TARGET COSTING:

Target costing is an approach in which companies set targets for its costs based on
the price prevalent in the market and the profit margin they want to earn. Keeping
its costs below the relevant targets helps the company generate profit.

Target cost = selling price profit margin

Profit margin may be based on cost or selling price.

In most of the industries competition is high which means that prices are
determined by the interaction of market demand and supply which the market
participants i.e. producers cant change. However, they can control their costs. In
target costing, companies leverage their ability to monitor and control their cost to
generate a profit.

Target costing can be contrasted with cost-plus pricing, in which companies set
price by adding a profit margin to whatever cost they incur. Target costing is a
more effective approach because it emphasizes efficiency in order to keep costs
low. Target costing is particularly useful in industries that have low profit margins
and high competition.

Formula
Where the profit margin is based on selling price, target total cost can be calculated
as follows:
Target cost = selling price profit percentage selling price
Where the profit margin is based on cost, target cost can be found as follows:

Target cost =

selling price
1 + profit percentage

Targets can be set for each individual cost component based on the standard
costing.
Example
D&D is a denim manufacturer that operates in a very competitive environment. It
sells denim to different companies that manufacture and market jeans under their
own brands. D&D can only charge $2 per meter. If the companys intended profit
margin is 15% on cost, calculate the target cost per unit. If 30% of the cost per
meter of denim is related to direct materials, whats the target cost per unit for
direct materials.
Solution

D&D wants to earn a margin of 15% on cost, so the following formula shall be
used to set the total target cost per unit.
Target cost per unit =
Target cost per unit =

selling price
1 + profit percentage
$2 per meter
(1 + 15%)

= $1.74

D&D has to keep its cost per unit below $1.74 in order to generate 15% profit
margin on cost.
If 30% of the unit cost is related to direct materials, target cost for direct materials
shall be $0.52 (0.3*$1.74).
If D&D wants to earn 15% on selling price, the total target cost per unit shall be
worked out as follows:
Target cost per unit = $2 * (1 15%) = $1.70

Comparing Traditional Management Accounting with Target Costing.

Traditional management accounting system starts with market research
followed by product specification. It may be noted that product cost is
not a significant factor at the initial factor of designing the product. It
is only after the engineers and designers have determined the product
design that an estimate design that an estimate of product cost is
made. Thus, no attempt is made to achieve a particular cost target.

Unlike traditional management accounting which has an internal focus,

target costing is outwardly focused and market driven as can be seen
in figure. The first element in target costing is understanding customer
requirements, including the performance and cost characteristics of the
competitors product. Understanding customer requirements a key
condition for the success of target costing. A company must carefully
define and select a market niche where there is opportunity to design phase to
create a product that meets the customer requirements and beats the competition.
Target costing, thus leads to establishment of cost targets and makes use of tools
like quality function deployment (QFD), value engineering (VE), and design for
manufacturing (DFM) to achieve the set cost. Quality function deployment is used
as a procedure to incorporate customer needs into product features during product
planning. Value engineering is the process of examining each component of a
product to determine whether its cost can be reduced while maintaining
functionality and performance. Design for manufacturing includes examination of
each component of a product in order to minimize the cost of ownership of a
product over its useful life.

Steps for Implementing Target costing.

Target Costing process steps

The target costing process begins by establishing a selling price, based on market
research, for the new product. From this target selling price, the desired (target)
profit is subtracted to determine the target cost. In all likelihood, this target is
below the companys current manufacturing cost.
Teams from many departments then perform functional cost analysis in an attempt
to reach the target cost. If the current cost estimate is at the target, the firm must
decide whether or not to introduce the new product. If the current cost estimate is
above the target, functional cost analysis is used to make changes and prepare
another cost estimate.
1. Establish a target profit for the product
Marketing plays a crucial role in the determination of the target cost. The starting
point for a target cost is the estimated selling price for the product determined by
market analysis. Sales volume is also estimated and, from the total estimated sales
revenue, the desired profit is subtracted. Management determines this desired
profit margin in reference to the companys long term strategy. Retail prices and
sales volumes are proposed by the marketing function based on its research and the
companys desired market share.
Total sales revenue for each new product over its life can now be estimated. The
target profit, usually determined by using return on sales, is subtracted from the
total sales revenue.
2. Determine the target cost
The target profit is subtracted from the target price to arrive at the target cost.
Management accounting can play an important role in effectively determining

target profits and target costs. Accountants can supply the information required to
support a marketing analysis for a new product and relate it to existing products.
After the target cost is determined by subtracting the target profit from the target
price, functional cost analysis is used to achieve the target cost. Functional cost
analysis is a group activity typically involving employees from different
departments (such as marketing, design, engineering, production, purchasing, and
accounting) and is aimed at proposing alternatives for reducing overall product
cost.
This team-oriented approach requires that the employees of different
departments bring together their knowledge and experience in the
organization to contribute to the cost reduction process. Working with product
designers, their motivation is not only to cut the number of parts but also to work
toward the use of standard parts in designs that give products desired functions at a
lower cost.
Target costing teams that function best have the following characteristics.
First, employees that are assigned to these projects must have a basic
understanding of how their work is translated into numbers that represent the firm's
performance. For example, production managers rely heavily on direct
performance indicators that employees can readily grasp and to which they can
readily respond. Typical indicators are the time it takes to set up the manufacturing
line to produce a batch of products or the amount of material that has to be
scrapped because of worker error. Traditional measures that emphasize goals based
on complex, financially-oriented yardsticks, such as return on investment, are
incomprehensible to most workers.
Second, team members responsible for projecting and measuring product costs
should not be narrowly trained individuals with no feel for the product and its
market. The best team members are those individuals who have rotated through

several departments, including design, purchasing and especially marketing, before

being assigned to a cost-planning project.
Broad backgrounds give team members a unique ability to spot and implement
ways to reduce costs.
3. Perform functional cost analysis
Functional cost analysis requires the preparation of a logical diagram for each
function of the product. It should be noted that this is not a diagram of each part of
the product since it is the functions of a product that determine its success in the
market. For example, Figure 2 shows the functional family tree for a desktop
stapler. Each function of the product is defined in terms of a verb and noun with
the primary function shown at the right being defined as attach paper. The sub
functions, such as put staple and hold stapling mechanism, show various
operations of the product.

