Target Costing

Target costing involves setting a target cost by subtracting a desired profit from a competitive market price

In effect it is the opposite of conventional 'cost plus pricing'.

Music Matters manufactures and sells cds for a number of popular artists. At present, it uses a traditional
cost-plus pricing system

Cost-plus pricing system

- The cost of the cd is established first. This is $14 per unit.
- A profit of $5 per unit is added to each cd
- This results in the current selling price of $19 per unit.
Required profit = $5 per cd
Cost = $14 per cd Selling price is $19 per cd

However, cost-plus pricing ignores:

- The price that customers are willing to pay – pricing the cds too
high could result in low sales volumes and profits.

The price charged by competitors for similar products – if competitor's are charging
less than $19 per cd for similar cds then customers may decide to buy their cds
from the competitor companies.

Cost control – the cost of the cd is established at $14 but there is little incentive to control this cost.

Target costing
Music Matters could address the problems discussed above through the implementation of target costing:

The first step is to establish a competitive market price. The company would consider how
much customers are willing to pay and how much competitors are charging for similar products
Let's assume this is $15 per unit.

Music Matters would then deduct their required profit from the selling price. The required
profit may be kept at $5 per unit.

A target cost is arrived at by deducting the required profit from the selling price,
i.e. $15 – $5 = $10 per unit.

The cost gap can then be identified. In this case the current cost per unit of $14 per unit must
be reduced to the target cost of $10. A gap of $4 per unit must be closed.

Steps must then be taken to close the target cost gap (see below for further details).

(2) Required profit = $5 per cd

(1) Cost = $10 per cd (3) Selling price is $15 per cd
etitive market price

uses a traditional

rol this cost.

of target costing:
Step 1
A target price is set, based on the perceived value of product.
(this will be a market based price)

Step 2
The required target operating profit per unit is then calculated.
(this may be based on either return on investment or return on sales)

Step 3
The target cost is arrived at by deducting the target profit from
the target selling price

Step 4
The cost gap is then calculated

Step 5
If there is a cost gap, attempts will be made to close the gap
Techniques such as value engineering may be used to observe
every aspect of business function, with an objective of reducing cost
Target cost gap = Estimated product cost – Target cost

It is the difference between what an organisation thinks it can currently make a product for,
and what it needs to make it 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 can be asked to reduce costs

- 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 without compromising quality, for example, by using lower skilled workers?
- Can productivity be improved, for example, by improving motivation?
- Can production volume be increased to achieve economies of scale?
- 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 w
This process is known as ‘value analysis’. Attention should be focused more on reducing the costs of features percei
customer not to add value
wer skilled workers?

eliminated by

mer perceived quality and which are not.

ng the costs of features perceived by the
Question

Company Cee is currently considering expansion into manufacturing two new products, a printer and a digital camer
Company Cee normally uses a pricing policy of a 10% mark-up on standard prime cost on its products.
However, as both the printing and camera markets are highly competitive, the finance director is considering
using a target costing approach but wants to retain the same mark-up.

Printer
The maximum price the market will support is $200 per unit of the new printer. 60% of the direct cost of each
printer is expected to be polymer.

Digital Camera
40% of the direct cost of each digital camera is expected to be software. The minimum price Company
Cee can source the software necessary to make one digital camera is currently $76, which has been
built into the budget. On this basis, Company Cee has determined that the cost gap between the budgeted
cost per digital camera and the target cost per digital camera is $23.70.

Required
What is the target cost of the polymer used in the manufacture of printers?

Assuming that target costing principles are adopted, what is the maximum selling
price that Company Cee can charge per digital camera?

Solution

Printer Target cost keeping in mind 200 selling price and 10%

Cost 100.00 181.82 [ 181.82 = 200 * 100 / 110 ]

Add: Mark-up 10.00 18.18
Selling Price 110.00 200.00

Target selling price

Polymer is 60% of cost = 181.82 * 60% = 109.09

Camera

Maximum price that can be charged = Target cost + Markup

Actual cost calculation

Software cost - Given 76
Software cost is 40% of total direct cost
Total direct cost 190 [ 76 / 40% ]

Target cost gap = Estimated budgeted cost - Target cost = 23.70

23.70 = 190 - Target cost
Target cost = 190 - 23.70 = 166.30

Selling price is after a 10% markup and markup is always on cost

166.30 + 10% of 166.30 = 182.93
ducts, a printer and a digital camera.
cost on its products.
nce director is considering

% of the direct cost of each

mum price Company

, which has been
between the budgeted

n mind 200 selling price and 10% markup on cost

Solution

Cost 100.00 96.0 Target cost

Mark up 25.00 24.0
Selling price 125.00 120.0 Selling price

Of the target cost, 46$ is the VC, leaving 50$ as Fixed cost
The current budgeted output is $600000 (10000 units * 60$)
So if these are to be absorbed at 50$ than the min prod must be 12,000 units

Solution:

Invst 1,000,000 440,000

Return 150,000
1,150,000 290,000
362.50

Solution

Invst 250,000 125,000

Return 37,500
87,500
175.00
Solution
100.0 44.8
25.0 11.2
125.0 56.0

MC 20.00

Labour Rat 24.80

Labour Rat 12.40

Value Analysis

Value analysis is a technique in which a firm’s products, and maybe those of its competitors, are subjected
to a critical and systematic examination by a small group of specialists. They can be representing various
functions such as design, production, sales and finance.

Value analysis seeks to close the cost gap by asking of a product the following questions: does it need
all of its features? Can a usable part be made better at lower cost?

A cost advantage may be obtained in many ways, e.g. economies of scale, the experience curve, product
design innovations and the use of ‘no-frills’ product offering. Each provides a different way of competing
on the basis of cost advantage.

Types of Value

Cost value: this is the cost incurred by the firm incurring the product

Exchange value: the amount of money that consumers are willing to exchange
to obtain ownership of the product, i.e. its price.

Use value: this is related entirely to function, i.e. the ability of a product to
perform its specific intended purpose. For example, a basic small car provides
personal transport at a competitive price and is reasonably economic to run.

Esteem value: this relates to the status or regard associated with ownership.
Products with high esteem value will often be associated with premium or even
price-skimming prices.
titors, are subjected
e representing various

ns: does it need

ce curve, product
way of competing
Question

The Swiss watchmaker Swatch reportedly used target costing in order to produce relatively low-cost,
similar-looking plastic watches in a country with one of the world’s highest hourly labour wage rates.

Suggest ways in which Swatch may have reduced their unit costs for each watch.

Solution
vely low-cost,
our wage rates.
Problems with target costing in service sector

The intangibility of what is provided means that it is difficult to define the ‘service’ and attribute costs

Inseparability/simultaneity of production and consumption: although the manufacturer of a tangible good

may never see the actual customer, customer often must be present during the production of a service, and
cannot take the service home. No service exists until it is actually being experienced/consumed by the person
who has brought it.

Heterogeneity – The quality and consistency varies, because of an absence of standards or benchmarks
to assess services against. In the NHS, there is no indication of what an excellent performance in service
delivery would be, or any definition of unacceptable performance

Perishability – the unused service capacity from one time period cannot be stored for future use. Service provid
and marketers cannot handle supply-demand problems through production scheduling and inventory techniques

No transfer of ownership – Services do not result in the transfer of property. The purchase of a service
only confers on the customer access to or a right to use a facility.
d attribute costs

urer of a tangible good

on of a service, and
nsumed by the person

s or benchmarks
mance in service

uture use. Service providers

nd inventory techniques

hase of a service