Chapter 2

Target costing
Introduction

Target costing is the second specialist cost accounting

technique we will consider. It is a process which
involves setting a target cost for a product by
subtracting a desired profit margin from a target
selling price. In a competitive market where
organisations are continually redesigning products
and developing new products, target costing can be an
invaluable technique for helping the organisation to
make a satisfactory profit on the items that it sells.
Practical usage
A number of companies have used target costing,
including Compaq, Culp, Cummins Engine, Daihatsu
Motors, Chrysler, Ford, Isuzu Motors, ITT Automotive,
Komatsu, Matsushita Electric, Mitsubishi Kasei, NEC,
Nissan, Olympus, Sharp, Texas Instruments, and
Toyota.
What is target costing?
Target costing involves setting a target cost for a
product, having identified a target selling price and a
required profit margin. The target cost is the target
sales price minus the required profit.
Why target costing?
In a competitive market, selling prices must be competitive.
In order to sell at a competitive price and make a required
amount of profit, the cost of production and sales must be
kept at a level that will provide the required profit at the
chosen selling price.
In industries such as FMCG, construction, healthcare, and
energy, competition is so intense that prices are determined
by supply and demand in the market, and hence producers
can’t effectively control selling prices. They can only control,
to some extent, their costs, so management’s focus is on
influencing every component of product, service, or
operational costs
When to use?
In many markets, new product innovation and the
redesigning of existing products is a continual process.
Target costing is most effective at the product design
stage, and is less effective for established products that
are made in established processes. At the design stage,
it is easier and cheaper to make changes that reduce
costs.
Implementing target costing
1. Determine a product specification of which an adequate sales
volume is estimated.
2. Decide a target selling price at which the organisation will be able to
sell the product successfully and achieve a desired market share.
3. Estimate the required profit, based on required profit margin or
return on investment
4. Calculate: Target cost = Target selling price – Target profit.
5. Prepare an estimated cost for the product, based on the initial design
specification and current cost levels.
6. Calculate: Target cost gap = Estimated cost – Target cost.
7. Make efforts to close the gap. This is more likely to be successful if
efforts are made to 'design out' costs prior to production, rather than
to 'control out' costs after 'live' production has started.
Case study
1. Swedish retailer IKEA dominates the home furniture market in
many countries. The 'IKEA concept' as defined on the company
website www.ikea.com is 'based on offering a wide range of well
designed functional home furnishing products at prices so low
that as many people as possible will be able to afford them.'
IKEA is widely known for pricing products at 30-50% below the
price charged by competitors. Extracts from the website outline
how the company has successfully employed a strategy of target
pricing. 'While most retailers use design to justify a higher price,
IKEA designers work in exactly the opposite way. Instead they
use design to secure the lowest possible price. IKEA designers
design every IKEA product starting with a functional need and a
price.
continued
Then they use their vast knowledge of innovative, low-
cost manufacturing processes to create functional
products, often co-ordinated in style. Then large
volumes are purchased to push prices down even
further. Most IKEA products are also designed to be
transported in flat packs and assembled at the
customer's home. This lowers the price by minimising
transportation and storage costs. In this way, the IKEA
Concept uses design to ensure that IKEA products can
be purchased and enjoyed by as many people as
possible.'
Question

A car manufacturer wants to calculate a target cost for

a new car, the price of which will be set at $17,950. The
company requires an 8% profit margin on sales.
Required What is the target cost?

