What is target costing?

Target costing involves setting a target cost by subtracting a desired profit margin from a competitive market price.[1][2] A lengthy but complete definition is "Target Costing is 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 products anticipated selling price over a specified period of time in the future." [3] This definition encompasses the principal concepts: products should be based on an accurate assessment of the wants and needs of customers in different market segments, and cost targets should be what result after a sustainable profit margin is subtracted from what customers are willing to pay at the time of product introduction and afterwards. These concepts are supported by the four basic steps of Target Costing: (1) Define the Product (2) Set the Price and Cost Targets (3) Achieve the Targets (4) Maintain Competitive Costs. To compete effectively, organizations must continually redesign their products (or services) in order to shorten product life cycles. The planning, development and design stage of a product is therefore critical to an organization's cost management process. Considering possible cost reduction at this stage of a product's life cycle (rather than during the production process) is now one of the most important issues facing management accountants in industry. Here are some examples of decisions made at the design stage which impact on the cost of a product. The number of different components Whether the components are standard or not The ease of changing over tools Japanese companies have developed target costing as a response to the problem of controlling and reducing costs over the product life cycle.

Definition, Explanation and Formula of Target Costing:

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 Planned Selling Price is Set Target Cost is Determined As: Selling Price Less Desired Profit Teams of Employees from Various Areas and Trusted Vendors Simultaneously

Design Product

Determine Manufacturing Determine Necessary Process Raw Materials

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

Projected sales (40,000 mixers $30 per mixer ) Less desired profit (15% $2,000,000)

$1,200,000 300,000 ------------

Target cost for 40,000 mixers

$9,00,000 =======

Target cost per mixer ($9,00,000 / 40,000 mixer)

$22.50

This $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 and Disadvantages 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. Minimize non value-added activities.

Encourages selection of lowest cost value added activities. Reduced time to market. Target costing approach has the following main disadvantages or limitations:

Effective implementation and use requires the development of detailed cost data. its implementation requires willingness to cooperate Requires many meetings for coordination May reduce the quality of products due to the use of cheep components which may be of inferior quality. In Business | Target Costing Approach--An Iterative Process: Target costing Technique is widely used in Japan. In the automobile industry, the target cost for a new model is decomposed into target costs for each of the elements of the car--down to a target cost for each of the individual parts. The designers draft a trial blueprint, and a check is made to see if the estimated cost of the car is within reasonable distance of the target cost. If not, design changes are made, and a new trial blueprint is drawn up. This process continues until there is sufficient confidence in the design to make a prototype car according to the trial blueprint. If there is still a gap between the target cost and estimated cost, the design of the car will be further modified.

After repeating this process a number of times, the final blueprint is drawn up and turned over to the production department. In the first several months of production, the target costs will ordinarily not be achieved due to problems in getting a new model into production. However after that initial period, target costs are compared to actual costs and discrepancies between the two are investigated with the aim of eliminating the discrepancies and achieving target costs.

Source: Yasuhiro Monden and Kazuki Hamada, "Target Costing-Kaizen Costing in Japanese Automobile Companies," Journal of Management Accounting Research 3, pp. 16-34.

You may also be interested in other articles form "pricing products and services" chapter:

Price Elasticity of Demand - Economists' Approach to Pricing

Absorption Costing Approach to Cost Plus Pricing Target Costing Time and Material Pricing in Service Companies

