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 / First Quarter 1997 / Issue 6(originally published by Booz & Company)


Setting Supplier Cost Targets: Getting Beyond the Basics

This third article in a series on balanced purchasing focuses on target costing and recommends a five-step process to optimize the cost of product designs still in development. A hypothetical development effort for a sports watch is used to demonstrate the process. If carried out properly and at the right level of detail, target costing can insure competitiveness without jeopardizing supplier cooperation.

(Third in a series)

Companies in a wide range of industries are becoming dependent on their suppliers -- and not just because outside purchases generally account for more than half of total product cost. These companies are also learning that suppliers are critical to driving continuous product innovation. As a result, managing relationships with the "extended enterprise" of suppliers is gaining executive-level attention.

In the first article in this series -- "Balanced Purchasing," in Issue 2 of Strategy & Business -- we argued for simultaneously pursuing a "commitment to a cooperative relationship" and a "commitment to competitive prices" with suppliers. However, only a handful of companies achieve the desired balance. These companies employ a fundamentally different, complex set of skills that simply cannot be found in a traditional purchasing organization.

The second article in the series -- "Systems, Modules or Components? New Light on Purchasing," in Issue 4 of Strategy & Business -- described one of the critical skills for achieving balanced purchasing. That skill is defining appropriate scope boundaries, which allow suppliers to create the maximum value through product innovation and/or improvements in the joint "delivery stream."

This third article builds upon the previous one by elaborating on another critical skill for balanced purchasing: target costing. Effective target costing moves the customer-supplier relationship away from traditional, competitive negotiations over existing designs and toward more cooperative efforts for optimizing the cost of a design that is still in development. If done properly and at the right level of detail, target costing can insure competitiveness without jeopardizing supplier cooperation in innovation. The benefits come in five ways:

Delivering the optimal value proposition to end consumers.
Minimizing product-line complexity.
Selecting the appropriate product and process technology.
Lowering design churn late in the innovation process.
Eliminating cost overruns.

Target-Costing Approaches

Target costing is not a new concept. It is not difficult to imagine that an early Roman artisan would have been asked, "Can you make me a shield for five sovereigns?" However, in a world of unrelenting global competition, setting the right target for a given product has become exceedingly important.

Three very different approaches to target costing are employed today -- and often without any clear distinction:

  • Price-based targeting.
  • Cost-based targeting.
  • Value-based targeting.

Price-based competition is at the heart of the free enterprise system. In its simplest form, price-based targeting simply sets the "target cost" through comparison with competitive offerings. This technique continues to be a standard negotiating tactic in working with suppliers -- however, many companies are also applying the technique proactively to their own products. These companies are examining "what the market will bear" and subtracting a desired margin to determine an appropriate target cost for a product. Products that do not meet the targets are canceled or sent back to product development to be redesigned to meet the cost target. The concept is described quite thoroughly in "Control Tomorrow's Cost by Today's Design," an article by Robin Cooper and W. Bruce Chew in the January-February 1996 issue of the Harvard Business Review.

An excellent example of price-based targeting of the end product was mentioned in an article in Issue 5 of Strategy & Business, "How Hewlett-Packard Runs Its Printer Division." Among other things, the article described H.P.'s entry into digital consumer photography. Although the digital system -- which includes a camera, printer/scanner and software -- provides functionality not available in a film camera, the digital camera is priced to compete with traditional high-end cameras. Furthermore, H.P. expects eventually to drive the cost down to a level that allows for competition at the lowest price point -- with a disposable digital camera.

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