Don't cut costs - manage them

At Finnies we can provide businesses with help and advice on finance and on a wide range of business issues. Here are some thoughts on target costing...

When there is competition in a marketplace, one of the key factors on which businesses typically try to compete is price. But when you wish to lower the price of your product, you usually need to find ways of cutting the costs involved in bringing it to market.

The traditional approach to cost reduction has always been one of trying to control costs during the production, or manufacturing, phase of a product. Unfortunately, this approach is becoming less and less effective.

This is because costs are often effectively determined at the design and development stage, and once a product reaches the factory floor there is often not a great deal you can do to reduce them. Combine this with the trend toward automation and streamlining in the workplace and it leaves very little scope for reducing costs during the manufacturing phase.

With little room to manoeuvre, manufacturers are often left fighting 'rearguard actions' to preserve market share, with reduced profit margins a frequent outcome.

Target costing

Because of these problems, many businesses are now approaching the issue of price from a very different angle. They use 'target costing' to manage costs from the outset rather than attempting to reduce costs that are effectively fixed.

When a new product is developed using this strategy, it is essentially market and profit driven. Market research determines the broad specifications for the product and the optimum selling price, and a company-wide profit strategy sets the desired profit.

The calculation is then straightforward:

Selling price – desired profit = target cost.

Different culture

By asking, 'What should the product cost?' rather than, 'What does it cost?' this approach creates a very different culture in the business and has an empowering effect throughout the whole organisation.

Right from the start, even before the designer sits at his or her desk, the cost parameters of the product are set and the challenge is for everyone involved in design, development, production, and marketing to work together to meet that target cost.

Closing the gap between estimated costs and target costs can be a very creative and stimulating exercise that keeps everyone focused on managing costs, improving products, and streamlining processes.

Profit management strategy

Target costing works best as part of broader profit management strategy in which products are grouped together, with overall profit targets set for each group and profit margins traded between individual products depending upon which stage of the product cycle they are at.

An essential component of this profit management strategy is the use of return on sales (ROS) rather than return on investment (ROI) to determine the desired profit from a new product.

This measure gives much greater flexibility in a marketplace, for example, where multiple products with short life cycles are produced at low volume. The traditional measurement of ROI is much less effective in such an environment.

With frequent ROS reports it is possible to switch emphasis from one product to another in that group, thus giving much greater flexibility in responding to changes in the marketplace.

In the driving seat

Target costing as part of an overall profit management strategy puts you in the driving seat, keeps you focused on increasing market share, raises the standard of excellence, and helps to create a culture of continuous improvement in the business.

If you are looking for advice from professional accountants, contact Finnies.