Read more at http://www.accounting4management.com/target_costing_pricing_products_and_services.htm#F1HEo QtMEGaJqsyB.99 In Business|Target Costing Approach--An Iterative Process: Target costing Technique is widely used inJapan. In the automobile industry, the target cost for a new model is decomposed into target costs for each of the elements of the car--down to a target cost for each of theindividualparts. The designers draft a trial blueprint, and a check is made to see if the estimated cost of the car is within reasonable distance of the target cost. If not, design changes are made, and a new trial blueprint is drawn up. This process continues until there is sufficient confidence in the design to make a prototype car according to the trial blueprint. If there is still a gap between the target cost and estimated cost, the design of the car will be further modified. After repeating this process a number of times, the final blueprint is drawn up and turned over to the production department. In the first several months of production, the target costs will ordinarily not be achieved due to problems in getting a new model into production. However after that initial period, target costs are compared to actual costs and discrepancies between the two are investigated with the aim of eliminating the discrepancies and achieving target costs. Source: Yasuhiro Monden and Kazuki Hamada, "Target Costing-Kaizen Costingin Japanese Automobile Companies," Journal of Management Accounting Research 3, pp. 16-34.

Read more athttp://www.accounting4management.com/target_costing_pricing_products_and_services.htm#F1HE oQtMEGaJqsyB.99

WHAT IS TARGET COSTING?

Target Costing is a tool, and comprehensive process, that dramatically improves an organization's capability to reduce costs and improve the bottom line. It is a tool for implementing a Lean Enterprise and managing a cost competitive company. There are several key components of Target Costing - in the forms and analysis that are used, thestandard work that is used to drive execution, and the standard management practices that are required to guide and lead the cost reduction teams. Target Costing is target driven; it is relentless in pushing the organization to establish and achieve the cost targets. The target setting process brings the factory floor together with the supporting departments to ensure there is total understanding of the market price for a product. This approach drives blunt force pragmatism about market realities. There are no functional hard targets in target costing. There is no hiding behind functional histories or silos. With Target Costing, it is common to redeploy some talent in the organization to projects with the most opportunity to reduce costs. This may be in manufacturing, in purchasing, in design, or even in sales. The tool drives the organization to efficiently allocate talent to the most productive projects for the company. Target Costing also ties together other contemporary management tools such as Lean, 6-Sigma, etc. In fact, Target Costing brings these tools out of a tool silo, and into the mainstream of necessary cost reductions. When an idea is bought off as a key element in the Target Cost reduction plan, the implementation team is signing up to be accountable for the project savings. Target Costing also ties in all the necessary components of cost - from design to purchased components to manufacturing to shipping to sales

AT THE HEART OF TARGET COSTING IS EXECUTION. THE KEY TOOLS FOR EXECUTING TARGET COSTING ARE: 1. Element Tracking List (ETL) - this is the master list of each cost reduction project that the team is working on for the Product Line. This tracks project number, description, project owner, implementation date, savings/unit, customer approval requirements, implementation status, and other data. 2. Key Task Monitor (KTM) - There is a KTM for each project. This is the implementation schedule for the project. It includes the owner, each individual task that needs to be accomplished, with dates. The KTM's track back to the ETL .

3. Sufficiency Chart (SC) - The Sufficiency Chart is the highest level of monitoring for Target Costing. This tracks actual costs, projected costs based on the ETL projects, actual profit margin, target profit margin, and price outlooks. In the context of Target Costing, the SC is the key report card for the product line on actual profit performance and future product line performance to target margins.

A VERY FORMAL STANDARD MANAGEMENT PLAN AND REVIEW IS PARAMOUNT TO THE SUCCESS OF TARGET COSTING.

The keys to this are constant checking of plan versus actual, corrective actions being addressed with no delay, and multiple levels of management involvement in the process. Monthly review with Senior Executives to review the Sufficiency charts for actual performance, and ensure that plans are sufficient, being executed, and resources allocated to achieve the plan.

WHY DOES TARGET COSTING WORK?

