Decision Making – Pricing Decisions and

Cost Management

Case - Nissan Motor Company Ltd.: Target Costing System

Overview

• This case describes the target costing system at Nissan Motor Company, Ltd.
• The case starts by describing the firm’s approach to consumer analysis and how
that analysis is used to identify the range of products the firm decides to sell.
• It then describes in-depth the target costing process at Nissan, including the
setting of target prices, margins, and the deconstruction of a proposed
product’s target cost to the component level.
• The development of target costs at different stages of the production process
up to the point at which the product is released for manufacture are also
described.
Objectives of this case

• The concepts of target costing.

• The factors that help shape the range and nature of products that Japanese firms
sell.
• The mechanisms firms use to deconstruct target costs for new products into
target costs for the components they contain.
• The processes used to determine the target selling prices and margins for
proposed products.
• The types of products that could benefit from target costing.
Q1. What is the competitive environment that creates the
range of products sold?
• Nissan faces an extremely competitive domestic automobile industry, with Toyota claiming 45%
of the market and Nissan following at 25%.

Two Elements
of Competitive
Environment

1. The sophisticated Japanese 2. The emergence of the lean

Consumer enterprise

• Japanese consumers are aware of product offerings and have no brand loyalty, thus are ready to
switch brands to purchase the most technologically advanced products.
• In the Japanese automobile industry, the lean enterprise form prevails because firms can
produce in lower volume more quickly with higher quality than can the equivalent mass producer.
• Therefore, the lean enterprise form allows producers to react quickly to the improvements in
quality, functionality, and price that technology-crazed Japanese consumers demand.
• As a result, Nissan continuously increases functionality while maintaining price as its
confrontation strategy to combat the intensely competitive Japanese automobile industry.
Q2. How does Nissan determine its future product mix?
• Nissan uses three major methods to determine the range of products it sells:

1. Product Matrix:
2. Consumer Analysis:
3. Mind-sets:

1. Product Matrix:
• The primary objective of the product matrix is to help Nissan achieve the
desired level of market coverage.
• The matrix is a system that helps Nissan determine its product mix for the next
ten years; it includes information about target customers such as income levels
and their needs.
• It helps identify the body types and models that appeal to a specific group of
target customers so that Nissan can determine the market position of its
products.
2. Consumer Analysis:
• Consumer analysis determines the attributes valued by customers to ensure that Nissan
produces cars that customers want.
• Specifically, Nissan uses consumer analysis to determine new entries in its product matrix.
• Consumer analysis is conducted by independent consulting firms; this analysis determined that
there were 50 potential models valued by customers.
• Nissan chose to narrow the selection to 30 models due to costs of differentiating and
maintaining inventory.
3. Mind-sets
• A mind-set captures how customers visualize themselves in relation to their cars.
• It helps the manufacturer narrow down characteristics so that it can maximize customers’
satisfaction.
• Mind-sets identify attributes that play an important psychological role when customers purchase
a new car.
• Nissan uses a cluster of mind-sets to identify market niches that warrant a new model.
• Nissan blurs the different mind-sets to broaden the market for individual models, allowing it to
reduce the number of models offered, as a result, Nissan ensures that maximum customer
satisfaction is achieved.
Q3. What is the purpose of Nissan’s target costing system?
• The purpose of the target costing system is to enable Nissan to manufacture products that deliver
functionality and quality at a cost that achieves the firms target profit.
• Target costing acts proactively to control manufacturing costs and set selling price and profit margin,
as show in the equation below:

C=S–P

where: S = Selling price per unit

C = Cost to manufacture per unit
P = Profits per unit

• Cost is viewed as a function of the interaction between price and profit.

• If the resulting cost is too low to be achieved, the product is redesigned until the product’s target cost
is considered achievable.
• Nissan utilizes this approach in an attempt to ensure product profitability because it allows each new
product’s price, quality, and functionality to be set in advance.
• It allows for better control of costs because target costs are identified during the design stage, not in
the production stage.
• Thus, target costing helps secure the firm’s long-term profitability.
Q4. What approaches could be used other than target costing?
1. The conventional western approach is to design the product so that it has the
lowest cost and then match its cost to the anticipated selling price.
• The profit margin is determined as shown in the equation:

P=S–C
• This approach treats profit margin as the dependent variable.
• If the profit margin is below an acceptable level, the product is redesigned, if
possible, to reduce its cost until the desired profit margin is achieved.
• Because this approach induces production efficiencies to be applied after the
product development stage, only an approximate 10% cost reduction is
attainable.
• Shorter product life cycles result in less latitude for management error, because
the cost recovery periods are short.
• Under the conventional western approach, cost accounting systems do not
provide product life cycle reports and thus mislead management as to the early
impact of engineering design changes, which determine the range of
manufacturing process and material costs.
2. The cost-plus approach is to design the product so that it has the lowest cost,
estimate this cost, add a desired profit margin, and then determine the required
selling price of the new product as shown in the following equation:

S=C+P

• Under this approach, if the required selling price is too high, the product’s
design is modified to reduce its cost and, therefore, the required selling price.
However, if the market price is not established, then the product is launched at its
cost-plus price.
• Theoretically, these two techniques should outperform target costing because
they minimize a product’s cost and do not reduce it to a predetermined level.
• However, in practice, the target costing approach focuses on the design of the
required functionality and the specific cost necessary to achieve it.
• In comparison, the other two approaches focus on the design at an undefined
“minimum cost”.
• For example, Nissan establishes target costs based on its historical cost data on
the components for the level of functionality required. This makes the target cost
a real value rather than a projection.
• Thus, target costing appears to lower the product’s cost more than the other
two approaches because there is intense pressure to reduce cost to a specified
minimum cost.
Q5. What is target costing?
• Target costing is a multifunctional, structured approach to determine the cost at
which a proposed product with specified functionality and quality must be
produced in order to generate the desired level of profitability at its anticipated
selling price.
• To ensure that the price, quality, and functionality of a product meet the profit
objectives of the company, all major departments, including engineering, R&D,
marketing, and accounting, are involved in the process.
• Target costing can better control costs while guaranteeing profitability.
Q6. What is value engineering?
• Value engineering can be defined as a systematic, interdisciplinary examination
of factors affecting the cost of a product in order to devise means of achieving
the specified purpose of the required standard of quality and reliability at its
target or kaizen cost.
• In practice, the firm determines and designs activities that reduce the
manufacturing costs for each major component.
• As part of target costing, value engineering encompasses the modification of
design and innovation of new production techniques to increase adaptability of
components.
• At Nissan, value engineering is applied from the conceptual design stage to the
final step of product development via redesigning components, assemblies and
production processes to achieve the target cost.
Q7. What role does the customer play in the target costing
system?
• The consumer identifies the required level of functionality of a product at a
given price.
• Nissan projects demand of consumers up to ten years in the future.
• All information about consumer tastes, preferences, values, and psychological
appeal are analyzed to form a conceptual design of the product before
proceeding to production.
• Thus, consumer analysis is the first major step in developing the conceptual
design of the product and establishing a target cost.
Q8. How does Nissan determine the target margin for a new
product?
• Each new product’s target margin is derived from a computer simulation that
forecasts the selling price of new models for the next ten years while achieving
the firm’s future profitability objectives.
• By plotting the actual profit margin of existing products and then adding the
firm’s profit objectives of future products, the firm’s overall profitability at
different sales levels is forecast.
• The higher profit margin on higher-priced cars is needed to cover their lower
sales volume.
• The firm uses the simulation as a risk assessment tool to explore the price/margin
curve for different product mixes.
Q9. What role does profitability play in the target costing
system?
• For Japanese firms, lifetime employment is an important mechanism behind
their objectives of ensuring growth and increasing sales.
• Because a Japanese firm values its employees first (followed by customers,
shareholders, and creditors, in that order), there is significant pressure on
employees to help the firm grow.
• To meet the contract of lifetime employment, profit is the primary component
of target cost and so sales, price and profits are the fixed elements of the
equation while target cost is the dependent component.
• Because profit is built into the equation, sales are considered more important
that profits. However, as long as the target cost is achieved and sales occur,
profits will follow.
Q10. What is the role of suppliers in target costing?
• Suppliers play a critical role in helping Nissan achieve its target costs.
• If the target cost of a component is too high, the supplier must meet Nissan’s
target cost through innovation.
• Under target costing, the supplier’s selling price can never exceed the target
cost unless extra functionality is supplied.
• Because most Japanese automobile firms outsource more than 70% of parts and
components, suppliers must be able to help Nissan meet the target cost.
• Nissan has created an incentive program to encourage suppliers to help them
achieve the target cost.
• Under this incentive program, the reward for significant innovation is a 50%
purchase contract for 12 months.
• In turn, if it is ethical for Nissan to share the technical innovation with other
purchasers, it will do so.
Q11. What role does the accounting department play?
• The accounting department provides a final check to make sure that the target
cost has been achieved.
• It policies the process to ensure the product meets Nissan’s overall objectives and
validates all department assumptions, including, marketing, and engineering.
Q12. Why is accounting’s role so limited?
• First, if the target costing-value engineering system can accomplish Nissan’s cost
reduction objectives, accounting does not need to create additional cost
reduction pressures.
• As long as every department, division, and supplier is working to achieve the
target cost, the accounting department is not required to monitor costs in the
design stage; that is the responsibility of the design engineers.
• Second, Japanese manufacturing firms do not employ accountants per se.
Japanese are hired to perform many functions, including engineering, marketing,
manufacturing, and accounting on a rotating basis.
• It is not uncommon to see engineers working in the accounting department.
• This rotation system deemphasizes the control function of the accounting
department after production is in place, but emphasizes preproduction
accounting.
• Because some employees in all departments have strong accounting skills, the
need for a powerful accounting department is eliminated.
Q13. What role does the cost system play?
• When a firm has a strong target costing system, the role of the cost system is
reduced and becomes another policing mechanism.
• It is a “feed forward” mechanism that provides planning information for design
engineers.
Q14. What types of products would benefit from target
costing? What types of products wouldn’t benefit?
• Most high-tech and assembly-oriented products will benefit from target costing.
• Products that require consistent change in functionality will also benefit from
target costing.
• However, mass-produced, standardized, and mature products will not benefit
from target costing because no model changes are needed, making target
costing at the product design stage less important.
• For example, commodity products such as copper, steel, and glass will not
benefit from target costing.
Q15. What barriers exist for introducing target costing into
Western firms?
• The first barrier is the relationship between Western firms and their suppliers.
• Western firms, particularly U.S. firms, tend to have a more combative
relationship with their suppliers, which limits a supplier’s willingness to innovate
solely to reduce cost for the purchaser.
• Second, Western firms do not emphasize teamwork. Suppliers and purchasers
are not “sister companies” willing to share ideas. The purchaser's strategic goals
are not shared with suppliers.
• Top managers of U.S. firms are the third barrier, they emphasize the
maximization of shareholder wealth.
• Objectives are designed around strategies that help them achieve short-term
profits.
• This practice makes it difficult for U.S. firms to share technological innovations
with their suppliers because they are interested in maximizing their own profits,
not those of their suppliers.