TARGET COSTING

Summary
Target costing is a modern technique of cost control. It is a reverse costing technique in which
selling price is determine by read the market environment and then the desire profit margin is
deducted from the selling price.
Traditional System:
Budget > Production > Total cost > Selling price > actual results > Variances
In the traditional system first the budget is prepared and then the production starts. After the
production total cost is calculated. From the calculated cost the desire profit is deducted and a
selling price is determined. The difference is notice by comparing the budgeted and actual results
of cost which is know as variance.
A target cost is a cost estimate derived by deducting a desired profit margin from a competitive
market price. It is the opposite of conventional cost plus pricing and is referred as price minus
costing. Target costing does not focus on finding what a new product does cost, instead it focuses
on finding what a new product should cost.
Companies like Toyota, Swiss Watch and Sony TV are the real world users of target costing.
It has been generally observed that costs are reduced by 25% to 30% under target costing as
compare to the traditional costing techniques. Right from the start external environment is
focused because there is a lot of market study required which helps to know the market
conditions from the day one resulting into more chances of success. And also cost control is
much more effective as compare to the traditional costing methods. However, The
implementation cost of target costing can be high and it maybe more time consuming than
traditional methods as it is not easy to identify a suitable price.
Target Costing Approach to Pricing:
In traditional costing system it is presumed that a product has already been developed, has
been costed, and is ready to be marketed as soon as a price is set. In many cases, the
sequence of events is just the reverse. That is, the company already knows what price
should be charged, and the problem is to develop a product that can be marketed profitably
at the desired price. Even in this situation, where the normal sequence of events is
reversed, cost is still a crucial factor. The company can use an approach called target
costing.
Definition, Explanation and Formula of Target Costing:
Target costing is the process of determining the maximum allowable cost for a new
product and then developing a prototype that can be profitably made for that maximum
target cost figure. A number of companies--primarily in Japan--use target costing,
including Compaq, Culp, Cummins Engine, Daihatsu Motors, DaimlerChrysler, Ford, Isuzu
Motors, ITT, NEC, Toyota, Swiss Watch and Sony TV are the real world users of target costing.
The target costing for a product is calculated by starting with the product's anticipated
selling price and then deducting the desired profit. Following formula or equation further
explains this concept:
Target Cost = Anticipated selling price Desired profit
The product development team is then given the responsibility of designing the product so
that it can be made for no more than the target cost.
Following set of activities further explains the concept of target costing technique:
TARGET COSTING PROCESS DIAGRAM
Determine Customer Wants and Price Sensitivity

Planned Selling Price is Set


Target Cost is Determined As: Selling Price Less Desired
Profit


Teams of Employees from Various Areas and Trusted
Vendors Simultaneously

Design Product
Determine
Manufacturing
Process
Determine
Necessary Raw
Materials


Costs are Considered Throughout this Process. The Process
Requires Trade-offs to Meet Target Costs


