TARGET COSTING

Target costing involves setting a target cost by subtracting a desired profit margin from
a competitive market price.
Target costing is a marketing approach to costing as it involves setting a selling price for
the product by reference to the market.
Target costing is used mainly for new product development. This is because whenever a
new product is designed and developed for a competitive market, a company used to
know what the maximum cost of the product so that it will sell at profit.

IMPLEMENTING TARGET COSTING

Steps in the implementations of the target costing process.
1. Determine a product specification of which an adequate sales volume is estimated.
2. Set a selling price at which organization will be able to achieve a desired market share.
3. Estimate the required profit based on return on sales or return on investment.
4. Calculate the target cost= Target selling price- Target profit.
5. Prepare an estimated cost for the product based on the initial design specification and
current cost levels.
6. Calculate target cost gap= Estimated cost – target cost
7. Make efforts to close the gap. This is more likely to be successful if efforts are made to
design out costs prior to production, rather than to control out costs during the
production phase.
8. Negotiate with the customer before making the decision about whether to go ahead
with the project.

Some of the decisions made at the design stage, which can affect the cost of a product:
The features of the product

 How to avoid ‘over design’

 The number of components needed
 Whether the components are standard or specialized.
 The complexity of machining and construction
 Where the product can be made
 What to make in house and what to sub contract
 The quality of the product
 The batch size in which the product can be made
 CLOSING THE TARGET COST GAP

 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.

 To discuss with key suppliers methods of reducing material costs. Target costing
involves the entire ‘ value chain ‘ from original supplier s of raw material to the
customer for the end products, and negotiations and collaborations with suppliers
might be an appropriate method of finding important reduction in cost.

 To eliminate non value added activities or non- value added features of the
product design. The cost of non value added activities or features of the product can 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.

 To train staff in more efficient techniques and working methods. Improvements in

efficiency will reduce costs.

 To achieve economies of scale. Producing in larger quantities will reduce unit cost as
fixed cost will be spread over a larger quantity of products. However, production in
larger quantities is of no benefits unless sales demand can be increased by the same
amount.

 To achieve cost reductions as a result of the learning curve or more likely

experience curve effect. The learning curve is most likely to exist in a labour intensive
environment. It result in cost saving as labour become more familiar with performing a
new and complex task. The experience curve effect relates to cost saving made in cost
rather than labour costs as the company become more familiar with the production of a
new product. For Eg: Mgt of the process and marketing may become more efficiency as
company gain experience of making and selling the product.

Target costing in Service Industry

Target costing is difficult to use in service industries due to the characteristics and
information requirements of service businesses.
Examples of service business include:
 Mass service e.g. the banking sector, transportation ( rail, air), mass entertainment.
 Either/ Or e.g. fast food, teaching, hotels and holidays, psychotherapy.
 Personal service e.g. Pensions and financial advice , car maintenance.

There are five major characteristics of services that distinguish it from manufacturing.
 Intangibility There is no substantial material or physical
aspects to a service.
Inseparability Many services are created at the same time as
/ simultaneity they are consumed. For example- dental
treatment. No service exists until it is actually
being experienced. Consumed by the person who
has bought it.
Variability/ It is hard to attain precise standardization of the
heterogeneity service offered.
Perishability Service are time bound.

No transfer of Services do not result in the transfer of property

ownership but only access to or a right to use a facility.

Benefits of Target Costing

a) It focuses on what consumers are prepared to pay for a product and establishes cost
budgets based on an expected selling price.
b) Only those features that are value to the customer will be included in the product
design.
c) Cost control will be considered earlier in the process. Managers can consider ways to
reduce the cost gap at the design stage.
d) Organizations have motivations to reduce cost and be more efficient in order to reduce
the cost gap.
e) The external focus results in companies focusing on what customers want, and they are
therefore more likely to provide something that customers value, improving
competitiveness.

Tear Down Analysis

 Tear down analysis is also known as reverse engineering. It involves examining a

competitor’s product in order to identify opportunities for product improvement
and/or cost reduction.
 The competitor’s product is dismantled to identify its functionality and design and to
provide insights about the processes that are used and the cost to make the product.
 The aim is to benchmark provisional product design with the designs of competitors
and to incorporate any observed relative advantages of the competitor’s approach to
product design.
 Value Engineering
 Value engineering is a cost reduction technique, used primarily in the design stage,
which uses information about all value chain functions to satisfy customer needs while
reducing costs.
 It is a systematic and generally team based approach to evaluating a product’s design in
order to identify alternatives that will improve the product’s value , which is defined as
the ratio of functionality to cost.
 The value can be improved by either reducing cost while holding functionality constant,
or increasing functionality while holding cost constant.
 Value engineering looks at all of the product’s elements , including the raw materials, the
manufacturing process , the type of labour and equipment used and the balance
between purchased and self- manufactured components.

Practical Questions

1. Helot Co develops and sells computer games. It is well known for launching innovative
and interactive role-playing games and its new releases are always eagerly anticipated
by the gaming community. Customers value the technical excellence of the games and
the durability of the product and packaging.

Helot Co has previously used a traditional absorption costing system and full cost plus
pricing to cost and price its products. It has recently recruited a new finance director
who believes the company would benefit from using target costing. He is keen to try this
method on a new game concept called Spartan, which has been recently approved.

