Target Costing as a Strategic Tool

Faced with increasing global competition, many firms are finding that cost-based pricing is becoming a relic of the past, whereas price-based or target costing is emerging as a key strategic tool. Consistent with the notion of price-based costing, several authors have argued that target costing is a superior approach to cost reduction and control when compared with typical standard-cost systems. Although many credit the Japanese with popularizing this technique, the idea and its early applications were evident in the philosophy of the Ford Motor Company in the early 1900s.1 Today, as firms outside Japan start to integrate target costing into their management systems, there is little consensus on the technique’s exact definition or when its use is most beneficial.

The logic of target costing is simple. The target cost is a financial goal for the full cost of a product, derived from estimates of selling price and desired profit. In a target-costing framework, product selling price is constrained by the marketplace and is determined by analysis along the entire industry value chain and across all functions in the firm. Top management sets the desired level of profit on the basis of firm strategy and financial goals. In many cases, the target profitability is based on desired return on assets or return on sales.2 In contrast with cost-based pricing, product cost does not drive the estimated selling price. Instead, the target cost is the goal that a firm must achieve to meet its strategic objectives.

Common to most target-cost applications is a process that starts with competitive end-use market prices as the basis for determining acceptable manufacturing costs and a belief that large-scale cost planning and reduction must occur early in the product life cycle. Several authors, in fact, assume that target costing is applicable only early in the product life cycle (i.e., during product specification and design).

For example, Cooper states: “The purpose of target costing is to identify the production cost for a proposed product such that the product, when sold, generates the desired profit margin. The focus of target costing is to reduce the cost of a product through changes in its design. It is therefore applied during the design phase of a product’s life cycle.”3

The Consortium for Advanced Manufacturing –International defines the concept as follows: “Target costing represents a set of management tools and methods designed to direct design and planning activities for new products, provide a basis for controlling subsequent operational phases, and ensure that products achieve given profitability targets throughout their life cycle.”4

These definitions imply that target costing is (1) driven by market price and desired profits and (2) performed only early in the product life cycle. Some also argue that target costing is only applicable in certain industries. For example, Atkinson et al. state that “target costing is a method of cost planning that focuses on products with discrete manufacturing processes and reasonably short product life cycles.” During the manufacturing phase of the product life cycle, such firms would incrementally improve processes by means of kaizen costing.5

Many U.S. firms use standard costing systems to control costs at the manufacturing phase. The focus of kaizen costing is much different. In general, standard cost systems focus on cost control (meeting the standard), whereas kaizen costing focuses on continuous improvement. That is, standard costing systems focus on meeting the cost standard and avoiding unfavorable variances. In contrast, kaizen costing stresses continuous cost reduction. Atkinson et al. present a detailed analysis of how these methodologies differ. In their view, combining target and kaizen costing under a single name is not beneficial since they rely on different cost-reduction techniques.6

In contrast with target costing, kaizen costing does not explicitly focus on market prices or planned profitability, but is internally focused on continual incremental product cost improvements. Several authors have argued that up to 80 percent of a product’s cost is fixed once it leaves product design, making major cost reduction difficult after the design stage. This implies that firms have little to gain by implementing target costing when products are in the manufacturing phase.7

The belief that target costing must be applied early in the product life cycle is based, in part, on the proposition that costs are fixed after a product is in manufacturing. In addition, increasingly shorter product life cycles also reinforce the supposition that major redesign loses its relevance when a product is being manufactured. These two propositions imply that any large-scale attempts at cost reduction at the manufacturing phase are pointless.

Atkinson et al. point out that Japanese firms apply target costing most often with discrete (i.e., assembly) manufacturing processes that undergo regular model changes.8 For example, Toyota, on average, changes models every four years, and Matsushita changes a disc player model every year. Although each model change can be viewed as a new product, many are actually modest modifications to the current product line. For example, when Toyota introduces a new Camry, it uses almost all the same manufacturing facilities and equipment to produce the new model, and a new Matsushita disc player may be almost identical to the previous model. Nevertheless, both manufacturers apply target costing to these product changes.

