Target Costing – with simple examples

Target Costing – with simple examples

Target Costing Overview

  • Target costing is a method of strategic management of costs and profits.
  • Target costing involves; setting a target or objective for the maximum cost of a product/service and then working how to achieve this target.
  • Target costing is used mainly for new product development.
    • Having identified a target price and target profit, a target cost of the product can be established.

Target cost = Target sales price – Target profit

  • The opportunities for cutting costs to meet a target cost are much greater during the product design stage than after the product development has been completed and production process has been set up.
  • The estimated costs of a product design can be compared with target cost.
  • If the expected cost is higher than target cost then there is a ‘Cost Gap’.
    The cost gap must be closed by finding ways at the product design stage without losing any of the features, so that target cost is achieved.

Cost Gap

Expected costsxx
Target cost(xx)
Cost Gapx

Target costing method

  • Target costing is based o the idea that when a new product is developed a company will have a reasonable idea about;
    • The sales price,
    • The sales volume over its expected life.
    • There may also be estimates of capital investment required and any incremental fixed cost.
  • Taking the estimates of above it should be possible to calculate target cost.
  • The target cost for a product might be the maximum cost for the product, which provide the minimum required return.

Elements in Estimated cost and Target costs

Raw materials costs:

The target cost should allow for expected wastage rates/loss in processing.

The price of materials should also allow for any possible increase up-to the time when the new product development has been completed.

Direct labour:

The target cost should allow for any expected idle time that will occur during manufacturing of product.

Production overheads:

A target cost could be a target marginal cost. However it is more like that target cost will be a full cost (i,e includes a share of fixed production overheads)

Target costing and Services

  • Target costing can be used for services as well as products.
  • Services vary widely in nature and differ from manufacturing as follows;
    • some service industries are labour intensive and direct materials costs can are only a small part of total costs.
    • overheads costs in many services are very high.

Implication of using target costing

  • The use of a target costing system has implication for pricing, cost control and performance measurement.
  • A company might decide on a target selling price for either a new or an existing product, which it considers necessary in order to win market share or target volume of sales.

Advantages of target costing

  • It helps to improve understanding within a company of product costs.
  • It recognizes, that the most effective way of reducing costs is to plan and control costs from the product design stage onward.
  • It helps to create a focus on the final customer for the product/services because the concept of ‘value’ is important; target costs should be achieved without loss of value for the customer.
  • Target costing can be used together with recognized methods for reducing costs; such as Just-in-time, Total Quantity management.

Closing the Target Cost Gap

  • Target costs are rarely achievable.
  • Target costing should involve a ‘multi-disciplinary approach‘ to resolving the problem of How to close the cost gap.
  • Ways of reducing costs might be in; product design and engineering, manufacturing processes used, selling methods and raw materials purchasing.
  • Other common methods of closing the target cost gap are;
    • To re-design products.
    • To discuss with key suppliers methods of reducing materials cost.
    • To eliminate non value added activities or non value added features of the product design.
    • To train staff.

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