F5- Performance Management

TARGET COSTING ( to have fair selling prices) (New products)

Traditionally, selling prices are set by adding a suitable margin to total cost of the product. This
approach is commonly used by organizations as it ensures that all the costs are recovered and required
profits are earned. However, major drawback or shortcoming of traditional approach is that it ignores
customer perspective when setting selling prices. In today’s competitive environment it is important to
take into account value of product in the eyes of customer as it will enable organization to set selling
prices that are in line with customer’s expectation and will enable organization to compete with other
sellers.

Target costing is an advanced method that is concerned with designing and making of a product so
that it could be sold at chosen price to generate required profit. It helps organizations to identify
possible cost savings that can help organization to cut out costs without effecting features and functions
of a product. Target costing is concerned with design stage of the product as it is less effective of already
established products.

STEPS INVOLVED IN TARGET COSTING:

Step 1: Determine a product with specifications that can create an adequate level of demand in today’s
working environment. (applicable only for new products being developed)

Step 2: Determine suitable selling price of the product. This could be done by market research and
surveys from potential customer to assess value of product in the eyes of the customer. (100)

Step 3: Determine required profit. Organizations usually have a required return that they make from
every product as per their policies. (25)

Step 4: Calculate target cost. This can be obtained by deducting required profit from suitable selling
price. Organization needs to manufacture and sell this product within this target cost to generate
required profit by selling product at suitable selling price. (75)

Target cost = Suitable selling price – Required profit

Step 5: Calculate expected cost. This step is usually done as a starting point to determine selling price
whereas in target costing setting competitive prices is the main priority.(78)

Step 6: Identify cost gap by comparing target cost and expected cost. (Expected cost > Target cost)

Step 7: Make efforts to reduce or eliminate cost gap without effecting quality, features, functions and
specifications of the product.

HOW TO REDUCE COST GAP:

1. Reducing the number of components

2. Using cheaper staff
3. Using standard components wherever possible

Farrukh Abbas
SKANS School of Accountancy Page 1
F5- Performance Management

4. Acquiring new, more efficient technology

5. Training staff in more efficient techniques
6. Cutting out non value added activities
7. Using different materials
8. Using ABC to control overheads

TARGET COSTING AND SERVICE INDUSTRIES:

There are five major characteristics of services that distinguish services from products. (Products vs
services)

 Intangibility (Products are tangible services are intangible)

 Inseparability/simultaneity (Provision of service and use of service are simultaneous)
 Variability/heterogeneity (Products are homogeneous, services are heterogeneous)
 Perishability (Products can be stored, services are perishable, cannot stored)
 No transfer of ownership (Products have transfer of ownership and services do not have any
transfer of ownership)

Target costing cannot be successfully used for service businesses because of two distinct differences
between manufacturing and service businesses.

 Intangibility: In order to determine the costs and making a strategy to reduce cost gap,
intangibility in services poses serious problems because all features of services cannot properly
specified.
 Variability: In manufacturing businesses, standard products are manufactured for every
customer whereas services vary from customer to customer. This causes serious problems in
determining average expected costs as services change from customer to customer.

Farrukh Abbas
SKANS School of Accountancy Page 2