CAF-03 Target costing

Chapter 13 Target costing

13.1 Target costing
Target costing is a profit management technique in which cost is reduced during design stage of new
technology-based products.
In traditional costing, cost is determined first and profit is added to set sale price but in target costing
approach sale price is determined first and profit is subtracted to determine required or target cost.
13.2 Target cost
When a new product is launched in a new market or a highly competitive market, it is difficult to set
price on a traditional basis like cost plus profit approach. In this case target sale price is determined by
market survey. Based on this price, if business wants to earn profit, then it must restrict its production
cost to a level allowed by that sale price.
Target cost = Target sale price – Desired profit
13.3 Cost gap
If the estimated production cost as estimated by production department is higher than target cost, the
difference is called cost gap and necessary steps must be taken to eliminate that cost gap to make the
product profitable.
Cost gap = Estimated cost – Target cost
13.4 Steps for implementing target costing
Step-1: Estimation of selling price from market survey.
Step-2: Identification of required / target profit.
Step-3: Calculation of target cost per unit.
Rs.
Estimated selling price per unit X
Less: Required profit per unit (X)
Target cost per unit X
Step-4: Calculation of current / expected cost per unit.
Rs.
Direct material cost X
Add: Direct labour cost X
Add: Direct expenses X
Add: Factory overheads
Variable FOH cost
(Variable FOH rate per hour x Labour hours per unit) X
Fixed FOH cost
(Fixed FOH rate per hour x Labour hours per unit) X
Add: Any other given cost X
Current expected cost per unit X
Step-5: Calculation of target cost gap per unit.
Rs.
Current expected cost per unit X
Less: Target cost per unit (X)
Target cost gap per unit X
Step-6: Make efforts to remove / close the target cost gap.
Closing the target cost gap
Common methods of closing the target cost gap are:
i) To re-design products to make use of common processes and components that are already used in
the manufacture of other products by the company.

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ii) To discuss with key supplier’s methods of reducing materials costs. Target costing involves the
entire ‘value chain’ from original suppliers of raw materials to the customer for the end-product,
and negotiations and collaborations with suppliers might be an appropriate method of finding
important reductions in cost.
iii) To eliminate non-value-added activities or non-value-added features of the product design.
Something is ‘non-value added’ if it fails to add anything in value for the customer. The cost of
non-value-added product features or activities can therefore be saved without any loss of value for
the customer. Value analysis may be used to systematically examine all aspects of a product cost to
provide the product at the required quality at the lowest possible cost. This is the crux of target
costing.
iv) Using standardized components will reduce the cost but it might impact the innovation element for
the product.
v) To train staff in more efficient techniques and working methods. Improvements in efficiency will
reduce costs.
13.5 Advantages of target costing
There are several possible advantages from the use of target costing.
i) It helps to improve the understanding within a company of product costs.
ii) It recognizes that the most effective way of reducing costs is to plan and control costs from the
product design stage onwards.
iii) It helps to create a focus on the final customer for the product or service, because the concept of
‘value’ is important: target costs should be achieved without loss of value for the customer.
iv) It is a multi-disciplinary approach, and considers the entire supply chain. It could therefore help to
promote co-operation, both between departments within a company and also between a company
and its suppliers and customers.
v) Target costing can be used together with recognized methods for reducing costs, such as value analysis,
value engineering, just-in-time purchasing and production, Total Quality Management, and
continuous improvement i.e. Kaizen costing.
vi) Target costing recognizes that process improvement and cost cutting is not a top down process but
rather one where workers who actually work on the product could come up with valuable
suggestions.

