CHAPTER 15

TARGET COSTING
Target costing is a pricing method used by firms. It is defined as "a cost management tool for reducing the
overall cost of a product over its entire life-cycle with the help of production, engineering, research and
design". A target cost is the maximum amount of cost that can be incurred on a product and with it the
firm can still earn the required profit margin from that product at a particular selling price.

Target costing is a system under which a company plans in advance for the price points, product costs,
and margins that it wants to achieve for a new product. If it cannot manufacture a product at these
planned levels, then it cancels the design project entirely.

Target costing means is a technique which is aimed at reducing the life-cycle costs of new products,
while ensuring quality, reliability, and other consumer requirements, by examining all possible ideas
for cost reduction at the
product planning, research and development, and prototyping phase of production. However, it is not
just a cost reduction technique; it is part of a comprehensive strategic profit management system.

Target costing involves setting a target cost by subtracting a desired profit margin from a competitive
market price. 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 product’s
anticipated selling price over a specified period of time in the future."

These concepts are supported by the four basic steps of Target Costing:
 Define the Product
 Set the Price and Cost Targets
 Achieve the Targets
 Maintain Competitive Costs.

Objectives of Target Costing:

- It is to enable management to manage the business to be profitable in a very competitive
marketplace.
- In effect, target costing is a proactive cost planning, cost management, and cost reduction
practice whereby costs are planned and managed out of a product and business early in the design
and development cycle, rather than during the latter stages of product development and
production.
- With target costing, a management team has a powerful tool for continually monitoring products
from the moment they enter the design phase and onward throughout their product life cycles.
- It is considered one of the most important tools for achieving consistent profitability in a
manufacturing environment.

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Deriving target cost for manufacturing and service industry
For both the manufacturing and service industry, the methodology of deriving target cost is similar. These
steps are explained below:
1. Identifying the target price
Normally, a target costing technique is employed at the product development stage. The focus remains on
the needs of potential customers. The challenge is to satisfy those needs. A manufacturer or service
provider tries to assess the value of the product or service as would be perceived by potential customers.
In order to assess the value perceived by potential customers, the manufacturer or service provider uses
extensive market research. Potential prices are influenced by a number of functions attached to a product
or service.
In a competitive environment, the competitors’ price for a similar product or service is taken into
consideration in order to determine the target price. For job orders, target price is the price which the
customer is willing to pay for the product with certain specifications.
2. Ascertaining the target operating profit
Top management, on the basis of the firm’s strategy and financial goals, determines the target profit.
Instead of expressing the profit target as ‘Return on Investment’ (as it is done traditionally), the target
profit is set as
‘Return on Sales’ (i.e., Operating profit / Revenue).
3. Deriving target cost by subtracting target profit from target price
Target cost per unit is the estimated long-run cost per unit of product or service, which enables the
manufacturer or service provider to achieve the desired profit per unit when selling at the target price. In
calculating target cost, we include all future costs, both variable and fixed. The rationale is that a firm’s
revenues must recover all its costs in the long run. Target cost per unit is often lower than the existing /
estimated full cost per unit of the product or service.
Target Cost per unit = Target price per unit –
Desired (target) profit per unit

Steps used in deriving a target cost (manufacturing industries)

Step.1
A target price is set, based on the customers’ perceived value of the product. This will therefore be a
market based price
Step.2
The required targeted operating profit per unit is then calculated. This may be based on either return on
sales or return on investment
Step.3
The target cost is derived by subtracting the target profit from the target price
Step.4
The cost gap is then calculated
Step.5
If there is a cost gap, attempts will be made to close the gap. Techniques such as value engineering may
be performed, which Looks at every aspect of the value chain business functions, with an objective of
reducing costs whilist satisfying customer needs
Closing the target cost gap
The target cost gap is established in step 4 of the target costing process
Target cost gap = Estimated product cost – Target cost
It is the difference between what an organisation thinks it can currently make a product for, and what it
needs to make it for, in order to make a required profit.

