Catholic University of Eastern Africa

Department of Accounting and Finance

Unit Name: Strategic Cost Management

Unit Code: CAC 425

Target Costing Assignment

Presented to: Mrs. Patricia Munyoki

Presented by:

1. Thodosia Sangoro 1008798

2. Anthony Makau 1008072
3. Vincent Kiprono 1008874
4. Lucy Wanjiku 1008393
5. Terrence Chanzu 1008783
6. Ndirangu Kaguthi 1008159
7. Nicholas Kemboi 1008836
8. Micheal Musila 1008807
9. Patrick Okumu 1008094

TARGET COSTING
It is a pricing method used by firms – it is defined as “a cost management tool for

reducing the overall cost of a product over its entire lifecycle with the help of a

production, engineering, research and design.”

A target cost is the maximum amount of cost that can be incurred on a product and

with it the firm can still earn the required profit margin from that product at a

particular selling price.

It is also the process of determining the maximum allowable cost for a new product

and then developing a prototype that can be profitably manufactured and

distributed for the maximum target cost figure.

Target costing involves setting a target cost by subtracting a desired margin from a

competitive market price.

Target cost = anticipated selling price – desired profit

To compete effectively, organizations must continually redesign their products /

services in order to shorten product lifecycles. The planning, development and

design stage of a product is therefore critical to an organization’s cost management

process.

Examples of decisions made at the design stage which impact on the cost of a

product include;

1. The number of different components.

2. Whether the components are standard or not.

3. The ease of changing over tools.

2
Justification / reasons for using: the target costing approach was developed in

recognition of the two important characteristics.

Costs: most firms really have less control over price than they would like to think.

The market: i.e. (demand and supply) really determine the process and a firm that

attempts to ignore this does so at its own peril/risk, therefore the anticipated

market price I taken as given in target costing.

Cost

The cost of a product is determined in the design stage. Once a product has been

designed and has gone into production then it follows that the major opportunities

comes in design stage.

At the designing stage

This is where valuable features the customers are willing to pay for can be added or

adopted and where most of the costs are really determined. So the focus is on

designing and developing the product.

The difference between target costing and other opportunities to product

development is profound. That is to say that instead of designing the product and

then finding out how much it costs, the target cost is first set and then the product

is designed so that the target cost is attained.

Merits of Target Costing

3
 i. It is embedded in a team environment i.e. that team members include

representatives from every department, be the design, process engineering,

purchasing, manufacturing and marketing. All the team members are focused

on the same objectives i.e. deliver a product with the target functionality,

quality and price to a specific market segment.

ii. The target costing idea reflects the reality that the most product and process

design, decisions are not the lowest. Cost designs but rather designs that the

organization has decided it can live with i.e. we use solutions that are good

enough, not necessarily the best solutions.

iii. Target costing places huge pressure on the design team. The design team

has a common objective; to meet target cost. This is to say that there is no

possibility of renegotiating the target costing; the product will not be

launched until or unless the team meets the target cost.

Demerits

i. The principle of target costing is simple to state but difficult to accomplish.

The idea that the team will continue its product and process design efforts

until it finds designs that yield the target cost, is time consuming and

tiresome.

DEFNITION: It is a method of determining the cost of product or service based on

the price (target price) that customers are willing to pay. The marketing department

determines what characteristics and price for a product are most acceptable to

4
customers; then it is the job of the company’s engines to design and develop the

product such that cost and profit can be covered by that price.

Retail stores employ target costing when they look for goods that can be priced at a

particular level to appeal to customers.

Target costing as a pricing strategy:

Target costing is also effectively used in conjunction with marketing decisions to

engage in price skimming or penetration pricing. Penetration pricing is the pricing of

a new product at a low initial price, perhaps even lower than cost, to build market

share quickly. This is useful when the product or service is new and customers have

great uncertainty as to its value.

– There must be a distinction between penetration pricing from predatory

pricing. The important difference is that, it is intent. The penetration price is

not meant to destroy competition.

Price skimming

This is means that a higher price is charged when a product or service is first

introduced. In essence, the company skims the dream of the market. It is used most

effectively when the product is new, a small group of consumers values it, and the

co. enjoys a monopolistic advantage.

Co.’s that engage in price skimming are hoping to recoup the expenses of research

and development through high initial pricing. A cost consideration is that, in the

start –up phase of production, economies of scale and learning effects have not

occurred.

5
In general, there are many ways in which the price of a product can be determined

which include.

