Unit – 5

What is Target Costing

• Target costing 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.
• According to Computer Aided Manufacturing International (CAM-I) “A
market-based cost that is calculated using sales price necessary to
capture a predetermined market share is known as Target Cost.” In
competitive industries, a unit selling price is set independent of initial
cost of the product.
• If target cost is lower than the initial forecast of product cost, the
manufacture/producer drives the unit cost to come down over a
definite period, so that it should compete. It should be noted that
target cost is found by deducting desired profit from predetermined
sales price.
• Hence, Target Costing = Selling Price – Desired Profit
Features of Target Costing
• The price of the product 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.
Objectives of Target Costing
• 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.
Process of Target Costing
• Identifying customer needs
• Planning of selling price as per the needs
• Identifying the target cost
• Keep the price in consideration after identifying suppliers and fixing
the manufacturing process
• Compare sample product with the target and start production for
product launch
Advantages of Target Costing
• It shows management’s commitment to process improvements and product
innovation to gain competitive advantages.
• The product is created from the expectation of the customer and, hence,
cost is also based on similar lines. Thus, the customer feels more value is
delivered.
• With the passage of time, the company’s operations improve drastically,
creating economies of scale.
• The company’s approach to designing and manufacturing products becomes
market driven.
• New market opportunities can be converted into real savings to achieve the
best value for money rather than to simply realize the lowest cost.
Key Principles of Target Costing
• According to Hilton, target costing involves seven key principles listed as follows:
• Price-Led Costing: 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 yields the target cost, that is, the cost at
which the product must be manufactured. 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.
• Focus on the Customer: 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.
• Focus on Product Design: Design engineering is a key element in target costing. 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 labour, machinery, and other elements of the production process.
In short, a product must be designed for manufacturability.
• Focus on Process Design: 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 labour, technology, global sourcing in procurement and every
aspect of the production process must be designed with the product’s target cost in mind
• Cross-Functional 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, 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.
• Life-Cycle Costs: 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.
• Value-Chain Orientation: 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.
Cost-based Pricing vs. Target Pricing
Method
Target Pricing Method Cost-based Pricing

Prices determine costs. Costs determine price

Design is key to cost reduction. Waste and inefficiency is focus of cost reduction
efforts.
Customer input guides cost reduction. Cost reduction is not customer driven.
Uses cross-functional teams to manage costs. Cost accountants are responsible for cost reduction.
Supplier involved early. Suppliers involved after product designed.
Minimizes cost of ownership to customer Minimizes initial price paid by customer.
Competitive market considerations drive cost Market considerations not part of cost planning
planning.
Activity based costing
• The activity-based costing (ABC) system is a method of accounting you
can use to find the total cost of activities necessary to make a
product. The ABC system assigns costs to each activity that goes into
production, such as workers testing a product, setting up of machines,
orders passed for purchase of raw materials etc.
Steps in ABC
• Identify which activities are necessary to create a product
• Separate each activity into its own cost pool
• Assign activity cost drivers to each cost pool
• Divide the total overhead in each cost pool by the total cost drivers to
get your cost driver rate
• Compute how many hours, parts, units, etc. that the activity used and
multiply it by the cost driver rate to find total cost
• Calculate Cost per Unit by dividing the Total Cost by Total Units
produced.
Uses of ABC
• Identification of necessary activities: The ABC system shows how overhead is used, which helps to
determine whether certain activities are necessary for production.
• Focus on Value adding activities: The Activity Based Costing helps the management on focusing the
forces on value adding activities and eliminate non-value adding activities.
• Ensuring profit margin: The specific allocation of costs also helps to set prices that produce a healthy
small business profit margin.
• Product pricing: With an ABC system, the business can assign costs to each activity in the production
process, allowing it to more accurately set a price that accounts for how much it costs to create a
product.
• Measures to improve productivity: The accurate cost information helps the management to adopt
productivity improvement approaches like Total Quality Management (TQM), Business Process Re-
engineering (BPR) etc.
