Target Costing

WHAT IS TARGET COSTING? 

Target costing involves setting a target cost by subtracting a desired profit margin from a competitive market price.

To compete effectively, organisations must continually redesign their products (or services) in order to shorten product life cycles (see Chapter 5). The planning, development and design stage of a product is therefore critical to an organisation’s cost management process. Considering possible cost reductions at this stage of a product’s life cycle (rather than during the production process) is now one of the most important issues facing management accountants in industry.

Here are some examples of decisions made at the design stage which impact on the cost of a product.

− The number of different components

− Whether the components are standard or not

− The ease of changing over tools

Japanese companies have developed target costing as a response to the problem of controlling and reducing costs over the product life cycle.

Target costing involves setting a target cost by subtracting a desired profit margin from a competitive market price.

Target cost is an estimate of a product cost which is determined by subtracting a desired profit margin from a competitive market price. This target cost may be less than the planned initial product cost but it is expected to be achieved by the time the product reaches the maturity stage of the product life cycle.

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IMPLEMENTING TARGET COSTING

In ‘Product costing/pricing strategy’ (ACCA Students Newsletter, August 1999),one of the examiners provided a useful summary of the steps in the implementation of the target costing process.

 

Step 1 Determine a product specification of which an adequate sales volume is estimated.
Step 2 Set a selling price at which the organisation will be able to achieve a desired market share.
Step 3 Estimate the required profit based on return on sales or return on investment.
Step 4 Calculate the target cost = target selling price – target profit.
Step 5 Compile an estimated cost for the product based on the anticipated design specification and current cost levels.
Step 6 Calculate target cost gap = estimated cost – target cost.
Step 7 Make efforts to close the gap – assuming estimated cost is greater than target cost and it usually is!. 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.
Step 8 Negotiate with the customer before making the decision about whether to go ahead with the project.

 

 

Case Study

The following comments appeared in an article in the Financial Times. (Emphasis is ours.)

‘Mercedes-Benz, one of the world’s most prestigious and tradition-laden carmakers, has taken its time to wake up to the daunting dimensions of the challenges it faces in the rapidlychanging world car market of the 1990s.

The company has accepted that radical changes in the world car market mean that MercedesBenz will no longer be able to demand premium prices for its products based on an image of effortless superiority and a content of the ultimate in automotive engineering.

Instead of developing the ultimate car and then charging a correspondingly sky-high price as in the past, Mercedes-Benz is taking the dramatic and radical step of moving to ‘target pricing’. It will decide what the customer is willing to pay in a particular product category – priced against its competitors – it will add its profit margin and then the real work will begin to cost every part and component to bring in the vehicle at the target price.

The following extracts are from an article which appeared three months later.

‘The marketing motto for the Mercedes-Benz compact C-class is that it offers customers more car for their money.

It is the first practical example of the group’s new pricing policy. The range embodies a principle new to Mercedes which states that before any work starts a new product will be priced according to what the market will bear and what the company considers an acceptable profit. Then each component and manufacturing process will be costed to ensure the final product is delivered at the target price.

Under the old system of building the car, adding up the costs and then fixing a price, the Cclass would have been between 15 per cent and 20 per cent dearer than the 10-year-old outgoing 190 series, Mr Vöhringer said.

Explaining the practical workings of the new system, he explained that project groups for each component and construction process were instructed without exception to increase productivity by between 15 and 25 per cent. And they had to reach their targets in record time.

One result was that development time on the new models was cut to 40 months, about a third less than usual. But the most important effect, according to Mr Vöhringer, has been to reduce the company’s cost disadvantages vis-à-vis Japanese competitors in this class from 35 per cent to only 15 per cent.’

DERIVING A TARGET COST

The target cost is calculated by starting with a market-based price and subtracting a desired profit margin. The target cost is simply the price minus the profit.

 

The car manufacturer will then need carefully to compile an estimated cost for the new car.

ABC will help to ensure that costs allocated to the new model are more accurate.

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IMPLICATIONS OF USING TARGET COSTING 

Target costing requires managers to change the way they think about the relationship between cost, price and profit.

  • Traditionally the approach is to develop a product, determine the production cost of that product, set a selling price, with a resulting profit or loss.
  • The target costing approach is to develop a product, determine the market selling price and desired profit margin, with a resulting cost which must be achieved.

