Target Costing Approach to Pricing:
Learning Objective of the Article:
- Define and explain target
costing.
- Compute the target cost for a new product or service. What are
advantages and disadvantages of target costing approach.
In traditional costing system it is presumed that a product has
already been developed, has been costed, and is ready to be marketed as soon
as a price is set. In many cases, the sequence of events is just the
reverse. That is, the company already knows what price should be charged,
and the problem is to develop a product that can be marketed profitably at
the desired price. Even in this situation, where the normal sequence of
events is reversed, cost is still a crucial factor. The company can use an
approach called target costing.
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Definition and Explanation of Target Costing
-
Reasons for Using Target Costing Technique
-
Example
of Target Costing Process
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Advantages and Disadvantages of Target Costing
Target costing is the process of determining
the maximum allowable cost for a new product and then developing a prototype
that can be profitably made for that maximum target cost figure.
A number of
companies--primarily in Japan--use target costing, including Compaq, Culp,
Cummins Engine, Daihatsu Motors, DaimlerChrysler, Ford, Isuzu Motors, ITT,
NEC, and Toyota etc.
The target costing for a product is
calculated by starting with the product's anticipated selling price and then
deducting the desired profit. Following formula or equation further
explains this concept:
Target
Cost = Anticipated selling price – Desired profit
The product development team is then given
the responsibility of designing the product so that it can be made for no
more than the target cost.
Following set of activities further explains
the concept of target costing technique:
TARGET
COSTING PROCESS DIAGRAM
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Determine Customer Wants
and Price Sensitivity |
| |
↓ |
| |
Planned Selling Price is
Set |
| |
↓ |
| |
Target Cost is Determined
As: Selling Price Less Desired Profit |
| |
↓ |
| |
Teams of Employees from
Various Areas and Trusted Vendors Simultaneously |
| |
↓ |
| |
Design Product |
Determine Manufacturing
Process |
Determine Necessary Raw
Materials |
| |
↓ |
| |
Costs are Considered
Throughout this Process. The Process Requires Trade-offs to Meet Target
Costs |
| |
↓ |
|
Once Target Cost is
Achieved the Manufacturing Begins and Product is Sold |
The target costing approach was
developed in recognition of two important characteristics of markets and
costs. The first is that many companies have less control over price than
they would like to think. The market (i.e., supply and demand) really
determines prices, and a company that attempts to ignore this does so at its
peril. Therefore, the anticipated market price is taken as a given in target
costing. The second observation is that most of the cost of a product is
determined in the design stage. Once a product has been designed and has
gone into production, not much can be done to significantly reduce its cost.
Most of the opportunities to reduce cost come from designing the product so
that it is simple to make, uses inexpensive parts, and is robust and
reliable. If the company has little control over market price and little
control over cost once the product has gone into production, then it follows
that the major opportunities for affecting profit come in the design stage
where valuable features that customers are willing to pay for can be added and
where most of the costs are really determined. So that it is where the
effort is concentrated--in designing and developing the product. The
difference between target costing and other approaches to product
development is profound. Instead of designing the product and then finding
out how much it costs, the target cost is set first and then the product is
designed so that the target cost is attained.
To provide a simple numerical example of
target costing, assume the following situations:
Handy Appliance Company
feels that there is a market niche for a hand mixer with certain new
features. Surveying the features and prices of hand mixers already in the
market, the marketing department believes that a price of $30 would be about
right for the new mixer. At that price, marketing estimates that 40,000 of
new mixers could be sold annually. To design, develop, and produce these new
mixers, an investment of $2,000,000 would be required. The company desires a
15% return on investment (ROI). Given these data, the target cost to
manufacture, sell, distribute, and service one mixer is $22.50 as calculated
below:
| Projected sales (40,000 mixers
$30 per mixer ) |
$1,200,000 |
| Less desired profit (15%
$2,000,000) |
300,000 |
| |
------------ |
| Target cost for 40,000 mixers |
$9,00,000 |
| |
======= |
| Target cost per mixer ($9,00,000 /
40,000 mixer) |
$22.50 |
This $22.5 target cost would be broken into
target cost for the various functions: manufacturing, marketing,
distribution, after-sales service, and so on. Each functional area would be
responsible for keeping its actual costs within target.
Target costing has the following main
advantages or benefits:
- Proactive approach to cost management.
- Orients organizations towards customers.
- Breaks down barriers between departments.
- Implementation enhances employee
awareness and empowerment.
- Foster partnerships with suppliers.
- Minimize non value-added activities.
- Encourages selection of lowest cost value
added activities.
- Reduced time to market.
Target costing approach has the following
main disadvantages or limitations:
- Effective implementation and use requires the development of
detailed cost data.
- its implementation requires willingness to
cooperate
- Requires many meetings for coordination
- May reduce the quality of products due to
the use of cheep components which may be of inferior quality.
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In Business |
Target Costing Approach--An Iterative Process:
Target costing Technique is widely used in
Japan. In the automobile industry, the target cost for a new model is
decomposed into target costs for each of the elements of the car--down
to a target cost for each of the individual parts. The designers draft a
trial blueprint, and a check is made to see if the estimated cost of the
car is within reasonable distance of the target cost. If not, design
changes are made, and a new trial blueprint is drawn up. This process
continues until there is sufficient confidence in the design to make a
prototype car according to the trial blueprint. If there is still a gap
between the target cost and estimated cost, the design of the car will
be further modified.
After repeating this process a number of
times, the final blueprint is drawn up and turned over to the production
department. In the first several months of production, the target costs
will ordinarily not be achieved due to problems in getting a new model
into production. However after that initial period, target costs are
compared to actual costs and discrepancies between the two are
investigated with the aim of eliminating the discrepancies and achieving
target costs.
Source: Yasuhiro Monden and Kazuki
Hamada, "Target Costing-Kaizen Costing in Japanese Automobile
Companies," Journal of Management Accounting Research 3, pp. 16-34. |
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