It sounds simple enough: Talk with customers about a new product concept, find out which features they like and don’t like, and ferret out how much they would pay. Subtract an acceptable profit margin, and you’re left with the target cost of the product. Now all you have to do is get everyone inside and outside the company to adhere to this number.
Easier said than done. Yet, target costing–a cost-management process imported from Japan– is helping a few dozen companies in the United States gain an edge by having them listen harder to customers to gauge the right product or service price. Boeing, Eastman Kodak, and Honda of America, for example, as well as pioneers DaimlerChrysler and Caterpillar, have implemented the strategy, reversing the way they traditionally design, price, and sell new products. “We’re working backward from the customer,” says Robert Brust, CFO of Eastman Kodak Co., in Rochester, New York. “By analyzing what they want in a product and what they’re willing to pay for it, we can create design, engineering, and manufacturing processes that meet those desires and enhance our profitability.”
Companies that have implemented the cost- management strategy insist they have boosted profitability. But, although virtually the entire Japanese manufacturing sector has gone the target-costing route since its inception in the 1970s, it hasn’t exactly taken root here. To date, it is estimated that only 65 companies–85 percent of which are discrete- parts and finished-product manufacturers–have embraced the concept. “That’s because most American companies think they’re already doing target costing,” explains Peter Zampino, director of research at Consortium for Advanced ManufacturingInternational (CAM-I), a Bedford, Texas-based research organization. “The truth is, they’re only doing part of it.”
Which part? Well, many companies conduct market research to determine what customers want in new products and features, and a few excavate a price, as well. Others break down their products (or services) to scrutinize individual components. But how many compel cross-functional teams to meet with customers and ensure a product at an acceptable price? There’s the rub. “The hardest part is tearing down the silos, the individual power bases that describe most companies,” Zampino says. Break down those silos “by getting people focused on cost in everything they do,” he adds, “and you obtain real power.”
Unlike in Japan, where target costing is a standard corporate practice, the U.S. companies that have embraced it have had compelling reasons to do so. “We haven’t found one company that practices target costing that didn’t initiate it in a crisis,” says Zampino.
What they’ve initiated is a cross-functional approach to understanding how much customers will pay for a new product or service before designing it. At Eastman Kodak, for example, a team that includes design and manufacturing engineers joins with procurement, marketing, and finance “at each gate of our formal target- costing process, beginning with the customer,” says Charles G. Ross, senior buyer in the company’s purchasing department. “Say we want to introduce a new flash feature on our reloadable camera. The team first asks customers if they like the concept, and then what they would pay for the camera if it had the feature.”
That interplay among the various groups is critical. “Most companies send in their sales personnel to assess customer wants and needs, yet they are ill-equipped to address, say, engineering functions,” Zampino says. “By having design engineers, marketing, procurement, logistics, and so on all talking to the customer, a company cuts down on engineering changes and design changes that otherwise might occur later and cost more.”
Those later changes are often the main focus of target costing. “The design process is where you can truly leverage your costs,” says Ron Gallaway, CFO of $500 million Micrus Semiconductors, which has been practicing target costing since the company’s inception, in 1995. “Once we determine through benchmarking and customer research what our product must cost to be world-class, it is up to our design and manufacturing engineers to meet that cost. If we were a company with the traditional ‘cost-plus’ mentality, we wouldn’t last long in this business.”
Of course, finance must be intimately involved in the process. At Hopewell Junction, New York based Micrus, for example, one member of the finance department is a “dedicated catalyst for the 14 teams” involved in activity-based management and target costing, says Gallaway. But finance’s most important contribution is in setting the final targets. Otherwise, he says, “everyone would be paranoid about what counts and what doesn’t.” Zampino agrees: “It’s like anything else; if finance doesn’t bless the numbers, they won’t have credibility throughout the organization.”