 

With target costing there is a focus on:

  • Price-led
  • Customers. Customer requirements for quality, cost and time are incorporated into product and process decisions. The value of product features to the customers must be greater than the cost of providing them.
  • Design. Cost control is emphasised at the design stage so any engineering changes must happen before production starts.
  • Faster time to market. The early external focus enables the business to get the process right first time and avoids the need to go back and change aspects of the design and/or production process. This then reduces the time taken to get a product to the market.
  • With Target Costing, it is too easy to design down to ensure the target cost is met and the manufacturer could be left with an inferior product

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CLOSING A TARGET COST GAP

The target cost gap is the estimated cost less the target cost. When a product is first manufactured, its target cost may well be much lower than its currently-attainable cost, which is determined by current technology and processes. Management can then set benchmarks for improvement towards the target costs, by improving technologies and processes. Various techniques can be employed.

 

− Reducing the number of components

− Using cheaper staff

− Using standard components wherever possible

− Acquiring new, more efficient technology

Training staff in more efficient techniques

− Cutting out non-value-added activities

− Using different materials (identified using activity analysis etc)

 

Even if the product can be produced within the target cost the story does not end there. Target costing can be applied throughout the entire life cycle. Once the product goes into production target costs will therefore gradually be reduced. These reductions will be incorporated into the budgeting process. This means that cost savings must be actively sought and made continuously over the life of the product.

When answering a question on closing a target cost gap, make sure you refer to the specific circumstances of the business in the question.

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TARGET COSTING IN SERVICE INDUSTRIES

Target costing is difficult to use in service industries due to the characteristics and information requirements of service businesses.

 

Characteristics of services

Unlike manufacturing companies, services are characterised by intangibility, inseparability, variability, perishability and no transfer of ownership.

 

Examples of service businesses include:

  • Mass service eg the banking sector, transportation (rail, air), mass entertainment
  • Either / or eg fast food, teaching, hotels and holidays, psychotherapy
  • Personal service eg pensions and financial advice, car maintenance d)

 

Services are any activity of benefit that one party can offer to another which is essentially intangible and does not result in the ownership of anything. Its production may or may not be tied to a physical product.’

(P Kotler, Social Marketing)

 

There are five major characteristics of services that distinguish them from manufacturing.

  • Intangibility refers to the lack of substance which is involved with service delivery. Unlike goods (physical products such as confectionery, books or even a CD with a software programme), there is no substantial material or physical aspects to a service: no taste, feel, visible presence and so on. For example, if you go to the theatre, you cannot take the ‘play’ with you when you leave.
  • Inseparability/simultaneity. Many services are created at the same time as they are consumed. (Think of dental treatment.) No service exists until it is actually being experienced/consumed by the person who is buying it.
  • Variability/heterogeneity. Many services face the problem of maintaining consistency in the standard of output. It may be hard to attain precise standardisation of the service offered, but customers expect it (such as with fast food).
  • Services are innately perishable. The services of a beautician are purchased for a period of time. An audit may last 2 weeks and after that it is no more.
  • No transfer of ownership. Services do not result in the transfer of property. The purchase of a service only confers on the customer access to or a right to use a facility.

 

Information requirements of services

Service businesses need the same aggregate information as manufacturing firms, but also need performance data as to their cost and volume drivers. Operational information is likely to be more qualitative.

A service business needs a mix of quantitative and non-quantitative information to price its services properly, to optimise capacity utilisation and to monitor performance.

  • They need to control the total cost of providing the service operation.
  • They need positive cash flow to finance activities.
  • They need operating information to identify how costs are incurred and on what services.

 

Arguably, small service businesses, whose expenses are mainly overheads, provide a model, in miniature, of the requirements of activity based costing.

Are ‘mass services’ any different?

  • Because mass services, such as cheque clearing, are largely automated, there may be a large fixed cost base.
  • Even if a service is heavily automated, each time the service is performed is a ‘moment of truth’ for the customer. Ensuring consistency and quality is important but this is true for small service businesses too.

Service industries, perhaps more than manufacturing firms, rely on their staff. Front-line staff are those who convey the ‘service’ – and the experience of the brand – to the consumer.

For service businesses, management accounting information should incorporate the key drivers of service costs.

− Repeat business

− Opportunity costs of not providing a service

− Churn rate (for subscriptions)*

− Avoidable / unavoidable costs

− Customer satisfaction surveys, complaints

* For any given period of time, the number of participants who discontinue their use of a service divided by the average number of total participants is the churn rate. Churn rate provides insight into the growth or decline of the subscriber base as well as the average length of participation in the service.

CHAPTER ROUNDUP

  • Target costing involves setting a target cost by subtracting a desired profit margin from a competitive market price.
  • Unlike manufacturing companies, services are characterised by intangibility, inseparability, variability, perishability and no transfer of ownership.
  • Service businesses need the same aggregate information as manufacturing firms, but also need performance data as to their cost and volume drivers. Operational information is likely to be more qualitative.
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