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Statements on Management Accounting

S T R A T E G I C C O S T M A N A G E M E N T

C R E D I T S

T I T L E

This statement was approved for issuance as aStatement on Management Accounting by theManagement Accounting Committee (MAC) of theInstitute of Management Accountants (IMA). IMAappreciates the collaborative efforts of the CostManagement Competency Center at Arthur AndersenLLP and the work of Dr. C.J. McNair, CMA, of BabsonCollege, who drafted the manuscript.

Special thanks go to Randolf Holst, CMA, KnowledgeManager at Arthur Andersen, for his continuing over-sight during the development of the Statement. IMAthanks the Consortium for Advanced Manufacturing-International (CAM-I) for their support in the develop-ment of this SMA. IMA is also grateful to the membersof the Management Accounting Committee for theircontributions to this effort.

Tools and Techniques for Implementing

Target Costing

Published byInstitute of Management Accountants10 Paragon DriveMontvale, NJ 07645www.imanet.org

IMA Publication Number 98355

Copyright 1998 in the United States of America by Institute of ManagementAccountants and Arthur Andersen LLP

All rights reserved

ISBN 0-86641-272-7

Statements on Management Accounting

T A B L E O F C O N T E N T S

Tools and Techniques for ImplementingTarget Costing


I. Rationale . . . . . . . . . . . . . . . . . . . . . . . 1

II. Scope . . . . . . . . . . . . . . . . . . . . . . . . . 1

III. The Role of Management Accounting . . . .1

IV. Target Costing Process Steps . . . . . . . . .3

V. Implementation Tools and Techniques . . .3

Product Planning Phase

Establishing the Target Market Price . . . . .3

Establishing the Target Profit Marginand Cost to Achieve . . . . . . . . . . . . .12

Calculating the Probable Cost of Current and New Products andProcesses . . . . . . . . . . . . . . . . . . . .14

Establishing the Target Cost . . . . . . . . .20

Product Design and Development Phase

Attaining the Target Cost . . . . . . . . . . . .22

Production Phase

Pursuing Cost Reductions OnceProduction Has Started . . . . . . . . . . .26

VI. Conclusion . . . . . . . . . . . . . . . . . . . . .29

VII. Bibliography

ExhibitsExhibit 1: Target Costing Process Steps . . .3

Exhibit 2: QFD Matrix in Product Planning of a Fax Machine . . . . . . . . . . . . .5

Exhibit 3: Product Design Process Chart . . .6Exhibit 4: Hierarchy of Defined Criteria . . . .8Exhibit 5: Determining the Priority of Criteria 9Exhibit 6: Ranking Customers by Criteria . . .9Exhibit 7: Voice of Customer Analysis Table 10Exhibit 8: Ratings within a Customer Voice

Analysis . . . . . . . . . . . . . . . . . .11Exhibit 9: Relationship Matrix . . . . . . . . . .12Exhibit 10: Target Costing and Profit

Management Process . . . . . . . .13Exhibit 11: Multi-Year Product/Profit Plan . . .15Exhibit 12: Rate Master List for Process

Costs . . . . . . . . . . . . . . . . . . . .16Exhibit 13: Component Cost Analysis . . . . .17Exhibit 14: Component Cost Breakdown . . .18Exhibit 15: Cost Table Structure . . . . . . . . .19Exhibit 16: Benchmarking Steps . . . . . . . . .21Exhibit 17: Computing the Cost Gap . . . . . .23Exhibit 18: Boeing DFMA Application

Results Summary . . . . . . . . . . .25Exhibit 19: Value Engineering (VE)

Framework . . . . . . . . . . . . . . . .26Exhibit 20: Value Engineering (VE) Ideas to

Reduce Costs . . . . . . . . . . . . . .27Exhibit 21: Relationships between ABC, ABM,

and Target Costing . . . . . . . . . .28

I . RAT IONALEToday, competition among companies in manyindustries is turning global. The companies com-peting in this global market are now in a highlycompetitive race in terms of quality levels, and toget ahead each company must come up withtechnological innovations. Because technologi-cal innovation has become a key part of thisrace, competing companies are also faced withsevere cost competition as they seek to pro-vide customers with desired quality at an afford-able cost.

Thus, for companies to survive, they must nowset prices that are competitive in todays marketwhile also setting costs that allow a sufficientprofit margin. As prices are increasingly deter-mined by market competition, costs must becarefully managed to create profits.

New forms of management tools and techniquesare emerging to help managers take on this dif-ficult task. Primary among these new approach-es is target costing. Driven by the voice of thecustomer to better understand what product andservice attributes are needed, target costingbecomes the means to long-term growthattained by doing what the customer wants, bet-ter and faster than the competition.

An organization that implements and masterstarget costing will continuously be ahead of thecompetition as it fine-tunes its integral efforts tothose most likely to be rewarded by the market.It is key to proactively building a competitiveadvantage.

I I . SCOPEThis Statement on Management Accounting(SMA) is addressed to financial professionalsand others who may lead or participate in effortsto implement target costing in their organiza-

tions. It supplements the Institute of Manage-ment Accountants Implementing Target Costing,published in 1998, which describes the targetcosting process, as well as Target CostingTheNext Frontier in Strategic Cost Management, pub-lished by the Consortium for AdvancedManufacturing-International (CAM-I) in 1997.

The focus of this publication is on core tools andtechniques that improve the effectiveness of tar-get costing. The focus is on core tools becauseit is beyond the scope of this guideline to dis-cuss all the tools and techniques that supportthe implementation of target costing.

This SMA assumes the reader is already familiarwith basic target costing concepts. It is intendedfor organizations that have already decided toimplement target costing. The tools and tech-niques discussed apply to:

all levels of an enterprise; all functions of an enterprise; enterprises in all business sectors; and small and large organizations.

This guideline will be useful to those who maylead or participate in efforts to implement targetcosting. It will help them to:

develop a framework for planning and manag-ing the implementation of target costing;

learn about the various core tools and tech-niques to improve the effectiveness of targetcosting; and

understand the roles and responsibilities offinancial professionals in the target costingprocess.

I I I . THE ROLE OF MANAGEMENTACCOUNTINGTarget costing is an integrative approach to

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product design and development that requiresthe active and ongoing participation of individu-als from across the organization. It builds froma sound understanding of current costs, trade-offs among cost, quality, and functionality, andthe changing requirements of customers. Itserves to coordinate design team efforts, com-municate needs to all involved parties, andclearly define the overall objectives and chal-lenges facing the organization during productlaunch and maintenance.