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QUESTIONS
Question-1 (Illustration)
Dawlance Ltd. is considering launching a new product. The sales department has determined that the estimated
selling price will be Rs. 200 per unit. Dawlance Ltd. require a gross profit of 25% of the selling price on all
products. Following information pertains to the current expected cost per unit of new product:
Material cost per unit 2 kgs @ Rs. 50 per kg
Labour cost per unit 1.5 hours @ Rs. 40 per hour
Variable overhead cost Rs. 10 per labour hour
Fixed overheads cost Rs. 8 per labour hour
Required:
Calculate the target cost gap per unit for the new product.
Question-2 (Illustration)
Dawlance Ltd. is considering launching a new product. The sales department has determined that the estimated
selling price will be Rs. 500 per unit. Dawlance Ltd. have a requirement that all products should generate a
net profit margin equal to 20% to cover production and non-production costs. Following information pertains
to the current expected cost per unit of new product:
Material cost per unit 2.5 kgs @ Rs. 50 per kg
Labour cost per unit 3 hours @ Rs. 40 per hour
Variable overhead cost Rs. 20 per labour hour
Fixed overheads cost Rs. 10 per labour hour
Selling cost 8 % of selling price
Administration cost 12% of production cost
Required:
Calculate the target cost gap per unit for the new product.
Question-3 (Illustration)
Haier Ltd. is considering launching a new product. The sales department has determined that a realistic
selling price will be Rs. 25 per unit. Haier Ltd. have a requirement that all products should generate a
markup of 25% of target cost. Current expected cost per unit of new product is Rs. 22.
Required:
Calculate the target cost gap per unit for new product.
Question-4 (Illustration)
Packages Ltd. is considering launching a new product. The sales department has determined that a realistic
selling price will be Rs. 25 per unit. Packages Ltd. have a requirement that all products should generate return
equal to 10% on investment. Production of new product will require additional investment in plant and
machinery equal to Rs. 10 million and it is expected that the company would be able to sell 200,000 units of
new product during whole life cycle. The current expected cost per unit of new product is Rs. 22.
Required:
Calculate target cost gap per unit and in total for new product.
Question-5 (Illustration)
A company manufactures a product Beta. A cost estimation study has produced the following estimate of
production cost of beta:
Cost items
Direct material A Each complete unit of product Beta requires 12 kgs of material A but there will be
loss in production of 20% of input quantity. Material A costs Rs. 18 per kg.
Direct material B Each complete unit of product Beta requires 8 liters of material B but there will be
loss in production of 10% of output quantity. Material B costs Rs. 10 per liter.
Direct material C Each complete unit of product Beta requires 4.8 meters of material C but there will
be loss in production of 20%. Material C costs Rs. 14 per meter.
Direct labour Each complete unit of product Beta requires 10.5 hours of labour. It is expected that
30% of the input time will be wasted (un-avoidable idle time). Labour is paid at the
rate of Rs. 80 per hour.
Required:
Compute expected cost per unit of product Beta, showing separately cost of material A, B, C and labour.

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Question-6 (ICAP study text example 4)
A company has designed a new product, NP8. It currently estimates that in the current market, the product
could be sold for Rs.70 per unit. A gross profit margin of at least 30% on the selling price would be required,
to cover administration and marketing overheads and to make and to make an acceptable level of profits. A
cost estimation study has produced the following estimate of production cost of NP8:
Cost items
Direct material M1 cost Rs. 9 per unit of product NP8
Direct material M2 cost Each complete unit of product NP8 will require three meters of material
M2, but there will be a loss in production of 10% of material used.
Material M2 costs of Rs.1.80 per meter.
Direct labour cost Each complete unit of product NP8 will require 0.5 hours of direct labour
time. However, it is expected that there will be unavoidable idle time
equal 5% of total labour time paid for. Labour is paid at the rate of Rs.19
per hour.
Production overheads cost It is expected that production overheads will be absorbed into products
costs at the rate of Rs.60 per direct labour hour, for each active hour
worked. (Overheads are not absorbed into the cost of idle time).
Required
i) Calculate the expected cost per unit of product NP8.
ii) Calculate target cost per unit of product NP8.
iii) Calculate the size of target cost gap.

