TARGET COSTING

TARGET COSTING:LEARNING OBJECTIVES

Derive a target cost in manufacturing and

service industries.
Explain the difficulties of using target costing
in service industries.
Suggest how a target cost gap might be
closed.
 TARGET COSTING

Target costing involves setting a target

cost by subtracting a desired profit
margin from a competitive market
price.
 TARGET COSTING
Target costing originated in Japan in the 1970s.
It began with recognition that customers were
demanding more diversity in products that they
bought, and the life cycles of products were
getting shorter. This meant that new products
had to be designed more frequently to meet
customer demands.
 TARGET COSTING
Target costing is used mainly for new product
development.
This is because whenever a new product is
designed and developed for a competitive
market, a company needs to know what the
maximum cost of the new product must be so
that it will sell at a profit.
 STEPS.
Implementing Target Costing
Steps in the implementation of the target costing process.
Step 1: Determine a product specification of which an adequate sales
volume is estimated.
Step 2: Set a selling price at which the organization will be able to achieve a
desired market share.
Step 3: Estimate the required profit based on return on sales or return on
investment.
Step 4: Calculate the target cost = target selling price target profit
Step 5: Compile an estimated cost for the product based on the anticipated
design specification and current cost levels.
Step 6: Calculate target cost gap = estimated cost target cost.
Step 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 during the production phase.
Step 8: Negotiate with the customer before making the decision about
whether to go ahead with the project.
 CLOSING THE COST GAP..
Target costs are rarely achievable immediately and ways must be
found to reduce costs and close the cost gap.
Methods of closing the target cost gap
To re-design products to make use of common processes and components that are already
used in other products by the company.
To discuss with key suppliers methods of reducing materials costs.
Target costing involves the entire value chain from original suppliers of raw materials
to the customer for the end-product, and negotiations and collaborations with
suppliers
To eliminate non value-added activities or non-value added features of the product design.
Something is non-value added if it fails to add anything of value for the customer.
The cost of non-value added product features or activities can therefore be saved
without any loss of value for the customer.
DO Value analysis
To train staff in more efficient techniques and working methods. Improvements in
efficiency will reduce costs.
To achieve economies of scale. Producing in larger quantities will reduce unit costs because
fixed overhead costs will be spread over a larger quantity of products.
To achieve cost reductions as a result of the learning curve or, more likely, the experience
curve effect.
 CLOSING THE COST GAP..details
Target costs are rarely achievable immediately and ways must be found to reduce
costs and close the cost gap.
Methods of closing the target cost gap
To re-design products to make use of common processes and components that are already used in the
manufacture of other products by the company.
To discuss with key suppliers methods of reducing materials costs.
Target costing involves the entire value chain from original suppliers of raw materials to the customer
for the end-product, and negotiations and collaborations with suppliers might be an appropriate method
of finding important reductions in cost.
To eliminate non value-added activities or non-value added features of the product design. Something is non-
value added if it fails to add anything of value for the customer.
The cost of non-value added product features or activities can therefore be saved without any loss of
value for the customer. Value analysis may be used to systematically examine all aspects of a product cost
to provide the product at the required quality at the lowest possible cost.
To train staff in more efficient techniques and working methods. Improvements in efficiency will reduce costs.
To achieve economies of scale. Producing in larger quantities will reduce unit costs because fixed overhead
costs will be spread over a larger quantity of products. However, production in larger quantities is of no benefit
unless sales demand can be increased by the same amount.
To achieve cost reductions as a result of the learning curve or, more likely, the experience curve effect.
NOTE: LEARNING CURVE is Future topic. Budgeting
The learning curve is most likely to exist in a labour intensive environment. It results in cost savings as labour becomes more
familiar with performing a new and complex task. The experience curve effect relates to cost savings made in costs other
than labour costs as the company becomes more familiar with production of a new product. For example, management of
the process and marketing may become more efficient as the company gains experience of making and selling the product.
 BENEFITS
Benefits of Target Costing
(a) The organisation will have an early external focus to its product development.
Businesses have to compete with others (competitors) and an early consideration of this
will tend to make them more successful. Traditional approaches (by calculating the cost
and then adding a margin to get a selling price) are often far too internally driven.
(b) Only those features that are of value to customers will be included in the product
design. Target costing at an early stage considers carefully the product that is intended.
Features that are unlikely to be valued by the customer will be excluded. This is often
insufficiently considered in cost plus methodologies.
(c) Cost control will begin much earlier in the process. If it is clear at the design stage that a
cost gap exists then more can be done to close it by the design team. Traditionally, cost
control takes place at the cost incurring stage, which is often far too late to make a
significant impact on a product that is too expensive to make.
(d) Costs per unit are often lower under a target costing environment. This enhances
profitability. Target costing has been shown to reduce product cost by between 20% and
40% depending on product and market conditions. In traditional cost plus systems an
organisation may not be fully aware of the constraints in the external environment until
after the production has started. Cost reduction at this point is much more difficult as
many of the costs are designed in to the product.
(e) It is often argued that target costing reduces the time taken to get a product to market.
Under traditional methodologies there are often lengthy delays whilst a team goes back
to the drawing board. Target costing, because it has an early external focus, tends to
help get things right first time and this reduces the time to market.
 BENEFITS elaboration..
Benefits of Target Costing
(a) The organisation will have an early external focus to its product
development. Businesses have to compete with others (competitors) and
an early consideration of this will tend to make them more successful.
(b) Only those features that are of value to customers will be included in the
product design. Target costing at an early stage considers carefully the
product that is intended.
(c) Cost control will begin much earlier in the process. If it is clear at the
design stage that a cost gap exists then more can be done to close it by
the design team.
(d) Costs per unit are often lower under a target costing environment. This
enhances profitability.
(e) It is often argued that target costing reduces the time taken to get a
product to market.
(f) Products more attractive to potential customer higher success rate. (due
to analysis and study at the dev stage.
 CASE
Case
Swedish retailer Ikea continues to dominate the home furniture market with more than 300 stores
across 35 countries at the end of 2009. 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 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. as possible.

