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Boston University School of Management

TARGET COSTING FOR START-UP COMPANIES


The main theme in the entire target costing practice is, "What should the new product cost?" It is
not, "What does it cost?1 What could be simpler? Yet the urge to determine prices and profits by
working up from expected costs is deeply imbedded in those who dont understand the key role
that customer focus and leadership play in successful new product and business development.
They dont realize that this approach puts the designer and the investors first and the customer and
considerations of competition last.
Effective leaders intuitively understand that financially successful products are born when the
customer comes first in the design process and when designers are challenged to meet their
demands. They know that the determinants of product cost should come from a clear strategic
vision of 1) the target markets in which the organization needs to compete, 2) the wants and needs
of the target customer in terms of quality and price, and 3) the target profit and returns required by
investors. By working backwards from these strategic visions to determine the most they can
spend to manufacture the product, business leaders are able to set clear goals for product designers
and give them the information they need to make appropriate tradeoffs between cost, quality, and
product features.
The target costing approach is so logical that its key elements must have been used by customeroriented product designers since the dawn of time. Toyota was one of the first companies to
formalize target costing methods and procedures in the late 1950s.2 Many other major companies
now use target costing to ensure that customer, marketing, and financial goals are attained. These
include Boeing, Caterpillar, Olympus, and Komatsu.
TARGET COSTING PRINCIPLES
There is a bit more to target costing than working backward from target markets, customers,
prices, and profits. Swenson has identified six basic principles of target costing as it is practiced
in large companies today3:
1 Lee, John Yee, Use target costing to improve your bottom-line, CPA Journal
Online, January 1994.
2 Cooper, Robin, Toyota Motor Corporation: Target Costing System, Harvard
Business School Case Study 9-197-031, May 30, 1997.
3 Swenson, Dan, Best Practices in Cost Accounting, Management Accounting Quarterly,
Winter, 2003.
This note was originally written by Jeffrey Miller, Professor of Operations and
Technology Management, in 2008. It was revised by Professor John Neale in 2010
and Professor Paul Morrison in 2015. Copyright Boston University and the authors.

1. Price-led costing. Market prices are used to determine allowable--or target--costs. Target
costs are calculated using a formula similar to the following: market price - required profit
margin - other costs = target cost.
2. Focus on customers. Customer requirements for quality, cost, and time are simultaneously
incorporated in product and process decisions and guide cost analysis. The value (to the
customer) of any features and functionality built into the product must be greater than the
cost of providing those features and functionality.
3. Focus on design. Cost control is emphasized at the product and process design stage.
Therefore, engineering changes must occur before production begins, resulting in lower
costs and reduced "time-to-market" for new products.
4. Cross-functional involvement. Cross-functional product and process teams are responsible
for the entire product from initial concept through final production.
5. Value-chain involvement. All members of the value chain--e.g., suppliers, distributors,
service providers, and customers--are included in the target costing process.
6. A life-cycle orientation. Total life-cycle costs are minimized for both the producer and the
customer. Life-cycle costs include purchase price, operating costs, maintenance, and
distribution costs.
Exhibit 1 below provides a view of how information from the various functional areas is
developed to provide target cost, as well as quality and functionality requirements information, to
the product developers. Their design challenge is to close the gap between the expected cost,
quality, and functionality of the most current design and target costs, quality, and functionality.

Exhibit 1: Information Flow in Target Costing4


Current
Production
Economics

Market
Mapping

Product
Definition and
Positioning

Quality
Functionality

Expected
Costs

Price
Volume

The Design
Challenge:
Closing the
Competitive Gap
Target
Costs

Corporate
Financial
Requirements

TARGET COSTING FOR START-UP COMPANIES


Target costing for start-up businesses, like those created in SM323 projects, differs in one
important respect from target costing in large established companies. Start-ups dont have
experience or existing company financial statements to help them to estimate costs for things like
marketing, general, and administrative expenses. Nor do they know much about what kind of
profits are reasonable to expect in their competitive environment at the beginning of the design
process. Start up businesses also initially lack established channels of distribution for getting their
product into the hands of customers, and detailed market research information to help them
establish product positions and target markets. As a consequence, SM323 teams, and for that
matter, most entrepreneurial ventures, must make loose initial estimates (SWAGS5) of expected
profits, selling prices and costs other than operations costs, as well as likely channel costs in order
to use the target costing method. These initial estimates will enable the design team to begin the
process of identifying target costs and the most significant design challenges. As the team
traverses the new product funnel, it will acquire more information to enable it to refine its initial
estimates.
1. Estimate the retail price for your product. In advance of detailed marketing research
information, teams can estimate a range of likely selling prices by examining the selling
prices of competitive or substitute products.
4 Cooper, Robin and Bruce Chew, Control Tomorrows Costs Through Todays
Designs, Harvard Business Review, January February 1996.
5 SWAGs, or Scientific Wild-Assed Guesses, are often used by entrepreneurs and leaders with a bias for
action to initiate iterative processes of estimation and or modeling, where each iteration makes each SWAG
successively less wild assed, and more scientific.