Within this customer-driven, product-focusedenvironment, financial professionals provide thetechnical expertise required to ensure that thedefined costs are reliable, that the trade-offsbeing made meet basic functionality and qualityrequirements, and that economic analysis isused as the basis for key decisions. The role ofthe financial professional in implementing targetcosting includes the following efforts andobjectives:

ensuring that the target costing initiatives arebased on strategic criteria and are designed tosupport company objectives;

providing economic expertise where needed toprioritize and assess specific product or ser-vice attributes;

creating a system of financial and performancemeasurements that support ongoing monitor-ing of pre- and post-launch activities againstobjectives set during the target costingprocess;

providing historical costs and estimated futurecosts for specific product or service attributes;

identifying gaps in current versus requiredcosts and functionality, and developing eco-nomic and performance-based assessmentsof the impact of these gaps;

ensuring that internal and external informationis validated and analyzed prior to use within

the target costing process; developing ongoing product cost systems that

will tie in with continuous improvement goalsfor the product launch;

supporting development of target price andprofit projections, including assuring that thenumbers are objective, reliable, and accurate;and

serving on the product design team to provideexpertise to support pre- and post-launch man-agement of the product within target-cost-defined parameters.

In target costing, the financial professionalserves as a team member with unique econom-ic expertise that can help to develop prelimi-nary cost estimates, validate assumptionsusing current and historical cost databases,and analyze the impact of various alternativeson the product/service costs. New forms ofcost information are used to accomplish manyof these tasks:

Life-cycle costing accumulates and analyzesproduct costs from birth to death of a productusing the life stages of a product as the struc-turing cost object.

Value-chain costing integrates cost informationacross traditional organizational boundaries toinclude suppliers, dealers, and customers. Itfocuses attention on the cost and contributionrequired from each value-chain member towardthe achievement of target cost and strategicobjectives.

Feature/function costing requires the decom-position and assignment of cost reduction tar-gets to product components based on theirrelationship to customer requirements and therelative importance of these needs.

Design driver costing focuses attention on theimpact of design on life-cycle and value-chaincosts, as well as the impact of changes in prod-

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uct attributes on the final cost of the product. Operations costing provides cost information

on a particular manufacturing operation. Activity-based costing identifies the drivers of

indirect manufacturing, marketing, and sup-port costs. It focuses attention on how productdesigns lead to the consumption of variousactivities, which in turn creates cost.

Tightly linked to the other cost managementtools, target costing is an important means bywhich finance professionals can help theirorganization avoid future costs. This proactiveposition provides for optimal impact as well ascreates a solid platform for the inclusion of finan-cial professionals on teams charged with devel-oping, managing, and measuring product or ser-vice performance.

IV. TARGET COSTING PROCESSSTEPSThe target costing process has six key steps.These steps, along with the pre-project prepara-tion, represent a standard work plan, a frame-work for training, and implementation. Whileeach target costing initiative is unique, an orga-nizations actual implementation will likely

include most or all six steps outlined in Exhibit1, although not necessarily in the order pre-sented. Keeping this in mind, the six basicsteps involved in implementing target costingare:

establishing the target market price; establishing the target profit margin and cost

to achieve; calculating the probable cost of current and

new products and processes; establishing the target cost; attaining the target cost; and pursuing cost reductions once production has

started.

While organizations can modify these core activ-ities to meet a particular situation, they are rec-ommended as a guide for structuring the imple-mentation of target costing initiatives.

V. IMPLEMENTAT ION TOOLS ANDTECHNIQUESEstablishing the Target Market PriceCost considerations play a minor role, at best, indetermining the target price under target cost-ing. Instead, target costing uses product or ser-

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EXHIBIT 1. TARGET COSTING PROCESS STEPS

vice features1 to identify a target market price.Driven by the market, and by expected relation-ships between supply, demand, and price sensi-tivity for the product, the determination of the tar-get market price incorporates several objectives,including:

identifying market and customer wants andneeds;

determining how much customers are willingto pay for alternative features;

transforming the desires of the customer/userinto the language required to implement aproduct; and

assessing what the competitive offerings are.

At the heart of the target-price-setting process isthe concept of perceived value. Customers canbe expected to pay more for a new product thanits predecessor, but only if its perceived value isgreater. Understanding what attributes lead tospecific value, and therefore price, is an essen-tial part of setting a market price that yields opti-mal return for the organizations efforts. Theseobjectives can be achieved by applying severaltools and techniques, including:

quality function deployment; analytic hierarchy process; customer voice analysis; and relationship matrix.

Quality Function DeploymentSince customers often make fairly subjectivestatements when evaluating a product, qualityfunction deployment (QFD) is a methodology use-ful for translating customer preferences system-atically into a number of objective design require-ments. These requirements can then be commu-nicated to the design and production teams to

ensure that everyone is working toward thesame objectives and outcomes.

QFD brings together the relationships betweencompetitive offerings, customer requirements,and design parameters, through a set of matri-ces. These matrices are used iteratively through-out the target costing process. In the productplanning phase, these matrices help determineexactly what the customer desires, how wellcompetitors are satisfying the customer, andwhere unfulfilled niches exist in the marketplace.A QFD matrix developed for the product planningphase of a fax machine is shown in Exhibit 2.

This matrix summarizes information about prod-uct functions and their associated customerrankings. It also shows the correlation betweencompetitor design parameters and customerrequirements. Additionally, information is provid-ed about how customers evaluate competitorofferings on these same features. The QFDmatrix shows that the customer requirement ofreceive/send speed has a high correlation withthe design of modem speed and memory.Similarly, printing speed is correlated to the printengine design parameters.

QFD is used successfully by both product- andservice-based organizations. For example, it hasbeen used in the manufacture of automobiles,electronics, home appliances, clothing, integrat-ed circuits, synthetic rubber, construction equip-ment, and agricultural engines. QFD has alsobeen used to design retail outlets, schools, andplant layouts.

Exhibit 3 provides a summary of the criticalprocesses, tasks, responsibilities, and stagesinvolved in QFD. Columns represent the organiza-

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1 A feature is a physical or aesthetic attribute of the product desired by the customer. Decomposing a target cost by productfeatures allows organizations to view these costs from a customers perspective.

tions functional units, while rectangles in theflowchart identify activities and required interde-partmental participation. Arrows indicate theflow of documents or decisions.

