Life cycle costing is not a new concept. A definition was provided in 1976 that suggested “the life cycle cost of an item is the sum of all funds expended in support of the item from its conception and fabrication through its operation to the end of its useful life” (White and Ostwald, 1976, p.39). We could extend this definition to explicitly include the cost of recycling materials from the product following the end of its useful life.
Target costing is said to have been developed by Toyota in the 1960s. The practice soon spread to the whole of the Japanese automotive industry (Tanaka, 1993), and by the 1990s had been adopted by 80% of Japanese manufacturing organisations (Kroli, 1997). The adoption rate in other countries was much slower. There is evidence that Ford was using the principles of target costing in the early 1990s (Shank and Fisher, 1999) and it has since become more wide spread in other organisations and countries (see for example, Yazdifar & Askarany, 2012; Helms, et al., 2005; Dekker and Smidt, 2003).
The target cost is derived by deducting the profit margin from the market selling price, that is, target cost = selling price minus expected profit margin. Kato (1993, p.33), states that ‘target costing is not a costing system as such; rather it is an activity which is aimed at reducing the life cycle costs of new products, while ensuring quality, reliability, and other customer requirements, by examining all ideas for cost reduction at the product planning, research and development process.’ As the definition suggests, it is the early stages of the new product development process where the technique is said to be the most useful.
One of the key strategic options available to organisations to sustain a competitive advantage is product development. This can encompass modifications to existing products, for example, adding cameras to cell phones, as well as developing completely new products. The speed of developments in technology, an increased degree of competition, changing consumer demands, and a heightened awareness of sustainability means that product development is becoming a key aspect of strategic planning and developing a successful business strategy. The implication being that resources need to be allocated to activities such as research and development, design, and marketing research.
These costs are becoming more significant for many businesses as product life cycles are shortening due to the aforementioned speed of developments in technology and the increased degree of competition, making constant innovation and product development a critical success factor in many business sectors. The management accounting concept of life cycle costing suggests that considering the costs of the complete product life cycle from cradle to grave, or cradle to cradle, if we consider the recycling after use, can provide additional benefits to the organisation, particularly in the activities of new product development, affordability studies, source selection, and repair or replace decisions.
Life cycle costing – a definition
Life cycle costing is not a new concept. A definition was provided in 1976 that suggested “the life cycle cost of an item is the sum of all funds expended in support of the item from its conception and fabrication through its operation to the end of its useful life” (White and Ostwald, 1976, p.39). We could extend this definition to explicitly include the cost of recycling materials from the product following the end of its useful life. The typical stages are illustrated in Figure 1.
The life cycle costs include all costs incurred from the initial concept emerging from the research and development process to the recycling of materials at the end of the products useful life. The diagram in Figure 1 also illustrates that modifications may be made to the initial design during a products life. This often takes place during the mature phase of the sales life cycle as competition moves away from price towards product features and companies adopt extension strategies to prolong the product and sales life cycle. Consider, for example, how the mobile cell phone has developed from a device that made telephone calls to be the product it is today, and the business sectors that have developed because of the device. It may not be possible to anticipate the additional functionality and modifications at the initial design phase, but there needs to be a recognition that the concept of life cycle costing should be considered when making product modifications, just as much as at the initial new product development stage.
The key phases where costs are incurred in the development of the product and its sales life cycle are illustrated in Figure 2. The duration, timing, and degree of overlap of these are dependent on the actual product or modification being developed, but they are useful headings under which to categorise the costs for planning and monitoring purposes. There may even be an element of ongoing consumable costs beyond the initial purchase. For example, a coffee maker such as the Nespresso machine where consumers purchase the machine, then purchase the consumable coffee capsules, which can be returned to a Nespresso recycling point after use. This creates an ongoing recycling cost as well as production cost.
Recognising the different categories of costs allows trade off between costs to be considered. For example, between design and manufacture. This also takes into account the fact that many costs are committed before they are incurred, for example, decisions about materials, the production process, product features, and so on, are made prior to commencement of manufacture. This can be up to 70-90 percent of the total product costs (Bescherer, 2005). The point here is that these costs are typically recorded and reported during the manufacturing phase, and therefore unless considered beforehand can create surprises for management. This is also true of the end of life costs, which are now becoming a key part of product development due to the increased awareness of sustainability issues.