Once Target Cost is Achieved the Manufacturing Begins
and Product is Sold

Reasons for Using Target Costing Technique:
The target costing approach was developed in recognition of two important
characteristics of markets and costs. The first is that many companies have less control over
price than they would like to think. The market (i.e., supply and demand) really determines
prices, and a company that attempts to ignore this does so at its peril. Therefore, the
anticipated market price is taken as a given in target costing. The second observation is that
most of the cost of a product is determined in the design stage. Once a product has been
designed and has gone into production, not much can be done to significantly reduce its
cost. Most of the opportunities to reduce cost come from designing the product so that it is
simple to make, uses inexpensive parts, and is robust and reliable. If the company has little
control over market price and little control over cost once the product has gone into
production, then it follows that the major opportunities for affecting profit come in the
design stage where valuable features that customers are willing to pay for can be added and
where most of the costs are really determined. So that it is where the effort is
concentrated--in designing and developing the product. The difference between target
costing and other approaches to product development is profound. Instead of designing the
product and then finding out how much it costs, the target cost is set first and then the
product is designed so that the target cost is attained.
Example of Target Costing:
To provide a simple numerical example of target costing, assume the following
situations:
Handy Appliance Company feels that there is a market niche for a hand mixer with certain
new features. Surveying the features and prices of hand mixers already in the market, the
marketing department believes that a price of $30 would be about right for the new mixer.
At that price, marketing estimates that 40,000 of new mixers could be sold annually. To
design, develop, and produce these new mixers, an investment of $2,000,000 would be
required. The company desires a 15% return on investment (ROI). Given these data, the
target cost to manufacture, sell, distribute, and service one mixer is $22.50 as calculated
below:
Projected sales (40,000 mixers $30 per mixer ) $1,200,000
Less desired profit (15% $2,000,000) 300,000
------------
Target cost for 40,000 mixers $9,00,000
=======
Target cost per mixer ($9,00,000 / 40,000 mixer) $22.50
This $22.5 target cost would be broken into target cost for the various functions:
manufacturing, marketing, distribution, after-sales service, and so on. Each functional area
would be responsible for keeping its actual costs within target.
Advantages of Target Costing Approach:
Target costing has the following main advantages or benefits:
1. Proactive approach to cost management.
2. Orients organizations towards customers.
3. Breaks down barriers between departments.
4. Implementation enhances employee awareness and empowerment.
5. Foster partnerships with suppliers.
6. Minimize non value-added activities.
7. Encourages selection of lowest cost value added activities.
8. Reduced time to market.
In Business | Target Costing Approach--An Iterative Process:
Target costing Technique is widely used in Japan. In the automobile industry, the target
cost for a new model is decomposed into target costs for each of the elements of the car--
down to a target cost for each of the individual parts. The designers draft a trial blueprint,
and a check is made to see if the estimated cost of the car is within reasonable distance of
the target cost. If not, design changes are made, and a new trial blueprint is drawn up. This
process continues until there is sufficient confidence in the design to make a prototype car
according to the trial blueprint. If there is still a gap between the target cost and estimated
cost, the design of the car will be further modified.
After repeating this process a number of times, the final blueprint is drawn up and turned
over to the production department. In the first several months of production, the target
costs will ordinarily not be achieved due to problems in getting a new model into production.
However after that initial period, target costs are compared to actual costs and
discrepancies between the two are investigated with the aim of eliminating the
discrepancies and achieving target costs.
Source: Yasuhiro Monden and Kazuki Hamada, "Target Costing-Kaizen Costing in Japanese Automobile
Companies," Journal of Management Accounting Research 3, pp. 16-34.