While target costing may be more easily applied early in the product life cycle, there is no conceptual reason the methodology cannot be applied to existing products. We believe that target costing can also be applied at the manufacturing stages of the product life cycle. By defining target costing too narrowly, managers may conclude that this methodology cannot be applied for existing products and may continue with their current ineffective cost-management systems. There are many industries that do not fit the profile of little flexibility in manufacturing costs and short product life cycles. For these industries, target costing later in the product life cycle may still be a value-added exercise.

Other researchers also see target costing as broadly as we do, suggesting that it can be applied throughout the full product life cycle. For example, Kato states: “In reality, target costing is not a cost-quantification technique, but rather a complete cost-reduction program. . . . Target costing is not a simple cost-reduction technique, but a complete, strategic profit management system.” And Horvath writes: “Target costing is just a part of the cost-management function for a product throughout its life cycle. The cost target set must then be achieved, while meeting customer requirements, using various methods designed to identify cost-reduction potentials.”9

The Institute of Management Accountants also advises that firms can apply target costing to new products and to those being modified.10 When sufficiently motivated, a firm can change production techniques, which may result in substantially different product costs and profitability. If managers were to believe that during manufacturing only incremental (i.e., slight) change is possible (through kaizen costing or controlling costs with standard-cost systems), firms might miss significant strategic opportunities. In fact, introducing a target-costing approach may drive product modification, rather than a planned modification prompting the initiation of target costing.

Next, we present a case study that demonstrates the relevance of target-costing techniques for a process-industry plant built in the 1890s that had been making largely the same products for fifty years. The firm’s managers had used a standard-cost system for many years and, given the usual restrictive definitions of target costing, might have concluded that kaizen costing was most appropriate for this plant. However, competitive realities necessitated a major strategic change that employed target costing as an important ingredient in cost-reduction efforts leading to strategic revitalization.

Montclair Paper Mill

Three months after becoming president of the Montclair Papers Division of Mohawk Forest Products, Tom Winton was trying to understand why the Montclair mill’s profitability was so low in order to formulate appropriate corrective actions. He focused on the manufacture of one product, Carnival Uncoated Cover Paper in Forest Green color, as representative of the mill’s problems.

Montclair is the oldest and smallest of the ten mills owned by Mohawk. The mill’s huge paper machines are some of the oldest in the industry, but, being well maintained, they still run well. The Montclair mill buys dry pulp, which it converts into coated and uncoated fine papers for premium applications, such as brochures, catalogs, magazines, annual reports, and labels. When creating viable strategies for Montclair’s 1,500 products, its managers strive to exploit the mill’s strengths and available market niches. Montclair’s machines are 200 feet long by 20 feet wide (60.9 × 6.1 meters). They differ in width (“trim”) and speed (feet per minute), which determines capacity. The machines can produce various colors, weights, and grades of paper, depending on pulp mix, additives, machine design, and machine settings.

It is widely believed in the papermaking industry that a firm can’t make money unless mills run continuously — three shifts a day, 365 days a year. What a machine produces is secondary to the fact that it is running. Changing products “on the run” (grade, weight, color, or texture) produces waste while the machine is achieving “on grade” performance. Estimated at 30 percent of overall mill cost, waste includes lost materials, sewage disposal, operating costs during changeover, and opportunities missed. The common wisdom is: “The fewer changes, the better.”

Narrow, old, and slow by parent-company standards, Montclair’s machines are new, wide, and fast for a premium papers niche mill. Montclair’s machines average ninety tons per day, whereas a typical premium papers machine produces from thirty tons to as little as ten tons per day. (A world-class commodity paper machine can produce 1,000 tons per day.) Management was not sure if Montclair’s size configuration constituted a strategic asset or liability in the premium niches. That is, management was unsure if there are scale economies or diseconomies for machines of this size.

