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Target Costing

The Target Costing Process


Achieving the
target cost

Establishing the
Target Price

Production
design and
value
engineering

Concept
development

Planning
and market
analysis

Target
price

Profit
margin

Target
cost
Production
and
continuous
improvement

Target Costing Process


Two stage process
Establish the target cost
Market research
Product planning, concept development stages

Achieve the target cost


Value engineering, continuous improvement
Design stage
Continuous improvement in later stages

Establishing the Target Cost


Determine the product and its market
Who is the target market?
What do they want?
What do competitors offer?

Introduce concept or prototype


Evolutionary or revolutionary?
Refine until it meets customer needs

Establishing the Target Cost


Determine the selling price
Must be acceptable to the customer
Must be able to withstand competition
Existing price +/- value of features added or deleted
Consensus of focus group
Price predicted to achieve a desired market share

Establishing the Target Cost


Determine the required profit
Return on sales
Desired return
Historical return for similar products
Industry average for similar products

Return on sales will fluctuate over the life of the


product
Price and costs fluctuate

Achieving the Target Cost


Perform value engineering to design out costs
without sacrificing needed features
Perform a cost analysis of major components and activities
List components or activities and their functions
Calculate a cost breakdown
Determine the current cost of each component or activity
and convert to percentage of total cost
Costs include materials, labor, overhead, etc.

Make the Decision

Organizational Impact
Positives
Customer focus
Cross-functional
integration
Open sharing of
information
Better process
understanding

Negatives
Too much customer
focus
Potential
organizational conflict
Too much pressure to
attain targets
Longer development
times

Concept Check: ABC


A digital manufacturing unit specializing in the aircraft component
market. The previous job-costing system had two direct cost
categories (direct materials and direct manufacturing labour) and a
single indirect cost pool (manufacturing overhead, allocated using
direct manufacturing labour hours). The indirect cost-allocation rate
of the previous system for current year would have been Rs. 230 per
direct manufacturing labour hours.
Recently a team with members from product design, manufacturing
accounting used an ABC approach to refine its job costing system.
The two direct cost categories are retained. The team decided to
replace the single indirect cost pool with five indirect cost pools. The
cost pools represent five activity areas at the facility, each with its
own supervisor and budget responsibility. Pertinent data are as
follows:

Activity Area

Cost-Allocation Base

Cost-Allocation Rate

Material handling

Parts

Rs. 0.80

Lathe work

Lathe turns

Rs. 0.40

Milling

Machine-hours

Rs. 40.00

Grinding

Parts

Rs. 1.60

Testing

Units tested

Rs. 30.00

Information gathering technology has advanced to the point at which the data necessary
For budgeting in these five activity areas collected automatically.
Two representative jobs processed under the ABC system at the facility in the most recent
Period had the following characteristics.
Particulars

Job 410

Job 411

Direct material costs per job

Rs. 9700

Rs. 59,900

Direct manufacturing labour cost per job

Rs. 750

Rs. 11, 250

Number of direct manufacturing labour


hours per job

25

375

Parts per job

500

2,000

20,000

60,000

Lathe turns per job


Machine hours per job

150

1050

Units per job (all units are tested)

10

200

1. Compute the manufacturing costs per unit of each job


under the previous job costing system.
2. Compute the manufacturing costs per unit for each job
under the activity based costing system.
3. Compare the per unit cost figures for Job 410 and 411
computed in requirements 1 and 2. Why do the
previous and activity based costing system differ in
manufacturing costs per unit for each job? Why might
these differences important

Concept Check-Variance
Pharout company uses a standard cost system. Job 822 is for the
manufacturing of 500 units of the product P521. The companys
standards for one unit of product P521 are as follows:
Quantity

Price ($)

Direct material

5 ounces

2 per ounce

Direct labour

2 hours

10 per hour

The job required 2,800 ounces of raw material costing $ 5880. An unfavorable
labour rate variance of $ 250 and a favorable labour efficiency variance of $100
also were determined for this job.

