GROUP 4

CAIGA, CASULLA, DATOR, DECENA & OBSANGA

TARGET COSTING
Learning Outcomes:

Once you've completed your review of the material, you will know the following:

1. Definition and objectives of target costing

2. Process and features of target costing
3. Advantages and disadvantages of target costing
4. Key principles of target costing
5. Example of real-life application of target costing
6. Necessary components of the formula of target costing
7. Practice problems related to target costing

History

Target costing originated in Japan in the 1960s, though it remained a secret for years. Since the 1980s, however, when target

costing was widely recognized as a major factor for the superior competitive position of Japanese companies, extensive efforts have

been made to convey target costing to Western companies. Many large companies in North America and Europe have tried to adopt

target costing to enhance their cost management and, thus, increase their competitiveness.

Definition of Target Costing

Target costing is a pricing method used by firms. It is defined as “a cost management tool for reducing the overall cost of a

product over its entire life-cycle with the help of production, engineering, research, and design”.

It is a system under which a company plans in advance for the price points, product costs, and margins that it wants to achieve

for a new product. Target costing is not just a method of costing, but rather a management technique wherein prices are determined

by market conditions, taking into account several factors, such as homogeneous products, level of competition, no/low switching costs

for the end customer, etc. When these factors come into the picture, management wants to control the costs, as they have little or no

control over the selling price.

Target Cost per unit = Target Price - Target Operating Income per unit
Target price - It is the estimated price of a product, which shall be payable by a potential customer. This estimate is based on the

understanding of the customer. The target price can be found by deducting the target income per unit from its target price.

Target operating income per unit - It is the income that a company aims to earn.

Target cost per unit - It is the estimated long-run cost of a product and the company tries to achieve its target income when the

product is sold out on target price. In target cost calculations, all future fixed and variable costs are included, because, in the long run,

the company must cover all its costs.

If target cost cannot be attained, then efforts are made to reduce the cost by redesigning and simplifying the product and by

changing the methods of production. In this connection, non-essential products are estimated. It is a technique, based on which cost

reduction and profit planning can be made.

Top 3 Objectives of a Target Costing System

The fundamental objective of target costing is to enable management to use proactive cost planning, cost management, and

cost reduction practices whereby, costs are planned and managed out of a product and business, early in the design and development

cycle, rather than during the later stages of product development and production. Broadly speaking, a target costing system has three

objectives:

To lower the costs of new products so that the required profit level can be
ensured.

The new products meet the levels of quality, delivery timing and price required by
the market.

To motivate all company employees to achieve the target profit during new
product development by making target costing a companywide profit
management activity.

Approaches to Target Costing

1. Price-based targeting
2. Cost-based targeting
3. Value-based targeting

A target cost is the maximum amount of cost that can be incurred on a product.

Price-based targeting

Sets target cost for the product through comparison with that of competitors.

This means setting the price of the product by observing what the market will bear, then deducting the desired profit margin

from the price, and thereby obtaining the target cost.

Cost-based targeting

It sets the cost first, then the desired profit margin is derived from the price of the product.
 This method requires the suppliers to reveal the various details of their cost structure and will sour the buyer-supplier

relationships so it isn’t good for the long run.

Value-based targeting

It sets the price by what it thinks the market will ‘value’ the product.

After that, the producer sets the desired profit margin and then tries all ways to keep the cost below that of the target cost.

Process of Target Costing

The process begins with a careful analysis of competing products and customer needs and wants. This leads to a specification of

product features and a price that the company believes will be attractive to customers given the product features. A thorough analysis

of competing products and customer needs and wants forms the foundation of successful target costing. By thoroughly analyzing

competing products, knowing customer expectations about features, quality, and price helps set realistic targets for the new product.

The next step in the target costing process is to specify a desired level of profit. This entails determining the target profit margin

for the business on each unit of the product under development. Typically, the target profit margin is stated as a percentage of the

selling price. For example, A business would want to target a 20% profit margin. The price and desired profit determine the target cost.

Finally, the product engineering department, working with substantial input from the cost accounting department, develops a

detailed design for a product that can be produced for a reasonable price. Cost accounting joins them. Engineers carefully consider

each design decision, material, and procedure, armed with precise cost targets and market information. They come up with value

engineering plans together, maybe looking for different suppliers, streamlining production processes, or exploring innovative

components. This is to design a product that satisfies consumer demands, exceeds rival products, and falls precisely inside the cost

target. If the product cannot be produced for a reasonable price, then the company will reconsider features and price.
Features of Target Costing

1. The price of the product is determined by market conditions. The company is a price taker rather than a price maker.
2. The minimum required profit margin is already included in the target selling price.
3. It is part of management’s strategy to focus on cost reduction and effective cost management.
4. Product design, specifications, and customer expectations are already built-in while formulating the total selling price.
5. The difference between the current cost and the target cost is the “cost reduction,” which management wants to achieve.
6. A team is formed to integrate activities such as designing, purchasing, manufacturing, marketing, etc., to find and achieve the
target cost.

