Setting Supplier Cost Targets: Getting Beyond the Basics

(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.

The second approach, cost-based targeting, has evolved substantially over the last few decades. In its least effective application, "cost-plus contracts" have been used by the Government to insure that contractors achieve an acceptable but not exorbitant profit margin. Unfortunately, the result has often been to limit the motivation of suppliers to lower the total cost. A modern version of the "cost-plus" mind-set is now being employed by many large companies. These companies now demand "open books" of their suppliers to pierce the veil of price quotes.

For example, the automotive industry aggressively employs cost-based targeting. The large vehicle manufacturers have the buying clout to force their suppliers to share detailed cost information. Unfortunately, suppliers complain that many of the Western vehicle manufacturers misuse the information to squeeze margins -- which often leads to an extra set of "books" that hides the profits. The Japanese vehicle manufacturers demand the same cost information, but use it differently. They use open books and a detailed understanding of "cost drivers" for joint improvement efforts to eliminate waste -- not simply to squeeze margins.

The third approach, value-based targeting, is the least understood technique and the most difficult to apply. From our observations, only a handful of companies do it well. This method of costing compares consumer "wants" with a willingness to pay. When done well, the desired "functionality" is mapped back to the subsystems that contribute to the functionality to drive the design process. Such a technique improves product development by insuring that new designs are not simply innovative -- but, more important, provide the right value proposition.

Swatch is an excellent example of value-based targeting. Major cost reductions were achieved by appropriately valuing the "subsystems" to reach a different level of functionality. For example, the Swatch design employs a plastic casing since the end product is priced cheaply enough to be discarded when the battery dies. Accordingly, the timepiece also has less severe reliability/durability requirements, which allow for less expensive mechanisms. The band is also significantly cheaper. Swatch uses integrated plastic moldings rather than expensive, sewn-leather bands that must be replaced over the longer life of a traditional watch. As a result, Swatch created a fundamentally new value proposition in the marketplace: a low-cost fashion accessory that also keeps time.

All three techniques have a place in insuring competitiveness in supplier pricing. But each is more effective in a given circumstance than the others.

For example, price-based targeting is quite effective in dealing with commodity products and services. Pricing of true "commodities" generally reflects supply-and-demand curves rather than bottoms-up cost. Likewise, pricing of a commodity like memory chips for personal computers does not vary due to changes in "consumer value" but rather due to changes in competitive dynamics.

Cost-based targeting -- supported by an understanding of cost drivers -- is effective at fostering improvement in supplier operations. Cost-driver understanding and comparative benchmarks can reduce quality costs, improve equipment up-time and lower manning levels. This technique is often applied effectively with suppliers of "modules," as described in the previous article in this series.

For its part, value-based targeting is unmatched for driving the kind of major innovation that is expected from a supplier serving in the role of "solutions provider." A solutions provider has the skills to take overall "black box" responsibility for specification, planning, execution and performance of an entire system and accordingly needs greater freedom. Appropriate value-based targets provide the freedom but within a firm envelope of what the customer will pay for a given functionality. The supplier must then creatively apply its expertise to develop a detailed design that meets the needs at the target cost.

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

Source: Booz-Allen & Hamilton

Focus groups held during the preliminary market research also examined what "attributes" the targeted consumers wanted in a "stylish sports watch for just under $100." The focus groups highlighted a wide variety of attributes that could be organized into five "functional needs". They are listed in Exhibit II.

Exhibit II

Determining What the Consumer Wants

Source: Booz-Allen & Hamilton

"Comfort" described how the watch needed to be light, slim and comfortable.

"Stylishness" captured a set of attributes indicating that the watch needed to avoid an appearance of a standard, mass-produced product. Also, the watch needed to be appropriate for virtually any occasion since the consumers expected it to be their primary (if not only) timepiece.

"Reliability" underscored the fact that the watch was a significant expenditure for these consumers and accordingly was expected to last.

"Simplicity" indicated that the watch should be easy to read, use and wear.

"Functionality" denoted that, for the most part, only a lap timer was required beyond the basic functions of date and time to meet the needs of the "athletic consumer." A few consumers indicated that waterproofing was desirable since they wanted to wear the watch when swimming and for water sports.

Even with all that information, the design team needed more detail: it needed to know the relative importance of each of the functional areas. Since any design offers a set of trade-offs, the team needed to understand the relative weighting of each factor in order to make the right decisions.

To quantify the importance, the team conducted a survey of consumers to rate the attributes that would be key to the decision to buy a "stylish sports watch for just under $100."

Not surprisingly, the consumers ranked "stylishness" very high for that level of expenditure on a sports watch. Also, since this targeted price point was more than double the price of the primary competitive product (the Timex Ironman), the consumers ranked "reliability" very high as well.

The next most important functional need was "simplicity." The team noted that this factor had often been overlooked by higher-priced competitors, whose designs were not very "user friendly." Still important, but further down the list, was "functionality." This ranking was consistent with the focus group findings, which concluded that even though the consumers wanted to use the watch when they exercised, they really didn't need a lot of functions. In fact, many of the users of the popular Ironman had never figured out how to use some of its functionality.