1. Competition –based pricing

This is the setting of price based upon prices of the similar competitor

products competitive pricing is based on three types of competitive product:

a) Products have lasting distinctiveness from competitor’s product

we can assume.

• The product has low price elasticity.

• The product has low cross elasticity.

• Demand of the product will rise.

a) Products have perishable distinctiveness from competitors’ product: -

assuming the product features are medium distinctiveness.

b) Products have little distinctiveness from competitors’ products assuming

that:

• The product has high price elasticity.

• The product has some cross elasticity.

• No expectation that demand of the product will rise.

1. Cost plus pricing

Cost plus pricing is the simplest pricing method. The firm calculates the cost

of producing the product and odds on a percentage (profit) to that price to

give the selling price. This method although simple has two demerits;

a) Takes no account of demand

6
b) There is no way of determining if potential customers will purchase the

product at the calculated price.

Price = cost of production + Margin of profit.

1. Limit pricing

A limit price is the price set by a monopolist to discourage economic entry

into a market, and is illegal in many countries. The limit price is the price that

the entrant would face upon entering as long as the incumbent firm did not

decrease output. The limit price is often lower than the average cost

profitable. The quality produced by the incumbent firm to act as a deterrent

to entry is usually larger than would be optimal for a monopolist, but might

still produce higher economic profits than would be earned under perfect

competition. The problem with limit pricing as strategic behavior is that once

the entrant has entered into the market, the quantity used as a threat to

deter entry is no longer the incumbent firm’s best response.

2. Loss leader

No market leader would wish to sell below cost unless this is part of its

overall strategy. The idea of selling at a loss may appear to be in the public

interest and therefore not often challenged. Only when the leader pushes up

prices, it then becomes suspicious.

3. Market- oriented pricing

Setting a price based upon analysis and research compiled from the targeted

market.

4. Penetration pricing

The price is deliberately set at low level to gain customer’s interest and

establishing a foot-hold in the market.

7
5. Price discrimination

Setting a different price for the same product in different segments to the

market what if involves is, setting the price of your product / service

according to research conducted on your target market.

6. Premium pricing

It is the practice of keeping the price of a product or service artificially high in

order to encourage favorable perceptions among buyers, based solely on the

price. The practice is intended to exploit the (not necessarily justifiable)

tendency for buyers to assume that expensive items enjoy an exceptional

quality and distinction.

7. Predatory pricing

It is the aggressive pricing intended to drive out competitors from a market.

8. Contribution margin based pricing

It maximizes the profit derived from an individual product, based on the

difference between the products’ price and variable costs (the product’s

contribution margin per unit) and one’s assumptions regarding the

relationship between the product’s price and the number of units that can be

sold at that price. The product’s contribution to total firm is maximized when

a price is chosen that maximizes.

a) Contribution margin per unit )X (Number of units sold)

1. Psychological pricing

Designed to have psychological impact e.g. selling a product at Sh. 499

rather than Sh. 500.

2. Dynamic pricing

8
 A flexible pricing mechanism is made possible by advance in information

technology, and employ mostly by internet based companies. By responding

to market fluctuations or large amounts of data gathered from customers.

3. Price leadership

An observation made of oligopic business behavior in which one company,

usually the dominant competitor among several, leads the way in

determining prices, the others soon following.

4. Target pricing

This is a pricing method whereby the selling price of a product is calculated

to produce a particular rate of return on investment for a specific volume of

production. It is not useful for companies whose capital investment is low

because, according to this formula; the selling price will be understated.

5. Absorption pricing

This is a method of pricing in which all costs are recovered. The price of the

product includes the variable cost of each item plus a proportional amount of

the fixed costs.

6. Marginal cost pricing

This is the practice of setting the price of a product to equal the extra cost of

producing an extra unit of output. By this policy, a producer charges, for each

product unit sold, only the addition to total cost resulting from materials and

direct labour. Businesses often set prices close to marginal cost during

periods of poor sales.

Generally: target costing considers several factors in determining everyday

product pricing in its stores. The primary factor is the competitive market

place. Target strives to provide competitive target’s pricing strategy is based

9
 purely on being competitive in the trade market area. It is not based on

demographics, income of an area or location.

TARGET PROFIT ANALYSIS

Target profit: This is the amount of net operating income of profit that

management desires to achieve at the end of a business period. Management

needs to know the required level of business activities to get target profits.

Cost volume profit (VCP) equations and formulas can be used to determine the sales

volume needed to achieve a target profit.

Example

Sales price per unit = KSh.250

Variable cost per unit = KSh.150.

