What is Target Costing?
Target costing is a system under which a company plans in advance for the price points, product costs, and margins that it wants to achieve for a new product. If it cannot manufacture a product at these planned levels, then it cancels the design project entirely.
With target costing, a management team has a powerful tool for continually monitoring products from the moment they enter the design phase and onward throughout their product life cycles. It is considered one of the most important tools for achieving consistent profitability in a manufacturing environment.
Table of Contents
- 1 What is Target Costing?
- 2 Definition of Target Costing
- 3 Features of Target Costing
- 4 Objectives of Target Costing
- 5 Difference between Traditional Costing and Target Costing
- 6 Advantages of Target Costing
- 7 Disadvantages of Target Costing
- 8 Principles of Target Costing
- 9 Process of Target Costing
Target Costing is a result of team-work that provides a way to link profit planning, market surveys, value analysis, budgetary control and effective financial management.
Definition of Target Costing
CIMA defines Target Cost as “a product cost estimate derived from a competitive market price”.
“a disciplined process for determining and achieving a full-stream cost at which a proposed product with specified functionality, performance and quality must be produced in order to generate the desired profitability at the product’s anticipated selling price over a specified period of time in the future”.
Features of Target Costing
The main features of target costing are as follows:
- The price of the product is determined by market conditions. The company is a price taker rather than a price maker.
- The minimum required profit margin is already included in the target selling price.
- It is part of management’s strategy to focus on cost reduction and effective cost management.
- Product design, specifications, and customer expectations are already built-in while formulating the total selling price.
- The difference between the current cost and the target cost is the “cost reduction,” which management wants to achieve.
- A team is formed to integrate activities such as designing, purchasing, manufacturing, marketing, etc., to find and achieve the target cost.
Objectives of Target Costing
The fundamental objective of target costing is to enable management to use proactive cost planning, cost management and cost reduction practices whereby, costs are planned and managed out of a product and business, early in the design and development cycle, rather to a during the later stages of product development and production. Broadly speaking, a target costing system has three objectives:
- To lower the costs of new products so that the required profit level can be ensured.
- The new products meet the levels of quality, delivery timing and price required by the market.
- To motivate all company employees to achieve the target profit during new product development by making target costing a companywide profit management activity.
Difference between Traditional Costing and Target Costing
|S.No.||Target Costing||Traditional Costing|
|1||Market price is not considered as a part of prime cost planning.||Competitive price is considered as a part of prime cost planning.|
|2||Costs determine sales price.||It is sales price that determine costs.|
|3||Losses and inefficiency are taken into consideration in order to reduce costs.||Design is an important factor in reducing costs.|
|4||Customers are not involved in cost reduction.||Customer data is considered as a guide for cost reduction.|
|5||Teamwork and multiple skills are not taken into account.||Teamwork and multiple skills are taken into account.|
|6||Prime cost and some proportion of profit stem from closed system.||It is an open system and takes into consideration the interactive function or the external effect of variables on the system|
|7||Suppliers of material and equipment are involved after designing the product.||Suppliers of material and equipment are involved before designing the product.|
|8||It does not use value engineering.||Value engineering is used as a prerequisite in this system.|
Advantages of Target Costing
The major advantages/benefits of target costing are as follows:
- It shows management’s commitment to process improvements and product innovation to gain competitive advantages.
- The product is created from the expectation of the customer and, hence, cost is also based on similar lines. Thus, the customer feels more value is delivered.
- With the passage of time, the company’s operations improve drastically, creating economies of scale.
- The company’s approach to designing and manufacturing products becomes marketdriven.
- New market opportunities can be converted into real savings to achieve the best value for money rather than to simply realize the lowest cost.
Disadvantages of Target Costing
The limitations of target costing method can be defined as follows:
- Transversal vision
- Organization turned to market
- Means of managing future performance
- Collective training process
The method involves several functions in a unique approach to market research, applying methods for product design, management control for revaluating items and purchases for choosing purchased and delivered components.
Cooperation between its functions is not hierarchical, it is multiple and varied, and the network and decisions of a function are passed on to all the other ones. This bond between functions requires the consideration of the constraints and finding a solution, in a global vision, to optimize value-cost couple.
