TARGET COSTING

 

 

TARGET COSTING

A target cost is the allowable amount of cost that can be incurred on a product and still earn the required profit from that product. It is a market driven cost that is computed before a product is produced. A budgeted cost is a predetermined cost after a product is in production. A budget is an operational definition of an allowable cost broken by items and by periods.

Nearly 80% of the costs of many products are committed at the design stage. Therefore, the best opportunity to reduce costs is during design and not after a product is being manufactured. Target costing occurs within the product development cycle. This means it starts when a product is in its concept stages and ends when a product has been released for manufacturing. An allowable target cost is the maximum amount that can be spent on a product. An achievable cost is the estimate that tells management whether the product and process design is capable of meeting the allowable cost target.

TARGET COSTING IS DIFFERENT FROM COST PLUS PRICING.

Competitive market considerations drive cost planning.

Market considerations not part of cost planning.

 

Prices determine costs.

Costs determine price.

 

Design is Key to cost reduction.

Waste and inefficiency is focus of cost reduction efforts.

 

Customer input guides cost reduction.

Cost reduction is not customer driven.

 

 

Uses cross-functional teams to manage costs.

Cost accountants are responsible for cost reduction.

 

Supplier involved early.

Suppliers involved after product designed.

 

Minimizes cost of ownership to customer

Minimizes initial price paid by customer.

 

Involves the value chain in cost planning.

Little or no involvement of value chain in cost planning.

 

EXAMPLE:

 

TARGET COSTING GLOWS WITH THE “NEON”

 

In 1990 Chrysler Corporation found itself in a very unhappy financial situation. Profits were down, cash flow was tight, and the stock was trading at a low price of $10 per share. The Japanese auto industry posed a serious threat. Despite a strong Yen, they had captured and continued to preserve a healthy share of the U.S. auto market. Chrysler management decided it was time to change their approach to new car design. They adopted a competitive weapon that the Japanese auto industry had used for many years called target costing. Target costing was applied to all product development efforts in the Company including the NEON, a new small car developed for the lower price range. A price and profit target was set for the car and it was then designed to meet that profit without sacrificing major customer requirements. The results of using target costing on the NEON were impressive. The NEON:

 

 

·       Provided dual airbags and a powerful engine for a small car.

         Was named" Auto of the Year" in 1994.

·       Had a relatively short development time going from product concept to market in 31 months.

·       Came in below its project development and investment budget.

·       Is one of a handful of small cars made in the USA that makes a positive return.

·       Is environmentally friendly built using a recyclable facia and non-toxic materials.

 

Since the introduction of target costing, Chrysler's profits have increased significantly. Its share price went up from $10 per share in 1990 to $54 per share in 1995.

           Assume that you worked for Chrysler in 1990 and were assigned to the development team for the Neon project. This project was developed under the target costing approach rather than the traditional cost-plus approach. Answer the following questions regarding the development of the Neon car. Be creative, using your knowledge of cars in general, in answering the questions. You should provide car specific examples.

 

Required:

1) Identify the seven steps in the establishment phase of target costing. Provide specific examples of activities undertaken for each of the seven steps.

The seven steps in establishing target costs used by Chrysler are:

·       Chrysler conducted extensive research on college and other young professional who buy small cars

·       Through competitive analysis Chrysler determined what other car companies were offering. For example, the Ford Fiesta was one of the key products Chrysler viewed as a competitive product.

·       The potential and current buyers of cars such as Ford Fiesta were chosen as target customers.

·       The initial product concept was developed based on two key customer requirements -- “fun to drive” and “safe” car.

·       Detailed product features were developed based on detailed and refined understanding of customer requirements. For example, a “neon key” that shines in the dark was designed to meet a customer requirement about being able to find car keys in a dark parking lot.

·       Market price was established using the Ford fiesta as an initial benchmark and adjusted for feature differentials between the two cars.

·       A required profit margin was subtracted from this price based on industry norms and Chrysler’s desired return to set an allowable cost for the car.

2) Discuss how each of the three steps in attaining target costs might have applied to the Neon project. Also discuss how Chrysler could design costs out or reduce costs through design improvements.

The manufacturing cost gap between the initial estimate and the target cost was approximately several thousand dollars. This gap was reduced by value engineering the car in several ways. The chassis was designed of lighter material, the cab design was simplified, suppliers were brought in early in the design and offered cost reduction suggestions for their components.

 

3) List some behavioral problems that may occur when target costing is used. Provide an example of how these problems may have impacted the Neon project.

A number of behavioral changes occurred at Chrysler as a result of target costing. People who were functional specialists worked on cross-functional teams. This caused initial problems for people who were not used to working as generalists. Team work rather individual output was rewarded. This created some motivational problems for people who were used to being rewarded for their work. The culture changed to encourage people to be customer oriented and to meet customer needs. Giving suppliers more power reduced the power of procurement staff who traditionally ran this operation.

 

 

 

 

CHRYSLER’S RESULTS -- 1994

·       Meets customer requirements for safety and drivability

·       Neon named “Auto of the Year” in 1994

·       Short development time (concept to market 31 months)

·       Below projected development and investment budget

·       Neon one of few small cars that earns a positive return

CHRYSLER’S RESULTS -- 1995

·       Chrysler's share price $10 in 1990 to $54 in 1995

·       Since 1990, revenue increase 70%

·       Market share increase by 2.1%

·       Profits and cash flows increase 400% since 1990

·       Profit margin ratio up from 0.33% to 7.1% in 1995

·       Chrysler’s Truck Line (including Jeeps and Minivans) number one among US carmakers in “Power Survey.”

·       Industry benchmark study finds Chrysler the low cost producer in North America for second straight year.

·       Standard & Poors and Duff & Phelps raised credit ratings - first time since 1974 to “A” level.

CHRYSLER’S RESULTS – 1996

·        Industry Sales Above Trend

·        Stock Levels -- Well Positioned for Launch of 1997 Models

·        Relatively Stable Incentives

·        Labor Contract

·        New Products

·        Full Wrangler Production

·       All New Dakota -- Very Well Received By Automotive Press

·       Jeep Cherokee Update