking
M : Moderate Correlation O : Our Ranking
W : Weak Correlation

This matrix summarizes information about product functions and their

associated customer rankings. It also shows the correlation between competitor
design parameters and customer requirements. Additionally, information is provided
about how customers evaluate competitor offerings on these same features. The QFD
matrix shows that the customer requirement of receive/send speed has a high
correlation with the design of modem speed and memory. Similarly, printing speed is
correlated to the print engine design parameters.

QFD is used successfully by both product- and service-based organizations. For

example, it has been used in the manufacture of automobiles, electronics, home
appliances, clothing, integrated circuits, synthetic rubber, construction equipment,
and agricultural engines. QFD has also been used to design retail outlets, schools,
and plant layouts.
 55

Figure 5.2 provides a summary of the critical processes, tasks, responsibilities,

and stages involved in QFD. Columns represent the organizations functional units,
while rectangles in the flow chart identify activities and required interdepartmental
participation. Arrows indicate the flow of documents or decisions.

The chart defines QFD team structure as well as the core documents and
information the team will require to complete tasks. Serving as a road map for
managing a QFD project, the chart helps an organization identify and answer several
core questions in the planning and design process, including which customers are
being emphasized, what their demands are, how much one customer segments
requirements should drive the design process, and what criteria should be used to
make these decisions.

Using the QFD methodology, a model is developed that consists of the following:

An Objective Statement, a description of the goal, problem, or objective of the

team effort;
The Whats, a list of characteristics of a product, process, or service, as defined
by customers;
Importance Ratings, or weighted values assigned the Whats , indicating relative
importance;
A Correlation Matrix, which shows the relationship between the Hows;
The Hows, ways of achieving the Whats;
Target Goals, indicators of whether the team wants to increase or decrease a
How or set a target value for it;
A Relationship Matrix, a systematic means for identifying the level of
relationship between a product/service characteristic What and a way to achieve it,
the How;
Customer Competitive Assessment, a review of competitive products/service
characteristics in comparison with the teams product or service;
 56

Technical Competitive As sessment, the organizations engineering

specifications for each How and the competitors technical specifications;
Probability Factors, values indicating the ease with which the organization
could achieve each How;
Absolute Score, the sum of the calculated values for each How or column in the
Relationship Matrix; and
Relative Score, a sequential numbering of each How according to its Absolute
Score. Number one is entered for the How with the highest score, two for the next
highest, and so on.

QFD methodology provides a framework for clarifying and meeting goals. For
decision makers, it helps them identify what is important by providing a fact-based
system to replace emotion-based decision making. The uniqueness of the
methodology is that this data can be captured and strategically evaluated in the initial
days of decision making. This is when decisions are made on whether to proceed
with production or service development. QFD helps organizations identify what will
work, what will not work, and what things should be avoided. Since as much as 80
percent of the projects cost is locked in during this early phase, this assessment can
greatly reduce program costs and development time.
 57

Figure 5.2 Product Design Process Chart , (Andersen A. ,1998)

For example, Toyota has used QFD since 1977. The results have been impressive.
Between 1977 and 1994, Toyota Autobody introduced four new van-type vehicles.
Using 1977 as the base year, Toyota reported a 20 percent reduction in start-up costs
on the launch of the new van in October 1979, a 38 percent reduction in November
1982, and a cumulative 61 percent reduction in April 1984. During this period, the
product development cycle (time to market) was reduced by one-third with a
 58

corresponding improvement in quality due to a reduction in the number of

engineering changes.

5.1.1.1.2 Analytic Hierarchy Process. The analytic hierarchy process (AHP) is a

multi-criteria, decisionmaking technique that combines qualitative and quantitative
factors in the overall evaluation of alternatives. AHP is an excellent tool for
considering different characteristic combinations of customer segments. By
examining these characteristics, an organization can uncover new market segments
and determine the relative importance of each.

The AHP methodology comprises four steps:

building a decision hierarchy by breaking the general problem into individual

criteria;
gathering relational data for decision criteria and encoding them using the AHP
relational scale;
estimating the relative priorities (weights) of decision criteria and alternatives;
and
performing a composition of priorities for the criteria that gives the rank of
alternatives relative to the top-most objective.

AHP begins with subject matter experts building a hierarchical representation of

the decision problem. At the top of this hierarchy is the overall objective, and the
decision alternatives are at the bottom. Between the top and bottom levels are the
relevant attributes of the decision problem that provide significant input to the
decision process. The hierarchy can be quite detailed, though most applications need
no more than three levels, as shown in Figure 5.3.
 59

Figure 5.3 Hierarchy of Defined Criteria , (Andersen A. ,1998)

Once the levels and elements have been determined, the subject matter experts
assign relative weights to each defined characteristic using a consensus method based
on the following nine-point scale of importance.

1. Equal importancethe row and column have the same impact upon the higher
order need.
2. Between 1 and 3.
3. Moderate importanceexperience and judgment slightly favor the row over the
column.
4. Between 3 and 5.
5. Strong importanceexperience and judgment strongly favor the row over the
column.
6. Between 5 and 7.
7. Very strong importancethe row is strongly favored and its dominance is
demonstrated in practice.
8. Between 7 and 9.
9. Extreme importancethe evidence favoring the row is of the highest possible
order of affirmation.
 60

Using a series of calculations, a resulting two-way comparison table is normalized

(the fraction of the characteristic as a percentage of the total for each column). The
average of the normalized scores in the rows ranks the importance of the criteria. As
shown in Table 5.2, market size, cost to support, ease to satisfy, and publicity are
0.604, 0.119, 0.066, and 0.211, respectively. Market size is nearly three times more
important than publicity.

Table 5.2 Determining the Priority of Criteria , (Andersen A. ,1998)

Market Cost to Easy to Normalized
Size Support Satisfy Publicity Total Average
Market Size 0.608 0.588 0.600 0.621 2.417 0.604
Cost to support 0.122 0.118 0.133 0.103 0.476 0.1198
Easy to satisfy 0.067 0.059 0.067 0.069 0.262 0.066
Publicity 0.203 0.235 0.200 0.207 0.845 0.211
Total 1.000 1.000 1.000 1.000 4.000 1.000

Once key criteria are identified, potential customers can be ranked, as illustrated
in Table 5.3. The left two columns show the criteria and their calculated weights. The
importance of each customer for each criterion is recorded in the next three columns.
The weighted importance of each customer for each criterion is the product of the
importance of the criterion and the importance of each customer for that criterion.
The column totals are the weighted importance for each of the customers. The table
illustrates that the market size criterion is the most important and the consultant is the
most desirable customer for this criterion. By helping organizations determine the
relative importance of customer segments, AHP allows firms to better determine
whom to talk to and how much weight to assign to their opinions.
 61

Table 5.3. Ranking Customers by Criteria , (Andersen A. ,1998)

Consul
Criteria Priority Teacher Student Teacher Student Consultant
tant
Market
size 0.604 0.090 0.010 0.900 0.05 0.01 0.54
Cost to
support 0.119 0.609 0.304 0.087 0.07 0.04 0.01
Easy to
satisfy 0.066 0.267 0.667 0.067 0.02 0.04 0.00
Publicity 0.211 0.177 0.085 0.737 0.04 0.02 0.16
Total 1.000 Importance 0.18 0.10 0.71

5.1.1.1.3 Customer Voice Analysis . Customer voice analysis helps an organization to

better understand customers expectations, voiced desires, and as yet unperceived
needs. These qualities, or attributes, become the whats of QFDthe individual
characteristics of the product or service that drive customer satisfaction and value
perceptions. If an inaccurate representation of customer desires is obtained, the QFD
process will fine-tune the system to bring forth the wrong product or service.
Therefore, obtaining the voice of the customer accurately is critical.

Customer voice analysis aids the development of an accurate list of product or

service characteristics. As illustrated in Table 5.4, customer voice analysis makes the
list of whats more manageable, focuses the QFD process, and helps clarify
meanings.
 62

Table 5.4. Voice of customer Analysis Table, (Andersen A. ,1998)

 63

Once the primary list of whats is identified, attention turns to rating these
qualities systematically. The resulting rankings play a key role in the QFD process,
serving as weighting factors that are used downstream as multipliers for other
analysis. It is critical that these rankings accurately reflect the customers opinions.
Table 5.5 provides an illustration of the delivery qualities and their rankings for a
large aerospace company.

Table 5.5 Ratings within a Customer Voice Analysis, (Andersen A. ,1998)

What Are The Important elements of a Importance
delivery? Rating (1 to 5)
On-time 3
Quantity 3
Received condition marking 2
Marking 1
No inspection 5
Paperwork 2
Cost and logistics 4

Puritan-Bennett used customer voice analysis to develop a new spirometer.

Information about customer demands came from physicians and nurses,
supplemented by dealer and distributor input. During the design process, there were
many lively discussions over which engineering solution a product feature should
use. Customer voice analysis ensured that decisions always favored the customer.
With a better design and reduced selling price, Puritan- Bennett took away the
competitors price edge and fulfilled a need that neither company had previously
satisfied.

5.1.1.1.4 Relationship Matrix. A relationship matrix focuses attention on how the

various customer requirements will be met using tangible and intangible product or
process characteristics. Since many customer requirements are too unclear or poorly
defined to provide guidance to the organization, they must be changed into the
language of engineering. Performance or technical measurements evaluating the
products performance, based on demanded quality, are used for this purpose.
 64

At least one quantifiable performance measure is typically identified for each

demanded quality. For instance, if the demanded quality for an easel pad includes
stay on wall, two performance measures can be envisioned: time on walls and
number of walls. Test procedures can then be developed to understand how long
the product remains on a variety of different wall surfaces.

Defining how well performance measures that detail the technical features of the
product will relate to the demanded qualities is key to transforming customer
information into specific, objective design language. Without this transformation,
product characteristics and potential price-creating value cannot be used to drive
internal efforts.

A relationship matrix details the strength of each performance measure in terms of

its predictive ability for each customerdemanded quality. For each row demanded
quality and column performance measure intersection, the following question should
be asked: If I know the value for performance measure X, how well will it predict the
customers satisfaction with the products ability to satisfy demanded quality Y?

Four options are offered in the example illustrated in Table 5.6: a strong
relationship, a medium relationship, a weak relationship, and no relationship. The use
of symbols for these weightings, similar to a Consumer Reports evaluation model,
facilitates the identification of patterns of relationships in the matrix.
 65

Table 5.6 Relationship Matrix , (Andersen A. ,1998)

Important demanded qualities should have a performance measure with at least a

medium relationship. Relatedly, more than 50 percent of the cells should represent
no relationship, in keeping with the Pareto principle that most of the value will come
from the critical few qualities and measures. If a row is blank in the relationship
matrix, it means that the demanded quality will not influence the design. This could
be a critical omission. A blank column, on the other hand, indicates that resources
would be wasted measuring something that does not directly satisfy customer needs.

