What is target costing?

[edit]
Target costing involves setting a target cost by subtracting a desired profit margin from a
competitive market price.[1][2]
A lengthy but complete definition is "Target Costing is a disciplined process for determining
and achieving a full-stream cost at which a proposed product with specified functionality,
performance, and quality must be produced in order to generate the desired profitability at
the products anticipated selling price over a specified period of time in the future."

[3]

This definition encompasses the principal concepts: products should be based on an

accurate assessment of the wants and needs of customers in different market segments,
and cost targets should be what result after a sustainable profit margin is subtracted from
what customers are willing to pay at the time of product introduction and afterwards. These
concepts are supported by the four basic steps of Target Costing:

Define the Product

Set the Price and Cost Targets

Achieve the Targets

Maintain Competitive Costs.

Japanese companies have developed target costing as a response to the problem of

controlling and reducing costs over the product life cycle.

Objectives of Target Costing[edit]

The fundamental objective of target costing is very straightforward. It is to enable
management to manage the business to be profitable in a very competitive marketplace. In
effect, target costing is a proactive cost planning, cost management, and cost reduction
practice whereby costs are planned and managed out of a product and business early in the
design and development cycle, rather than during the latter stages of product development
and production.

http://en.wikipedia.org/wiki/Target_costing

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. If it cannot
manufacture a product at these planned levels, then it cancels the design project entirely.
With target costing, a management team has a powerful tool for continually monitoring
products from the moment they enter the design phase and onward throughout their
product life cycles. It is considered one of the most important tools for achieving consistent
profitability in a manufacturing environment.

The primary steps in the target costing process are:

1. Conduct research. The first step is to review the marketplace in which the company
wants to sell products. The design team needs to determine the set of product
features that customers are most likely to buy, and the amount they will pay for
those features. The team must learn about the perceived value of individual features,
in case they later need to determine what impact there will be on the product price if
they drop one or more features. It may be necessary to later drop a product feature
if the team decides that it cannot provide the feature while still meeting its target
cost. At the end of this process, the team has a good idea of the target price at
which it can sell the proposed product with a certain set of features, and how it must
alter the price if it drops some features from the product.
2. Calculate maximum cost. The company provides the design team with a
mandatedgross margin that the proposed product must earn. By subtracting the
mandated gross margin from the projected product price, the team can easily
determine the maximum target cost that the product must achieve before it can be
allowed into production.

3. Engineer the product. The engineers and procurement personnel on the team now
take the leading role in creating the product. The procurement staff is particularly
important if the product has a high proportion of purchased parts; they must
determine component pricing based on the necessary quality, delivery, and quantity
levels expected for the product. They may also be involved in outsourcing parts, if
this results in lower costs. The engineers must design the product to meet the cost
target, which will likely include a number of design iterations to see which
combination of revised features and design considerations results in the lowest cost.
4. Ongoing activities. Once a product design is finalized and approved, the team is
reconstituted to include fewer designers and more industrial engineers. The team
now enters into a new phase of reducing production costs, which continues for the
life of the product. For example, cost reductions may come from waste reductions in
production (known as kaizen costing), or from planned supplier cost reductions.
These ongoing cost reductions yield enough additional gross margin for the company
to further reduce the price of the product over time, in response to increases in the
level of competition.
The design team uses one of the following approaches to more tightly focus its cost
reduction efforts:

Tied to components. The design team allocates the cost reduction goal among the
various product components. This approach tends to result in incremental cost reductions to
the same components that were used in the last iteration of the product. This approach is
commonly used when a company is simply trying to refresh an existing product with a new
version, and wants to retain the same underlying product structure. The cost reductions
achieved through this approach tend to be relatively low, but also result in a high rate of
product success, as well as a fairly short design period.

Tied to features. The product team allocates the cost reduction goal among various
product features, which focuses attention away from any product designs that may have
been inherited from the preceding model. This approach tends to achieve more radical cost
reductions (and design changes), but also requires more time to design, and also runs a
greater risk of product failure or at least greater warranty costs.

