TARGET COSTING

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, and Toyota etc.
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 and Disadvantages 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.
Target costing approach has the following main disadvantages or limitations:
1. Effective implementation and use requires the development of detailed cost data.
2. its implementation requires willingness to cooperate
3. Requires many meetings for coordination
4. May reduce the quality of products due to the use of cheep components which
may be of inferior quality.
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.