CHAPTER - 8CHAPTER - 8

TARGET COSTING

DEFINING TARGET COSTINGDEFINING TARGET COSTING

Target costing is a cost management tool for making cost reduction a key focus throughout the life of a product.

“The purpose of target costing is to identify the production cost for a proposed product such that the product, when sold, generates the desired profit margin.”

MEANING OF TARGET COSTINGMEANING OF TARGET COSTING

Target costing requires a company to first determine what a customer will pay for a product and then work backward to design the product and production process that will generate a desired level of profit.

The emphasis of target costing is on proactive, up-front planning throughout every activity of the new product development process.

OBJECTIVE OF TARGET COSTINGOBJECTIVE OF TARGET COSTING

A desired, or target cost is set before creating or even designing the product.

A basic goal of target costing is to reduce costs before they occur. After all once a company has incurred costs it cannot change them.

Thus target costing focuses on reducing costs in the product design and development stages- when costs can really be affected. Product design affects a vast majority of costs. It is not easy to reduce these costs once production begins.

Such a strategy is especially important when product life cycles are short. Because most product life cycles are shrinking, use of target costing is expanding.

KEY PRINCIPLES OF TARGET KEY PRINCIPLES OF TARGET COSTINGCOSTING

Emphasis on understanding customer demands. While customer input is obtained early in the marketing research process, it is also collected continually throughout the target costing process

Emphasizing the importance of target price and profit determination before calculating the target cost.

Emphasizing the importance of early cost planning to reduce costs incurred over the products entire life time.

Indicating that a cross functional team is needed to successfully implement target costing.

TARGET COSTING PROCESSTARGET COSTING PROCESS

1. Market research is conducted before product development to determine the customer demands and requirements and the price the customer is willing to pay.

Customer input is sought on the design of product features. The cost of the feature is compared to its value to determine whether to add it to the product. It is important to determine what a customer will pay for a product. This is the product’s predicted price.

2. Determine the desired profit margin.

3. Determination of target cost.

Management bases the target cost on the product’s predicted price and the company’s desired profit.

The target cost is the difference between the target selling price and the target profit margin

4. Determine target costs for each component.

Management accountants are responsible for setting final targets for all components and processes.

5. Reduction and control costs to achieve the target cost.

Managers must then try to reduce and control costs so that the product’s cost does not exceed its target cost.

A cross-functional team consisting of design and manufacturing engineers, procurement, and marketing, as well as management accountants now must determine if the company can implement cost reductions large enough to meet the target cost.

The cross-functional team which is made up of individuals representing the entire value chain guides the process throughout from both inside and outside the organization.

Value engineering is used during the design stage. Value engineering is a cost reduction technique that

uses information about all value chain functions to satisfy customer needs while reducing costs. The value chain consists of functions within a

company that add value to a product or service. The value engineering process includes examination

of each component of a product to determine whether it is possible to reduce costs while maintaining functionality and performance.

The companies that use target costing often go beyond the internal chain to involve both customers and suppliers during the design process.

Suppliers play a critical role in making target costing work- If there is a need to reduce the cost of specific components, firms will ask their suppliers to find ways to reduce costs.

In some cases, product design may change, materials used in production may need replacing, or manufacturing processes may require redesign.

Several iterations usually are needed before it is possible to determine the final target cost.

ADVANTAGES OF TARGET ADVANTAGES OF TARGET COSTINGCOSTING

Forced planning Cost reductionsCompetitive atmosphereTeam spirit

PROBLEMS IN TARGET COSTINGPROBLEMS IN TARGET COSTING

Increase in Product Development time : It may require a number of designs before it can devise a sufficiently low cost product. (Repeated value engineering cycles to reduce costs). ◦May lead to the product coming late to market.◦For some types of products, being six months late

may be far more costly than having small cost overruns.

Accountability : Large amount of mandatory cost cutting can result in finger pointing in various parts of the company.

Lack of consensus: Different representatives of design team may not reach a consensus on product design because of too many options regarding design issues.

Alienation and/or failure of subcontractors and suppliers : Excessive pressure on subcontractors and suppliers to conform to a schedule and reduce costs can lead to alienation and/or failure of the subcontractor

Lack of Cost consciousness in other parts of the organization: Design engineers may become upset when other parts of the organization are not cost conscious◦ They argue that they exert much effort to squeeze pennies

out of the cost of a product while other parts of the organization (administration, marketing, distribution) are wasting dollars.

Employee burnt-out: Employees in many Japanese companies working under target costing goals experience burnt-out due to the pressure to meet the target cost.◦Burnt-out is particularly evident in design

engineers.

COST-PLUS PRICINGCOST-PLUS PRICING

Adding a standard markup to cost◦Ignores demand and competition◦Popular pricing technique because: It simplifies the pricing process Price competition may be minimized It is perceived as more fair to both buyers and

sellers

EXAMPLEEXAMPLE

Question: Variable cost = Rs 20, Fixed cost = Rs 5,00,000, Expected sales = 1,00,000 units, Desired Sales Markup = 20%. Calculate Markup Price.

Solution: Unit Cost = Variable Cost + Fixed Cost

Unit Sales

= Rs 20 + Rs 5,00,00

1,00,000

= Rs 25 per unit

Markup Price = Unit Cost

(1 – Desired return on sales)

= Rs 25

(1- 0.20)

= Rs 31.25 per unit