Working Paper

Strategic Cost Management: The Mechanics of Target Costing

Mahmuda Akter, Ph.D.

Dewan Mahboob Hossain

Mahfuzul Hoque, Ph.D.

Abstract

This paper provides a basis of target cost setting for products as well as their
components.
The overall target costing process would be unsuccessful if targets for cost and
profit are made unrealistic because the target cost achievement of the product
designers may vary according to the levels of tightness of different target cost
and target profit methods since these will motivate them in different ways. In
this paper, we showed the mechanism of target cost setting for products and their
parts with the help of a hypothetical example. In a target-costing environment,
identifying the appropriate degree of tightness of the targets for profit and cost
is very crucial factor to take into account. In certain situations performance
improves with the level of tightness while in the other circumstances, it
deteriorates. The tight but attainable target should be established for high and
persistent cost-reduction performance. In target costing, the overall accounting
process consists of target cost establishment and allocation processes. The policy
that is suitable for getting higher cost-reduction performance in the target cost
establishment process may not be desirable for the same in target cost allocation
process.

Introduction
Increased competition and vocal customers have made it imperative for every
company to upgrade its processes constantly to stay ahead of the competition. In
the midst of an overabundance of products and choices for the customer, it becomes
increasingly important for any company to make its products better, faster,
cheaper and more innovatively. Increasing the efficiency of products has the two
aspects of cost and functionality attached to it. An efficient designing technique
takes the cost and functionality aspects into consideration during the early
stages of product design where extensive design efforts are given on important
features and simultaneously reducing the cost on less important features. Target
costing is a planning tool that helps us to identify the features to be improved
and helps us in setting targets for designing and cost reduction. It is generally
known that challenging goals lead to better performance than the general goal of
doing ones best (Cooper and Slagmulder, 1997). Target costing focuses on searching
for opportunities for cost reduction at the product planning stage, as well as
providing continuous cost reductions once a product commences manufacture. It is a
multidisciplinary tool of cost management to reduce overall costs applied at the
planning and design stages with cooperation of the engineering, production,
marketing, development, and accounting departments (Sakurai and Scarbrough, 1997).

The core concept of target costing is very straightforward. It is based on

the logic that a company should manufacture the products that yield the desired
profit. If the product is not yielding the desired amount of profit, the design of
the product should be changed to obtain the desired profit or the product should
be abandoned. The target costing process is a system of profit planning and cost
management that is price led, customer focused, design centered, and cross
functional. Target costing initiates cost management at the earliest stages of
product development and applies it through out the product life cycle by actively
involving the entire value chain (Ansari, 1997).
Target costing, a technique that many Japanese companies use to sustain a
competitive advantage, has begun to invade the province of management accountants
(Bayou and Reinstein, 1996) Invented by Toyota, target costing has been used by
Japanese managers for nearly 30 years (Kato, 1993). More than 80 percent of major
Japanese companies in assembly industries 60 percent in process industries use the
system (Kato, 1993). Some U.S. and European corporations, perhaps assuming that
target costing is a major reason for Japan’s success, turn to target costing to
possibly replace standard cost accounting (Financial Management, 1991, p. 12).
Therefore, management accountants should understand target costing as an
alternative to the product costing method, but recognize that it can dilute
management accounting’s role in “doing” accounting and in developing and
evaluating cost management systems (Inoue, 1989).
Target costing occurs in two phases: an establishment phase and an
attainment phase. The establishment phase occurs during product planning and
concept development stages of the product development cycle and it focuses on
defining a product concept and setting allowable cost targets for products or a
family of products. The attainment phase occurs during the design development and
production stages of target costing and involves achieving that target cost
(Ansari, 1997).
After determining a product’s target cost in the establishment phase, the next
major step is to decompose that target cost down to the function, component, and
part level in the attainment phase so that the purchase prices of those items can
be determined. An organization's target costing effectiveness represents the
degree of success in achieving the target costs of products, functions, or parts.
The overall target costing process would be futile if targets for cost and profit
are made unrealistic because the target cost achievement of the product designers
may vary according to the levels of tightness of different target cost and target
profit methods since they will motivate them in different ways (Akter, Lee and
Monden, 1999).
Therefore, the purpose of this paper is to provide a basis for target cost setting
for products as well as their components. To this end, this paper is organized
into six sections. The paper first section presents an overview of the target
costing process. The second describes the phases in target costing process. The
third provides a target costing example. Sixth section concludes the paper.

