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Catholic University of Eastern Africa
Catholic University of Eastern Africa
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TARGET COSTING
It is a pricing method used by firms – it is defined as “a cost management tool for
reducing the overall cost of a product over its entire lifecycle with the help of a
A target cost is the maximum amount of cost that can be incurred on a product and
with it the firm can still earn the required profit margin from that product at a
It is also the process of determining the maximum allowable cost for a new product
Target costing involves setting a target cost by subtracting a desired margin from a
process.
Examples of decisions made at the design stage which impact on the cost of a
product include;
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Justification / reasons for using: the target costing approach was developed in
Costs: most firms really have less control over price than they would like to think.
The market: i.e. (demand and supply) really determine the process and a firm that
attempts to ignore this does so at its own peril/risk, therefore the anticipated
Cost
The cost of a product is determined in the design stage. Once a product has been
designed and has gone into production then it follows that the major opportunities
This is where valuable features the customers are willing to pay for can be added or
adopted and where most of the costs are really determined. So the focus is on
development is profound. That is to say that instead of designing the product and
then finding out how much it costs, the target cost is first set and then the product
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i. It is embedded in a team environment i.e. that team members include
purchasing, manufacturing and marketing. All the team members are focused
on the same objectives i.e. deliver a product with the target functionality,
ii. The target costing idea reflects the reality that the most product and process
design, decisions are not the lowest. Cost designs but rather designs that the
organization has decided it can live with i.e. we use solutions that are good
iii. Target costing places huge pressure on the design team. The design team
has a common objective; to meet target cost. This is to say that there is no
Demerits
The idea that the team will continue its product and process design efforts
until it finds designs that yield the target cost, is time consuming and
tiresome.
the price (target price) that customers are willing to pay. The marketing department
determines what characteristics and price for a product are most acceptable to
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customers; then it is the job of the company’s engines to design and develop the
product such that cost and profit can be covered by that price.
Retail stores employ target costing when they look for goods that can be priced at a
a new product at a low initial price, perhaps even lower than cost, to build market
share quickly. This is useful when the product or service is new and customers have
Price skimming
This is means that a higher price is charged when a product or service is first
introduced. In essence, the company skims the dream of the market. It is used most
effectively when the product is new, a small group of consumers values it, and the
Co.’s that engage in price skimming are hoping to recoup the expenses of research
and development through high initial pricing. A cost consideration is that, in the
start –up phase of production, economies of scale and learning effects have not
occurred.
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In general, there are many ways in which the price of a product can be determined
which include.
This is the setting of price based upon prices of the similar competitor
we can assume.
that:
Cost plus pricing is the simplest pricing method. The firm calculates the cost
give the selling price. This method although simple has two demerits;
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b) There is no way of determining if potential customers will purchase the
1. Limit pricing
into a market, and is illegal in many countries. The limit price is the price that
the entrant would face upon entering as long as the incumbent firm did not
decrease output. The limit price is often lower than the average cost
to entry is usually larger than would be optimal for a monopolist, but might
still produce higher economic profits than would be earned under perfect
competition. The problem with limit pricing as strategic behavior is that once
the entrant has entered into the market, the quantity used as a threat to
2. Loss leader
No market leader would wish to sell below cost unless this is part of its
overall strategy. The idea of selling at a loss may appear to be in the public
interest and therefore not often challenged. Only when the leader pushes up
Setting a price based upon analysis and research compiled from the targeted
market.
4. Penetration pricing
The price is deliberately set at low level to gain customer’s interest and
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5. Price discrimination
Setting a different price for the same product in different segments to the
market what if involves is, setting the price of your product / service
6. Premium pricing
7. Predatory pricing
difference between the products’ price and variable costs (the product’s
relationship between the product’s price and the number of units that can be
sold at that price. The product’s contribution to total firm is maximized when
1. Psychological pricing
2. Dynamic pricing
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A flexible pricing mechanism is made possible by advance in information
3. Price leadership
4. Target pricing
5. Absorption pricing
This is a method of pricing in which all costs are recovered. The price of the
product includes the variable cost of each item plus a proportional amount of
This is the practice of setting the price of a product to equal the extra cost of
producing an extra unit of output. By this policy, a producer charges, for each
product unit sold, only the addition to total cost resulting from materials and
direct labour. Businesses often set prices close to marginal cost during
product pricing in its stores. The primary factor is the competitive market
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purely on being competitive in the trade market area. It is not based on
Target profit: This is the amount of net operating income of profit that
needs to know the required level of business activities to get target profits.
Cost volume profit (VCP) equations and formulas can be used to determine the sales
Example
Required
How many units will have to be sold to earn a profit of KSh. 40,000?
Solution
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The cup equation method
Under this approach, we can find the number of units to be sold to obtain target
profit by solving the equation where profits are equal to target profit of 40,000.
= 100Q = 75,000
Thus the target profit can be achieved by selling 750 units per month, which
represents KSh.187,500 in total sales (250/= X 750 units). This equation is also
extensively used to calculate break even point when the break even joint is
= Sh. 187,500
750 units
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Review problem
Mwangi and Shiko co. manufacture and sell a telephone answering machine. The
company’s contribution margin format income statement for the most recent year is
given below.
that next year management wants the co. to earn a minimum profit of Sh. 90,000.
How many units will have to be sold to meet the target profit figure?
Solution
1. Equation method
15Q = 330,000
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Q = 330,000 = Q = 22,000 units.
= 240,000/= + 90,000/=
Q = 22,000 units.
manufacturing companies.
Consumers are demanding new and diversified products in short interves and
product cycles are becoming or getting shorter and shorter. Due to factory
and designed, there is a limit to how much cost cutting companies can in the
manufacturing stage.
It is primarily used and most effective in the product development and design
stage. It is based on the price down, cost – down strategy, which allows
and sony.
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3. Connect with profit planning
It is really closely linked with the company’s long-term profit and product
planning process. This link allows the co. to focus on profit and product in an
integrated strategy which does not discriminate against high quality, high-
When the target sales price is established based on the market research, the
desired profit is subtracted to yield the allowance cost. This allowance cost is
co.’s desired Return on sales), rather than Return on investment. There are
Technical reason
2. Strategy reason
on the profitability of ponfolios of related products and the role each product
plays for the product group for this, ROS provides a better measure.
the target cost into each cost element according to their relations to detailed
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and part usage, labour consumption e.t.c which become the basic cost data
4. Value engineering
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