The main feature of target costing is the price of the product as it is determined by market conditions. The company is a price

taker rather than a price maker, The minimum required profit margin is already included in the target selling price. It is part of

management’s strategy to focus on cost reduction and effective cost management. Product design, specifications, and customer

expectations are already built-in while formulating the total selling price. The difference between the current cost and the target cost is

the “cost reduction,” which management wants to achieve. A team is formed to integrate activities such as designing, purchasing,

manufacturing, marketing, etc., to find and achieve the target cost.

Advantages and Disadvantages of Target Costing

Advantages Disadvantages

1. Target costing will demonstrate the management's 1. Any miscalculation in target costing, which depends on
devotion to the improvement process and the the estimation of the product's final selling price, could
innovation of the product to acquire benefits in the lead to the failure of the entire marketing strategy.
marketplace. 2. The business can use less expensive technology or
2. The product is generated based on the customer's materials to meet the target cost, which is ultimately
expectations, the cost is likewise based on those unfavorable and even turns out to be the worst
expectations. This is how the value of the consumer is disadvantage.
fulfilled via target costing. 3. Target costing can place an unreasonably heavy strain
3. The organization's strategy for production, and the on the production line when the predicted cost is too
design of the product itself, will ultimately be low.
determined by the market's demands. 4. A loss may result when the company doesn't sell all of
4. Opportunities for the new market might be converted the quantity it produces due to improper quantity
into genuine savings to maximize monetary value rather assessment.
than focus on reducing expenses to their absolute
minimum.

Key Principles of Target Costing

1. Price-led costing - The price the customer is willing to pay determines allowable costs, beginning with design costs and ending
with service costs.
2. Focus on the Customer - It is a strategy that puts customers at the center of business decision-making. Customer-focused
businesses make decisions based on how those decisions impact customers.
3. Focus on Product and Process Design - It is the process designers use to blend user needs with business goals to help brands
make consistently successful products. This can be especially important if a company wants to expand or reach new customers
with efficient operations.
4. Cross-functional teams - A group of people with a variety of expertise who come together to achieve a common goal. It typically
includes employees from all levels of an organization.
5. Life-Cycle Costs - The process of estimating how much money you will spend on an asset over the course of its useful life.
Whole-life costing covers an asset’s costs from the time you purchase it to the time you get rid of it.
6. Value-Chain Orientation - A value chain refers to the full lifecycle of a product or process, including material sourcing,
production, consumption, and disposal/recycling processes. Ideally, companies can use the value chain model to strengthen their
point of view and widen their profit margin—more efficiency and fewer costs.
Example of Real-Life application of target costing (Type of Companies that use Target Costing)

Target Cost Management (TCM) has been a formidable competitive tool extensively utilized by Japanese companies,

demonstrating successful implementation within the Japanese business context.

Toyota Motor Corporation is renowned for its pioneering use of target costing, aligning with the philosophy of continuous

improvement (Kaizen) and producing high-quality, cost-effective vehicles. Through cross-functional collaboration, Toyota implements

target costing during product development to ensure efficient cost control.

Other companies that use target costing are listed below:

Companies that use target costing: Although it is a relatively new concept, it is being used heavily in most large companies

especially automotive (transportation), heavy equipment, and aerospace industries.

a. General Electric
b. Motorola
c. U.S. auto companies G.M.
d. Ford and Daimler Chrysler.
e. Japan’s auto companies: Toyota, Honda, Nissan, and Mitsubishi
f. NASA
g. U.S. Military
h. Sony

They use target costing due to the following reasons:

i. Intensive competition
ii. Excessive supply chains
iii. Relatively long product development cycles

Computation of Target Costing

Part 1. Formula

Target Cost is the calculated cost based on the sales price required for a specific market share. In competitive industries, the unit

selling price is set independently of the initial product cost. If the target cost is lower than the initial product cost forecast, the

manufacturer reduces the unit cost to enhance competitiveness, derived by subtracting the desired profit from the predetermined

sales price. Hence,

Target cost = Selling price - Desired profit

This is the same as the formula shown above.

Target Cost: This is the cost a company plans to spend on making each unit of a product.

Selling Price: This is the price at which the company wants to sell the product, influenced by market conditions, customer

expectations, and the company's pricing strategy.

Desired Profit: This refers to the profit the company aims to make on each unit sold, covering expenses and contributing to overall

profitability.

In this context, the sales price is the one suitable for achieving a specific market share, while the desired profit represents the

contribution expected from the product to cover the ongoing operational costs of the enterprise. The remaining component is the

target cost. Consequently, target costing optimally utilizes the formula Profit = Sales – Costs.

Part 2. Sample Problems

This learning material provides you with three different sample problems that all use target costing.

