Book Review: Target Cost Management

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Target costing is a term often used in pricing circles but rarely defined. We know it was pioneered by Japanese companies, especially Toyota, but what, exactly, does it mean?

Target Cost Management: The Ladder to Global Survival and Success by Jim Rains sets out to shed light on a practice that is all but unknown in the USA.

Rains has an interesting background: He worked for 32 years at General Motors. He learned about Target Costing (TC) in 1993 from an Arthur Andersen report, "Product Development: Global Best Practices."

Rains admits he's never deployed the techniques he writes about because GM wouldn't listen to him (though he does consult on them now).

Further, no USA company he knows of has embraced TC, leaving the USA 40 years behind the Japanese (Toyota began using TC in 1963, but I've read elsewhere it was doing it long before then, though admittedly maybe not in the way Rains describes now).

Obviously the book is written for manufacturers, but I think there are some lessons in here for Professional Knowledge Firms, which I'll share at the end.

Management by Cost, not of Cost

The Japanese term for TC is Genka Kikaku, literally "planning for the achievement of true costs." Rains provides his own definition of TC:

TC is a system that plans for and expects a constant, consistent, and acceptable level of profitability now and far into the future.

TC is not about management of cost, but rather management by cost. Rains goes on to distinguish TC from budgets and cost accounting, which deal with past costs, not future costs:

TC is not just about setting cost targets. It is an entire value chain approach to managing an enterprise. Cost targets are not budget targets. Too many managers have been taught that budgets are what you spend. Cost targets, by contrast, are something that you achieve. 

TC is not a financial system. Typically financial systems are used by the finance department to report costs that have already been spent, rather than to manage cost expenditures before they occur.

The definition used by the Japanese is probably better since it incorporates the customer:

TC is a comprehensive profit management activity to plan and develop a product through establishing targets for quality, price, reliability and delivery satisfying customer requirements and through striving to achieve the targets simultaneously across the processes.

The formula looks like this: Market Price -- Target Profit = Target Cost (TC)

The process is really value engineering (VE), recognizing that the design phase is where most costs are committed, and value is what drives the market price. This is different from Activity Based Costing (ABC), which allocates past costs based on activities. 

VE focuses on the function (Function-Based Costing, FBC), which acknowledges that only a few functions drive the total cost, and the importance of the function has little correlation to the cost to perform the function.

What makes FBC so effective is the focus is on the functionality the customer is willing to pay for. Rains provides an example of door hinges. GM tends to change them every year, whereas Toyota keeps the same ones since the customer doesn't really care about the aesthetics of the hinge, only its function. 

The average car contains approximately 10,000 parts, so it's easy to imagine how this approach can avoid a large number of costs.

Traditional managerial accounting has no way to capture cost avoidance, hence it's not rewarded. Japanese companies think about cost avoidance through the entire design and manufacturing processes, which is why they are not guided in their decision making by standard cost accounting procedures.

Indeed, Toyota and other Japanese companies don't even utilize standard cost accounting.

Ladder to Global Survival and Success

A ten-rung ladder is illustrated that plots the journey to TC, while the book is designed to focus on the top three rungs. The bottom 7 include strategies such as Lean, Six Sigma, Value Analysis, Theory of Constraints, Benchmarking, VE, ABC and a host of other acronyms I won't bore you with.

The top three rungs are "Begin TC; Utilize Cost Tables; and TC Institutionalized." Developing Cost Tables is the Holy Grail of TC, as they allow companies to project future costs and achieve TC objectives. There are three ways to formulate cost tables:

  • Time motion study
  • Actual plant floor benchmarks
  • Statistically derived parametric estimation or regression techniques

What's interesting is how Japanese companies have embedded TC into their DNA. Every major Japanese company has a cost planning department, with half of them being separate departments, 40% report to engineering, the rest to purchase and finance.

Nissan alone employs 220 people in cost engineering. Cannon, the most profitable Japanese company, has 267 people, and even Isuzu has 60.

