CA Megh Raj Aryal Gurukul CA

CHAPTER 14 – TARGET COSTING

Chapter Learning outcomes

1. Meaning of Target Costing
2. Steps in Target costing
3. Requirement of Market research for Target costing
4. Benefits of Target Costing
5. Value Engineering and Value Analysis
6. Value added cost and Non Value added cost
7. Kaizen costing

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Concept:
Target costing is defined as “ a structured approach to determine the cost at which a proposed product with
specified functionality and quality must be produced, to generate a desired level of profitability at its anticipated
selling price.

The traditional approach of price determination is based on the cost. i.e first the cost of the product is
determined and then the selling price is determined by adding a mark up to the cost. There is a major drawback
of this approach- the customers may not buy at this price.

Target costing is an alternative approach to the pricing. It takes a market driven approach towards costs. Target
costing suggests focusing on the voice of the customer. In today’s highly competitive environment, where
customer is the king, meeting the customer affordability is critical to success. In such a scenario the firm is just
a price taker and not a price maker.
Under target costing, first the realizable price is set and works backwards to determine affordable costs by
deducting the profit margin from the price. If the firm can produce goods at or below the affordable cost, the
firm goes for production, otherwise not.

Steps of Target Costing

1. Define the specifications of the product the company wants to offer to the customers. For this market
needs are assessed and competitive products are evaluated.
2. Determine the price which the customer may be willing to pay. Determine the volume of output.
3. Determine the desired profit.
4. Calculate the target cost as target price “ less desired profit”
5. Estimate the estimated cost(for new product) or current cost (for existing product) of the product based
on available resource and condition.
6. If estimated cost or current cost exceeds the target cost, set cost reduction target in order to match the
current cost with the target cost.
7. Identify the cost reduction opportunities by using Value Engineering and Value Analysis.
8. Estimate the final estimated cost.
9. Decide to produce or not. If production is done, focus on further cost reduction possibilities i.e
continuous improvement program.

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Practical problems
Target Cost, Cost reduction target, Feasibility of the product
Q.1. a) Samsung is developing a high speed modem. From the following information compute Samsung cost
reduction target.
Expected market price Rs. 500
Required return on sales 20%
Product life 3 years
Current feasible cost over 3 years Rs. 750 lakh
Expected average annual sales 50,000 units
b) If Samsung believes it can reduce the cost of the modem by no more than 18% is this a feasible product for
Samsung? [Ans: a) Rs 150 lakh, b) Yes]

Q.2. A company has the normal capacity of production of 80,000 units and presently sells 20,000 units at Rs 100
each. The demand is sensitive to selling price and it has been observed that with every reduction of Rs 10 in
selling price, the demand is doubled.
Required:
a) What should be the target cost at full capacity if profit margin on sale is taken at 25%?
[Ans: Rs 48 lakh]
b) What should be the cost reduction scheme at full capacity if at present 40% of unit cost is variable with
same % of profit? [Ans: Rs 12 lakh]
c) If Rate of Return is 16% on investment, what will be maximum investment at full capacity?
[Ans: Rs 100 Lakh]
Computation of Target Cost at Manufacturing Level
Q.3. You are a manager of paper mill (XYZ ltd) and have recently come across a particular type of paper, which is
being sold at a substantially lower rate (by another company, ABC Ltd) than the price charged by your own mill.
The value chain for use of one tonne of such paper for ABC Ltd is as follow:
ABC Ltd Merchant Printer Customer
ABC Ltd sells this particular paper to merchant at the rate of Rs 1466 per tonne. ABC Ltd pays for the freight
which amounts to Rs 30 per tonne. Average returns and allowances amount to 4% of sales and approximately
equals to Rs 60 per tonne.
The value chain of your company, through which the paper reaches the ultimate customer is similar to that of
ABC ltd. However, your mill does not sell directly to the merchant, the latter receiving the paper from huge
distribution centre maintained by your company at Haryana. Shipment costs from the mill to the distribution
centre is Rs 11 per tonne while the operating costs in the distribution centre are estimated at Rs 25 per tonne. The
return on investments required by the distribution centre for the investments made amount to an estimated Rs 58
per tonne.
You are required to calculate the “Mill Manufacturing Target Cost” for this particular paper for your company.
You may assume that the return on investment expected by your company is Rs 120 per tonne of such paper.
[Ans: Target Cost at XYZ mills Rs 1162]

Target Costing- Computation of Cost Gap

Q.4. Madhav Ltd. assembles and sells many types of electronic calculators (EC). The company is planning to come
out with a new electronic calculator in the market. The target selling price is Rs. 4,880. Madhav Ltd’s policy is to
earn 22% profit on cost.
An electronic calculator is produced by assembling a variety of components. Production overheads are currently
adsorbed on a labour hour basis. Normal annual activity level is 24,00,000 assembly hours.

