14.2 Target Costing & Kaizen Costing

14.2 Target Costing & Kaizen Costing

In highly competitive global markets, manufacturers are increasingly price takers. When consumers enjoy abundant substitutes, companies cannot simply tally internal costs, add a markup, and dictate the price. Originating in the Japanese automotive industry (notably Toyota and Nissan), Target Costing (genka kikaku) inverts traditional accounting: competitive market prices dictate allowable internal costs.

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The Target Costing Philosophy & Equation

Traditional cost-plus accounting follows an internally focused, additive sequence:

$$\text{Cost} + \text{Target Profit} = \text{Selling Price}$$

If the resulting price exceeds market willingness to pay, the firm faces inventory write-downs, margin dilution, and post-launch restructuring.

Target Costing establishes a market-driven deductive relationship:

$$\text{Target Cost} = \text{Target Selling Price} - \text{Target Profit Margin}$$

• Target Selling Price: The price customers will pay, determined through competitor benchmarking and market research over the product lifecycle.
• Target Profit Margin: Convert the percentage to a currency amount per unit before subtracting from price. It is set by corporate long-term financial plans (e.g., return on sales or return on capital employed).
• Target Cost: The maximum allowable full unit cost across all lifecycle stages (R&D, manufacturing, distribution, and warranty).

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The 5-Stage Target Costing Process

Target costing follows a structured, cross-functional sequence:

1. Establish Competitive Target Selling Price: Conduct market analysis to determine customer utility, perceived value, and competitor pricing for comparable offerings over the expected product life.
2. Determine Required Target Profit Margin: Corporate strategy sets the required return on sales (ROS) or return on capital employed (ROCE).
3. Calculate Allowable Target Cost: Deduct target profit from target selling price ($\text{Target Cost} = \text{Target Price} - \text{Target Margin}$).
4. Estimate Current Feasible Cost (Drift Cost): Engineering, procurement, and accounting teams calculate expected unit production cost using current designs and components.
5. Determine and Close the Cost Gap: Identify the difference between current estimated cost and target cost:

$$\text{Cost Gap} = \text{Current Estimated Cost} - \text{Target Cost}$$

If a positive Cost Gap exists, cross-functional teams apply Value Engineering prior to manufacturing launch.

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Closing the Cost Gap: Value Engineering & Value Analysis

The primary tool for closing the Cost Gap is Value Engineering (VE):

• Value Engineering (VE): Systematic examination of product design prior to manufacturing launch to achieve required functional performance at minimum cost.
• Value Analysis (VA): Examination of cost structures applied to existing products already in active manufacturing to improve margins or extend maturity lifecycles.

Key Value Engineering Techniques

1. Function-Cost Analysis & The Value Index: Products are decomposed into functional components. Customers rate functional importance, while engineers calculate the cost percentage of each function. Strategic accountants compute the Value Index:

$$\text{Value Index} = \frac{\% \text{ of Perceived Customer Value}}{\% \text{ of Component Cost}}$$

• Value Index < 1.0 (Over-Engineered): Component cost exceeds customer perceived utility. Action: simplify, substitute cheaper materials, or eliminate.
• Value Index > 1.0 (High Value Opportunity): Component delivers high customer value at modest cost. Action: potential to enhance differentiation.

1. Tear-Down Analysis (Reverse Engineering): Dismantling competitor products to benchmark assembly methods, component choices, and manufacturing tolerances.
2. Design for Manufacture and Assembly (DFMA): Redesigning components to reduce part counts, eliminate threaded fasteners (using snap-fits), and minimize assembly touch time.
3. Component Standardization: Using common parts and modules across product families to leverage bulk purchasing discounts and reduce inventory handling.
4. Feature Pruning: Eliminating unnecessary features that customers do not appreciate or pay for.

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Kaizen Costing: Operational Cost Reduction

While Target Costing operates during pre-production design, Kaizen Costing drives continuous, incremental cost reductions during the active manufacturing phase.

Derived from the Japanese philosophy of kaizen (continuous improvement), Kaizen Costing empowers shop-floor workers, cell leaders, and process engineers to eliminate waste (muda). Instead of standard costing's static focus on avoiding negative variances, Kaizen Costing establishes progressively declining monthly cost standards.

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Corporate Application: Vanguard Biomedical Ltd

Vanguard Biomedical Ltd is developing a portable point-of-care blood analyzer (Model VB-400):

• Target Selling Price (based on competitor analysis): $1,200
• Required corporate Return on Sales (ROS): 25.0%
• Target Profit Margin: $1,200 × 25.0% = $300
• Allowable Target Cost: $1,200 - $300 = $900

Engineering Cost Estimates & Value Engineering Interventions

Assume the estimate includes all manufacturer lifecycle costs allocated per expected unit, including development and support. Initial engineering estimates indicated a full lifecycle unit cost of $1,080, revealing a Cost Gap of $180 ($1,080 - $900). A Value Engineering team decomposed the gap across five subsystems:

Post-Launch Kaizen Costing

Following production launch at the $900 target cost, Vanguard instituted a 3.0% Year 1 Kaizen reduction target. Factory floor initiatives eliminated $27 per unit in scrap and calibration time, lowering unit cost to $873 and expanding operating margin to 27.25%.

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Exam Traps to Avoid

Integrated New-Product Case: Carry the Design into Operations

Return to the fictional VB-400 device. Assume the AUD 900 target unit cost includes allocated development, manufacturing, distribution and expected support across the planned lifetime volume. A lifecycle budget must recover these costs; a manufacturing-only estimate cannot be compared with a full-lifecycle target without a bridge. The AUD 300 target profit is an amount per unit, calculated as 25% of AUD 1,200 sales, rather than a percentage subtracted directly from a price.

The cross-functional team connects the proposed design to its value chain. Marketing tests which functions customers value; engineering checks that cheaper components preserve required performance; procurement assesses supplier capability and whole-life costs. Quality specialists retain necessary validation and safety tests. The accountant checks the cost estimate, sales assumptions and activity demands instead of approving each departmental saving in isolation.

Assume two assembly designs each satisfy the required functions. Design X has AUD 20 less direct material cost per unit but requires 12 minutes more testing and support work. A measured practical-capacity rate for that resource is AUD 2 per minute. The activity resource cost difference is 12 × 2 = AUD 24, so X has AUD 4 higher full resource cost per unit on those assumptions. The apparent material saving is offset by greater activity demand. If the resource is already supplied with idle capacity, its immediate cash effect can differ from its full-cost effect; disclose both before deciding.

A supplier offering pre-tested modules can reduce internal activity demand, but review contract quality, continuity and upstream environmental or labour impacts. Supply-chain optimisation should not merely transfer an unmeasured burden outside the factory. Track accepted modules, defects, lead time and supplier performance. Any assumed reduction in resource expenditure needs an owner and a feasible action, such as cancelling an avoidable support contract.

Pricing must also consider customer behaviour. Suppose a distributor pays the same product price but requires frequent small deliveries and additional engineering support. Trace those service activities to the customer rather than spreading them across all units. A product meeting its target manufacturing cost can still create a poor customer surplus after cost-to-serve. Consider order consolidation or explicit service fees before ending a relationship; test what costs would actually disappear.

After launch, use kaizen, process management and quality measures to test the design assumptions. A lower reported unit cost caused by producing unwanted inventory is not an improvement. Monitor customer acceptance, first-pass quality, warranty experience and actual cash benefits alongside financial margins. If savings release capacity, plan its removal or productive use. Compare results with the original case and update forecasts transparently. This connects costing, pricing, suppliers, customers, quality and performance management in one value-creation decision.