Narrowing the total list of potential measures to the critical few is important in
order to focus design efforts and ensure that the needs of target customers are met. If
multiple customer segments are to be addressed, the answers to these questions can
be expected to differ by segment. The final choice of performance criteria will then
 66

need to be adjusted to accommodate the optimal level of satisfaction for the largest
number of potential customers, incorporating the least amount of variety and
complexity in the final product design.

5.1.1.2 Establishing the Target Profit Margin and Cost to Achieve

After the target price is set, the focus shifts to establishing the target profit margin
and specification of the achievable cost objective. The overall goal is to ensure that
the profitability and return on investment goals of the organization are met by the
new product or service. Specific objectives of this phase include:

determining return on sales objectives; and

linking capital investment planning to profitability and the costs associated with
product development and delivery.

The long-term general profit plan of the organization is the backdrop for the
development of product-line-specific objectives. Specifically, target profit margins
for product line models and the various strategic project plans that together make up
the organizations basic management structure must be determined. Strategic project
plans include new product development plans for each product or service, plant
investment plans, and capital procurement plans. New product development plans are
required for each year of the projected product life.

For example, at Nissan, the corporate development plan coordinates the new-
product life-cycle plans for each vehicle model with long-term profit plans as part of
the long-term profit planning process. Corporate new-product development plans are
required for each year in the projected product life and cover all full model changes
or minor changes that are planned for all target models. Thus, all production and
sales plans for the companys vehicle models are coordinated under one plan that
takes the perspective of the companys overall business strategy.
 67

Coordinating all of an organizations production and sales plans ensures that these
efforts reflect the strategic business perspective. Figure 5.4 details the role of the
target profit management process within a target costing system of a major
automobile manufacturer.

Figure 5.4 Target Costing and Profit Management Process, (Andersen A. ,1998)
 68

Target profit margins must be realistic and sufficient to offset the life-cycle costs
of the product. A useful tool used for establishing target profit margins is a multi-
year product/profit plan.

5.1.1.2.1 Multi-Year Product/Profit Plan. A multi-year product/profit plan integrates

the various product plans, establishes baseline targets for each product over its useful
life, and ensures that the timing of new product releases are staggered to prevent
bunching, while supporting the effective use of company resources. The plan has a
series of inputs and outputs, specifically:

Inputs:

life-cycle plans for the proposed new products;

current position of existing products on cash flow/product portfolio charts; and
estimated values for the companys overall personnel capacity (for design,
prototype development, and production setup work), manufacturing plant capacity,
and new plant investment capacity (including capital procurement ability).

Outputs:

multi-year general profit plan (exact timeframe varies by the nature of the
planning cycle in a given industry);
products/services to be developed and introduced over a certain time period;
target profit for each product or product series;
target return-on-sales ratio for each product;
plant investment plan for each product;
personnel plan; and
overall new product introduction plan.

Figure 5.5 illustrates a multi-year product/profit plan structure. It is an annual

product mix that shows aggregate target profits by year for each product. The sum of
all products in a given year is the annual profit plan, while the total of annual profits
 69

by products is the product life-cycle profit. The product level profit includes all
directly traceable recurring costs (such as materials) and conversion, and
nonrecurring traceable costs (such as special tooling and dedicated machinery and
other costs.)

Figure 5.5. Multi-Year Product/Profit Plan, (Andersen A. ,1998)

Having laid out the parameters for an individual product within the context of the
overall company strategic profit and product plans, attention can turn to calculating
the probable cost of current and new products and processes.

5.1.1.3 Calculating the Probable Cost of Current and New Products and
Processes

A key step in the product planning phase involves the examination of the
organizations cost information in order to generate reliable cost estimates for the
probable costs of current and new products and processes. These estimates may
include production costs, R&D costs, physical distribution costs, and end-user costs.
The underlying objectives during this phase include the following:
 70

determining what a new products costs would be using existing product

specifications and manufacturing processes;
cost modeling; and
analyzing internal costs.

Several core tools and techniques typically used in this effort include:

process (operational) costing;

component cost analysis; and
cost tables.

5.1.1.3.1 Process (Operational) Costing. Process (operational) costing can be used to

identify the cost drivers for each step of the manufacturing process. Process costing
makes no attempt to account for the costs of individual units or specific groups of
products. Instead, all costs are accumulated by operations or processes. These costs
are subsequently allocated from processes to products on a systematic basis.

Process costing directly considers the effects of customer requirements and

differentiates the value-added costs likely to be incurred by serving one group of
customers versus another. The technique includes the impact of requirements on
process characteristics such as capacity. The result of this effort is an economic
model of the organization that clearly defines customer needs and the processes
required to satisfy those needs. The model integrates marketing, operational, and
financial data to better understand the total cost caused by a potential change to the
product matrix.

An advantage of placing the costing emphasis on processes is that the trade-offs

between competing products can be better identified. As the flow of a new product is
tracked through an existing facility, the target costing team can begin to isolate its
impact on existing products to determine where the new demand on resources will
trigger constraints on overall throughput.
 71

The creation of cost estimates for existing or new processes provides the basis for
developing capital acquisition plans and finalizing product profitability analysis.
Table 5.7 provides an example of a process-specific cost list that details prime
assumptions and current demand for parts of the process affected by a new product.

Whether process costing is used to understand the overall impact of a new product
on the existing plant or to estimate the cost implications of various design decisions,
it plays a pivotal role in creating the probable cost estimate for current and new
products and processes.

5.1.1.3.2 Component Cost Analysis. Component cost analysis decomposes the

product level target cost into the major component and parts categories. For example,
a target cost list might be broken down by the following major component categories
and then by more detailed parts categories:

Breakdown of chassis functions: front axle, front brakes, rear brakes, etc.;
Breakdown of body functions: white body metal, bumpers, window glass, etc.;
and
Breakdown of interior functions: seats, air conditioning, interior panels, audio
system, etc.

A major component category may be further broken down into detailed part
categories, for example, breakdown of seat systems:
frame, slide rails, reclining mechanism, trim covers, etc.
 72

Table 5.7 Rate Master List of Process Costs, (Andersen A. ,1998)

 73

Component cost analysis is particularly useful for assembly industries that

purchase thousands of components, parts, and subassemblies. Component analysis
has several important uses. First, it identifies the expensive components of a product.
Second, it focuses on the cost relationships between components. This helps to
determine if decreasing the cost of one component increases the cost of another
component. Finally, it ensures that no outdated or soon to be out-of-production
components are used.

Table 5.8 illustrates a component cost matrix. The cost column reveals the
component cost and the availability column provides the last available date for the
component before it becomes unavailable. The plus or minus entries highlight
positive or negative relationships between the costs of components. A plus sign
indicates that as the cost of the component in row 1 is reduced, the cost of the
component in the column increases. For example, when the cost of component C1 is
reduced, the cost of component C2 increases, but the cost of component C3
decreases.

Table 5.8 Component Cost Analysis (Andersen A. ,1998)

Inputs and outputs required for effective component cost analysis include:

Inputs:
function-specific target cost outline;
actual costs of internal components in existing or similar products;
current costs of purchased components in existing or similar products;
 74

component functional drawings and concept manuals that show that the QFD
objectives are being met;
component-specific comparison of specifications for current and proposed
models;
planned volume of products that will use common components; and
component availability information.

Outputs:
component-specific target costs of in-house components;
component-specific target costs of purchased components; and
component-specific target costs for the complete product.

Table 5.9 provides a breakdown of component costs for a hypothetical

coffeemaker. This information can be used to identify and prioritize cost-reduction
efforts at the component level. Care must be taken to ensure that the sum of the
component-level target costs does not exceed the target cost of the product. Often an
increase in the cost of one component requires an exploration of ways to reduce the
costs of other components by an equivalent amount.

Table 5.9 Component Cost Breakdown (Andersen A. ,1998)

5.1.1.3.3 Cost Tables. Calculating the probable cost of current and new products and
processes depends, in large part, on reliable historical data. Cost tables enable
estimating costs for materials, parts, utilities, and conversion. In essence, a cost table
 75

is a database that defines and depicts the cost effects of using different materials,
production methods, and product designs.

Figure 5.6 shows one branch of a hypothetical cost table. Additional branches
would stem from each of the cost driver alternatives under drilling activity. In
addition, similar branches would be prepared for cutting and lathing. At each
stage, the cost table would show unit product cost split into direct material, direct
labor, and production overhead.

Figure 5.6 Cost Table Structure (Andersen A. ,1998)

There are two general types of cost tables: approximate cost tables and detailed
cost tables. Approximate cost tables emphasize a small number of key variables that
are known to have significant impacts on the final cost of a product, such as the
 76

impact of different engine specifications on the cost to design and produce a

motorcycle.

Relatedly, a detailed cost table includes the relationship between a large number
of variables and their relevant costs. Typically developed over many years, cost
tables are used from the original design throughout the life cycle of the product. They
are updated on an ongoing basis, serving as a critical decision-making aid in the
design and ongoing management of a product portfolio.

Cost tables are typically developed using both internal and external expertise from
across multiple functions, perspectives, and organizations. Since upwards of 80
percent of a products lifecycle cost is set before the product is launched into
production, the time and effort required to develop and maintain cost tables is an
essential investment in current and future profitability.

Combined with computer-aided design (CAD), cost tables can provide for real-
time analysis of the cost implications for a proposed change in product or component
design or redesign. Finally, cost tables are often used to support what if
(sensitivity) analysis at all stages of the product life cycle.

Toyota uses cost tables in five key production steps: machining, casting, body
assembly, forging, and general assembly. The cost tables detail the machine rates for
each step of the production process. These rates include labor, electricity, supplies,
and depreciation costs. The exact form of Toyotas cost tables depends on the type of
production step being analyzed; for example, for stamping, the cost table contains the
cost per stroke while for machinery it contains the cost per machine hour. Toyotas
cost tables are highly detailed, and in most cases, each production line has its own
cost table.
 77

5.1.1.4 Establishing the Target Cost

Once the target market price and target profit have been established, the target
cost can be calculated. The target cost reflects the relative competitive position of the
organization. It also represents the cost at which the product must be manufactured if
it is to achieve the target profit margin when sold. The target cost acts as a signal to
all involved in the target costing process as to the magnitude of the cost reduction
objective that eventually must be achieved. The established target cost should be
attainable, but only with considerable effort. Objectives that drive the achievement of
these goals include:

setting continuous improvement targets;

measuring performance; and
communicating cost requirements.