The final functional need that made the cut for significance was "comfort."

As shown in Exhibit III, the team converted the relative rankings to percentage scores and multiplied them by the overall target cost to set dollar values for each functional need.

Exhibit III

Putting a Price on Each Need

Source: Booz-Allen & Hamilton

Obviously, having a target of $6.83 for "comfort," for example, does not provide enough guidance to the design team and the suppliers. To create meaningful targets, the designers used their understanding of how different parts of the watch contribute to the functional needs expressed by the consumers. This translation of the "voice of the consumer" into engineering requirements begins with a breakdown of the major "subsystems" of the watch.

The first major subsystem is the watch band assembly, which includes the typical band plus the attachment screws and bar. The power supply is another major subsystem. It consists of the battery, coil block and generating stator. The display subsystem includes the key elements making up the face of the watch. The clock subsystem consists of oscillator components that insure reliable time tracking. The timer includes the special functionality that makes the watch a sports watch: the switches, lap counter and memory functions. Exhibit IV provides a breakdown of the five subsystems as agreed to by the design team.

Exhibit IV

Breaking Things Down into Subsystems

Source: Booz-Allen & Hamilton

The next step -- setting target costs at the subsystem level -- is among the more complex and critical ones facing the team. The objective is to translate the cost targets for functional needs to the major subsystems. Once targets are set at that level, the team can work with suppliers to create the designs that provide the right trade-offs vis-à-vis cost and value.The translation is performed by creating a matrix in which the five major subsystems are listed in rows while the five sets of "functional needs" are listed as column headings. (See Exhibit V.)

Exhibit V

Translating Cost Targets from Needs to Subsystems

.

Source: Booz-Allen & Hamilton

By comparing the primary functional needs and secondary attributes with the subsystems and components, the team allocated percentages of each need to the various subsystems. These percentages were then multiplied by the cost targets for each of the needs, as previously determined by their importance weightings. The sum of those multiplications (i.e., the addition of the numbers by row) generated cost targets for each subsystem.

Next, tear-down analysis of the higher-end products offered by Tag Heuer and Rolex were used to create a composite, "best-in-class" subsystem design. This composite design was nearly 50 percent above the market-based price target. The team then compared these subsystem cost estimates to the value-based targets. This analysis showed that although the overall "best-in-class" design was over by 50 percent, the cost gap at the subsystem level ranged from 42 percent under the target to 99 percent over the target. Exhibit VI shows the calculations of the gaps by subsystem.

Exhibit VI

Finding Gaps in the Price Targets

Source: Booz-Allen & Hamilton

The team also constructed a value graph, by plotting the targets against the tear-down cost estimates for each major subsystem. Exhibit VII provides a clear visual focus on the appropriate areas of opportunity: the band and the power supply.

Exhibit VII

The Value Graph: Focusing on Opportunity

Source: Booz-Allen & Hamilton

An internal sub-team was asked to examine a wide range of new concepts for the band other than the gold-plated style employed by the high-end competitors. In fact, the team discovered that the gold-plating was viewed as "too flashy" by the target consumer segment and not practical for true athletic use. The team visited a wide variety of suppliers -- not just watchband makers -- to get ideas. Ultimately, the team members agreed on a design employing a cloth-covered nylon strap that was stylish enough for business wear and rugged enough for athletic use -- and at a significant cost savings.

To address the power supply cost gap, the team conducted a design competition among the key suppliers in the industry -- including some non-traditional sources from emerging markets in Asia. Simultaneously, the team members examined the option of deleting some memory functions, which required additional power but were not highly valued by the consumer. This option reduced the cost of the timer subsystem as well.

The value graph also persuaded the team to revisit the functionality provided by the displays of the competitive products. The team noted that neither of those products provided back-lighting for nighttime use -- a "want" by some, but not all, of the target consumer segment. Given the current favorable gap on the display front, the team set out to add the back-light functionality while still retaining some of the target "cushion" currently available.

When the team re-aggregated the new cost estimates, the design came in just under the overall cost target -- and the individual subsystems now ranged from 30 percent under the value-based target to 69 percent over. (See Exhibit VIII.)

Exhibit VIII

The New Cost Estimates: Closer to the Targets

Source: Booz-Allen & Hamilton

The team assessed whether further efforts to drive the individual subsystem targets closer to the value-based targets would be needed, but concluded that the current design was appropriate to the target consumer market. The team agreed that value-analysis efforts after product launch would focus on the remaining gaps and be incorporated into the next version of the product, which would also reflect evolving consumer desires.

Conclusion

Systematically applying all five steps in a product or service development process is rare -- especially when it comes to the steps for developing true value-based targets. Many companies are beginning to apply quality-function deployment techniques that are very effective at capturing and quantifying consumer needs. However, too few push the process far enough to generate value-based cost targets.

We believe that more companies should apply cost targeting systematically with the appropriate mix of techniques. As the case example illustrates, the targeting methodology is straightforward and logical -- though admittedly not simple to apply to complex products. However, even when applied with simplifying assumptions, it provides structure to the process of developing new products. It is an investment that will ultimately lead to better products, prices and margins for both customers and their suppliers.

Reprint No. 97103