Target costing

Q1. Pitlane Electronic Components (Pitlane) manufactures components for use in the electricity
distribution network in Deeland. Demand from Pitlane’s biggest customer, to replace identical but worn-
out components, has been constant for many years. Pitlane has recently renewed an exclusive long-term
supply agreement with this customer, who has always agreed to buy the components for their total
standard cost plus a fixed profit margin of 15%. Variances between standard and actual costs of the
components are negligible. Pitlane runs several production lines in two factories located in different areas
of Deeland. The factories’ layout is poorly designed, and the production process requires components to
be transported around and between the factories.
The Deeland government wants to encourage renewable electricity generation. It is offering a three-year
subsidy scheme, beginning in 2018, for consumers to have solar panels installed on the roofs of their
homes. As an added incentive, businesses will be exempt from tax on profits made on the sale of solar
panels and related components.
To take advantage of this scheme, Pitlane has built a prototype of a new electrical component, known as
the ‘Booster’, which increases the output from domestic solar panels. The Booster will be sold to
installers of solar panels and not directly to consumers. Pitlane’s marketing department has estimated
market data for the duration of the scheme based on a similar scheme in Veeland (Appendix 1). As a
result of its products being unchanged for many years, Pitlane has little recent experience of developing
new products and estimating costs and potential revenues from them. It is expected that many competitor
products will be launched during the scheme, at the end of which demand is expected to fall greatly, and
production of the Booster will discontinue.
Pitlane’s shareholders insist that for the Booster project to go ahead, it must meet the financial
performance objective of achieving a 15% net profit margin, after all costs, for the duration of the
scheme.
The Booster’s total fixed costs during the scheme are estimated to be $10m, including $2·8m upfront
development costs to enable the Booster to communicate the amount of solar energy generated directly to
consumers’ smartphones via an app. The product development team at Pitlane believes this feature, and
the use of highest quality packaging, will allow it to charge 10% more that the average price of its
competitors. The marketing team, however, has questioned the overall value of these two features and
whether customers would be prepared to pay extra for them, as most of the Deeland population do not yet
own smartphones.
Pitlane has estimated the direct costs for the Booster (Appendix 2). The largest direct cost is for the four
main sub-components. These are bought in bulk from six different suppliers in Deeland, though all are
readily available from suppliers worldwide. The sub-components are fragile. During production of the
Booster prototype, many sub-components were found to be damaged during the production process by
workers incorrectly assembling them. This resulted in the completed prototype Boosters being scrapped
after testing by the quality control department. The manufacturing director is concerned that the incorrect
assembly of sub-components by workers may mean that it may not be profitable for Pitlane to start full
scale production of Boosters. To counteract these quality problems, Pitlane will employ more highly
skilled workers, who are paid around 30% more than most other workers in the business which is
accounted for in the cost estimate given in Appendix 2. Pitlane staff have never been encouraged to
suggest any ways to improve the manufacturing process.
 
Pitlane’s directors are concerned that the Booster project will not meet the shareholders’ financial
performance objective. They have asked you, as a consultant experienced in target costing, Kaizen
costing and other Japanese business practices, for your advice.
 
Required:
(a) Calculate the cost gap per unit in each of the three years of the Booster’s life, considering all estimated
costs. (6 marks)
(b) Advise on the extent to which target costing would help Pitlane to achieve the financial performance
objective set by the shareholders. (12 marks)
 

ANSWERS

2a:
2b:
Target costing
Pitlane currently operates a traditional cost plus pricing method, where customers pay a fixed mark up
on Pitlane’s standard cost. This has been appropriate because the components currently produced have
been manufactured in the same way for some time and their cost structure is well understood. Actual
costs of production are very close to the standard costs. There is little competition in the market for
Pitlane’s current products, as a long-term contract was recently renewed with its biggest customer.

In contrast, for the proposed Booster product, the market price is only estimated. To compete with
similar products, the Booster will need to sell at a price reflecting that of competitors’ products, taking
into account the different benefits and quality which each product has.