Cost information for the new product is given below:

Component 1: It is bought at a cost Rs. 405 each. It is bought in batches of 5,000 units and delivery costs are Rs.
3,00,000 per batch.
Component 2: It can be purchased @Rs. 120 per piece as per requirements. There is no delivery cost. Madhav
estimates that 4% of the purchased pieces are lost in the assembly process.
Other materials cost Rs. 800 per EC.
Labour: Highly skilled workers are required for the job. They are paid Rs. 250 per hour. Each EC requires 5
hours to assemble. Normal idle time is estimated to be 20% of hours required for production
Period Total production overhead Total assembly labour hours
Month 1 Rs. 6,20,00,000 1,90,000
Month 2 Rs. 6,80,00,000 2,20,000
Calculate the expected cost per unit for the EC and identify any cost gap that might exist.
[Ans: Expected cost per unit Rs 4490/unit, Cost Gap Rs 490]

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Target Cost using ABC System

Q.5. Toshiba manufacture one brand of personal computer called Toshiba. Following is the profitability statement for
Toshiba personal computer:
Particulars Amount(Rs.) Amount(Rs.)
For75,000 units per unit
Revenues (A) 30,00,00,000 4,000
Cost of Goods sold
Direct Materials Cost 13,80,00.000 1,840
Direct manufacturing labour costs 1,92,00,000 256
Direct machining costs (Fixed) 2,28,00,000 304
Manufacturing Overheads cost 2,40,00,000 320
Cost of Goods Sold (B) 20,40 00,000 2,720
R & D Costs 108,00.000 144
Design Cost of product and processor 1,20,00,000 160
Marketing costs 3,00,00,000 400
Distribution Costs 72,00.000 96
Customer Service Costs 60,00.000 80
Operating Costs (C) 6,60,00,000 880
Full product Costs (D = B+ C) 27,00,00,000 3600
Operating income (A-D) 3,00,00,000 400
Following further information has been provided:
a) No opening and closing inventory.
b) Manufacturing Overhead Cost = Ordering and Receiving cost + Testing and inspection Cost+ Rework
Cost.
c) Toshiba expects its competitors to lower the prices of PCs that compete against Toshiba, by 15%.
Toshiba's management believes that it must respond aggressively by reducing Toshiba's price by 20%.
Required:
(1) Compute the target cost? [Ans: Target cost Rs 2880/unit]
(2) Compute difference between target and allocable cost. [Ans: Rs 720 ]

Q.5 b)
Toshiba's value engineering team focus their cost-reduction efforts on analyzing the Toshiba design. Their goal?
To design a high-quality, highly reliable machine with fewer feature that meets customer price expectations and
achieves target cost.
Toshiba is discontinued in its place. Toshiba introduced Toshiba II, Toshiba II has fewer components than
Toshiba and is easier to manufacture and test. The following tables compare the direct costs and the
manufacturing overhead costs and cost drivers of Toshiba and Toshiba II. In place of the 75,000 Toshiba units
manufactured and sold in 2002, Toshiba expects to make and sell 1,00,000 Toshiba II units in 2003 on account of
the reduction in prices.
Direct Cost Category Costs per unit in Rs. Explanation of Costs for Toshiba II
Toshiba- Toshiba
II
1 Direct materials 1840 1540 The Toshiba II design will use a simplified main printed
circuit board, fewer components and no audio features.
2. Direct manufacturing Lab 256 212 Toshiba II will require less labour and assembly time.
3. Direct machining Costs 304 228 Toshiba can use the machine capacity to produce
100,000 units of Toshiba II. The new design will enable
Toshiba to manufacture each unit of Toshiba II in less
time than a unit of Toshiba.

Cost Driver Quantity of Explanation for ~Quantity of Explanation for

Cost Driver quantity of Cost Cost Driver quantity of Cost Driver
for Toshiba Driver used by Toshiba for Toshiba II used by Toshiba II
1.Number of orders 22,500 Toshiba places 50 21,250 Toshiba will place
orders for each of the 450 50 orders for each of
components in Toshiba. the 425 components
Cost per order Rs. 160 in Toshiba II