The chart defines QFD team structure as well asthe core documents and information the teamwill require to complete tasks. Serving as a roadmap for managing a QFD project, the chart helpsan organization identify and answer several corequestions in the planning and design process,including which customers are being empha-sized, what their demands are, how much onecustomer segments requirements should drivethe design process, and what criteria should beused to make these decisions.

Using the QFD methodology, a model is devel-oped that consists of the following:

An Objective Statement, a description of thegoal, problem, or objective of the team effort;

The Whats, a list of characteristics of a product,process, or service, as defined by customers;

Importance Ratings, or weighted values assignedthe Whats, indicating relative importance;

A Correlation Matrix, which shows the relation-ship between the Hows;

The Hows, ways of achieving the Whats; Target Goals, indicators of whether the team

wants to increase or decrease a How or set atarget value for it;

A Relationship Matrix, a systematic means for

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EXHIBIT 2. QFD MATRIX IN PRODUCT PLANNING OF A FAX MACHINE

Source: Ansari, et al., 1996: 152.

6S T R A T E G I C C O S T M A N A G E M E N T

EXHIBIT 3. PRODUCT DESIGN PROCESS CHART

Source: Terninko, 1997: 27.

identifying the level of relationship between aproduct/service characteristic What and a wayto achieve it, the How;

Customer Competitive Assessment, a review ofcompetitive products/service characteristics incomparison with the teams product or service;

Technical Competitive Assessment, the organiza-tions engineering specifications for each Howand the competitors technical specifications;

Probability Factors, values indicating the easewith which the organization could achieve eachHow;

Absolute Score, the sum of the calculated val-ues for each How or column in the RelationshipMatrix; and

Relative Score, a sequential numbering of eachHow according to its Absolute Score. Numberone is entered for the How with the highestscore, two for the next highest, and so on.

QFD methodology provides a framework for clari-fying and meeting goals. For decision makers, ithelps them identify what is important by provid-ing a fact-based system to replace emotion-based decision making. The uniqueness of themethodology is that this data can be capturedand strategically evaluated in the initial days ofdecision making. This is when decisions aremade on whether to proceed with production orservice development. QFD helps organizationsidentify what will work, what will not work, andwhat things should be avoided. Since as muchas 80 percent of the projects cost is locked induring this early phase, this assessment cangreatly reduce program costs and developmenttime.

For example, Toyota has used QFD since 1977.The results have been impressive. Between1977 and 1994, Toyota Autobody introducedfour new van-type vehicles. Using 1977 as thebase year, Toyota reported a 20 percent reduc-

tion in start-up costs on the launch of the newvan in October 1979, a 38 percent reduction inNovember 1982, and a cumulative 61 percentreduction in April 1984. During this period, theproduct development cycle (time to market) wasreduced by one-third with a correspondingimprovement in quality due to a reduction in thenumber of engineering changes.

Analytic Hierarchy ProcessThe analytic hierarchy process (AHP) is a multi-criteria, decision-making technique that com-bines qualitative and quantitative factors in theoverall evaluation of alternatives. AHP is anexcellent tool for considering different character-istic combinations of customer segments. Byexamining these characteristics, an organizationcan uncover new market segments and deter-mine the relative importance of each.

The AHP methodology comprises four steps:

building a decision hierarchy by breaking thegeneral problem into individual criteria;

gathering relational data for decision criteriaand encoding them using the AHP relationalscale;

estimating the relative priorities (weights) ofdecision criteria and alternatives; and

performing a composition of priorities for thecriteria that gives the rank of alternatives rela-tive to the top-most objective.

AHP begins with subject matter experts buildinga hierarchical representation of the decisionproblem. At the top of this hierarchy is the over-all objective, and the decision alternatives are atthe bottom. Between the top and bottom levelsare the relevant attributes of the decision prob-lem that provide significant input to the decisionprocess. The hierarchy can be quite detailed,though most applications need no more than

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three levels, as shown in Exhibit 4.

Once the levels and elements have been deter-mined, the subject matter experts assign relativeweights to each defined characteristic using aconsensus method based on the following nine-point scale of importance.

1. Equal importancethe row and column havethe same impact upon the higher order need.

2. Between 1 and 3.3. Moderate importanceexperience and judg-

ment slightly favor the row over the column.4. Between 3 and 5.5. Strong importanceexperience and judg-

ment strongly favor the row over the column.6. Between 5 and 7.7. Very strong importancethe row is strongly

favored and its dominance is demonstratedin practice.

8. Between 7 and 9.9. Extreme importancethe evidence favoring

the row is of the highest possible order ofaffirmation.

Using a series of calculations, a resulting two-way comparison table is normalized (the fraction

of the characteristic as a percentage of the totalfor each column). The average of the normalizedscores in the rows ranks the importance of thecriteria. As shown in Exhibit 5, market size, costto support, ease to satisfy, and publicity are0.604, 0.119, 0.066, and 0.211, respectively.Market size is nearly three times more importantthan publicity.

Once key criteria are identified, potential cus-tomers can be ranked, as illustrated in Exhibit 6.The left two columns show the criteria and theircalculated weights. The importance of each cus-tomer for each criterion is recorded in the nextthree columns. The weighted importance of eachcustomer for each criterion is the product of theimportance of the criterion and the importanceof each customer for that criterion. The columntotals are the weighted importance for each ofthe customers. The exhibit illustrates that themarket size criterion is the most important andthe consultant is the most desirable customerfor this criterion. By helping organizations deter-mine the relative importance of customer seg-ments, AHP allows firms to better determinewhom to talk to and how much weight to assignto their opinions.

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EXHIBIT 4. HIERARCHY OF DEFINED CRITERIA

Customer Voice AnalysisCustomer voice analysis helps an organization tobetter understand customers expectations,voiced desires, and as yet unperceived needs.These qualities, or attributes, become thewhats of QFDthe individual characteristics ofthe product or service that drive customer satis-faction and value perceptions. If an inaccuraterepresentation of customer desires is obtained,the QFD process will fine-tune the system to

bring forth the wrong product or service.Therefore, obtaining the voice of the customeraccurately is critical.

