Learning objectives

At the end of this lecture, participants should be able to discuss:

 the meaning of target costing

 the primary steps in target costing process
 the features and key principles of target costing
 the benefits of adopting target costing
 the limitations of target costing
 the meaning of value and value engineering
 value engineering Methodology/ Job Plan
 the relationship between target costing and value engineering

Introduction

For more than a decade, target costing has been recognized as an important tool for lowering
costs and increasing competitiveness in a competitive market price environment. Target costing
has its origin in Japan in the 1960s; the Japanese industry adapted the American idea of value
engineering and expanded it into a dynamic cost reduction system (Ansari & Bell, 1997). It is a
customer- and market- orientated cost management method, which is conceptually different from
standard costs, wherein the costs are driven from the production and internal factors. “Target
costing is a comprehensive cost planning, cost management and cost control concept used
primarily at the early stages of product design in order to influence product cost structures
depending on the market derived requirements. The target costing process requires the cost-
oriented co-ordination of all product related organizational functions,” (Horvath, 1993). An
explanation of the target costing goal came from Cooper (2001) where he opined that the object
of target costing is to identify the production cost of a product so that, when sold, it generates the
desired profit margins.
To competes effectively in today’s competitive market, organization must continually redesign
their products with the aim of meeting customers’ needs while achieving the desired profit. The
planning, development and design stages of a product is therefore very critical to an organization
process. Cost of production at this stage of the product’s cost life cycle is one of the most
important issues facing or confronting management accountant in the manufacturing industry

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rather than any other production process. Thus, target cost management will be interested in
managing costs in new product planning, development and design stages such that production
cost of a proposed product can be identified immediately.

Meaning of Target Costing

To compete effectively in today’s competitive market, organizations must continually redesign

their products with the result that product life-cycles have become much shorter. The planning
development and design state of a product is therefore critical to an organization’s cost
management process. Cost reduction at this stage of a product’s cost life-cycle, rather than
during the production process, is now one of the most important issues facing management
accountants in industry.
Target costing involves setting a target cost by subtracting a desired profit margin from a
competitive market price.
It is a customer-focused management tool used to determine the market price for a new product,
in which market research is adopted as a basis for measuring performance needs and setting
target selling price. In this type of techniques management change the way they think about the
relationship between cost, price, profit and set benchmarks for the improvement towards target
costs, by improving technologies and processes.

Target costing is a reverse process where companies compare the potential intended benefits of a
product or solution with the optimal market price. Once an ideal price point is established, you
set an ideal profit margin. Your profit goals show the necessary cost basis, or target cost, you
must achieve when developing the product. This is a common financial technique, and it can be
beneficial to small producers and resellers trying to compete in the marketplace.
Traditionally, the approach to developing a product involves determining the production cost of
that product, set a selling price with a resulting profit or loss, or to develop a product cost, set a
selling price and desired profit margin, with a resulting cost which be achieved.

A major feature of target costing is that a team approach is adopted to achieve the target cost.
The team members include designers’ engineers, purchasing, manufacturing, marketing and
management accounting personnel i.e. to say a team of designers, engineers, marketing,

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purchasing and production personnel, together with the management accountant would
concentrate on producing a product that meets the target cost requirement. The management
accountant’s role is to produce cost estimates for the various projected product designs, measure
and monitor product cost once the production process begins. Value engineering undertakes and
works with the project team closely with the design engineers. Their objective is to identify new
design that will accomplish the same functions at a lower cost and also to eliminate any functions
that are deemed to be unnecessary. Apart from that, their aim is to achieve the target cost
specified for the product at the prescribed level of functionality and quality. Target costs usually
incorporate learning effects overtime.