Life cycle costing is connected to other concepts and techniques. For example, the use of target costing. Once the target cost is identified, which is derived from deducting the desired profit from the selling price (Garrett, 2018), all phases of the life cycle can be considered in achieving the target cost. The concept is also widely used in the building and construction industry, and also found in the defence industry and state sector (Woodward, 1997). Life cycle costing is not confined to the design and development of new products, but include uses in affordability studies, for example investigating the cost of acquiring and operating a building; source selection studies, for example, between different vendors or products; evaluating alternative operational decisions, such as whether to take out an extended warranty or simply repair or replace.
These uses recognise that life cycle costing can be used from different perspectives. For example, in new product development it is being used from the perspective of the manufacturer, but in the selection of alternative suppliers and purchase options, it is being used from the perspective of the client.
The full article explores examples of new product development, building and construction projects, affordability studies, comparison of alternative options, methods, and the benefits, drawbacks and implications of life cycle costing.
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Target costing is said to have been developed by Toyota in the 1960s. The practice soon spread to the whole of the Japanese automotive industry (Tanaka, 1993), and by the 1990s had been adopted by 80% of Japanese manufacturing organisations (Kroli, 1997). The adoption rate in other countries was much slower. There is evidence that Ford was using the principles of target costing in the early 1990s (Shank and Fisher, 1999) and it has since become more wide spread in other organisations and countries (see for example, Yazdifar & Askarany, 2012; Helms, et al., 2005; Dekker and Smidt, 2003). Target costing is often viewed as a technique for use in manufacturing, rather than service organisations, however, Yazdifar & Askarany (2012) note that service organisations are also finding the technique useful. Target costing uses a market based approach to pricing to derive an allowable cost for new products, as opposed to deriving the selling price by adding a mark-up on cost. This makes cost an input to the product development process, rather than an output (Cooper and Slagmulder, 1990).
Hiromoto (1991) suggests that the market based approach to pricing is highly relevant in a competitive market, and that management accountants are able to help to motivate a market-driven behaviour by working as part of the team to derive a market allowable cost, and to ensure continued profitability of the organisation. Due to its market based approach, recognition of the customer perspective, and forward looking orientation, it is often included among the techniques described as strategic management accounting.
This article explains what target costing is, where it is appropriate, the process, and the benefits and limitations of the technique.
What is target costing?
The target cost is derived by deducting the profit margin from the market selling price, that is, target cost = selling price minus expected profit margin. Kato (1993, p.33), states that ‘target costing is not a costing system as such; rather it is an activity which is aimed at reducing the life cycle costs of new products, while ensuring quality, reliability, and other customer requirements, by examining all ideas for cost reduction at the product planning, research and development process.’ As the definition suggests, it is the early stages of the new product development process where the technique is said to be the most useful. This should not, however, preclude the principle elements of the technique from being used to reduce costs of existing products, or of the downstream activities of delivery and customer service. Ansari and Bell (1997) place the focus of target costing as being a means of managing the organisation’s future profits. It provides a system for integrating strategic variables to simultaneously plan how to satisfy customers, capture market share, plan and control costs, and hence, generate future profits.
The main reason why the technique is focused at the early stages of new product development process is that, in most cases, 80% of the costs are determined at the design stage. It is easier, and cheaper, to manage the costs during the early stages of product development (Ulrich and Eppinger, 2000) than to make changes after the product is introduced, which can often be quite costly (Cokins, 2002).
Where is target costing appropriate?
Target costing is becoming more relevant today due to the shorter product life cycles and increasing product diversity required to satisfy increasingly sophisticated consumer markets (Gagne and Discenza, 1995). Dekker and Smidt (2003) identified in their study of Dutch firms that it was used more by assembling firms, and those organisations that operated within a competitive and unpredictable environment. Hibbets et al. (2003) suggested that it is more likely to be used by firms following a differentiation strategy, where functionality may be more significant, and there is strong rivalry among organisations. The argument here is that an organisation following a cost leadership strategy would be trying to reduce costs on a continuous basis, and therefore, as the product is only designed to fulfil its main purpose, rather than being loaded with functionality, the organisation is targeting those customers that just require the basic product. It could equally be argued, however, that even the cost leader would find techniques such as value engineering and functional cost analysis useful in helping to reduce costs, making the principles of target costing appropriate for all organisations.