In the premium paper segment, converting — the process of creating finished products from the huge “logs” of paper that come off the machines — is essential for a mill to produce exactly what each customer needs. The converting process includes coating, supercalendering, rewinding, slitting, sheeting, embossing, and packaging, with processes differing widely among products. Some paper is sold the way it comes off the paper machine; some products use nearly all the converting processes. At the Montclair mill, the converting area operates like a job shop.

Most of the converting equipment at the mill is not considered state-of-the-art. However, even modern precision sheeters and sheet packers do not perform at their rated capacities because of the many changeovers that occur during the process. In addition, some operations add no value, such as the process during which a machine flips huge stacks of sheets “face up” after a manual inspection operation flips them “face down” one at a time.

Montclair maintains one of the largest premium paper warehouses in the United States, called the Distribution Center (DC), that holds more than 20,000 tons of finished goods comprising 1,000 products. Montclair sells about half of its 200,000-ton output each year through the DC and about half in manufacturing orders.

Dark or “deep” colors are vital to product lines in the premium papers segment because they increase the visual appeal of a mill’s swatch books — critical tools for marketing these papers to printers and graphic designers. The mill’s 1,000-plus uncoated products differ in color, size, finish texture, basis weight, and package type. “Merchant” distributors usually sell these uncoated papers to job-shop printers that contract with end-use customers.

The Montclair mill produces deep colors on one paper machine with frequent grade changes to produce a wide variety of weights, colors, and textures. The mill produces the darkest colors least frequently — demand for any one product (i.e., variants of color, size, or texture) being limited to about four to six tons annually. A typical specific deep-color order from a merchant is two tons, which requires only about forty minutes of machine time. As a result, management infrequently schedules production of deep colors to allow longer runs in order to amortize the high set-up cost and production waste.

Forest Green Carnival grade paper is a typical deep-color product. It is difficult to run, difficult to sell in large quantities, and difficult to position in the marketplace. (See Table 1 for a typical value-chain analysis of one use of this product.)

The mill’s standard cost for Forest Green Carnival was $2,900 per ton (see Table 2 for a cost report). Selling at $2,200 per ton, the Montclair mill was losing $700 per ton. With warehousing costs and a capital charge for the prorated share of mill investment added, the loss was $1,020 per ton (see Table 3). The managerial challenge was to determine what the mill could and should do about this problem product.

Standard Cost Methodology

Montclair’s cost-analysis supervisor was convinced that the marketplace price for deep-color, uncoated cover grades was the problem, not Montclair’s manufacturing process. The standard cost of $2,900 per ton for Forest Green Carnival was solidly constructed on:

• Union wage rates for labor costs. (“Pattern bargaining” virtually assured comparable labor costs among the major firms, all of which were unionized.)
• Standard yield rates for all manufacturing steps, based on latest performance measured against longstanding norms at the Montclair mill.
• Current market prices for all purchased components.
• Generally accepted industry procedures for building the “normal” cost of scrap into the standard cost, after deducting the offset for the market value of the scrap generated.

The standards were updated annually for changes in purchase prices, process flows, and yield targets. With more than 1,500 products manufactured at the mill, more frequent updating was deemed infeasible.

Manufacturing management and the division president, Tom Winton, accepted that the standard cost represented the best practices of the mill and thus was an appropriate basis for monitoring manufacturing performance. Standard costs were also helpful to simplify calculating the month-end cost of goods sold and the ending inventory for financial statements. Updated only once a year, the standard cost was stable from month to month. Management viewed this stability as a positive feature in monitoring monthly performance against the annual plan.11

In short, this was a typically derived standard cost for a product that was infrequently produced and hard to make. Also typical was the high level of skepticism among financial, manufacturing, and general management that a substantially lower cost was feasible in this mill.