Thus, where the target costing approach is adopted, market prices determine product costs, and
cost-plus pricing is not used. Even though the calculated cost of a new product may exceed its
target cost, it is target cost that forms the basis for product decisions. Production management is
expected to meet the target costs. Target costing therefore involves working backwards from the
target competitive price to a target cost, at a specified demand level, which then becomes the
goal to achieve. In contrast with the cost-plus pricing approach, costs are measure first and a
mark-up is added to determine the selling price. Target costing therefore overcomes the problem
of having to estimate demand prior to setting selling price, which is a feature of the cost-plus
pricing method.

Note that if the predicted actual cost is above the target cost, intensive efforts are made to close
the gap so that the predicted cost will be equals to the target cost.

Primary Steps in Target Costing Process

The primary steps in target costing process requires a step by step approach which include;

(a) Establish/ define the target cost: The first step in target costing process requires the
establishment of a target cost of the product to be produce. This will enable the producer to know
the benchmarks of the product cost.

(b) Conduct market research: The second step requires market research to determine the
customers’ perceived value of the product, its differentiation value relatives to competing

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products and the price of competing product. Apart from that the review of the market place in
which the company wants to sell the products.

The design team needs to determine the set of product features that customers are most likely to
buy, and the amount they will pay for those features. The team must learn about the perceived
value of individual features, in case they later need to determine what impact there will be on the
product price if they drop one or more features. It may be necessary to later drop a product
feature if the team decides that it cannot provide the feature while still meeting its target cost. At
the end of this process, the team has a good idea of the target price at which it can sell the
proposed product with a certain set of features, and how it must alter the price if it drops some
features from the product.

(c) Calculate maximum cost: The company provides the design team with a mandated gross
margin that the proposed product must earn. By subtracting the mandated gross margin from the
projected product price, the team can easily determine the maximum target cost that the product
must achieve before it can be allowed into production.

(d) Engineer the product: The engineers and procurement personnel on the team now take the
leading role in creating the product. The procurement staff is particularly important if the product
has a high proportion of purchased parts; they must determine component pricing based on the
necessary quality, delivery, and quantity levels expected for the product. They may also be
involved in outsourcing parts, if this results in lower costs. The engineers must design the
product to meet the cost target, which will likely include a number of design iterations to see
which combination of revised features and design considerations results in the lowest cost.

(e) Ongoing activities: Once a product design is finalized and approved, the team is
reconstituted to include fewer designers and more industrial engineers. The team now enters into
a new phase of reducing production costs, which continues for the life of the product. For
example, cost reductions may come from waste reductions in production (known as kaizen
costing), or from planned supplier cost reductions. These ongoing cost reductions yield enough
additional gross margins for the company to further reduce the price of the product over time, in
response to increases in the level of competition. The design team uses one of the following
approaches to more tightly focus its cost reduction efforts:

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(f) Tied to components: The design team allocates the cost reduction goal among the various
product components. This approach tends to result in incremental cost reductions to the same
components that were used in the last iteration of the product. This approach is commonly used
when a company is simply trying to refresh an existing product with a new version, and wants to
retain the same underlying product structure. The cost reductions achieved through this approach
tend to be relatively low, but also result in a high rate of product success, as well as a fairly short
design period.

(g) Tied to features: The product team allocates the cost reduction goal among various product
features, which focuses attention away from any product designs that may have been inherited
from the preceding model. This approach tends to achieve more radical cost reductions (and
design changes), but also requires more time to design, and also runs a greater risk of product
failure or at least greater warranty costs.

Target costing is a customer-oriented technique that is widely used by Japanese companies and
which has recently been adopted by companies in Europe and the United States of America.
Information that enables target costing operates successfully is needed from a wide range of
support systems which include:
(i) Sales pricing systems
(ii) Target profit computation support systems
(iii)Research and Development support systems
(iv) Value Engineering and Variety Reduction
(v) Human Resources/Capital Management Systems

