Cost-plus pricing can be fine when a lean manufacturer offers a standardized product with limited competition. Unfortunately, most manufacturers offer highly unique products or highly commoditized products. For these manufactures, target costing is a vital part of the product development process. Target costing involves understanding the needs and wants of customers, determining how much they are actually willing to pay for the value a product delivers, and defining the organization’s necessary profit before determining product cost.

Cost Plus Pricing Vs. Target Costing

Historically, most manufacturers have determined product prices by simply adding a margin to the product cost. As such, this approach is often called cost-plus pricing.

Typically, manufacturers that use cost-plus pricing calculate product cost by utilizing a standard cost method.
Cost-plus pricing can often work perfectly fine when a manufacturer faces limited competition. However, the approach is often insufficient for products in highly competitive markets. That said many companies only utilize cost-plus pricing and some government contracts even dictate for prices to be set using this approach.
It is vital to recognize that as customer choice increases, prices tend to decrease. This force often leads manufacturers to reflexive cost-cutting measures while neglecting the significant impact of those measures on customer value.

How costs are cut varies. Costs may be cut by laying off employees, haggling with suppliers, or using less expensive materials. While any single cost reduction activity may not ultimately impact customer value, they certainly all have the potential to. Unfortunately, in many cases, if customer value is considered at all it’s often ignored until a significant change to revenue or market share is noticed and any damage is done.

It’s important to recognize that in crowded markets customers ultimately base price on the perceived value they associate with the good or service. Lean organizations recognize and apply this insight. Instead of defining price as the sum of cost and margin, the cost is defined as the difference between customer value and profit.
The result of this minor mental shift is simple yet seismic. For starters, in lean organizations, price ceases to be an afterthought. Instead, price becomes one of the first considerations in product development. Determining price is the first step in target costing. Thus, lean organizations must first determine customer value since value determines the price the market is willing to pay

A good example is the Toyota Prius. When it was first introduced to the market, it was much more expensive than other cars in the same category, including other cars manufactured by Toyota like the Camry. However, much of the success of the Prius is the result of the perceived value the market placed on hybrid technology beyond the dollars savings in gas mileage. In fact, many Prius owners saw their purchase as an essential public statement of their values.

Customer Values
One approach to understanding what customers value is to first understand the competition you’re up against. Benchmarking against existing competitor offerings and reverse engineering these alternatives can greatly improve your understanding of what a customer perceives as valuable.

That said, when there’s little competition, or when a product is a custom made, customer value can be more difficult to determine, but determining customer value is still vital. In these cases, you must carefully analyze and articulate the customer’s state before implementing your solution. The goal is to get a better idea of the value they might place on your good or service.

Voice of Customer

Regardless of competition and analysis, nothing substitutes for the actual voice of the customer (i.e. what the customer says directly and indirectly). The most powerful way to access the voice of the customer is by talking with and observing your actual customers and your target market. Confirming initial insights with role-playing can provide additional clarity. By collecting the voice of the customer, you involve in product development make intelligent decisions on pricing and cost.

It’s important to recognize that accurately understanding and articulating the voice of the customer is a challenging and on-going effort. For starters, people’s situations are often evolving. Their situation changes over time. Additionally, people continuously reevaluate their situations, wants, and needs. How people perceive their situations changes. Furthermore, how people articulate situations and values change over time as well. The key takeaway is that you cannot simply rely on customer service feedback or survey results. Understand that many follow-up conversations are often necessary in order to appropriately understand a problem.
Whatever you do, don’t downplay or allow others to downplay the importance of the voice of your customers. Unfortunately, many executives try to do this. They even reference quotes from great innovators to justify ignoring customer feedback. Probably the most famous one of these quotes is attributed (wrongly) to Henry Ford: “If I had asked people what they wanted, they would have said faster horses.”

Keep in mind, that even if Henry Ford actually said this (which is disputed) and we assume it’s accurate, instead of illustrating why customer feedback is worthless, this quote actually illustrates why deeper analysis of that feedback is vital. You must recognize that people typically don’t really want form (i.e. a horse). They want a benefit (i.e. faster transportation). After all, did people really want combustion engines? Certainly not!

Quality Function Deployment (QFD)
Many companies have adopted a process for applying customer requirements determined from customer recommendations into product design. The process is called Quality Function Deployment (QFD). QFD aims to balance the overall product quality, styling, and features with product cost and reliability.

Understand that quality function development, benchmarking, and voice of the customer are deceptively simple, yet complex subjects the details of which are far beyond the scope of this article. It is vital that your team fully understand the nuances and application of these processes if your company strives to become truly exceptional.

Profit Margin
The second step in target costing is determining the needed profit margin. It’s important to recognize that the needed profit margin, as opposed to the wanted profit margin, is not arbitrary. That said, the needed profit margin does account for the company’s strategy which should include how the company plans to be perceived by customers (i.e. commodity vs luxury).

Elements of Target Cost

The difference between the value the customer is willing to pay and the needed profit equals our total target cost. Now, we need to break the total cost down further to into component target costs.
Each organization will have various costs they need to take into consideration. For example, a manufacturer might break target costs down into the following categories:

  • Materials
  • Design
  • Tooling
  • Conversion (labor and overhead)
  • Support

Each of these component costs must be scrutinized and understood to make certain that customer value can be delivered at that cost.

Of course, this necessitates a full understanding of the particular factors of value as previously discussed. If an initial analysis of a given cost reveals a conflict, deeper analysis will be required to identify if there are other methods or technologies that can rein in costs to meet their target. Additionally, it may also be necessary to question any assumptions made about customer value and needed profit.

Unfortunately, value-based pricing and target costing is not simple. It can be even more challenging in markets where customers perceive very little difference between competitors and their offerings.
Alternatively, challenges can arise when products are highly customized or have very few direct competitors. In these situations, it’s even more vital to really spend quality time with the customer in order to gain a clearer understanding of how they perceive value. Likewise, in these situations, it’s equally as important to educate customers on how you understand the value.

Keep in mind that target costing is a key tool on your organization’s lean journey. For that reason, it must include all departments in the organization including marketing, engineering, finance, maintenance, and customer service,