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2. Testing- hours 22,50,000 Toshiba requires 30 15,00,000 Toshiba II is easier

testing hours p.u. Cost to test and will
per testing hour is Rs. 8. require 15 testing
hours per unit
3. Units reworked 6,000 The rework rate is 8% of 6,500 Toshiba II will have
the units manufactures. a lower re-work rate
The rework cost is Rs. of 6.5% because it is
400 per unit reworked. easier manufacture.
Further there is a change in the non-manufacturing cost as follows:
R&D Rs 80,00,000
Design of Product & Process cost Rs 1,20,00,000
Marketing Costs Rs 3,60,00,000
Distribution costs Rs 1,00,00,000
Customer- Service Costs Rs 60,00,000
Required:-
Determine whether Toshiba achieves the Target Cost? [Ans: Yes, Revised cost /unit Rs 2880]

Q.6. Speedo Limited is a specialist car manufacturer that produces various models of cars. The organization is due to
celebrate its 100th anniversary next year. To mark the occasion, Speedo Limited intends to produce a sports car,
the Model Royal. As this will be a special edition, production will be limited to 1000 numbers of Model Royal
cars.
Speedo Limited is considering using a Target costing approach and has conducted a market research to determine
the features that consumers require in a sports car. Based on this market research and knowledge of competitor’s
products, the company has decided to price the Model Royal at Rs 9.75 lakhs. The company requires operating
profit margin of 25% of the selling price of the car. Details for the forthcoming year are as follow:-

Forecast of direct costs for a Model Royal car are- Labour Rs 250,000 and Material Rs 475,000.
Forecast of Annual Overhead Costs:-
Particulars Rs in Lakhs Cost driver
Production Line cost 2310 See Note 1
Transportation Costs 900 See Note 2

Note 1: The production line that would be used for Model Royal has a capacity of 60,000 machine hours per
year. The production line time required for Model Royal is 6 machine hours per car. This production line will
also be used to make other cars and will be working at full capacity.

Note 2: Some models of cars are delivered to showrooms using car transporters. 60% of the transportation costs
are related to the numbers of deliveries made. 40% of the transportation costs are related to the distance travelled.

The car transporters have forecast to make a total of 640 deliveries in the year and carry 10 cars each time. The
car transporter will always carry its maximum capacity of 10 cars.

The total distance travelled by car transporter is expected to be 225,000 kms. 50,000 kms of this is for the
delivery of Model Royal cars only. All 1000 Model Royal Cars that will be produced will be delivered in the
year using the car transporters.
Required
1. Calculate the forecast total cost of producing and delivering a Model Royal Car, using Activity Based
Costing principles to assign the overhead costs. [Ans: 7645.375 lakh]
2. Calculate the cost gap that currently exists between the forecast total cost and target total cost of a
Model Royal car. [Ans: Rs 33,287.5 /car]

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Q.7. Kala Ltd manufactures many products. To compute manufacturing cost, it uses a costing system with one direct
cost category (Direct materials) and three indirect cost categories.
• Batch- related set up, Production Order, and Material- Handling costs, all of which vary with the
number of batches.
• Manufacturing Operations costs that vary with machine- hours.
• Cost of Engineering changes that vary with the number of engineering changes made.
In response to competitive pressures at the end of year 1, Product Designers at the company employed Value
Engineering techniques to reduce manufacturing costs. Actual Information for Year 1 and Year 2 is as follows:-
Particulars Actual Results for Year 1 Actual Results for Year 2
Total Set up, Production – Order, and Material- Rs 72,00,000 Rs 75,00,000
Handling Costs
Total Number of Batches 900 1000
Total Manufacturing Operations Costs Rs 12100,000 Rs 125,00,000
Total Number of Machine hours worked 220,000 250,000
Total Costs of Engineering Changes Rs 2640,000 Rs 20,00,000
Total Number of Engineering Changes made 220 200

The company wants to evaluate whether Value Engineering has succeeded in reducing the Target manufacturing
cost per unit of one of its main products, KL-69, by 12%. Actual Results for Year 1 and Year 2 for KL-69 are:-
Particulars Actual Results for Year 1 Actual Results for Year 2
Units of KL-69 produced 3500 4000
Direct materials costs per unit of KL-69 Rs 1200 Rs 1100
Total No of batches required to produce KL-69 70 80
Total machine hours required to produce KL-69 21000 22000
Number of Engineering Changes made 14 10
Required:
1. Calculate the Manufacturing Cost per unit of KL-69 for Year 1 and Year 2. [Ans: Rs 1738, Rs 1550]
2. Did the Company achieve the Target Manufacturing Cost per unit for KL-69? Show your calculations.
[Ans: No]

