2 Targeting costs

　　2.1 Definition of target costing

　　Target cost

　　A target cost is a cost estimate derived by subtracting desired profit margin from a competitive market price.

　　In effect it the opposite of conventional ‘cost plus pricing’ and is sometimes referred to as ‘price minus costing’.

　　It may be used in both manufacturing and service industries.

　　The main theme behind target costing is thus not finding what a new product does cost but what it should or needs to cost. The firm can then focus on which costs can be reduced and which can not to see whether such a target cost is achievable. Obviously cost reductions must be seen in the context of quality concerns as well. This will involve product comparisons with the competitors used to set the competitive market price in the first place.

　　Illustrative 4 targeting costs

　　Real world users:

　　§ Sony

　　§ Toyota

　　§ Swiss watchmakers – Swatch.

　　Test your understanding 6

　　Briefly identify the implications for a profit-orientated organisation if it chooses to use cost plus pricing.

　　2.2 Deriving a target cost

　　Steps

　　1 Estimate a selling price for a new product that will enable a firm to capture a required share of the market.

　　2 Reduce this figure by the firm’s required level of profit. This could take into account the return required on any new investment and on working capital requirements or could involve a target margin on sales.

　　3 Produce a target cost figure for product designers to meet.

　　4 Reduce costs to provide a product that meets that target cost.

　　Illustration 5 – Targeting costs

　　Katy Inc, a toy manufacturer, is about to launch a new type of bicycle on which it requires a Return on Investment of 30%.

　　Buildings and equipment needed for production are to cost $5,000,000.

　　Expected sales levels are $40,000 toys pa at a selling price of $67.50 per item costs are currently estimated to be $32 per unit.

　　Required:

　　What is the target cost for annual production?

　　Solution

　　Working$

　　Revenue(67.50×40,000)2,700,00

　　Target costs(balancing figure)(1,200,000)

　　Target return(30%×5,000,000)1,500,000

　　2.3 The difficulties of using target costing in service industries

　　Target costing was introduced by major Japanese manufacturers for use in a manufacturing environment where:

　　§ a new product was to be designed to meet the target cost

　　§ a substantial part of the production cost consisted of bought-in materials.

　　§ This environment facilitates use of a target cost approach since:

　　§ Professional design teams can alter the design specification of a new product until it matches their cost requirements.

　　§ Very large manufacturers such as Sony and Toyota are able to exert considerable pressure on (usually much smaller) suppliers to reduce their prices.

　　Service industries (e.g. banking, insurance, travel) provide a less favourable environment for the use of target costing:

　　§ It is much more difficult to make service comparisons than product comparisons, making it harder to determine a market driven price in the first place.

　　§ The introduction of new products and services in service industries usually occurs far less frequently than in manufacturing environment (e.g. Sony and Toyota introduce new models on a regular basis) and, in consequence, the equivalent of manufacturing design teams are rarely found in service industries.

　　§ Bought in materials are usually of modest significance so there is little scope for exerting pressure on external suppliers.

　　§ The major cost of any new product or service is salaries and unless lower cost delivery mechanisms (e.g. the internet) or radically different ways of working can be exploited there is limited scope for substantial cost reduction.

　　2.4 The implications of using target costing on pricing, cost control and performance management

　　Pricing

　　§ Target costing forces product/service designers to ‘think outside the box’ and identify new and imaginative ways in which costs can be reduced in order to meet the target cost.

　　§ This approach can result in substantial cost saving being identified, thereby enabling prices to be set at levels that are very competitive but still generate a profit. A policy of penetration pricing can then be pursued with a view to substantial market share being captured.

　　§ Target costing is usually considered superior to cost plus pricing as it considers the demand for a product or service. As long as the estimates for demand at the target price are accurate and costs are controlled then an organisation will achieve its required return on investment.

　　Cost control and performance management

　　§ Target costing has a potentially major positive impact on cost control since it seeks to change the accounting mindset from one of recording costs to one of reducing costs in order that the cost target can be met.

　　The requirement to meet a target cost can generate new ideas and new ways of working which in turn can generate substantial cost savings and facilitate a more proactive approach to cost control.

　　§ Performance management is also potentially enhanced since the setting of a target cost requires a business to identify how costs can be managed down to the target cost level. This may involve product/service redesign and new ways of working (e.g. outsourcing, greater use of the internet etc.).

　　Test your understanding 7

　　LMN Ltd makes and sells two products, X and Y. Both products are manufactured through two consecutive processes – assembly and finishing. Raw material is input at the commencement of the assembly process. An ABC approach is used in the absorption of product specific conversion costs.

　　The following estimated information is available for the period ending 31 December 20x5:

　　Product XProduct Y

　　Production/sales (units)12,0007,200

　　Selling price per unit$75$90

　　Direct material cost per unit$20$20

　　ABC variable conversion cost per unit

　　- assembly$20$28

　　- finishing$12$24

　　Product-specific fixed costs$170,000$90,000

　　Company fixed costs$50,000

　　LMN Ltd uses a minimum contribution/sales (C/S) ratio target of 25% when assessing the viability of a product. In addition, management wish to achieve an overall net profit margin of 12% on sales in this period in order to meet return on capital targets.

　　Explain how target costing may be used in achieving the required returns and suggest specific areas of investigation.

　　2.5 Closing the target cost gap

　　Target cost gap = Estimated product cost – Target cost

　　It is the difference between what an organisation thinks it can currently make a product for, in order to make a required profit.

　　Alternative product designs should be examined for potential areas of cost reduction that will not compromise the quality of the products.

　　Questions that a manufacturer may ask in order to close the gap include:

　　§ Can any materials be eliminated, e.g. cut down on packing materials?

　　§ Can a cheaper material be substituted without affecting quality?

　　§ Can labour savings be made, for example, by using lower skilled workers?

　　§ Can productivity be improved, for example, by improving motivation?

　　§ What production volume is needed to achieve economies of scales?

　　§ Could cost savings be made by reviewing the supply chain?

　　§ Can part-assembled components be bought in to save on assembly time?

　　§ Can the incidence of the cost drivers be reduced?

　　§ Is there some degree of overlap between the product-related fixed costs that could be eliminated by combining service departments or resources?

　　A key aspect of this is to understand which features of the product are essential to customer perceived quality and which are not. This process is known as ‘value analysis’. Attention should be focused more on reducing the costs of features perceived by the customer not to add less value.