• Help in deciding Make or Buy: The management can take make or buy decisions by considering the
cost of manufacture of a product or sub contract the same with an outside agency through Activity
Based Costing analysis.
What is Life-cycle Costing
• Life cycle costing is a system that tracks and accumulates the actual costs
and revenues attributable to cost object from its invention to its
abandonment. Life Cycle Cost (LCC) of an item represents the total cost of
its ownership, and includes all the cots that will be incurred during the
life of the item to acquire it, operate it, support it and finally dispose it.
• Life Cycle Costing adds all the costs over their life period and enables an
evaluation on a common basis for the specified period (usually
discounted costs are used).
• Life cycle costing is defined as the total cost throughout its life including
planning, design, acquisition & support costs & any other costs directly
attributable to owning / using the asset.
Characteristics of Life Cycle Costing
• Product life cycle costing involves tracing of costs and revenues of a
product over several calendar periods throughout its life cycle.
• Product life cycle costing traces research, design and development
costs and total magnitude of these costs for each individual product
and compared with product revenue.
• Each phase of the product life-cycle poses different threats and
opportunities that may require different strategic actions.
• Product life cycle may be extended by finding new uses or users or by
increasing the consumption of the present users.
Elements of Life cycle cost
• Disposal cost
• Initial cost
• Installation cost
• environmental cost
• Operational cost
• Failure cost
• Maintenance cost
Types of Life-cycle costing
Product Life-cycle Costing:
The life-cycle of a product or service begins in the following order:
• Identification of new consumer need or new need of existing consumer.
• Invention of a new product and get it patented.
• Development of new product to make it saleable.
• Manufacturing/producing the product.
• Expansion of market with product’s market acceptability.
• Entrance of competitors with rival/initiation products and diminishing of
product’s market.
• Gradually product is degenerated.
Stages of Product Life Cycle Costing
Following are the main stages of Product Life Cycle:
• Market Research: It will establish what product the customer wants, how much he is prepared to pay for
it and how much he will buy.
• Specification: It will give details such as required life, maximum permissible maintenance costs,
manufacturing costs, required delivery date, expected performance of the product.
• Design: Proper drawings and process schedules are to be defined.
• Prototype Manufacture: From the drawings a small quantity of the product will be manufactured. These
prototypes will be used to develop the product.
• Development: Testing and changing to meet requirements after the initial run. This period of testing and
changing is development. When a product is made for the first time, it rarely meets the requirements of
the specification and changes have to be made until it meets the requirements.
• Tooling: Tooling up for production can mean building a production line; building jigs, buying the
necessary tools and equipment’s requiring a very large initial investment.
• Manufacture: The manufacture of a product involves the purchase of raw materials and components,
the use of labour and manufacturing expenses to make the product.
Purpose of Product Life-cycle
Costing
• To help in developing a sense of total costs associated with a product;
this will help in identifying as the profits earned during manufacturing
phase would cover the costs in development & decommissioning
phase.
• To identify a product’s environmental cost consequences and to
initiate action for reducing or eliminating such costs.
• To help in identifying the planning and decommissioning costs during
the product and process design phase, so that costs in that phase be
managed and control.
Benefits of Product Life Cycle
Costing:
• It results in earlier action to generate revenue or lower costs than
otherwise might be considered. There are a number of factors that
need to be managed in order to maximise return in a product.
• Better decision should follow from a more accurate and realistic
assessment of revenues and costs within a particular life cycle stage.
• It can promote long term rewarding in contrast to short term
rewarding.
• It provides an overall framework for considering total incremental
costs over the entire span of a product.
• Manufacture: The manufacture of a product involves the purchase of
raw materials and components, the use of labour and manufacturing
expenses to make the product.
• Selling
• Distribution
• Product support
• Decommissioning: When a manufacturing product comes to an end,
the plant used to build the product must be sold or scrapped.
Project Life-cycle costing
• “Project life-cycle costing includes costs associated with acquiring, using,
caring for and disposing of physical assets.” At the same time costs
generated by the acquisition, use, maintenance and replacement of
permanent physical assets in respect of feasibility studies, research design,
development, production, maintenance, replacement and disposal as well
as support, training and operating are also included in project life-cycle
cost.