Q.8. AML Ltd is engaged in production of three types of ice-cream products: Coco, Strawberry and Vanilla. The
company sells 50,000 units of Coco @ Rs 25 per unit, 20,000 units of Strawberry @Rs 20 per unit and 60,000
units of Vanilla @ Rs 15 per unit. The demand is sensitive to the selling price and it has been observed that Re 1
per unit reduction in price increases the demand by 10% of the previous level. The company has a capacity of
producing 60,500 units of Coco, 24,200 units of Strawberry and 72,600 units of Vanilla. The company marks up
25% on cost of the product.
The company management decides to apply ABC analysis. For this purpose it identifies four activities and the
rates are as follows:
Activity Cost rate
Ordering Rs 800 per order
Delivery Rs 700 per delivery
Shelf stocking Rs 199 per hour
Customer support and assistance Rs 1.10 per unit
The other relevant information for the products is as follows:
Particulars Coco Strawberry Vanilla
Material per unit Rs 8 Rs 6 Rs 5
Direct labour p.u. Rs 5 Rs 4 Rs 3
No. of purchase orders 35 30 15
No. of deliveries 112 66 48
Shelf stocking hours 130 150 160
Under the traditional costing system, overhead costs are charged at 30% of prime cost.
Required:
i) Calculate target cost for each product after a reduction of selling price required to achieve the sales equal to
the production capacity. [Ans: Rs 18.4, Rs 14.4, Rs 10.4]
ii) Calculate the total cost and unit cost of each product at the maximum level using traditional costing.
[Ans: Rs 16.9, Rs 13, Rs 10.4]
iii) Calculate the total cost and unit cost of each product at the maximum level using activity based costing.
[Ans: Rs 16.286, Rs 15.24, Rs 10.16]
iv) Compare the cost of each product calculated in (i) and (ii) with (iii) and comment on it.

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Q.9. X Ltd is engaged in the production of four products: A,B,C and D. The price charged for the four products are Rs
180, Rs 175, Rs 130 and Rs 180 respectively. Market research has indicated that if X Ltd. can reduce the selling
prices of its products by Rs 5, it will be successful in getting bulk orders and gain a significant share of market of
those products. The company’s profit markup is 25% on the cost of the product. The relevant information of the
products after price revision is as follows:
Products A B C D
Output (Units) 600 500 400 600
Cost per unit:
Direct material (Rs) 40 50 30 60
Direct Labour (Rs) 28 21 14 21
Machine Hours per unit 4 3 2 3

The four products are usually produced in the production run of 20 units and sold in the batches of 10 units. The
production overhead is currently absorbed by using machine hour rate, and the total of the production overhead
for the period has been analyzed as follows:
Particulars Amount in Rs
Machine Department costs Rs 52130
Set up costs Rs 26250
Stores receiving Rs 18000
Inspection Rs 10500
Material handling and dispatch Rs 23100

The cost drivers to be used for the overhead costs are as follows:
Cost Cost Drivers
Set up costs Number of production runs
Store receiving Requisitions raised
Inspection Number of production runs
Material handling and dispatch Orders executed
The number of requisitions raised in the stores was 100 for each product and the number of orders executed was
210, each order being for a batch of 10 units of a product.
You are required to :
1) Compute the target cost for each product. [Ans: A Rs 140, B Rs 136, C Rs 100, D Rs 140]
2) Compute total cost of each product using activity based costing.
[Ans: A Rs 136.08, B Rs 132.56, C Rs 99.79, D Rs 141.06]
3) Compare target cost and activity based cost of each product and comment on it.

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Q.10. Computo ltd. manufactures two parts P and Q for Computer industry:
P : Annual production and sales of 1,00,000 units at a selling price of Rs 100.05 per unit.
Q : Annual production and sales of 50,000 units at a selling price of Rs 150 per unit.

Direct and indirect costs incurred on these two parts are as follows:
Particulars P (`Rs 000) Q (`Rs 000) Total (`Rs 000)
Direct material cost (variable) 4,200 3,000 7,200
Labour cost (variable) 1,500 1,000 2,500
Direct machining cost (see note) 700 550 1,250
Indirect costs:
Machine set up cost 462
Testing cost 2,375
Engineering cost 2,250
Total 16,037

Note: Direct machining costs represent the cost of machine capacity dedicated to the production of each product.
These costs are fixed and are not expected to vary over the long run horizon.
Additional information is as follows:
Particulars P Q
Production batch size 1,000 units 500 units
Set up time per batch 30 hours 36 hours
Testing time per unit 5 hours 9 hours
Engineering cost incurred on each product Rs 8.40 lakh Rs 14.10 lakh