Features and Key Principles of Target Costing

The major feature of target costing is that a team approach is adopted to achieve the target cost.
The team members include designers, engineers, purchasing, manufacturing, marketing and
management accounting personnel. Their aim is to achieve the target cost specified for the
product at the prescribed level of functionality and quality.
Be that as it may, target costing contains six key ideas, which are mentioned in Ansari, Bell,
Klammer and Lawrence (1997):
1. Price led costing

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Target costing sets the target cost by first determining the price at which a product can be sold in
the marketplace. Subtracting the target profit margin from this target price (competitive market
price) yields the target cost, that is, the cost at which the product must be manufactured. This is
simple, but strategically important, relationship can be expressed in the following equation.
C=P-π
C = Target cost
P = Competitive market price
π = Target profit

Notice that in a target costing approach, the price is set first, and then the target product cost is
determined. This is opposite from the order in which the product cost and selling price are
determined under traditional cost-plus pricing.

2. Customer driven
To be successful at target costing, management must listen to the company’s customers. What
products do they want? What features are important? How much are they willing to pay for a
certain level of product quality? Management needs to aggressively seek customer feedback, and
then products must be designed to satisfy customer demand and be sold at a price they are
willing to pay. In short, the target costing approach is market driven.
3. Design
Design engineering is a key element in target costing because the cost reduction process takes
place at the design stage. The design of a product and the production process is the core of cost
reduction. Engineers must design a product from the ground up so that it can be produced at its
target cost. This design activity includes specifying the raw materials and components to be used
as well as the labor, machinery, and other elements of the production process. In short, a product
must be designed for manufacturability. Every aspect of the production process must be
examined to make sure that the product is produced as efficiently as possible. The use of touch
labor, technology, global sourcing in procurement and every aspect of the production process
must be designed with the product’s target cost in mind.
4. Cross-functional product teams
Manufacturing a product at or below its target cost requires the involvement of people from
many different functions in an organization: market research, sales, design engineering,

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procurement, production engineering, production scheduling, material handling, and cost
management. Individuals from all these diverse areas of expertise can make key contributions to
the target costing process. Moreover, “a cross-functional team is not a set of specialists who
contribute their expertise and then leave; they are responsible for the entire product.”

5. Life cycle costing

Target costing considers all costs of a product over its whole life cycle. In specifying a product’s
target cost, analysts must be careful to incorporate all of the product’s life-cycle costs. These
include the costs of product planning and concept design, preliminary design, detailed design and
testing, production, distribution, and customer service. Traditional cost- accounting systems have
tended to focus only on the production phase and have not paid enough attention to the product’s
other life-cycle costs.
6. Value chain
Sometimes the projected cost of a new product is above the target cost. Then efforts are made to
eliminate non-value-added costs to bring the projected cost down. In some cases, a close look at
the company’s entire value chain can help managers identify opportunities for cost reduction. For
example, order-entry computers in stores. This resulted substantial savings in order-processing
costs for both companies.
All members of the supply chain are involved in the target costing process, such as supplier,
dealers, service and support personal. It is based on an active and collaborative relationship,
where all members of the chain share cost reduction techniques.

Benefits or Advantages of Target costing

Target costing as a cost reduction technique can be beneficial in the following ways;

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

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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.

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 more fine-tuned. Target costing
involves consideration of all equipment, processes, labor and materials needed to make goods, or
the costs to acquire goods and get them ready to sell to your customers.

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.

Profitability

If it's effective, target costing ultimately gives your business greater profitability. It considers
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 customer will value. In essence, you achieve the
optimal price-to-cost relationship possible for your products.

Limitations of Target Costing

The following are the limitations of target costing:

(i) It results in employee’s demotivation as pressure is mounted to meet target
(ii) It consumes longer product development time because of many changes to designs and
costing.

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 (iii)There exist conflicts (organizational conflicts) between designers who try to reduce costs
and marketing staff who give away promotional items costing even more.

