Life-cycle cost management emphasizes cost reduction, not cost control. Target costing becomes a particularly useful tool for establishing cost reduction goals during the design stage. A target cost is the difference between the sales price needed to capture a predetermined market share and the desired per-unit profit. The sales price reflects the product specifications or functions valued by the customer (referred to as product functionality). If the target cost is less than what is currently achievable, then management
must find cost reductions that move the actual cost toward the target cost. Finding those cost reductions is the principal challenge of target costing. Three cost reduction methods are typically used: (1) reverse engineering, (2) value analysis, and (3) process improvement. In reverse engineering, the competitors’ products are closely analyzed (a “tear down” analysis) in an attempt to discover more design features that create cost reductions. Value analysis attempts to assess the value placed on various product functions by customers. If the price customers are willing to pay for a particular function is less than its cost, the function is a candidate for elimination. Another possibility is to find ways to reduce the cost of providing the function, e.g., using common components. Both reverse engineering and value analysis focus on product design to achieve cost reductions. The processes used to produce and market the product are also sources of potential cost reductions. Thus, redesigning processes to improve their efficiency can also contribute to achieving the needed cost reductions. The target-costing model is summarized in Exhibit 11-14.
A simple example can be used to illustrate the concepts described by Exhibit 11- 14. Assume that a company is considering the production of a new trencher. Current product specifications and the targeted market share call for a sales price of $250,000. The required profit is $50,000 per unit. The target cost is computed as follows
It is estimated that the current product and process designs will produce a cost of $225,000 per unit. Thus, the cost reduction needed to achieve the target cost and desired profit is $25,000 ($225,000 $200,000). A tear down analysis of a competitor’s trencher revealed a design improvement that promised to save $5,000 per unit. When compared with the $25,000 reduction needed, additional effort was still necessary. A marketing study of customer reactions to product functions revealed that the extra trenching speed in the new design was relatively unimportant. Changing the design to reflect a lower trenching speed saved $10,000. The company’s supplier also proposed the use of a standardized component, reducing costs by another $5,000. Finally, the design team was able to change the process design and reduce the test time by 50 percent. This saved $6,000 per unit. The last change reached the threshold value, and production for the new model was approved.
Target costs are a type of currently attainable standard. But they are conceptually different from traditional standards. What sets them apart is the motivating force. Traditional standards are internally motivated and set, based on concepts of efficiency developed by industrial engineers and production managers. Target costs, on the other hand, are externally driven, generated by an analysis of markets and competitors.
Supplier and Firm Interaction
The example just given indicated that one source of cost reduction came from a supplier suggestion. During the design stage, target costing requires a close interaction between the firm and its suppliers. This interaction should produce lower cost solutions than would be possible if the design teams acted in isolation.9 Joint design efforts require cooperative relationships. Incentives for such relationships come from a willingness to search for mutually beneficial solutions.
Short Life Cycles
Although life-cycle cost management is important for all manufacturing firms, it is particularly important for firms that have products with short life cycles. Products must recover all life-cycle costs and provide an acceptable profit. If a firm’s products have long life cycles, profit performance can be increased by such actions as redesigning, changing prices, reducing costs, and altering the product mix. In contrast, firms that have products with short life cycles usually do not have time to react in this way so their approach must be proactive. Thus, for short life cycles, good life-cycle planning is critical, and prices must be set properly to recover all the life-cycle costs and provide a good return. Activity-based costing can be used to encourage good life-cycle planning. By careful selection of cost drivers, design engineers can be motivated to choose costminimizing designs.
Target costs are a type of currently attainable standard. But they are conceptually different from traditional standards. What sets them apart is the motivating force. Traditional standards are internally motivated and set, based on concepts of efficiency developed by industrial engineers and production managers. Target costs, on the other hand, are externally driven, generated by an analysis of markets and competitors.
Supplier and Firm Interaction
The example just given indicated that one source of cost reduction came from a supplier suggestion. During the design stage, target costing requires a close interaction between the firm and its suppliers. This interaction should produce lower cost solutions than would be possible if the design teams acted in isolation.9 Joint design efforts require cooperative relationships. Incentives for such relationships come from a willingness to search for mutually beneficial solutions.
Short Life Cycles
Although life-cycle cost management is important for all manufacturing firms, it is particularly important for firms that have products with short life cycles. Products must recover all life-cycle costs and provide an acceptable profit. If a firm’s products have long life cycles, profit performance can be increased by such actions as redesigning, changing prices, reducing costs, and altering the product mix. In contrast, firms that have products with short life cycles usually do not have time to react in this way so their approach must be proactive. Thus, for short life cycles, good life-cycle planning is critical, and prices must be set properly to recover all the life-cycle costs and provide a good return. Activity-based costing can be used to encourage good life-cycle planning. By careful selection of cost drivers, design engineers can be motivated to choose costminimizing designs.
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