Davila and Wouters (2004) suggested that target costing is less useful where technology, time-to market, or very demanding customers are important to a product’s success. However, there is evidence that suggests that using target costing can reduce time-to-market (Afonso et al., 2008) if the concept becomes part of the culture of the organisation, and customer demands can be met more profitably via target costing methods, no matter how demanding the customer.
The principles of target costing should be applied to all product developments and increases in functionality as it moves through the product life cycle. Adding new features should be subject to the same process as the initial product. For example, the mobile phone was initially developed to make phone calls, and later to send text messages. As the technology developed and the Smart phone (a new product development) became the norm, additional features were added, such that Smart phones are now marketed and purchased because of the quality of the camera and ease of use, and the functionality of the ‘phone call’ is now incidental to the product. The look, feel and ease of use, have become key value drivers for the customer. The mobile phone also serves to illustrate the complexity of the markets and interlinkages between product and service elements, as digital coverage, and signal strength provided by competing networks also impacts on the mobile phone market.
The process of target costing
There is no one definitive series of steps to undertake the activity of target costing. There are elements where an iterative approach is appropriate and elements can be undertaken simultaneously, rather than sequentially. The following steps are indicative of the process.
1. Re-orient culture and attitudes towards a market based approach
Target costing requires a market orientation and this may require a change in the organisational mind-set to enable the customer focus to take precedence. Implementing target costing may well entail a change of culture (Crow, 1999) as employees need to be empowered and motivated to find innovative solutions to reducing costs without losing the required functionality of the product, or compromising on quality. Monden (1995) suggests that an objective is not just to reduce costs of a new product, but to motivate all employees to constantly seek ways of managing costs, or, as Ansari and Bell (1997) noted, a way of managing future profits. Kato (1993, p.43) notes that a characteristic of Japanese management processes is that it ‘combines a human intelligence for effective thinking and a technological innovation to make daily operations efficient.’
2. Establish a market-driven target price
Ascertaining the price of the product is the responsibility of the marketing department. Target costing is about maximising profit over the product life cycle (Cokins, 2002). Therefore, factors that need to be considered include the impact on the price of the product concept itself; the characteristics of the target market; the anticipated product life cycle; expected sales volumes, as this will impact on production costs; sales price adjustments as the life cycle progresses; competitor pricing , if similar products already exist; and any dealer incentives. Pricing strategy and objectives also need to be considered throughout the product life cycle, such as, whether an initial profit maximising objective is to be employed to skim profit of the market before competitor offerings appear, or a volume maximising objective, which will lead to a lower price being employed.
If the product is at the forefront of technological design other theories, such as the diffusion of innovation, may come into play. For example, the electric vehicle, which is in the early stages of the product life cycle, is probably being purchased by the innovators and moving towards early adopters. The theory of diffusion of innovation suggests that new technology is adopted by the population in a certain pattern – innovators are the first to purchase the product (who represent 2.5% of the market), early adopters (13.5%), next the early majority purchase (34%), followed by the late majority (34%), and finally laggards (16%). The volume aspect of the life cycle is significant for manufacturing costs, as these may become lower as the product progresses through the life cycle, due to learning curve effects, or economies of scale, as the volume increases. This may mean that the target cost is only achieved at a given volume and early sales incur losses, requiring continued additional investments, before the product eventually breaks even and begins to enter the profitable stage of the life cycle. There is an obvious risk involved here in that it may take longer than anticipated to reach the required volumes, or that they may never be reached. Plus, if the product grows successfully competitors will undoubtedly enter the market. Therefore, if the whole of the life cycle is to be considered it requires a forecast to be made of the pattern of future demand, and the likely response of competitors. Data from existing products and past market information can be used to help forecast the likely pattern of future demand for new products, and building up competitor response profiles will help to anticipate the potential response of competitors.