Illustration of target costing

Illustration I.
Cadbury Nigeria Plc employed Mr. John Joseph a management accountant to determine the
target cost of a product, whose price will be set at ₦1,000. The company requires a minimum
profit margin of 10%.
Suggested solution
CADBURY NIGERIA PLC
Target selling price= ₦1,000
Profit margin = 10% * ₦1,000 = ₦100
Target cost = ₦1,000 – ₦100 = ₦900
Therefore, the target cost of the product is determined at ₦900.

Illustration II
Suppose a company is planning to produce a new product. Market research information suggests
that the product should serve 10,000 units at N21 per unit.

The company seeks to make a mark-up of 40% of the product cost. It is estimated that the life
time cost of a product will be as follows:

(a) Design and development cost N50,000

(b) Manufacturing cost N10 per unit

(c) End of life cost N20,000

The company estimates that it requires to spend additional N15,000 on design, manufacturing
cost per unit could be reduced.

Required:

(a) What is the target cost of the product?

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(b) What is the original life cycle cost per unit and the product?

(c) If the additional amount were spent on design, what is the maximum cost per unit that
could be tolerated if the company is to earn its required mark-up.

Solution

(a) To find the target cost of the product.

Note: Target cost – N21

Cost Profit

100% 40%

:. Selling price = 100% + 40% = 140%

= 21 x 100/140 = 15

Target cost = N15

(b) R & D = N50,000

Manufacturing cost = (N10 x 10,000) = N100,000

End of life = N20,000 ÷ 10,000 units

170,000

= N17 per unit

But target cost = N15, while life cycle cost = N17

Advice: - The product should not be produced because, the life cycle is more than the
target cost.

(c) To find the additional cost were spent:

Target cost = N15

We know that manufacturing cost = N10

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 R & D = 50,000

End of life = 20,000

Additional cost = 15,000 ÷ 10,000 unit

85,000
= N8.50

:. The acceptable cost price that will be tolerated = N15 – N8.50

= N6.50 is the acceptable to be tolerated

:. N6.50 is the acceptable manufacturing cost per unit.

Meaning of Value and Value Engineering

Meaning of Value

According to the Society of American Value Engineering (SAVE) 1998, the concept of value
can be defined “as the lowest possible cost to reliably provide required functions at the desired
time and place with the essential quality and other performance factors to meet user
requirements.”

Therefore, if a product meets the requirements of the users at the lowest price, then that product
is considered valuable. “Functionality and cost thus define what value can be placed on a
product,” (Sperling, 2001). “Clearly a value-added activity is an activity that customers perceive
as adding usefulness to the product or service they purchase,” (Feather, 1998). Cost should not
be mistaken for value, added cost should improve quality of function been provided unless value
is reduced. Function, quality, and cost constitutes and determines what makes a value to the
customer.

Therefore, value can be measured and represented in a formula as:

FUNCTION + QUALITY
COST

Where:

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Function = The function of a given product or component is the given tasks that a component
must fulfill. Therefore, identifying the function of a product/component is essential step in value
improvement because it leads to creative thinking that lead to developing alternative. If a product
does not perform its set out function, it is of no benefit and economic value to its users and all
cost reduction will not be achievable. Udot (2013), states that “functions beyond what is needed
are also of little value to the user. Anything less than required performance is unacceptable.
Anything more than required performance is unnecessary and wasteful. Therefore, carefully
defined functions can achieve the best value and properly determine and assign costs.” function
analysis is recommended to be carried out by all members for the successful application of VE
job plan.

Quality/worth = It is the owners or user’s need, desires and expectations. A product worth
comprises of those benefits, satisfaction to be derived from using the product. If the product fails
to provide the desired satisfaction and benefits, therefore the worth is poor.

Cost = cost comprises initial cost-plus life cycle cost which the long-term cost that is involved in
keeping the product in service and functional. In Value Engineering, the value of a product can
be ascertained based on the product functionality which means that products value can be
improved on by enhancing the function or by reducing cost or both actions simultaneously.