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 Problems with target costing in service industries
Unlike manufacturing, service industries have the following characteristics which could make target
costing more difficult:
(1) The intangibility of what is provided means that it is difficult to define the ‘service’ and attribute
costs; in the NHS, it is challenging to define what a ‘procedure’ is. Clinical specialities cover a wide
range of disparate treatments, and services include high levels of indirect cost. Consistent methods of
cost attribution are needed, and this is not always straightforward. Direct charging is not always possible
and there are different configurations of cost centres across providers. This may limit the consistency
which can be achieved.
(2) Inseparability/simultaneity of production and consumption: although the manufacturer of a tangible
good may never see the actual customer, customer often must be present during the production of a
service, and cannot take the service home. No service exists until it is actually being
experienced/consumed by the person who has brought it.
(3) Heterogeneity – The quality and consistency varies, because of an absence of standards or
benchmarks to assess services against. In the NHS, there is no indication of what an excellent
performance in service delivery would be, or any definition of unacceptable performance.
(4) Perishability – the unused service capacity from one time period cannot be stored for future use.
Service providers and marketers cannot handle supply-demand problems through production scheduling
and inventory techniques.
(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.

The primary steps in the target costing process are:-

(a) Conduct research. The first step is to review the marketplace in which the company wants to sell
products. The design team needs to determine the set of product features that customers are most
likely to buy, and the amount they will pay for those features. The team must learn about the
perceived value of individual features, in case they later need to determine what impact there will
be on the product price if they drop one or more features. It may be necessary to later drop a
product feature if the team decides that it cannot provide the feature while still meeting its target
cost. At the end of this process, the team has a good idea of the target price at which it can sell the
proposed product with a certain set of features, and how it must alter the price if it drops some
features from the product.
(b) Calculate maximum cost. The company provides the design team with a mandated gross margin
that the proposed product must earn. By subtracting the mandated gross margin from the
projected product price, the team can easily determine the maximum target cost that the product
must achieve before it can be allowed into production.
(c) Engineer the product. The engineers and procurement personnel on the team now take the
leading role in creating the product. The procurement staff is particularly important if the product
has a high proportion of purchased parts; they must determine component pricing based on the
necessary quality, delivery, and quantity levels expected for the product. They may also be
involved in outsourcing parts, if this results in lower costs. The engineers must design the product
to meet the cost target, which will likely include a number of design iterations to see which
combination of revised features and design considerations results in the lowest cost.
(d) Ongoing activities. Once a product design is finalized and approved, the team is reconstituted to
include fewer designers and more industrial engineers. The team now enters into a new phase of
reducing production costs, which continues for the life of the product. For example, cost
reductions may come from waste reductions in production (known as kaizen costing), or from
planned supplier cost reductions. These ongoing cost reductions yield enough additional gross
margins for the company to further reduce the price of the product over time, in response to
increases in the level of competition.

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The design team uses one of the following approaches to more tightly focus its cost reduction
efforts:
Tied to components. The design team allocates the cost reduction goal among the various product
components. This approach tends to result in incremental cost reductions to the same components that
were used in the last iteration of the product. This approach is commonly used when a company is simply
trying to refresh an existing product with a new version, and wants to retain the same underlying product
structure. The cost reductions achieved through this approach tend to be relatively low, but also result in a
high rate of product success, as well as a fairly short design period.
Tied to features. The product team allocates the cost reduction goal among various product features,
which focuses attention away from any product designs that may have been inherited from the preceding
model. This approach tends to achieve more radical cost reductions (and design changes), but also
requires more time to design, and also runs a greater risk of product failure or at least greater warranty
costs.
Of these methods, companies are more likely to use the first approach if they are looking for a routine
upgrade to an existing product, and the second approach if they want to achieve a significant cost
reduction or break away from the existing design.

Target cost in manufacturing and service industries:

Target Costing has been applied to manufactured products for decades. The basic principles and
methodology are equally applicable to service products and process improvement initiatives.
Target costing methodology starts with establishing the allowable incurred cost of the services that
achieves required margins. It is a market driven cost management system where cost targets are set early
in the development of a service.
Setting the cost target requires consideration of the voice of the customer, market research, competitive
intelligence and internal strategic plans. The cost target guides the extended enterprise throughout the
development cycle to find the optimal solution that meets the customer’s value expectations and
maximizes the potential for launching the service at the desired margin.
Let’s start with Voice of the Customer. Understand the customer that purchases and uses the services.
Then understand their expectations. Finally prioritize their requirements.
Market research provides information about the unrecognized needs and wants of customers. The
research is used to define the market or service niche a company plans to exploit. Typically, a market
niche is a broad definition of a class of customers such as “showcase homeowners” for a lawn care
company. These customers want a pristine looking lawn and set high expectations for the delivery of that
service.
Competitive analysis determines what competitors’ services are currently available to the target
customers, how the customers evaluate these other services, and how competitors might react to our
company’s new service introductions. In the lawn care example, what services are included in the lawn
care package and at what price level. Also the experience level of the competitors is important to
understand.
Once the market is understood, awareness of competitors and market niche is determined, the service
features are determined. Service features involve setting specific requirements about the features a
service will have and the level of performance of each feature. In the lawn care example, a service
feature is cutting the grass to a height of between 2 1/2 and 3 inches tall. The level of performance in
relation to the grass cutting is the consistency the company applies to the feature. Can the customer
depend on the lawn service to cut their grass to look the same each time and provide that service on a
timely basis?
Pricing and cost analysis comes next. During competitive analysis, price information was collected
about competitors and voice of the customer provided customer pricing expectations. With a price point
in mind, a desired profit margin is subtracted to calculate the target cost for the service. Next we need to
understand the cost of the service components. The service is lawn mowing but the features of the service