Target costs can be calculated using the target return-on-sales ratio or a

compilation of estimated costs. In the former case, one of two primary formulas can
be used to set a sales-price-based target cost:
Target cost = target sales price x (1 target return-on-sales ratio)
or
Target cost = target sales price target operating profit.

Relatedly, the target cost can also be calculated by subtracting the per-unit profit
improvement target from the estimated cost, then isolating those costs.

Having established the basic parameters for the target costing system and
identified the appropriate level of execution at which it should be carried out,
attention turns to establishing specific cost and performance targets. A useful tool
that can be used in this step is benchmarking.

5.1.1.4.1 Benchmarking. One of the most important aspects of creating a target cost
for a product or service is guaranteeing, at both the total and component level, that
 78

functionality and costs are competitively established. Benchmarking, which

compares costs of specific products, activities, and outcomes to those of competitive
or best-practice companies, provides valuable input to target costing in this effort.
Issues that can be addressed through benchmarking studies include:

identification of the best practice in completing core and support activities for
the product or service;
establishment of objective cost targets and performance metrics for component
suppliers and internal processes;
definition of quality and delivery parameters for similar products, processes, or
components across comparable industries;
identification of process improvements that can provide quantum improvements
in overall cost and profit performance;
development of innovative analysis and design techniques based on
benchmarking site visits and case studies; and
creation of an ongoing network of organizations capable of supporting current
and future improvements and target costing initiatives.

The benchmarking process has been formalized into several steps by the leading
practitioners. They all use an integrated approach to benchmarking reflected in the
following five general steps:

planning, data gathering, analysis and integration, implementation/ execution, and

re-calibration .

Organizations that are at a significant competitive disadvantage will benefit most

from estimating benchmark costs and calculating the difference between those costs
and their target cost. If the disadvantage is significant, it might not be possible to
reach the benchmark costs in a single generation of product design. Such
organizations will have to adopt a multi-release strategy of product design, setting
ever more aggressive cost targets for each release. The narrowing gap between the
 79

benchmark and the target cost would demonstrate the achievement of competitive
parity.

5.1.2 Product Design and Development Phase

5.1.2.1 Attaining the Target Cost

Once the target cost has been established, the goal is to develop a new product
concept that attains the target cost while meeting all customer requirements. The
process of attaining the target cost is supported by various methods that reveal cost-
reduction potentials and show ways to transform those potentials into design
alternatives.

Key objectives at this stage of the target costing effort include:

optimize the relationship between materials, parts, and manufacturing processes;
minimize costs;
focus design efforts on market-driven variables for quality and cost of
ownership;
link product development with customer desires and to achieving a sustainable
competitive advantage;
link the product development process so that it assures product quality; and
estimate the cost prior to implementation.

Turning the allowable cost target into an achievable cost requires three primary
steps: (1) compute the cost gap; (2) design costs out of the product; and, (3) release
the design to manufacturing and undertake continuous improvement.

5.1.2.1.1 Computing the Cost Gap. Calculating the difference between the target cost
(calculated from the target price and profit margin) and current cost estimates is the
first step in attaining target costs. Using the total, fully absorbed costs as the baseline,
 80

current costs represent the as-is estimate of the cost of producing the product or
providing the service.

The resulting cost gap is decomposed into two primary parts: lifecycle costs and
value-chain costs. Life-cycle decompositions emphasize the total product cost of the
birth-to-death activities performed in research, manufacturing, distribution, service,
general support, and disposal. Conversely, value-chain analysis examines costs based
on whether they are incurred and controlled by the organization or by one of its
value-chain partners (e.g., suppliers, dealers, or disposers). As noted by Ansari, the
two breakdowns take the same total cost but provide two different kaleidoscopic
views of the product cost. Each helps to highlight where cost reduction efforts need
to be focused. Table 5.10 provides a detailed illustration of the cost gap analysis
effort.

Table 5.10 Computing the Cost Gap (Andersen A. ,1998)

Value Chain Inside Outside
Life Cycle Allowable Current Gap Allowable Current Gap
Research and Development 3.60 $ (4%) 5$ 1.40 $
Manufactoring 15.30 (17%) 20 4.7 21.60 (24%) 30 $ 8.40 $
Selling and distribution 5.40 (6%) 6 0.6 12.60 (14%) 17 4.4
Service and support 9.00 (10%) 10 1
Genereal business overhead 18.00 (20%) 19 1
Recycling costs 4.50 (5%) 7 2.5
Total 55.80 $ (62%) 67 $ 11.20 $ 34.20 $ (38%) 47 $ 12.80 $

Value Chain Total

Life Cycle Allowable Current Gap
Research and Development 3.60 $ 5$ 1.40 $
Manufactoring 36.9 50 13.1
Selling and distribution 18 23 5
Service and support 9 10 1
Genereal business overhead 18 19 1
Recycling costs 4.5 7 2.5
Total 90 $ 114 $ 24 $
 81

5.1.2.1.2 Designing Costs Out of the Product. Reducing costs through the product
design stage is the most critical step in attaining target costs. The key to achieving
desired reductions lies in the answer to one specific question: How does the design of
this product affect all costs associated with the product from its inception to its final
disposal? Identifying all costs, whether incurred in distribution, selling, warehousing,
service, support, or recycling, is essential as all of these cost elements, which are
generated by the different functions, are affected by the design chosen.

For instance, the weight and control panel are two elements of a convection oven
that are affected by the products design. A heavy oven will increase loading,
transportation, and installation costs if two people are required to perform these
activities. Relatedly, an elaborate control panel will increase the time required to
explain the products use to customers, as well as increasing the potential for product
support and repair costs, due to failures in electronic and mechanical components.
Finally, the materials used may ultimately pose an environmental hazard that has to
be handled at the point of disposal. All these factors add to the products cost with
little or no improvement in customer satisfaction.

5.1.2.1.3 Releasing Design to Manufacturing and Undertaking Contin. Improv. The

final stage in attaining the target cost is to continue to make product and process
improvements that will reduce costs beyond the point where it is possible through
design alone. It includes eliminating waste (scrap, rework, etc.), improving
production yield (i.e., getting more production from raw materials), and other such
measures.

Achieving cost reductions before production begins is aided by the use of two
specific tools and techniques: (1) design for manufacture and assembly and (2) value
engineering.

5.1.2.1.3.1 Design for Manufacture and Assembly (DFMA). DFMA is an

approach to product design that can improve an organizations ability to compete
based on its manufacturing capability. Specifically, DFMA focuses on reducing costs
 82

by making products easier to manufacture, while holding functionality at specified

levels. DFMA guides development of the detailed product design, ensuring that at
every stage of the assembly and manufacture process minimal cost and waste
elimination targets will be reached.

The DFMA methodology is based on five basic principles:

Reduce the number of parts by combining parts (i.e., multifunction parts). Seek
to combine parts unless separate parts are necessary because they must be of a
different material, move relative to each other, or are necessary to ease assembly or
disassembly.
Assemble from the top down, rather than from the side or bottom.
Design symmetry into parts so that they may be assembled in many orientations.
If this is not possible, be sure they are very symmetrical so they can be easily
oriented and fed.
Design parts to be easily handled and inserted without restricted access.
Use flexible manufacturing processes wherever possible (e.g., powder metal
processing, injection molding, stamping).

Without DFMA, the projected benefits of a new product design may not be attained.
For instance, at an organization making a variety of mechanical counters, a product
was designed that required extreme dexterity to manufacture because multiple wires
had to be encapsulated in a snap-together casing. Once the casing was assembled, it
could not be disassembled (it became scrap). As the product rolled out to
manufacturing, it was found that only one person could produce it reliably. No one
else in the plant could consistently accomplish the task of getting all the wires into
the casing before its closure. The entire production of this item was limited by poor
execution of a good design concept , a failure to apply DFMA.

DFMA enables the attainment of cost targets by finding unique, low-cost, yet
robust ways, to transform product concepts into reality. The benefits it can provide
include:
 83

elimination of excess parts;

active inclusion or development of common parts for a wide range of
applications;
through disassembly, reduction of life-cycle costs for maintaining the product in
the field;
reduction of potential defects and related engineering-change notices to correct
design or assembly problems;
increase in assembly efficiency and effectiveness; and
improve throughput and time-to-market.

DFMA methodology has been successfully applied at many organizations,

including several different development programs within the Boeing Company. In
each case, cross-functional teams were established to develop a new product that
either enhanced performance and/or reduced cost. These specific examples include
737 flight deck air valve, 737 windshield replacement, and 737/ 757 passenger cabin
sidewall panel assemblies. The teams applied the DFMA process in developing their
new products. Table 5.11 shows the top level results from these three different
programs.

Table 5.11. Boeing DFMA Application Results Summary (Andersen A. ,1998)

Program
Measure Valve Windshield Sidewall Panel
Cost Reduction 90% 25% 42%
Part count reduction 79% 10% 45%
Assembly time reduction 94% 70% 22%
Team size 3 people 7 people 5 people
Study duration 5 months 6 weeks 5 months

5.2.1.3.2 Value Engineering (VE). VE is used by organizations to increase product

functionality and quality while at the same time reducing costs. The scope of VE
includes design costs reduction, process improvements and working with suppliers.
The output of VE is a series of improvement plans that raise the value of the target
 84

product. Emphasizing functionality and meeting customer requirements within the

allowable cost parameters, VE goes beyond the particular styles or configurations of
current products to consider the functions that lie at the heart of the product in order
to come up with innovative ways to achieve desired functionality with less cost or
effort.

As suggested by Figure 5.7, VE studies the various requirements of functionality

and quality that occur during the entire life cycle of a product. These include:

user requirements: use-objectives, use-conditions and environments,

performance features, reliability, safety, durability, design, shape, color, etc.;
sales requirements: selling points, competitive performance features,
competitive pricing, and related factors;
design-related requirements: performance levels, addedfunction levels, etc.;
manufacturing-related requirements: processing technologies, manufacturing
processes, and related labor hours, materials, and purchased parts;
distribution-related requirements: packaging, loading, storage, transportation,
etc.;
cost-related requirements: management of progress toward achieving target
costs; and
legal and regulatory requirements: patents and utility models, environmental
protection laws, industry regulations, government guidelines, and related factors.

Table 5.20 illustrates an example of VE cost-cutting ideas that focus on reducing

the number of parts, simplifying the assembly, and not over-engineering the product
beyond what will meet a customers needs.

