Target costing more in sync with the market

ACCOUNTANCY

Cost management is essential for any firm that wishes to remain competitive. To survive, a firm must establish its competitive advantage.

There are two generic strategies to achieve this: differentiation and cost leadership. A firm that pursues differentiation tries to earn a premium for its product over generic alternatives while ensuring that the cost of differentiation remains less than the premium that can be charged. A firm that pursues cost leadership strategy takes the market price as given but aims to produce at a cost lower than that of its competitors. Neither of these two strategies can succeed without an effective system of cost management.

Most firms are not lucky enough to capture a source of sustained competitive advantage. Rather, the competitive struggle has to be fought out afresh almost on a day-to-day basis. Firms, which are price takers, and which do not have a unique value proposition that can be protected from imitation for long cannot build sustainable competitive advantage. Therefore, their survival depends on continuous innovations, improvements and cost management.

Cost management is a misnomer. Firms consume resources to earn revenue. More resource consumption may lead to more revenue. It would be misleading to focus on resource consumption in isolation from revenue.

The goal of managers is to increase net revenue i.e. revenue minus cost. Therefore, cost management should be understood as cost and revenue management taken together.

With increased business complexity, product and market proliferation, and increase in the cost of support services as a proportion of total cost of delivering product and services to the customer, new cost management techniques have evolved. All of them are based on three fundamental principles. First, costs should be managed at the point of commitment of resources and not at the point of incidence, that is, when the cost is incurred or resources are consumed. For example, your design of the product and selection of the process to manufacture the same determines the amount of resources (e.g. materials and machine and labour hours) to be consumed. Consumption of resources cannot be managed when the product is actually produced.

Second, cost should be managed through the management of cost drivers. Cost drivers are the factors that lead to consumption of resources. Unless the causes are removed, consumption of resources cannot be avoided. Therefore, cost management should be preceded by the mapping of cost drivers. Third, look outside the boundaries of the firm to identify potentials for cost management. For example, reduction of ownership cost of equipment (e.g. cost of operating, maintaining and disposing of the equipment after its useful life) may result in customer sharing the benefit of lower ownership cost with the producer. This improves the net value to the producer.

Target costing is one of the important techniques that used by business firms to manage costs. In contrast to standard costing, which is an engineering-driven cost control technique, target costing is a market-driven cost management technique.

In standard costing, the quality and attributes of the product or service are taken as given. Standard cost for a product is determined based on engineering specifications and budgeted price per unit of various resources. Actual costs are compared with standard costs and variances are reported. Variance reporting is used as a feedback system to enable managers to take remedial actions. Standard costing was appropriate when firms could decide the price based on standard cost and the product life cycle was long. Once standards for quantity of resources to be consumed to produce one unit of the product were established, those could be used for a length of time unless the product quality or attributes or the production method were changed. However, with increased competition and shortening of the product life cycle, standard costing technique has lost its position as the most preferred cost control technique. It has been overshadowed by the target costing technique for cost management.

The basic premise of target costing is that price is determined by market forces and is, therefore, out of the management's control once a particular market has been chosen. On the other hand cost is internal to the firm and can be managed. Cost and value can be managed by managing attributes and quality of the product or service.

Value is what is perceived by the customer and is measured in terms of price at which the product or service can be sold in the market. It does not make sense to add features to a product, however desirable they may seem, unless there are customers willing to pay a premium that is adequate for covering the cost of the added feature. The aim of target costing is to optimize the net value, in terms of net operating profit, to the firm.

Target cost is the difference between the estimated price and the target margin. Estimated price is determined through intensive market research. A firm that has adopted the target costing technique tries to find answers to the question of 'who will pay and why'. Managers try to assign value (in terms of price) and cost to each attribute and to different quality levels that can be offered by the firm.

Market research is initiated much before the product is launched. This information is collected at the design stage itself. The challenge for the design engineers is to then modify the design and the process to keep the resource consumption (cost) at the target level. They examine various alternative designs and estimate the net value that the firm will derive from different alternative product attributes and quality. Based on these estimates, they finalise the design of the product. The target cost then becomes the standard cost.

In fact a firm that follows the target costing system establishes the minimal attributes that the target customers will accept and the maximum that it can offer; the minimum quality that the target customers will accept and the maximum that it can offer. It maneuvers within the space acceptable by target customers and the maximum that it can offer.

Value engineering and value analysis are the two techniques that support target costing. Value engineering focuses on the material cost while value analysis focus on overheads or customer services being offered before and after sales. For example, the rubber beading used in a car doors protects the car body from water damage. Customers in the small car segment will be ready to pay a price for high quality rubber beading that will protect the car, but they may not be ready to pay a premium for the aesthetic value of the rubber beading.

On the other hand, high-end customers will be ready to pay a significant premium for the aesthetic value of the component. The car manufacturer will decide the material, design, and the process of manufacturing of the rubber beading before the launching of the vehicle. Therefore, it should have an insight into customer preferences which can be converted into a price premium. The value that customers assign to different quality and attributes might change over time. For example, even a couple of years back, the middle class was not ready to pay a premium on add-on facilities like crèches and food marts in theatres. But with changes in the family structure and increase in purchasing power, middle class families are now ready to pay a premium for those services in multiplexes. To beat the competition a firm should be able to visualise such changes much in advance. Target costing demands intensive market research and this in turn helps managers identify such signals in time.

The writer is prof, finance & control at IIM-C