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Target Costing

Compiled by : Bhupendra Jain; 9811255704

Target costing is the process of determining the maximum allowable cost for a new product and then developing a prototype that can be profitably made for that maximum target cost figure. A number of companies--primarily in Japan--use target costing, including Compaq, Culp, Cummins Engine, Daihatsu Motors, DaimlerChrysler, Ford, Isuzu Motors, ITT, NEC, and Toyota etc.

The target costing for a product is calculated by starting with the product's anticipated selling price and then deducting the desired profit. Following formula or equation further explains this concept:

Target Cost = Anticipated selling price – Desired profit

The product development team is then given the responsibility of designing the product so that it can be made for no more than the target cost.

Following set of activities further explains the concept of target costing technique:

TARGET COSTING PROCESS DIAGRAM

Determine Customer Wants and Price Sensitivity

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Planned Selling Price is Set

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Target Cost is Determined As: Selling Price Less Desired Profit

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Teams of Employees from Various Areas and Trusted Vendors Simultaneously

↓                                    ↓                                                                                       ↓

Design Product     Determine Manufacturing Process     Determine Necessary Raw Materials

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Costs are Considered Throughout this Process. The Process Requires Trade-offs to Meet Target Costs

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Once Target Cost is achieved the Manufacturing Begins and Product is Sold

Reasons for Using Target Costing Technique:

The target costing approach was developed in recognition of two important characteristics of markets and costs. The first is that many companies have less control over price than they would like to think. The market (i.e., supply and demand) really determines prices and a company that attempts to ignore this does so at its peril. Therefore, the anticipated market price is taken as a given in target costing. The second observation is that most of the cost of a product is determined in the design stage. Once a product has been designed and has gone into production, not much can be done to significantly reduce its cost. Most of the opportunities to reduce cost come from designing the product so that it is simple to make, uses inexpensive parts, and is robust and reliable. If the company has little control over market price and little control over cost once the product has gone into production, then it follows that the major opportunities for affecting profit come in the design stage where valuable features that customers are willing to pay for can be added and where most of the costs are really determined. So that it is where the effort is concentrated--in designing and developing the product. The difference between target costing and other approaches to product development is profound. Instead of designing the product and then finding out how much it costs, the target cost is set first and then the product is designed so that the target cost is attained.

Example of Target Costing:

To provide a simple numerical example of target costing, assume the following situations:

Handy Appliance Company feels that there is a market niche for a hand mixer with certain new features. Surveying the features and prices of hand mixers already in the market, the marketing department believes that a price of $30 would be about right for the new mixer. At that price, marketing estimates that 40,000 of new mixers could be sold annually. To design, develop, and produce these new mixers, an investment of $2,000,000 would be required. The company desires a 15% return on investment (ROI). Given these data, the target cost to manufacture, sell, distribute, and service one mixer is $22.50 as calculated below:

This Rs. 22.5 target cost would be broken into target cost for the various functions: manufacturing, marketing, distribution, after-sales service, and so on. Each functional area would be responsible for keeping its actual costs within target.

Advantages of Target Costing Approach:

Target costing has the following main advantages or benefits:

1. Proactive approach to cost management.

2. Orients organizations towards customers.

3. Breaks down barriers between departments.

4. Implementation enhances employee awareness and empowerment.

5. Foster partnerships with suppliers.

6. Minimize non value-added activities.

7. Encourages selection of lowest cost value added activities.

8. Reduced time to market.

Disadvantages of Target costing approach:

1. Effective implementation and use requires the development of detailed cost data.

2. Its implementation requires willingness to cooperate.

3. Requires many meetings for coordination.

4. May reduce the quality of products due to the use of cheep components which may be of inferior quality.

Q. 1: Samsung is developing a high speed modem:

A . Given the following information, compute Samsungs cost reduction target.

Expected Market Price                                    Rs. 500

Required return on sales                                 20%

Product life                                                      3 years

Current Feasible cost                          Rs. 7,50,00,000

Expected average annual sales                      50,000 units

B. If Samsung believe it-can reduce the cost of the modem by not more than 18% is this a feasible product for Samsung?

CASE STUDY - 1 (A) : Toshiba manufacturer on brand of personal computers Calles TOSHIBA. Following is the profitability statement for Toshiba personal computer:

Following further information has been provided :

(i) No opening & closing inventory.

(ii) Manufacturing overhead cost = Ordering and Receiving cost + Testing and Inspection cost + Rework cost

(iii) Toshiba expects its competitors to lower the prices of PCs that complete against Toshiba by 15%.

Toshiba’s management believe that it must responded aggressively by reducing Toshiba’s price by 20%.

Required: Compute the target cost.

CASE STUDY -1 (B): Toshiba’s Value engineering team focuses their cost-reduction efforts on analyzing the Toshiba design. Their goal – To design a high-quality, highly reliable machine with fewer features that meets customers price expectations and achieve target cost.

Toshiba is discontinued in its place. Toshiba introduced TOSHIBA – II has fewer components than Toshiba and is easier to manufacturer and test. The following tables compare the direct costs and the manufacturing overhead costs and cost drivers of TOSHIBA and TOSHIBA – II. In place of the 75,000 Toshiba units manufactured and sold in 2002. Toshiba expects to make and sell 1,00,000 Toshiba –II units in 2003 on account of the reduction in prices.

Further there is a change in the non-manufacturing cost as follows:

R &D                                                                  80,00,000

Design of product & process cost                   1,20,00,000

Marketing cost                                                 3,60,00,000

Distribution cost                                              1,00,00,000

Customer – service costs                                   60,00,000

Required : Determine whether Toshiba achieves the Target Cost?