There are four basic steps involved in target costing, which are:
1. Price and value research. Conduct market research to determine the price points that a
company is most likely to achieve if it creates a product with a certain set of features.
The research should include information about the perceived value of certain features on
a product, so that the design team can add or subtract features from the design with a full
knowledge of what these changes will probably do to the final price at which the product
will be sold.
2. Maximum allowable cost calculation. Subtract from the prospective product price a gross
margin that must be earned on the product. By subtracting the required margin from the
expected price, we arrive at the maximum amount that the product can cost.
3. Value engineering. Use value engineering to drive down the cost of the product until it
meets its overall cost target. Value engineering requires considerable attention to the
elimination of production functions, a product design that is cheaper to manufacture, a
planned reduction of product durability in order to cut costs, a reduced number of product
features, less expensive component parts, and so on in short, any activity that will lead
to a reduced product cost. A standard procedure is to force the team to come within a set
percentage of its cost target at various milestones (such as being within 12% of the target
after three months of design work, 6% after four months, and on target after five months);
if the team cannot meet increasingly tighter costing targets, then the project is cancelled.
4. Follow-on activities. Once these design steps have been completed and a product has met
its targeted cost level, the target costing effort is shifted into a different activity, which is
follow-on activities that will reduce costs even further after the product has entered its
production phase. This final step is used to create some excess gross margin over time,
which allows the company to reduce the price of the product to respond to presumed
increases in the level of competition. The sources of these cost reductions can be either
through planned supplier cost reductions or through waste reductions in the production
process (known as kaizen costing).
Target Costing Vs. Cost-Plus in Pricing
A business makes a profit when the price it charges customers for its goods or services exceeds
the cost of producing those goods or services. Target costing and cost-plus pricing are two well-
recognized methods of managing the relationship between cost and price, but they approach the
equation from opposite directions.
Cost vs. Price
Consumers often use the terms "cost" and "price" interchangeably, but to a business person,
these are fundamentally different concepts. Price is what your business charges its customers.
Cost is the expense your business incurs to provide the goods or services that customers are
paying for. In short, cost is what the business owner pays, price is what the business owner
receives, and the larger the difference between the two, the larger the profit.
Cost-Plus Pricing
Cost-plus pricing is the simplest and most intuitive method of setting a price. A business adds up
the total cost of producing an item, tacks on a markup for its profit, and the result is the selling
price. For example, assume your business makes shoes. Each pair requires $10 worth of
materials, two hours' worth of labor at $12.50 an hour, and $5 in fixed costs such as rent and
utilities. The cost of producing each pair is $40. If your business' policy is to mark up items 25
percent over cost, you'd set the price at $50.
Cost-Plus Pros and Cons
The primary advantages of the cost-plus method are simplicity and predictability. A key
disadvantage is that it sets a price without taking into consideration how that price will affect
demand. The price it sets could be either too low or too high. A strict cost-plus policy may also
discourage efficiency -- or even punish it. Since all costs get passed directly to the customer,
there may be no incentive to save money in the production process. At the same time, a business
that finds ways to operate more efficiently might wind up passing cost savings to customers in
the form of a lower price rather than keeping them as profit, even when those customers are
perfectly happy with the price they're paying.
Target Costing
While the cost-plus method uses cost to determine price, target costing works the other way
around. It uses price to determine cost. In target costing, a business starts by determining how
much it wants to charge for a product. It then subtracts its desired profit from that price to arrive
at the maximum cost it can afford to pay to produce that product. For example, assume again
your business makes shoes, and you want to introduce a new line. Your assessment of the market
tells you that you shouldn't charge more than $60 per pair. If you desire a markup of 25 percent
over cost, then you must be able to produce each pair for $48 or less.
Target Costing Pros and Cons
Target costing recognizes that a business doesn't have total control over pricing; price is limited
by what the market will pay. It also encourages -- requires, even -- businesses to operate
efficiently. On the other hand, target costing often requires a business to design its entire
production process around meeting the cost. That's a challenge for a small business that doesn't
have a dedicated development team. Target costing can also lead to corner-cutting -- using cheap
materials or skimping on workmanship in order to get the cost down to the proper level.
What is the difference between traditional based costing and target
costing?

Traditional Cost Accounting System: In this system company first produce the product and then
determine the cost of production and then try to sell that product at price covering that cost plus
certain percentage of markup on cost.

Target Costing: In this system first of all company determines the value of product in the eyes of
customer that is how much a customer is willing to pay for the product and then if cost of
production of that product is more then the customer willing to pay then company makes
analysis of how they can reduce the cost of production to the level of cost a customer willing to
pay by reducing the components of product which is costing towards final price but not giving
any value to customer and in this way company tries to achieve the target cost customer willing
to pay.

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TARGET COSTI NG COST-PLUS
Competitive market considerations drive
cost planning.
Market considerations not part of cost
planning.
Prices determine costs. Costs determine price.
Design is key to cost reduction. Waste and inefficiency is focus of cost
reduction efforts.
Customer input guides cost reduction. Cost reduction is not customer driven.
Uses cross-functional teams to manage
costs.
Cost accountants are responsible for cost
reduction.
Supplier involved early. Suppliers involved after product
designed.
Minimizes cost of ownership to customer Minimizes initial price paid by customer.
Involves the value chain in cost planning. Little or no involvement of value chain in
cost planning.