Mill managers believed that the loss per ton was related to price rather than cost. They believed that the sales organization (see Table 3) was keeping the $2,200 per ton selling price artificially low to compete against firms operating small, fully depreciated, obsolete mills that might be employing nonunion labor or following a marginal cost-pricing strategy to keep their mills running. Sales managers considered pricing as a variable based solely on market competition. They were already selling Carnival grade at prices several hundred dollars per ton higher than competitors, such as Ajax Paper Company (see Table 1), because the market perceived Carnival as a high-price/high-quality specialty grade. Although some customers willingly paid the price premium, many did not, making further price increases infeasible. According to the sales force, the loss was not a sales problem. Manufacturing thought that costs were based on well-established production processes and materials requirements. The loss was, therefore, not a manufacturing problem. Financial management monitored mill-production performance using its well-substantiated standard costing. Thus, from its perspective, the loss was certainly not an accounting problem. None of the groups considered the mill’s loss on Forest Carnival as originating with their processes or methodologies.

Target Cost Methodology

Starting with a price acceptable to end-use customers, target costing involves deducting normal costs and margins along the value chain back to the mill (see Table 1). In this case, Ajax Paper had won out over Montclair with a bid of $1,466 per ton, thereby setting the prevailing price in the market.

The last step in netting back to an “allowable” mill target cost is to deduct an allowance for a reasonable return on the investment at the Montclair mill. This is the residual income concept12 that recently resurfaced as economic value analysis (EVA). Calculating “economic earnings” can be a major challenge. Mill managers would have to make difficult choices about what to include in mill investment, how to value mill assets, how to allow for capacity utilization, and how to choose the required earning rate — all topics beyond the scope of this article. For our purposes, we estimate a capital charge of $120 per ton, on the basis of multiplying a fully allocated mill investment of $800 per ton (valued at replacement cost with full-capacity utilization) by an earnings rate of 15 percent (based on a factory-level proxy for the firm’s cost of capital). With this step complete, we can calculate a competitive target cost for the Montclair mill (see Table 4). Because the Montclair mill sells to merchant distributors from the DC, we must also deduct from $1,256 the cost of getting the product to and through the DC, including a capital charge on investment in the DC (see Table 5; data derived from Tables 2 and 3).

This clearly represented a depressing scenario for Montclair’s managers. The product had a target manufacturing cost of $1,162 per ton, but a standard cost of $2,900 per ton — a daunting prospect for the mill, to say the least! Even more depressing was the fact that the problem lay deeper than just cost inefficiencies at the mill, as we demonstrate next.

Although it is not usually defined this way, it is possible to decompose standard cost into an “ideal” cost (allowing for no waste, scrap, or conversion inefficiency) and an “allowable variance.”13 Such a definition highlights part of the problem with standard costing — a “normal” level of waste is sanctioned and buried in the allowable cost. (See Table 6 for a breakdown of ideal cost and allowable variance for Forest Green Carnival.) The Montclair mill’s ideal cost would be $1,342 per ton versus a target cost of $1,162 per ton. That is, even if operations were perfect, the cost would still be $180 per ton too high! Perhaps the market price of $1,466 per ton was “unreasonably low,” as mill management believed. When examined more closely, however, a competitor cost study not described here demonstrated that Ajax Paper Company probably earned a reasonable return on investment while charging $1,466 per ton, which translates to Montclair’s $1,162 per ton manufacturing cost target (see Tables 4 and 5).

Montclair management’s realization that an important competitor could be operating under a dramatically different mill cost structure seriously undermined the credibility of the assertion that a $2,900 per ton standard cost reflected the best practices of the mill.

Target Costing in Action

As a result of this externally motivated, value-chain–driven analyis, managers decided to take action. After Montclair managers accepted that the allowable cost of $2,900 per ton was more than $1,700 per ton too high, they decided to reengineer the manufacturing process for the product. The target-cost approach forced management to remove its standard-cost blinders.

Once the mill management team accepted the challenge of reducing by more than 60 percent the manufacturing cost for deep-color grades, it focused on the four major cost components:

• Fiber cost (changing the mix of recycled paper and virgin pulp to reduce raw materials cost).
• Paper machine cost (getting on grade faster to improve yields).
• Dye costs.
• Conversion cost (“make” versus “buy”).

