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Strategic Cost Management: The Mechanics of Target Costing
Mahmuda Akter, Ph.D. Dewan Mahboob Hossain Mahfuzul Hoque, Ph.D.
Abstract This paper provides a basis of target cost setting for products as well as their components. The overall target costing process would be unsuccessful if targets for cost and profit are made unrealistic because the target cost achievement of the product designers may vary according to the levels of tightness of different target cost and target profit methods since these will motivate them in different ways. In this paper, we showed the mechanism of target cost setting for products and their parts with the help of a hypothetical example. In a target-costing environment, identifying the appropriate degree of tightness of the targets for profit and cost is very crucial factor to take into account. In certain situations performance improves with the level of tightness while in the other circumstances, it deteriorates. The tight but attainable target should be established for high and persistent cost-reduction performance. In target costing, the overall accounting process consists of target cost establishment and allocation processes. The policy that is suitable for getting higher cost-reduction performance in the target cost establishment process may not be desirable for the same in target cost allocation process.
Introduction Increased competition and vocal customers have made it imperative for every company to upgrade its processes constantly to stay ahead of the competition. In the midst of an overabundance of products and choices for the customer, it becomes increasingly important for any company to make its products better, faster, cheaper and more innovatively. Increasing the efficiency of products has the two aspects of cost and functionality attached to it. An efficient designing technique takes the cost and functionality aspects into consideration during the early stages of product design where extensive design efforts are given on important features and simultaneously reducing the cost on less important features. Target costing is a planning tool that helps us to identify the features to be improved and helps us in setting targets for designing and cost reduction. It is generally known that challenging goals lead to better performance than the general goal of doing ones best (Cooper and Slagmulder, 1997). Target costing focuses on searching for opportunities for cost reduction at the product planning stage, as well as
providing continuous cost reductions once a product commences manufacture. It is a multidisciplinary tool of cost management to reduce overall costs applied at the planning 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 on the logic that a company should manufacture the products that yield the desired profit. If the product is not yielding the desired amount of profit, the design of the product should be changed to obtain the desired profit or the product should be abandoned. The target costing process is a system of profit planning and cost management that is price led, customer focused, design centered, and cross functional. Target costing initiates cost management at the earliest stages of product development and applies it through out the product life cycle by actively involving the entire value chain (Ansari, 1997). Target costing, a technique that many Japanese companies use to sustain a competitive advantage, has begun to invade the province of management accountants (Bayou and Reinstein, 1996) Invented by Toyota, target costing has been used by Japanese managers for nearly 30 years (Kato, 1993). More than 80 percent of major Japanese companies in assembly industries 60 percent in process industries use the system (Kato, 1993). Some U.S. and European corporations, perhaps assuming that target costing is a major reason for Japan’s success, turn to target costing to possibly replace standard cost accounting (Financial Management, 1991, p. 12). Therefore, management accountants should understand target costing as an alternative to the product costing method, but recognize that it can dilute management accounting’s role in “doing” accounting and in developing and evaluating cost management systems (Inoue, 1989). Target costing occurs in two phases: an establishment phase and an attainment phase. The establishment phase occurs during product planning and concept development stages of the product development cycle and it focuses on defining a product concept and setting allowable cost targets for products or a family of products. The attainment phase occurs during the design development and production stages of target costing and involves achieving that target cost (Ansari, 1997). After determining a product’s target cost in the establishment phase, the next major step is to decompose that target cost down to the function, component, and part level in the attainment phase so that the purchase prices of those items can be determined. An organization's target costing effectiveness represents the degree 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 profit are made unrealistic because the target cost achievement of the product designers may vary according to the levels of tightness of different target cost and target profit methods since they will motivate them in different ways (Akter, Lee and Monden, 1999). Therefore, the purpose of this paper is to provide a basis for target cost setting for products as well as their components. To this end, this paper is organized into six sections. The paper first section presents an overview of the target costing process. The second describes the phases in target costing process. The third provides a target costing example. Sixth section concludes the paper. 