TARGET COSTING

ACCA PM Syllabus - B2

In a competitive market, the price of a product may be determined by the market. Companies,
therefore, have to accept the market price.

▪ Target costing is a marketing approach to costing. It attempts to achieve an acceptable

margin in a situation where the price of a product is determined externally by the market.
This margin is achieved by identifying ways to reduce the product's costs.

Definition

Target costing – subtracting a desired profit margin from a competitive market price to determine
the maximum acceptable cost.

Target costing is most appropriately used during the design phase of a product (where cost
savings can be identified by changing the design of the product to avoid unnecessary costs from
being designed into the product);

Steps in Target Costing

1. Determine the price the market will accept for the product based on market research. This
may take into account the market share required.
2. Deduct a required profit margin from this price − this gives the target cost.
3. Estimate the actual cost of the product. If it is a new product, this will be an estimate.
4. Identify ways to narrow the gap between the actual cost of the product and the target cost.

The following flow diagram illustrates target costing:

Source: Sakurai, M., Journal of Cost Management for the Manufacturing Industries, Target
Costing and How to Use It, iii No. 2 (1989).
The flow diagram above summarises how the target price and profit may be determined:

▪ The starting point is to define the product specification. This involves designing the product
and determining, in detail, which features will be included.
▪ The sales volume is defined, and the target price is set. This price will be based on the
organisation's pricing strategy and market research, which will help determine the price at
which the required output volume can be sold that meets profit objectives.
▪ The required profit may be based on the investment required to produce the product and
the needed return on investment.
▪ The target profit is then divided by the number of units to obtain the required profit per
unit, which is deducted from the target price to give the target cost.

Activity 1 Target Costing

Exclusive Motors is designing a new version of its luxury car, the Z123 series. The vehicle
will be launched next year. It is expected to have a lifecycle of 10 years.

The production of the car will require an investment of $3 billion. The company needs a
profit of 20% a year on this investment.

The marketing department believes that the car could be sold for a price of $40,000 each.
100,000 cars would be manufactured and sold each year.

Required:

Calculate the target cost of one Z123.

Application to Service Industries

Target costing is likely most appropriate in manufacturing industries, where a volume

ofstandard products is to be made. Although it can also be used in service industries, there may
be additional challenges:

▪ In many service industries, the "products" are non-standard and customised. It is difficult
to define a target cost when there is no standard product.
▪ A higher portion of the expenses in service industries are indirect (overheads). It is harder
to reduce these on a product-by-product basis.
▪ Reducing costs in a service industry may be at the expense of customer service or quality.
In manufacturing industries, it may be possible to identify cost savings that remove product
parts that customers do not value.

Narrowing the Target Cost Gap

Target costing relies on multi-disciplinary teams discussing ways to reduce the gap between
the actual (expected) and target costs.

There are various methods to reduce product cost; an important consideration when using these
techniques is to ensure that the perceived value of the final product/service is not reduced
(which would lead to lower effective selling prices).
Some methods which may be used are:

▪ Reconsider the design to eliminate non-value-added elements.

For example, snap-together fasteners and automated glue dispensing may be used
instead of screws (which require high labour manipulation)

▪ Reduce the number of components or standardise components.

For example, multiple separate components that need to be welded together in car
assembly may be cast as a single piece, reducing welding costs and improving structural
integrity.

▪ Use less expensive materials.

Using cheaper materials may reduce overall unit cost, but there is a significant risk of
reducing perceived value.

▪ Employ a lower grade of staff on production.

Using a lower staff grade may reduce labour costs. However, management must closely
monitor quality costs. It might be suitable if the production process does not require
specialist skills.

▪ Invest in new technology.

This usually involves a significant upfront cost to acquire the technology, and its value
may be related to how effectively the new technology is utilised.

Lifecycle costing may be used to have better insight into the actual cost of the
investment

▪ Outsource elements of the production or support activities.

Outsourcing activities is a common cost reduction action; however, care must be taken
to ensure outsourced components and services are of the required quality and that
crucial value drivers and capabilities are not lost in the outsourcing process.

▪ Reduce manning levels or redesign the workflow.

Redesigning workflows and processes (using Kaizen, for example) helps reduce
production costs. Ensure dysfunctional shortcuts disguised as cost-cutting measures are
not built into the redesigned workflow.

For example, removing supposedly non-value-adding activities such as precision

measurement and quality tests might lead to deterioration in the consistency of quality.
The following techniques may assist such methods:

"Tear down analysis" (also called "reverse engineering") − involves examining a

competitor's product to identify possible improvements or cost reductions.

Value engineering − involves investigating the factors that affect the cost of a product or
service. The aim is to improve the design of a product so the same functions can be provided
for a lower cost or save cost by eliminating those the customer does not value.

Some writers distinguish between four elements of value:

1. Utility or use value – how useful the product is to the owner.

2. Esteem value – how the product increases the owner's well-being.
3. Scarcity value – how rarity impacts value, for example the high value of diamonds results
partly from their scarcity.
4. Exchange value – the amount the owner sells the product for.

Key Point
The value engineering technique is applied to new products/services at the beginning of the
development process during the design stage (i.e. before production starts). Value analysis
evaluates the value of an existing product or service.

Functional analysis − involves identifying the attributes/ functions of a product that customers
value. The price the customer is prepared to pay for each function is then determined. The
function should be dropped (abandoned) if the cost of providing it exceeds the value (marginal
revenue) it generates.

Businesses should ensure that any steps taken to reduce product costs do not lead to a lower
perceived (or actual) quality, as this may reduce the price the product could sell for. This would
then reduce rather than increase the margin from selling the product.

Increasing the sales price is not a viable method of reducing the gap.

• The whole purpose of target costing is to achieve a reasonable margin when the market
determines the competitive price.
• Charging a higher price would lead to a significant fall in demand for the product.

Key Point
Target costs can be driven down by directing attention to any costs related to any part of a
product’s lifecycle.