As we show, each area yielded substantial cost savings when a target-cost mind-set replaced standard-cost dogma.

Fiber Cost.

A project team began a series of manufacturing trials showing that the mill could increase the percentage of recycled paper in the raw-materials mix above the standard allowance of 22 percent — a figure largely based on levels of internal scrap generation. Experience proved that recycled percentages ranging from 30 percent to 75 percent would not detrimentally affect the quality of the finished sheet if the scrap paper were handled carefully. The results of the scrap-usage experiments were so impressive that the mill kept increasing its scrap percentage. As in other industries, steady application of the kaizen philosophy achieved positive results.14

Using 75 percent scrap in the raw-material mix reduced the Montclair mill’s fiber cost by 60 percent with no negative effect on paper quality. In addition, market acceptance of the paper was favorable because Montclair could tout its product’s “high recycled content.”

Paper Machine Cost.

The dismal paper machine yield of 46 percent resulted from a self-reinforcing, negative cycle in the mill. Montclair management needed to schedule a four-hour run to achieve a yield as high as 46 percent (i.e., at least two hours to get the right shade and two hours of good production). But because the product had such poor yields, the mill scheduled a production run only about twice a year. Batching orders for six months allowed sufficient volume to justify a production run long enough to amortize the anticipated heavy changeover costs. The two-hour changeover time for Forest Green Carnival reflected infrequent product runs that did not enable crews to apply revised processes and improve yields. High losses meant that management was unwilling to run the product more frequently, thus causing the inefficient cycle to repeat itself. Breaking this cycle started a “must improve/can improve” mind-set driven by the target-cost study

For Montclair, a root-cause analysis of the long changeover time revealed that the biggest time loss was getting “on shade” for a designer-created color such as Forest Green. A project team tackled this problem by first observing that if the production run could start with a fiber mix closer to the desired shade, there was a dramatically reduced “off shade” time. That implied starting with green fiber, rather than white. This had never been possible when 80 percent of the fiber was virgin pulp that can only be purchased in one color — white. But increasing the percentage of recycled fiber in the raw material mix opened the possibility of buying green scrap paper instead of white. Since there was virtually no market demand for green “broke” (scrap), the mill was able to buy essentially unlimited quantities at low prices. Broke dealers were perplexed as to why anyone would want colored broke! The thin demand for colored broke was because other mills (using their standard cost systems?) did not have color-mixing systems able to start with anything other than white fiber.

Another project team experimented with Montclair’s computerized color-mixing system. Over the course of a year, they were able to develop proprietary software that allowed the color-mixing crew to get “on shade” in 40 minutes instead of 2 hours by starting with green broke. The software they developed could take any combination of green shades of broke and mix to the exact Forest Green shade in only 40 minutes. This breakthrough derived from “branch and bound” sort routines starting with a CD-ROM containing digital equivalents of 500,000 color shades. Reducing changeover time from 2 hours to 40 minutes raised the yield rate to 75 percent when producing 2 hours of good paper (120 minutes ÷ [120 + 40]).

Dye Costs.

Starting the papermaking process with up to 75 percent green fiber required much less dye to achieve the exact Forest Green shade. The newly developed proprietary software enabled getting on shade with an average dye cost of only $250 per ton instead of $500 per ton. Considering the 75 percent paper-machine yields, this reduced dye-related costs from $1,196 to $400 — an amazing $796 reduction in the cost per ton (see Table 7).

Conversion Costs.

