The following points highlight the seven main features of target costing.
1. Target Costing is viewed as an integral part of the design and introduction of new products. As such, it is part of an overall profit management process, rather than simply a tool for cost reduction and cost management. The first part of the process is driven by customers, market and profitability considerations.
Given that profitability is critical for survival, a target profit margin is established for all new product offerings. The target profit margin is derived from the company’s long term business plan. Each product or product line is required to earn at least the target profit margin.
2. For any given product, a target selling price is determined using various sales forecasting techniques. Critical to setting the target selling price are the design specifications which reflect certain levels of functionality and quality of the new product. These specifications are based on customer requirements and expectations and are also affected by the products of competitors.
Importantly, while setting the target selling price, competitive conditions and customers’ demands for increased functionality and higher quality, without significant increase in price, are clearly recognized, as charging a price premium may not be sustainable. Hence, the target selling price is market driven and should encompass a realistic reflection of the competitive environment.
3. Integral to setting the target selling price is the establishment of target production volumes, given the relationship between price and volume. The expected target volumes are also critical to computing unit costs, especially with respect to capacity-related costs (such as tooling costs), as product costs are dependent upon the production levels over the life cycle of the product.
Once the target selling price and required profit margin have been determined, the difference between these two figures indicates the allowable cost for the product. Ideally, the allowable cost becomes the target cost for the product.
4. The next stage of the target costing process is to determine cost reduction targets. Some firms will do this by estimating the “current cost” of the new product. The current cost is based on existing technologies and components, but encompasses the functionalities and quality requirements of the new product. The difference between the current cost and the target cost indicates the required cost reduction that is needed.
This amount may the divided into target cost reduction objective and a strategic cost reduction challenge. The former is viewed as being achievable (yet still a very challenging target), while the latter acknowledges current inherent limitations. After analyzing the cost reduction objectives, a product level target cost is set which is the difference between the current cost and the target cost reduction objective.
5. A fair degree of judgment is needed where the allowable cost and the targeted cost differ. As the ideal is to produce at the allowable cost, it is important that the difference is not too great. Once the product level target cost is set, however, it generally cannot be changed, and the challenge for those involved is to meet this target.
6. Having achieved consensus about the product-level target cost, a series of intense activities commences to translate the cost challenge into reality. These activities continue throughout the design stage up until the point when the new product goes into production. Typically the total target is broken down into its various components, each component is studied and opportunities for cost reduction are identified.
These activities are often referred to as value engineering (VE) and value analysis (VA). VE involves searching for opportunities to modify the design of each component or part of a product to reduce cost, but without reducing functionality or quality of the product.
VA entails studying the activities that are involved in producing the product to detect non-value adding activities that may be eliminated or minimized to save cost, but without reducing the functionality or quality of the product.
Where components are sourced from suppliers (which are often the case in automobile industry) target prices are established for each part and the company’s employees work with the suppliers to ensure that the targets are achieved.
Overall the aim of the process is to ensure that when the production commences, the total cost will meet the target, and profit goal will be achieved. There is also a continuous improvement programme, known as kaizen costing, that focuses on the reduction of waste in the production process, thereby further lowering costs below the initial targets specified during the design phase.
7. To achieve the objectives of target costing, a team-based set up is required that integrates essential disciplines such as marketing, engineering, manufacturing, purchasing and finance.