Of these methods, companies are more likely to use the first approach if they are looking for
a routine upgrade to an existing product, and the second approach if they want to achieve a
significant cost reduction or break away from the existing design.
What if the project team simply cannot meet the target cost? Rather than completing the
design process and creating a product with a substandard profit margin, the correct
response is to stop the development process and move on to other projects instead. This
does not mean that management allows its project teams to struggle on for months or
years before finally giving up. Instead, they must come within a set percentage of the cost
target on various milestone dates, with each successive milestone requirement coming
closer to the final target cost. Milestones may occur on specific dates, or when key
completion steps are reached in the design process, such as at the end of each design
iteration.
Though management may cancel a design project that cannot meet its cost goals, this does
not mean that the project will be permanently shelved. Instead, management should review
old projects at least once a year to see if the circumstances have changed sufficiently for
them to possibly become viable again. A more precise review approach is to have each
project team formulate a set of variables that should initiate a product review if a trigger
point is reached (such as a decline in the price of a commodity that is used in the product
design). If any of these trigger points are reached, the projects are immediately brought to
the attention of management to see if they should be revived. Such a revival should take
into consideration any changes in the market prices of comparable products since the
project was last examined.
Target costing is most applicable to companies that compete by continually issuing a stream
of new or upgraded products into the marketplace (such as consumer goods). For them,
target costing is a key survival tool. Conversely, target costing is less necessary for those
companies that have a small number of legacy products that require minimal updates, and
for which long-term profitability is more closely associated with market penetration and
geographical coverage (such as soft drinks).
The target costing concept has limited application in a services business where labor
comprises the primary cost.

Target costing is an excellent tool for planning a suite of products that have high levels of
profitability. This is opposed to the much more common approach of creating a product that
is based on the engineering departments view of what the product should be like, and then
struggling with costs that are too high in comparison to the market price.

http://www.accountingtools.com/target-costing

TARGET COSTING APPROACH TO

PRICING:
Learning Objective of the Article:
1.

Define and explain target costing.

2.

Compute the target cost for a new product or service. What are advantages
and disadvantages of target costing approach.

In traditional costing system it is presumed that a product has already been

developed, has been costed, and is ready to be marketed as soon as a price
is set. In many cases, the sequence of events is just the reverse. That is, the
company already knows what price should be charged, and the problem is to
develop a product that can be marketed profitably at the desired price. Even
in this situation, where the normal sequence of events is reversed, cost is
still a crucial factor. The company can use an approach calledtarget costing.
1.

Definition and Explanation of Target Costing

2.

Reasons for Using Target Costing Technique

3.

Example of Target Costing Process

4.

Advantages and Disadvantages of Target Costing

DEFINITION, EXPLANATION AND FORMULA OF

TARGET COSTING:
Target costing is the process of determining the maximum allowable cost
for a new product and then developing a prototype that can be profitably
made for that maximumtarget cost figure. A number of companies
primarily in Japanuse target costing, including Compaq, Culp, Cummins
Engine, Daihatsu Motors, DaimlerChrysler, Ford, Isuzu Motors, ITT, NEC,
and Toyota etc.
The target costing for a product is calculated by starting with the products
anticipated selling price and then deducting the desired profit.
Following formula or equationfurther explains this concept:
Target Cost = Anticipated selling price Desired profit
The product development team is then given the responsibility of designing
the product so that it can be made for no more than the target cost.
Following set of activities further explains the concept of target costing
technique:
TARGET COSTING PROCESS DIAGRAM
Determine Customer Wants and Price Sensitivity

Planned Selling Price is Set

Target Cost is Determined As: Selling Price Less

Desired Profit

Teams of Employees from Various Areas and

Trusted Vendors Simultaneously

Determine
Determine

Necessary

Design

Manufacturing

Raw

Product

Process

Materials

Costs are Considered Throughout this Process.

The Process Requires Trade-offs to Meet Target
Costs

Once Target Cost is Achieved the Manufacturing

Begins and Product is Sold

REASONS FOR USING TARGET COSTING

TECHNIQUE:
The target costing approach was developed in recognition of two
important characteristics of markets and costs. The first is that many
companies have less control over price than they would like to think. The

market (i.e., supply and demand) really determines prices, and a company
that attempts to ignore this does so at its peril. Therefore, the anticipated
market price is taken as a given in target costing. The second observation is
that most of the cost of a product is determined in the design stage. Once a
product has been designed and has gone into production, not much can be
done to significantly reduce its cost. Most of the opportunities to reduce cost
come from designing the product so that it is simple to make, uses
inexpensive parts, and is robust and reliable. If the company has little
control over market price and little control over cost once the product has
gone into production, then it follows that the major opportunities for
affecting profit come in the design stage where valuable features that
customers are willing to pay for can be added and where most of the costs
are really determined. So that it is where the effort is concentratedin
designing and developing the product. The difference between target costing
and other approaches to product development is profound. Instead of
designing the product and then finding out how much it costs, the target
cost is set first and then the product is designed so that the target cost is
attained.