Determine the direct material price variance for job 822 based on actual
quantity.
Determine the direct material quantity variance for job 822.
Determine the actual quantity of direct labour hours used in job 822 based on
the actual quantity of materials used.
Determine the actual labour costs incurred for job 822.

Concept Check-Variance
Each unit of job Y703 has standard requirements of 5 pounds of raw
material at a price of $ 100 per pound and 0.5 hour of direct labour at
$12 per hour. To produce 9,000 units of this product, Job Y703
actually required 40,000 pounds of the raw material costing $97 per
pound. The job used a total of 5,000 direct labour hours costing total
of $60,000.
Determine the material price and material quantity variance for job
Y703.
Assume that the material used on this job were purchased from a
new supplier. Would you recommend continuing with this new
supplier? Why or why not?
Determine the direct labor rate and direct labor efficiency
variance.

Concept Check-Variance
Assembly of product P13 requires one unit component X, two units of
component Y, and three units of component Z. Job J372 produced 220
units of P13. The following information pertains to material variances
for this job, analyzed by component:
X

Price Variance

160 U

120 F

192 U

Quantity Variance

168 U

100 U

84 F

The actual material price were $0.30 more, $0.20 less, and $0.50 more
per unit of components X,Y and Z respectively than their standard
material price per unit.
Determine the number of material units consumed of each type of
component.
Determine the standard materials price per unit of each type of
component.

Concept Check (Product mix and over time decision)


Excel corporation manufactures three products. The plant capacity is
Limited by 120,000 machine hours per year on a single shift basis.
Direct material and direct labor costs are variable. The following data
are available for planning purposes.
Product Total unit
Sales
Direct
Direct Variabl Machine
demand for price per Material Labor e
Hours
the new year unit
Cost
Costs Suppor Per Unit
t
Costs

XL1

200,000

10.00

4.00

2.00

2.00

0.20

XL2

200,000

14.00

4.50

3.00

3.00

0.35

Given the capacity constraint, determine the production levels for the
XL3
200,000
12.00
5.00
2.50
2.50
0.25
Three products that will maximise profits.
If the company authorizes overtime in order to produce more units of XL3, direct
labour costs per unit will be higher by 50% because of the Overtime premium.
Variable support costs and material costs per unit will be same for over time
production as regular production. Is it orthwhile to go for operating overtime.

(a).
Sales price
Direct materials
Direct labor
Variable support
Unit contribution margin
Machine hours per unit
Contribution margin per machine hour

XLl

XL2

XL3

$10.00
(4.00)
(2.00)
(2.00)
$2.00
0.20
$10.00

$14.00
(4.50)
(3.00)
(3.00)
$3.50
0.35
$10.00

$12.00
(5.00)
(2.50)
(2.50)
$2.00
0.25
$8.00

Products XLl and XL2 should be produced first because they have a higher
contribution margin per machine hour. Maximum production of these two products
requires 110,000 machine hours:
XL1: 200,000 units

0.20 machine hours

40,000 machine hours

XL2: 200,000 units

0.35 machine hours

70,000 machine hours


110,000 machine

hours
Therefore, a balance of 10,000 120,000 110,000 machine hours are available for
XL3 production, which is sufficient for 40,000 units of XL3 (10,000 machine hours
0.25 machine hours).
Optimal Production Levels:
XL1: 200,000 units; XL2: 200,000 units, XL3: 40,000 units

(b) Under the current capacity constraint, Excel Corporation cannot meet all of XL3s demand. If
additional capacity becomes available, it can produce more units of XL3. To determine whether it is
worthwhile operating overtime, Excel needs to analyze the contribution margin of XL3 when operating
overtime.
XL3
$12.00

Sales price
Direct materials

$5.00

Direct labor

3.75*

Variable support

2.50

Unit
contribution
* 3.75 margin
2.50 150%

11.25
$0.75

Because the unit contribution margin of XL3 using overtime is positive, it is worthwhile operating overtime.

BRIEF CASE: PRICING WITH


ELASTIC DEMAND

Degree of Operating
Leverage = Contribution
Margin/ Operating
Income