SMART MANAGER

Cost management

Target costing methods

In the first two articles of our series on cost management, the perspective and focus of cost management were
discussed. The perspective of cost management is customer value creation while focus of cost management is
economic value creation. The third part of our series on cost management discusses the concept of target costing and
how the perspective & focus of cost management are fulfilled by target costing at the design stage. Read on…

T
M Hariharan he cost management of a product
begins with the conception of a new
product. More than 85 per cent of the
product’s ultimate acquisition or life
cycle costs is determined or committed by the
time the detailed design is made. It is driven
by decisions made from conception through
product development cycle. Once the design of
the product has been established, relatively little
latitude exists to reduce the cost of a product.
Decisions made after the product moves into
production, account for another 10-15 per cent
of the product’s costs. Though most of the
costs are incurred after the design stage, most
of the costs are locked by the design decisions
made in accordance to the company’s products
(Figure 1).
Firms get conscious about cost when they start
making losses. They resort to cutting, controlling
and reducing costs during the production, sales
and service stages of a product. Though this is
important, it is done to ensure that wastes are
eliminated. Restricting only to the post design
level is more like trying to catch the bull by the
tail. Addressing cost issues after the design stage
is too late and too little. Hence, a cost or profit
management initiative has to start with the design
of the company’s products at the very beginning
of the development cycle.
Effective product cost management requires a
target costing approach to addressing cost during
the design stage. Target costing aims to achieve
an affordable product by treating target cost as an
independent design parameter that needs to be
achieved during the development of a product.
Price-based costing
Target costing is ‘price-based costing’ rather
than ‘cost-based pricing’. In traditional cost
reimbursement approach, cost plus profit
constituted sales. But in today’s context, cost has
to be contained within sales, minus the profit.
Thus, target costing is a structured approach used
to achieve the desired profit over the lifecycle of