EXAMPLE OF TARGET COSTING:

To provide a simple numerical example of target costing, assume the
following situations:
Handy Appliance Company feels that there is a market niche for a hand
mixer with certain new features. Surveying the features and prices of hand
mixers already in the market, the marketing department believes that a
price of $30 would be about right for the new mixer. At that price, marketing
estimates that 40,000 of new mixers could be sold annually. To design,
develop, and produce these new mixers, an investment of $2,000,000 would
be required. The company desires a 15% return on investment (ROI). Given
these data, the target cost to manufacture, sell, distribute, and service one
mixer is $22.50 as calculated below:

Projected sales (40,000 mixers $30 per mixer )

$1,200,000

Less desired profit (15% $2,000,000)

300,000

Target cost for 40,000 mixers

$9,00,000

=======

Target cost per mixer ($9,00,000 / 40,000 mixer)

$22.50

This $22.5 target cost would be broken into target cost for the various
functions: manufacturing, marketing, distribution, after-sales service, and so
on. Each functional area would be responsible for keeping its actual costs
within target.

ADVANTAGES AND DISADVANTAGES OF

TARGET COSTING APPROACH:
Target costing has the following main advantages or benefits:
1.

Proactive approach to cost management.

2.

Orients organizations towards customers.

3.

Breaks down barriers between departments.

4.

Implementation enhances employee awareness and empowerment.

5.

Foster partnerships with suppliers.

6.

Minimize non value-added activities.

7.

Encourages selection of lowest cost value added activities.

8.

Reduced time to market.

Target costing approach has the following main disadvantages or

limitations:
1.

Effective implementation and use requires the development of detailed cost

data.

2.

its implementation requires willingness to cooperate

3.

Requires many meetings for coordination

4.

May reduce the quality of products due to the use of cheep components
which may be of inferior quality.

http://www.accounting4management.com/target_costing_pricing_products_and_
services.htm

What Are the Benefits of Target

Costing?
By Kathy Adams McIntosh, eHow Contributor

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Many companies face pressure from customers and competitors to

keep prices low. Customers threaten to stop buying or to patronize

competitors if the company raises prices. These companies may also

face rising costs, reducing their profit on each item they sell. These
companies pursue different tactics to in order to increase their
profits. Some companies use a strategy of target costing to increase
their profits without affecting price. These companies receive
several benefits from using this approach.

Other People Are Reading

Target Costing & Traditional Costing

How to Calculate Target Cost Expense

1.
o

Definition

Target costing involves a reverse analysis of the product,

starting with the selling price. The company considers the projected
price for each unit and its desired profit on the item. The company
subtracts the desired profit from the selling price to determine the
target cost per unit. The company assembles representatives from
various departments to participate on a team to achieve the target
cost. The team leader starts with the current cost information and
calculates the amount of cost that it needs to eliminate. Together,
the team comes up with ideas for reducing costs and reaching the
target.

Proactive Focus on Cost

o

One benefit of target costing falls on the side of

proactively focusing on cost. By pursuing a strategy of target
costing, the team aims to reduce the product cost before the
company starts losing money. This reduces total losses incurred by

the company. The alternative approach, less beneficial, is reacting to

customer pressures and focusing on cost reduction after the
company starts losing money.
o

Improved Processes
o

Another benefit of target costing is the improved

processes that result from the team's efforts. Target costing teams
consider material costs, labor requirements and processes. Teams
often discover inefficiencies in current processes and recommend
improvements that increase efficiency and reduce costs. These
improvements apply to the product being targeted as well as other
products using the same process. By improving processes, the
company reduces costs in other product lines as well.

Collaboration Between Departments

o

Target costing teams require employees from different

departments to collaborate on finding ways to reduce the product
cost. These employees learn about the activities that occur in other
departments and how their own actions affect others. These
employees gain an appreciation for the big picture of the business
and build relationships that transfer to future projects.

http://www.ehow.com/info_8403796_benefits-target-costing.html