Isuzu is a significant user of VE. The development of their NAVI- 5 transmission

system, which combines the higher fuel efficiency and performance of a manual
transmission with the convenience of an automatic transmission, used VE concepts.
Specifically, VE was used to develop a Gemini (ceramic) heater that would reduce
the time it took to warm up a cars interior by focusing early heat from the engine
 85

through a secondary heating system that directed warm air at occupants feet until the
engine was warm enough to support the traditional heating system. Also, VE was
used to develop a gear lever that would fold down while the vehicle was stationary
but that would not collapse while the vehicle was in motion.

Figure 5.7 Value Engineering (VE) Framework, (Andersen A. ,1998)

 86

Table 5.12 Value Engineering (VE) Ideas to Reduce Costs

Panel Subcomponent Cost Reduction Idea
Power supply Reduce wattage-more than needed in current design.
Flexible circuit Eliminate flexible circuit. Use iwring harness.
Printed wire board Standardize board specifications. Use mass-produced unit.
Clock timer Combine with printed wire board.
Central processor chip Substitute standard 8088 chip instead of custom design.
Heater connector Rearrange layout of board to heater connection.

Having made the improvements required to transform the target costs into
achievable costs, attention can now turn to achieving continuous improvements on
the plant floor.

5.1.3 Pursuing Cost Reductions Once Production Has Started

The start of production signals the beginning of the cost maintenance phase,
which emphasizes the stabilization of or continuous improvement in product- and
component-level costs. The objective at this stage is to pursue cost reductions
relentlessly at every stage of manufacturing to close any remaining gaps between
targeted and actual profits.

Organizations that have successfully implemented target costing, such as Texas

Instruments and Toyota, note the importance of cost information in cost reduction
initiatives. Key objectives at this stage include:

providing improved product cost information;

providing improved performance monitoring; and
improving understanding of the true cost structure.

A useful tool for this cost reduction effort is activity-based costing/ activity-based
management (ABC/ABM).
 87

5.1.3.1 ABC and ABM

Achieving cost reduction objectives requires information that identifies the causes
of current cost and the potential impact of attacking these cost drivers. ABC and
ABM are valuable target costing tools because they focus attention on how product
design leads to the consumption of various activities and therefore, increases overall
costs. For instance, material handling is related to the number of unique parts
purchased, which is a function of design complexity. 98 ABC and ABM can also be
used to increase the understanding of cost items such as manufacturing overhead,
marketing, distribution, service and support, and general business overhead. Where
ABC and ABM provide inputs to a decision technique for improving the use of
current and anticipated resources, target costing applies this information to change
the nature and amount of currently available resources.

Table 5.13 details the relationship between ABC, ABM, and target costing. The
interaction of reductions in direct costs that remain the primary focus of target
costing and the cuts in, or improvement of, indirect costs and activities under ABC
and ABM creates an ongoing basis for improvement and development of a
competitive cost and profit profile for existing and new products.

Table 5.13 Relationships between ABC, ABM, and Target Costing

Tools Main Purpose Cost Elements Emphasis
Product Cost assignment for
ABC profitability Overhead managerial decision
analysis making
Process Overhead and Process
ABM
reengineering direct costs improvement
Strategic cost Overhead and
Target Costing Cost reduction
management direct costs

At almost every turn, target costing can utilize information available in ABC and
ABM systems to identify current actual costs, analyze the causes of that cost, and
find ways to reduce overall indirect costs by changing the ways products are
 88

designed, developed, manufactured, and sold. Using ABC and ABM in the target
costing process provides the following benefits:

quantification of costs, both value-added and nonvalue-added, by activity, cost

element, component, and product;
identification and estimation of the costs to meet specific customer functionality
and quality requirements;
analysis of the costs of complexity;
measurement of the impact of QFD, DFMA, and VE initiatives on current and
projected costs;
enhanced ability to take action to reduce overhead costs;
support of cost of quality and related analysis, which reflect trade-offs made by
the organization to hit cost targets;
sensitivity analysis, which incorporates the underlying behavior of cost and the
cost of idle or unused capacity to increase the accuracy of target cost estimates; and
creation of cross-functional, process-oriented costing tools that support
brainstorming, concurrent engineering, and kaizen costing efforts.

ABC and ABM are important tools that support target costing. Both tools are
applied on a prospective basis to estimate product and process costs. During the early
stages of product development, ABC is used to estimate product cost at a general
level. This is useful for preliminary evaluation of product feasibility. As product and
process definition become more precise, predictive ABM process cost models are
applied to estimate the costs of particular functions and components using particular
processes. This has been particularly valuable to engineers as they work to reduce
product and process cost, improve utilization of current machines and equipment,
and eliminate waste and process variation.
 89

5.2 The Factors Influencing TC Process

All of the target costing processes documented contain three major steps,
marketdriven costing, product-level target costing, and component-level target
costing.

Figure 5.8 The Target Costing Process (Cooper R.,1997)

Each step has a defined output: allowable cost, product-level target cost, and
component-level target costs respectively. While these outputs are essentially
identical across firms, the process of target costing is more difficult to observe and
varies by firm. There are at least five major factors that apparently influence the
target costing process. Two of these primarily influence the market-driven costing
portion of the target costing process. These are the intensity of competition and the
nature of the customer. The next two factors influence the product-level target
costing process. These are the firms product strategy and the characteristics of the
product. Finally, the last factor, the firms supplier-base strategy shapes the
component-level target costing process.

5.2.1 Factors Influencing Market-driven Costing

The factors that apparently help shape the market-driven costing portion of the
target costing process include the intensity of competition and the nature of the
customer (Figure 5.9). These two factors help determine how difficult it will be to
ensure that products are successful when launched and hence, the magnitude of the
benefits derived from target costing. They also help determine the nature and extent
 90

of the information collected about customers and competitors in the market analysis
portion of the target costing process. It is reasonable to suspect that the intensity of
competition is a factor to consider since it has been shown in other environments to
influence the energy expended on cost management (Khandwalla, 1972).

Figure 5.9 Factors Influencing Market-Driven Costing (Cooper R.,1997)

5.2.1.1 Intensity of Competition

The intensity of competition apparently influences how much attention the firm is
paying to competitive offerings in the target costing process. All of the firms studied
could identify four to six direct competitors who were fairly evenly technologically
matched. These firms had adopted a confrontational strategy because they lacked the
ability to develop sustainable competitive advantages over each other (Cooper,
1995). Three product-related characteristics, referred to as the survival triplet, play a
critical role in determining the success of firms. The survival triplet comprises the
product price, quality and functionality. Quality is defined as conformance with
product specification.
 91

Functionality, which includes service, refers to the degree of success in designing

the product to meet the specifications that customers require.

Figure 5.10 The Survival Zone for a Product (Cooper R.,1997)

A products survival zone (Figure 5.10) is bounded by the minima and maxima of
these three elements. For example, there will be a level of functionality above which
it will be too costly for the firm to operate if it wishes to retain customers by
charging prices that they are prepared to pay. Similarly, there will be minimum levels
of quality and functionality required by customers. In markets with perfect
information and only strictly economic rational customers, the specific customer
trade-offs between price, quality and functionality would be clearly visible and a well
specified functional relationship between values for the three triplet elements could
be set down as the basis for determining strategy. In reality, firms can usually only
identify the approximate position of the maxima and minima of the three triplet
elements. There is in other words, a three-dimensional space within which a product
can succeed that is bounded by the maxima and minima of price, quality and
functionality. Where the minima and maxima are set widely apart, it may not be
possible to detect trade-offs in a precise functional form and it will be more likely
that there will be more than one survival zone with customers forming rivalry
groupings, such as those competing on cost for a minimum quality and functionality
in contrast to those attempting to operate a differentiated product strategy (Figure
5.11). But, increasingly, and especially in markets faced by the Japanese companies
 92

described in this study, competition is very different. Customers have become

more informed, rivals more aggressive and survival zones have been squeezed. In
such a situation, the traditional approach of selecting whether to use a cost-leadership
or differentiated product strategy is no longer available. If a firm wants to survive,
there is no alternative but to compete head on in terms of cost, quality and
functionality.

Figure 5.11 The Survival Zone of the Cost Leader and Differentiators (Cooper R.,1997)

When these conditions exist, certain realities are present (Cooper, 1995):

Profit margins are low,

Customer loyalty is low,
First mover advantages are small,
Product that are launched outside their survival zones fail dramatically.

Under such conditions, the benefits of target costing are potentially high. The low
profit margins and customer loyalty mean that the firm can not afford to make too
many mistakes when launching new products. By transmitting the competitive
pressure faced by the firm to its product designers and suppliers, target costing
increases the probability that new products are inside their survival zones when
launched. In contrast, in environments where the intensity of competition is lower,
 93

non-confrontational strategies, such as cost leadership and differentiation, can be

successful. Such strategies allow for higher profits and increased customer loyalty.
Therefore, the benefits of target costing will be potentially lower in such
environments.

The ability of competitors to rapidly bring out me-too products makes it difficult
for firms to recoup their investments in product development. First, the rapid copying
leads to shorter life cycles and second, the inability to reap first mover advantages
leads to lower profits. Thus, the firm is forced to amortize its development costs over
fewer units that are generating lower profits. Therefore, the ability of the successful
products to offset failures is reduced. This inability creates significant pressure on the
firm to minimize product failures.

Consequently, it is postulated that target costing is particularly valuable for firms

that have adopted confrontational strategies because failure to launch products that
are in their survival zones typically leads to rapid and significant loss of market
share. These losses are driven by the narrow survival zones that result from
equivalent competitors chasing the same customers. In general, it is conjectured that
as the intensity of competition increases, so does the value of target costing to the
firm. For example, Sony has managed to differentiate its products based upon their
superior functionality over those of the firms competitors. This lowered intensity of
competition is thought to be one of the main reasons that Sony has a less well
developed target costing process compared to the other firms in the sample. In
contrast, all of the other firms are in confrontation and, with the exception of Topcon,
have well developed and elaborate target costing systems.

5.2.1.2 Nature of the Customer

There are many characteristics of customers that can influence the intensity of
consumer analysis that is undertaken by firms, but evidence suggests that three are
particularly important in helping determine the benefits derived from target costing.
 94

The first is the degree of customer sophistication, the second is the rate at which
future customer requirements are changing, and the final characteristic is the degree
to which customers understand their future product requirements. These three
characteristics appear to help determine the benefits that a firm can potentially derive
from target costing because they deal with the width, rate of change of location, and
ease of predicting the location of survival zones. Analysis of the practices observed
in the six companies suggests that target costing is particularly valuable for firms that
have to compete in environments that have narrow survival zones, whose locations
are changing rapidly, but are relatively predictable.