100
95

85

66
Incurred costs (%)
Committed Costs (%)

Product Design & Production Logistics

concept development support

Time
Figure 1: Cost commitment and cost incurrence

54 Modern Plastics & Polymers ● October-November 2005


the product by providing the customer his
desired quality, functionality and price.
Target costing combines the different
approaches of new product development
at varying levels. Methodologies like value
engineering, value analysis, quality function
deployment (QFD), rapid prototyping, tear
down analysis and reverse engineering are
used depending upon the specific market
requirement and internal capabilities.
Steps in target costing
Conceptually, the target costing
methodology is simple to understand but
quite challenging to implement (Figure 2).
Step 1: Establish the target-selling price
based on the customer, competition and the
strategy of the organisation
Step 2: Establish the target profit
requirement based on the expected rate of
return on the investment, the history of the
product profitability for the portfolio of the
products or the firm’s pricing strategies
Step 3: Arrive at the target cost -
difference between target selling price
and target profit
Step 4: Compute the probable cost or
current cost; for eg, if one goes ahead with
one’s new product, what is that cost which
will be incurred at the current levels of one’s
efficiency and suppliers
Step 5: Match the probable cost and the
target cost
Setting target selling price
Target selling price can be fixed in three
ways, viz, cost-based targeting, price-based
targeting and value-based targeting.
Cost-based targeting is a cost plus
approach. This is appropriate where
the supplier has the clout in the
marketplace, the customer has limited
options or where there is no other
reasonable way of setting the price, for
eg, construction industry.
Price-based targeting is applicable
where there are similar kinds of
products available for reference in the
marketplace. This is appropriate for
commodity products, matured consumer
durables, or where reliable information
on price is available in the market.
Value-based targeting is a very difficult
approach to target selling price setting. This
Modern Plastics & Polymers ● October-November 2005
Target selling price minus
• Customer requirement • Product history
• Competitive pressure • Long term profit objective
• Strategic thrust
• Designer creativity
• Internal process efficiency/capabilities
• Suppliers’ creativity / involvement
Figure 2: Methodology of target costing
is also not very clearly understood by many
players. Value-based targeting is based on
setting the price as: “What is the function
for which the customer is paying?”“Is he
paying for the saving he is getting? For the
convenience he may experience? What
value proposition are we fulfilling with our
offerings to the customer?”
The plastics and polymers industry to a
greater extent should adopt this approach,
more than anybody else.
Examples of value-based targeting
(Names of all the Indian companies taken as
examples have been changed):
TS Steel supplied teeth for bucket
excavators to a coal mining company.
The mining company asked TS Steel to
develop an alloy that would extend the
life of the bucket excavator. If TS Steel
had priced the teeth as material cost, plus
conversion cost, plus R&D cost, it would
have been cost-based pricing. Instead,
TS Steel went for a value-based pricing
model based on ‘saving to the mining
company due to prevention of
break-downs”
Bala Bearings manufactures balls for
ball-bearing. One of its overseas customers
suggested that the balls be packed in a
vacuumised pack. Bala Bearings put up a
small facility to take care of the need of
this specific customer. It priced the balls
by adding the depreciation of the new
packing facility and other conversion cost
plus profit. However, Bala Bearings failed
to realise that its customer had indeed
closed down an effluent treatment facility
that was treating this oil. Had it been
SMART MANAGER
Target profit = Target cost
Meet
target
cost
Probable Cost
Current internal capabilities of
design and process
• Current supplier capabilities of
design and process
Current linkages with the suppliers
value-based pricing, the price would have
been based on ‘savings to the user due to
elimination of effluent treatment’.
FinSolutions, a software company,
develops software for specific requirements
of accounts and finance. It was approached
by PI Ltd, by its existing client, to
develop software for bank reconciliation.
FinSolutions assessed that the assignment
would take about 20 days to complete.
It also realised that PI was reducing its
manpower and was planning to replace the
existing resources due to retire with this
package. Then instead of a cost-based price,
it quoted a price based on the ‘savings due
to reduction in manpower.’
There have been many instances like
these where value-based targeting has
led to better realisation than cost-based
targeting. However, value-based targeting
may backfire by driving everyone’s prices
down too far. Hence, the following issues
should be considered while employing
value-based targeting:
Value-based targeting is sustainable only
if it is difficult for the competitor to replicate.
Otherwise, ‘me too’ service providers can
bring the prices down quickly. Innovation
is undetected plagiarism. Value-based
targeting is not possible if the customer
does not find value in innovation.
As long as the customer finds value in
value-based price and competition takes
time to catch up, the innovator can gain a
margin advantage. However, in the longer
run, the prices will find its floor, that will be
cost. Value will match the cost plus in the
longer run.
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SMART MANAGER
Figure 3: Value-based targeting – polymer as
substitutes (Source: www.omnexus.com)
Examples of value-based targeting
(plastics and polymers): Manufacturers of
polymers should take into account the users
of metal, wood, paper, cement and glass for
value-based targeting (Figure 3).
Starter motor gears usually use metal
parts. However, as the temperature ranges
between -40°C to 130°C, a unique material
is needed. Besides, this part undergoes
extreme wear and tear, and therefore should
have lower weight, corrosion resistance
properties, excellent torque resistance and
high shear modulus at high temperatures.
If the price for this component has to be
decided, one has to compare the price with
the metal it substitutes, the replacement
cost that will be incurred by the user over
its life cycle and thus the total cost of
ownership for the user.
Electronic throttle control gear regulates
the position of the throttle valve in a car.
The spring-loaded valve is driven by an
electric motor. Through a set of gears, the
valve is put in the required position. This
requd 1`1 red properties are extreme
wear and friction resistance, cost savings,
excellent torque resistance, and high shear
modulus at high temperatures. A polymer
part can provide these options at reduced
cost due to absence of grease and also
add values like reduction of noise. Here,
the total cost of ownership of the part is
reduced for the user.
Building and construction materials like
windows, doors, fencing, plumbing, and
corrugated sheets require key performances
like transparency, impact resistance and
weatherability. Glass attempts to fulfill
these requirements. Polymers face problem
56
of weather resistance and transparency.
However, rigid PVC provides these
requirements as well. Thus, the total cost of
ownership of the user may be reduced as
this can provide all the three requirements.
Automotive body parts use aluminum
or steel. GE Advanced Materials recently
launched two new solutions, viz, high
modulus ductile (HMD) and high
performance thermo plastic composites
(HPPC) offering weight reduction, design
flexibility, improved mouldability and
impact properties. HPPC materials consist
of a glass fibre reinforced composite core
with a thermoplastic skin layer. It is claimed
that these are 50 per cent lighter than
conventional metals used to produce large-
surface horizontal body panels. Pricing for
this has to necessarily consider the total cost
of ownership of the alternatives available for
the customer.
Setting target profit margin and
target cost
Target profit margin depends upon the
return expectation of the investor, cost of
capital of the firm and the profit and cost
history of the product family. Normally
the existing profitability of similar
products within the firm’s portfolio is
considered for simplicity. However, over
a period of time, the target profit margin
should ensure the long-term profit
objective of the firm. The target profit
margin is also driven by the strategic
intent of the firm, like penetration pricing,
skimming or operating at status quo.
Target cost is the difference between
target selling price and target profit. For the
design engineer, the target cost provided
is adjusted for the channel cost. This is the
initial step taken during designing, today, to
control tomorrow’s cost. Now, the cost has to
be achieved by the time the product comes
out of the designer’s table.
Target cost will then be allocated to the
elements of functionality valued by the
consumer. This is based on different end-
user requirements and varying elements of
functionality. This step is called function level
target costing.
The function level target cost is aligned
to key inputs into the product. This step is
called component level target costing. For
Modern Plastics & Polymers ●
a product like automobile, this step is more
elaborate. However, for a polymer, it is more
to do with the combinations of various
elements that come out of research.
Computing the probable cost
Probable cost is the cost that is incurred if
one goes ahead and launches the product,
at the current levels of creativity, efficiency,
technology and waste. If this cost is higher
than the target cost arrived at Step 3, then
one has to bridge the gap to achieve the
target cost. The product will not be allowed
to launch if the target cost is not achieved.
This is the cardinal rule of target costing.
Achieving the target cost
Here the R&D experts take over. There are
various methodologies that help achieve
the target cost. One of the more popular
methodologies is value engineering.
Value engineering
Value engineering is a systematic,
interdisciplinary examination of factors
affecting the cost of a product with the
aim of devising the means to achieve its
specified purpose at the required standards
of quality & reliability and at an acceptable
cost. VE follows two simple equations:
Value = function/cost (producer’s
perspective)
Perceived value = perceived benefits/price
(customer’s perspective)
For example, while designing polymers for
metal replacement, it has to be ensured
that the qualities of the metal that fulfills
the specific customer application (weight,
design flexibility, mouldability and
impact properties) at a cost of material
and conversion that is lesser than the
metal it proposes to replace. Similarly, in
the case of transparent applications, the
polymer should provide the properties
of transparency, impact resistance
and weatherability at a material and
conversion cost that is lesser than that of
the material it intends to replace.
Basic questions of VE
VE answers the following five
fundamental questions:
What is it? – Here, the focus of
analysis - the new product itself is
October-November 2005
 SMART MANAGER