1. An Overview of Target Costing Process

Target costing is intimately linked to an organization’s competitive strategy and
its product development cycle. Since the late 1980s, target costing has become
ever more closely connected with business strategy and considered as a strategic
cost management tool for attaining target profit as well as for cost reduction
(Sakurai and Scarbrough, 1997). Competitive strategy defines the goals that an
organization must attain to satisfy market demands and remain profitable. Target
costing provides the means by which the organization achieves these goals. It does
so by integrating the strategic variables of market trends, customer needs,
technology advances, and quality requirements into a product definition that meets
a customer’s price, quality, and time expectations. Target costing is the
simultaneous planning of how to satisfy customers, capture market share, generate
profits, and plan and manage costs. Without target costing system, meeting
competitive prices and generating acceptable returns on a consistent basis is
difficult, if not impossible, in today’s environment (Ansari, 1997).
Target costing identifies the cost at which the product must be manufactured if it
is to achieve its target profit margin when sold at its target-selling price. In
the contemporary industrial environment that changes rapidly and plays by its own
set of rules, prices are largely market driven and not controlled by management.
Target profit, on the other hand, is based on corporate profit expectations,
historical results and competitive analysis, and therefore is a decision variable.
If the target profit margin is very demanding, the resulting target cost will be
difficult to achieve. However, the difficulty of implementing target cost methods
depends not only on the rigidity exercised in setting target profit, but also on
the degree of tightness inherent in the target cost methods.
Competitive environment, company’s efficiency, and development stage of management
accounting system mainly persuade the selection of a particular method for
determining target profit. The attainability of target profit influences the
decision of using a target cost method. When a company decides to use a particular
target profit method, it does not finalize the target profit figure immediately.
Rather, a provisional target profit is determined first based on which allowable
cost, the cost at which the product must be manufactured if it is to generate the
desired profit margin, is determined. Subsequently, the attainability of allowable
cost is checked. If this allowable cost is attainable, the management accepts
provisional figure as the final profit and here target cost is determined by
subtractive method. On the other hand, if management feels that the allowable cost
objective is not possible to achieve, target cost is determined by adding-up or
combination method. When either one of these two methods is used, the provisional
target profit could not be attained because the target cost will be higher than
the allowable cost. Thus, the target profit will be changed downward to derive the
target costs. Therefore, the selection of a particular target cost method depends
on the attainability of the allowable cost. Moreover, setting target profit
margins in this manner makes the allowable cost reflect the relative competitive
position of the firm. A highly efficient firm will set target profit margins
higher and will have lower allowable cost (Cooper and Slagmulder, 1997, 102).
Figures 1(a) and 1(b) depict this process (Akter, 2006 ; Akter, Hoque and Monden,
2004).

Figure 1(a). Relationship between target profit and target cost

Figure 1(b). Selection process of target cost

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 functionality and quality requirements of the new product. The
difference between the current cost and the target cost indicates the required
cost reduction. 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.
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 for
those involved is to meet this target.
Having achieved consensus about the product-level target cost, a series of intense
activities commences 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 referred 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
company’s employees work with the suppliers to ensure 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. Figure 2
summarizes the steps in the target costing process.

Figure 2. Steps in the target costing process

2. Phases in the Target Costing Process

Target costing occurs in two phases, establishment phase, and attainment phase.
The establishment phase occurs during product planning and concept development
stages of the product development cycle and involves setting a target cost. The
attainment phase occurs during the design development and production stages of
target costing and involves achieving that target cost (Ansari, 1997).
2.1 Establishment Phase of the Target Costing Process
The establishment phase needs a product price and required profit to determine the
allowable cost of a product. Here product level target cost is determined where
product strategy and the long-term profit fix a product’s price and its required
profit. The difference between price and the required profit margin is the
allowable target cost. The allowable target cost is the initial target that guides
product development efforts (Ansari, 1997).

2.1.1 Setting Target Prices in a Target Costing Environment

Target Costing typically occurs in a competitive environment, in which firms
differentiate their products on the basis of quality, service, support, features,
product functions, and time to market. In this environment, customer needs, wants
and tastes, coupled with their ability to pay, are central in determining product
prices (Ansari, 1997).
Usually, there are two methods of target sales price, cost-based and market-based.