An aligned organization around ONE cost reduction plan Only realistic plans are included in the tracking activities Standard management drives the discipline and engagement of the total organization Continuous feedback loop in Plan-Do-Check-Act to ensure savings are flowing to the bottom line

Target costing is defined as a cost management tool for reducing the overall cost of a product over its product life cycle. Management utilizes this pricing technique to meet both the demands of its customers as well as company profit goals. Target costing is particularly popular among Japanese firms such as Toyota, Nissan, Toshiba and Daihatsu Motor in various industries such as automobile manufacturing, electronics, machine tooling, and precision machine manufacturing. As Japanese tastes became more diverse, assembly-oriented production grew in popularity. This growing demand for a diverse range of products shortened product life cycles. With shorter product life cycles more focus is placed on the costs occurring at each phase (development, planning and design.) Compared to traditional standard costing approaches in which an estimate of product, general administrative, marketing, and distribution costs is taken into consideration, target costing takes on a more proactive approach to pricing. Traditional costing determines cost based on the design of goods, adds a markup and establishes a price. In comparison, the marketplace directs target costing by first setting a selling price, then subtracting target income and finally reaching a cost. Traditionally, a cost figure is obtained, implemented and once found to be poorly configured, sent back to management and engineers for reworking of production processes and cutting of costs. In comparison, target costing utilizes costing information and focuses on the best possible price up front, preventing wasted time on after-the-fact discussions concerning design and re-engineering of the product. The decision making process involves a cross functional team, in which employees from various departments (Production, Engineering, R&D, Marketing, and Accounting) are given the responsibility of determining an acceptable market price and corresponding Return on Sales, as well as a feasible cost in which a given item may be produced. In order to minimize costs, team members focus on eliminating non-value-added costs of the process, improving product design and modifying process methods. Target costing, in particular, emphasizes the reduction of costs during the planning and design stage of the product life cycle since the majority of product cost is determined at this stage. In comparison to traditional product costing methods, target costing allocates more of the total cost to the development stage, simultaneously reducing costs during the production stage. A number of cost-engineering techniques are used in the cost reduction process. Just-in-Time, Total Quality Control, Material Requirements Planning and Value Engineering are among such methods promoted by target costing. With the increased popularity of assembly-oriented industries, Economic Order Quantity analysis, a traditional means of keeping certain amounts of inventory on hand, became less useful. Instead, many firms, realizing the dangers of housing high inventory, turned to Just-In-Time and Material Requirements Planning. JIT and MRP provided a great advantage to these companies that manufacture high variety, low-volume products. Value engineering involves the design of a product after gathering input from employees and from various departments within a company, each offering a different perspective on possible cost

minimization tactics. Value engineering considers all aspects of the value chain and frequently involves individuals outside of the company such as suppliers in order to reach a decision that encompasses the most successful combination of price and quality. Total Quality Control is a Japanese process that initially developed in the United States as a method of Quality Control. Inspection is the main issue that distinguishes between the two. TQC incorporates QC (inspection) activities throughout a company, rather than in isolation within specific departments. Initially a project is either accepted or rejected based on marketability and cost and profit data. Once a project is accepted, the engineering department constructs an engineering development plan. This plan considers all aspects of product cost up-front. Target profit is then subtracted from expected sales to reach an estimate of allowable cost. In order to successfully reach this allowable cost, a great deal of effort is required from each department to tighten overall cost. Individual processes are evaluated in order to direct efforts toward the most valuable and feasible cost saving areas. The prevalence of assembly-oriented products along with shortened product life cycles has contributed to the success of target costing. Many firms have turned to target costing as a way of improving the price and quality of their products, creating a benefit in terms of a companys profits as well as increased customer satisfaction. Target costing adds value to the production process by eliminating non-value added activities, thus paving the way for decreased costs passed on to the consumer. Target costing enables companies to ascertain a more realistic price as well as strengthen competition among firms to offer quality products at lower costs. Target Costing vs. Standard Costing Characteristic When applied Target Costing During the Planning and Design Stage of the product's life cycle Traditional Standard Costing Applied during the Production Stage of the product's life cycle

Approach

Involves a proactive Cost Involves a reactive Cost Control Planning Approach where pricing Approach during production is considered prior to production Assembly Oriented Industries Process-Oriented Industries (Variety, medium to small volume (Continuous production) production)

Type of Industry Best-Suited