Target costing

Target costing involves setting a target cost by subtracting a desired profit margin
from a competitive market price. A lengthy but complete definition is "Target
Costing is a disciplined process for determining and achieving a full-stream cost at
which a proposed product with specified functionality, performance, and quality
must be produced in order to generate the desired profitability at the products
anticipated selling price over a specified period of time in the future."
This definition encompasses the principal concepts: products should be based on
an accurate assessment of the wants and needs of customers in different market
segments, and cost targets should be what result after a sustainable profit margin is
subtracted from what customers are willing to pay at the time of product
introduction and afterwards. These concepts are supported by the four basic steps
of Target Costing: (1) Define the Product (2) Set the Price and Cost Targets (3)
Achieve the Targets (4) Maintain Competitive Costs.
To compete effectively, organizations must continually redesign their products (or
services) in order to shorten product life cycles. The planning, development and
design stage of a product is therefore critical to an organization's cost management
process. Considering possible cost reduction at this stage of a product's life cycle
(rather than during the production process) is now one of the most important issues
facing management accountants in industry.
Here are some examples of decisions made at the design stage which impact on the
cost of a product.
1. The number of different components
2. Whether the components are standard or not
3. The ease of changing over tools
Japanese companies have developed target costing as a response to the problem of
controlling and reducing costs over the product life cycle.

Main features of Target Costing system:

The main features or practices followed in different Japanese companies can be

understood by going through the following points:

1. Target costing is viewed as an integral part of the design and introduction of new
products. As such, it is part of an overall profit management process, rather than
simply a tool for cost reduction and cost management. Diagram 1 summarizes the
steps in the target costing process. The first part of the process is driven by
customer, market and profitability considerations. Given the profitability is critical
for survival, a target profit margin is established for all new product offerings. The
target profit margin is derived from the companys long-term business plan, which
incorporates its long-term strategic intent and profit margins. Each product or
product line is required to earn at least the target profit margin.

2. For any given product, a target selling price is determined using various sales
forecasting techniques. Critical to setting the target selling price are the design
specifications (reflecting certain levels of functionality and quality) of the new
product. These specifications are based on customer requirements and expectations
and are often influenced by the offerings of competitors. Importantly, while setting
the target selling price, competitive conditions and customers demands for
increased functionality and higher quality, without significant increases in price, are
clearly recognized, as charging a price premium may not be sustainable. Hence, the
target selling price is market-driven and should encompass a realistic reflection of
the competitive environment.

4.

Integral to setting the Target selling price is the establishment of target

production volumes, given the relationship between price and volume. The
expected targets volumes are also critical to computing unit costs, especially with
respect to capacity related costs (such as tooling costs), as product costs are
dependent upon the production levels over the life cycle of the production. Once the
target selling price and required profit margin have been determined, the difference
between these two figures indicates the allowable cost for the product. Ideally, the
allowable cost becomes the target cost for the product. However, in many cases the
target cost agreed upon will exceed the allowable cost, given the realities with
existing capacities and capabilities.

Set target selling

price based on
customer
expectations and
sales forecasts

Establish profit
margin based on
long term profit
objectives and
projected volume

Determine target
(or allowable) cost
per unit (target
selling price less
required profit
margin)

Compare
with

Establish cost
reduction
targets for each
component and
production
activity, using
value
engineering and

Estimate the
current cost
of the new
product

4. The next stage of the target costing process is to determine cost reduction targets.
Some firms will do this by estimating the current cost of the new product. The
current cost is based on existing technologies and components, but encompasses
the functionalities and quality requirements of the new product. The difference
between the current cost and the target cost indicates the required cost reduction
that is needed. This amount may be divided into a target cost-reduction objective
and a strategic cost-reduction challenge. The former is viewed as being achievable
(yet still a very challenging target), while the latter acknowledges current inherent
limitations. After analyzing the cost reduction objective, a product-level target cost
is set which is the difference between the current cost and the target cost-reduction
objective.

5. It should be noted that a fair degree of judgment is needed where the allowable
cost and the target cost differ. As the ideal is to produce at the allowable cost, it is
important that the difference is not too great. Once the product-level target cost is
set, however, it generally cannot be changed, and the challenge or those involved is
to meet this target.

6. Having achieved consensus about the product-level target cost, a series of intense
activities commence to translate the cost challenge into reality. These activities
continue throughout the design stage up until the point when the new product goes
into production. Typically, the total target is broken down into its various
components, each component is studied and opportunities for cost reductions are
identified. These activities are often refer to as value engineering (VE) and value
analysis (VA). Value engineering involves searching for opportunities to modify the
design of each component or part of a product to reduce cost, but without reducing
functionality or quality of the product. Value analysis entails studying the activities
that are involved in producing the product to detect non-value-adding activities that
may be eliminated or minimized to save costs, but without reducing the
functionality or quality of the product. Where components are sourced from
suppliers (which is often the case in the automotive industry), target prices are

established for each part and the companys employees work with the suppliers to
ensure that the targets are achieved. Overall, the aim of the process is to ensure
that when production commences, the total cost will meet the target, and profit
goals will be achieved. There is also an ongoing continuous improvement program,
known as Kaizen costing, that focuses on the reduction of waste in the production
process, thereby further lowering costs below the initial targets specified during the
design phase.

While the above description captures the essential features of the target costing
process, it should be emphasized that successful, target costing requires careful
planning, attention to detail and a strong degree of commitment from those
involved. The description, however, does not provide any insights into what is
entitled in implementing a target costing approach in an organization.