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are cutting, edging and clean up. How much will each component cost? And what ranking does the
customer place on each of these functions? Is the edging most important, then clean up and the least
important is cutting? If edging is the most important function, then cost cutting in this area that might
jeopardize quality is a bad idea.
Understanding your market, your customer and your cost structure well, will improve the chances of a
successful and profitable service.

Difficulties of using target costing in service industries:

Cost variability is still an issue
Recent research carried out by Northcott and Llewellyn (2004) identified cost variability as an ongoing
issue within the target costing in service industries which impacts on the use of reference costs for
benchmarking and as a basis for the national tariff. One factor contributing to this is a real and inherent
difference in costs, both direct and indirect, which is due to variations in emphasis and case-mix between
hospitals, geographical considerations and the characteristics of the local population.
Northcott and Llewellyn also pointed to variations in cost allocation methods and levels of sophistication
of costing which limit the usefulness of reference costs for benchmarking and pricing.
An absence of standards
A further issue identified by Northcott and Llewellyn (2004), when considering the use of the National
Schedule of Reference Costs for benchmarking, is the lack of a benchmark as there is no indication of
what an excellent performance would be or any definition of unacceptable performance. In the absence of
such standards Trusts aim for average or ‘normal’ performance, such that the norm becomes the standard
aimed for. Although, it is not clear whether a provider having a low reference cost index compared with
the average is a superlative outcome and whether having a high index should be worrying or seen as an
indicator of being a high quality centre of excellence.
Suggestion how a target cost gap might be closed:
Target costing
(1) The first step is to establish a competitive market price. The company would consider how much
customers are willing to pay and how much competitors are charging for similar products.
(2) Determine the required profit
(3) A target cost is arrived at by deducting the required profit from the selling price
(4) Steps must then be taken to close the target cost gap from the current cost per unit if higher.
The target cost gap is established in step 4 of the target costing process.
Target cost gap = Estimated product cost – Target cost

It is the difference between what an organization thinks it can currently make a product for, and what it
needs to make it for, in order to make a required profit. Alternative product designs should be examined
for potential areas of cost reduction that will not compromise the quality of the products.
QUESTIONS THAT A MANUFACTURER MAY ASK IN ORDER TO CLOSE THE GAP
INCLUDE:
 Can any materials be eliminated, e.g. cut down on packing materials?
 Can a cheaper material be substituted without affecting quality?
 Can labour savings be made without compromising quality, for example, by using lower skilled
workers?
 Can productivity be improved, for example, by improving motivation?
 Can production volume be increased to achieve economies of scale?
 Could cost savings be made by reviewing the supply chain?
 Can part assembled components be bought in to save on assembly time?
 Can the incidence of the cost drivers be reduced?

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 Is there some degree of overlap between the products related fixed costs that could be
eliminated by combining service departments or resources?
 A key aspect of this is to understand which features of the product are essential to customer
perceived quality and which are not. This process is known as ‘value analyses. Attention
should be focused more on reducing the costs of features perceived by the customer not to add
value.