A foreign competitor has introduced product very similar to ‘P’. To maintain the company’s share and profit,
Computo Ltd. has to reduce the price to Rs 86.25. The company calls for a meeting and comes up with a
proposal to change design of Product P. The expected effect of new design is as follows:
i) Direct material cost is expected to decrease by Rs 5 per unit.
ii) Labour cost is expected to decrease by Rs 2 per unit.
iii) Machine time is expected to decrease by 15 minutes; previously it took 3 hours to produce 1 unit of ‘P’.
The machine will be dedicated to the production of new design.
iv) Set up time will be 28 hours for each set up.
v) Time required for testing each unit will be reduced by 1 hour.
vi) Engineering cost and batch size will be unchanged.
Required:
a) Company management identifies that cost driver for machine set up is “set up hours” used in batch setting
and for testing costs is “testing time”. Engineering costs are assigned to products by special study. Calculate
the full cost per unit for P and Q using Activity based costing. [Ans: P Rs 87/unit, Q Rs 146.74/unit]
b) What is the mark – up on full cost per unit of P? [Ans: 15%]
c) What is the Target cost per unit for new design to maintain the same mark -up percentage on full cost per
unit as it had earlier? [Ans: Rs 75/unit]
d) Will the new design achieve the cost reduction target? (Assume cost per unit of cost drivers for the new
design remains unchanged). [Ans: Expected Cost per unit Rs 77.36/unit]
e) List four possible management actions that the Computo Ltd should take regarding new design.

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Q.11. ABC electronics make audio player model “AB 100”. It has 80 components. ABC sells 10,000 units each month
at Rs 3,000 per unit. The cost of manufacturing is Rs 2,000 per unit or Rs 200 lakhs per month for the production
of 10,000 units. Monthly manufacturing costs incurred are as follows:
(Rs in lakhs)
Direct material costs 100.00
Direct manufacturing labour costs 20.00
Machining costs 20.00
Testing costs 25.00
Rework costs 15.00
Ordering costs 0.20
Engineering costs 19.80
Total 200.00

Labour is paid on piece rate basis. Therefore, ABC considers direct manufacturing labour costs as variable cost.

The following additional information is available for ‘AB 100’:

(i) Testing and inspection time per unit is 2 hours
(ii) 10 percent of ‘AB 100’ manufactured are reworked.
(iii) It currently takes 1 hour to manufacture each unit of ‘AB 100’.
(iv) ABC places two orders per month for each component. Each component is supplied by a different supplier.
ABC has identified activity cost pools and cost drivers for each activity. The cost per unit of the cost driver for
each activity cost pool is as follows:
Manufacturing Description of activity Cost driver Cost per unit of cost
activity driver
Machining costs Machining components Machine hours of capacity Rs 200
Testing costs Testing components and finished Testing hours Rs 125
products (Each unit of ‘AB 100’ is
tested individually)
Rework costs Correcting and fixing errors and Units of ‘AB 100’ Rs 1,500 per unit
defects reworked
Ordering costs Ordering of components Number of orders Rs 125 per order
Engineering costs Designing and managing of Engineering hours Rs 1,980 per engineering
products and processes hour
Over a long run horizon, each of the overhead costs described above vary with chosen cost drivers.
In response to competitive pressure ABC must reduce the price of its product to Rs 2,600 and reduce the cost by
at least Rs 400 per unit. ABC does not anticipate increase in sales due to price reduction. However, if it does not
reduce the price it will not be able to maintain the current sales level.
Cost reduction on the existing model is almost impossible. Therefore, ABC has decided to replace ‘AB 100’ by a
new model ‘AB 200’, which is modified version of ‘AB 100’. The expected effect of design modifications are as
follows:
(i) The number of components will be reduced to 50.
(ii) Direct material costs to be lower by Rs 200 per unit.
(iii) Direct manufacturing labour costs to be lower by Rs 20 per unit.
(iv) Machining time required to be lower by 20 percent.
(v) Testing time required to be lower by 20 percent.
(vi) Rework to decline to 5 percent.
(vii) Machining capacity and engineering hours capacity to remain same.
ABC currently outsources the rework on defectives.
Required:
(i) Compare the manufacturing cost per unit of AB 100 and AB 200. [Ans: Rs 2000/unit, Rs 1654.25/unit]
(ii) Determine the immediate effect of design change and pricing decision on the operating income of ABC.
Ignore income tax. Assume that the cost per unit of each cost driver for AB 100 continues to apply AB 200.
[Ans: Loss Rs 5.425 lakh]

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Target labour time to achieve desired profit

Q.12. Sterling Enterprise has prepared a draft budget for the next year as follows:
Particulars 10,000 units
Sale price per unit Rs 30
Variable cost per unit:
Direct material Rs 8
Direct Labour (2 hours *Rs 3) Rs 6
Variable Overhead (2 hours *Re 0.5) Rs 1
Contribution per unit Rs 15
Budgeted Contribution Rs 150,000
Budgeted Fixed Costs Rs 140,000
Budgeted Profit Rs 10,000
The Board of Directors is dissatisfied with his budget, and asks a working party to come up with an alternate
budget with a higher profit figures.

