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


Setting Supplier Cost Targets: Getting Beyond the Basics

The overall challenge is to apply the right mix of target-costing techniques to achieve affordable end-product designs that maximize the suppliers' contributions.

Target-Setting Process

Unfortunately, setting targets properly, at just the right level of detail, is not simple. Fortunately, the rewards are tremendous. The remainder of this article describes a structured methodology for setting targets and illustrates the technique through a simplified case example.

Effective target costing -- down to the supplier level -- is a five-step process.

Step 1. Establish target cost for the end product or service.

Initial end-product targets are generally price-based -- through comparison with a competitor's offering or a specific price point. However, when completely new products or services are developed, targets might be value-based as determined by consumer research and hypothetical pricing scenarios. Either way, the required channel markup and desired margins for the producer are then backed-out to achieve the target cost.

Step 2. Allocate target to the elements of functionality valued by the consumer.

Next, the "value proposition" must be understood by documenting the functionality that the consumer values in the product or service. Then, the value that consumers attribute to each function must be quantified -- recognizing that different end users may emphasize different elements of functionality for the same product or service.

Step 3. Link functionality to key subsystems and modules.

Understanding the value of the functions does not provide guidance to a design team. The team needs to understand target costs at the "subsystem" level. These subsystems can then be designed with suppliers to achieve targets for cost and functionality. A translation table from "functions" to "subsystems" provides the link.

Step 4. Compare value-based targets with cost estimates.

The design proceeds against the target, using continuously evolving designs and cost estimates. The cost estimates can come from bottoms-up costing or from price-based competitions. The mix will vary by subsystem and may even vary over time for a given subsystem.

Step 5. Re-aggregate targets across subsystems to insure end-product profitability.

Although the cost target for the end product must be fixed to achieve profitability objectives, the target may be reallocated across subsystems if needed. As a result, step 5 operates in tandem with step 4: as designs evolve and new cost estimates are generated, the team needs to aggregate the results and make any needed trade-offs until the overall target is achieved.

To demonstrate this five-step process, the following section describes a hypothetical, and simplified, product development effort for a sports watch.

Target-Setting Example

Market research at the Gamma Watch Company identified a significant consumer segment that wanted a sporty, yet stylish, watch. This group wanted a product with the functionality of a sports watch like the Timex "Ironman" series but stylish enough so that it could be worn on all occasions. The current offerings of premium sports watches by Tag Heuer and Rolex were stylish enough for all occasions. However, their products were priced too expensively for the target market, which consisted of athletic men and women who were entry-level, white-collar workers.

Ultimately, market research determined a retail price point of "under $100," which the design team translated to $97.50 per unit. Using a 40 percent markup in the channel, the wholesale price target was $69.64. The company had a goal of a 17 percent return on sales and a 7.6 percent allocation for sales and general administration costs, which were subtracted from the wholesale price to yield a target cost of $52.50 for the design team. Exhibit I shows how the overall cost target was derived from the "price based" retail target.

Exhibit I 

Determining Price and Product Costs

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