5.2.1.2.1 Degree of Customer Sophistication. The degree of customer sophistication

determines how good customers are at detecting differences between the price,
quality, and functionality of competitive products. Sophisticated customers are
highly educated about the product offerings that are available, can detect minor
differences, and will freely switch between manufacturers to buy the products that
best satisfy their needs. Consequently, as customers become more sophisticated, the
survival zones of products become narrower. When survival zones are narrow, it is
easier to launch products that fall outside them and hence fail. To increase the
probability that products are launched inside these narrow survival zones, firms
expend considerable energy on consumer analysis trying to determine the location of
survival zones when the product is launched.

For example, in the automobile industry, the primary characteristic of the survival
triplet used to differentiate products is functionality. Firms compete by continuously
increasing the functionality of their products while keeping the price and quality
essentially unchanged. Customers therefore, have come to expect a steady increase in
product functionality and have quite clear expectations for their future purchases. For
example, to ensure that their products are successful, Toyota and Nissan both expend
considerable energy on consumer analysis to help them identify the future
automobiles that will both satisfy their customers and sell sufficient volumes to be
profitable. The same holds true in the camera industry where most consumers are
highly sophisticated and capable of identifying the exact features they expect in a
 95

new camera. Survival zones are narrow in that industry and there is no price
freedom. For example, Olympus expends considerable energy on collecting
qualitative information about consumer preferences. The firm collects information
about consumer trends from seven sources including recent purchases, professional
photographers, and focus groups. In addition, the firm monitors its competitors
actions closely.

The evidence suggests that target costing becomes especially valuable in

environments with highly sophisticated customers because survival zones are narrow
and therefore, products must be designed that satisfy customer requirements as
closely as possible. For example, without the discipline of target costing engineers
sometimes add extra functionality to the products in the belief that they are attractive
to customers. Unfortunately, these extra features often cost more than the value that
the customer places on them. The outcome of such design improvements is
products that cost too much and therefore have profits that are below expectations.
However, in confrontational environments profits are already low and there is little
room for error, rendering the discipline on the product designers imposed by target
costing critical to firm survival. Therefore, it is postulated that target costing systems
will be especially valuable in environments with sophisticated customers. In
addition, the target costing process will have a strong external orientation in such
environments because understanding the customers requirements is critical. In
contrast, it is postulated that in environments where consumers are less sophisticated,
target costing will not be as beneficial and will be more internally focused.

5.2.1.2.2 The Rate at which Customer Requirements Change. The rate at which
customer requirements change defines how rapidly the location of survival zones
moves over time. When survival zones are moving rapidly, it becomes more difficult
for the firm to predict where a products survival zone will be when it is launched.
This inability makes it more difficult to ensure that new products are inside their
zones when launched than when zones move more slowly. In the automobile
 96

industry, the rate of change of customer expectations is relatively high and therefore,
Nissan samples consumer preferences on a regular basis during the product design
process. For example, the market is sampled when the product is first conceptualized,
just before it enters the product design stage, and just before it enters the production
stage. The primary purpose of these market revisits is to capture how the position of
survival zones has changed since the last survey. The products design is then
modified where possible to increase its probability of success. In contrast, Komatsus
customers are commercial buyers not consumers. They are highly sophisticated and
well aware of their preferences which given the nature of the firms products
(bulldozers and excavators), do not change rapidly. Therefore, it is easier for
Komatsu to keep track of changing customer expectations than it is for an automotive
company. Consequently, Komatsu expends considerably less energy than Nissans or
Toyotas on customer analysis. Consequently, it is postulated that target costing is
more beneficial in environments where consumer preferences are changing rapidly.
Under such conditions it is easier to launch products that are outside their survival
zones. Firms with such customers are forced to expend considerable effort on
predicting future customer requirements. In contrast, it is postulated that when
customer requirements are stable, less effort is required to locate the position of a
products survival mode and target costing provides smaller benefits. Reflecting the
diminished benefits, the target costing systems at these firms are more internally
focused.

5.2.1.2.3 The Degree to which Customers Understand their Future Product

Requirements. The degree to which customers understand their future requirements,
in part, determines the amount of energy expended on customer analysis in the target
costing process. As the degree of understanding increases, it becomes more
beneficial to rely upon espoused customer preferences to determine the future
location of survival zones. In contrast, when customers have little understanding of
their future requirements, firms that pay too much attention to customers risk
launching products that fail because they are outside their survival zones.
 97

In the earth moving business, customers have a high degree of awareness of their
future requirements. For example, Komatsus customers can be relied upon to tell the
firm what needs to be improved in their designs and to a certain extent by how much.
In such an environment, target costing will offer considerable benefits because the
customer is able to specify quite accurately the location of future survival zones. In
contrast, in the consumer electronics industry consumers have a lower degree of
understanding of their future requirements. Consequently, product failures are more
common because the critical attribute often only becomes apparent after the firm has
launched a new product. Consequently, it is postulated that target costing is less
beneficial in environments where the future locations of survival zones are hard to
predict. In contrast, it is postulated that target costing will be more beneficial when
the future locations are predictable.

5.2.2 Factors Influencing Product-Level Target Costing

Based upon the analysis of the target costing practices at the sample firms, it is
conjectured that the factors that help shape the product-level target costing portion of
the target costing process are the firms product strategy and the characteristics of the
product (Figure 5.12). These two factors help determine the nature and extent of the
information collected about historical cost trends and customer requirements. The
product strategy establishes the number of products in the line, the frequency of
redesign, and the degree of innovation in each generation of products. The
characteristics of the product include the complexity of the product, the magnitude of
the up-front investments, and the duration of the product design process.
 98

Figure 5.12 Factors Influencing Product-Level Target Costing (Cooper R.,1997)

5.2.2.1 Product Strategy

The evidence suggests that the firms product strategy is a primary determinant of
the degree of effort expended on target costing and where and how that effort is
expended. Therefore, it is postulated that firms with product strategies that create a
lot of uncertainty about how the customer will react to new products will typically
spend considerable efforts on target costing, while those whose product strategy
creates only a small amount of uncertainty will typically expend less energy. There
are three characteristics of a firms product strategy that analysis indicates help
determine the benefits to be derived from target costing, these are the number of
products in the line, the frequency of redesign, and the degree of innovation.

5.2.2.1.1 Number of Products in the Line. Customers have different requirements

and these can be satisfied by developing products that are either vertically or
horizontally differentiated. Vertically differentiated products differ by the degree of
functionality they provide and their selling price. The higher the price, the higher the
functionality (and perhaps quality) of the product. Horizontally differentiated
products sell at the same price, but deliver a different bundle of quality and
functionality. Relatively small variations in functionality and price are often achieved
 99

by developing optional features; for example, a Corolla with or without a passenger

airbag. In contrast, major variations in functionality are achieved via the introduction
of different product models; for example, a Corolla versus a Camry.

The greater the number of different products1 that the firm supports, the higher
the overall level of customer satisfaction. The evidence suggest that as the number
of products in the line increases, so does the effort expended on target costing
because new product launches occur more frequently. This observation is intuitively
reasonable because target costing operates predominantly at the individual product
level, hence the benefits must derive at that level. For example, Olympus had a
relatively ineffective target costing system prior to the reconstruction of its camera
business. As part of their strategy to reconstruct their camera business they
significantly increased the number of horizontally differentiated products in its line.
The enhanced benefits from target costing that was the outcome of the increased
number of products might have helped motivate the decision to upgrade the firms
target costing system.

An exception to the above observation occurs when customers demand a greater

variety of products than the firm can afford to support. When this condition exists,
the market analysis the firm undertakes must include procedures to identify the
products that are going to be launched. Such procedures are necessary if the firms
overall profit objective is to be met. As the number of products has to be rationed,
the role of the target costing system shifts away from helping ensure individual
product profitability towards helping identify the most profitable mix of products.
For example, at Nissan, computer simulations are used to ensure that the right mix of
products is developed. Thus, it is postulated that target costing is especially
beneficial for firms that have to ration the number of products they produce. In
contrast, it is postulated that firms that can launch as many new products as they
choose will derive lower benefits from target costing.

5.2.2.1.2 Frequency of Redesign. At the heart of the product strategies of the sample
firms is the objective to increase product functionality as rapidly as possible. This
 100

objective is achieved via the rapid introduction of new products with each new
generation incorporating the latest technology and hence providing increased
functionality. In all of the firms, product development times have been reduced to
enable more frequent product introduction to occur. Thus, intense competition has
forced the firm to become expert at developing and launching products at a rapid
rate.

However, this ability has a downside. First, the duration of the manufacturing
phase is short, therefore the time available to generate an adequate return on the up-
front investment is limited and it leads to lower sales volumes of each product. To
remain profitable, the firm must launch a high percentage of profitable as opposed to
unprofitable products.

Second, due to the short product life cycles, there is inadequate time to correct any
errors. If an unprofitable product is launched, it will often remain unprofitable until it
is withdrawn. Therefore, it becomes critical to design new products so that they are
profitable. Consequently, it is postulated that the higher the rate of new product
introduction, the greater the benefits derived from target costing. Therefore, such
firms are expected to have well developed target costing systems that subject the
product design process of all new products to systematic cost reduction pressures. In
contrast, it is hypothesized that firms that rarely introduce new products will not
require formal target costing systems, but will probably apply target costing
principles on an ad hoc basis as required.

5.2.2.1.3 Degree of Innovation. The degree of innovation in each new product

generation helps determine how much historical cost information can be used to
estimate future costs. As the degree of innovation increases, information about past
products becomes less valuable. Especially, for revolutionary products that rely upon
completely new technologies, historical cost information about earlier products will
have little value. Similarly, customer, competition, and supplier information can be
invalidated by significant innovations in product design. In contrast, for products that
are similar to the ones that they are replacing, the past is often highly predictive of
 101

the future and value engineering techniques such as functional analysis, which
depend upon the use of the same technology, can be applied.

Target costing is most difficult to apply to revolutionary products. First, target

selling prices are often difficult to establish because the value to the customer of the
new product is difficult to estimate. Second, because the firm has never applied the
technology in its products, historical cost information is not available and third, a
higher percentage of new suppliers are typically involved. When the new model does
not rely upon existing designs, the target costing system is of less value as more
intuition as opposed to hard facts is required. For example, when Toyota introduced
the Lexus, they were able to derive less benefits from target costing because of the
high degree of innovation in the new vehicle. When the degree of innovation is low,
then the target costing process becomes relatively straightforward. First, the selling
price of the new product is primarily determined by the selling price of the product it
replaces and second, historical cost information is highly predictive of the costs of
the new products. Third, the suppliers are typically unchanged. For example, most
new Walkmans are essentially technologically equivalent to the ones they replace.
Therefore, Sony derives less advantage from target costing than Nissan or Toyota
where the level of innovation in each new product generation is higher. It is
postulated that target costing has increased benefits in environments where the
degree of innovation is relatively low and decreased benefits when high.
Furthermore, in environments where the degree of innovation is low, the target
costing system will rely more heavily upon historical information than in
environments were the rate of innovation is higher.