Total fixed expenses = KSh.35,000

Target profit = KSh.40,000

= Number (Quantity) of units sold.

Required

How many units will have to be sold to earn a profit of KSh. 40,000?

Solution

10
The cup equation method

Under this approach, we can find the number of units to be sold to obtain target

profit by solving the equation where profits are equal to target profit of 40,000.

Sales = variable expenses + fixed expenses + profit

250Q – 150Q + 35,000 + 40,000

= 100Q = 75,000

Q = 750 units (75,000/100)

Thus the target profit can be achieved by selling 750 units per month, which

represents KSh.187,500 in total sales (250/= X 750 units). This equation is also

extensively used to calculate break even point when the break even joint is

calculated the value of profit in the equation is taken to equal to zero.

The contribution margin approach

A second approach involves appending the contribution margin formula to include

the target profit.

(Unit sales to attain target profit = (Fixed expenses + Target profit)

Unit contribution margin

= (35,000 + 40,000) divide 0.40

= Sh. 187,500

No. of units to be sold = 187,500/= Q = 750 units.

750 units

11
Review problem

Mwangi and Shiko co. manufacture and sell a telephone answering machine. The

company’s contribution margin format income statement for the most recent year is

given below.

Total per unit percent of sales

Shs Shs Shs

Sales (20,000 units) 1,200,000 60 100%

Less: variable expenses 900,000 45 ?%

Contribution margin 300,000 15 ?%

Less : Fixed expenses 246,000

Net operating income 60,000

Management is anxious to improve the company’s profit performance. Assuming

that next year management wants the co. to earn a minimum profit of Sh. 90,000.

How many units will have to be sold to meet the target profit figure?

Solution

1. Equation method

Sales = variable expenses + fixed expenses + profits.

Shs 60 Q = Sh 45Q + 240,000 +90,000.

60Q – 45Q = 330,000

15Q = 330,000

12
 Q = 330,000 = Q = 22,000 units.

2. Contribution margin method

(fixed expenses + Target profit) divide contribution margin per unit)

= 240,000/= + 90,000/=

Q = 22,000 units.

JUSTIFICATION FOR USING TARGET COSTING

Target costing is a cost management concept that is based on a long-term, market-

driven perspective rather than on a short-term, profit- driven outlook of most

manufacturing companies.

Target costing thus helps in:

1. Changing product life and requirement

Consumers are demanding new and diversified products in short interves and

product cycles are becoming or getting shorter and shorter. Due to factory

automation, robot and computer – controlled manufacturing systems are

replacing the conventional production lines once the product is developed

and designed, there is a limit to how much cost cutting companies can in the

manufacturing stage.

2. Control cost early

It is primarily used and most effective in the product development and design

stage. It is based on the price down, cost – down strategy, which allows

companies to win a considerable share of their respective markets e.g Toyota

and sony.

13
 3. Connect with profit planning

It is really closely linked with the company’s long-term profit and product

planning process. This link allows the co. to focus on profit and product in an

integrated strategy which does not discriminate against high quality, high-

price, high-margin products that require high costs.

4. Setting the target costs

When the target sales price is established based on the market research, the

desired profit is subtracted to yield the allowance cost. This allowance cost is

top management’s dream. The desired profit is determined based on the

co.’s desired Return on sales), rather than Return on investment. There are

two reasons for this;

Technical reason

1. In the fast changing market of today, manufactures need a variety of

products in low volumes to survive. Calculating the profitability of each of

those products in ROI is well hot impossible.

2. Strategy reason

In the implementation of long- term strategies, manufactures need to focus

on the profitability of ponfolios of related products and the role each product

plays for the product group for this, ROS provides a better measure.

3. Achieving the target costs

Cost management people help engineering planners and designs decompose

the target cost into each cost element according to their relations to detailed

production functions production engineers determine standards for material

14
 and part usage, labour consumption e.t.c which become the basic cost data

for financial accounting purposes.

4. Value engineering

It is a mechanism used generally by Japanese to enhance the value of

products and services, which is measured by the relationship between the

functions performed by products and services and the costs incurred.

The process of VE consists of describing the functions of each product, part

and services, and vitrifying the components of those functions.

5. Rest audit of target costing performance

The short life cycles of manufactured goods in today’s market require

manufacturers to recover investment in a short time. A short payback period

is usually assumed in planning and evaluating target costs. Post –audit of

target costing performance is done on a regular basis to targets have not

been achieved, investigations follow.

15