Target Costing, Life-Cycle costing

Vol.6

Mgr. Andrea Gažová, PhD.

Traditional vs. Target cost
management
Life cycle costing
Life cycle costing is a system that tracks and accumulates the actual
costs and revenues attributable to cost object from its invention to its
abandonment. Life cycle costing involves tracing cost and revenues on a
product by product base over several calendar periods. Life Cycle Cost
(LCC) of an item represents the total cost of its ownership, and includes
all the cots that will be incurred during the life of the item to acquire it,

operate it, support it and finally dispose it.

Phases of product life cycle
Costs are committed and incurred at very different times. A committed
cost is a cost that will be incurred in the future because of decisions
that have already been made. Costs are incurred only when a resource
is used.
 Traditional System
• Budget > Production > Total cost > Selling price
> Actual results > Variances

• In the traditional system first the budget is

prepared and then the production starts. After
the production total cost is calculated. From the
calculated cost the desire profit is deducted and
a selling price is determined. The difference is
notice by comparing the budgeted and actual
results of cost which is know as variance.
 Target costing
• Target costing is a modern technique of cost control. It is
a reverse costing technique in which selling price is
determine by read the market environment and then the
desire profit margin is deducted from the selling price.
Target cost = Target selling price – Target profit margin
• A target cost is a cost estimate derived by deducting a
desired profit margin from a competitive market price. It
is the opposite of conventional cost plus pricing and is
referred as price minus costing. Target costing does not
focus on finding what a new product does cost, instead it
focuses on finding what a new product should cost.
• Cost reduction must be in a way that does not affect
quality because if quality is damaged target costing plan
will immediately fail.
? ?
 5 step approach of TC
• Step # 1
Estimate a selling price at which a product could be sold.
• Step # 2
Then estimate the desired profit margin.
• Step # 3
Deduct the profit margin from the selling price to arrive at target
cost.
• Step # 4
Calculate the estimate cost of the product and compare it with target
costing.
• Step # 5
Difference is known as the cost gap that needs
to be closed.
 Example:
• if the selling price of the product is $25 and the
desired profit margin is $5.
• Then, the target cost would be?
$25-$5 = $20
• The real cost of the product came out to be $22.
• Now, the cost gap calculated would be?
$20-$22 = -$2.
This negative $2 or the cost gap of $2 needs to
be reduce as the selling price is less than the
real cost of the product.
 How can the cost gap be closed?
Give some tips...
• Using substitute materials provided if it does not
affect the quality of the product.
• Focusing on the alternative production designs/
production methods.
• Reviewing the entire supply chain.
• Focusing on the economies of scales. For
example, bulk purchase discounts.
• Using cheap labour provided if it does not affect
the quality of the product.
• Improving productivity by motivating the
workforce.
 A numerical example of target and lifecycle
costing

A company is planning a new product. Market research

information suggests that the product should sell 10,000
units at $21.00/unit. The company seeks to make a
mark-up of 40% product cost. It is estimated that the
lifetime costs of the product will be as follows:

• Design and development costs $50,000

• Manufacturing costs $10/unit
• End of life costs $20,000

The company estimates that if it were to spend an

additional £15,000 on design, manufacturing costs/unit
could be reduced.
Required

(a) What is the target cost of the product?

(b) What is the original lifecycle cost per
unit and is the product worth making on
that basis?
(c) If the additional amount were spent on
design, what is the maximum
manufacturing cost per unit that could be
tolerated if the company is to earn its
required mark-up?
Solution

The target cost of the product can be calculated as follows:

(a)  Cost     +     Mark-up     =     Selling price
      100%           40%                  140%
      $15              $6                      $21

(b) The original life cycle cost per unit =

($50,000 + (10,000 x $10) + $20,000)/10,000 = $17
This cost/unit is above the target cost per unit, so the
product is not worth making.

(c) Maximum total cost per unit = $15.

Some of this will be caused by the design and end of life
costs:
($50,000 + $15,000 + $20,000)/10,000 = $8.50

Therefore, the maximum manufacturing cost per unit would

have to fall from $10 to ($15 – $8.50) = $6.50