1. An Overview of Target Costing Process Target costing is intimately linked to an organization’s competitive strategy and its product development cycle. Since the late 1980s, target costing has become ever more closely connected with business strategy and considered as a strategic cost management tool for attaining target profit as well as for cost reduction (Sakurai and Scarbrough, 1997). Competitive strategy defines the goals that an organization must attain to satisfy market demands and remain profitable. Target costing provides the means by which the organization achieves these goals. It does so by integrating the strategic variables of market trends, customer needs,
technology advances, and quality requirements into a product definition that meets a customer’s price, quality, and time expectations. Target costing is the simultaneous planning of how to satisfy customers, capture market share, generate profits, and plan and manage costs. Without target costing system, meeting competitive prices and generating acceptable returns on a consistent basis is difficult, if not impossible, in today’s environment (Ansari, 1997). Target costing identifies the cost at which the product must be manufactured if it is to achieve its target profit margin when sold at its target-selling price. In the contemporary industrial environment that changes rapidly and plays by its own set 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 be difficult to achieve. However, the difficulty of implementing target cost methods depends not only on the rigidity exercised in setting target profit, but also on the degree of tightness inherent in the target cost methods. Competitive environment, company’s efficiency, and development stage of management accounting system mainly persuade the selection of a particular method for determining target profit. The attainability of target profit influences the decision of using a target cost method. When a company decides to use a particular target profit method, it does not finalize the target profit figure immediately. Rather, a provisional target profit is determined first based on which allowable cost, the cost at which the product must be manufactured if it is to generate the desired profit margin, is determined. Subsequently, the attainability of allowable cost is checked. If this allowable cost is attainable, the management accepts provisional figure as the final profit and here target cost is determined by subtractive method. On the other hand, if management feels that the allowable cost objective is not possible to achieve, target cost is determined by adding-up or combination method. When either one of these two methods is used, the provisional target profit could not be attained because the target cost will be higher than the allowable cost. Thus, the target profit will be changed downward to derive the target costs. Therefore, the selection of a particular target cost method depends on the attainability of the allowable cost. Moreover, setting target profit margins in this manner makes the allowable cost reflect the relative competitive position of the firm. A highly efficient firm will set target profit margins higher 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 cost The next stage of the target costing process is to determine cost reduction targets. Some firms will do this by estimating the 'current cost' of the new product. The current cost is based on existing technologies and components, but encompasses the functionality and quality requirements of the new product. The difference between the current cost and the target cost indicates the required cost reduction. This amount may be divided into a target cost-reduction objective and a strategic cost-reduction challenge. The former is viewed as being achievable (yet still a very challenging target), while the latter acknowledges current inherent limitations. After analyzing the cost reduction objective, a productlevel target cost is set which is the difference between the current cost and the target cost-reduction objective. It should be noted that a fair degree of judgment is needed where the allowable cost and the target cost differ. As the ideal is to produce at the allowable cost,