The marketing department also need to consider the use of ‘pricing by function’ (Kato, 1993) or ‘customer value oriented product pricing’ (Bock and Putz, 2017). This feeds into the functional cost analysis used later in the process to identify where cost reductions can be made without destroying the value to the customer. Data on customer needs can be gathered from a range of sources, such as: market research; reviewing competitors’ products; specific requests from customers; using a form of idea generation, such as brainstorming sessions; the formation of creative teams; and employee suggestion schemes. It is important to realise that establishing demand is more than just identifying what the customer wants, as there is a difference between the customer need (a basic need for social interaction), and the want (such as a mobile phone with a specific functionality). Demand is the want, coupled with the ability to pay. Many people may want, or desire, the prestige of a very expensive car, but not everyone can afford to buy one. The skill, therefore, is estimating how many people are likely to buy a product and the pattern of demand over the life of the product – this is where experience counts.
In reality due to the potential complexity of the sales price variations that may occur over a products life, some of which may not be anticipated at the outset but made as a competitive response in the growth or mature stage of the life cycle, a price is established that represents a competitive price that the product will be sold at during the mature stage of the products life. This is the price that the product will settle at in a competitive market. It may be that the early price at which the product is introduced may be slightly higher.
The performance of existing and past products can be an important factor in determining a pricing strategy, so organisations need to ensure that they employ data collection systems that are capable of collecting data on sales volumes, pricing and costs over a period of time, and the ability to integrate the system to determine trends, and what works, and what did not. Target costing is most effective when the organisation has access to good data.
3. Determine required profit
Each product or service that an organisation sells makes a contribution to the overall profit achieved. Therefore, it is not just a case of taking a broad approach to setting a profit target of 10% for all products. Not all products necessarily make the same contribution to overall profit. The profit associated with a product has to be determined in relation to the overall strategy of the firm. Existing products can provide a reference point for assessing the profit potential of new products, but senior managers need to be aware of managing a portfolio of products, and a portfolio of customers, so profit targets needs to be set by the people in the organisation who are aware of the overall strategy.
Information systems play a key role in setting profit targets, as profits are affected by indirect manufacturing and general overhead costs, as well as direct product costs. Therefore, costing systems that are capable of allocating costs to products on a reasonable and fair basis, such as activity-based costing, can greatly assist the process of target costing. Tani et al. (1994) found that over 80% of firms in their survey indicated that overheads and depreciation on new investments were included within the target costs. Cooper and Slagmulder (1997) also indicate that final target costs should include indirect manufacturing costs.
A few authors have suggested that it should also take account of financing costs. Indeed Kee (2010) provides a numerical example where target costing that ignores the finance cost can lead an organisation into making an incorrect decision about the long term viability of a new product. Kee demonstrates that undertaking a net present value calculation can indicate that the product is not viable, even if the target cost is achieved. The examples, however, do depend on the level of investment required to produce the new products. It is therefore, important that the level at which profit targets are set is fully understood as this will impact on the costs that are included in the analysis. For example, is it a target profit expressed as a contribution, or a target return on investment. In practice the profit expected is after deducting all costs incurred up to the point when the product is ready for sale.
4. Determine the target cost
The target cost equals: selling price minus the required profit margin. This provides the allowable, or target cost. Cooper and Slagmulder (1990) determined a cardinal rule that the target cost should never be exceeded. In theory if the target cost cannot be achieved then the product should not be approved. However, the target cost can be broken down in to setting allowable cost targets at component level, and therefore, if this rule is applied throughout the process it ensures that making changes to smaller component elements of the overall design does not create a situation where the overall target cost is exceeded.
The marketing research undertaken around the product concept, functionality and price acceptable to the consumer gives an indication of the market cost drivers. This provides information about the importance of various functionality, and hence identifies sensitive areas where the balance between functionality and cost needs to be carefully managed. They are referred to a market cost drivers as it defines the functionality required by the market.
The use of functional cost analysis can then be used to identify target or allowable costs for functions, and the components required to provide that function. Where bought-in components are used it is important to involve suppliers as early as possible (Ellram, 2000), and to develop a close working relationship, as achieving cost savings in this area requires their cooperation. A challenge of working with suppliers and outsourcing elements of the production process is determining the exact specification and expectations of performance from the suppliers. This has links to the concept of total quality management and ensuring that there are systems in place to monitor suppliers, not just in terms of cost, but also in terms of performance (Quelin and Duhamel, 2003; Natovich, 2003).