Customer voice analysis aids the developmentof an accurate list of product or service charac-teristics. As illustrated in Exhibit 7, customervoice analysis makes the list of whats moremanageable, focuses the QFD process, andhelps clarify meanings.

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EXHIBIT 5. DETERMINING THE PRIORITY OF CRITERIA



EXHIBIT 6. RANKING CUSTOMERS BY CRITERIA

Once the primary list of whats is identified,attention turns to rating these qualities system-atically. The resulting rankings play a key role inthe QFD process, serving as weighting factorsthat are used downstream as multipliers forother analysis. It is critical that these rankingsaccurately reflect the customers opinions.Exhibit 8 provides an illustration of the deliveryqualities and their rankings for a large aerospacecompany.

Puritan-Bennett used customer voice analysis todevelop a new spirometer. Information aboutcustomer demands came from physicians andnurses, supplemented by dealer and distributorinput. During the design process, there weremany lively discussions over which engineeringsolution a product feature should use. Customervoice analysis ensured that decisions alwaysfavored the customer. With a better design and

reduced selling price, Puritan-Bennett took awaythe competitors price edge and fulfilled a needthat neither company had previously satisfied.

Relationship MatrixA relationship matrix focuses attention on howthe various customer requirements will be metusing tangible and intangible product or processcharacteristics. Since many customer require-ments are too unclear or poorly defined to pro-vide guidance to the organization, they must bechanged into the language of engineering.Performance or technical measurements evalu-ating the products performance, based ondemanded quality, are used for this purpose.

At least one quantifiable performance measureis typically identified for each demanded quality.For instance, if the demanded quality for aneasel pad includes stay on wall, two perfor-

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EXHIBIT 7. VOICE OF CUSTOMER ANALYSIS TABLE


mance measures can be envisioned: time onwalls and number of walls. Test procedurescan then be developed to understand how longthe product remains on a variety of different wallsurfaces.

Defining how well performance measures thatdetail the technical features of the product willrelate to the demanded qualities is key to trans-forming customer information into specific,objective design language. Without this transfor-mation, product characteristics and potentialprice-creating value cannot be used to driveinternal efforts.

A relationship matrix details the strength of eachperformance measure in terms of its predictiveability for each customer-demanded quality. Foreach row demanded quality and column perfor-mance measure intersection, the following ques-tion should be asked: If I know the value for per-formance measure X, how well will it predict the

customers satisfaction with the products abilityto satisfy demanded quality Y?

Four options are offered in the example illustrat-ed in Exhibit 9: a strong relationship, a mediumrelationship, a weak relationship, and no rela-tionship. The use of symbols for these weight-ings, similar to a Consumer Reports evaluationmodel, facilitates the identification of patterns ofrelationships in the matrix.

Important demanded qualities should have a per-formance measure with at least a medium rela-tionship. Relatedly, more than 50 percent of thecells should represent no relationship, in keep-ing with the Pareto principle that most of thevalue will come from the critical few qualities andmeasures. If a row is blank in the relationshipmatrix, it means that the demanded quality willnot influence the design. This could be a criticalomission. A blank column, on the other hand,indicates that resources would be wasted meas-

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EXHIBIT 8. RATINGS WITHIN A CUSTOMER VOICE ANALYSIS

Source: L. Guinta and N. Praizler, 1993: 55.

uring something that does not directly satisfycustomer needs.

Narrowing the total list of potential measures tothe critical few is important in order to focusdesign efforts and ensure that the needs of tar-get customers are met. If multiple customer seg-ments are to be addressed, the answers tothese questions can be expected to differ by seg-ment. The final choice of performance criteriawill then need to be adjusted to accommodatethe optimal level of satisfaction for the largestnumber of potential customers, incorporating the

least amount of variety and complexity in thefinal product design.

Establishing the Target Profit Margin and Cost to AchieveAfter the target price is set, the focus shifts toestablishing the target profit margin and specifi-cation of the achievable cost objective. The over-all goal is to ensure that the profitability andreturn on investment goals of the organizationare met by the new product or service. Specificobjectives of this phase include:

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EXHIBIT 9. RELATIONSHIP MATRIX


determining return on sales objectives; and linking capital investment planning to prof-

itability and the costs associated with productdevelopment and delivery.

The long-term general profit plan of the organiza-tion is the backdrop for the development ofproduct-line-specific objectives. Specifically, tar-

get profit margins for product line models andthe various strategic project plans that togethermake up the organizations basic managementstructure must be determined. Strategic projectplans include new product development plans foreach product or service, plant investment plans,and capital procurement plans. New productdevelopment plans are required for each year of

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EXHIBIT 10. TARGET COSTING AND PROFIT MANAGEMENT PROCESS

Source: Monden, 1995: 50.

the projected product life.

For example, at Nissan, the corporate develop-ment plan coordinates the new-product life-cycleplans for each vehicle model with long-term prof-it plans as part of the long-term profit planningprocess. Corporate new-product developmentplans are required for each year in the projectedproduct life and cover all full model changes orminor changes that are planned for all targetmodels. Thus, all production and sales plans forthe companys vehicle models are coordinatedunder one plan that takes the perspective of thecompanys overall business strategy.

Coordinating all of an organizations productionand sales plans ensures that these effortsreflect the strategic business perspective.Exhibit 10 details the role of the target profitmanagement process within a target costing sys-tem of a major automobile manufacturer.

Target profit margins must be realistic and suffi-cient to offset the life-cycle costs of the product.A useful tool used for establishing target profitmargins is a multi-year product/profit plan.

Multi-Year Product/Profit PlanA multi-year product/profit plan integrates thevarious product plans, establishes baseline tar-gets for each product over its useful life, andensures that the timing of new product releasesare staggered to prevent bunching, while sup-porting the effective use of company resources.The plan has a series of inputs and outputs,specifically:

Inputs: life-cycle plans for the proposed new products; current position of existing products on cash

flow/product portfolio charts; and estimated values for the companys overall per-

sonnel capacity (for design, prototype develop-ment, and production setup work), manufactur-ing plant capacity, and new plant investmentcapacity (including capital procurement ability).

Outputs: multi-year general profit plan (exact timeframe

varies by the nature of the planning cycle in agiven industry);

products/services to be developed and intro-duced over a certain time period;

target profit for each product or product series; target return-on-sales ratio for each product; plant investment plan for each product; personnel plan; and overall new product introduction plan.

