The ins and outs of target costing
By Staff -- Purchasing, 3/12/1998
As difficult as it may be to break down the old functional barriers between procurement and engineering, there are plenty of compelling reasons for procurement--and more important, for suppliers--to become involved in setting product cost targets, argues Tim Laseter, vice president with Booz-Allen, & Hamilton in New York."Effective target costing can move the customer-supplier relationship away from competitive negotiations over existing designs and toward more cooperative efforts for optimizing the cost of a new design," Laseter says. "If done properly and at the right level of detail, target costing can insure competitiveness without jeopardizing supplier cooperation in innovation."
The benefits come in five ways:
* Delivering the "optimal value proposition" to end customers.
* Minimizing product-line complexity.
* Selecting appropriate product and process technologies.
* Lowering "design churn" late in the innovation process.
* Eliminating cost overruns.
While target costing may be an ancient practice, Laseter observes that "three very different approaches to target costing are being employed today--often without any clear distinction." These are--
* Price-based targeting: In its simplest form, a firm sets target cost through simple comparison with competitive offerings. For outside purchases, such targets are developed through competitive quoting. The same logic also can apply to a company's own products as well. "Many companies now examine what the market will bear and subtract a desired margin," Laseter notes. Products that don't meet target are either canceled or redesigned. As an example, Laseter cites Hewlett-Packard's entry into digital consumer photography. "Although HP's digital system--which includes a camera, printer/scanner, and software--provides functionality not available in a film camera, the digital camera is priced to compete with traditional high-end cameras," he observes. "Furthermore, HP expects eventually to drive the cost down to a level that allows for competition at the lowest price point--with a disposable digital camera."
* Cost-based targeting: In its least effective application, Laseter notes, "the Government has used cost-plus contracts to ensure that contractors achieve an acceptable but not exorbitant profit margin." The result, he says, has been to limit the motivation of suppliers to reduce total cost. A modern version of this mindset is to demand that suppliers open their books. Laseter observes, for example, that some large vehicle manufacturers have used their buying clout to force suppliers to share detailed cost information. "Unfortunately," he says, "suppliers complain that many Western vehicle manufacturers misuse the information to squeeze margins--which often leads to an extra set of books that hide profits." Other companies, he notes, may demand the same cost information, but use it differently. "They use open books and a detailed understanding of cost drivers for joint improvement efforts to eliminate waste--not simply to squeeze margins."
* Value-based targeting: This approach is the least understood and the most difficult to apply, Laseter says. "The technique compares consumer wants with willingness to pay, and improves product development by ensuring that new designs are not merely innovative-- but, more important, provide the right value proposition." By way of example, Laseter cites the original Swatch watch. "Major cost reductions were achieved by appropriately valuing the subsystems to reach a different level of functionality." For example, Swatch used a plastic casing since the product was priced cheaply enough to be discarded when the battery died. "Accordingly," Laseter notes, "the timepiece had less severe reliability and durability requirements, which allowed for less expensive mechanisms." Likewise, Laseter remarks that Swatch used "integrated plastic moldings instead of expensive, sewn-leather bands that must be replaced over the longer life of a traditional watch." The new value proposition: "A low-cost fashion accessory that also keeps time." Since the initial introduction, Swatch has become a major success and consumers have placed increasing value on the product. As a result, the company has gradually evolved to higher price points and product designs.
How to choose
All three techniques, Laseter says, can ensure competitiveness in supplier pricing. "However, each is more effective in a given circumstance than the others." For example, he suggests that price-based targeting is most effective in dealing with commodity products and services because their pricing is determined by market rather than cost to produce. "For example," he notes, "pricing of a commodity like memory chips for personal computers does not vary due to changes in consumer value but rather due to changes in competitive dynamics."
If improvements are wanted in supplier operations, Laseter suggests that cost-based targeting can be an effective tool: "Understanding cost drivers and using comparative benchmarks can reduce quality costs, improve equipment up-time, and lower manning levels."
Alternatively, if supply "solutions" are a goal, Laseter clearly favors the value method of creating target costs. "Value-based targeting is unmatched," he says, "for driving the kind of major innovation that is expected from a supplier serving in the role of solutions provider." Such a supplier, he explains, will have the wherewithal to take "black box" responsibility for specification, planning, execution, and performance of an entire system. Accordingly, he adds, such a supplier requires the freedom to do so. "Appropriate value-based targets provide that freedom within a firm envelope of what the customer will pay for a given functionality. The supplier must creatively apply its expertise to develop a detailed design that meets the needs at the target cost."
The process
Laseter--with colleagues at ba&h--has devised a five-step process for "effective value-based target costing" down to the supplier level:
* Step 1: Establish target cost for end product or service. Initial end-product targets are generally price-based--through comparison with a competitor's offering or a specific price point. However, when completely new products or services are developed, targets might be value based as determined by consumer research and hypothetical pricing scenarios. Either way, the required channel markup and desired margins for the producer are then backed-out to achieve the target cost.
* Step 2: Allocate target to the elements of functionality valued by the consumer. First, the "value proposition" must be understood by documenting the functionality that the consumer values in the product or service. Then, the value that consumers attribute to each function must be quantified--recognizing that different end users may emphasize different elements of functionality for the same product or service.
* Step 3: Link functionality to key subsystems and modules. Understanding the value of the functions does not provide guidance to a design team. The team needs to understand target costs at the subsystem level. These subsystems can then be designed with suppliers to achieve targets for cost and functionality. A translation table from functions to subsystems provides the link.
* Step 4: Compare value-based targets with cost estimates. The design proceeds against the target using continuously evolving designs and cost estimates. The cost estimates can come from bottoms-up costing or from price-based competition. The mix will vary by subsystem and may even vary over time for a given subsystem.
* Step 5: Re-aggregate targets across subsystems to ensure end-product profitability. Although the cost target for the end product must be fixed to achieve profitability objectives, the target may be reallocated across subsystems if needed. As a result, Step 5 operates in tandem with Step 4: as designs evolve and new cost estimates are generated, the team needs to aggregate the results and to make any needed tradeoffs until the overall target is achieved.
Next issue, Purchasing will present a simplified hypothetical example of how this five-step process might be pursued.
Timothy M. Laseter is a VP at Booz-Allen, & Hamilton in New York and a part-time doctoral student in the Darden School at the U. of Virginia. His consulting work and academic research address strategic issues in purchasing management. Jossey-Bass will publish his book on strategic purchasing this fall.
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