The working party reports back with the following suggestions which will lead to a budgeted profit of Rs 25,000.
The company should spend Rs 28,500 on advertising and put the sales price up to Rs 32 per unit. It is expected
that sales volume would also rise, in spite of the price increase, to 12000 units.

In order to achieve the extra production capacity , however, the work force must be able to reduce the time taken
to make each unit of the product. It is proposed to offer a pay and productivity deal, in which the wage rate per
hour is increased to Rs 4. The hourly rate for variable overhead will be unaffected.

Ascertain the revised labour time required to achieve the target profit. [Ans: 1.75 hr/unit]

Employee reduction to achieve Target Cost

Q.13. A company has sales of 100,000 units at a price of Rs 200 per unit and profit of Rs 40 lakhs in the current year.
Due to stiff competition, the company has to reduce its price of product next year 5% to achieve same volume
target of sales. The cost structure and profit for the current year is given as below:
Particulars Rs in lakhs
Direct material Rs 60
Direct wages Rs 45
Variable factory Overheads Rs 20
Fixed overheads including sales and admin expenses Rs 35
Total Cost Rs 160

To achieve the Target cost to maintain the same profit, the company is evaluating the proposal to reduce labour
cost and fixed factory overhead. A vendor supplying the machine suitable for the company’s operation has
offered an advanced technology Semi- Automatic Machine of Rs 20 lakhs as replacement of old machine worth
Rs 5.0 lakhs. The Vendor is agreeable to take back the old machine at Rs 2.7 lakhs only. The company’s policy
is to charge depreciation at 10% on WDV. The maintenance charge of the existing machine is Rs 1.2 lakhs per
annum whereas there will be warranty of services free of cost for the new machine first two years. There are ten
(10) supervisors whose salary is Rs 1.5 lakhs each per annum.

The new machine having Conveyor Belt is expected to help in cost cutting measures in the following ways:-
1. Improve productivity of workers by 20%.
2. Cut- down material cost by 1% due to reduction in wastage.
3. Elimination of services of Supervisors because of automatic facilities of the machine.
4. Saving in Packaging cost by Rs 1.5 lakhs.

Assuming cost of capital to be 15%, calculate how many supervisors should be removed from the production
activities to achieve the Target cost. [Ans: 4 Supervisors]

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Miscellaneous Questions
Q.14. Spares Ltd produces spare part X for cars. The company has an annual production capacity of 1,80,000 units of
X. However, the production is carried out according to the volume of order received. For the next year, the
company has received an order for the value of Rs 64,00,000. To meet the requirements of the order, the
company has to work at 70% capacity for first 4 months, 80% capacity for next 6 months and 90% capacity for
the remaining period of the year. Assume no opening or closing stock.
The following information is available:
Material Rs 15 per unit
Labour Rs 12 per unit, subject to a minimum of Rs 1,30,000 p.m.
Variable Overheads Rs 5 per unit
Fixed Overheads Rs 16,000 per month
Semi-variable overheads Rs 75,000 per annum incurred up to 70% of average annual capacity
utilization. Thereafter, it increases at Rs 5000 p.a. for every 10% average
annual capacity increase.
If the company targets a return of 27% on the budgeted cost, should the order be accepted? Justify your answer
showing the budgeted annual values for each element of cost for the next year.
[Ans: Target Sale value Rs 60,96,000]

Q.15. 6,000 pen drives of 2 GB are to be sold in a perfectly competitive market to earn Rs 1,06,000 profit, whereas in
monopoly market only 1,200 units are required to be sold to earn the same profit. The fixed costs for the period
are Rs 74,000. The contribution per unit in the monopoly market is as high as three fourths its variable cost.
Determine the target selling price per unit under each market condition
[Ans: Perfect comp SP Rs 230, Monopoly market SP Rs 350/unit]

Q.16. MR Limited undertake market research for clients. A typical study takes, three months and uses two types of
staff as follows:
Type of staff used Proportion of variable costs incurred in
Ist Month 2nd Month 3rd Month Total
Research 40% ----- 60% 100%
Tabulating ------ ------ 100% 100%
Research staff and tabulating staff account for 80% and 20% respectively of the variable costs of a study.