Another project team tackled this cost component by seriously considering the make-versus-buy option. Based on a preliminary best-practices survey, a world-class conversion cost of $150 per ton was deemed possible (as compared to Montclair’s cost of $303 per ton). Each converting department was challenged to develop competitive programs or risk job loss to outsourcing. In fact, one salvage rework department was closed because improved “first pass” yields eliminated much of the “second pass” rework. Management also enacted a hiring freeze with the aim of absorbing all turnover in conversion jobs through productivity improvements. Over eighteen months, the $303 per ton conversion cost for Forest Green Carnival fell to $240 —a 20 percent reduction (see Table 8). Although no individual component in the calculation improved by more than 11 percent, a 20 percent overall improvement was possible thanks to the benefits of compound arithmetic! Interestingly, this dramatic reduction did not become the new “standard,” but was just the first step in a continuing kaizen effort to halve the original cost. The externally derived best-practice number of $150 per ton continued to be the benchmark.

By combining the improvements contributed by the four project teams, it was possible to envision lowering the manufacturing cost from $2,900 to $1,162 (see Table 9).

Although the mill did not regularly achieve these benchmarks, the management team was greatly encouraged. A target-cost mind-set could bring the lower numbers well within reach. The revised standard cost was lower by $1,738 ($1,162 versus $2,900) — almost a 60 percent reduction. Clearly, for this mill, the concept of “achievable standard” was amenable to continuous improvement after incorporating a target-cost framework. The target-costing framework dramatically lowered manufacturing costs, after which the mill continued to decrease costs through kaizen efforts.

The revised standard — $1,162 — was $180 below the $1,342 figure that had been considered the ideal cost in the first stage of the target-cost study. Yet, $1,162 still included 25 percent machine loss and 10 percent conversion loss. With substantial room for further cost reduction, the ideal cost dropped from $1,342 to $832 — a 38 percent reduction. Clearly, the concept of ideal cost is not an absolute, but is relative to how one thinks about the process.

Conclusion

The Montclair mill experienced a dramatic turnaround. Initially, the revitalization project teams faced a standard cost of $2,900 versus a target cost of $1,162, and an ideal cost of $1,342. After about eighteen months of price-based costing initiatives, Winton and mill management could see the possibility of an achievable target cost of $1,162 versus an ideal cost of $832. Thus, additional savings of $330 per ton remained a goal for future project teams to attain.

The following cost concepts featured prominently during the evolution of cost-reduction efforts at the Montclair paper mill:

• Ideal manufacturing cost (viewed from an internal perspective). No waste, no scrap, no inefficiency, no delays, perfect formulations, and perfect plant layout.
• Target cost (viewed from an external perspective). Ideal value proposition price to the end user. From the ideal value proposition price to the end user subtract normal costs and margins along the value chain back to the manufacturer.
• Standard cost (tough but attainable). Ideal cost plus the allowable waste and inefficiency.
• Actual cost.

At the beginning of this field study, management focused too much attention on standard cost versus actual cost. There was heavy pressure to move standard cost toward actual cost in order to minimize unfavorable variances for public financial reporting. Management focused too little attention on ideal manufacturing cost, which is often dismissed as having dysfunctional motivational impact.15 Target costing received no attention. At the end of the field study, the most useful cost-management tool focused on ideal manufacturing cost versus target cost in relation to actual cost. The standard cost concept essentially dropped out of the picture.

The Montclair story illustrates the potential of using target costing as a proactive cost-reduction tool in place of ineffective standard costing. Although this account — as a single story — could be subject to “small sample bias,” it does not suffer from selection bias. The mill management team had no idea at the start of the target-cost project that results would be so dramatically positive. In fact, the prognosis for continued production of deep colors looked so bleak at the outset that the problem was viewed as more likely a make-versus-buy choice.

Target costing forced Montclair’s managers to rewrite the rules of the game by changing the way the mill delivered value to the customer. Because standard costing accepts the existing game rules and the existing value chain, we believe that fundamental cost breakthroughs are much more probable when using target costing.

We hope that this case study will encourage further field research to either confirm or refute our findings. We believe target costing is often too narrowly defined, which results in managers clinging to their current cost-management systems in the belief that target costing is irrelevant to their businesses. Cost-management practitioners need to seriously reappraise the prominence of standard costing as a cost-reduction or cost-control tool.