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Strategic Cost Managemen- The Mechanics of Target Costing

Strategic Cost Managemen- The Mechanics of Target Costing

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Published by: Mahfuzul on Jun 26, 2009
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Working PaperStrategic Cost Management: The Mechanics of Target CostingMahmuda Akter, Ph.D.Dewan Mahboob HossainMahfuzul Hoque, Ph.D.AbstractThis paper provides a basis of target cost setting for products as well as theircomponents.The overall target costing process would be unsuccessful if targets for cost andprofit are made unrealistic because the target cost achievement of the productdesigners may vary according to the levels of tightness of different target costand target profit methods since these will motivate them in different ways. Inthis paper, we showed the mechanism of target cost setting for products and theirparts with the help of a hypothetical example. In a target-costing environment,identifying the appropriate degree of tightness of the targets for profit and costis very crucial factor to take into account. In certain situations performanceimproves with the level of tightness while in the other circumstances, itdeteriorates. The tight but attainable target should be established for high andpersistent cost-reduction performance. In target costing, the overall accountingprocess consists of target cost establishment and allocation processes. The policythat is suitable for getting higher cost-reduction performance in the target costestablishment process may not be desirable for the same in target cost allocationprocess.IntroductionIncreased competition and vocal customers have made it imperative for everycompany to upgrade its processes constantly to stay ahead of the competition. Inthe midst of an overabundance of products and choices for the customer, it becomesincreasingly important for any company to make its products better, faster,cheaper and more innovatively. Increasing the efficiency of products has the twoaspects of cost and functionality attached to it. An efficient designing techniquetakes the cost and functionality aspects into consideration during the earlystages of product design where extensive design efforts are given on importantfeatures and simultaneously reducing the cost on less important features. Targetcosting is a planning tool that helps us to identify the features to be improvedand helps us in setting targets for designing and cost reduction. It is generallyknown that challenging goals lead to better performance than the general goal ofdoing ones best (Cooper and Slagmulder, 1997). Target costing focuses on searchingfor opportunities for cost reduction at the product planning stage, as well as
providing continuous cost reductions once a product commences manufacture. It is amultidisciplinary tool of cost management to reduce overall costs applied at theplanning and design stages with cooperation of the engineering, production,marketing, development, and accounting departments (Sakurai and Scarbrough, 1997).The core concept of target costing is very straightforward. It is based onthe logic that a company should manufacture the products that yield the desiredprofit. If the product is not yielding the desired amount of profit, the design ofthe product should be changed to obtain the desired profit or the product shouldbe abandoned. The target costing process is a system of profit planning and costmanagement that is price led, customer focused, design centered, and crossfunctional. Target costing initiates cost management at the earliest stages ofproduct development and applies it through out the product life cycle by activelyinvolving the entire value chain (Ansari, 1997).Target costing, a technique that many Japanese companies use to sustain acompetitive advantage, has begun to invade the province of management accountants(Bayou and Reinstein, 1996) Invented by Toyota, target costing has been used byJapanese managers for nearly 30 years (Kato, 1993). More than 80 percent of majorJapanese companies in assembly industries 60 percent in process industries use thesystem (Kato, 1993). Some U.S. and European corporations, perhaps assuming thattarget costing is a major reason for Japan’s success, turn to target costing topossibly replace standard cost accounting (Financial Management, 1991, p. 12).Therefore, management accountants should understand target costing as analternative to the product costing method, but recognize that it can dilutemanagement accounting’s role in “doing” accounting and in developing andevaluating cost management systems (Inoue, 1989).Target costing occurs in two phases: an establishment phase and anattainment phase. The establishment phase occurs during product planning andconcept development stages of the product development cycle and it focuses ondefining a product concept and setting allowable cost targets for products or afamily of products. The attainment phase occurs during the design development andproduction stages of target costing and involves achieving that target cost(Ansari, 1997).After determining a product’s target cost in the establishment phase, the nextmajor step is to decompose that target cost down to the function, component, andpart level in the attainment phase so that the purchase prices of those items canbe determined. An organization's target costing effectiveness represents thedegree of success in achieving