Those target numbers, once established, must be broken down into component features or functions and related costs. And to determine those expenses, companies assign a dollar value based on the feature’s importance to customers. For example, if research indicates speed is the most important function of a computer, representing to customers 60 percent of the value of that computer, then 60 percent of the product cost should be spent on speed functionality. Says Zampino, “If you spend less, you’re not spending enough. If you spend more, you’re missing the boat.”
Like other companies aiming for a target cost, Eastman Kodak tears down features into component parts. A flash on a camera, for instance, would be broken down into a circuit board, a light source, and a reflective source. Individual costs would be allocated to each component, based on function importance, supplier price, and logistical and freight- related costs. “We’ll also do a ‘tear down’ of our competitors’ products to assess their costs versus what we’re paying,” says Charles Ross.
The team then decides whether they can make the product at the price customers want. If they determine they can’t, that does not spell the end of the cost-searching process. “We may consider a redesign of the product, taking out some of the functions that are deemed less important to the customer,” explains Richard S. Morabito, Eastman Kodak’s chief purchasing officer.
Other tactics employed by target costing practitioners include revisiting material composition, overhauling current production processes, negotiating with suppliers, or even abandoning an effort completely.
At Honda of America Manufacturing Inc., for example, getting to a target cost can mean sending in a team from the purchasing department to work with suppliers to improve efficiencies, co-locating “resident guest engineers” from key suppliers at the product design location, or improving production processes by cutting waste and improving throughput and quality. “If our customers indicate they will pay ‘x’ more for a car that has a radio/CD player with a remote control button on the steering wheel, we will break down the components of the radio/CD player, establish a price for each, and then ask individual suppliers if they can meet that price,” says Peter Schmitz, associate chief engineer at the Marysville, Ohio-based division of Honda Motors of Japan.
“I have parts managers swearing to me that they cannot do this, and they’re absolutely sincere,” he says. “But we cycle through the process repeatedly until we get there.”
Keith Hallin, senior manager of finance for decision support initiatives at Seattle-based Boeing Commercial Airplane Group, knows the feeling. At Boeing, which implemented target costing as a pilot project in 1994 and now advocates the strategy companywide, reaching target costs is a challenge for the company’s entire value chain. “We work with our suppliers to explain the current market pressures on cost, benchmark market performance, and work together to find solutions to the challenges we face,” he says. “Sometimes this means changing our requirements to enable suppliers to achieve both the performance and cost goals.”
A Slow Sell
Getting suppliers to buy into target costing, however, “is probably the most difficult aspect of target costing,” says Dr. Shahid Ansari, a professor of accounting at California State University in Northridge, and author of Target Costing: The Next Frontier in Strategic Cost Management. Companies are trying to educate their suppliers on the merits of the practice through joint classes and team-building exercises, he says, as well as with promises of shared savings. But, he admits, it is a slow sell.
DaimlerChrysler, Ansari says, is probably the company that is most advanced in this area. According to a best practices study, sponsored by CAM-I, the University of Akron, and the American Institute of Certified Public Accountants, the company rates the performance of each supplier on an annual basis with a system called SCORE (Supplier Cost-Reduction Effort). Each supplier is then asked to achieve an annual 5 percent cost reduction based on its total annual sales to DaimlerChrylser. Savings are achieved through supplier-suggested design or assembly changes. Those suppliers that score well are considered “role models,” and are given credit for their innovations, according to the study.
Getting employees to buy into target costing by linking it to variable compensation is also a tough sell. Those that have taken that step, however, insist that it is vital. At Micrus, for example, says Gallaway, “our universal cost target” is the only variable for most of the company’s 1,000 employees’ annual bonuses. Based on the wafer-unit costs achieved by Micrus’s main competitor in Taiwan, such a metric “closes the loop,” he says. “We don’t worship budgets here; we worship costs–world- class, competitive costs. And in the five years since the company’s inception, payouts have been a significant part of total compensation for all our regular employees.”