5.2.2.2 Characteristics of the Product

There are three characteristics of the product that apparently have a particularly
strong influence on the benefits derived from target costing and the way it is
practiced. These characteristics are the product complexity, the magnitude of up-
front investments, and the duration of the product development process. The
 102

complexity of the product captures how difficult it is to manage the product design
process. The magnitude of up-front investments captures the amount of capital
consumed in the research and development process, getting ready for production, and
actually launching the product. The duration of the product development process
captures the time it takes to go from product conception to release to production.

5.2.2.2.1 Product Complexity. Product complexity captures the number of

components in the product, the number of distinct production steps required to
manufacture it, the difficulty of manufacturing the components it contains, and the
range of technologies required to produce them. As the complexity of the product
grows, there are two major reasons that the benefits of target costing increase. First,
the degree to which costs can be influenced in the product design stage versus the
manufacturing stage increases. Second, it becomes more difficult to manage the
product design process and ensure that component-level target costs sum to the
product-level target cost. Therefore, the benefits of target costing are expected to
increase with the complexity of the product. However, as the complexity increases,
so does the cost of applying target costing at the component level. Fortunately, there
are ways to simplify the target costing process to reduce the effect of product
complexity by only performing detailed target costing on two or three representative
variations, as opposed to all of them.

Consequently, as product complexity increases, it is postulated that target costing

becomes more beneficial and ways to reduce the costs of performing target costing
emerge. Toyota, Nissan, and Komatsu manufacture products that are considerably
more complex than the other firms. Their target costing processes reflect this
increased complexity by being more formalized. This formalization helps the firms
cope with the large number of components that have to be subjected to target costing.

5.2.2.2.2 Magnitude of Up-Front Investments. As the magnitude of the up-front

investment increases, the number of products that a firm is willing to launch typically
will decrease because the firm will be less willing to take risks. Consequently, firms
that produce products that have high up-front investments typically develop a fairly
 103

small range of products, each carefully designed to satisfy a specific market segment.
For firms that have products with high up-front investments target costing will have
increased benefits, because every product has to have the maximum probability of
being successful. In contrast, when up-front investments are small, the benefits of
target costing are lower. Furthermore, for firms with product with high up-front
investments that have short manufacturing lives, target costing is even more
important because it is critical that the products launched have both adequate profit
levels and sales volumes. Under such conditions, careful product selection is critical
and target costing can play an important role in helping ensure that product
profitability is adequate.

Finally, for high up-front investment products, life cycle analyses are especially
important. Therefore, it is postulated that life cycle target costing is more commonly
practiced in such firms than those producing products with low up-front costs. For
example, Nisan uses life-cycle analysis to justify the launching of new automobiles,
whereas Sony does not.

5.2.2.2.3 Duration of Product Development. The length of time it takes to develop a

new product also helps determine the benefits derived from a target costing system.
As the duration of design gets longer, the probability that the market conditions that
were used to validate the design of the new product might change increases.
Therefore, for products with long development cycles, such as automobiles and
bulldozers, the target costing system needs to contain several stages at which market
conditions are reviewed. In contrast, for products with short development cycles,
such as cameras and consumer electronics, fewer reviews are required. Thus, as the
product design cycle increases in length, the target costing system typically becomes
more complex with greater interaction with the marketing function.

The product development cycle for automobiles is relatively long at six years.
This extensive period required multiple reviews of market conditions and decision
points about continuing the project. For example, at Nissan and Toyota reviews
occur at the beginning and end of the conceptual design stage and during the product
 104

design stage. In addition, just prior to entering production, a final adjustment to the
new model specifications is undertaken to make sure that it achieves its target cost.
Consequently, just prior to product launch, the firm decides exactly which features
will be treated as optional versus standard. This fine tuning ensures that, where
possible, the target cost will be achieved and that the new model satisfies the
customer.

It is postulated that longer product development cycles make target costing more
beneficial because the long time between design and launch increases the risk that
unsuccessful products will be launched. In addition, it is postulated that longer
product development cycles typically lead to more formal target costing systems with
multiple decision points reflecting a disciplined product development process. Even
when the duration of product development is short, as is the case with Olympus
cameras, there does not appear to be any significant delays introduced into the
process by target costing. The target costing process is so integrated into the market
analysis and product development processes that most if not all of the extra time
required by the target costing process can be undertaken in parallel.

5.2.3 Factors Influencing Component-Level Target Costing

The analysis indicates that the component-level target costing portion of the
process is most influenced by the supplier-base strategy of the firm. This strategy
helps determine the benefits that can be derived from component-level target costing
because it shapes the amount of information that the firm has about the costs and
design capabilities of its suppliers.

5.2.3.1 Supplier-Base Strategy

There are three aspects of the supplier-base strategy that have a particularly strong
influence on the benefits derived from component-level target costing (Figure 5.13).
These characteristics are the degree of horizontal integration, the power over
suppliers, and the nature of supplier relations. The degree of horizontal integration
 105

captures the percentage of the total cost of the firms products that are sourced
externally. The power over suppliers helps establish the ability of the firm to legislate
selling prices to its suppliers. Finally, the nature of supplier relations deals with the
degree of cooperation that the firm can expect from its suppliers and in particular the
amount of design and cost information sharing.

Figure 5.13 Factors Influencing Component-Level Target Costing. (Cooper R.,1997)

5.2.3.1.1 Degree of Horizontal Integration. Lean enterprises are typically

horizontally not vertically integrated. Therefore, they buy a large percentage of the
inputs required to produce their products from external sources. The higher reliance
that lean enterprises place upon external suppliers increases the importance of
supplier management and hence, component-level target costing. Evidence suggests
that the potential benefits that can be derived from component-level target costing
are increased for two primary reasons. First, since a greater percentage of the product
is externally sourced, there are greater potential savings because target costs can be
developed for each of the externally acquired components and used to help create
pressure on suppliers to reduce their prices. In contrast, in vertically integrated firms,
it is often difficult to put effective pressure on the other divisions to reduce their
costs. Second, the returns from focusing supplier creativity are greater. Suppliers not
only provide a higher percentage of the firms products, they are also responsible for
 106

a greater portion of the design. For example, Komatsus suppliers are now asked to
design and produce complete engine cooling systems instead of producing individual
components such as radiators, electric motors, and fans.

5.2.3.1.2 Power over Major Suppliers. The relative power of buyer-supplier relations
determines how much energy is expended on determining purchase prices for
components. When buyer power is high, it is hypothesized that buyers will expend
considerable energy developing component-level target costs (i.e., purchase prices)
for purchased components. In contrast, in industries where production volumes are
low and buyer power is low, the firms will expend less energy on developing target
costs for purchased components because suppliers will not accept them as the selling
prices for their products (unless they provide adequate returns). Therefore, it is
postulated that the more power the firm has over its suppliers, the more benefits it
can derive from target costing by using it to create cost pressures on its suppliers. In
contrast, it is postulated that when a firm has little power over its suppliers, the
benefits of target costing will be reduced. For example, Topcon due to the low
volume of specialty ophthalmic equipment it sells has little power over its suppliers
and therefore expends little energy on developing component-level target costs. In
contrast, the other firms have considerable power over their suppliers and have
sophisticated component-level target costing systems.

5.2.3.1.3 Nature of Supplier Relations. The evidence suggests that as supplier

relations become more cooperative, the target costing process in general and, in
particular, the component-level step become richer and more beneficial. At the heart
of the increased benefits lies the ability of the two firms to combine their design
creativity to find superior ways to reduce costs. For example, Komatsus design
engineers frequently visit their suppliers and help them with design problems. In
addition, in cooperative relations it can be supplemented by a number of inter-
organizational cost management techniques. These other mechanisms primarily
enable product designers and suppliers to pool their expertise to find creative
solutions to increase functionality and quality or reduce costs through joint meetings
and frequent interactions. When used in this cooperative setting, component-level
 107

target costing still places suppliers under considerable cost pressure. However, this
pressure is offset, to some extent, by the product designers helping suppliers to find
ways to achieve their cost reduction objectives. In contrast, in adversarial supplier
relations, while component-level target costing can be used to force selling prices on
the firms suppliers, there is no mechanism to take advantage of any synergy
between the designers.
 CHAPTER SIX
CASE STUDY

6.1 Objective of the Case Study

The objective of the case study is to apply target costing to a real life situation of
product redesign. The analysis is conducted retroactively on the product redesigning
of DEKORPANs D-ELK-9 towel radiator.

DEKORPAN is a manufacturer of towel radiators. The D-ELK-9 towel radiator is

manufactured by Dekorpan during the late 90s was the D-ELK-9, and it did not meet
the increasing demands of customers. This required DEKORPAN to introduce an
improved version of the D-ELK-9 , known as the D-ELK-10 .

This case study retroactively analyzes the design process of the D-ELK-10 towel
radiator model from the D-ELK-9 model using target costing to determine the
insights target costing could have provided to DEKORPAN today.

6.2 Introduction to DEKORPAN

The towel radiators that considered as the principal indicator among the functional
and aesthetics features of stylish and modern life , are produced as an independent
industrial item by DEKORPAN, which is a leading company in its sector all around
the world.

When examining the company profile of leader DEKORPAN ,which targets a

perfection in design , production and system quality , you will notice, both for your
personal and commercial needs, the signs of meticulous production and service
quality, then explore, in a wide range of products, the immaculate optimization of
design, capacity, quality and price.

108
 109

DEKORPAN, carrying on its commercial activities with a plant having 15.000 m2

closed area, 750 personnel and 3.500 pcs/per day production capacity in Kemalpaa-
izmir , has an inaccessible status among the EEC countries. Knowing well that
preserving a leadership is harder than having it, DEKORPAN , by its self experience
and skill, has succeeded to form her own design and production technologies, on a
sound, highly dynamic superstructure and institutional body and then , with % 95 of
her production, has obtained and deserved a unique market share , firstly in UK and
among other leading EEC countries such as Germany, France, Italy, Spain and
Greece.