Organization turned to market
Target costing vision is market-oriented and determines the value of a product and empowers the organization to optimize value-cost couple.
Means of managing future performance
Target cost allows for a simulation of the organization’s future and forces to reflect from upstream processes, according to their future implications.
Collective training process
The multitude of means included in a target costing approach will lead to a result if the necessary skills are mobilized and all the stakeholders are informed.
In order to effectively implement the target costing method, it is necessary to involve all responsible people, to ensure transparency, to evaluate and collectively monitor errors that may occur.If human, cultural and managerial aspects are not taken into account within the organization, the target costing method is not subject of discussion.
Although, the cost estimations, the setting of the value or the design of the target costing method are known and sometimes implemented, the management practices and strategic vision that the target cost is based on, encounter cultural incompatibilities.
Principles of Target Costing
According to Hilton, target costing involves seven key principles listed as follows:
- Price-Led Costing
- Focus on the Customer
- Focus on Product Design
- Focus on Process Design
- Cross-Functional Teams
- Life-Cycle Costs
- Value-Chain Orientation
Target costing sets the target cost by first determining the price at which a product can be sold in the marketplace. Subtracting the target profit margin from this target price yields the target cost, that is, the cost at which the product must be manufactured.
Notice that in a target costing approach, the price is set first, and then the target product cost is determined. This is opposite from the order in which the product cost and selling price are determined under traditional cost-plus pricing.
Focus on the Customer
To be successful at target costing, management must listen to the company’s customers. What products do they want? What features are important? How much are they willing to pay for a certain level of product quality?
Management needs to aggressively seek customer feedback, and then products must be designed to satisfy customer demand and be sold at a price they are willing to pay. In short, the target costing approach is market driven.
Focus on Product Design
Design engineering is a key element in target costing. Engineers must design a product from the ground up so that it can be produced at its target cost. This design activity includes specifying the raw materials and components to be used as well as the labour, machinery, and other elements of the production process. In short, a product must be designed for manufacturability.
Focus on Process Design
Every aspect of the production process must be examined to make sure that the product is produced as efficiently as possible. The use of touch labour, technology, global sourcing in procurement and every aspect of the production process must be designed with the product’s target cost in mind.
Manufacturing a product at or below its target cost requires the involvement of people from many different functions in an organisation: market research, sales, design engineering, procurement, production engineering, production scheduling, material handling and cost management.
Individuals from all these diverse areas of expertise can make key contributions to the target costing process. Moreover, a cross-functional team is not a set of specialists who contribute their expertise and then leave; they are responsible for the entire product.
In specifying a product’s target cost, analysts must be careful to incorporate all of the product’s life-cycle costs. These include the costs of product planning and concept design, preliminary design, detailed design and testing, production, distribution and customer service.
Traditional cost-accounting systems have tended to focus only on the production phase and have not paid enough attention to the product’s other life-cycle costs.
Sometimes the projected cost of a new product is above the target cost. Then efforts are made to eliminate non-value-added costs to bring the projected cost down. In some cases, a close look at the company’s entire value chain can help managers identify opportunities for cost reduction.
Process of Target Costing
Target Costing applies to new products and succeeding generations of a product. It begins with understanding the market thoroughly and an intention to satisfy customer needs, concerning product quality, features, timeline and price:
- Identifying customer needs.
- Planning of selling price as per the needs.
- Identifying the target cost.
- Keep the price in consideration after identifying suppliers and fixing the manufacturing process.
- Compare sample product with the target and start production for product launch.
Target costing is an excellent tool for planning a suite of products that have high levels of profitability. This is opposed to the much more common approach of creating a product that is based on the engineering department’s view of what the product should be like, and then struggling with costs that are too high in comparison to the market price.
Target costing is a tool for Cost Management which helps in reducing the cost of a product over its entire life-cycle. Target costing induces those actions which management must take for establishing reasonable target costs, developing methods to achieve these targets and developing the mechanisms to test the cost effectiveness of various reduction efforts.
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