The cost-based method, also known as the cost-plus method, adds on a set profit
margin to either the full cost or the variable costs to get a sales price for a
particular product. This method is more effective when it is a seller’s market and
when our company’s product is clearly superior to and distinct from competitors’
products, so that setting a sales price based on our company’s cost will not run
risk of losing out in price competition with rival companies (Monden, 1995).
Although cost-based pricing is a very popular method of pricing used by many
companies, it is unsuited for target costing environments. Use of cost-based
pricing in competitive environments negates the entire rational for the use of
target costing. In fact, being wedded to cost for product pricing is an impediment
to the successful adoption of target costing (Ansari, 1997).
The market-based method looks at the prices of competing products on the market
and sets similar prices for its own products. This method is most effective in an
environment where: (i) there is no conspicuous differences among competing
products in terms of quality and functions, (ii) short product life cycles due to
technological advancements, and (iii) the market has become a buyer’s market.
Consequently, the price of products (i.e., competitive products) in a highly
competitive market depends upon the functional level reached by the product’s
various functions (Monden, 1995). Even if there is no noticeable difference in the
quality and functions of competing products on the market, prices may be set
according to slight differences in a product’s functional level or the inclusion
of extra functions. Here functions include not only practical functions but also
aesthetic functions such as the product’s styling. Also, one must consider all
competing products in the same market segment including company’s own competing
products. Three methods are used in practice.
Function based adjustment method sets prices by adding or subtracting the
value of functions added or deleted from an existing product. Here the pricing
formula is,

New market price = current price + value placed by market on a function

Physical attributes-based adjustment method sets prices with reference to the
physical attributes of a product, such as weight, torque ratio, horsepower, and so
on. Here the pricing formula is,

New market price = current price + measure of physical attributes of the

product
Competitor based adjustment method sets prices with reference to competitors’
products or attributes.