Note: By following the steps below, you will be able to solve the target costing problems easier:

1. Derive need and selling price.

2. Required target profit by the company.
3. Calculate the target cost by applying the formula.

Sample Problem 1:

Mango Delights, a local company, is planning to launch a new line of premium dried mangoes in a competitive market. After

market research, Mango Delights finds that similar high-quality dried mango products are priced at ₱150 per 100 grams.

Mango Delights aims for a market share of 12% in the premium dried mango segment. The company decides to set the selling

price of their premium dried mangoes at ₱130 per 100 grams to attract customers while still maintaining a competitive edge.

The intended profit margin is 18% of the selling price.

Now, let's calculate the target cost using the target costing formula:

Target Cost = Selling Price − Desired Profit

Target Cost = ₱130 − (18%×₱130)

Target Cost = ₱130 − ₱23.40

Target Cost = ₱106.60

Interpretation: Therefore, Mango Delights sets a target cost of ₱106.60 per 100 grams of premium dried mango. This means that
the company must manage its production costs effectively to ensure that the cost of producing each unit of dried mango does
not exceed ₱106.60 to meet the target profit margin and competitive selling price.

Sample Problem 2:

Your company in the United States manufactures different types of trucks and would like to compute the target cost for your
truck. It determines the following costs:

Estimated selling price = $7,000 and the Target profit required is 5% of the estimated selling price
What is the target cost?
Formula:

Target Cost = Selling Price − Desired Profit

Target Cost = $7,000 − (5% x $7,000 )

Target Cost = $7,000 - $350

 Target Cost = $6,650

Interpretation: We must manufacture a product that keeps costs below $6,650 to meet our target profit margin.

Sample Problem 3:

Your construction equipment company is looking to introduce a heavy-duty excavator to compete with a popular model
produced by a competitor, XYZ Heavy Machinery. XYZ sells its excavator for $210,000.

Your company aims to gain a competitive edge by offering a lower price. Your marketing team projects that you could sell 1,000
units of your excavator at a price of $200,000 each.

To achieve this, you will need to invest $10,000,000 in research and development, manufacturing setup, and marketing efforts.
Your company requires a return on investment of 20%. Determine the maximum allowable cost per unit to meet your target
profit margin.

Calculate the target cost per unit using the formula:

Target Cost = Selling Price - Desired Profit

Target Cost = (1,000 units x $200,000 price) - ($10,000,000 x 20% return)

Target Cost = $200,000,000 - $2,000,000

Target Cost = $198,000,000

Target cost per unit = $198,000,000 / 1,000 units

Target cost per unit = $198,000 / unit

Interpretation: To achieve your desired profit margin, you need to design the heavy-duty excavator in such a way that it doesn't
cost more than $198,000 per unit.

Conclusion (Key Takeaways)

1. Target costing which has been widely used by Japanese firms since the 1960s is now spread all over the world.
2. Target costing is a management technique wherein prices are determined by market conditions.
3. The formula for target costing is Target Cost per unit = Target Price - Target Operating Income per unit; or simply, Target Cost =
Selling Price - Desired Profit.
4. The 3 objectives of a target costing system are: to lower the costs of new products so that the required profit level can be
ensured, the new products meet the levels of quality, delivery timing, and price required by the market, and to motivate all
company employees to achieve the target profit during new product development by making target costing a companywide
profit management activity.
5. There are 3 approaches to target costing: Price-based costing, Cost-based costing, and Value-based costing
6. The process of target costing comprises Market analysis, Product specification, and Cross-department collaboration.
7. There are 6 features of target costing that determine its use and effectiveness in implementation.
8. There are several advantages and disadvantages of target costing if it is applied in market industries.
9. The key principles of target costing are Price-led costing, Focus on the Customer, Focus on Product and Process Design, Cross-
functional teams, Life-Cycle costs, and Value-Chain Orientation.
10. Main industries that utilize target costing: Transportation and Heavy equipment industries due to the following reasons:
(Intensive competition, extensive supply chains, and relatively long product development cycles)
Prepared by:

Caiga, Hannah Trixie Sydney Students from BSA 221C in the course

Casulla, John Ian Patrick

Strategic Cost Management (BASTRCSX).

Dator, Marinela Nadine

Decena, Maffrey Yuna

Obsanga, Andy

References:

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Feil, P. F., Yook, & Kim, I.-W. (n.d.). Japanese Target Costing: A Historical Perspective. https://www.uakron.edu/cba/docs/ins-

cen/igb/scm/TCHistory_formatted.pdf

Gupta, R. (n.d.). Strategic Cost Accounting. University of Lucknow. Strategic Cost Accounting.

https://www.lkouniv.ac.in/site/writereaddata/siteContent/202004261306373464rajni_com_Target_Costing.pdf

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Target costing Prepared By Melwin Mathew. (2017, March 30). [Slide show]. PPT. https://www.slideshare.net/MelwinMathew5/target-

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Sons.

GROUP 4
CAIGA, CASULLA, DATOR, DECENA & OBSANGA

TARGET COSTING