With her modern investments and highly professional management and

production staff, DEKORPAN is fully capable to meet her customers needs in
various design, specification, high production quality and suitable prices , and
besides these, is the first and only producer having ISO 9001 (2000) certificate in the
sector. Furthermore, DEKORPAN towel radiators are produced under a conformity
certificate providing TSE_EN-442 norms.

The meticulous production, starting from quality raw material, passing the special
welding and polishing phases in black production, ends in a world famous chromium
coating plant , specially designed by DEKORPAN for only towel radiators and also
fully automatic electrostatics powder paint plant , designed by expert industrialists.
One of the main feature of DEKORPAN production that gains appreciation is the
utmost care given to the raw material and the process that subject to the highest
quality criteria, with contemporary devices, equipped as per the latest technology ,
used for product controls.

On the other hand, apart from the serial production, DEKORPAN, having a
special design supported by an effective production capacity, forms an excellent
source for the architects who design Turkish and European interiors.
 110

6.3 Problem Statement

Product redesigning and development is a continuous process and this process

started for D-ELK-9.

The current report takes the goals established by the management and tries to
redesign the D-ELK-9 to compete with the competitors products. The actual re-
designing is considered outside the scope of the current report. But the report
identifies the components that required redesigning and the components that require
to be made cost efficient.

Target costing was used to lead a customer-focused pricing system in order to

improve the current model of the D-ELK-9. The data used for the analysis is
obtained from DEKORPAN. Hypothetical estimates were made assuming myself as
the customer where data is not available.

Figure 6.1 Basic DEKORPAN Electrostatic/Chrome Flat towel radiators

 111

6.4 Applying Target Costing in Product Design

6.4.1 Product Strategy and Profit Planning

The objective of DEKORPANs re-designing effort is to increase its market share

in the segment of towel radiators, especially in the category of electrical towel
radiators.

Rapid industrialization led to an increase in the demand for towel radiators are;

The heating need for towels and bathroom increasing all over the world
because of the moisture.
Most attractive and decorative than towel rail.

6.4.2 Product Concept Development and Feasibility

As mentioned earlier, this section selects the best feasible product concept from
various alternatives, if available. In the current case study, new product concepts that
satisfy customer requirements are not considered. Instead the current product is
analyzed for re-design to meet customer requirements.

The preliminary list of customer requirements can be obtained by analyzing the

life of the product using the Pugh Method. The basic list of customer requirements
considered by DEKORPAN is as follows:

Better heating performance

Lower owning and operating costs
Greater comfort / ergonomics
Increased operator and environmental safety
Attractive appearance
Aesthetics
Modular design
 112

More tubes
Bigger profiles.

Some of the major customer requirements are technically established to analyze

product concepts and they are:

Heating power (Watt) > 400.

Output (Kcal) > 350.
Better surface cover.
Less energy expences.

Two basic approaches for redesigning the D-ELK-9 were considered;

First, Dekorpan could use the basic D-ELK-9 model and to add some
modifications to meet the performance requirements.
The second concept consisted of complete re-designing; this would involve
greater effort from the Research and Development (R&D) department.

The target price for the new model is incrementally established based on the
current model (D-ELK-9). The D-ELK-9 in 2005 was priced at $ 25.90. And the
hypothetical price a customer is willing to pay for every improved physical attribute
is listed in table.

Table 6.1 Target prices for functions (hypothetical personal estimates)

1 Better heating performance $7.50

2 Lower owning and operating costs $2.00
3 Greater comfort / ergonomics $1.50
4 Increased operator and environmental safety $1.00
5 Attractive appearance $1.00
6 Aesthetics $2.00
7 Modular design $0.50
8 More tube $0.50
9 Bigger profile $0.50
10 Other factors $2.00
TOTAL $18.50
 113

The incremental pricing technique is currently not in practice due to the heavy
competition. This is particularly true for the computer industry. But in the late 70s,
the price of tractors was increasing and the customer was willing to pay the increase
in price for a better model.

The price a customer is willing to pay for the new product, the Target Price, is
obtained by adding all the prices of improved physical attributes to the price of
D-ELK-9,

$ 25.90 + $ 18.50 = $ 44.40

and it is calculated to be $ 44.40 . The desired profit is usually determined by the

financial rates of return. In the current case study, ROS is used to measure the
desired profit to be $ 8.88 at 20% (over sales price). The target cost is then estimated
using the equation;

Target cost = Target Price Desired Profit

= $ 44.40 - $ 8.88
= $ 35.52

Product concepts must be analyzed to see if they can be manufactured within the
target cost. Product re-designing concept 1, that involves scaling up, can meet the
target cost (estimated, exact cost not available) as the manufacturing processes are
the same.

The re-designing concept 1 would not involve any changes in the processes,
materials, work-methods and many components can be made common with the
D-ELK-9. The requirement by R&D and the risk of marketability will be less. But it
involves some major tradeoffs, such as the increased weight makes it hard to operate,
increasing wear and making it cumbersome to assemble or transport. No real
estimates for the cost of manufacturing the first concept are available and it was
 114

assumed to be $ 37.5. This cost almost meets our requirement of target cost. But it
would have been very difficult to manufacture such a large tractor. For example, a
tractor-size link would have been needed for the scaled-up D-ELK-10 and was
considered impractical. In this scenario,

Concept 2, involving re-designing becomes our only option. For the purpose of
the case study, the initial estimate for manufacturing concept 2 is taken to be $ 40.

Concept 2 Profitable = ( 44.40 40.00)/44.40 = about 10%

This makes our concept profitable (to about 10%) and further efforts must be
taken to increase the profit margin to 20% as desired. The next step determines
design specification based on customer requirements. It also identifies potential
candidates for cost reduction.

6.4.3 Product Design and Development

DEKORPANs list of customer demands is shown in Table 6.2.

 115

Table 6.2 List of customer attributes

Performance / Capability Safety / Environment
a. Productive a. Sound
b. Efficient b. Safety
c. Predictable c. Temperature
d. Versatile
e. Severity capability

Operating Costs Perceptions / Impressions

a. Reliable a. Technology Leader
b. Serviceable b. Apperance
c. Durable c. Quality
d. Maintainable
e. Repair costs Costs
f. Electric Economy a. Lower costs

Comfort / Ergonomics Others

a. Comfortable
b. Operable
c. Quiet
d. Visibility

The customer requirements listed above are correlated to product

components/functions so as to determine the candidates for major redesign using
QFD. The resultant QFD table is shown in Appendix Table 6.3.

The important customer requirements are listed on the left-hand side of the table
and the point to which (on a scale of 5) these requirements are satisfied
(hypothetical) in the current (D-ELK-9) and new (D-ELK-10) models is listed on the
far right side. The desired level (D-ELK-10) is divided by the current level (D-ELK-
9) to obtain the ratio of importance.

Some functions are more marketable than others are and due weight should be
given to user-preferences. This weight is given by multiplying the ratio of
importance by a value known as Sales point. The sales point, which is the marketing
weight, for each customer requirement is determined hypothetically and multiplied
 116

with the ratio of improvement to obtain the absolute weight. Ideally, sales point
should be limited within the range of 0.5 to 1.5 to avoid excessive influence of
marketing. In the current analysis, a constant sales ratio of 1 is considered, as the
marketability of functions is not precisely known. This makes the absolute weight
equal to the ratio of improvement. The demanded weight for every requirement is
calculated as a percentage of the total absolute weight. These values are determined
hypothetically in the analysis.

The complete list of components or assemblies is taken on top of the table and the
extent to which every component effect the performance of a customer requirement
(correlating value) is mentioned in the body of the table. These correlating values are
also hypothetical and are multiplied with the demanded weight of every requirement
and added along the column.

The customer requirements are correlated to components. For example, Bigger

Profile helps improve the performance and is strongly correlated (9). The decreased
wear will result in lower costs and it is less strongly correlated to Bigger Profile (3)
similar to perceptions. Final cost is strongly influenced (9) due to the costs incurred
in designing Bigger Profile, and ergonomics improved due to the improved commort
(1). Similarly, correlation between customer requirements and all physical
components considered for re-designing is established.

The ratio of importance is determined by dividing the level of satisfaction to be

obtained for the new model by the current level. For example, the performance is
currently at a level of 2 on a scale of 5 and the new model will achieve a level of 5.
This will give a ratio of importance of 2.5 for performance capability. Similarly, the
ratio of importance is calculated for the other functions. The ratio of importance is
multiplied by the sales point to get absolute weight. The demanded weight is
calculated as the percentage of the total of absolute weight.

The values of correlation are multiplied by the demanded weight and added up
along the column. The relative importance of every component is obtained by
 117

calculating the percentage of the totals. For example, the sum of 9 times 22.9, 3 times
12.2, 1 times 18.3, 3 times 9.2 and 9 times 6.9 obtains the total value for Bigger
Profile. The current analysis lists the important components based on the correlating
values, which are determined hypothetically.

Based on the hypothetical values, the major components that need to be

considered for re-designing are , heating performance, more tubes and reparability of
equipment. The actual process of re-designing is technical and is considered out of
scope for the current report. But, it is supposed that the re-designing is done to meet
the customer requirements and the report proceeds to identify potential cost reduction
candidates.

After the re-designing, the costs of manufacturing components are related to the
importance of components so as to identify potential cost reduction candidates. This
is achieved by using value engineering and the detailed calculations of value
engineering are shown in the appendix.

The weight of each function is determined based on the total functionality and the
values are determined hypothetically. The sum of the weights should equal the
number of involved functions (7 in the current case). The contribution of each
component to the satisfaction of a function is determined. The sum total contribution
of all components for every function should equal a value of 100. The percent
importance of a component is determined by the sum total of the product of the
contribution of the components with the importance of every function. The percent of
total cost consumed by a component is divided by the percent of importance to
obtain the value index for that component. All the values in this analysis are
hypothetical. The Table 6.4 illustrating the calculation of value indices for different
products is shown below.
 118

Table 6.4 Value Indices of components (hypothetical)

% of total % importance Value

cost of components index
Components
Bigger Profiles 12.50 12.11 1.03
Better Heating Performance 7.50 22.71 0.33
More Tubes 15.00 15.61 0.96
Thickness of Tubes 10.00 6.07 1.65
Thickness of Profiles 7.50 4.82 1.56
Shapes of Profile 7.50 4.82 1.56
Transportation (modularity) 10.00 4.89 2.04
Repair (ease and costs) 10.00 6.11 1.64
Materials 2.50 2.41 1.04
Frame Size and Weight 5.00 3.98 1.26
Package 5.00 4.64 1.08
Overall Safety 5.00 5.75 0.87
Optional equipment 2.50 6.07 0.41
Total 100.00 99.99

Potential cost reduction candidates are the components with value indices greater
than 1 and they are drive train, bulldozer, ripper, modularity, repair, and frame size
and weight. Supposing that the cost of manufacturing the mentioned components is
reduced to obtain a value index of 1, the present cost of manufacturing is calculated
as shown in Table 6.5 (based on hypothetical value engineering tables):

Table 6.5 Cost reductions obtained by component

Value current new

Components index cost cost
Thickness of Tubes 1.65 4 2.43
Thickness of Profiles 1.56 3 1.93
Shapes of Profile 1.56 3 1.93
Transportation (modularity) 2.04 4 1.96
Repair (ease and costs) 1.64 4 2.44
Frame Size and Weight 1.26 2 1.59
TOTAL 20 12.28
 119

The reduced cost of manufacturing is then calculated to be

=20.00 12.28 = $ 7.72

Cost Of Manufacturing ; 40.00 7.72 = $ 32.28.