Competitor’s market price = Our product’s price × (Measure of attribute of

competitor’s product/measure of attribute of
our product)
2.1.2 Setting Target Profits in a Target Costing Environment
Target profit is the expected profit from total sales of the product over its
life. It is determined by corporate profit expectations, historical results,
competitive analysis, and sometimes, computer simulations (Cooper, 1995). The
objective in setting target profit margins is to ensure the achievement of the
firms long-term profit plan. Setting target profit is a function of bringing
together business level plans with product level plans (Ansari, Bell and CAM-I,
1997). The two considerations in setting target profit margins are to ensure that
they are realistic and that the margin is sufficient to offset the life-cycle cost
of the product (Cooper and Slagmulder, 1997, 100).
Usually, there are three methods of calculating target profit by targeting: (i)
return on sales ratio determined in the middle-range profit plan, (ii) reduction
rate in the cost of the existing or similar product, and (iii) return on sales
ratio based on past actual performance of the related product. Among these, the
first one is used for formulating macro plan and the would-be profit is termed as
required profit, the third one is used at micro level and the profit to be
materialized under the method is called planned profits, while the second one
adjusts the gap between the first and third.
At the business level, target profit is determined by considering the profit
requirements for the business as a whole. This is done by considering the firm’s
intended product portfolio and by establishing a required profit from this
portfolio. The product portfolio comes from a firm’s multiyear product plan and
the profit comes from the middle-range profit plan applying a target return on
sales (ROS) ratio to the sales revenue from the product portfolio. Product level
plans, on the other hand, represent a product manager’s expectations for his or
her product. To develop a projected sales volume, the product manager considers
the projected market size, targeted market share, and the competitive market
price. Applying the ROS targets from the profit plans to this projected sales
levels yield the planned profit at the product level. Here, the ROS ratio is
determined based on the past actual performance of the related product. The two
profits, required and planned, are compared to set a final target profit for the
product.
Target profit, if it is to be determined in the middle-range profit plan, reflects
management’s expectations that allow them at best to run the company smoothly or
at worst to survive. This is somewhat unrealistic in that its attainability is
presumed to be assured. (Akter, 2006 ; Akter, Hoque and Monden, 2004). On the
other hand, when target profit is based on the past actual performance of the
related product, the actual return-on-sales ratio for the current product is more
achievable since the company has experiences in attaining this profit (Monden,
1995). Usually, there is a gap between management’s profit expectations and actual
profit.
Target profit determined at middle-range planning often begins at executive levels
and follows top-down approach. It reflects the strategic profit needs of the
organization for ensuring the survival and growth of the firm and its affiliates.
By contrast, target profit based on past actual performance of the related
products is usually determined at the product department level using a bottom-up
approach. (Akter, 2006 ; Akter, Hoque and Monden, 2004). If there is gap between
the profit decided at executive and departmental levels, the reconciliation
process continues until there is no gap or both sides agree that it is not
possible to close the gap. A company’s prosperity depends on playing this kind of
“catch” between top management and managers at the operational level (Sakurai and
Scarbrough, 1997).
Simply by adhering to the target profit based on past actual performance of the
related products the company is unlikely to reduce cost below the current level,
which has already been achieved. When the profit expected in the middle-range
profit plan exceed the actual one, the reconciliation process, or “catch” can
proceed by calculating the target profit based on targeting reduction rate of cost
of the existing or similar product. This method helps to identify the unachievable
or unrealistic portion of target profit determined in the middle-range profit
plan. In terms of earnings, this method stands in the middle of the desired and
achievable earnings level.
2.1.3 Setting Target Costs in a Target Costing Environment
The allowable cost is calculated by subtracting the target profit from the target
sales price. It is known as the ‘maximum permissible cost’ that can be committed
to a product in the product planning stage. It is the desired cost based only on
market conditions, and is called ‘market-driven’ cost. In competitive environment
firms that are highly efficient will have higher target profit margins and hence
lower allowable costs than their less efficient competitor. Since the allowable
cost is determined by market forces and does not take into account the internal
design and production capabilities of the firm, there is a possibility that the
allowable cost will not be achieved. In practice, however, it is not always
possible for the designers to find ways to achieve the allowable cost and still
satisfy the customers. (Cooper and Slagmulder, 1997).
Usually, allowable cost is the early estimate of the target cost. It is considered
as the final target cost only when the product can be made for this amount. If
this cost is adopted as the target of efforts, the requirement is very severe and
not immediately attainable (Monden and Hamada, 1991). Target cost determined in
this way is called ‘Subtractive method’ or ‘Sales price-based method’.1
Subtractive method acts as a signal to all involved in the target costing process
as to the magnitude of the cost-reduction objective that inevitably must be
achieved. From the management viewpoint, it is desirable to realize the largest
possible profit and for this the target cost requirement by the subtractive method
is likely to be demanding (Monden, 1995). The subtractive method will clearly have
a strong linkage with firm’s middle-range profit plan that incorporates projected
profit figures to target costing. When allowable cost is not achievable, to check
its attainability the ‘drifting cost’, which is the current estimated cost with no
targets in mind, is calculated for each part. It is the preliminary estimate of a
product, assuming the existing work structures, technology, and processes. The
primary task in target costing is to perform the VE and continuous improvement
activities to reduce the gap between drifting and allowable costs. The cost
reduction target is continually refined until the ‘allowable’ and ‘achievable’
cost merge. If the allowable cost cannot be achieved, the process of attaining the
target cost increases the allowable cost of the product to a level that can
reasonably be expected to be achievable, given the capabilities of the firms and
its extended enterprises, i.e. suppliers. Target cost determined in this way is
called ‘Adding-up method’ or ‘Estimated cost-based method’.2 (Akter, 2006 ; Akter,
Hoque and Monden, 2004).
Under this method target cost is determined by examining every possible cost
reduction opportunities, taking likely VE proposals, work structures, technology,
and processes into considerations. In adding-up method, the target amount of cost
reduction is deducted from the estimated or current cost of the product, where the
target cost is set to an achievable level by considering the firm’s and its
suppliers’ capabilities. This method is used when the designers are unable to
achieve the allowable cost and signals that the firm is not as efficient as
demanded by the competitive conditions. Usually, target cost requirement via the
subtractive method is much harder to meet than that through the adding-up method
because non-value-added cost slack still exist when adding-up method is applied
(Tani and Kato, 1994).
When determining target cost by adding-up method, however, if there is any cost
slack, the target cost figure is made lower and set somewhere in the middle of
allowable and achievable costs. A hybrid of subtractive and adding-up methods,
called the ‘Combination method’3 is used when target cost cannot be finalized
either by subtractive or by adding-up method (Kato, 1993). It consolidates the
operating focus on profitability and the technological focus on feasibility
(Sakurai and Scarbrough, 1997). From the viewpoint of the tightness of target cost
methods, combination method stands in the middle of the two extremes of
subtractive and adding-up methods.
2.2 Attainment Phase of the Target Costing Process
The attainment phase focuses on how to make the allowable target cost achievable.
Attaining target cost requires cost planning, which has two key steps: computing
the cost gap between attainable and current costs and analyzing this cost gap so
value engineering and continuous improvement efforts can be focused on closing the
gap (Ansari, 1997). The process of making an allowable target cost to an
achievable one has been illustrated in terms of the steps of the cost planning
process.
2.2.1 Computing Cost Gap
In computing cost gap, the gap between the allowable cost and the initial
estimated cost is to be computed based on full product life cycle cost.
2.2.2 Decomposing Allowable Cost
The next major step is to decompose that target cost down to the function,
component, and part level so that the purchase prices of those items can be
determined. Here, cost elements are viewed form different perspectives, each of
which provides unique view, like value chain, life cycle, customers, engineers,
and accounting. The value chain view arranges costs by where in the extended
enterprise they are incurred. This helps a firm to focus cost reduction efforts
both within and outside own boundaries. The life cycle view arranges costs by time
when they are incurred. The customer view arranges costs by product features where
total allowable cost is assigned to each feature in proportion to the importance
customers place on that feature. The engineering view is a functional view from
which design engineers view a product. The accounting view arrays costs by three
main subcategories, (1) one time or recurring cost, (2) new or legacy costs, and
(3) design or activity driven costs.
2.2.3 Assigning Cost Targets to Designers
In target cost allocation process, to attain the per-unit target cost of a
product, the designers initially break down this target cost into functional
elements assigned to corresponding design departments which are again broken into
parts elements. After cost breakdown to functional and parts level, cost reduction
targets are assigned to various participants simultaneously. In target costing,
the product designers scrupulously design a product taking into account
information about alternative methods to achieve the required functions of
products and its parts and selecting the best methods to attain the lowest costs.
If the target cost cannot be achieved, i.e. if the estimated cost is greater than
the target cost, the cost-reduction activities will be repeated by investigating
alternative designs, until the estimated cost becomes, at most, equal to the
target cost. In most organizations, departments are responsible for function level
costs, teams are responsible for component level costs, and designers are
responsible for individual parts (Ansari, 1997). Figure 3 illustrates the design
process from target costing perspective (Monden, Akter and Kubo, 1997).