it is important that the difference is not too great. Once the product-level target cost is set, however, it generally cannot be changed, and the challenge for those involved is to meet this target. Having achieved consensus about the product-level target cost, a series of intense activities commences to translate the cost challenge into reality. These activities continue throughout the design stage up until the point when the new product goes into production. Typically, the total target is broken down into its various components, each component is studied, and opportunities for cost reductions are identified. These activities are often referred to as value engineering (VE) and value analysis (VA). Value engineering involves searching for opportunities to modify the design of each component or part of a product to reduce cost, but without reducing functionality or quality of the product. Value analysis entails studying the activities that are involved in producing the product to detect non-value-adding activities that may be eliminated or minimized to save costs, but without reducing the functionality or quality of the product. Where components are sourced from suppliers (which is often the case in the automotive industry), target prices are established for each part and the company’s employees work with the suppliers to ensure the targets are achieved. Overall, the aim of the process is to ensure that when production commences, the total cost will meet the target, and profit goals will be achieved. Figure 2 summarizes the steps in the target costing process. Figure 2. Steps in the target costing process 2. Phases in the Target Costing Process Target costing occurs in two phases, establishment phase, and attainment phase. The establishment phase occurs during product planning and concept development stages of the product development cycle and involves setting a target cost. The attainment phase occurs during the design development and production stages of target costing and involves achieving that target cost (Ansari, 1997). 2.1 Establishment Phase of the Target Costing Process The establishment phase needs a product price and required profit to determine the allowable cost of a product. Here product level target cost is determined where product strategy and the long-term profit fix a product’s price and its required profit. The difference between price and the required profit margin is the allowable target cost. The allowable target cost is the initial target that guides product development efforts (Ansari, 1997). 2.1.1 Setting Target Prices in a Target Costing Environment Target Costing typically occurs in a competitive environment, in which firms differentiate their products on the basis of quality, service, support, features, product functions, and time to market. In this environment, customer needs, wants and tastes, coupled with their ability to pay, are central in determining product prices (Ansari, 1997). Usually, there are two methods of target sales price, cost-based and market-based. The cost-based method, also known as the cost-plus method, adds on a set profit margin to either the full cost or the variable costs to get a sales price for a particular product. This method is more effective when it is a seller’s market and when our company’s product is clearly superior to and distinct from competitors’ products, so that setting a sales price based on our company’s cost will not run risk of losing out in price competition with rival companies (Monden, 1995). Although cost-based pricing is a very popular method of pricing used by many companies, it is unsuited for target costing environments. Use of cost-based pricing in competitive environments negates the entire rational for the use of target costing. In fact, being wedded to cost for product pricing is an impediment to the successful adoption of target costing (Ansari, 1997).
The market-based method looks at the prices of competing products on the market and sets similar prices for its own products. This method is most effective in an environment where: (i) there is no conspicuous differences among competing products in terms of quality and functions, (ii) short product life cycles due to technological advancements, and (iii) the market has become a buyer’s market. Consequently, the price of products (i.e., competitive products) in a highly competitive market depends upon the functional level reached by the product’s various functions (Monden, 1995). Even if there is no noticeable difference in the quality and functions of competing products on the market, prices may be set according to slight differences in a product’s functional level or the inclusion of extra functions. Here functions include not only practical functions but also aesthetic functions such as the product’s styling. Also, one must consider all competing products in the same market segment including company’s own competing products. Three methods are used in practice. Function based adjustment method sets prices by adding or subtracting the value of functions added or deleted from an existing product. Here the pricing formula is, New market price = current price + value placed by market on a function Physical attributes-based adjustment method sets prices with reference to the physical attributes of a product, such as weight, torque ratio, horsepower, and so on. Here the pricing formula is, New market price = current price + measure of physical attributes of the product Competitor based adjustment method sets prices with reference to competitors’ products or attributes. Competitor’s market price = Our product’s price × (Measure of attribute of competitor’s product/measure of attribute of our product) 2.1.2 Setting Target Profits in a Target Costing Environment Target profit is the expected profit from total sales of the product over its life. It is determined by corporate profit expectations, historical results, competitive analysis, and