Target Costing

Definition
Target costing is a pricing method used by firms. It is defined as "a cost management tool for
reducing the overall cost of a product over its entire life-cycle with the help of production,
engineering, research and design".
Objective
To enable management to manage the business to be profitable in a very competitive
marketplace.
Target costing is a proactive cost planning, cost management, and cost reduction
practice whereby costs are planned and managed out of a product and business early
in the design and development cycle, rather than during the later stages of product
development and production.
Steps in the implementation of the target costing process.
Step 1: Determine a product specification of which an adequate sales volume is estimated.
Step 2: Set a selling price at which the organization will be able to achieve a desired market
share.
Step 3: Estimate the required profit based on return on sales or return on investment.
Step 4: Calculate the target cost = target selling price target profit
Step 5: Compile an estimated cost for the product based on the anticipated design
specification and current cost levels.
Step 6: Calculate target cost gap = estimated cost target cost.
Step 7: Make efforts to close the gap. This is more likely to be successful if efforts are made
to design out costs prior to production, rather than to control out costs during the production
phase.
Step 8: Negotiate with the customer before making the decision about whether to go ahead
with the project.

Target costing = Target Price Target Profit Margin

If the actual cost > target cost, the management should find way to reduce the cost by
using iterative process, which ideally should result in the design team continuing with
its product and process design attempts until it finds designs that give an expected
cost that is equal to or less than the target cost. The iterative process are:
1. Tear-down analysis
(a) Tear-down analysis (also known as reverse engineering) involves examining a
competitors product in order to identify opportunities for product
improvement and/or cost reduction.
(b) The competitors product is dismantled to identify its functionality and design
and to provide insights about the processes that are used and the cost to make
the product.

(c) The aim is to benchmark provisional product designs with the designs of
competitors and to incorporate any observed relative advantages of the
competitors approach to product design.
2. Value engineering
(a) Value engineering is a cost-reduction technique, used primarily in the design
stage, which uses information about all value chain functions to satisfy
customer needs while reducing costs.
(b) It is a systematic and generally team-based approach to evaluating a products
design in order to identify alternatives that will improve the products value,
which is defined as the ratio of functionality to cost.
(c) The value can be improved by either reducing cost while holding functionality
constant, or increasing functionality while holding cost constant.
(d) Value engineering looks at all of the products elements, including the raw
materials, the manufacturing process, the type of labour and equipment used,
and the balance between purchased and self-manufactured components.
Application of target costing in Company
Toyota Motor Corporation Australia Ltd (TMCA)
Company Background:
Is a fully-owned subsidiary of Toyota Japan.
Operation commenced in 1959 with the import of the Land Cruiser, and in 1963 a
passenger car assembly plant, which initially produced the Tiara, was opened at Port
Melbourne, in Victoria, Australia.
In addition to its domestic sales, TMCA supplied a number of markets overseas
including Japan, New Zealand, Thailand, Malaysia, South Africa, Turkey and
Oceania.
In 1996, new market opened in the Middle East (Saudi Arabia, United Arab Emirates,
Oman, Kuwait, Bahrain and Qatar)
Adopting Process and Technique of Target Costing.
At TMCA, cost management is considered critical to ensuring long-term viability and
success. Like all companies in the Australian automotive industry, TMCA is subject to tight
profit margins, and there is little scope for increasing selling prices beyond that of
competitors. The level of competitiveness within the automotive industry is expected to
increase in the future, due to tariff reductions and the ongoing cost improvements of
competitors. Thus, TMCAs cost competitiveness must exceed that of its competitors to
regain the number one position in the domestic market.

1. Determining the target price and reducing selling costs:

- setting the market price for the new model

- Any reassessment of the selling price will obviously impact on the planned profit
margin and target cost.
- While reduction in cost such as transportation is pursued, the amounts are small
relative to those achieved by the engineering and purchasing.
2. Managing supplier relationship to achieve cost target:
- The Purchasing Division is a major player in the Product Cost Planning (PCP)
process at TMCA.
- The buyers work closely with engineers in actively participating in the VE/VA
process.
- They responsible for driving down costs of components of new models through the
close relationships that they build up with their suppliers.
- The high level of specialized knowledge and expertise.
3. Value engineering; creativity in cost management:
- At TMCA value engineering is a critical part of product cost planning, as it is the
process whereby cost reduction targets are translated into specific actions, on a part by
part basis.
- Summary of what VE at TMCA embodies.
What we force our engineers to do is to think very much outside the square - dont
just design parts. Thats what VE means, value - put yourself in the customers shoes.
If you have a cost reduction idea and customer value is not impaired, and it meets all
the Toyota standards, go ahead.
- A number of factors influence the approach and processes undertaken in value
engineering at Toyota Australia.
- At TMCA, value engineering is a critical part of product cost planning, as it is the
process whereby cost reduction targets are translated into specific action, on a part by
part basis.
4. Cost target and value analysis in manufacturing:
- The interaction of cost targets and cost savings during the pre-start of volume
production (pre-SVP) period.
- The very specific targeting of activities or processes allows manufacturing to focus
on problem area.
- The activities undertaken within manufacturing also serves to encourage actions that
lead to more effective cost management.

Benefits
1. Cost Optimization
A primary advantage of target costing is that it allows you to analyze the best way to make or
acquire products at the lowest costs. Minimizing costs is a common financial goal of any

small business, regardless of whether they offer high, medium or low prices. Minimizing
costs gives a small company financial flexibility to focus on achieving high profit margins or
to enter the market at low price points to attract a large customer base.
2. Systematic
Target costing is a much more formal and systematic way to focus on cost optimization than
other less-formal approaches often used by small businesses. It requires more time to go
through a systematic approach like this, but the results are typically finer tuned. Target
costing involves consideration of all equipment, processes, labour and materials needed to
make goods, or the costs to acquire goods and get them ready to sell to your customers.
3. Reduced Development Cycle
A point of emphasis in reducing costs with target costing is minimizing product cycle time.
This is the amount of time it takes from conception to market-ready product. A reduced cycle
time means you eliminate unnecessary steps or waste that take time and don't add value to the
end solution for the customer. A shorter cycle time is a competitive advantage as well, since
you can present your product to the market sooner, perhaps as the first mover.
4. Profitability
If it's effective, target costing ultimately gives your business greater profitability. It takes into
account both factors in profit: the costs and the price. Many companies start by developing
products and base pricing on costs. By starting with market pricing first, you help ensure that
you end up with a product that has benefits and a price point customers will value. In essence,
you achieve the optimal price-to-cost relationship possible for your products.
The key issues that emerged from the description of the target costing system (product
costing planning system) at TMCA were as follows:
The adaptation of target costing to a western context
The operation of a target costing system within a global product strategy
The critical nature of value engineering to the success of the target costing process
The integrated nature of the cost management system
The cross-functional nature of the target costing system
The important coordinating role of the finance function