Exhibit 11 illustrates a multi-year product/profitplan structure. It is an annual product mix thatshows aggregate target profits by year for eachproduct. The sum of all products in a given yearis the annual profit plan, while the total of annu-al profits by products is the product life-cycleprofit. The product level profit includes all direct-ly traceable recurring costs (such as materials)and conversion, and nonrecurring traceablecosts (such as special tooling and dedicatedmachinery and other costs.)

Having laid out the parameters for an individualproduct within the context of the overall compa-ny strategic profit and product plans, attentioncan turn to calculating the probable cost of cur-rent and new products and processes.

Calculating the Probable Cost of Currentand New Products and ProcessesA key step in the product planning phaseinvolves the examination of the organizationscost information in order to generate reliablecost estimates for the probable costs of currentand new products and processes. These esti-

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mates may include production costs, R&D costs,physical distribution costs, and end-user costs.The underlying objectives during this phaseinclude the following:

determining what a new products costs wouldbe using existing product specifications andmanufacturing processes;

cost modeling; and analyzing internal costs.

Several core tools and techniques typically usedin this effort include:

process (operational) costing; component cost analysis; and cost tables.

Process (Operational) CostingProcess (operational) costing can be used toidentify the cost drivers2 for each step of themanufacturing process. Process costing makesno attempt to account for the costs of individualunits or specific groups of products. Instead, allcosts are accumulated by operations or process-es. These costs are subsequently allocated fromprocesses to products on a systematic basis.

Process costing directly considers the effects ofcustomer requirements and differentiates thevalue-added costs likely to be incurred by servingone group of customers versus another. Thetechnique includes the impact of requirementson process characteristics such as capacity. Theresult of this effort is an economic model of theorganization that clearly defines customer needs

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EXHIBIT 11. MULTI-YEAR PRODUCT/PROFIT PLAN


2 Process cost drivers are process parameters that affect the efficiency or effectiveness of a process. Process cost driversaffect process costs independently of any particular product mix.

and the processes required to satisfy thoseneeds. The model integrates marketing, opera-tional, and financial data to better understandthe total cost caused by a potential change tothe product matrix.

An advantage of placing the costing emphasis onprocesses is that the trade-offs between compet-ing products can be better identified. As the flowof a new product is tracked through an existingfacility, the target costing team can begin to iso-late its impact on existing products to determinewhere the new demand on resources will triggerconstraints on overall throughput.

The creation of cost estimates for existing or new

processes provides the basis for developing cap-ital acquisition plans and finalizing product prof-itability analysis. Exhibit 12 provides an exampleof a process-specific cost list that details primeassumptions and current demand for parts of theprocess affected by a new product.

Whether process costing is used to understandthe overall impact of a new product on the exist-ing plant or to estimate the cost implications ofvarious design decisions, it plays a pivotal role increating the probable cost estimate for currentand new products and processes.

Component Cost AnalysisComponent cost analysis decomposes the prod-

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EXHIBIT 12. RATE MASTER LIST FOR PROCESS COSTS


uct level target cost into the major componentand parts categories. For example, a target costlist might be broken down by the following majorcomponent categories and then by more detailedparts categories:

Breakdown of chassis functions: front axle,front brakes, rear brakes, etc.;

Breakdown of body functions: white bodymetal, bumpers, window glass, etc.; and

Breakdown of interior functions: seats, air con-ditioning, interior panels, audio system, etc.

A major component category may be further bro-ken down into detailed part categories, for exam-ple, breakdown of seat systems: frame, sliderails, reclining mechanism, trim covers, etc.

Component cost analysis is particularly usefulfor assembly industries that purchase thou-sands of components, parts, and subassem-blies. Component analysis has several importantuses. First, it identifies the expensive compo-nents of a product. Second, it focuses on thecost relationships between components. Thishelps to determine if decreasing the cost of onecomponent increases the cost of another compo-

nent. Finally, it ensures that no outdated or soonto be out-of-production components are used.

Exhibit 13 illustrates a component cost matrix.The cost column reveals the component cost,and the availability column provides the lastavailable date for the component before itbecomes unavailable. The plus or minus entrieshighlight positive or negative relationshipsbetween the costs of components. A plus signindicates that as the cost of the component inrow 1 is reduced, the cost of the component inthe column increases. For example, when thecost of component C1 is reduced, the cost ofcomponent C2 increases, but the cost of compo-nent C3 decreases.

Inputs and outputs required for effective compo-nent cost analysis include:

Inputs: function-specific target cost outline; actual costs of internal components in existing

or similar products; current costs of purchased components in

existing or similar products; component functional drawings and concept

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EXHIBIT 13. COMPONENT COST ANALYSIS


manuals that show that the QFD objectives arebeing met;

component-specific comparison of specifica-tions for current and proposed models;

planned volume of products that will use com-mon components; and

component availability information.

Outputs: component-specific target costs of in-house

components; component-specific target costs of purchased

components; and component-specific target costs for the com-

plete product.

Exhibit 14 provides a breakdown of componentcosts for a hypothetical coffeemaker. This infor-mation can be used to identify and prioritizecost-reduction efforts at the component level.Care must be taken to ensure that the sum ofthe component-level target costs does notexceed the target cost of the product. Often anincrease in the cost of one component requiresan exploration of ways to reduce the costs of

other components by an equivalent amount.

Cost TablesCalculating the probable cost of current and newproducts and processes depends, in large part,on reliable historical data. Cost tables enableestimating costs for materials, parts, utilities,and conversion. In essence, a cost table is adatabase that defines and depicts the costeffects of using different materials, productionmethods, and product designs.

Exhibit 15 shows one branch of a hypotheticalcost table. Additional branches would stem fromeach of the cost driver alternatives under drillingactivity. In addition, similar branches would beprepared for cutting and lathing. At eachstage, the cost table would show unit productcost split into direct material, direct labor, andproduction overhead.

There are two general types of cost tables:approximate cost tables and detailed costtables. Approximate cost tables emphasize asmall number of key variables that are known to

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EXHIBIT 14. COMPONENT COST BREAKDOWN

Source: Ansari, Bell, Klammer, and Lawrence, 1997: TC-15.

have significant impacts on the final cost of aproduct, such as the impact of different enginespecifications on the cost to design and producea motorcycle.

