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Target Costing

Target Costing
Target Costing

Market-oriented cost management is essential to successful corporate planning

Target costing is a strategic cost management tool that helps you to adapt project budgeting and planning to market requirements as well as to those of your company. This enables you to focus on the right product functions and components from the start of your project planning and to control the value creation of your company within a framework of sound economic business management.

 

Target costing is a solution to cost problems in the life sciences industry

The life sciences industry has a high potential for innovation, but is currently struggling with research and production costs. Accordingly, it is necessary to examine critical decisions from a quantitative point of view in order to draw the right conclusions for successful project planning. These are required primarily in the areas of portfolio management, capacity planning, process development and system planning due to economic, technical and clinical uncertainties.

 

The traditional cost-plus calculations are obsolete

In traditional cost planning, the sales price in the broadest sense is calculated from the manufacturing costs (including development expenses and approval costs) and the desired profit margin. This pushes the customer and market requirements more into the background, which can have devastating results in today’s harsh competition. In market--oriented target costing, on the other hand, project budgets are specified so that the customer is satisfied with the sales price and the company with the profit earned.

 

Until now, cost planning issues were processed in one of two ways: either the project managers defined the target costs based on the internally calculated bottom-up costs, or the top management established the budget for new developments as a percentage of the financial key figures such as sales and profit for R&D. In the first case, the costs could rise so far that the final sales price might not produce the expected profit. This could be due to the higher sales price causing the number of products sold to fall and thus sales to drop accordingly. In the second case, the possibly ambitious budget may rapidly become insufficient and thus limit the options for R&D.

 

The basic idea of target costing is to avoid the aforementioned scenarios and design the planning processes so that they are based on a sound and market-oriented business policy. Only this balance makes it possible to minimize the required resources right from the development phase. The focus has to be on the user benefits while complying with the temporal, financial and qualitative requirements that the situtations of the company and market basically define.

 

Target costing mediates between internal and external conditions of the company

In the first step of the target costing process, an estimated «maximum sales price», is developed via Internet research, market studies and surveys of the target group, for example. Based on this, the desired profit margin specified by the company for the new product is calculated. The development and manufacturing budget for the new product is subsequently calculated from the difference between the expected sales and the desired profit and defines the «allow-able costs». Due to the immediate orientation towards the competitive situation and the user specifications, this process of top-down budget planning requires a sound understanding of development, manufacturing and market requirements.

 

The bottom-up standard costs envisioned for the project by R&D are known as «drifting costs». These are based on the design and production capacities of the company and on empirical values from similar projects in the past. When the budget is determined in this fashion, functions and product components that are not essential to the success of the project are often included. Accordingly, the «drifting costs» are frequently higher than the «allowable costs». The compromise between these two figures comprises the «target costs», which are specified as the upper cost limit for the project. Compliance with this budget must be maintained to achieve the desired profit.

 

The target cost index is the key to monitoring your cost planning

After the target costs have been determined, the specified budget is then allocated to individual product functions and subsequently to product components during the target cost splitting phase. It is thereby important that the share of costs for the individual components does not differ much from the «relative importance» of the relevant components to the overall product. The «relative importance» of the individual components is determined in a function/component matrix in which the individual weightings of both individual functions with regard to the product as well as the weightings of the product components with regard to individual functions are combined. During the subsequent budgeting for individual product components, the so-called «target cost splitting», the relationship between the share of costs and the relative importance of the relevant product component must be determined and valued. The resulting figure is designated as the target cost index and serves as a basis for target cost monitoring and control during the implementation of the project plan.

 

Target costing can be used for a wide variety of applications

One of the first applications was during the development of the VW Beetle, for which the Reichsverband der Automobilindustrie (German Association of the Automobile Industry) specified 990 Reichsmark as the upper limit for the sales price. Various developments were adapted to the ambitious budget without influencing the quality of the car or disappointing customers. This was one of the first automotive success stories as is well known.

As target costing is a useful option for all intensively competitive markets, it is now increasingly used in the life sciences industry as well. The following issues can be resolved with the assistance of target costing:

 

Strategic/commercial issues:

·  How much can I spend on the development and production of my new product?

·  What products in my pipeline should I commercialize?

·  What part of the production do I have to outsource?

 

Operative/tactical issues:

·  To what degree is it practical to integrate new technologies in my manufacturing process?

·  Did I set the right priorities when budgeting individual process steps?

·  Is my production strategy resistant to fluctuating production factors and changing needs?

 

Being exposed to tough competition as an entrepreneur is delightful precisely when both costs and quality are under control. Using target costing to realign your own product pipeline means exploiting that small but crucial advantage.

 

The specialists at Chemgineering look forward to showing you how this works. Try it!   

 

Freedanz Ferdinandz | Junior Consultant Management Consulting |Chemgineering – The Business Designers
freedanz.ferdinandz@chemgineering.com

 

Figure 1: The target costing process leads to a cost strategy that takes the entire value creation network of the company into account.

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