Meaning of Value Engineering

According to West Virginia division of highway (2004), “Value engineering is the systematic
application of recognized technique by multi- discipline team that identifies the function of a
product or service, establishes a worth for that function; generates alternative through the use of
creative thinking, and provides the needed functions, reliability at the lowest overall cost.” This
approach requires that in the process of mini mizing cost, the required quality and
performance should not be sacrifice. Value engineering as a technique involves the
identification of new alternatives to product design at a reduced cost (Celestine, 2016).
It is defined “as the systematic application of recognized techniques which identify the
function of the product or service, establish a monitory value for that function and provide the
necessary function reliability at the lowest overall cost,” (Chougule and Kallurkar, 2012).

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Abdulaziz (2010) opined that “Value Engineering can improve decision-making that leads to
optimal expenditure of owner funds while meeting required function and quality level. This
means that value engineering is a management technique for cost control.” “VE is a tool
whose strength lies in the ability to clearly delineate design alternatives and to suggest choices
based on the necessity or desirability of the function, the economic availability achieving that
function, and the cost-worth relationships that assures growth and prosperity” (UDOT, 1993).

Value engineering is defined by the Chartered Institute of Management Accountants (CIMA) as

the functional analysis and redesign of products and services to provide value to the customer.
Value engineering helps businesses achieve cost efficiencies and meet their cost and profitability
targets.

Currently, business organizations are in constant search for skilled employees that can constitute
a multi-disciplinary to solve complex problems like the value engineering team. Value
engineering is a productivity improvement approach that increases the value derived from a
product by a customer at a lower price with the same functionality. It is defined as “a complete
system for identifying and dealing with factors that cause un-contributing cost or effort in
products, process, or services. This system uses all existing technologies, knowledge and skills to
efficiently identify cost or efforts that do not contribute to the customer’s need and wants”
(Miles,1989).

Drury (2000) asserted that “The aim of Value Engineering is also to achieve an assigned target
product cost by (i) identifying improved product designs that reduce the product’s cost without
sacrificing functionality and/or (ii) eliminating unnecessary functions that increase the product’s
costs and for which customers are not prepared to pay extra for.” According to Sivaloganathan,
Kermode and Shahin (2000), “Value Engineering is a form of cost /benefit analysis where
functions are viewed as the beneficial characteristics of the product.” Value Engineering
technique is centered on value concept and it show whether a cost is worth incurring or not.

Value Engineering is quite different from value analysis as both terms may sound the same and
may raise a conflicting concept, Value Engineering is applied to the product at the design stage
and thus ensures prevention rather than elimination while value Analysis is applied to the
existing product with a view to improve its value and it is a remedial procedure. Though the two

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terms are use synonymously and philosophy underlying is same. But the two approaches are
different; the difference lies in time and phase of product life cycle at which the technique is
applied

Value Engineering Methodology/ Job Plan

Another name for Value engineering (VE) methodology the “job plan” is applicable in
organizations. According to West Virginia Department of transportation (2004), “The VE job
plan is an organized plan of action for accomplishment of value engineering studies. It is a
vehicle to carry the project from inception to conclusion. By adhering to certain formalities, the
VE job plan ensures that consideration is given to all necessary facets of the problem.
Although the job plan divides the study into a distinct set of work elements, judgment is
necessary to determine the depth to which each phase is performed as a function of the resources
available and the results expected.”

It encourages creativity so as to ascertain the alternative choices for development of the product/
project. It divides the plan into eight (8) phases which must be carried out sequentially. They are
as follows namely:

1. Orientation Phase: This is the first phase in VE job plan and it is carried out in preparation
for the value analysis by refining observed problem and preparing for the value study proper.
This phase is characterized by problem refining, data collection about the problem and
organizing strategies to follow up the problem.

2. Information Phase: At this phase, project information is gathered and reviewed among the team
members and questions such as ‘’What is it’? ‘What does it do’? And ‘what does it cost’? are
answered. It is critical that correct information be obtained at this stage otherwise alternatives
developed later will not suitably accomplish the required functions.