Relatedly, a detailed cost table includes therelationship between a large number of vari-ables and their relevant costs. Typically devel-oped over many years, cost tables are usedfrom the original design throughout the life cycleof the product. They are updated on an ongoingbasis, serving as a critical decision-making aidin the design and ongoing management of aproduct portfolio.

Cost tables are typically developed using bothinternal and external expertise from acrossmultiple functions, perspectives, and organiza-tions. Since upwards of 80 percent of a prod-ucts life-cycle cost is set before the product islaunched into production, the time and effortrequired to develop and maintain cost tables isan essential investment in current and futureprofitability.

Combined with computer-aided design (CAD),cost tables can provide for real-time analysis ofthe cost implications for a proposed change inproduct or component design or redesign.

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Source: Yoshikawa, et al., 1996: F3-25.

EXHIBIT 15. COST TABLE STRUCTURE

Finally, cost tables are often used to supportwhat if (sensitivity) analysis at all stages of theproduct life cycle.

Toyota uses cost tables in five key productionsteps: machining, casting, body assembly, forg-ing, and general assembly. The cost tablesdetail the machine rates for each step of theproduction process. These rates include labor,electricity, supplies, and depreciation costs.The exact form of Toyotas cost tables dependson the type of production step being analyzed;for example, for stamping, the cost table con-tains the cost per stroke while for machinery itcontains the cost per machine hour. Toyotascost tables are highly detailed, and, in mostcases, each production line has its own costtable.

Establishing the Target CostOnce the target market price and target profithave been established, the target cost can becalculated. The target cost reflects the relativecompetitive position of the organization. It alsorepresents the cost at which the product mustbe manufactured if it is to achieve the targetprofit margin when sold. The target cost acts asa signal to all involved in the target costingprocess as to the magnitude of the cost reduc-tion objective that eventually must be achieved.The established target cost should be attain-able, but only with considerable effort.Objectives that drive the achievement of thesegoals include:

setting continuous improvement targets; measuring performance; and communicating cost requirements.

Target costs can be calculated using the targetreturn-on-sales ratio or a compilation of estimat-ed costs. In the former case, one of two primary

formulas can be used to set a sales-price-basedtarget cost:

Target cost = target sales price x (1 target return-on-sales ratio)

orTarget cost = target sales price target

operating profit.

Relatedly, the target cost can also be calculatedby subtracting the per-unit profit improvementtarget from the estimated cost, then isolatingthose costs.

Having established the basic parameters for thetarget costing system and identified the appropri-ate level of execution at which it should be car-ried out, attention turns to establishing specificcost and performance targets. A useful tool thatcan be used in this step is benchmarking.

BenchmarkingOne of the most important aspects of creating atarget cost for a product or service is guarantee-ing, at both the total and component level, thatfunctionality and costs are competitively estab-lished. Benchmarking, which compares costs ofspecific products, activities, and outcomes tothose of competitive or best-practice companies,provides valuable input to target costing in thiseffort. Issues that can be addressed throughbenchmarking studies include:

identification of the best practice in completingcore and support activities for the product orservice;

establishment of objective cost targets andperformance metrics for component suppliersand internal processes;

definition of quality and delivery parametersfor similar products, processes, or compo-nents across comparable industries;

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identification of process improvements thatcan provide quantum improvements in overallcost and profit performance;

development of innovative analysis and designtechniques based on benchmarking site visitsand case studies; and

creation of an ongoing network of organiza-tions capable of supporting current and futureimprovements and target costing initiatives.

The benchmarking process has been formalized

into several steps by the leading practitioners.They all use an integrated approach to bench-marking reflected in the following five generalsteps: planning, data gathering, analysis andintegration, implementation/execution, and re-calibration, as illustrated in Exhibit 16.

Organizations that are at a significant competitivedisadvantage will benefit most from estimatingbenchmark costs and calculating the differencebetween those costs and their target cost. If the

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EXHIBIT 16. BENCHMARKING STEPS

Source: IMA, Effective Benchmarking.

disadvantage is significant, it might not be possi-ble to reach the benchmark costs in a single gen-eration of product design. Such organizations willhave to adopt a multi-release strategy of productdesign, setting ever more aggressive cost targetsfor each release. The narrowing gap between thebenchmark and the target cost would demon-strate the achievement of competitive parity.

Attaining the Target CostOnce the target cost has been established, thegoal is to develop a new product concept thatattains the target cost while meeting all cus-tomer requirements. The process of attaining thetarget cost is supported by various methods thatreveal cost-reduction potentials and show waysto transform those potentials into design alter-natives. Key objectives at this stage of the targetcosting effort include:

optimize the relationship between materials,parts, and manufacturing processes;

minimize costs; focus design efforts on market-driven variables

for quality and cost of ownership; link product development with customer

desires and to achieving a sustainable com-petitive advantage;

link the product development process so thatit assures product quality; and

estimate the cost prior to implementation.

Turning the allowable cost target into an achiev-able cost requires three primary steps: (1) com-pute the cost gap; (2) design costs out of theproduct; and (3) release the design to manufac-turing and undertake continuous improvement.

Computing the Cost GapCalculating the difference between the targetcost (calculated from the target price and profitmargin) and current cost estimates is the first

step in attaining target costs. Using the total,fully absorbed costs as the baseline, currentcosts represent the as-is estimate of the costof producing the product or providing the service.

The resulting cost gap is decomposed into twoprimary parts: life-cycle costs and value-chaincosts. Life-cycle decompositions emphasize thetotal product cost of the birth-to-death activitiesperformed in research, manufacturing, distribu-tion, service, general support, and disposal.Conversely, value-chain analysis examines costsbased on whether they are incurred and con-trolled by the organization or by one of its value-chain partners (e.g., suppliers, dealers, or dis-posers). As noted by Ansari, The two break-downs take the same total cost but provide twodifferent kaleidoscopic views of the productcost. Each helps to highlight where cost reduc-tion efforts need to be focused. Exhibit 17 pro-vides a detailed illustration of the cost gapanalysis effort.

Designing Costs Out of the ProductReducing costs through the product design stageis the most critical step in attaining target costs.The key to achieving desired reductions lies inthe answer to one specific question: How doesthe design of this product affect all costs associ-ated with the product from its inception to its finaldisposal? Identifying all costs, whether incurredin distribution, selling, warehousing, service,support, or recycling, is essential as all of thesecost elements, which are generated by the differ-ent functions, are affected by the design chosen.