These folks aren't just concerned with cost, but also are responsible for value creation and establishing the Market Price. 

The chief engineer at Toyota, for example, spends one year in between projects in the field interacting with both dealers and customers to determine value. This is similar to the functions we advocate the Chief Value Officer (CVO) perform for PKFs.

Disagreements with the Book

Not everything in this book is worthwhile. The author seems to think that Japanese companies are superior because of TC, and no doubt that may be true among automobile companies. But the USA is far more innovative than Japan in many other sectors, so TC can't be holy grail he claims it is.

The author also doesn't seem to realize that costs are prices, and have their own value component built in. He advocates suppliers share full costing data with the company, and then tack on a desired profit--that is, cost-plus pricing, the very opposite of what he thinks companies should be doing.

If Value is right for Toyota, then why isn't it right for suppliers to Toyota? The contradiction is never addressed.

He also claims that raising prices isn't normally an option in today's global economy, but this is nonsense. Price is set by value created, not costs incurred.

Lowering costs is just one alternative to increasing profitability. Creating more value is another, not to mention more strategic pricing strategies.

Yet my biggest disagreement with this author is his attitude that business is war, and that you have to be so competitive your competition doesn't survive. 

This, too, is nonsense. Business is not war. It doesn't destroy, it creates. Sure, a lot of companies fail--like GM--but that doesn't mean that outcome should be the overarching the goal of Toyota. The market is big enough for many competitors, even in automobiles.

The author's zero-sum mentality makes me question other topics he addresses in the book on corporate strategy.

Lessons for PKFs

Rains also seems to believe in Frederick Taylor's distinction between managers and workers, writing:

Those involved in intellectual work should not be diverted from it by other responsibilities. Line managers and workers are there to realize the plans created by the intellectual efforts of others.

I don't know if this attitude comes from his years at GM and its militant unions, but it seems to me that Toyota treats all of its workers as knowledge workers, which is why they implement so many ideas (over a million per year) from line workers.

This attitude is very similar to the strategies laid out in the E-Myth Accountant by Michael Gerber and Darren Root, which are suboptimal because they don't tap into the knowledge that exists across the entire firm.

In a PKF, everyone is a knowledge worker and is in charge of designing their own responsibilities, contributions, plans, processes, and systems. All the knowledge is not embedded at the top, but dispersed throughout the knowledge workers themselves.

There is no "one best way," as Taylor and Gerber advocate, in a PKF.

In an auto plant, the worker serves the system and a lot of the knowledge is embedded in that system. But in a PKF, the system serves the knowledge worker, with the knowledge embedded in the human capital. 

This is precisely the difference between an Industrial/Service Era organization and a PKF.

Reading this book taught me a lot about TC and it was interesting, but it also convinced me that TC is not the right approach for a PKF.

Focusing on creating value, implementing Value Pricing, appointing a CVO, establishing a Value Council, implementing project management, and conducting After Action Reviews are far superior strategies than fretting about costs that are largely fixed.

Cost Tables really don't apply to a PKF. You have to pay the rent and salaries (the overwhelming majority of costs in the average PKF) no matter what, and trying to allocate those costs to any activity or function by the hour is completely arbitrary and fraught with misguided and misleading assumptions. Hint: you can allocate rent by the hour, but you're on the hook for the whole lease cost once you sign.

Perhaps Rains himself says it best:

Managing the intellectual effort should focus not on improving efficiency but on achieving effectiveness in product specifications.

Ultimately, effectiveness is achieved by creating value and capturing a fair portion of it, not achieving exact cost targets.

However, if you have manufacturing customers you may want to have them read this book. It could be the beginning of a very interesting journey.

There's no doubt in my mind that TC is superior to standard cost accounting and Activity Based Costing.

I wonder how many Six Sigma Black Belts advocate TC? Rains is skeptical about Six Sigma, claiming the ROI on it has been much higher for the Black Belts than any company. I wonder why?


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