Target Costing and Understanding Product Costs
Lean Accounting for NPD Blog #8
Most traditional companies calculate prices based on the product cost.
Lean organization turn this completely around. They set product costs from the price.
Where do you get the price from? It is fundamental to lean thinking that we focus on the value created for the customer. The price of a product is determined by the amount of value created for the customer by our products and services.
In most cases, the information required to create these prices come from the voice of the customer (VOC) and the quality function deployment (QFD). These are the places where we gain the knowledge and understanding of the customers’ true needs and how those needs create customer value.
In lean thinking, once we know the price – then we know the cost. When we know the cost then we can design the product to meet that cost. This is known as Target Costing.
There are five elements of the Target Cost; material costs, the cost of manufacture, tooling costs, the costs of supporting the product, and the cost of designing the product.
1. The material costs are designed into the product. When we first start the product design we will estimate the materials costs required to manufacture the product. During the design of the product we will make decisions that will firm up these material costs. We will strive to make these decisions at the latest possible time so that our design process can have maximum flexiblity. The build up of firm material costs throughout the design process is shown visually on the project board. Here’s an example:
The initial estimated target cost is $152 and this is shown in week 1 and week 2. During week 3 the sub-system related to gears is firmed up and the related material costs are shown on the chart. This changes the estimated material costs. Later the same thing happens with the frame sub-system. As the project progresses the true material costs emerge, and are posted on this chart.
2. Those familiar with Lean Accounting (or students of the theory of constraints) with regard to production operations will recall that we do not usually calculate the product cost because it is not possible to calculate accurate and useful numbers, and it is usually not required. The cost of production is not related to the amount of labor required to make it, or the amount of machine time. The cost of making a product is primarily related to the rate of flow of the product through the manufacturing process. If this is new to you, please take a look at our book “Practical Lean Accounting” or “The Lean Business Management System”. (www.maskell.com)
The primary issue is to design for the fastest flow through the plant. The faster the product flows through the plant the lower the cost. The second issue is to design the product so that the production cycle time matches the customer takt time. Having said that, the real issue is the contribution this new product makes to the order fulfillment value stream.
As we showed in Blog #2, we do not look at these design projects as if they stand alone. The financial benefit of a design project is how it contributes the NPD value stream as a whole. It is the combination of projects that gives the desired results. The same is true for production. The contribution of an individual product can only be seen in the context of all the other products being manufactured, shipped, and invoiced. When making a significant decision we look at the impact of the decision on the value stream as a whole.
While the rate of flow through production is a useful measurement throughout design, as is the comparison of cycle time to takt time; we must understand the impact of our decisions on the value stream as a whole.
Having said all this, if there is a requirement to calculate the production costs of a product during the design phase, it can be easily done. If the order fulfillment value stream that will make the product has total conversion costs of $120,000 per month and the month consists of 22 days and two 8 hour shifts, then the cost per minute is ($120,000 / (22*16*60)) = $5.68 per minute. If the cycle time of the product through the bottleneck operations (and therefore the value stream as a whole) is 25 minutes, the production cost of the product is $142.00.
This is a quick & easy calculation, and it is more accurate than a traditional standard cost; this should not be used for any decision-making. Decision-making is done by looking at the impact of the decision on the value stream as a whole, not the individual product.
3. Tooling costs are often very high and these – like materials – are real costs and need to be controlled. As with material costs, we will estimate the tooling costs when we start the project and throughout the design process we will improve the estimates as we gain more knowledge. Once we have selected the tooling supplier and determined the tooling design, these costs can be firmed up in our plan. Tooling very often has long lead times and traditional companies will design the tooling early in the process. The problem is that we will be required to make some significant design decisions very early in the design process, when we have the least amount of knowledge. This also limits our flexibility as we progress with the design, because we are tied to our early tooling decisions. Lean product designers often work closely with the supplier so that the specification of the tooling can be progressive. At the early stages the tooling specifications can be provided to the supplier as “rough cut” level and then gradually firm up the design towards the end of the process. This way the supplier gets the longer lead time and you get the flexibility. Throughout the process we track the estimated tooling costs and these estimates gradually become firmer.
4. Some products have considerable support costs associated with them, and many of the support costs can be impacted by the product design. When this occurs, we need to estimate the support costs as a part of the lifetime costs and profitability, and then track the progress of these costs throughout the design process.
5. The cost of the design of the product is one of our four primary measurements. But we do not try to calculate the cost of the design for this specific project or product. We track the deviations from the plan. As we showed in Blog #2, the costs and profitability are tracked and estimated for the whole value stream. It is the combination of projects that makes up the financial impact of the design value stream. But we do need to carefully track when additional costs are incurred. (This was discussed in Blogs #4 & #5).
The purpose of Target Costing is to make sure the design process creates a product designed to make the right amount of money for the company over the longer term; the lifecycle of the product. The starting point is to understand the value created for the customers, and from that to determine the price of the product. Once we know the price, we can work out the required product cost to ensure appropriate profitability over the product lifecycle. We then design to these costs into the product and track them weekly to make sure we are on-track.
In the next blog we will take a look at the weekly reporting that is appropriate for Lean New Product Development.