sometimes, computer simulations (Cooper, 1995). The objective in setting target profit margins is to ensure the achievement of the firms long-term profit plan. Setting target profit is a function of bringing together business level plans with product level plans (Ansari, Bell and CAM-I, 1997). The two considerations in setting target profit margins are to ensure that they are realistic and that the margin is sufficient to offset the life-cycle cost of the product (Cooper and Slagmulder, 1997, 100). Usually, there are three methods of calculating target profit by targeting: (i) return on sales ratio determined in the middle-range profit plan, (ii) reduction rate in the cost of the existing or similar product, and (iii) return on sales ratio based on past actual performance of the related product. Among these, the first one is used for formulating macro plan and the would-be profit is termed as required profit, the third one is used at micro level and the profit to be materialized under the method is called planned profits, while the second one adjusts the gap between the first and third. At the business level, target profit is determined by considering the profit requirements for the business as a whole. This is done by considering the firm’s intended product portfolio and by establishing a required profit from this portfolio. The product portfolio comes from a firm’s multiyear product plan and the profit comes from the middle-range profit plan applying a target return on sales (ROS) ratio to the sales revenue from the product portfolio. Product level plans, on the other hand, represent a product manager’s expectations for his or her product. To develop a projected sales volume, the product manager considers the projected market size, targeted market share, and the competitive market
price. Applying the ROS targets from the profit plans to this projected sales levels yield the planned profit at the product level. Here, the ROS ratio is determined based on the past actual performance of the related product. The two profits, required and planned, are compared to set a final target profit for the product. Target profit, if it is to be determined in the middle-range profit plan, reflects management’s expectations that allow them at best to run the company smoothly or at worst to survive. This is somewhat unrealistic in that its attainability is presumed to be assured. (Akter, 2006 ; Akter, Hoque and Monden, 2004). On the other hand, when target profit is based on the past actual performance of the related product, the actual return-on-sales ratio for the current product is more achievable since the company has experiences in attaining this profit (Monden, 1995). Usually, there is a gap between management’s profit expectations and actual profit. Target profit determined at middle-range planning often begins at executive levels and follows top-down approach. It reflects the strategic profit needs of the organization for ensuring the survival and growth of the firm and its affiliates. By contrast, target profit based on past actual performance of the related products is usually determined at the product department level using a bottom-up approach. (Akter, 2006 ; Akter, Hoque and Monden, 2004). If there is gap between the profit decided at executive and departmental levels, the reconciliation process continues until there is no gap or both sides agree that it is not possible to close the gap. A company’s prosperity depends on playing this kind of “catch” between top management and managers at the operational level (Sakurai and Scarbrough, 1997). Simply by adhering to the target profit based on past actual performance of the related products the company is unlikely to reduce cost below the current level, which has already been achieved. When the profit expected in the middle-range profit plan exceed the actual one, the reconciliation process, or “catch” can proceed by calculating the target profit based on targeting reduction rate of cost of the existing or similar product. This method helps to identify the unachievable or unrealistic portion of target profit determined in the middle-range profit plan. In terms of earnings, this method stands in the middle of the desired and achievable earnings level. 2.1.3 Setting Target Costs in a Target Costing Environment The allowable cost is calculated by subtracting the target profit from the target sales price. It is known as the ‘maximum permissible cost’ that can be committed to a product in the product planning stage. It is the desired cost based only on market conditions, and is called ‘market-driven’ cost. In competitive environment firms that are highly efficient will have higher target profit margins and hence lower allowable costs than their less efficient competitor. Since the allowable cost is determined by market forces and does not take into account the internal design and production capabilities of the firm, there is a possibility that the allowable cost will not be achieved. In practice, however, it is not always possible for the designers to find ways to achieve the allowable cost and still satisfy the customers. (Cooper and Slagmulder, 1997). Usually, allowable cost is the early estimate of the target cost. It is considered as the final target cost only when the product can be made for this amount. If this cost is adopted as the target of efforts, the requirement is very severe and not immediately attainable (Monden and Hamada, 1991). Target cost determined in this way is called ‘Subtractive method’ or ‘Sales price-based method’.1 Subtractive method acts as a signal to all involved in the target costing process as to the magnitude of the cost-reduction objective that inevitably must be achieved. From the management viewpoint, it is desirable to realize the largest possible profit and for this the target cost requirement by the subtractive method is likely to be demanding (Monden, 1995). The subtractive method will clearly have a strong linkage with firm’s middle-range profit plan that incorporates projected profit figures to target costing. When allowable cost is not achievable, to check