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 REVIEW QUESTIONS-ACCA,NBAA,CIMA
QUESTION.1 ACCA DEC 2009
Big Cheese Chairs (BCC) manufactures and sells executive leather chairs. They are considering a new
design of massaging chair to launch into the competitive market in which they operate.
They have carried out an investigation in the market and using a target costing system has targeted a
competitive selling price of $120 for the chair. BCC wants a margin on selling price of 20% (ignoring any
overheads).
The frame and massage mechanism will be bought in for $51 per chair and BCC will upholster it in
leather and assemble it ready for dispatch.
Leather costs $10 per metre and two metres are needed for a complete chair although 20% of all leather is
wasted in the upholstery process.
The upholstery and assembly process will be subject to a learning effect as the workers get used to the
new design. BCC estimates that the first chair will take two hours to prepare but this will be subject to a
learning rate (LR) of 95%. The learning improvement will stop once 128 chairs have been made and the
time for the 128th chair will be the time for all subsequent chairs. The cost of labour is $15 per hour.
The learning formula is shown on the formula sheet and at the 95% learning rate the value of b is –
0·074000581.
Required:
(a) Calculate the average cost for the first 128 chairs made and identify any cost gap that may be
present at that stage.
(b) Assuming that a cost gap for the chair exists suggest four ways in which it could be closed.
The production manager denies any claims that a cost gap exists and has stated that the cost of the 128 th
chair will be low enough to yield the required margin.
(c) Calculate the cost of the 128th chair made and state whether the target cost is being achieved on
the 128th chair.

QUESTION.2
Handy Appliance feels there is a niche for a hand mixer with special features. The marketing department
believes price of Shs30 would be about right and that about 40,000 mixers could be sold. An investment
of 2milion is required to gear up for production.
The company required a 15% ROI on invested funds
If the current costs is Shs 25
Required:
Calculate the target cost and cost gap if any.

QUESTION.3
ABC Company Ltd produces a special product JJ, which is for hospital use
If it was established that the company can be able to sell about 5000 units per annum, at the most
competitive price of Shs 2500
And it it the company policy to earn profit mark-up of 25%
Required
Calculate the target cost and profit margin on current price
If production of each product JJ requires 2 Litres of material Q at Shs 400 per Litre and 3 Labor hours are
required per unit at wage rate of 200 per Litres. Production overhead to be incurred as follows
Production set-up 1,250,000
Production testing 800,000
Customer orders delivery 1,200,000
Required
Calculate the cost gap if any

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QUESTION.4
Edward Co assembles and sells many types of radio. It is considering extending its product range to
include digital radios. These radios produce a better sound quality than traditional radios and have a large
number of potential additional features not possible with the previous technologies (station scanning,
more choice, one touch tuning, station identification text and song identification text etc).
A radio is produced by assembly workers assembling a variety of components. Production overheads are
currently absorbed into product costs on an assembly labour hour basis. Edward Co is considering a target
costing approach for its new digital radio product.
Required:
(a) Briefly describe the target costing process that Edward Co should undertake. (3 marks)
(b) Explain the benefits to Edward Co of adopting a target costing approach at such an early stage
in the product development process. (4 marks)
(c) Assuming a cost gap was identified in the process, outline possible steps Edward Co could take
to reduce this gap. (5 marks)
A selling price of $44 has been set in order to compete with a similar radio on the market that has
comparable features
to Edward Co’s intended product. The board have agreed that the acceptable margin (after allowing for all
production costs) should be 20%.
Cost information for the new radio is as follows:
Component 1 (Circuit board) – these are bought in and cost $4·10 each. They are bought in batches of
4,000 and additional delivery costs are $2,400 per batch.
Component 2 (Wiring) – in an ideal situation 25 cm of wiring is needed for each completed radio.
However, there is some waste involved in the process as wire is occasionally cut to the wrong length or is
damaged in the assembly process. Edward Co estimates that 2% of the purchased wire is lost in the
assembly process. Wire costs $0·50 per metre to buy.
Other material – other materials cost $8·10 per radio.
Assembly labour – these are skilled people who are difficult to recruit and retain. Edward Co has more
staff of this type than needed but is prepared to carry this extra cost in return for the security it gives the
business. It takes 30 minutes to assemble a radio and the assembly workers are paid $12·60 per hour. It is
estimated that 10% of
hours paid to the assembly workers is for idle time.
Production Overheads – recent historic cost analysis has revealed the following production overhead data:
Total production overhead Total assembly labour hours
$
Month 1 620,000 19,000
Month 2 700,000 23,000
Fixed production overheads are absorbed on an assembly hour basis based on normal annual activity
levels. In a typical year 240,000 assembly hours will be worked by Edward Co.
Required:
(d) Calculate the expected cost per unit for the radio and identify any cost gap that might exist. (13
marks)
(25 marks)

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