Figure illustrates the links between the functions and the parts of the stapler, along
with the applicable costs. Every part is treated as a component and each is assigned
a target cost. This is where the negotiating begins. The negotiations may involve
the company and its outside suppliers as well as the departments that are
responsible for different aspects of the product. The total of the initial estimates
may exceed the overall target cost by 25% or more. At the end of the discussion,
compromises and trade-offs by the product designers, manufacturing engineering,
and marketing specialists generally produce a projected cost that is close to the
original target. Note that Table I provides the actual manufacturing cost for each
function and parts required to carry out the function. Management sets the target
cost for each product under consideration. These costs may be derived from a
purely technical assessment of the resources required, or a market-oriented
perspective, or a combination of both. Market intelligence data are often used to
help determine the target cost of each function. These combined estimates help
determine the target cost for the product and should reflect the perceived
importance by the customer. When actual costs exceed the market-oriented
estimate, there is a need for modifications which may consist of alternatives for
improvement. For example, a range of new materials or new parts may be
considered or modifications to the function may be proposed in order to improve
the value of the product to customers.

Functional analysis is closely linked to value engineering. Functional analysis is a

cost management system that focusses on the various functions of each product.
The individual functions of a product become the set of cost objectives and provide
the basis for the costing system (Yoshikawa, et al.,
1990). Value engineering (VE) involves designing a product from different angles
at a lower cost by reviewing the functions needed by customers. VE is used for
purchasing, planning, design, production, and other processes on a company-wide
basis. There is a variety of methods for conducting value engineering. The process
generally starts with performance checks on test parts. Designs are changed to give
each part a specific degree of performance. Then discussion turns to ways to cut
costs while maintaining performance. The aim is to use the information provided
by the functional analysis to propose alternatives for improving costs.
4. Determine the cost estimate
Functional analysis requires information concerning engineering Specifications
and accounting data. The actual manufacturing cost and the target cost for each
products functions are compared. Alternatives are
Identified to bring each functions actual cost estimate to its target cost.
Management accountants provide information on the cost effects of the proposed
functional modifications. When needed, they prepare very detailed sets of cost
tables that include the costs of alternative materials, of using different types of
manufacturing technologies, and so on.
5. Decision: is the cost estimate on target?

After the teams consisting of members from the various functions of the company
have used value engineering and functional cost analysis to determine the new
products estimated cost, the estimate is compared with the target cost. If the cost
estimate equals the target cost, they move to the final decision. If the cost estimate
exceeds the target cost, functional cost analysis is used again to reduce the
estimated cost to the target cost.

6. Make the final decision

Once the cost estimates are on target, management makes the final decision to
introduce the product based on manufacturing feasibility, market needs and
consumer acceptability. If the decision is to go ahead with the product,
manufacturing is instructed to proceed with production.
Once the decision has been made to manufacture the new product, however, there
are other considerations necessary for successful implementation of the process.
Since the target cost is often below the actual cost based on the current production
technology (i.e. the standard cost), a team effort is required to enable the
organization to achieve the target cost. Teams of people from marketing,
engineering, purchasing, manufacturing, and accounting work together to assure
that a cost position on the product is such that the company can sell the product at
its required market price and make money doing it (Howell and Sakurai, 1992).
Value engineering requires access to many kinds of information found in various
departments, so cooperation must be promoted.
Finally, target costing does not end once the decision has been made to move the
product into the production stage. The standard manufacturing cost of the product

depends on specific production line conditions. For example, production on lines

below capacity pushes costs up, while production on lines near full capacity leads
to the best cost performance.
Often during the planning stage, it is difficult to visualize the line conditions and
thus reflect accurately these conditions in cost estimates. Therefore, once the initial
target cost has been calculated, the manufacturing division then initiates an effort
to improve on the standard cost, in order to get it down to the target cost.
7. Conclusion
The objective of target costing is to assure that a firm achieves its product specific
and firm-wide profit objectives in a very competitive market environment. It is
becoming increasingly essential as more firms are realizing that they cannot
increase prices to solve cost and profit squeeze problems.

Costs can be reduced in a variety of ways such as the following:

1. Simplifying the design
2. Reducing the cost of direct materials
3. Reducing the direct labor costs
4. Eliminating waste

 Key Principles of Target Costing:

According to Hilton, target costing involves seven key principles listed as
follows:
1. 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.
2. Focus on the Customer:
To be successful at target costing, management must listen to the companys
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.
3. 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 labor, machinery, and other elements of the production process. In short, a
product must be designed for manufacturability.
4. 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 labor, technology,
global sourcing in procurement and every aspect of the production process must be
designed with the products target cost in mind.
5. 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.
6. Life-Cycle Costs:
In specifying a products target cost, analysts must be careful to incorporate all of
the products 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
products other life-cycle costs.

7. 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 companys entire value chain can help
managers identify opportunities for cost reduction.
Target costing is a common practice in Japan where markets are extremely
competitive. The market determines the price of products and there is a little
opportunity for the individual organizations to set prices. Therefore, controlling
cost is extremely important.