For instance, the weight and control panel are twoelements of a convection oven that are affectedby the products design. A heavy oven willincrease loading, transportation, and installationcosts if two people are required to perform theseactivities. Relatedly, an elaborate control panel

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will increase the time required to explain theproducts use to customers, as well as increasingthe potential for product support and repaircosts, due to failures in electronic and mechani-cal components. Finally, the materials used mayultimately pose an environmental hazard that hasto be handled at the point of disposal. All thesefactors add to the products cost with little or noimprovement in customer satisfaction.

Releasing Design to Manufacturing andUndertaking Continuous ImprovementThe final stage in attaining the target cost is tocontinue to make product and process improve-ments that will reduce costs beyond the pointwhere it is possible through design alone. Itincludes eliminating waste (scrap, rework, etc.),improving production yield (i.e., getting more pro-duction from raw materials), and other suchmeasures.

Achieving cost reductions before productionbegins is aided by the use of two specific toolsand techniques: (1) design for manufacture andassembly and (2) value engineering.

Design for Manufacture and Assembly(DFMA)DFMA is an approach to product design that canimprove an organizations ability to competebased on its manufacturing capability.Specifically, DFMA focuses on reducing costs bymaking products easier to manufacture whileholding functionality at specified levels. DFMAguides development of the detailed productdesign, ensuring that at every stage of theassembly and manufacture process minimalcost and waste elimination targets will bereached. The DFMA methodology is based onfive basic principles:

Reduce the number of parts by combining

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EXHIBIT 17. COMPUTING THE COST GAP


parts (i.e., multifunction parts). Seek to com-bine parts unless separate parts are neces-sary because they must be of a different mate-rial, move relative to each other, or are neces-sary to ease assembly or disassembly.

Assemble from the top down, rather than fromthe side or bottom.

Design symmetry into parts so that they maybe assembled in many orientations. If this isnot possible, be sure they are very symmetri-cal so they can be easily oriented and fed.

Design parts to be easily handled and insert-ed without restricted access.

Use flexible manufacturing processes wherev-er possible (e.g., powder metal processing,injection molding, stamping).

Without DFMA, the projected benefits of a newproduct design may not be attained. Forinstance, at an organization making a variety ofmechanical counters, a product was designedthat required extreme dexterity to manufacturebecause multiple wires had to be encapsulatedin a snap-together casing. Once the casing wasassembled, it could not be disassembled (itbecame scrap). As the product rolled out to man-ufacturing, it was found that only one personcould produce it reliably. No one else in the plantcould consistently accomplish the task of gettingall the wires into the casing before its closure.The entire production of this item was limited bypoor execution of a good design concepta fail-ure to apply DFMA.

DFMA enables the attainment of cost targets byfinding unique, low-cost, yet robust ways to trans-form product concepts into reality. The benefitsit can provide include:

elimination of excess parts; active inclusion or development of common

parts for a wide range of applications;

through disassembly, reduction of life-cyclecosts for maintaining the product in the field;

reduction of potential defects and relatedengineering-change notices to correct designor assembly problems;

increase in assembly efficiency and effective-ness; and

improve throughput and time-to-market.

DFMA methodology has been successfully appliedat many organizations, including several differentdevelopment programs within the Boeing Company.In each case, cross-functional teams were estab-lished to develop a new product that eitherenhanced performance and/or reduced cost.These specific examples include 737 flight deck airvalve, 737 windshield replacement, and 737/757passenger cabin sidewall panel assemblies. Theteams applied the DFMA process in developingtheir new products. Exhibit 18 shows the top levelresults from these three different programs.

Value Engineering (VE)VE is used by organizations to increase productfunctionality and quality while at the same timereducing costs. The scope of VE includes designcosts reduction, process improvements, andworking with suppliers. The output of VE is aseries of improvement plans that raise the valueof the target product. Emphasizing functionalityand meeting customer requirements within theallowable cost parameters, VE goes beyond theparticular styles or configurations of currentproducts to consider the functions that lie at theheart of the product in order to come up withinnovative ways to achieve desired functionalitywith less cost or effort.

As suggested by Exhibit 19, VE studies the vari-ous requirements of functionality and quality thatoccur during the entire life cycle of a product.These include:

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user requirements: use-objectives, use-conditions and environments, performancefeatures, reliability, safety, durability, design,shape, color, etc.;

sales requirements: selling points, competitiveperformance features, competitive pricing, andrelated factors,

design-related requirements: performance lev-els, added-function levels, etc.;

manufacturing-related requirements: processingtechnologies, manufacturing processes, and relat-ed labor hours, materials, and purchased parts;

distribution-related requirements: packaging,loading, storage, transportation, etc.;

cost-related requirements: management ofprogress toward achieving target costs; and

legal and regulatory requirements: patents andutility models, environmental protection laws,industry regulations, government guidelines,and related factors.

Exhibit 20 illustrates an example of VE cost-cutting ideas that focus on reducing the numberof parts, simplifying the assembly, and not over-

engineering the product beyond what will meet acustomers needs.

Isuzu is a significant user of VE. The develop-ment of their NAVI-5 transmission system, whichcombines the higher fuel efficiency and perfor-mance of a manual transmission with the con-venience of an automatic transmission, used VEconcepts. Specifically, VE was used to develop aGemini (ceramic) heater that would reduce thetime it took to warm up a cars interior by focus-ing early heat from the engine through a second-ary heating system that directed warm air atoccupants feet until the engine was warmenough to support the traditional heating sys-tem. Also, VE was used to develop a gear leverthat would fold down while the vehicle was sta-tionary but that would not collapse while thevehicle was in motion.

Having made the improvements required totransform the target costs into achievable costs,attention can now turn to achieving continuousimprovements on the plant floor.

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Source: Behun, 1995: 101.

EXHIBIT 18. BOEING DFMA APPLICATION RESULTS SUMMARY

Pursuing Cost Reductions Once Production Has Started

The start of production signals the beginning ofthe cost maintenance phase, which emphasizesthe stabilization of or continuous improvement in

product- and component-level costs. The objec-tive at this stage is to pursue cost reductionsrelentlessly at every stage of manufacturing toclose any remaining gaps between targeted andactual profits.