Question-7 (ICAP study text example 5)

Scriba Company (SC) trying to launch a new product into competitive market in North America. Test
marketing has revealed the following demand curve for the product:
P = 600 – 0.005Q
where P = Sale price per unit , Q = Sales Quantity
The estimated market for the product is 500,000 units per year. The company would like to capture 10% of
this market. The company has estimated a cost card based on 50,000 units of sales each year.
Rs.
Direct material 100
Direct Labour 30
Fixed Overheads 70
Total cost 200
The company Wishes to achieve a target profit of Rs. 10,000,000 for sale of this product per year.
Required:
(a) What price will the company have to charge to capture its required market share and what is the target
unit cost to achieve its target profit?
(b) What is the size of the target cost gap and how might Scriba Company seek to close this gap?

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Question-8 (ICAP study text comprehensive example 1)
Pollar company assembles and sells a range of components for motor vehicles, and it is considering a proposal
to add a new component to its product range. This is a component for electric motor cars, which has been given
to code number NP 19. The company sees an opportunity to gain market share in the market that is expected
to grow considerably over time, but already competition from rival producer is strong.
Component NP19 would be produced by assembling a number of parts bought in from external suppliers and
would then be sold on to manufacturers of electric cars. Pollar company would use its current workforce as
assemble workers to make the component.
Production overheads are currently absorbed into production costs on an assembly hour basis. Pollar company
is considering the use of target costing for the new component. Cost information for the new component NP19
is as follows:
1. Part 1922: Each unit of component NP19 requires one unit of part 1922.These bought-in parts are
purchased in batches of 5,000 units, and the purchase cost is Rs. 5.30 each plus delivery costs of 2,750
per batch.
2. Part 1940: Each unit of component NP19 requires 20 cm of part 1940, which costs of Rs. 2.40 per
meter to purchase. However, it is expected that there will be some waste due to cutting and that 5% of
the purchased part will be lost in the assembly process.
3. Other parts for component NP19 will also be bought in and will cost Rs. 7.20 per unit of the
component.
4. Assemble labour. It is estimated that each unit of the component NP19 will take 25 minutes to
assemble. Assembly labour, which is not in short supply, is paid Rs. 24 per hour. It is estimated that
10% of paid labour time will be idle time.
5. Production overheads. Analysis of recent historical costs for production overheads shows the
following costs.
Total production overheads Total assembly hours
(Rs.) worked
Month 1 912,000 18,000
Month 2 948,000 22,000
Fixed production overheads are absorbed at a rate per assembly hour based on normal activity levels.
In a normal year, Pollar Company works 250,000 assembly hours.
6. Pollar company estimates that its need to sell component NP19 at a price of no more than Rs. 56 per
unit to be competitive, and it is considered than an acceptable gross profit on components sold by the
company is 25%.
Required:
(a) Calculate the expected cost per unit of component NP19 and calculate any cost gap that exists. (13)
(b) Explain briefly how target costing might be used in the development & production of a new product. (03)
(c) Explain the benefits of adopting a target costing approach at an early stage in the development of a new
product. (04)
(d) If a target costing approach is used and a cost gap is identified for component NP19, suggest possible
measures that Pollar Co might take to reduce the gap. (05)

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Question-9 (Spring 2022, Q-3)
Denmark Ice Cream (DIC) runs various ice cream parlors across the city. Below is the average weekly
information extracted from DIC's records:
Rs. in '000
Sales 500
Variable cost (350)
Fixed cost (100)
Profit 50
DIC is now planning to introduce frozen yogurt in addition to its existing ice cream range to attract more
customers. In this regard, following information has been gathered:
(i) Sale of 800 frozen yogurt cups every week is expected to be achieved at selling price of Rs. 190 per
cup. It is expected that introduction of frozen yogurt would also increase the sales volume of ice cream
by 10%.
(ii) Variable cost of frozen yogurt will be Rs. 150 per cup.
(iii) Fixed cost will increase by 12% due to launching of marketing campaign for frozen yogurt.
(iv) DIC's target is to achieve a profit margin of 14% after introducing frozen yogurt.
Required:
(a) Compute the cost gap. (03)
(b) Discuss the methods that DIC can use to close the cost gap identified in (a) above. (04)

