Target costing
Target costing
When a new product is launched, traditionally profit was added to cost
that is cost plus pricing considering internal factors to get to the selling
price. But target costing involves setting a target cost by subtracting a
desired profit margin from a target selling price.
When a product is first planned, its estimated cost will often be higher
than its target cost. The aim of target costing is then to find ways of closing
this target cost gap, and producing and selling the product at the target
cost.
Cost reduction must be considered at the design stage of a product’s life
cycle, rather than during the production process.
Steps in target costing
1. Determine a product and adequate sales volume.
2. Decide a target selling price.
3. Estimate the required profit to meet companys requirements..
4. Calculate target cost.(Target cost = Target selling price – Target
profit )
5. Based on current cost levels find the estimated cost.
6. Calculate cost gap. ( cost gap = Estimated cost – Target cost)
7. Make efforts to close the gap.
EX 1
Exclusive Motors is designing a new version of its luxury car, the
Z123 series. The vehicle will be launched next year. It is
expected to have a lifecycle of 10 years.
The production of the car will require an investment of $3 billion.
The company needs a profit of 20% a year on this investment.
The marketing department believes that the car could be sold for
a price of $40,000 each. 100,000 cars would be manufactured
and sold each year.
Calculate the target cost of one Z123.
Closing a Target Cost Gap
• Use more cheaper labour(low grade) and materials
• Reconsider design to eliminate non value added elements.
• Investing in new and updated technology can reduce cost per unit.
• Reduce the number of components and use standardizing components.
• Outsourcing
• Reducing manning levels(labour related costs) or redesign workflow
A risk with target costing is that cost reductions may affect the perceived
value of the product
Techniques used for cost reduction
• Tear down analysis (also called "reverse engineering") − involves
examining a competitor's product to identify possible improvements or cost
reductions.
• Value engineering − involves investigating the factors that affect the cost
of a product or service. The aim is to improve the design of a product so
the same functions can be provided for a lower cost.The value
engineering technique is applied to new products/services at the
beginning of the development process during the design stage .
• Functional analysis − involves identifying the attributes/ functions of a
product that customers value. The price the customer is prepared to pay
for each function is then determined. The function should be dropped
(abandoned) if the cost of providing it exceeds the value (marginal
revenue) it generates.
• Value Analysis – analysis used to identify where small cost reductions
can be applied to close a cost gap once production commences.
• Activity analysis identifies and describe activity in an organisation and
evaluates their impact on operations to assess where improvements can
be made.
Target Costing in Service Industries
The target costing approach is a sensible basis for estimating/driving down costs
regardless of the type of business. However, due to the nature of service
industries this process is more difficult in these businesses.
Characteristics of Service Industries
Service industries have the following characteristics which make cost and
performance measurement more difficult:
1. Simultaneity
2. Variability/Heterogeneity
3. Intangibility
4. Perishability
5. No transfer of ownership.
6. Higher indirect costs.
