Target Costing & Lean

Lean philosophy focuses on the concept of value stream generation. The process of value stream generation entails cross-departmental co-ordination to deliver what customer desires. The philosophy also aims to eliminate the muda or the waste processes that don't add any value for the customers.

This philosophy of Lean revolutionises the way in which an organisation defines, measures, analyses, implements and controls its processes. In this purview, the Lean champions also believe that accounting as a function can contribute towards this cause of aligning all the processes.

While traditional managers would concentrate on cost plus approach for determining the Cost of Goods Sold (COGS), and use this to arrive at the final market price, Lean practitioners expect accounting to play a powerful consultative role in achieving a lean value stream.

Target costing for reducing the Costs

"Costs do not exist to be calculated. Costs exist to be reduced" - Taiichi Ohno.

Target Costing is defined as a disciplined process for determining and achieving a full stream cost at which a product with specified functionality, performance, and quality must be produced in order to generate the desired profitability at the product’s anticipated selling price over a specified period of time in the future.

In essence, this is a tool for proactive cost management and cost reduction to be implemented during the product development phase.

Many Japanese automobile companies employed the Lean philosophy in the product development phase itself. This required them to collaborate with vendors for spare parts in the process of development of components. The purpose of such collaboration was to reduce component development and testing time and minimise the costs during production phase through production-oriented design approach.

For implementing such proactive approach to cost management, it was essential to have cost estimates of components prior to their design development. This need gave rise to the idea of target costing.

Target Costing involves reverse costing. It starts from value delivered to customers and then the production value is calculated back up the supply chain to the vendors.

Target Cost = Value to Customer - Margin

It is this unique nature of Target costing that enables companies to proactively manage costs, thus making it a powerful tool for implementing Lean practices.

The next post will describe steps for implementing Target Costing.