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Target Costing

Feb 1, 2006 12:00 PM, By Wallace Weeks

You don't have to face your target to shoot it; an old trick of marksmen is to use a mirror
to see the target behind them and aim over their shoulder. A cue ball doesn't have to
strike a selected ball to put it in a pocket; pool players become skilled at making
combination shots. And the road to the top of a steep mountain doesn't go straight up its
face; road builders make it zigzag.

In a way, these facts are like business. Straightforward, direct and simple methods are
sometimes unavailable or offer a poor approach. In business, net profit does not have to
be determined by price minus cost. Some businesses have succeeded in taking the
approach that cost is determined by subtracting profit from price.

One example belongs to Toyota, which surpassed GM in 2005 as the largest auto
manufacturer in the world. It has been reported that Toyota's approach to entering the
U.S. market was first to be steadfast in achieving a certain net profit margin. Second, they
determined what price they had to offer in order to get Americans to buy their small
import instead of more well-appointed domestic cars. Third, since the difference was the
cost of the car they could offer, Toyota designed the solution accordingly. This method is
known as “target costing.”

Home medical equipment providers are in a perfect environment for this alternate
approach to business.

According to the December 2005 issue of HomeCare, providers responding to a survey

said that at least 65 percent of their revenue comes from payers that have set the prices
they will pay for products and services. One of them, Medicare, accounts for 41 percent
of revenues for these providers, and 82 percent of them said they have no plan to move
away from Medicare in 2006.

This means that home care is not really in a different position than Toyota when it
entered the U.S. market. There is a maximum price. If an HME provider will be steadfast
in achieving a certain net profit margin, he can find a way to engineer the solution he
offers to meet the cost.

The first step is committing to achieving an acceptable net profit margin. That number
may vary among the universe of HME business-owners, and it will likely change over
time. Today, we believe that mediocre performance produces a 7 percent pre-tax net
income when all product lines are considered. We also know that some providers have
sustained pre-tax margins greater than 20 percent.
The second step is to multiply the reimbursement for a code by 1 minus the acceptable
profit margin. For example, if the reimbursement for oxygen is $195, and your acceptable
profit margin is 15 percent, then your target cost equals $195 times 85 cents (1 minus .
15), or $167.75.

The third step is to figure out what the current cost of providing the products and services
associated with a particular reimbursement rate is. Determining the cost of goods is the
easy part; inventory and accounts payable systems usually hold adequate data to make
this calculation.

However, actual cost goes beyond the cost of goods. Providers incur cost for evaluations,
delivery, pick-up, intake, third-party documentation, billing, collecting, accounting,
maintenance and so on. These calculations are more difficult to make, but this is essential
information if a provider is to create a predetermined profit margin.

Activity-based costing can produce the best information here. To estimate this, multiply
the number of minutes an activity uses by the cost per man-minute for your company.

Take a period of time such as two months. Total the number of man-hours used and
divide them into the sum of expenses (excluding the cost of goods sold). An example is a
company with 20 full- time employees. In two months, the employees would typically
work 6,933 hours. If expenses are $200,000, the cost of a man-hour would be $28.85.
The cost of a man-minute is the man-hour cost divided by 60 minutes, or in this case, 48
cents. In this example, if a delivery takes 45 minutes, its cost can be estimated at $21.60.

The final step is to total these costs and compare them to the target cost. If current cost is
greater than target cost, your company must find ways to achieve its target cost. But if the
target cost is greater than the current cost, your company may have more pressing
priorities for improvement.