• Thus, life cycle costing, or whole-life costing, is 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. In contrast to product life-cycle costs, the
project life-cycle costs are incurred for fixed assets.
The components of a project cost over its entire life include the following
• Costs of research, design, testing, production, construction or purchase of capital
equipment i.e., cost of acquisition.
• Costs of transportation and handling of capital equipment.
• Cost of maintenance of capital equipment.
• Costs incurred in operations like, energy costs, various facilities costs and utility costs.
• Training costs.
• Costs of holding spare parts, warehousing etc.
• Costs of purchasing any technical data (information).
• Retirement and disposal costs at the end of economical life of the capital equipment.
Purpose of Project Life-cycle Costing
Analysis
• Choose between two or more assets: Using life cycle costing helps you make purchasing decisions. If you
only factor in the initial cost of an asset, you could end up spending more in the long run. For example,
buying a used asset might have a lower price tag, but it could cost you more in repairs and utility bills
than a newer model. Life cycle cost management depends on your ability to make a smart investment.
When you are deciding between two or more assets, consider their overall costs, not just the price tag in
front of you.
• Determine the asset’s benefits: How do you know if you should buy an asset? Generally, you weigh the
pros and cons of your purchase. But if you only consider the initial, short-term cost, you won’t know if the
asset will benefit your business financially in the long run. By using life cycle costing, you can more
accurately predict if the asset’s return on investment (ROI) is worth the expense. If you only look at the
asset’s current purchase cost and don’t factor in future costs, you will overestimate the ROI.
• Create accurate budgets: When you know how much an asset’s total price is, you can create budgets that
represent your business’s actual expenses. That’s way, you won’t underestimate your business’s costs. A
budget is made up of expenses, revenue, and profits. If you underestimate an asset’s cost on your budget,
you are overestimating your profits. Failing to account for expenses can result in overspending and
negative cash flow.
Uses of Project Life-cycle Costing
• When projects are to be operated in capital intensive industry.
• Where projects have sizeable on-going constructing program
• Where projects depend on numerous and expensive items of plant
with consequent substantial replacement programmes.
• Where projects relate to major expansion.
• Where projects contemplate the purchase or design or development
of expensive new technology.
• Where projects are sensitive to disruption due to down-time.
Life Cycle Costing Process
Stage 1: LCC Analysis Planning:
The Life Cycle Costing process begins with development of a plan, which addresses the purpose, and
scope of the analysis. The plan should:
• Define the analysis objectives in terms of outputs required to assist a management decision.
• Make the detailed schedule with regard to planning of time period for each phase, the operating,
technical and maintenance support required for the asset.
• Identify any underlying conditions, assumptions, limitations and constraints (such as minimum asset
performance, availability requirements or maximum capital cost limitations) that might restrict the
range of acceptable options to be evaluated.
• Identify alternative courses of action to be evaluated. The list of proposed alternatives may be refined
as new options are identified or as existing options are found to violate the problem constraints.
• Provide an estimate of resources required and a reporting schedule for the analysis to ensure that
the LCC results will be available to support the decision-making process for which they are required.
Stage 2: Life Cost Analysis Preparation:
• The Life Cost Analysis is essentially a tool, which can be used to control and manage the
ongoing costs of an asset or part thereof. It is based on the LCC Model developed and
applied during the Life Cost Planning phase with one important difference: it uses data on
real costs.
• The preparation of the Life Cost Analysis involves review and development of the LCC
Model as a “real-time” or actual cost control mechanism. Estimates of capital costs will be
replaced by the actual prices paid. Changes may also be required to the cost breakdown
structure and cost elements to reflect the asset components to be monitored and the level
of detail required.
• Targets are set for the operating costs and their frequency of occurrence based initially on
the estimates used in the Life Cost Planning phase. However, these targets may change
with time as more accurate data is obtained, from the actual asset operating costs or from
the operating cost of similar another asset.