Figure 3. Design process from the perspective of target costing

2.2.4 Cost Estimation

As teams and individuals strive to meet target costs, they must continually
estimate costs to determine their progress toward the allowable cost. Each firm
develops models for cost estimation that meet its needs. It is unrealistic to
expect the same level of cost estimation accuracy at each sage of the product
development cycle. As the product concept becomes better defined, and processes
and parts finalized, the accuracy of cost estimates should improve.
2.2.5 Dealing with Unattainable Costs
Non-attainment of targets at the product team level means the product will not
meet its target cost. Failure of a design or build sub-team means that a function,
component, or part will not meet its assigned target cost. It is important to
remember that allowable costs and target profits are meant to be realistic and
achievable. They are commitments that should not be taken lightly. Non-attainment,
therefore, is a serious problem and policies to deal with it should be put into
place (Ansari, 1997).
3. Target Costing: A Hypothetical Example
System kitchen designs and manufactures exhaust fans for kitchen and bathroom use.
These are different models with different sizes, functionalities, and capacities.
For a standard model of exhaust fan, system kitchen conducted a market survey to
know the customers needs regarding the features and functionalities of the exhaust
fan. Seven issues are ranked by the customers on a 5-point likert scale with 1
being the lowest importance. Customers’ requirements are collected and Table 1
shows that the airflow capacity is the most important issue (23.81%) from the
customers’ perspective, while size and shape of the fan is found to be of least
importance (4.76%).
Table 1: Customer requirements rankings

Degrees of importance
Customer requirements Raw Score
based on customer
feedback % of Total
Raw Score
Multiple speed 3 14.29
Airflow capacity 5 23.81
Quietness 4 19.05
Compact Size 1 4.76
Good looks 2 9.52
Easy to clean 4 19.05
Multiple installations 2 9.52
 21 100.00