After discussion with the board, the finance director undertook some market research
to find out customers’ opinions on the new game concept and to assess potential new
games offered by competitors. The results were used to establish a target selling price
of $45 for Spartan and an estimated total sales volume of 350,000 units. Helot Co wants
to achieve a target profit margin of 35%.

The finance director has also begun collecting cost data for the new game and has
projected the following:
Production costs per unit $
Direct material 3.00
Direct labour 2.50
Direct machining 5.05
Set-up 0.45
Inspection and testing 4.30
Total non-production costs $000
Design (salaries and technology) 2,500
Marketing consultants 1,700
Distribution 1,400
 Solutions:
Target costing= Estimated selling price- Desired profit

SP= $45
Desired profit=45*35%
=15.75
Target costing=45-15.75=29.25

Estimated Cost= 3+2.5+5.05+.45+4.3

=15.25*350,000
=5,337,500+2500000+1700000+1400000
=10,937,500/-
Target cost=29.25*350000
=10,237,500/-
Target cost gap-= Estimated cost- Target cost
= 10,937,500-10,237,500
=700,000
Target cost gap per unit= 700000/350000=2.00

Adopt steps to eliminate the cost gap

2. Which of the following statements describes target costing?

a) It calculates the expected cost of a product and then adds a margin to it to arrive at
the target selling price
b) It allocates overhead costs to products by collecting the costs into pools and
sharing them out according to each product’s usage of the cost driving activity
c) It identifies the market price of a product and then subtracts a desired profit
margin to arrive at the target cost
d) It identifies different markets for a product and then sells that same product at
different prices in each market.

ANS: Option C
3. Which of the following techniques is NOT relevant to target costing?
A Value analysis
B Variance analysis
C Functional analysis
D Activity analysis
Solution:
The correct option is B.
  Variance analysis is not relevant to target costing as it is a technique used
for cost control at the production phase of the product life cycle. It is a
feedback control tool by nature and target costing is feed forward.
 Value analysis can be used to identify where small cost reductions can be
applied to close a cost gap once production commences.
 Functional analysis can be used at the product design stage. It ensures
that a cost gap is reached or to ensure that the product design is one
which includes only features which customers want.
 Activity analysis identifies and describes activities in an organisation and
evaluates their impact on operations to assess where improvements can
be made.

4. In target costing, which of the following would be an appropriate strategy to reduce a cost
gap for a product that existed in a competitive industry with demanding shareholders?
A. Increase the selling price
B. Reduce the expectation gap by reducing the selling price
C. Reducing the desired margin on the product
D. Mechanising production in order to reduce average production cost.

Solution: Option D

5. Which of the following strategies would be an immediately acceptable method to reduce

an identified cost gap?
A. Reduce the desired margin without discussion with business owners
B. Reduce the predicted selling price
C. Source similar quality materials from another supplier at reduced cost
D. Increase the predicted selling price

Solution: Option C

6. The predicted selling price for a product has been set at $56 per unit. The desired mark
up on cost is 25% and the material cost for the product is estimated to be $16 before
allowing for additional materials to allow for shrinkage of 20% (for every 10 kg of
material going in only 8 kg comes out).
If labour is the only other cost and 2 hours are needed what is the most the
business can pay per hour if a cost gap is to be avoided?

The maximum rate per hour is (2 d.p) $

Solution:
SP=56
Markup=25%
Target Cost=56/1.25=44.8
 Material Cost=16
Shrinkage=20 %
Total material cost=16/80*100= 20
Labour cost=44.8-20=24.80

Labour can pay per hours=24.8/2=12.40

7. The selling price of product Zigma is set to be $250 for each unit and sales for the
coming year are expected to be 500 units. The company requires a return of 15% in the
coming year on its investment of $250,000 in product Zigma.

What is the target cost for each unit of Zigma for the coming year? Select from the
list as appropriate.
List options are as follows:
• $145
• $155
• $165
• $175

Solutions:
SP=250
Desired profit=15% on 250,000=37500
Per unit=37,500/500=75
Target cost= 250-75
=175
8. VC Co is a company of opticians. It provides a range of services to the public, such as eye
tests and contact lens consultations, and has a separate dispensary selling glasses and
contact lenses. Patients book appointments with an optician in advance.

A standard appointment is 30 minutes long, during which an optician will assess the
patient’s specific requirements and provide them with the eye care services they need.
After the appointment, patients are offered the chance to buy contact lenses or glasses
from the dispensary.
Which of the following describes a characteristic of the services provided by an
optician at VC Co during a standard appointment?
A. Tangible
B. Homogeneous
C. Non-perishable
D. Simultaneous
Solutions: Option D- It is simultaneous as there is no delay between the service being provided
by the optician and consumed by the patient
9. Match the stages required to the correct step number to describe the sequence used
when operating target costing.

Stages required Order of steps

Cost the product Step 1
Determine the profit margin Step 2
Set the selling price Step 3
Use functional and value analysis Step 4
Identify the cost gap Step 5
Develop the product concept Step 6

Solution:

1. Step 6
2. Step 3
3. Step 2
4. Step 1
5. Step 5
6. Step 4