2. Estimate the channel margin for your channels of distribution. You will likely use
middlemen to get your product to the end consumer. These middlemen might include
brokers and distributors as well as the retail stores that they supply. If you have not yet
determined how you will distribute your product, you can again use industry averages to
make an initial estimate. Typical retail distribution channel margins are around 50%. This
means the manufacturers price (revenue to you) will be 50% of the retail price charged to
end consumers. 6
3. Estimate the gross margin required for your product to be profitable. Gross margin
measures the difference between net sales and the cost to make the product (i.e., cost of
goods sold or COGS). In order to be profitable, your gross margin must be large enough to
cover all expenses beyond COGS. These are known as operating expenses and include
advertising and market research costs, sales salaries and commissions, executive and
clerical salaries, office rent, and R&D and legal expenses. In finance, you will learn how
to examine similar companies in order to get a better estimate of these costs. By the time
you finish the project you will have estimated these costs in detail. But to begin, you may
initially assume a gross margin of 50% in order to cover the typical manufacturing industry
averages below:
Sales and marketing expenses (20% of sales)
General and administrative expenses (20% of sales)
Profit (10% of sales)
4. Compute the target cost by subtracting the channel margin and gross margin from the
retail price. This amount represents the most you can spend to make each product (COGS)
and still achieve your desired margins.
5. Begin the process of identifying the actual COGS (material, labor, and overhead costs)
required to manufacture your current product design. 7
6. Compare your actual costs with the target cost. Work to close any gap between your
estimates of actual and target costs. This is your design challenge!
7. Conduct research on markets, customers, competition, and channels of distribution. Be
sure to update your initial estimates for price, channel margin, and gross margin as
you make decisions and find better information. Redesign the product to either reduce
costs, justify a higher price, or appeal to a larger or more profitable target market. Return
to step 1 above and iterate through these seven steps again, and again, and again.

6 Be careful about the difference between margins and mark-ups. Margins are measured as a percentage
of the top line (i.e., sales) while mark-ups are calculated as a percentage of the bottom line (i.e., costs). For
example, a product with a price of $100 and cost of $50 has a margin of 50% but a mark-up of 100%.
7 Manufacturing overhead (MOH) costs, which include indirect labor and depreciation on buildings and
equipment, will likely be the most difficult to estimate in the early design stages. You might want to use
the rule-of-thumb that MOH costs typically account for about 30% of COGS.

Target costing models are replaced by more sophisticated financial models as the product design
process for the new product nears completion. If the target costing and design processes have
been well managed and the design team has been appropriately challenged, then the product has a
higher likelihood of success and the final business plan financial models becomes easier and easier
to do. New product introduction is not the end of the target costing process however. Once the
product is introduced, the start-up company must begin consideration of the next product
generation, or of other new products. At this point, the target costing process begins to look much
more like that employed by large established companies as shown in Exhibit 1.
AN EXAMPLE
$10.00 Retail price per unit
- 5.00 50% channel margin
=$5.00 Manufacturers price per unit
- 2.50 50% gross margin (to cover profit and operating expenses)
=$2.50 Target cost per unit (i.e., maximum COGS per unit)
USING THE BASES MODEL TO ESTIMATE PRODUCT UNIT VOLUME AND COSTS
As in real world new product development, in Core the team needs to be gathering forecasts of
market demand for the product at the same time that the team needs to be estimating production
costs. This leads to a chicken-and-egg problem where teams cannot easily get price quotes from
potential suppliers until the team can give the suppliers estimates of the volume of components
they will purchase. This is because suppliers typically offer dramatically different prices at
different volumes (called price breaks): if your company is buying 1,000 units per year the
supplier will typically offer a far higher price per unit than if your company is buying 500,000
units per year. Your Core team cannot easily estimate these product volumes before the team has
gathered the Marketing data. However, getting a good sales volume estimate takes a lot of work,
so it is typically late in the semester before the team has these reliable, data-based product unit
volume numbers. Long before that, the team needs to make significant progress getting price
quotes from suppliers.
Early in Core your Marketing professor will introduce you to the BASES model for estimating
sales volume. We would like you to use the BASES model to estimate your production unit
volume, which will help you to estimate component costs. This should start very soon after OM 6,
the Design Workshop session, after which point you should have a good idea of the components
that make up your product - so you will need rough volume estimates to get price quotes on them.
We would like to emphasize that the volume estimates you derive this way are initially rather
rough. We do not want any team to make estimates this way and then just ride that number through
to the end. The volume forecasts you build into your Business Plan have to come from the hard
work you do figuring them out, not from this rule of thumb. We offer this rule of thumb only to
help you make some progress with your suppliers early in the semester.
DISCUSSION QUESTIONS
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1. Draw a diagram like Exhibit 1 for the revised target costing process used by start-up
companies. What do you think your team will find to be the most difficult parts of this
process?
2. Why not just wait to get precise data on channels, profit expectations, and operating
expenses before calculating target costs?
3. How might volume impact the determination of target costs?
4. How might the target costs of a company that distributed its products on-line be different
from those shown in the example?
5. Is it better to estimate costs on the high or the low side?
6. As a leader, who would you involve in the determination of target costs? What do you do
if a team tells you the target cost cannot be met?