Implementing and Monitoring:
• Implementation of the Life Cost Analysis involves the continuous
monitoring of the actual performance of an asset during its operation
and maintenance to identify areas in which cost savings may be made
and to provide feedback for future life cost planning activities.
• For example, it may be better to replace an expensive building
component with a more efficient solution prior to the end of its useful
life than to continue with a poor initial decision.
Quality Costing
• Cost of Quality is the total expenses incurred by an organization in
achieving and maintaining good quality as well as in managing poor
quality throughout its line of operations with an aim of attaining the
highest level of customer satisfaction. Therefore, quality costing
technique has become as one of the most “effective
management tool” for collecting and “measuring” the expenses in
maintaining quality in a production process and also identifies
the non-value-added expenses.
Components of Cost of Quality

• Components of Cost of Quality

Cost of Quality (COQ) can be classified into two categories
• Cost of Conformance (COC) or Cost of Good Quality (COGQ): Can be
defined as Costs associated with doing quality job, conducting quality
improvements, and achieving quality goals. These are the costs that
aim at assurance of quality and prevention of bad quality. That means
Cost of Conformance has two sub-divisions: Cost of Assurance and
Cost of Prevention.
• Cost of Assurance : These costs are associated with the quality requirements, systems and
procedures, control measures and audits to ensure appropriate quality standards are used
and complied such as money spent on establishing methods and procedures; Process
Capability Studies; robust Product Design; proper employee training in performing good
quality job; supplier rating / supplier certification (assessment and approval of suppliers of
products and services), Quality audits (confirmation that the quality system is functioning
correctly) acquiring tools, and planning for quality. Quality assurance provides confidence in
the system that ensures quality of deliverables.
• Cost of Prevention: The costs that arise from efforts to keep defects from occurring at all-
prevent errors to happen and to do the job right the first time. Prevention costs may include
Costs of Verifications – checking of incoming material, processes, products, and services to
ensure that they conform to agreed specifications; Preventive Maintenance; Calibration of
measuring and test equipment etc. These are planned and incurred before actual operation
and money is all spent before the product is actually built. The focus on prevention tends to
reduce preventable costs of bad quality.
• Cost of Non-Conformance (CONC) or Cost of Poor Quality (COPQ) is the
costs associated with all activities and processes that do not meet
agreed performance and / or expected outcomes. These costs would
disappear if every task were always performed without deficiency. These
costs have two sub-divisions: Cost of Appraisal and Cost of Failure.
• (A) Cost of Appraisal: Money spent to review completed products
against requirements. Appraisal includes the cost of inspections, testing,
and reviews. This money is spent after the product is built but before it
is shipped to the user or moved into customers place. They could
include: inspection of finished goods, field testing, pre- dispatch
inspection, checking the shipping documents before dispatch etc.
• Cost of Failure: All costs associated with defective products produced and or that have been delivered
to the user. These costs are further sub-divided into Internal Failure Costs and External Failure Costs.
• (a) Internal Failure Costs– These are the Costs generated before a product is shipped but after a
product is made and inspected and found non-conformance to requirements, such as –
Product/service design failure costs (internal – Design corrective action; Rework due to design
changes; Scrap due to design changes); Purchasing failure costs (Purchased material reject disposition
costs; Purchased material replacement costs; Supplier corrective action; Rework of supplier rejects;
Uncontrolled material losses); Operations (product or service) failure costs (Material review and
corrective action costs – Disposition costs – Troubleshooting or failure analysis costs (operations) –
Investigation support costs – Operations corrective action; Operations rework and repair costs –
Rework – Repair; Reinspection / retest costs; Extra operations; costs of Scrap (operations);
Downgraded end product or service; Internal failure – labour losses; Other internal failure costs
• External Failure Costs—Costs generated after a product is shipped as a result of non-conformance to
requirements, such as Complaint investigation/customer service; Returned goods; Retrofit costs;
Recall costs; Warranty claims; Liability costs; Penalties; Customer/user goodwill; Lost sales; Other
external failure costs