So; The profit margin at this cost is ;

= (44.40-32.28) / 44.40 = 27%

6.4.4 Recommendations for Cost reduction

Some recommendations for reducing the cost of manufacturing the above

mentioned components are as follows.
1. Different materials can be investigated to reduce the cost of manufacturing.
2. The customer demands and needs of a operators station must be listed from the
QFD or value engineering table along with their importance. This process will help
us in concentrating our efforts on the correct issues.
3. Transportability can be studied along with the marketing department. The
amount of transportability required for an international market will be greater than a
national market and our efforts must be in proportion to the area of the market
covered.
4. The components that are most fatigued must be made modular and more
serviceable to provide for easy replacement.
5. The transportability can be studied from a servicing perspective and the method
by which spare parts and tools are distributed should be analyzed. The spare parts
must be available separately, but must be easy to assemble.
6. The value engineering table must be made dynamic to verify the cross links
between the several components and functions instead of a one time thing.
7. The service department can be contacted and most wearing parts can be
identified to improve performance.
8. Implement concurrent engineering to avoid the designing of similar part by
various departments.
 120

6.4.5 Production and Logistics

This step of target costing is the actual implementation phase. The approved
product concept is taken and the designs are set in production. Data is collected to
verify the costs and performance of products. Opportunities for further improvement
are identified during implementation.

If the costs of production vary from the estimates, the value-engineering phase
must be conducted again in order to reduce the total manufacturing costs. As the new
product becomes old, competition catches up and the company needs to add more
features and reduce the prices for old features. This constant process of updating a
product should be carried on in order to stay ahead of competitors.

6.5 Case Study Results

Retroactively analyzing the customer requirements and the feasibility of the

product concepts, it is more beneficial to re-design the D-ELK-9 than to make a
scaled up version. The target costing analysis achieved the following:

1. Compared different concepts based on manufacturing feasibility along with

their profit making ability.
2. Applied QFD and identified components to be re-designed based on customer
requirements. It is known that these were the components that were re-designed to
achieve the desired profit in real life. Conducting a target costing analysis would
have helped the Dekorpan designing team in identifying the components to be re-
designed.
3. Identified potential cost reduction candidates to obtain the desired profit. If the
cost of manufacturing in reality was higher than the selling price, value engineering
would have helped DEKORPAN in cost reduction. However, no data is available to
compare the real cost of manufacturing to the estimates.
 CHAPTER SEVEN
CONCLUSION

Target costing seeks to anticipate costs before they are incurred, continually
improve product and process designs, externally focus the organization on customer
requirements and competitive threats, and systematically link an organization to its
suppliers, dealers, customers, and recyclers in a cohesive, integrated profit and cost
planning system.

Target costing is the means to achieve competitive advantage through active

management of the unavoidable trade-offs and constraints faced by any organization
providing goods and services to the market. Emphasizing proactive, rather than
reactive, cost containment, target costing ensures short- and long-term profitability
and success by putting customer needs and functionality first, using them to drive the
design, development, manufacture, and provision of products. Target costing
redefines the competitive playing field a challenge that cannot be avoided, only
enjoined.

This report explained the process of target costing and mentioned the aspects to be
considered during the implementation of target costing in a manufacturing firm. It
also illustrated the process of applying target costing with a real life analysis. It is
hoped that the illustration of the process along with the analysis will help industries
in implementing target costing.

Some aspects not covered by the current report include the measurement of
product life cycle costs and the establishment of organizational and employee
preparedness. The importance of product life cycle costs depends on the type of the
product. The costs of ownership were considered. But, the costs of disposal and
environmental effects were not considered. Methods to analyze organizational and
employee preparedness were mentioned. But, precise methods for evaluating
software, employee understanding of target costing, etc. are not mentioned. The case
study does not address the change of customer attributes over the life cycle of the

121
 122

product. Last but not least, the actual process of designing is not described, due to the
involved complexity.

The process of target costing and the case study illustrate the following points:
The feasibility and the method of integrating product designing and
manufacturing into the overall planning.
Application of QFD to provide the designing team with goals.
Designing takes the concerns of manufacturing from the initial stages of
concept development..
Identifies the components / functions to be designed or innovated.
Identifies the components / functions to reduce the costs.
Increases the understanding between functional departments.

It is finally concluded that target costing will provide a company with the means
to improve decision making by structuring the process of product introduction and
designing.
 123

REFERENCES

Andersen A. (1998). Tools and Techniques for Implementing Target Costing,

Institute of Management Accountants.

Ansari S., and J. Bell, (1996), CAM-I Target Cost Core Group, Target Costing: The
Next Frontier in Strategic Cost Management (Homewood, IL: Irwin).130-135

Ansari S., (1997), M.D. Ferguson and P.A. Zampino, Target Costing: The Next
Frontier in Strategic Cost Management, Chicago: Irwin Professional Publishing.
72-76

Carr. C. And C. Tomkins,(1997), Reflection on the papers and a commentary on the

state of strategic accounting. Management Accouning Research. 271-280

Cooper R.,(1997), Factors Influencing the Target Costing Process , Study of

U.S./Japan Relations in the World Economy.16-25

Cooper R., and R. Kaplan, (1999), The Design of Cost Management Systems, (Upper
saddle River, NJ: Prentice Hall).52-55

Cooper R. and Slagmulder R. ,(1997), Target Costing and Value Engineering,

Portland: Productivity Press and Montvale, NJ: The IMA Foundation for Applied
Research, Inc. 81-85

Cooper R. and Chew W.B., (1996) .Control Tomorrows Costs through Todays
Designs, Harvard Business Review , 88-97.

Frank T., (1998), Accounting and Financial Management: Finding the Projects
Bottom Line, The Technical track, 101 127.

Goldratt E. and Cox J.,(1984), The Goal

 124

Horngren C. T., S. M. Dadar, and G. Foster, (2003), Cost Accounting: A Managerial

Emphasis.

J. M. Brausch, (1994) Target Costing for Profit Enhancement, Management

Accounting, (November 1994):45-49.

Jorgensen T., and W. Stein, (2000), Improving Cost Estimation by Taking into
Account Managerial Flexibility, European Journal of Operational Research, 127,
pp. 239 251.

Kaplan, R. and A.A. Atkinson, (1998), Advanced Management Accounting, (Upper

saddle River, NJ: Prentice Hall).

Kinsella, S.M., (2002), Activity Based Costing: Does It Warrant Inclusion in A Guide
to the Project Management Body of Knowledge (PMBOK Guide)? Project
Management Journal, Vol. 33, No. 2, (June), pp. 49-56.

Laszlo, G. P., (1997), The Role of Quality Cost In TQM, TQM Magazine, 9(6), 410 -
413.

Monden Y. and Hamada K., (1991), Target Costing and Kaizen Costing in Japanese
Automobile Companies, Journal of Management Accounting Research . 16-34.

Nixon B., (1998). Research and Development Performance: A Case Study,

Management Accounting Research, 9, 329 355.

Pugh S. ,(1991). Integrated Methods for Successful Product Engineering,

Wokingham, England, Addison-Wesley Co.

P. Horvath, (1994). Advanced Target Costing: CAM-I State of the Art Review,
CAM-I Publications.
 125

Raz T., and D. Elnathan, (1999), Activity Based Costing For Projects, International
Journal of Project Management, Vol. 17, No.1. 61 67.

Sakurai M. ,(1989). Target Costing and How to Use i, The Journal of Cost
Management (Summer 1989): 3.1-3.12.

Sakurai M. ,(1995). Integrated Cost Management: A Company wide Prescription for

Higher Profits and Lower Costs, Productivity Press 1995

Sakurai M. ,(1995). Measures of Organizational Improvement: Emerging cost

management techniques, Productivity Press 1995.

Sakurai M. ,(1992). The Concept of Target Costing and Its Effective Utilization,
Senshu University, Tokyo, Japan.

V. Amara (1998). Target Costing For Product Design, Virginia Institute Blacksburg,
Virginia

Worthy F. S. ,(1991). Japans Smart Secret Weapon, Fortune 72-75.

APPENDIX

Table 6.5: QFD table to identify candidates for the re-design of a towel radiator

Ratio of Importance(Improvement)
Better Heating Performance

Transportation (modularity)

D10 Model (on a scale of 5

D9 Model (on a scale of 5
Repair (ease and costs)

Frame Size and Weight

Thickness of Profiles
Importance (weight)

Thickness of Tubes

Optional equipment

Demanded weight
Shapes of Profile

Absolute Weight
Bigger Profiles

Overall Safety
More Tubes

Sales Point
Materials

Package
Customer requirements
Performance / Capability 9 9 3 3 3 3 1 3 1 2 5 2,50 1 2,50 22,9
Owning and Operating Costs 3 3 9 1 1 1 3 9 1 1 3 4 1,33 1 1,33 12,2
Comfort / Ergonomics 1 1 9 1 1 1 9 3 2 4 2,00 1 2,00 18,3
Safety / Environment 3 9 3 4 1,33 1 1,33 12,2
Perceptions / Impressions 3 3 3 3 3 3 3 3 3 3 3 3 3 1,00 1 1,00 9,2
Costs 9 9 9 3 3 1 3 3 3 4 3 0,75 1 0,75 6,9
Others 1 1 1 3 2 4 2,00 1 2,00 18,3
Total 2523 350 350 469 108 147 147 64 273 74 28 115 204 193 10,91 100,00
Percentage (%) 13,87 13,87 18,59 4,28 5,83 5,83 2,54 10,80 2,93 1,09 4,56 8,09 7,65
Company now
Competitor 1/ (D9)
Plan (D10)
9-Strongly Related , 3-Less Strongly related , 1-Weakly Related

126