3. Function Analysis Phase: This phase has to do with identifying the most beneficial areas for
study. This phase is considered the soul of the Value Engineering process as it involves looking
back to the previous component so as to ascertain its functional value. The aim of the VE job plan is
to remove unnecessary functions that increases cost and provides an alternative and cheaper means
to perform the functions without sacrificing the value to be derived by customers. And this must be

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brainstorm and deemed acceptable by the design team. According to Oludimu (2008), “this phase
challenges the VE team to relate their functional findings to the product hardware in order for the
redesigning recommendations to be properly planned.” Also, Stocks and Singh (1999), Tucson
(1992); SAVE (1998); opined that “during this phase function models should also be developed
especially the FAST (Function Analysis System Technique) model combined with Programme
Evaluation and Review technique (PERT) and FACD (Function Analysis Concept Design) which
would allow for the clarification of product functions and the assignment of costs to these functions
in order to highlight areas that need improvement and redesigning.”

4. Creative Phase: According to Sperling, (2001) as cited by Oludimu (2008), describe this phase
as the “brainstorming” session. In this phase, alternative designs are provided through creative
thinking i.e. brainstorming by team members.

5. Evaluation Phase: This phase involves refining and selection of the most suitable alternative for
value-improvement recommendations by value engineering team members. In this phase the
alternatives are ranked in order of relevance and importance so as to choose the best out all
alternatives.

6. Development Phase: At this phase, the most ranked out of the alternatives are chosen and
presented to managers for decision-making in the organization. According to Hauser (1997), “The
objective of the Development phase is to expand the best ideas generated into workable solutions.”

7. Presentation Phase: This phase involves presenting the developed proposals in a formal
presentation to decision makers. The strategies and outcome of value engineering job plan will be
explained in details by a representative of the group.

8. Implementation Phase: in the implementation phase final approval of the proposal are
obtained in order to facilitate implementation. This Phase takes place when conclusive decision
has been taken by management. After which, authorization will be obtained after the completion of
follow-up actions such as providing more data and meeting with others. Implementation as soon as
the final authorization is granted.

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 Orientation Phase Information Phase

Function Analysis Phase

Creative Phase

Evaluation Phase

Development Phase

Implementation Phase Presentation Phase

Figure 1: Eight Phase of Value Engineering Job Plan

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Relationship Between Target Costing and Value Engineering

Target costing is a pricing method used by firms. It is basically a cost management tool or
technique for reducing the overall cost of a product over its entire production life-cycle with the
help of other personnel in production, engineering, research and design. A target cost is the
maximum amount of cost that can be incurred on a product of which the firm can still earn the
required profit margin from that product at a particular selling price. To achieve this, value
engineering employs a systematic means or application of recognized technique to identify the
factor affecting the cost of a product or services in order to devise means of achieving the
specified purpose at the required standard of quality and reliability of the target cost. The aim of
value engineering is to achieve the assigned target cost by providing the most acceptable design
standard for the product that would meet the customers perceive value of the product based on
functions or requirements in the market, identifying improved product designs that reduce the
product cost without sacrificing functionality and eliminating unnecessary functions that may
increase the products cost and for which customers may not prepared to pay extra. Value
engineering works closely with design engineer to identify new designs that will accomplish all
these.

Conclusion

In conclusion, it’s a well-known fact that executives of organizations across the globe seek to
deliver higher profit which entails reducing the cost of production. For this to be possible, there
should be effective cost management in the respective manufacturing companies. Effective cost
management start at the design stage because as much as 90-95% of a product's costs are added
in the design process. That is why effective cost management programs focus on design and
manufacturing. So be it, the primary cost management method to control cost during design is a
combination of target costing and value engineering.

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References

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Retrieved from www.alyousefi.com, aziz@alyousefi.com
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