Selling price: Rs 1,00,000 the suppliers of components and sub-

assemblies. Thus, the target cost for the
Taxes & duties: Local taxes; CST; ED; Rs 24,250 suppliers gets set by breaking the target
cost for the OEM across the functions and
components. If a polymer manufacturer
Channel costs: Dealer margin, transport to dealer: Rs 14,000 intends to have a pie of that that market,
he should look for options to provide
value to the OEM’s customer at the lowest
Manufacturer's profit: Rs 6,500 total cost of ownership.

Product specific non-mfg cost: Conclusion

Warranty cost, sales promotion Rs 5,000 Many firms do not apply all the five
steps systematically; nor is it applicable.
The step of converting the target cost
Development cost: Rs 1,250 into functional target and through that
component level target cost is a difficult
task for any firm. Some firms use QFD
Overheads: Mfg, S, G & A; Rs 10,000 techniques that are very effective at
capturing and quantifying consumer
needs. However, value-based cost
Material and purchased parts: Rs 39,000 targets are still a far cry for many of the
Indian firms.
Figure 4: Setting target cost for a car costing Rs 1 lakh (assumption) A polymer manufacturer needs to
understand the price pressure faced by
identified. Later, the focus shifts to major the car at Pune, sells it to the dealer in his customers, and apply cost targeting
functions and components Chennai, who in turn sells the vehicle to the systematically with the appropriate mix
What does it do? – This deals with customer in Chennai. Figure 4 represents the of techniques. The concept is simple to
identifying the functions that the typical target cost computation. understand but difficult to implement
product is expected to perform. The The material and purchased input cost unless guided properly.
basic function is the principal reason for of Rs 39,000 include all the sub assemblies, Target costing initiative is not a
the existence of the ‘thing’. The components & main assemblies, margin cost control initiative but a profit
secondary is a function that occurs of the suppliers, transportation cost from management initiative. It calls for
because of the method selected to carry suppliers to the OEM. If the government commitment from the top management.
out the basic function. gives a tax sop for this car, the cost would Target costing helps design engineers
What does it cost? – Here, the cost of increase to about Rs 55,000. Further, the and suppliers work towards goals that
functions is determined. Cost reduction component supplier’s price to Tata Motors are clear and attainable. Hence, one
happens by focussing on the high cost has to be competitive enough for Tata should adhere to the cardinal rule, which
components. Functions are identified Motors to achieve Rs 39000 as the target says that “the product is not out if target
where value is low compared to cost. And, this car should have components cost is not met”.
the costs. that fulfill the customer’s requirement of “A company that meets those requirements
Who else can do the job? being fuel efficient, high on aesthetics, is not guaranteed a victory in the markets it
How much does that cost? low in price, and high safety (voice of the enters. It does earn the right to compete”
The last two questions lead to finding customer); emanating from the weight, – Robin Cooper Q
alternative solutions to product design that design flexibility, mouldability and impact
provide increased value. properties (product technical requirements). M Hariharan is the director
Impact on plastics and polymers: (*This example is not based on Tata Motors’ of Savoir Faire Management
Example of target costing in the numbers. This is the author’s assumption of Services, Mumbai. He has been
automobile industry how the target cost will look in case a car costs helping firms across sectors in
identifying their core problem,
To understand the meaning of target Rs 1 lakh.)
aligning their processes
costing, consider the example of Tata Motors*, The pressure on profit for the OEM
according to customer needs
which is planning to manufacture a car for forces him to look for ways to deliver the and enable sustenance of the efforts. He preaches
the Indian market that costs Rs one lakh. same value at lesser cost. He looks for what he practices and has successfully trained
Now, assume that the customer is in options that can reduce the total cost of more than 5,000 executives on these aspects.
Chennai. Tata Motors on its part, assembles ownership. He passes on the pressure to Email: sfgroup@vsnl.com

Modern Plastics & Polymers ● October-November 2005 57