Can you list some of the ways IKEA has reduced the cost in its operations?
 TARGET COSTING AT CHRYSLER
1) Identify the seven steps in the establishment phase of target costing. Provide specific
examples of activities undertaken for each of the seven steps.
The seven steps in establishing target costs used by Chrysler are:
Chrysler conducted extensive research on college and other young professional who
buy small cars
Through competitive analysis Chrysler determined what other car companies were
offering. For example, the Ford Fiesta was one of the key products Chrysler viewed as a
competitive product.
The potential and current buyers of cars such as Ford Fiesta were chosen as target
customers.
The initial product concept was developed based on two key customer requirements -
- fun to drive and safe car.
Detailed product features were developed based on detailed and refined
understanding of customer requirements. For example, a neon key that shines in the
dark was designed to meet a customer requirement about being able to find car keys in
a dark parking lot.
Market price was established using the Ford fiesta as an initial benchmark and
adjusted for feature differentials between the two cars.
A required profit margin was subtracted from this price based on industry norms and
Chryslers desired return to set an allowable cost for the car. THIS IS THE TARGET COST
 TARGET COSTING:CHRYSLER
2) Discuss how each of the three steps in attaining target costs might have applied to the
Neon project. Discuss how Chrysler could design costs out through design improvements.
The manufacturing cost gap between the initial estimate and the target cost was
approximately several thousand dollars.
This gap was reduced by value engineering the car in several ways. The chassis was
designed of lighter material, the cab design was simplified, suppliers were brought in
early in the design and offered cost reduction suggestions for their components.
3) List some behavioral problems that may occur when target costing is used. Provide an
example of how these problems may have impacted the Neon project.
A number of behavioral changes occurred at Chrysler as a result of target costing. People
who were functional specialists worked on cross-functional teams. This caused initial
problems for people who were not used to working as generalists. Team work rather
individual output was rewarded.
This created some motivational problems for people who were used to being rewarded
for their work. The culture changed to encourage people to be customer oriented and to
meet customer needs.
Giving suppliers more power reduced the power of procurement staff who traditionally
ran this operation
 CASE..
IKEA designers design every IKEA product starting with a functional
need and a price.