When quoting a price for a study MR Ltd adds the following contribution on the estimated variable cost;
Research Staff 112.50% of Variable Cost and Tabulating Staff 50% of VC In April MR started work on orders of
Rs. 30,000 & in May Rs.40,000 & in June Rs.23,000. For calculation of monthly income the value of an order is
divided on the basis of: first month 34%, second month 6% and third month 60%. MR’s target contribution is
10% over and above fixed cost which is Rs.16,000 per month. Calculate the value of additional orders which
should be received by MR for work to start in June to achieve the target contribution in June.
[Ans: Rs 18111.11]

Value added and Non value added cost reporting

Q.17. Sanford Inc, has developed value added standards for four activities; purchasing parts, receiving parts, moving
parts, and setting up equipment. The activities, the activity drivers, the standard and actual quantities, and the
price standards for 2013are as follows:

Activity Activity Driver Std. Qty. Actual Qty. Std. Price (Rs.)
Purchasing parts Purchase orders 2600 3640 300
Receiving parts Receiving orders 5200 7800 195
Moving parts Number of moves 0 2600 390
Setting up equipment Set up hours 0 10400 117
The actual prices paid per unit of each activity driver were equal to the standard prices.
Required:
1. Prepare a cost report that lists the value added, non value added, and actual cost for each activity.
[Ans: Rs 1794000, Rs 3049800]
2. Which activities are non value added? Explain why value added activities can have non-value added
costs.

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THEORY
Q.1. Define Target Costing.
Ans:
Target costing is defined as “ a structured approach to determine the cost at which a proposed product with
specified functionality and quality must be produced, to generate a desired level of profitability at its anticipated
selling price.
Under target costing, first the realizable price is set and works backwards to determine affordable costs by
deducting the profit margin from the price. If the firm can produce goods at or below the affordable cost, the firm
goes for production, otherwise not.

Q.2. Explain the four steps approach in Target costing.

Ans:
Step 1: Define Product Design specification
- Design specification for new products, or modification of existing products.
- Competitors products features are also considered.
Step2: Determine Target Selling price & Volume
Step 3: Determine Target profit Margin
Step 4: Determine Target cost

Q.3. List the steps/stages involved in Target Costing approach to pricing.

Ans:
Steps in Target Costing
10. Define the specifications of the product the company wants to offer to the customers. For this market
needs are assessed and competitive products are evaluated.
11. Determine the price which the customer may be willing to pay and determine the volume of output.
12. Determine the desired profit.
13. Calculate the target cost as target price “ less desired profit”.
14. Estimate the cost of the product based on available resource and condition.
15. If estimated cost exceeds the target cost, set cost reduction target in order to match the estimated cost
with the target cost.
16. Identify the cost reduction opportunities by using Value Engineering and Value Analysis.
17. Estimate the final estimated cost.
18. Decide to produce or not. If production is done, focus on further cost reduction possibilities i.e
continuous improvement program.

Q.4. Write short note on “Achieving target cost”.

Ans:
Once the gap has been identified between the target cost and the cost estimate, it is necessary to identify possible
ways to close the gap. Target or allowable costs are identified for individual components or processes and cost
improvement teams works to reduce the estimated costs to meet the target.
There may also be a process of negotiation between different suppliers, production departments, staffs to arrive
at final target costs. This process of cost reduction is an iterative one which continues until the target cost is
reached or it is concluded that the overall target cost cannot be reached and a decision is made to launch or not to
launch the product.

Q.5. Explain why intensive market research is required to implement target costing technique?
Ans:
Under Target costing , the products are priced at the level acceptable to the market. Hence it begins with
understanding the market which comes from market research. The following information can be collected from
market research :-
1. Customer expectation from the product, features of the product desired.
2. Price that customer will be willing to pay
3. Substitutes products, competing products available or likely to be available
4. After sales service required by the customer
5. Elasticity of demand, Expected sales volumes at different target prices.

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 CA Megh Raj Aryal Gurukul CA

Q.6. What are the components of Target costing? Or

Define the concept of Value Engineering and Value Analysis. What are the issues considered during a
VE/VA review?
Ans:
Value Engineering (VE) involves searching for opportunities to modify the design of each component or part
of a product to reduce cost, but without reducing the functionality or quality of the product.
Value Analysis (VA) entails studying the activities that are involved in producing the product to detect non
value added activities that may be eliminated or minimized to save costs but without reducing functionality and
quality of the product.

Value engineering and Value analysis helps to identify the cost into:
(a) Value added Cost:
- are the cost which customer are willing to pay for.
- are the costs to perform value added activities with perfect efficiency.
- are the cost if eliminated, would reduce the utility of the product.
(b) Non Value added Cost :-
- - are the cost which customer are not willing to pay for.
- are the cost that are caused either by non value added activities or the inefficient performance of value
added activities.
- the cost if eliminated would not reduce the utility of the product.