Question-10 (Spring 2015, Q-6)

A Hi-tech Limited (HL) assembles and sells various components of heavy construction equipment. HL is
working on a proposal of assembling a new component EXV-99. Based on study of the product and market
survey, the following information has been worked out:
Projected lifetime sale of the component EXV-99 (Units) 500,000
Selling price per unit (Rs.) 11,000
Target gross profit percentage 40%
Information about cost of production of the new component is as follows:
i. One unit of EXV-99 would require:
Parts no. Net quantity Cost (Rs.)
XX 1 unit Rs. 2,350 per unit
YY 1.5 kg Rs. 1,400 per kg
ZZ 1 unit Rs. 1,200 per unit
The above parts would be imported in a lot, for production of 1,000 units of EXV-99. Custom duty
and other import charges would be 15% of cost price. HL is negotiating with the vendor who has
agreed to offer further discount.
ii. On average, assembling of one unit of EXV-99 would require 1.8 skilled labour hours at Rs. 200 per
hour. The production would be carried out in a single shift of 8 hours. At the start of each shift, set-
up of machines would require 30 minutes. 6% of the input quantity of YY and ZZ would be lost
during assembly process.
iii. HL works at a normal annual capacity of 4,000,000 skilled hours. Actual production overheads and
skilled labour hours for the last two quarters are as under:
Quarter Total assembly Production
ended hours overheads (Rs.)
30-Sep-2014 950,000 65,600,000
31-Dec-2014 1,050,000 68,000,000
iv. A special machine that would be used exclusively for the production of EXV-99 would be purchased
at a cost of Rs. 1,500,000.
Required:
From the above information, determine the discount that HL should obtain in order to achieve the target gross
profit. (16)
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Question-11 (ICAP study text comprehensive example 3)
Fintech company assembles and sells many types of radios. It is considering to apply target costing for one
of its new product which includes technology advancement. Following data is provided for calculation of
estimated cost of production.
(i) Selling price of Rs. 2,500 has been set in order to compete with the similar radio on the market that
has comparable features to Fintech Company’s intended product. The board have agreed that the
acceptable margin (after allowing for all production costs) should be 20%.
(ii) Component 1- Circuit board: These are bought in and cost Rs. 410 each. They are bought in batches
of 4,000 and additional delivery costs are Rs. 240,000.
(iii) Component 2- Wiring: In an ideal situation 25cm of wiring is needed for each completed radio.
However, there is some waste involved in the process as wire is occasionally cut to the wrong length
or is damaged in the assembly process. Fintech company estimates that2% of the purchase wire is
lost in the assembly process. Wire costs Rs. 50 per meter to buy.
(iv) Other material: Other material cost Rs. 810 per radio.
(v) Assembly Labour: these are skilled people who are difficult to recruit and retain. Fintech company
has more staff of this type than needed but is prepared to carry this extra cost in return for the security
it gives the business. It takes 30 minutes to assemble a radio and the assembly workers are paid Rs.
1,260 per hour. It is estimated that 10% of hours paid to assembly workers is for idle time.
(vi) Production overheads: Recent historic cost analysis has revealed the following production overhead
data:
Total Production Total assembly
Month
overheads Rs. labour hours
Month 1 62,000,000 190,000
Month 2 70,000,000 230,000
Fixed production overheads are absorbed on an assembly hour basis based on normally annual
activity levels. In a typical year 2,400,000 assembly hours will be worked by Fintech Company.
Required:
Calculate the expected cost per radio and any cost gap that exists.

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