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EXHIBIT 19. VALUE ENGINEERING (VE) FRAMEWORK


Organizations that have successfully implement-ed target costing, such as Texas Instrumentsand Toyota, note the importance of cost informa-tion in cost reduction initiatives. Key objectivesat this stage include:

providing improved product cost information; providing improved performance monitoring;

and improving understanding of the true cost

structure.

A useful tool for this cost reduction effort isactivity-based costing/activity-based manage-ment (ABC/ABM).

ABC and ABMAchieving cost reduction objectives requiresinformation that identifies the causes of currentcost and the potential impact of attacking thesecost drivers. ABC and ABM are valuable target

costing tools because they focus attention onhow product design leads to the consumption ofvarious activities and, therefore, increases over-all costs. For instance, material handling is relat-ed to the number of unique parts purchased,which is a function of design complexity.

ABC and ABM can also be used to increase theunderstanding of cost items such as manufactur-ing overhead, marketing, distribution, serviceand support, and general business overhead.Where ABC and ABM provide inputs to a decisiontechnique for improving the use of current andanticipated resources, target costing applies thisinformation to change the nature and amount ofcurrently available resources.

Exhibit 21 details the relationship between ABC,ABM, and target costing. The interaction ofreductions in direct costs that remain the pri-mary focus of target costing and the cuts in, or

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EXHIBIT 20. VALUE ENGINEERING (VE) IDEAS TO REDUCE COSTS

Source: Ansari, Bell, Klammer, Lawrence, 1997: TC-20.

improvement of, indirect costs and activitiesunder ABC and ABM creates an ongoing basis forimprovement and development of a competitivecost and profit profile for existing and newproducts.

At almost every turn, target costing can utilizeinformation available in ABC and ABM systemsto identify current actual costs, analyze the caus-es of that cost, and find ways to reduce overallindirect costs by changing the ways products aredesigned, developed, manufactured, and sold.Using ABC and ABM in the target costingprocess provides the following benefits:

quantification of costs, both value-added andnonvalue-added, by activity, cost element, com-ponent, and product;

identification and estimation of the costs tomeet specific customer functionality and qual-ity requirements;

analysis of the costs of complexity; measurement of the impact of QFD, DFMA, and

VE initiatives on current and projected costs; enhanced ability to take action to reduce over-

head costs; support of cost of quality and related analysis,

which reflect trade-offs made by the organiza-tion to hit cost targets;

sensitivity analysis, which incorporates theunderlying behavior of cost and the cost of idleor unused capacity to increase the accuracy oftarget cost estimates; and

creation of cross-functional, process-orientedcosting tools that support brainstorming, con-current engineering, and kaizen costingefforts.

ABC and ABM are important tools that supporttarget costing at Caterpillar. Both tools areapplied on a prospective basis to estimate prod-uct and process costs. During the early stages ofproduct development, ABC is used to estimateproduct cost at a general level. This is useful forpreliminary evaluation of product feasibility. Asproduct and process definition become moreprecise, predictive ABM process cost models areapplied to estimate the costs of particular func-tions and components using particular process-es. This has been particularly valuable to engi-neers as they work to reduce product andprocess cost, improve utilization of currentmachines and equipment, and eliminate wasteand process variation.

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Source: Sakurai, 1996: 124.

EXHIBIT 21. RELATIONSHIPS BETWEEN ABC, ABM, AND TARGET COSTING

VI . CONCLUSIONTarget costing seeks to anticipate costs beforethey are incurred, continually improve productand process designs, externally focus the orga-nization on customer requirements and competi-tive threats, and systematically link an organiza-tion to its suppliers, dealers, customers, andrecyclers in a cohesive, integrated profit and costplanning system.

Target costing is the means to achieve competi-tive advantage through active management ofthe unavoidable trade-offs and constraints facedby any organization providing goods and servicesto the market. Emphasizing proactive, ratherthan reactive, cost containment, target costingensures short- and long-term profitability andsuccess by putting customer needs and function-ality first, using them to drive the design, devel-opment, manufacture, and provision of products.Target costing redefines the competitive playingfielda challenge that cannot be avoided, onlyenjoined.

V I I . B IBL IOGRAPHYAnsari, S., J. Bell, T. Klammer, and C. Lawrence.

Target Costing in Management Accounting:A Strategic Focus. Homewood, IL: Irwin,1997.

Ansari, et al. Target CostingThe Next Frontier inStrategic Cost Management. Homewood, IL:Irwin and Bedford, TX: Consortium forAdvanced Manufacturing-International (CAM-I), 1996.

Behun, J.R., ed. Design for Manufacturability.Design Engineering, Vol. 81. New York: TheAmerican Society of Mechanical Engineers,1995.

Cooper, R., and R. Slagmulder. Target Costing andValue Engineering. Portland, OR: ProductivityPress and Montvale, NJ: Institute ofManagement Accountants, 1997.

Cooper, R. Nissan Motor Company, Ltd.: TargetCosting System. Harvard Business SchoolCase #9-194-040, 1994.

Dutton, J. John, and Mark Ferguson. TargetCosting at Texas Instruments. Journal ofCost Management, Fall 1996, pp. 33-38.

Fisher, Joseph. Implementing Target Costing.Journal of Cost Management, Summer 1995,pp. 50-59.

Guinta, L.R., and N.C. Praizler. The QFD Book.New York: AMACOM Books, 1993.

Institute of Management Accountants.Statement on Management Accounting,Implementing Activity-Based Management:Avoiding the Pitfalls. Montvale, NJ: May1998.

IMA. Statement on Management Accounting,Implementing Target Costing. Montvale, NJ:November 1998.

Monden, Y. Cost Reduction Systems. Portland,OR: Productivity Press, 1995.

Sakurai, M. Integrated Cost Management.Portland, OR: Productivity Press, 1996.

Tanka Takao. Target Costing at Toyota. Journalof Cost Management, Spring 1993, pp. 4-11.

Terninko, J. Step-by-Step QFD: Customer-DrivenProduct Design. Boca Raton, FL: St. LuciePress, 1997.

Yoshikawa, R., J. Innes, and F. Mitchell.Japanese Cost Management Practices.Handbook of Cost Management. New York:Warren, Gorham and Lamont, 1996: p. F-3.

Yutaka, Kato, Germain Boer, and Chee W. Chow.Target Costing: An Integrated ManagementProcess. Journal of Cost Management,Spring 1995, pp. 39-51.

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