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CHAPTER - 8

TARGET COSTING

DEFINING TARGET COSTING


Target

costing is a cost management tool for


making cost reduction a key focus throughout
the life of a product.
The purpose of target costing is to identify the
production cost for a proposed product such
that the product, when sold, generates the
desired profit margin.

MEANING OF TARGET COSTING


Target

costing requires a company to first determine what


a customer will pay for a product and then work backward
to design the product and production process that will
generate a desired level of profit.
The emphasis of target costing is on proactive, up-front
planning throughout every activity of the new product
development process.

OBJECTIVE OF TARGET COSTING


A

desired, or target cost is set before creating or even


designing the product.
A basic goal of target costing is to reduce costs before
they occur. After all once a company has incurred costs it
cannot change them.
Thus target costing focuses on reducing costs in the
product design and development stages- when costs can
really be affected. Product design affects a vast majority
of costs. It is not easy to reduce these costs once
production begins.
Such a strategy is especially important when product life
cycles are short. Because most product life cycles are
shrinking, use of target costing is expanding.

KEY PRINCIPLES OF TARGET


COSTING
Emphasis

on understanding customer demands. While


customer input is obtained early in the marketing research
process, it is also collected continually throughout the
target costing process
Emphasizing the importance of target price and profit
determination before calculating the target cost.
Emphasizing the importance of early cost planning to
reduce costs incurred over the products entire life time.
Indicating that a cross functional team is needed to
successfully implement target costing.

TARGET COSTING PROCESS


1. Market research is conducted before product
development to determine the customer
demands and requirements and the price the
customer is willing to pay.
Customer input is sought on the design of
product features. The cost of the feature is
compared to its value to determine whether to
add it to the product. It is important to
determine what a customer will pay for a
product. This is the products predicted price.

2. Determine the desired profit margin.


3. Determination of target cost.
Management bases the target cost on the
products predicted price and the companys
desired profit.
The target cost is the difference between the
target selling price and the target profit margin
4. Determine target costs for each component.
Management accountants are responsible for
setting final targets for all components and
processes.

5.

Reduction and control costs to achieve the target


cost.

Managers must then try to reduce and control costs


so that the products cost does not exceed its target
cost.
A cross-functional team consisting of design and
manufacturing engineers, procurement, and
marketing, as well as management accountants now
must determine if the company can implement cost
reductions large enough to meet the target cost.
The cross-functional team which is made up of
individuals representing the entire value chain
guides the process throughout from both inside and
outside the organization.

Value engineering is used during the design stage.


Value engineering is a cost reduction technique that
uses information about all value chain functions to
satisfy customer needs while reducing costs.
The value chain consists of functions within a
company that add value to a product or service.
The value engineering process includes examination
of each component of a product to determine whether
it is possible to reduce costs while maintaining
functionality and performance.

The companies that use target costing often go


beyond the internal chain to involve both customers
and suppliers during the design process.
Suppliers play a critical role in making target costing
work- If there is a need to reduce the cost of specific
components, firms will ask their suppliers to find
ways to reduce costs.
In some cases, product design may change, materials
used in production may need replacing, or
manufacturing processes may require redesign.
Several iterations usually are needed before it is
possible to determine the final target cost.

ADVANTAGES OF TARGET
COSTING
Forced

planning
Cost reductions
Competitive atmosphere
Team spirit

PROBLEMS IN TARGET COSTING


Increase

in Product Development time : It may


require a number of designs before it can devise a
sufficiently low cost product. (Repeated value
engineering cycles to reduce costs).
May lead to the product coming late to market.
For some types of products, being six months late
may be far more costly than having small cost
overruns.
Accountability : Large amount of mandatory cost
cutting can result in finger pointing in various parts
of the company.

Lack

of consensus: Different representatives of design


team may not reach a consensus on product design
because of too many options regarding design issues.
Alienation and/or failure of subcontractors and
suppliers : Excessive pressure on subcontractors and
suppliers to conform to a schedule and reduce costs can
lead to alienation and/or failure of the subcontractor
Lack of Cost consciousness in other parts of the
organization: Design engineers may become upset
when other parts of the organization are not cost
conscious
They argue that they exert much effort to squeeze pennies
out of the cost of a product while other parts of the
organization (administration, marketing, distribution) are
wasting dollars.

Employee

burnt-out: Employees in many Japanese


companies working under target costing goals
experience burnt-out due to the pressure to meet the
target cost.
Burnt-out is particularly evident in design
engineers.

COST-PLUS PRICING
Adding a standard markup to cost
Ignores demand and competition
Popular pricing technique because:
It simplifies the pricing process
Price competition may be minimized
It is perceived as more fair to both buyers and
sellers

EXAMPLE
Question: Variable cost = Rs 20, Fixed cost = Rs
5,00,000, Expected sales = 1,00,000 units, Desired
Sales Markup = 20%. Calculate Markup Price.
Solution: Unit Cost = Variable Cost + Fixed Cost
Unit Sales
= Rs 20 + Rs 5,00,00
1,00,000
= Rs 25 per unit

Markup

Price =

Unit Cost
(1 Desired return on sales)
= Rs 25
(1- 0.20)
= Rs 31.25 per unit

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