5. Establish a multidisciplinary team to undertake the exercise
Target costing, and particularly functional cost analysis, which is part of the process of achieving the target cost, should ideally involve a group of employees drawn from different departments such as marketing, design, production engineering, purchasing, and accounting (Gagne and Discenza, 1995). The members of the team should work together to fully understand the interplay and trade-offs between costs and functionality, and consequently, whilst a broad background is desirable, there may be some training involved in order to make the team operate effectively. In large organisations this is often a permanent team within the organisation, indeed, there could be several teams working on different product developments at the same time. In smaller organisations it may be a team pulled together for specific projects, but the key factor is having the right mix of skills, and their ability to make decisions. This team approach needs to feed into a process of organisational learning so that future projects benefit from the experience gained, and lessons learned from previous successes and failures.
6. Establish initial cost estimate via a product cost model
The initial product cost is established by creating a detailed breakdown of the manufacturing cost including materials, labour and manufacturing overheads. It is useful to include within the model the anticipated volumes and demand forecast profile over the life cycle of the product, or at least over an extended period of time. This enables factors such as a reduction in manufacturing cost due to learning curve effects, economies of scale, and any anticipated changes in costs, to be accounted for in the analysis.
The model should include all costs that can be managed in respect of the product. Techniques such as activity-based costing can be used to help ascertain the indirect costs. Inventory related costs and distribution costs should be included as these costs can be managed to reach the desired profit level. If new investment is required, and a time period profile is prepared, the cost of financing can be included by developing the model into a net present value calculation.
It goes without saying that a good costing system is required so that the cost estimates can be made as accurately as possible, bearing in mind that the accounting policies, such as the method of calculating depreciation rates, and the availability of information, can impact on the costs when assigned to products.
7. First look at ideas to reduce cost – generate ideas and evaluate alternatives
If the initial cost exceeds the allowable cost then ideas are generated to reduce the cost. This should include all costs associated with the product. In attempting to reduce costs the basic idea of target costing should not be forgotten, that is, the customer view of functionality and quality of the product is paramount, so any reduction in costs should not impact on the customer perception of the product. The objective is to make reductions in cost without changing the value of the product in the eyes of the customer.
8. Use tools to reduce cost such as value engineering and functional cost analysis
8.1 Value engineering
The basic concept of value engineering (VE) involves designing a product at a lower cost by reviewing the functions needed by customers. Park (1999, p.195) suggests that VE includes the following main tasks:
1) Identifying the relevant function of the product or service;
2) Establishing a monetary value for identified functions;
3) Providing the require functions at the lowest cost.
There are several aspects to value. For example, cost value is, as the name suggests, the cost of the function or product. Exchange value is how much the customer is prepared to pay for the product. Use value is the purpose the product fulfils, that is, when the product can be, and is, used for the purpose for which it was intended, for example, a chair has use value in that you can sit on it. A customer that merely wants something to sit on may not be looking for a high quality, handmade leather chair. Esteem value is related to the prestige that the customer places on the products ownership, for example, a customer may be looking for high quality furniture, not just because it serves a use, but also because it has a certain prestige value of owning high quality, luxury and therefore, possibly, expensive furniture. This highlights the significance of determining the target market before undertaking value analysis, as different consumers will place a different value on aspects of a product depending on how it is viewed by them.
Value engineering can be broken into stages. Ibusuki and Kaminski (2007) highlight three levels that focus on the product concept, the design phase and the production phase. The product concept phase involves a zero look. This considers new concepts and new functionalities that do not currently exist. First look is concerned with the product design stages and primarily seeks to develop new products from existing concepts. First look identifies the main areas to target for a reduction of costs. This can include using existing products as a reference point to look for improvements. Second look picks up at the later design stages, detailed component design, and moves into the production stage. Tear down analysis can also be used to facilitate the understanding of functionality and costs if competitor products exit. This is a process of taking a competitor’s product to pieces to understand how it is designed and manufactured and is part of competitor analysis.
Value engineering techniques often include the use of checklists of functionalities along with their associated costs. It is not, however, a process of simply choosing functions from a list and deleting those that save money, as the requirements of the customer need to be taken into account, as well as the knock on effects of one function on another within the overall design, and the potential impact on quality.