its attainability the ‘drifting cost’, which is the current estimated cost with no targets in mind, is calculated for each part. It is the preliminary estimate of a product, assuming the existing work structures, technology, and processes. The primary task in target costing is to perform the VE and continuous improvement activities to reduce the gap between drifting and allowable costs. The cost reduction target is continually refined until the ‘allowable’ and ‘achievable’ cost merge. If the allowable cost cannot be achieved, the process of attaining the target cost increases the allowable cost of the product to a level that can reasonably be expected to be achievable, given the capabilities of the firms and its extended enterprises, i.e. suppliers. Target cost determined in this way is called ‘Adding-up method’ or ‘Estimated cost-based method’.2 (Akter, 2006 ; Akter, Hoque and Monden, 2004). Under this method target cost is determined by examining every possible cost reduction opportunities, taking likely VE proposals, work structures, technology, and processes into considerations. In adding-up method, the target amount of cost reduction is deducted from the estimated or current cost of the product, where the target cost is set to an achievable level by considering the firm’s and its suppliers’ capabilities. This method is used when the designers are unable to achieve the allowable cost and signals that the firm is not as efficient as demanded by the competitive conditions. Usually, target cost requirement via the subtractive method is much harder to meet than that through the adding-up method because non-value-added cost slack still exist when adding-up method is applied (Tani and Kato, 1994). When determining target cost by adding-up method, however, if there is any cost slack, the target cost figure is made lower and set somewhere in the middle of allowable and achievable costs. A hybrid of subtractive and adding-up methods, called the ‘Combination method’3 is used when target cost cannot be finalized either by subtractive or by adding-up method (Kato, 1993). It consolidates the operating focus on profitability and the technological focus on feasibility (Sakurai and Scarbrough, 1997). From the viewpoint of the tightness of target cost methods, combination method stands in the middle of the two extremes of subtractive and adding-up methods. 2.2 Attainment Phase of the Target Costing Process The attainment phase focuses on how to make the allowable target cost achievable. Attaining target cost requires cost planning, which has two key steps: computing the cost gap between attainable and current costs and analyzing this cost gap so value engineering and continuous improvement efforts can be focused on closing the gap (Ansari, 1997). The process of making an allowable target cost to an achievable one has been illustrated in terms of the steps of the cost planning process. 2.2.1 Computing Cost Gap In computing cost gap, the gap between the allowable cost and the initial estimated cost is to be computed based on full product life cycle cost. 2.2.2 Decomposing Allowable Cost The next major step is to decompose that target cost down to the function, component, and part level so that the purchase prices of those items can be determined. Here, cost elements are viewed form different perspectives, each of which provides unique view, like value chain, life cycle, customers, engineers, and accounting. The value chain view arranges costs by where in the extended enterprise they are incurred. This helps a firm to focus cost reduction efforts both within and outside own boundaries. The life cycle view arranges costs by time when they are incurred. The customer view arranges costs by product features where total allowable cost is assigned to each feature in proportion to the importance customers place on that feature. The engineering view is a functional view from which design engineers view a product. The accounting view arrays costs by three main subcategories, (1) one time or recurring cost, (2) new or legacy costs, and (3) design or activity driven costs. 2.2.3 Assigning Cost Targets to Designers
