Definition, Explanation and Formula of Target Costing:

Target costing is the process of determining the maximum allowable cost for a new
product and then developing a prototype that can be profitably made for that maximum
target cost figure. A number of companies--primarily in Japan--use target costing,
including Compaq, Culp, Cummins Engine, Daihatsu Motors, DaimlerChrysler, Ford, Isuzu
Motors, ITT, NEC, and Toyota etc.

The target costing for a product is calculated by starting with the product's anticipated
selling price and then deducting the desired profit. Following formula or equation further
explains this concept:

Target Cost = Anticipated selling price – Desired profit

The product development team is then given the responsibility of designing the product so
that it can be made for no more than the target cost.

Following set of activities further explains the concept of target costing technique:

TARGET COSTING PROCESS DIAGRAM

  Determine Customer Wants and Price Sensitivity

  ↓
  Planned Selling Price is Set

  ↓
Target Cost is Determined As: Selling Price Less Desired
  Profit

  ↓
Teams of Employees from Various Areas and Trusted
  Vendors Simultaneously

  ↓
Determine Determine
  Design Product Manufacturing Necessary Raw
Process Materials

  ↓
Costs are Considered Throughout this Process. The
  Process Requires Trade-offs to Meet Target Costs

  ↓
Once Target Cost is Achieved the Manufacturing Begins
and Product is Sold

Reasons for Using Target Costing Technique:

The target costing approach was developed in recognition of two important
characteristics of markets and costs. The first is that many companies have less control over
price than they would like to think. The market (i.e., supply and demand) really determines
prices, and a company that attempts to ignore this does so at its peril. Therefore, the
anticipated market price is taken as a given in target costing. The second observation is that
most of the cost of a product is determined in the design stage. Once a product has been
designed and has gone into production, not much can be done to significantly reduce its
cost. Most of the opportunities to reduce cost come from designing the product so that it is
simple to make, uses inexpensive parts, and is robust and reliable. If the company has little
control over market price and little control over cost once the product has gone into
production, then it follows that the major opportunities for affecting profit come in the
design stage where valuable features that customers are willing to pay for can be added and
where most of the costs are really determined. So that it is where the effort is
concentrated--in designing and developing the product. The difference between target
costing and other approaches to product development is profound. Instead of designing the
product and then finding out how much it costs, the target cost is set first and then the
product is designed so that the target cost is attained.

Example of Target Costing:

To provide a simple numerical example of target costing, assume the following
situations:

Handy Appliance Company feels that there is a market niche for a hand mixer with certain
new features. Surveying the features and prices of hand mixers already in the market, the
marketing department believes that a price of $30 would be about right for the new mixer.
At that price, marketing estimates that 40,000 of new mixers could be sold annually. To
design, develop, and produce these new mixers, an investment of $2,000,000 would be
required. The company desires a 15% return on investment (ROI). Given these data, the
target cost to manufacture, sell, distribute, and service one mixer is $22.50 as calculated
below:

Projected sales (40,000 mixers  $30 per mixer ) $1,200,000

Less desired profit (15%  $2,000,000) 300,000
  ------------
Target cost for 40,000 mixers $9,00,000
  =======
Target cost per mixer ($9,00,000 / 40,000 mixer) $22.50

This $22.5 target cost would be broken into target cost for the various functions:
manufacturing, marketing, distribution, after-sales service, and so on. Each functional area
would be responsible for keeping its actual costs within target.

Advantages and Disadvantages of Target Costing Approach:

Target costing has the following main advantages or benefits:

1. Proactive approach to cost management.

2. Orients organizations towards customers.
3. Breaks down barriers between departments.
 4. Implementation enhances employee awareness and empowerment.
5. Foster partnerships with suppliers.
6. Minimize non value-added activities.
7. Encourages selection of lowest cost value added activities.
8. Reduced time to market.

Target costing approach has the following main disadvantages or limitations:

1. Effective implementation and use requires the development of detailed cost data.
2. its implementation requires willingness to cooperate
3. Requires many meetings for coordination
4. May reduce the quality of products due to the use of cheep components which may
be of inferior quality.

In Business | Target Costing Approach--An Iterative Process:

Target costing Technique is widely used in Japan. In the automobile industry, the target
cost for a new model is decomposed into target costs for each of the elements of the car--
down to a target cost for each of the individual parts. The designers draft a trial blueprint,
and a check is made to see if the estimated cost of the car is within reasonable distance of
the target cost. If not, design changes are made, and a new trial blueprint is drawn up. This
process continues until there is sufficient confidence in the design to make a prototype car
according to the trial blueprint. If there is still a gap between the target cost and estimated
cost, the design of the car will be further modified.

After repeating this process a number of times, the final blueprint is drawn up and turned
over to the production department. In the first several months of production, the target
costs will ordinarily not be achieved due to problems in getting a new model into
production. However after that initial period, target costs are compared to actual costs and
discrepancies between the two are investigated with the aim of eliminating the
discrepancies and achieving target costs.

Source: Yasuhiro Monden and Kazuki Hamada, "Target Costing-Kaizen Costing in Japanese Automobile
Companies," Journal of Management Accounting Research 3, pp. 16-34.

You may also be interested in other articles form "pricing products and
services" chapter:

1. Price Elasticity of Demand - Economists' Approach to Pricing

2. Absorption Costing Approach to Cost Plus Pricing
3. Target Costing
4. Time and Material Pricing in Service Companies