Some issues analyzed during VE and VA are as under.

a) Can we eliminate unnecessary functions from the production process.
b) Can we eliminate unnecessary product qualities
c) Can we change design[fewer parts, fewer features]
d) Can we substitute cheaper parts.
e) Can we combine steps.
f) Can we get knowledge sharing from suppliers.
g) Is there a better way of doing things.

Q.7. What are the benefits of Target Costing System? Or Discuss how Target costing may assist a company in
controlling costs and pricing of products.
Ans
Benefits of Target Costing
a) Competitive advantage: Target costing focuses on competition from the very beginning. This helps in
succeeding later on. It enables the organization to face and stay in ever growing competitive environment.
b) Market driven management: Target costing starts from understanding the customer and market. This
reduces the time to market and enhances the possibility of the acceptance of the product.
c) Innovation: Due to value engineering, value analysis, different innovation in design, process of doing work
etc will come forward.
d) Real Cost reduction: Target costing results in significant reductions in product costs before they are “
locked in” ie before production start and even though out the production continuous cost improvement is
done. Minimize or eliminate non value added activities will also reduce cost.
e) Proper planning ahead of production

Q.8. It is said that Target costing fosters team work within organization. Explain how target costing creates an
environment in which team work fosters?
Ans:
i) Target costing fosters team work between all internal departments with planning, developing,
manufacturing, and marketing the product.
ii) Target costing teams require employees from different departments to collaborate on finding ways to
reduce the product cost. These employees learn about the activities that occur in other departments and
how their own actions affects others.
iii) They firmly believe that the foundation of the target costing is co-operation of all the stakeholders of the
organization.
iv) They learn to respect the views of others.

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 CA Megh Raj Aryal Gurukul CA

Q.9. Define term Kaizen costing

Ans:
1. Kaizen costing refers to the ongoing continuous improvement program that focuses on the reduction
of waste in the production process, thereby further lowering costs below the initial targets specified
during the design phase. It is a Japanese term for a number of cost reduction steps that can be used,
subsequent to issuing a new product design to a factory floor.
2. The initial VE/VA review may not be complete and perfect in all cost aspects. There may be further
chances of waste reduction, cost and time reduction and product improvement, change of design. Such
continuous cost reduction technique is called Kaizen costing.
3. Unlike the target costing which is applied during the design stage, kaizen costing is applied during the
manufacturing stage of product life cycle. Unlike the target costing, potential cost reduction are smaller
in Kaizen costing since the products are already in the production stage and a significant portion of the
cost have already been committed. Such improvements are continuous though minor [No heavy capital
expenditure made]. Kaizen results in small savings which are worth in long run.
4. Such improvements are taken by taking suggestions from all level staffs, employees working in the
factory. Quality is maintained or improved and not reduced.
5. Kaizen costing also aims to bring clarity in roles and responsibilities for all employees so that
improvements can be suggested from the particular employees.

Q.10. ABC Ltd is planning to introduce Kaizen Costing approach in its Manufacturing Plant. State whether and
why the following are valid or invalid, in respect of Kaizen costing.
(1) VP (Finance) is of the view that the company has to make a huge initial investment to bring a large
scale modification in production process .
(2) Head( Personnel) has made a point that introduction of Kaizen Costing does not eliminate the training
requirement of employees.
(3) General manager (Manufacturing) firmly believes that only Shop Floor Employees and Worker’s
involvement is prerequisite of Kaizen Costing approach.
(4) Manager (Operations) has concerns about creation of confusion among employees and workers
regarding their roles and degradation in quality of production.
Ans:
1. Invalid: Kaizen costing seeks cost reduction through small and continuous improvement rather than
innovations or large scale investment.
2. Valid: Training of employees is a long term and ongoing process under Kaizen costing approach, to
enhance the abilities of employees.
3. Invalid: Kaizen costing involves active participation of all personnel from Top level management to
Shop floor level.
4. Invalid: Kaizen costing seeks to reduce the cost without loss of quality. Further Kaizen costing also
aims to bring clarity in roles and responsibilities for all employees.

Q.11. Difference between Kaizen Costing and Standard Costing

Ans:
Basis of Difference Kaizen Costing Standard Costing
Focus Focus on cost reduction Focus on cost control
Time of revision Standards are continuously revised. Standard are long term and stable.
(reduced).
Employee Suggestion from employees. Standards are prepared by management.
participation Employee seen as vital to the cost No employee participation. Employee
reduction process. blamed for variances.

Q.12. Explain the term “Tear down analysis”.

Ans:
“Tear down analysis” involves a thorough examination of competitors product with a view to identify
opportunities for own product improvement or cost reduction. In this analysis, the product of the competitor is
dismantled to identify its functionality and design. This is done to provide ideas about the processes that are used
as well as to ascertain the cost to make such products.

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