In the quest for cost certainty, procurement professionals risk leaving value at the door. Could target cost agreements provide the power to unlock innovation from the supply base and achieve new personal bests for progressive organisations?
The concept of target cost agreements is nothing new. Largely of Japanese origin, it may have played a crucial role in the 1960s growth and success of the eastern automotive industry.
Since being adopted globally in the 1980s, the popularity of target cost management has ebbed and flowed within the procurement fraternity. Pockets of industry have embraced the practice and others have shunned it in favour of perceived cost certainty.
Steered by senior managers whose objectives are often budget driven, organisations are often prepared to concede the opportunity to pursue the best possible commercial deals in return for stability of landed cost. This is typically achieved by loading more risk onto the shoulders of the supplier; fluctuations in currency, raw material cost and volume are all commonly expected to be absorbed into a supplier delivering at a fixed cost.
The effectiveness of this can be debated - it may be effective when working in higher margin areas where suppliers are more able to withstand these fluctuations, but in lower margin sectors vendors delivering long term contracts will not readily make losses on large projects. Consequently quality or delivery suffers and inevitably the buying organisation ends up inventing more to either find a replacement supplier or rescue the project with the existing one.
The real drawback, however, comes in the form of lost opportunity.
What's the alternative?
Embracing target cost agreements can provide a viable option for those clients seeking to outperform their norms from either a cost or delivery viewpoint.
In its most basic form, a target cost agreement functions by tracking actual project costs on an accurate basis and comparing them with a pre-agreed target for the project. This can be on a piece price, project price or landed cost basis but is most effective when Total Cost of Ownership can be accurately measured.
The difference between the actual cost and the target cost is then shared between both parties in a pre-agreed ratio. This is often known as pain and gain sharing.
This effectively incentivises the supplier to deliver the project in the leanest possible way, whilst providing them with the security that any project risks are not solely borne by themselves.
But how and why can this promote innovation?
Getting the specification right
The gateway to encouraging innovation from the supply chain with target costing is specifying the need at the right level.
Engineering firms commonly over-specify their requirements. Experienced engineers may have a preconceived idea about how to achieve the outcome and consequently these methods creep into to the specification. Whilst projects can still be delivered adequately, opportunity for innovation is missed as suppliers endeavour to deliver the specification in full.
Ensuring an accurate and comprehensive functional specification is used allows suppliers room for manoeuvre when it comes to how a project is delivered.
Coupling this with a target cost agreement acts as a facilitator for suppliers to propose these innovative methods as a way to outperform traditional methods whilst sharing any potential risks of the novel solution with the client.
Maximising the impact
In order to extract the most from a target cost agreement, the target needs to be robust and set at an optimal time in the process.
This varies from project to project and is largely dependent on the balance of knowledge - a reasonable amount of unknown elements within a project can make it effective to set an early target cost and work with the selected supplier to define the detailed scope of works.
This makes it possible for both parties to benefit from value engineering the design as well as making gains in the methodology and delivery.
If the client seeks only to share risk, target cost can be set later in the process and buyers should ensure that the baselines are robust, using industry benchmarks. This is particularly important with potentially volatile commodities such as metals, minerals and currencies.
Seizing the benefit
Organisations are often initially reluctant to take on portions of risk, especially if they are used to fixed cost contracts. Ignoring the opportunity to utilise target costing means not only accepting higher costs than necessary but also passing up the chance to engage with the supply base to extract innovation, more forward and stake a step ahead, gaining competitive advantage and adding value across the whole business.
To successfully convert the perception of a 'giant leap' into that of a 'baby step' for the firm, quantifying both the potential benefits and risks is crucial.
To aid the buyer in this quest, contractual tools can be applied in order to act as a safety net. The most common of these is to insert a ceiling and floor into the agreement in the form of caps on pain and gain. When applied at reasonable levels, a supplier would gain 100% of the benefit once a certain threshold is reached and assume 100% of the detriment if the target is exceeded by set amounts.
The client can also skew the share of pain and gain in their favour, but this erodes the potential for benefit and moves the contract back toward a fixed price.
Target cost contracts should form a key part of a buyer's arsenal when looking at large projects or supply contracts, particularly where advancements can be made in technology either in the design phase or over the lifespan of a contract.
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