In Table 2, costs are broken down by life cycle and value chain. The bottom right
corner of the table indicates the total current or estimated cost to manufacture
the product ($24.70) and the target or allowable cost ($20.80). The difference
between the product-level estimated and allowable target cost is $3.9. The
difference between the estimated ($18) and target ($15) production cost $3. This
$3 constitutes 77% of $3.9. Hence, in our example, we focus on reducing the cost
of production because the difference between the estimated and target cost of
production is the highest among all the life cycle costs. Table 3 illustrates the
allocation of the $18 current manufacturing cost to the individual components that
make up the product. Among others, two functions performed by the components of
the exhaust fan are, ‘blade moves air’, and ‘blade-guard secure the blade’. The
costs of blade and blade guard are $1 and $1.5 respectively. The individual costs
are then expressed as a percentage of the total $18.

Table 2: Cost breakdown by life cycle

Life cycle cost Current cost of

the product Target cost of
the product
Research and development $0.45 $0.30
Production $18.00 $15.00
Marketing and distribution $5.00 $4.50
After sales service and support $0.25 $0.25
General administration $1.00 $0.75
Total life cycle cost of the product $24.70 $20.80

Table 3: Components, functions, and breakdown of current production cost

Parts/ Components Function Current Cost Percent of Total Cost

Motor Turns blades 7.00 38.89
Control/switch Speed control 2.50 13.89
Body Houses motor 2.00 11.11
Blade Move air 1.00 5.56
Blade guard Secure the blade 1.50 8.33
Installation frame To fix the system on the wall/window 4.00 22.22
Total cost 18.00 100.00

Table 4 explains the relation among the parts and the customers’ requirements or
demanded quality (DQ). Once the relations between parts and customer requirements
are understood, the engineering and design staff can provide relative weights to
the parts relating to the various customer requirements. The relationship among
parts and demanded quality are expressed with three levels, strong ( : 1.5),
moderate (∆: 1.2), and normal (O: 1.0) (Hoque, Akter, and Monden, 2005). The
airflow capacity is a function required by customers, which requires two
functionalities like, motor ( : 1.5) and blade ( : 1.5). In other words, to
achieve the customer requirements of “air flow”, the most important components are
motor and blade.
 Table 4: Relationship among the demanded quality and parts

Parts Motor Control/

Switch Body Blade Blade guard Installation
Frame
Customer Requirements Relation between Components and DQ Component Contribution
to DQ (%) Relation between Components and DQ Component Contribution to DQ (%)
Relation between Components and DQ Component Contribution to DQ (%)
Relation between Components and DQ Component Contribution to DQ (%)
Relation between Components and DQ Component Contribution to DQ (%)
Relation between Components and DQ Component Contribution to DQ (%)
Multiple speed 1.50 50.00 1.50 50.00

Airflow capacity 1.50 50.00 1.50 50.00

Quietness 1.50 38.46 1.20 ∆ 30.77 1.20 ∆ 30.77

Compact Size 1.50 22.39 1.50 22.39 1.50 22.39

1.20 ∆ 17.90 1.00 O 14.93
Good look 1.50 42.86 1.00 O 28.57
1.00 O 28.57
Easy to clean 1.00 O 25.00 1.00 O 25.00 1.00 O
25.00 1.00 O 25.00
Multiple installment
1.20 ∆ 100.00
Note: : (1.5) Strong, ∆: (1.2) Moderate, O: (1.0) Normal
In Table 5, customers’ requirements are adjusted with the technical requirements
of the product and the output (i.e., the component weight based on customer
feedback) is the basis for the target cost allocation among the components. For
example, customer requirement for airflow is 23.81 and the correlation matrix
entails that the airflow has two related components, motor (50.0) and blade
(50.0). The weight of the component, motor is (50.0 ×23.81) = 11.90. The total of
the column for motor reflect the ultimate weight of the motor (27.44%) that should
be considered while allocating the target cost.

