1

School of Business and Computer Science Limited

ACCA F5 – Performance Management

Lecture 3 – Target Costing

Introduction:
Target costing is an approach to determine a product’s life-cycle cost which should be
sufficient to develop specified functionality and quality, while ensuring its desired profit.

Target Costing was developed independently in both USA and Japan in different time
periods.

Target costing was adopted earlier by American companies to reduce cost and improve
productivity, such as Ford Motor, American Motors, Boeing, Caterpillar, Northern
Telecom etc.

Target costing is applied in the Japanese automobile industry, e.g. Toyota and Nissan.

Target Costing spread the competitive pressure faced by the company to product’s
designers and suppliers. Target costing consists of cost planning in the design phase of
production as well as cost control throughout the resulting product life cycle.

The cardinal rule of target costing is to never exceed the target cost. However, the focus
of target costing is not to minimize costs, but to achieve a desired level of cost reduction
determined by target costing process.

Target costing is a cost management process which involves setting a target cost for a
product, having identified a target selling price and a required profit margin.
The Target Cost is the target sales price minus the required profit.

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 reductions 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 in a product
 Whether the components are standard or not
 The ease of changing over tools to simplify the production process
 Exclude design features that do not add value to the customer
 2

 Use of cheaper material to make products that does not affect product quality

Japanese companies have developed target costing as a response to the problem of

controlling and reducing costs over the product life cycle.

Implementing target costing

Step 1 Determine a product specification of which an adequate sales volume is

estimated.

Step 2 Set a target selling price at which the organization will be able to achieve a
desired market share.

Step 3 Estimate the required profit based on return on sales or return on investment.

Step 4 Calculate the target cost = target selling price – target profit.

Step 5 Compile an estimated cost for the product based on the anticipated design
Specification and current cost levels.

Step 6 Calculate target cost gap = estimated cost – target cost.

Step 7 Make efforts to close the gap. This is more likely to be successful if efforts are
made to 'design out' costs prior to production, rather than to 'control out' costs
during the production phase.

Step 8 Negotiate with the customer before making the decision about whether to go
ahead with the project.
 3

Deriving a target cost

Example (1): Target Cost

A car manufacturer wants to calculate a target cost for a new car, the price of which will
be set at $17,950. The company requires an 8% profit margin.
Required
What is the target cost?
 4

Example (2)

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 customer’s
views on the value of the product and also to obtain a comparison with competitor’s
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 $
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

Closing a Target Cost Gap

The target cost gap is the estimated cost less the target cost. When a product is first
manufactured, its target cost may well be much lower than its currently-attainable cost,
which is determined by current technology and processes. Management can then set
benchmarks for improvement towards the target costs, by improving technologies
and processes.

Various techniques can be employed:

 Reducing the number of components

 Using cheaper staff
 Using standard components wherever possible
 Acquiring new, more efficient technology
 Training staff in more efficient techniques
 Cutting out non-value-added activities
 Using different materials (identified using activity analysis etc)
 5

Target costing in service industries

Target costing is difficult to use in service industries due to the characteristics and
information requirements of service businesses.

Services are any activity of benefit that one party can offer to another that is
essentially intangible and does not result in the ownership of anything. Its production
may or may not be tied to a physical product.'

Examples of service businesses include:

(a) Mass service eg the banking sector, transportation (rail, air), mass entertainment
(b) Either / or eg fast food, teaching, hotels and holidays, psychotherapy
(c) Personal service eg pensions and financial advice, car maintenance

There are five major characteristics of services that distinguish

services from manufacturing.

(1) Intangibility refers to the lack of substance which is involved with service
delivery. Unlike goods, there is no substantial material or physical aspects to a service:
no tastes, feel, visible presence and so on.

(2) Inseparability/simultaneity. Many services are created at the same time as

they are consumed. No service exists until it is actually being experienced/consumed by
the person who has bought it.
(3) Variability/heterogeneity. Many services face the problem of maintaining
consistency in the standard of output. It may be hard to attain precise standardization of
the service offered, but customers expect it.

(4) Perishability. Services are innately perishable. The services of a beautician are
purchased for a period of time.

(5) No transfer of ownership. Services do not result in the transfer of property.

The purchase of a service only confers on the customer access to or a right to use a
facility.
 6

Problems with Target Costing for Services

Some of the characteristics of services make it difficult to use target costing, and identify
a target cost for a service having established a target selling price.

Some of the Characteristics of Services that make it difficult to use

target Costing are:

(1) Intangibility – Some of the features of a service cannot be properly specified

because they are intangible. The quality of the personal service a customer receives is
difficult or impossible to specify.
When services do not have any material content, it is not possible to reduce cost to a
target level by reducing material costs.
Example: going to a cinema

(2) Variability/Homogeneity – A service can differ every time it is provided.

Therefore a standard service may not exist. When services are variable, it is possible to
calculate an estimated average cost, but this is not specific and therefore not ideal for
target costing.
Example: Providing an Accountancy Service.

Main Points to Remember: Target Costing

(1) Target costing is an approach that sets the selling price of a product or service with reference to the
marketplace.

(2) Target Cost = Target Selling price less desired profit

(3) Target Cost Gap = Estimated Costs > Target Cost

(4) Cost control is considered up front during the development stage.

(5) Target costing can be applied to service industries but the measurement of cost is
more difficult.

(6) Target costing makes the business look at what competitors are offering at an early
stage in the new product development process.

(7) It is more difficult to implement target costing in service industries rather than
manufacturing because of the lack of a tangible product.

(8) Target Costing is a pull system i.e. information flows from market to management

(9) Target Costing is based on attainable standards

 7

(10) Target Costing is a cost reduction technique

(11) It is difficult to get a hold of comparative data from competitors which can make
setting a target cost more difficult.

(12) Target costing is applicable to businesses faced with competitive pressures

(13) If after calculating a target cost, and a cost gap exists, the company will then be
forced to examine its internal processes and costs more closely