the target costs of products, functions, or parts.The overall target costing process would be futile if targets for cost and profitare made unrealistic because the target cost achievement of the product designersmay vary according to the levels of tightness of different target cost and targetprofit methods since they will motivate them in different ways (Akter, Lee andMonden, 1999).Therefore, the purpose of this paper is to provide a basis for target cost settingfor products as well as their components. To this end, this paper is organizedinto six sections. The paper first section presents an overview of the targetcosting process. The second describes the phases in target costing process. Thethird provides a target costing example. Sixth section concludes the paper.1. An Overview of Target Costing ProcessTarget costing is intimately linked to an organization’s competitive strategy andits product development cycle. Since the late 1980s, target costing has becomeever more closely connected with business strategy and considered as a strategiccost management tool for attaining target profit as well as for cost reduction(Sakurai and Scarbrough, 1997). Competitive strategy defines the goals that anorganization must attain to satisfy market demands and remain profitable. Targetcosting provides the means by which the organization achieves these goals. It doesso by integrating the strategic variables of market trends, customer needs,
technology advances, and quality requirements into a product definition that meetsa customer’s price, quality, and time expectations. Target costing is thesimultaneous planning of how to satisfy customers, capture market share, generateprofits, and plan and manage costs. Without target costing system, meetingcompetitive prices and generating acceptable returns on a consistent basis isdifficult, if not impossible, in today’s environment (Ansari, 1997).Target costing identifies the cost at which the product must be manufactured if itis to achieve its target profit margin when sold at its target-selling price. Inthe contemporary industrial environment that changes rapidly and plays by its ownset of rules, prices are largely market driven and not controlled by management.Target profit, on the other hand, is based on corporate profit expectations,historical results and competitive analysis, and therefore is a decision variable.If the target profit margin is very demanding, the resulting target cost will bedifficult to achieve. However, the difficulty of implementing target cost methodsdepends not only on the rigidity exercised in setting target profit, but also onthe degree of tightness inherent in the target cost methods.Competitive environment, company’s efficiency, and development stage of managementaccounting system mainly persuade the selection of a particular method fordetermining target profit. The attainability of target profit influences thedecision of using a target cost method. When a company decides to use a particulartarget profit method, it does not finalize the target profit figure immediately.Rather, a provisional target profit is determined first based on which allowablecost, the cost at which the product must be manufactured if it is to generate thedesired profit margin, is determined. Subsequently, the attainability of allowablecost is checked. If this allowable cost is attainable, the management acceptsprovisional figure as the final profit and here target cost is determined bysubtractive method. On the other hand, if management feels that the allowable costobjective is not possible to achieve, target cost is determined by adding-up orcombination method. When either one of these two methods is used, the provisionaltarget profit could not be attained because the target cost will be higher thanthe allowable cost. Thus, the target profit will be changed downward to derive thetarget costs. Therefore, the selection of a particular target cost method dependson the attainability of the allowable cost. Moreover, setting target profitmargins in this manner makes the allowable cost reflect the relative competitiveposition of the firm. A highly efficient firm will set target profit marginshigher and will have lower allowable cost (Cooper and Slagmulder, 1997, 102).Figures 1(a) and 1(b) depict this process (Akter, 2006 ; Akter, Hoque and Monden,2004).Figure 1(a). Relationship between target profit and target cost Figure 1(b). Selection process of target costThe next stage of the target costing process is to determine cost reductiontargets. Some firms will do this by estimating the 'current cost' of the newproduct. The current cost is based on existing technologies and components, butencompasses the functionality and quality requirements of the new product. Thedifference between the current cost and the target cost indicates the requiredcost reduction. This amount may be divided into a target cost-reduction objectiveand a strategic cost-reduction challenge. The former is viewed as being achievable(yet still a very challenging target), while the latter acknowledges currentinherent limitations. After analyzing the cost reduction objective, a product-level target cost is set which is the difference between the current cost and thetarget cost-reduction objective.It should be noted that a fair degree of judgment is needed where the allowablecost and the target cost differ. As the ideal is to produce at the allowable cost,

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