Target costing begins with taking the price which the market will pay for the product for a given market
share. From that, the required profit margin is deducted to arrive at a target cost. The difference
between the estimated cost for the product and the target cost is the cost gap. Where the estimated
costs exceed the target cost, steps are taken to reduce the cost gap. The product can then be sold at a
price which the market will accept, and which generates an acceptable profit margin.
Determining the market price
Pitlane’s marketing department has estimated the average market price of competitors’ products and
the likely market share over the three years of the scheme. The estimates are based on the success of a
similar scheme in Veeland, and the assumptions used could be incorrect. Electricity prices may already
be higher in Veeland than in Deeland, meaning consumers there would reduce their energy costs more
by installing solar panels. Similarly, consumers in Veeland could save more on energy costs if there is
more sunshine there than in Deeland, enabling solar panels to generate more energy. Both factors
would, in this case, reduce the take up of subsidies by consumers in Deeland and the amount they
would be willing to pay for solar panels.

The domestic solar energy market is new in Deeland, and Pitlane has no experience in estimating market
share or price for this type of product. Pitlane’s belief that consumers would be willing to pay a 10%
premium for highest quality packaging, or for the Booster to communicate with consumers’ mobile
phones, may be incorrect.

Calculating the target cost using the required profit margin

Pitlane charges a 15% profit margin on its existing projects. The shareholders’ financial objective
indicates that they require the same profit margin to be earned on Booster.

For its existing products, Pitlane can set a selling price based on its own costs, whereas the Booster’s
price must reflect external market conditions more closely. Target costing will focus Pitlane on the
external environment by considering prices and relative benefits of competitors’ products.

Estimating total costs of Booster

The total direct costs of Booster have been estimated at $134·00. The fixed overhead per unit relating to
Booster for the three years of the scheme is $44·05, making total estimated costs per unit of $178·05.
The cost estimates may be incorrect, especially as Booster is new, and different from Pitlane’s existing
products. As Booster includes costs which are fixed, estimating sales volumes is also crucial in
determining costs per unit.

Pitlane has no recent experience of developing new products or of estimating costs and sales volumes
for them. This makes it more likely that the cost estimates for the Booster will be incorrect. Estimating
the total costs is needed for the next stage in the target costing process, to identify the cost gap.

Reducing the cost gap

A big advantage for Pitlane of using target costing is that it is often easier to reduce costs of a product at
the design stage rather than after it has entered production.

As Boosters are not sold directly to consumers, the buyers of the product, who are professional
installers, may not see value in the highest quality packaging. This could be a significant yet unnecessary
cost, to be eliminated at the design stage. In deciding what costs to eliminate, Pitlane will have to take
into account the effect of these on the quality and perception of the final product.

The features where the Booster can communicate with consumers’ smartphones, and the use of highest
quality packaging, are believed to enable Pitlane to charge 10% more than competitors’ products. The
$3·8m (W1) of estimated additional total revenue from the packaging and smartphone features may not
justify the $2·8m upfront development costs for the smartphone feature alone, especially if the time
value of money were to be taken into account. Consumers may not value these two features or be
prepared to pay more for them. Eliminating them would therefore have little effect on sales volumes
and would enable Pitlane to charge a more competitive price, or obtain higher gross profit margins.

Due to damage of sub-components when assembling the prototype, the estimated assembly labour cost
assumes highly skilled labour will be used. This is 30% more expensive than other labour. By providing
additional training, lower paid labour could be used to produce the Booster, and hence reduce the cost
gap.

Pitlane plans to purchase the four main sub-components in bulk from six different suppliers.
Consolidating suppliers, or using suppliers in lower cost countries, could help reduce the cost gap by
reducing purchase costs. Moving to a just-in-time production system, rather than buying supplies in
bulk, would help reduce costs of holding inventory as suppliers would only deliver sub-components
when needed. This may increase other costs such as by requiring investment in information technology.
It would also take time to develop the close relationship required with suppliers.

Another source of waste is due to internal transport and handling, which forms over 5% of the total
direct cost of the Booster. This will also increase production cycle times, and is an unnecessary process
which does not add value. It could be eliminated by changing the layout of the factory, or reorganising
production into teams and ensuring all production was done at a single factory, rather than in both of
Pitlane’s factories.

W1 – Additional revenue from smartphone feature and highest quality packaging

2018 – 60,000 units x $198 = $11·880m
2019 – 75,000 units x $187 = $14·025m
2020 – 92,000 units x $176 = $16·192m
Total revenue = $42·097m
= $42,097,000 x 10/110 = $3,827,000