Target costing introduction

Sunday, 3 October 2021 2:46 am

Homework: Today's Topics:

 Introduction
 Target cost gap
 Steps for implementing target costing

Important Points:

Lecture Topic:
During the lecture, take notes here. Insert a sub-page for each lecture topic.

 Introduction
Target costing is the process which involves determining a target cost (estimate cost) for a product by subtracting a
desired profit margin from a target selling price.
A target cost is the cost at which a product must be produced and sold in order to achieve the required amount of profit
at the target selling price.
When a product is first planned, its estimated cost may often be higher so we may need to reduce this estimated cost to a
target cost amount and to reduce the estimated cost we may need to re-design the product, change the production
process and removal unnecessary costs.
Target costing is most effective at the product design stage as it is easier and cheaper to make changes that reduce costs
at this stage.
Target costing is a modern way of calculating costs and is a more market driven approach as before a product is
produced a company go into the market and survey what the people want and research what the interests of the
customers are and may also find out customers views on the value of the product. The company may then establish a
target price based on the results of the market research undertaken. This price is what the company thinks it will have to
sell to achieve the required sales volume.

 Target cost gap

When a product is planned to be manufactured for the first time, its currently-attainable cost (estimated cost) may be
higher than its target cost and the difference between this estimated cost and the target cost is known as target cost gap.
In short target cost gap is the difference between estimated cost and target cost. Management may do anything possible
to close this gap for instance by improving production processes and technologies etc..

 Steps for implementing target costing

The following are the steps involved in target costing:
a. Determine a target selling price at which the organisation will be able to achieve a desired market share
(demand).
b. Determine the profit required i.e. a required profit margin
c. Calculate maximum cost per unit to achieve the required target cost.
Target cost = target selling price - profit margin
d. Prepare an estimated cost for the product, based on the initial design specification and current cost levels.
e. Calculate target cost gap by comparing estimated cost with target cost.
Target cost gap = Estimated cost - Target cost
f. Make efforts to close the gap.

 Example 1
Packard plc are considering whether or not to launch a new product. The sales department have
determined that a realistic selling price will be K20 per unit.
Packard have a requirement that all products generate a gross profit of 40% of selling price.

Required
Calculate the target cost.

Solution

Target Costing Page 1

 Solution
Given SP/unit = K20
Gross profit = K20 x 40%
= K8

Target cost = SP - GP
= 20 - 8
= K12

 Example 2
Hewlett plc is about to launch a new product on which it requires a pre-tax ROI of 30% p.a..
Buildings and equipment needed for production will cost K5,000,000.
The expected sales are 40,000 units p.a. at a selling price of K67.50 p.u..

Required
Calculate the target cost.

Solution
Total revenue = SP/unit x no. of units sold
= 67.5 x 40,000
= K2,700,000

Pre-tax ROI = 30% x 5,000,000

= K1,500,000

Therefore, target cost = 2,700,000 - 1,500,000

40,000
= K30 per unit

 Example 3
Great Games, a manufacturer of computer games, is in the process of introducing a new game to the
market and has undertaken market research to find out about customers’ views on the value of the
product and also to obtain a comparison with competitors’ products. The results of this research have
been used to establish a target selling price of $60. This is the price that the company thinks it will have to
sell the product to achieve the required sales volume.

Cost estimates have been prepared based on the proposed product specification.

Manufacturing cost K
Direct material 3.21
Direct labour 24.03
Direct machinery costs 1.12
Ordering and receiving 0.23
Quality assurance 4.60

Non-manufacturing costs
Marketing 8.15
Distribution 3.25
After-sales service 1.30

The target profit margin for the game is 30% of the target selling price.

Required
Calculate the target cost of the new game and the target cost gap.

Solution
K
Target selling price = 60
Target profit margin (60 x 30%) = 18
Target cost = 60 -18
= K42

Projected (estimated) cost = Manufacturing costs + non-manufacturing costs

= (3.21 + 24.03 + 1.12 + 0.23 + 4.60) + (8.15 + 3.25 + 1.30)

Target Costing Page 2

 = (3.21 + 24.03 + 1.12 + 0.23 + 4.60) + (8.15 + 3.25 + 1.30)
= 33.19 + 12.7
= K45.89

The projected cost is higher than the target cost hence the difference is target cost gap.
Target cost gap = 45.89 - 42
= K3.89
Great Games therefore should investigate ways to reduce the cost from the current estimated cost down to the target
cost.

 g
 gg

Summary
After the lecture, use this space to summarize the main points of this Lecture
Topic.
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Target Costing Page 3