In target cost allocation process, to attain the per-unit target cost of a product, the designers initially break down this target cost into functional elements assigned to corresponding design departments which are again broken into parts elements. After cost breakdown to functional and parts level, cost reduction targets are assigned to various participants simultaneously. In target costing, the product designers scrupulously design a product taking into account information about alternative methods to achieve the required functions of products and its parts and selecting the best methods to attain the lowest costs. If the target cost cannot be achieved, i.e. if the estimated cost is greater than the target cost, the cost-reduction activities will be repeated by investigating alternative designs, until the estimated cost becomes, at most, equal to the target cost. In most organizations, departments are responsible for function level costs, teams are responsible for component level costs, and designers are responsible for individual parts (Ansari, 1997). Figure 3 illustrates the design process from target costing perspective (Monden, Akter and Kubo, 1997). Figure 3. Design process from the perspective of target costing 2.2.4 Cost Estimation As teams and individuals strive to meet target costs, they must continually estimate costs to determine their progress toward the allowable cost. Each firm develops models for cost estimation that meet its needs. It is unrealistic to expect the same level of cost estimation accuracy at each sage of the product development cycle. As the product concept becomes better defined, and processes and parts finalized, the accuracy of cost estimates should improve. 2.2.5 Dealing with Unattainable Costs Non-attainment of targets at the product team level means the product will not meet its target cost. Failure of a design or build sub-team means that a function, component, or part will not meet its assigned target cost. It is important to remember that allowable costs and target profits are meant to be realistic and achievable. They are commitments that should not be taken lightly. Non-attainment, therefore, is a serious problem and policies to deal with it should be put into place (Ansari, 1997). 3. Target Costing: A Hypothetical Example System kitchen designs and manufactures exhaust fans for kitchen and bathroom use. These are different models with different sizes, functionalities, and capacities. For a standard model of exhaust fan, system kitchen conducted a market survey to know the customers needs regarding the features and functionalities of the exhaust fan. Seven issues are ranked by the customers on a 5-point likert scale with 1 being the lowest importance. Customers’ requirements are collected and Table 1 shows that the airflow capacity is the most important issue (23.81%) from the customers’ perspective, while size and shape of the fan is found to be of least importance (4.76%). Table 1: Customer requirements rankings Degrees of importance Customer requirements Raw Score based on customer feedback % of Total Raw Score Multiple speed 3 14.29 Airflow capacity 5 23.81 Quietness 4 19.05 Compact Size 1 4.76 Good looks 2 9.52 Easy to clean 4 19.05 Multiple installations 2 9.52
In Table 2, costs are broken down by life cycle and value chain. The bottom right corner of the table indicates the total current or estimated cost to manufacture the product ($24.70) and the target or allowable cost ($20.80). The difference between the product-level estimated and allowable target cost is $3.9. The difference between the estimated ($18) and target ($15) production cost $3. This $3 constitutes 77% of $3.9. Hence, in our example, we focus on reducing the cost of production because the difference between the estimated and target cost of production is the highest among all the life cycle costs. Table 3 illustrates the allocation of the $18 current manufacturing cost to the individual components that make up the product. Among others, two functions performed by the components of the exhaust fan are, ‘blade moves air’, and ‘blade-guard secure the blade’. The costs of blade and blade guard are $1 and $1.5 respectively. The individual costs are then expressed as a percentage of the total $18.
Table 2: Cost breakdown by life cycle Life cycle cost Current cost of the product Target cost of the product Research and development $0.45 $0.30 Production $18.00 $15.00 Marketing and distribution $5.00 $4.50 After sales service and support $0.25 $0.25 General administration $1.00 $0.75 Total life cycle cost of the product $24.70 $20.80 Table 3: Components, functions, and breakdown of current production cost Parts/ Components Function Current Cost Percent of Total Cost Motor Turns blades 7.00 38.89 Control/switch Speed control 2.50 13.89 Body Houses motor 2.00 11.11 Blade Move air 1.00 5.56 Blade guard Secure the blade 1.50 8.33 Installation frame To fix the system on the wall/window 4.00 Total cost 18.00 100.00
Table 4 explains the relation among the parts and the customers’ requirements or demanded quality (DQ). Once the relations between parts and customer requirements are understood, the engineering and design staff can provide relative weights to the parts relating to the various customer requirements. The relationship among parts and demanded quality are expressed with three levels, strong ( : 1.5), moderate (∆: 1.2), and normal (O: 1.0) (Hoque, Akter, and Monden, 2005). The airflow capacity is a function required by customers, which requires two functionalities like, motor ( : 1.5) and blade ( : 1.5). In other words, to achieve the customer requirements of “air flow”, the most important components are motor and blade.