Table 5: Part’s contribution to demanded quality (DQ)

Parts Motor Control/switch Body Blade Blade guard Installation frame
Customer requirements Relation between Component and DQ (%) DQ weight based
on customer feedback (%) Component weight based on customer feedback
Relation between Component and DQ (%) DQ weight based on customer
feedback (%) Component weight based on customer feedback Relation between
Component and DQ (%) DQ weight based on customer feedback (%) Component
weight based on customer feedback Relation between Component and DQ (%) DQ
weight based on customer feedback (%) Component weight based on customer
feedback Relation between Component and DQ (%) DQ weight based on customer
feedback (%) Component weight based on customer feedback Relation between
Component and DQ (%) DQ weight based on customer feedback (%) Component
weight based on customer feedback
Multiple speed 50.00 14.29 7.14 50.00 14.29 7.15
Airflow capacity 50.00 23.81 11.90 50.00 23.81
11.91
Quietness 38.46 19.05 7.33 30.77 19.05 5.86 30.77 19.05 5.86

Compact Size 22.39 4.76 1.07 22.39 4.76 1.07 22.39 4.76
1.07 17.90 4.76 0.85 14.93 4.76 0.70
Good look 42.86 9.52 4.08
28.57 9.52 2.72 28.57 9.52 2.72
Easy to clean 25.00 19.05 4.76 25.00 19.05
4.76 25.00 19.05 4.76 25.00 19.05 4.77
Multiple installment
100.00 9.52 9.52
27.44 7.15 15.77 23.60
8.33 17.71

Table 6 presents the allocation of target production cost based on customer’s

requirements and value indices for cost improvement. The 3rd column of this table
shows the weight of the components according to the actual cost allocation. Value
index (column 4) is one of the most important phases of target costing system as
it indicates the scopes for improvements and the level of effort to achieve the
target cost. The value index for motor (27.44/38.89=0.71) indicates that the
actual cost is significantly higher than the target cost and implies that an
effort for reducing the cost is essential. A value index of greater than 1 (e.g.,
body and blade) indicates items whose relative importance is higher than its
relative cost. However, if the component is adequate for the function it performs
(e.g., blade guard = 1), and the customer is satisfied with that performance,
there is no need to upgrade the component. Value indices of less than one indicate
components (e.g., motor, control/switch, installation frame) whose cost is
proportionally greater than the component’s importance to the customer. These may
be targets for cost reduction because they may represent over-engineered
components.

Table 6: Target cost, actual cost and value indices for

improvement

Components Component weight based on

customer feedback
(%) Ratio based on
actual cost
(%) Value
index
Action implied
Allocated
Target cost
($15×Col. 2)
Cost based
on current
situation
Motor 27.44 38.89 0.71 Cost reduce required 4.12 7.00
Control/switch 7.15 13.89 0.52 Cost reduce required 1.08 2.50
Body 15.77 11.11 1.42 Room for improve 2.37 2.00
Blade 23.60 5.56 4.25 Room for improve 3.54 1.00
Blade guard 8.33 8.33 1.00 Target achieved 1.25 1.50
Installation frame 17.71 22.22 0.79 Cost reduce required 2.65 4.00
100.00 100.00 15.00 18.00

The example is a simplified version of what exists in the real world. The cost
allocation process under the Target costing framework can be improved to a higher
level of sophistication or perfection by introducing QFD, VE tools which we did
not include in the example to keep it simple (Hoque, et al, 2000; Hoque and
Monden, 2002; Hoque, Akter and Monden, 2000).

4. Conclusion

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. The first part of the
process is driven by customer, market, and profitability considerations. Given
that profitability is critical for survival, a target profit margin is established
for all new product offerings. The target profit margin is derived from the
company’s 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.
For any given product, a target-selling price is determined by using various sales
forecasting techniques. When 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.
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 associated with existing capacities and capabilities.
The difference between the current cost and the target cost indicates the required
cost reduction. This amount may be divided into a target cost-reduction objective
and a strategic cost-reduction challenge. 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. Once the product-level
target cost is set, however, it generally cannot be changed, and the challenge for
those involved is to meet this target. Then, a series of intense activities
commences 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. 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.
Therefore, in target costing the adoption of a particular method of target cost
and profit depends on company’s ability in the periodical revision or continuous
improvement of the target profit and cost. In a target-costing environment,
identifying the appropriate degree of tightness of the targets for profit and cost
is very crucial factor to take into account. In certain situations performance
improves with the level of tightness while in the other circumstances, it
deteriorates. The tight but attainable target should be established for high and
persistent cost-reduction performance. In target costing, the overall accounting
process consists of target cost establishment and allocation processes. The policy
that is suitable for getting higher cost-reduction performance in the target cost
establishment process may not be desirable for the same in target cost allocation
process.
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.