Benchmarks of Success
The major benefit of the strategy, proponents insist, is in lowering the cost of bringing products to market. “In Japan, target costing has yielded as much as 13 to 17 percent in annual savings in direct product costs,” Zampino says. “That translates directly into improved profits.”
In the United States, however, practitioners of target costing are cautious about revealing actual metrics on its effectiveness. Gallaway at Micrus says his product costs prior to implementing the process were nearly three times that of his leading competitors, both Taiwanese companies. Parity, he says, was achieved in fall 1999. “But with costs in the semiconductor business decreasing 20 to 30 percent annually,” he says, “you can’t waste time patting yourself on the back.”
Honda’s Peter Schmitz cites the profitability of Honda Motors as an indication that target costing is working for the company. “With the recession in the early 1990s, and the strong yen, our net return on sales had fallen from an acceptable 4 percent range in the early 1980s to less than one-tenth of 1 percent in the early 1990s,” he says. “Focusing on cost efficiency helped offset this, and we’re now up to a 5 percent return on sales. Target costing is a big part of it.”
And Eastman Kodak set a benchmark of a 10-to-1 return on the costs associated with implementing the strategy, meaning that if it cost the company $100,000 to have an engineer sit down with customers, the return on that activity must generate at least $1 million in cost reductions. “We doubled our benchmark; that’s how incredibly effective the strategy has been,” says Andrew Grisin, unit director of strategic cost management.
Barriers To Adoption
Still, target costing is far from mainstream. There are three great impediments to its adoption, says Boeing’s Hallin. First, he says, “it is not well known in Corporate America.” While the Japanese literature is rich with information on the subject, Hallin notes that there is little English-language instruction. Moreover, he says, there are barriers both cultural (“people tend to build fences around their responsibilities because that’s what they believe they are measured on”) and organizational (“employees are organized according to functions in most companies”) to implementing such a team- oriented strategy.
What also can’t be denied is that there is a perceived irrelevance about the effects of target costing. Given the strength of the economy and the minimal pressure on margins, says Zampino, there is no pressing need for target costing to be embraced. He expects that it will be adopted throughout the auto industry and eventually make inroads into the electronics, oil, and pharmaceuticals industries. But beyond that, expansion is uncertain. “American companies are scared to take on such wholesale change,” he says.
For the companies that have taken the target- costing route, however, Zampino says it is a journey that really never ends. “In Japan, there is no literal word for the process,” he notes. “The best translation I’ve heard is ‘drifting cost.’ The term recognizes that the better you get at meeting a target cost, [the more] cost drifts. Each time you hit the target, it moves. And isn’t that a great way to stay focused?”
One exasperating part of target costing is analyzing the expense of thousands of components, raw materials, and process activities. But because the number of companies practicing the strategy is limited, few tools exist to help with the process. Typically, says Peter Zampino, director of research at Consortium for Advanced Manufacturing International, companies “piece together something in their legacy systems” that ties their reporting system to costing tables.
There is, however, at least one software product that has been developed to calculate these costs. “We offer an empirical database that permits comparative information and price transparency right at the fingertips of product designers,” says Kurt Niebuhr, chief operating officer at Tokyo-based AlphaBrain Corp. (www.alphabrain.com), a cost-management consultancy, whose clients include Makino Milling Machines, Sharp, Kawasaki, and Matsushita Electric.
The software exposes cost drivers (helping companies pit one supplier against another), and predicts how costs will affect a design change. “If a company manufactures cell phones and it wants to change the casing to include, say, an additional button or larger screen, the software can calculate that cost based on the degree of difference from previous models,” says Niebuhr. The software includes a data warehouse that can be used by target- costing teams for shared informational purposes.
The main problem for U.S. firms is that the software/database is written in Japanese. But AlphaBrain, which charges approximately $50,000 to $80,000 per module, is currently working on an international model, which will be available in English in September. In addition, Niebuhr points out that the data will be available “virtually free” on the Internet by mid-November.