Table 4: Relationship among the demanded quality and parts Parts Motor Control/ Switch Body Blade Blade guard Installation Frame Customer Requirements Relation between Components and DQ Component Contribution to DQ (%) Relation between Components and DQ Component Contribution to DQ (%) Relation between Components and DQ Component Contribution to DQ (%) Relation between Components and DQ Component Contribution to DQ (%) Relation between Components and DQ Component Contribution to DQ (%) Relation between Components and DQ Component Contribution to DQ (%) Multiple speed 1.50 50.00 1.50 50.00 Airflow capacity Quietness 1.50 1.50 38.46 50.00 1.20 ∆ 1.50 30.77 1.20 ∆ 50.00 30.77
Compact Size 1.50 22.39 1.50 22.39 1.50 22.39 1.20 ∆ 17.90 1.00 O 14.93 Good look 1.50 42.86 1.00 O 28.57 1.00 O 28.57 Easy to clean 1.00 O 25.00 1.00 O 25.00 1.00 O 25.00 1.00 O 25.00 Multiple installment 1.20 ∆ 100.00 Note: : (1.5) Strong, ∆: (1.2) Moderate, O: (1.0) Normal In Table 5, customers’ requirements are adjusted with the technical requirements of the product and the output (i.e., the component weight based on customer feedback) is the basis for the target cost allocation among the components. For example, customer requirement for airflow is 23.81 and the correlation matrix entails that the airflow has two related components, motor (50.0) and blade (50.0). The weight of the component, motor is (50.0 ×23.81) = 11.90. The total of the column for motor reflect the ultimate weight of the motor (27.44%) that should be considered while allocating the target cost. Table 5: Part’s contribution to demanded quality (DQ) Parts Motor Control/switch Body Blade Blade guard Installation frame Customer requirements Relation between Component and DQ (%) DQ weight based on customer feedback (%) Component weight based on customer feedback Relation between Component and DQ (%) DQ weight based on customer feedback (%) Component weight based on customer feedback Relation between Component and DQ (%) DQ weight based on customer feedback (%) Component weight based on customer feedback Relation between Component and DQ (%) DQ weight based on customer feedback (%) Component weight based on customer feedback Relation between Component and DQ (%) DQ weight based on customer feedback (%) Component weight based on customer feedback Relation between Component and DQ (%) DQ weight based on customer feedback (%) Component weight based on customer feedback Multiple speed 50.00 14.29 7.14 50.00 14.29 7.15
Airflow capacity 50.00 23.81 11.90 11.91 Quietness 38.46 19.05 7.33 Compact Size 22.39 1.07 17.90 4.76 Good look 28.57 9.52 2.72 Easy to clean 4.76 25.00 19.05 Multiple installment 27.44 8.33 17.71 4.76 0.85 1.07 14.93 4.76 2.72 0.70
50.00 23.81 30.77 19.05 5.86 22.39 4.76 42.86 9.52 4.08 25.00 19.05 30.77 19.05 5.86 1.07 22.39 4.76
28.57 9.52 4.76
25.00 19.05 4.76 9.52 9.52
25.00 19.05 4.77 100.00 7.15 15.77 23.60
Table 6 presents the allocation of target production cost based on customer’s requirements and value indices for cost improvement. The 3rd column of this table shows the weight of the components according to the actual cost allocation. Value index (column 4) is one of the most important phases of target costing system as it indicates the scopes for improvements and the level of effort to achieve the target cost. The value index for motor (27.44/38.89=0.71) indicates that the actual cost is significantly higher than the target cost and implies that an effort for reducing the cost is essential. A value index of greater than 1 (e.g., body and blade) indicates items whose relative importance is higher than its relative cost. However, if the component is adequate for the function it performs (e.g., blade guard = 1), and the customer is satisfied with that performance, there is no need to upgrade the component. Value indices of less than one indicate components (e.g., motor, control/switch, installation frame) whose cost is proportionally greater than the component’s importance to the customer. These may be targets for cost reduction because they may represent over-engineered components.
