Tools: Target Costing

If your NPV analysis reveals that the product will not be profitable, you have two options. Most likely, you'll kill the concept (this is the no-go decision). However, sometimes a product concept is too important to your company's future to simply kill it. For example, when the finance guys at Honda calculated the profitability of its newly redesigned 1998 model Accord, to everyone's shock, the results showed that Honda would lose money on every Accord sold. Two findings riveted decisions makers' attention:

  1. The new design really was what Honda needed to bring to market in order to compete.

  2. Rivals offered competing vehicles for 25% less than Honda's new design.

The Target-Costing Process

After carefully considering these two facts, the Honda team initiated a rigorous target-costing analysis. Figure 4.14 shows the six-step target costing process. Let's briefly comment on each step.

Step 1: Identify Product Characteristics

Product characteristics define the product; that is, both what it should do for the customer and how it will do it.

Step 2: Establish Target Sales Price

The sales price is determined by "what the market will bear." This market-bearing price is determined by three factors.

  • Competitors' Offerings. What do competitors' offerings look like?

  • Customer Expectations. What do customers expect? Let's make a key point here: The Internet has increased pricing pressure. For example, customers can visit Best Buy, check out the products they are interested in, and then go home and look for a lower-priced equivalent on line. This practice is called showrooming. Similarly, you can download a manufacturer's invoice price from before going to an auto dealership to negotiate the price of the new car you want to buy.

  • Distinctiveness. How distinctive is your product? Few companies offer a distinct-enough product to possess pricing power; that is, to be able to set their own price. Even Apple had to bring out a low-cost iPhone to stay competitive!

Step 3: Compute Target Cost

The target cost is simply the target sales price minus the target profit (i.e., how much you need to make from each product sold).

Step 4: Perform Cost Breakdown

The cost breakdown is where target-costing's rigor first comes into play. At this point in the analysis, you need to identify all of the components that make up your product. For a product as simple as a watch, you would want to consider the band, the case, the dial assembly, the timing mechanisms, the battery, et cetera. For a car, the component list is much longer.

Step 5: Engage in Target Costing Process

The target costing process takes place at the component level. Each component team goes back to the proverbial "drawing board" and asks a series of questions:

  • If we changed the design, could we reduce the costs?

  • If we changed the materials, could we reduce the costs?

  • If we changed specifications, could we reduce the costs?

  • If we work with suppliers to help them build better skills, could we reduce the costs?

  • What other cost trade-offs could we evaluate to take costs out of the product/process?

Step 6: Make Decision: Launch or Kill Product

If the target costing process is successful, you can proceed to launch. If not, it may be time to kill—or radically redesign—the product.

Figure 4.14: The Target Costing Process

Honda's Outcome

You may have already deduced the outome of Honda's target-costing initiative for the 1998 Accord. Working closely with suppliers, the product team actually reduced the cost of the new design by 30%. The launch was successful and many of the new innovations were incorporated into the next-generation Civic—a model that became a huge hit for Honda. Target costing became a standard tool in Honda's NPD process.

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