Develop Profitable New Products with Target Costing

With the emergence of the lean enterprise and global competition, companies face ever-increasing competition. To survive, companies must become experts at developing products that deliver the quality and functionality that customers demand, while generating the desired profits.1 One way to ensure that products are sufficiently profitable when launched is to subject them to target costing.2

Target costing is primarily a technique to strategically manage a company’s future profits. It achieves this objective by determining the life-cycle cost at which a company must produce a proposed product with specified functionality and quality if the product is to be profitable at its anticipated selling price.3 Target costing makes cost an input to the product development process, not an outcome of it. By estimating the anticipated selling price of a proposed product and by subtracting the desired profit margin, a company can establish its target cost. The key is then to design the product so that it satisfies customers and can be manufactured at its target cost.

In Japan, lean enterprises have learned to view target costing not as a stand-alone program, but as an integral part of the product development process. To document the “Japanese” approach to target costing, we visited seven companies with mature and effective target costing systems and documented their procedures in depth. The companies we studied were Isuzu Motors Ltd., Komatsu Limited, Nissan Motor Corporation, Olympus Optical Company Ltd., Toyota Motor Corporation, Sony Corporation, and Topcon Corporation.4 While the target costing practices at each company differed, we identified a common underlying generic approach that we document here to give managers a road map for implementing target costing systems.

Target costing, to be effective, must be a highly disciplined process. The process used at the seven firms studied can be divided into three sections (see Figure 1). The discipline starts by forcing alignment with the marketplace and requiring a new level of specificity about what customers want and what price they are prepared to pay. Market analysis plays a critical role in shaping the market-driven costing section of target costing by determining so-called allowable costs. Target costing systems use these allowable costs to transmit the competitive cost pressures that the company faces to the product designers.