Table 6: Target cost, actual cost and value indices for
Components Component weight based on customer feedback (%) Ratio based on actual cost (%) Value index Action implied Allocated Target cost ($15×Col. 2) Cost based on current situation
Motor 27.44 38.89 0.71 Cost reduce required 4.12 7.00 Control/switch 7.15 13.89 0.52 Cost reduce required 1.08 Body 15.77 11.11 1.42 Room for improve 2.37 2.00 Blade 23.60 5.56 4.25 Room for improve 3.54 1.00 Blade guard 8.33 8.33 1.00 Target achieved 1.25 1.50 Installation frame 17.71 22.22 0.79 Cost reduce required 100.00 100.00 15.00 18.00
The example is a simplified version of what exists in the real world. The cost allocation process under the Target costing framework can be improved to a higher level of sophistication or perfection by introducing QFD, VE tools which we did not include in the example to keep it simple (Hoque, et al, 2000; Hoque and Monden, 2002; Hoque, Akter and Monden, 2000). 4. Conclusion Target costing is viewed as an integral part of the design and introduction of new products. As such, it is part of an overall profit management process, rather than simply a tool for cost reduction and cost management. The first part of the process is driven by customer, market, and profitability considerations. Given that profitability is critical for survival, a target profit margin is established for all new product offerings. The target profit margin is derived from the company’s long-term business plan, which incorporates its long-term strategic intent and profit margins. Each product or product line is required to earn at least the target profit margin. For any given product, a target-selling price is determined by using various sales forecasting techniques. When setting the target-selling price, competitive conditions and customers’ demands for increased functionality and higher quality, without significant increases in price, are clearly recognized, as charging a price premium may not be sustainable. Hence, the target-selling price is marketdriven and should encompass a realistic reflection of the competitive environment. Once the target-selling price and required profit margin have been determined, the difference between these two figures indicates the allowable cost for the product. Ideally, the allowable cost becomes the target cost for the product. However, in many cases the target cost agreed upon will exceed the allowable cost, given the realities associated with existing capacities and capabilities. The difference between the current cost and the target cost indicates the required cost reduction. This amount may be divided into a target cost-reduction objective and a strategic cost-reduction challenge. After analyzing the cost reduction objective, a product-level target cost is set which is the difference between the current cost and the target cost-reduction objective. Once the product-level target cost is set, however, it generally cannot be changed, and the challenge for those involved is to meet this target. Then, a series of intense activities commences to translate the cost challenge into reality. These activities continue throughout the design stage up until the point when the new product goes into production. Typically, the total target is broken down into its various components, each component is studied, and opportunities for cost reductions are identified. The aim of the process is to ensure that when production commences, the total cost will meet the target, and profit goals will be achieved. Therefore, in target costing the adoption of a particular method of target cost and profit depends on company’s ability in the periodical revision or continuous improvement of the target profit and cost. In a target-costing environment, identifying the appropriate degree of tightness of the targets for profit and cost is very crucial factor to take into account. In certain situations performance improves with the level of tightness while in the other circumstances, it deteriorates. The tight but attainable target should be established for high and persistent cost-reduction performance. In target costing, the overall accounting process consists of target cost establishment and allocation processes. The policy
that is suitable for getting higher cost-reduction performance in the target cost establishment process may not be desirable for the same in target cost allocation process. While the above description captures the essential features of the target costing process, it should be emphasized that successful target costing requires careful planning, attention to detail and a strong degree of commitment from those involved.
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