Target costing is the practice of setting a cost for a new product prior to its design that when combined with the planned selling price will give the profit margin necessary to achieve the return on investment (ROI) that has been given in the business case.
This should mean that the desired price and profit margin are more likely to be achieved than when using the more traditional ‘cost plus’ method.
However the target price must be realistic, as there is no point in setting a pie-in-the-sky target that cannot be achieved. You are just deluding yourselves.
How to do Target Costing
Thus the best way is to approach it in 2 ways; top-down and bottom-up and then do your best to resolve any mismatch in the 2 figures in the feasibility stage of the programme before it is finally approved.
This starts with a prioritised list of requirements, functions and features and a target selling price that is expected to give the desired sales volumes. (See Value Pricing) Allowing for VAT, dealer margins, transport etc. an ex-works price can be calculated.
Then by deducting the profit margin that is in the business case, one can calculate the cost that would give the required margin and selling price. This is the target cost for the product. If there is to be a family of products and perhaps also optional features, they should all have target costs calculated.
If there is a similar product currently in production, then the target cost calculated as above can be compared with the actual cost, and any differences understood and resolved if necessary. Please note that it is important that you are comparing like with like, so you should be clear what has been included in each case, e.g. overhead burden, tooling amortisation, development costs, launch costs etc.
If you don’t have an existing product to compare with, then benchmarking competitors costs is recommended, i.e. buying one and tearing it down to estimate their manufacturing cost. (See bottom-up, below)
If that is not possible than you must make the best estimate that you can.
The overall cost of the product should then be split into target costs for a final assembly and a each major system. This should be further cascaded down as far as is practical, in the same way that requirements are cascaded down. Individual features should also have a target cost allocated to them.
The bottom up method starts by having a preliminary Bill of Material (BoM) and an estimated cost for every part on the BoM. This is relatively straight forward if you are planning a ‘Mark 2’ of an existing product, as the current product should already have a costed BoM, and many items may be carry-over or similar. The total cost can then be built up from the bottom by taking the piece cost for each sub-assembly plus its assembly cost and repeating this until you have the total cost for the product, making estimates for new parts.
This cost can then be compared with the top down one, and any differences resolved. In particular you should be able to make judgements about whether to include features or not depending on their cost and their expected sales value.
If you don’t have an existing product upon which to base a bottom-up estimate, then life becomes more difficult. If there is a competitor product available, then one could do a tear-down to estimate their costs (see above). Otherwise one either foregoes doing a bottom-up costing at this stage, or spends some time doing a feasibility study to be able to figure roughly what a BoM would look like and how much the parts and assembly would cost (at least the major items)
Design to Cost
Once you have an agreed target cost for the product as a whole, and for each system and sub-system (and possibly even each part), you are then in a position to use that cost as a design parameter. In other words it then becomes a viable engineering parameter, like performance or weight, that should be calculated and optimised during the design process, and thus kept in control.
The variance between estimated production cost and target cost should be tracked and if it is looking to be excessive, it should be flagged up as an issue, and the system concerned should be redesigned to cost less. If this is not possible, then the effect of the cost increase should be assessed with regard to the impact on margin and/or sales volume, and in the limit if the project no longer looks to be financially viable it should potentially be stopped.
Note: Here we are speaking about the production cost of the product, as opposed to the development cost of the project, but those and other costs, e.g. tooling costs should also be tracked. Of course if the product is a ‘one-off’, then the project and product cost are potentially the same thing.
Some authors contrast Design-to-Cost with what they call Design-to-Value which emphasises the value that can be delivered to the customer, instead of the production costs for the manufacturer or company. However we think that those authors are confusing ‘cost’ i.e. how much it cost to make, with ‘price’, i.e. how much the customer is charged (see Value Pricing for further discussion).