8.2 Functional cost analysis
Functional cost analysis as the name suggests is the process of mapping the functions of the product broken down into component parts, and assigning the cost to each element. The function is described in terms of verbs, that is, what activity or function is it that the product or the component needs to perform. This is then linked to the actual physical elements of the product. For example, in a household water tap, the basic function is to allow the free flow of water as and when desired. There are several component parts that make up the tap. Each element performs a particular function within the design and has a cost attached to it. This could be materials and labour. If component parts are bought-in the suppliers also need to be involved in the process. The parts are then assembled, packaged, stored, delivered, marketed and sold to customers.
A table can be used that identifies the following elements: the functions, the parts, and the costs (materials, labour and indirect costs which can be assigned using technique such as activity-based costing). This forms the basis of a cost table that can be prepared with the help of the accountants. The marketing department will also have some input as certain elements will provide much more value to the customer than others. For example, those parts that are purely functional, that is, they have to be there to make the product work, may not be seen as a key selling point to the customer, but what customers value is the look, style, and finish of the product. Therefore, the handle design may have much more significance for the customer than the tap spindle, but the tap will not work without a spindle. This does not necessarily mean that the component parts can be made from a lower quality and hence less costly material, as this may affect the reliability of the product, which may be a factor valued by the customer. This illustrates that some of the functionality required by the customer is subjective. For example, mobile phones include a camera, but the ease of use, and ease of handling the device when taking selfies are just as significant as the physical attributes and functions of the camera. Techniques such as functional cost analysis and value engineering enable a better understanding and consideration of the trade-off between product function and cost (Iranmanesh and Thomson (2008). For example, the question would be, can the product be made from different materials that provide the desired reliability and quality?
The relative importance of various functions and attributes to the customer can be assigned based on a value 1 – 10 with 1 being not required, to 10 being of extreme importance. Or more loosely, it could be based on a simple scale of: not required, nice to have, or essential.
The difficulty of understanding how components add value and contribute to the whole cannot be underestimated. Imagine how many parts there are in an Airbus A380. There are several thousand engineers involved in the design, so it can be a significant project undertaking and requires appropriate project management skills and leadership as well as the technical skills and knowledge. Pronin et al. (2004) highlighted how engineers often overestimate the important of their component, or overdesign it to demonstrate their competence in design (Siemen, 2008). Overdesign can also occur through risk aversion, or believing that the component must perform under extreme situations. This emphasises the need to engender a team approach to value engineering and functional cost analysis, and to include review and critique sessions to guard against overdesign, but also to ensure that cost savings do not impact on the required functionality, reliability and quality of the product.
9. Reduce indirect costs
There may be scope to reduce the indirect costs that help to achieve the target cost. Techniques such as just-in-time management of inventory, production patterns, and improving the efficiency and effectiveness of activities such as machine set-up, maintenance and so on, can provide cost savings. Nor should we ignore the concept of continuous improvement (Ellram, 2000), which can provide significant benefits in achieving the target cost through the life cycle as well as increasing the cost accountability of all those involved.
10. Undertake overall net present value analysis over estimated life of product or reasonable time period
Where significant investment is required to produce the new product, or further investments to meet capacity requirements as the product grows, it is useful to undertake a net present value calculation feeding in the cost estimates and demand profile. This then takes account of the cost of capital and provides additional comfort that the product is viable in the long term. It is always worth remembering that the NPV calculation will include estimates, and sensitivity analysis should be undertaken to establish acceptable levels of error in the estimates for the future years.
11. Ensure cost management system in place to monitor ongoing costs and take corrective action where necessary.
Target costing requires a good cost management system for monitoring the costs and taking corrective action in the future. The database of costs can be developed and improved over time as experience is gained of using the technique. This should also include supplier evaluation and the continuous monitoring of supplier performance to ensure that costs are managed throughout the whole value system.
12. Feedback for organisational learning
Not all new product launches are successful, and not all estimates will be accurate. The experience of target costing exercises need to be fed back into future products so that the process can be continuously improved.
Benefits of target costing
Target is gaining in popularity, but the level of detail can be off-putting, particularly for smaller organisations that do not have the appropriate skills and resources. The basic concept of market driven pricing and establishing an allowable cost target, can improve the chances of products being successful and improving overall profits. However, employing target costing is not a guarantee of success, as there are many variables at work, but using any market driven approach will bring benefits in today’s complex and dynamic business environment.