Then they use their vast knowledge of innovative, low-cost

manufacturing processes to create functional products, often
coordinated 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.
If you want delivery and assemble.you can hire it.
In this way, the IKEA Concept uses design to ensure that IKEA
products can be purchased and enjoyed by as many people .
 CLASS EXERCISES: 1
Target selling price $21 per unit
Target mark up on cost 1/3
Estimated production cost $16 per unit
HOW MUCH IS THE TARGET COST?
HOW MUCH IS THE COST GAP?
 CLASS EXERCISE: 2
1. Packard plc are considering whether or not to launch a
new product. The sales department have determined
that a realistic selling price will be $20 per unit. Packard
have a requirement that all products generate a gross
prot of 40% of selling price.
Calculate target cost.
2. Hewlett plc is about to launch a new product on which it
requires a pre-tax ROI of 30% p.a. .Buildings and
equipment needed for production will cost
$5,000,000.The expected sales are 40,000 units p.a. at a
selling price of $67.50 p.u..
Calculate the target cost.
 CLASS EXERCISES
Taurus Tools has developed a new kitchen utensil. The firm has conducted
significant market research and estimated the following pattern for sales of the
new product:
Expected Price
Year Expected Volume per Unit
1 38,000units $19
2 48,000units 18
3 90,000units 16
4 40, 000units 12

If the firm desires to net $4.50 per unit in profit over the life of the product,
what is the target cost to produce the new utensil?
 workings
Units Sales
19 38000 722000
18 48000 864000
16 90000 1440000
12 40000 480000
216000 3506000

average profit 4.5

average SP 3506000/216000
16.2314815

TARGET COST IS 16.2314815less 4.5

11.7314815
or 11.73
 HOMEWORK
A company is planning a new product. Market research suggests that demand for the
product would last for 5 years.
At a selling price of $10.50 per unit they expect to sell 2,000 units in the rst year and
12,000 units in each of the other four years. The company wishes to achieve a mark up of
50% on cost.
It is estimated that the lifetime costs of the product will be as follows:
1. Manufacturing costs - $6.00 per unit
2. Design and development costs - $60,0003.
End of life costs - $30,000
You are required to:
(a) Calculate the target cost for the product.
(b) Calculate the lifecycle cost per unit and determine whether or not the product is worth
making.
It has been further estimated that if the company were to spend an additional $20,000 on
design, then the manufacturing costs per unit could be reduced.
(c) If the additional amount on design were to be spent, calculate the maximum
manufacturing cost per unit that could be allowed if the company is to achieve the required
mark-up.
 PYQ HYBRIDDEC15
The Chemical Free Clean Co (C Co) provides a range of environmentally-friendly cleaning services to
business customers, often providing a specific service to meet a clients needs. Its customers range
from large offices and factories to specialist care wards at hospitals, where specialist cleaning
equipment must be used and regulations adhered to. C Co offers both regular cleaning contracts and
contracts for one-off jobs. For example, its latest client was a chain of restaurants which employed
them to provide an extensive clean of all their business premises after an outbreak of food poisoning.

The cleaning market is very competitive, although there are only a small number of companies
providing a chemical free service. C Co has always used cost-plus pricing to determine the prices which
it charges to its customers but recently, the cost of the cleaning products C Co uses has increased. This
has meant that C Co has had to increase its prices, resulting in the loss of several regular customers to
competing service providers.
The finance director at C Co has heard about target costing and is considering whether it could be
useful at C Co.

Required:
(a) Briefly describe the main steps involved in deriving a target cost. (3 marks)
(b) Explain any difficulties which may be encountered and any benefits which may arise when
implementing target costing at C Co. (7 marks)(10 marks)Refer to answer in doc. file