Profit required = 8%  $17,950 = $1,436 Target cost =

$(17,950 – 1,436) = $16,514 The car manufacturer will
then need to carefully compile an estimated cost for
the new car. ABC will help to ensure that costs
allocated to the new model are more accurate.
QUESTION
Great Games, a manufacturer of computer games, is in
the process of introducing a new game to the market
and has undertaken market research to find out about
customers' views on the value of the product and also
to obtain a comparison with competitors' products.
The results of this research have been used to establish
a target selling price of $60. This is the price that the
company thinks it will have to sell the product at to
achieve the required sales volume.
continued
 Cost estimates have been prepared based on the proposed product
specification.
 DM=3.21
 Dl=24.03
 Machin=1.12
 Ordering=0.23
 Quality=4.6
 Marketing=8.15
 Distribution=3.25
 After sales=1.3
The target profit margin for the game is 30% of the target selling price
solution
Target selling price 60.00
Target profit margin (30% of selling price) 18.00
Target cost (60.00 – 18.00) 42.00
 Projected cost 45.89
The projected cost exceeds the target cost by $3.89.
This is the target cost gap. Great Games will therefore
have to investigate ways to reduce the cost from the
current estimated amount down to the target cost.
How to reduce gap
the total target cost is split into broad cost categories,
such as development, marketing and manufacturing.
Then the manufacturing target cost per unit is split up
across the different functional areas of the product. The
product is designed so that each functional product
area can be made within the target cost. If a functional
product area cannot be made within the target cost, so
that a cost gap exists between the currently achievable
cost and the target cost, the targets for the other areas
must be reduced, or the product redesigned or
scrapped.
General reduction techniques
1. Reducing the number of components
2. Using cheaper staff
3. Using standard components wherever possible
4. Acquiring new, more efficient technology
5. Training staff in more efficient techniques
6. Cutting out non value added activities
7. Using different materials (identified using activity
analysis etc)
Target costing in service industries
Service industries: banking, hotels,teaching,transportation
etc.
Difficult to apply due to below reasons
1. Intangibility
2. Inseparability/simultaneity
3. Variability/heterogeneity
4. Perishability
Problems with target costing for services
Intangibility. Some of the features of a service cannot
be properly specified because they are intangible. What
exactly does a customer receive, for example, when they
go to a cinema? When services are provided by a
human, the quality of the personal service can be
critically important for the customer, but this is difficult
or impossible to specify. When services do not have any
material content, it is not possible to reduce costs to a
target level by reducing material costs. In comparison,
reducing material costs can be an effective approach to
target costing for products.
continued
(b) Variability/homogeneity. A service can differ every
time it is provided, and a standard service may not
exist. For example, repairing a motor car, providing an
accountancy service, or driving a delivery truck from
London to Paris are never exactly the same each time.
When services are variable, it is possible to calculate
an estimated average cost, but this is not specific and
so not ideal for target costing.
Test your understandings
An estimated price, which is expected to be paid by
customers for particular market offering is classified as
target price
target cost
outsource price
off shore price
Difference
Target costing
Competitive market considerations
drive cost planning
Prices determines cost
Design is key focus
Supplier involved early
Involves value chain
Customer input guides cost reduction
Cost-plus
Market considerations not part of cost
planning
Costs determine price.
Waste and inefficiency is key focus
Supplier involved after product
designed
No involvement of value chain
Cost reduction is not customer driven
An estimated cost per unit in long run, which enables
company to achieve it's per unit target, operating income
is classified as
target operating income per unit
target cost per unit
total current full cost
total cost per unit
Target price is subtracted from per unit target operating
income to calculate
total current full cost
total cost per unit
target operating income per unit
target cost per unit
An income, which a company aims to earn by selling
each unit of market offering is classified as
target operating income per unit
target cost per unit
total current full cost
total cost per unit
Process which leads to disassembling and analysis of
competitors, operating activities to become acquainted
with competitors' technologies is called
outsource engineering
reverse engineering
target engineering
off shore engineering
mcqs
Selling price of a product has been set at 450 and the
company expects to sell 1000 units per month. Required
profit is 20% of sales and expected production cost is $400
Calculate target cost gap
1. 35
2. 25
3. 40
4. 30
The selling price of a product has been set at $300 per
unit and expect to sell 1000 units per year. The
company requires return 20% p.a on its investment of
$1250000
Calculate target cost per unit
1. 60
2. 250
3. 300
4. 50
The following are the steps in the implementation of
target cost
1. Calculate target cost
2. Calculate estimate cost of production
3. Determine required profit
4. Decide selling price
5. Calculate target cost gap
a) 4,3,1,2,5
b) 1,2,3,4,5
c) 2,3,4,1,5
d) 4,5,3,1,2
Following information is available for a product
Target selling price $20 per unit
Target profit margin 30%
Estimated production cost $16 per unit
What is the target cost gap for this product?
1. 2
2. 4
3. 0
4. 1
The new CEO of rusty manufacturing wants some data related to
missing information
Total sales revenue ?
Number of units made and sold 500,000 units
Selling price ?
Operating income $180,000
Total investment in assets $2250,000
Variable cost per unit $4
Fixed cost for the year $2500,000
Requirement
1. Find total sales revenue, selling price, rate of return
on investment?
2. The CEO plans to reduce fixed costs by 225000 and
variable cost by $0.3 per unit while still selling
500,000 units. Calculate new selling price?
Further reading
https://
www.accaglobal.com/pk/en/student/exam-support-re
sources/fundamentals-exams-study-resources/f5/tech
nical-articles/target-lifestyle.html

https://www.youtube.com/watch?v=Xxy8e_Y1wtg
Kaizan costing
Japanese technique used in manufacturing stage of
exisiting products as cost reduction process.
Kai= change
Zen=good change for good
Application: only applied to a product that is already
under production for cost reduction
Implementation
List your own problems
Grade problems as to minor, difficult and major
Start with the smallest minor problem
Remember improvement is part of daily routine
Never accept status quo
Never reject any idea before trying
Eliminate tried but failed attempts
Highlights problems rather than hiding
Evaluation
0 marks for no improvement
0 to 30 marks depends upon improvement but failed
30 to 50 marks for small to moderate improvements
50 to 75 marks for good improvement
>75 marks for extraordinary improvement
Philosophy
Continuous improvement
Employees are assets
Information shared
Emotional relationship not commercial
Participative change
Supportive management
Cross-functional
How differs from target costing
Target costing is applied during the design stage where
as kaizen costing is applied during the manufacturing
stage
Target costing focus on product, where as kaizen
costing focus on production process and cost
reduction is achieve through increased efficiency of
the production process.