Target Costing: Definition, Objectives and Advantages

In this article we will discuss about Target Costing:- 1. Origin of Target Costing 2. Definition of Target Costing 3. Steps 4. Objectives 5. Process 6. Advantages 7. Reasons for the Late Development 8. Problems.

Contents:

  1. Origin of Target Costing
  2. Definition of Target Costing
  3. Steps in Target Costing
  4. Objectives of Target Costing
  5. Target Costing Process
  6. Advantages of Target Costing
  7. Reasons for the Late Development of Target Costing
  8. Problems with Target Costing



1. Origin of Target Costing:

In Japan, target costing is has gained importance and widely practiced in more than 80% of the companies in the assembly industries and more than 60% of the companies in processing industries. It emerged in Japan in 1960s as a consequence of difficult market conditions. A proliferation of consumer and industrial products of western firms were overcrowding the markets in Asia.

Japanese companies were also experiencing shortages of resources and skills needed for the development of new concepts, tools and techniques, which were required to achieve parity with the toughest western competitors in terms of quality, cost and productivity.

Many Japanese companies considered modified cross-functional activities, as used by western firms for manufacturing. They believed that good results can be achieved by combining employees from strategy, planning, marketing, engineering, finance and production into expert teams.

These teams were able to examine new methods and techniques for the design and development of new products and aimed at increasing the degree of integration between upstream and downstream activities of a firm’s operations. Target costing thus emerged from this background.

A range of specialized tools, including functional analysis, value engineering, value analysis and concurrent engineering were introduced to support the target costing. This made Japanese companies particularly effective in the area of product design and development.

They were able to identify all relevant elements to formulate a holistic management approach in order to achieve performance levels to meet the firm’s objective.



2. Definition of Target Costing
:

Target costing can be defined as “a structured approach for determining the cost at which a proposed product with specified functionality and quality must be produced to generate a desired level of profitability at its anticipated selling price”. A critical aspect of this definition is that it lays emphasis on the fact that target costing is much more than a management accounting technique.

Rather, it is an important part of a comprehensive management process aimed at helping a firm to survive in an increasingly competitive environment. Target costing is a management technique aimed at reducing a product’s life-cycle costs. A general concept of target costing is discussed here.

Target Costing is a disciplined process for determining and realizing a total cost at which a proposed product with specified functionality must be produced to generate the desired profitability at its anticipated selling price in the future. CIMA defines target cost as “a product cost estimate derived from a competitive market price”

Target Costing is a disciplined process that uses data and information in a logical series of steps to determine and achieve a target cost for the product. In addition, the price and cost are for specified product functionality, which is determined from understanding the needs of the customer and the willingness of the customer to pay for each function.

Target costing is a formal process that attempts to match a proposed product’s features (benefits) with a viable market price that achieves the company’s profitability goals by:

(a) Determining a price point (or range of prices) for an approximate combination of features and benefits.

(b) Subtracting a desired profit from the market price to determine the maximum bearable level of costs.

(c) Iterating the product design—eliminating or reducing unnecessary attributes with costs that can’t be recovered in higher prices—until the cost target is met.

(d) Revising the market price for the redesigned product in view of changed market conditions.



3. Steps in Target Costing
:

Following are the main steps (or stages) involved in target costing:

(i) To conduct market research in order to see what products are in the market place, what new products the competitors are trying to bring in the market, to ascertain customers’ requirement and the price they can afford for the product.

(ii) Determining the price, margin and cost feasibility. Target price is determined on the basis of market survey, at which the product can be sold. On the selling price a standard margin is determined to finally come to the cost figure (Target Price − Target Profit = Target Cost).

(iii) To meet margin target by design improvement. If the product designed cannot be produced in the cost range decided, value engineering is used to drive down the product cost to a level, at which target price and margin can be attained.

(iv) To implement continuous improvement. This is needed to ensure that targeted cost levels are maintained subsequent to design phase. Value engineering technique is applied for reduction of waste, misuse, etc. and for elimination of non-value added costs and processes, etc.




4. Objectives of Target Costing
:

The fundamental objective of target costing is to enable management to use proactive cost planning, cost management and cost reduction practices whereby, costs are planned and managed out of a product and business, early in the design and development cycle, rather to an during the later stages of product development and production.

It obviously applies to new products, but car also be applied to product modifications or succeeding generations of products. It might also be used for existing products, but costs are more difficult to reduce once a product is developed and designed.

Target costing is primarily used and most effective in the product development and design stage. The costs most typically emphasized in the target costing process are such things as: material and purchased parts, conversion costs (such as labour and identifiable overhead expenses), tooling costs, development expenses and depreciation.

However, all costs and assets that may be affected by early product planning decisions should be considered. This would include more indirect overhead expenses through the production stage, and beyond, such as service costs, and assets like inventory. Target costing is intended to get managers thinking ahead and comprehensively about the cost and other implications of the decisions they make.

Target costing is as much a significant business philosophy as it is a process to plan, manage and reduce costs.

It emphasizes understanding the markets and competition; it focuses on customer requirements in terms of quality, functions and delivery, as well as price; it recognizes the necessity to balance the tradeoffs across the organization, and establishes teams to address them early in the development cycle; and it has, at its core, the fundamental objective to make money, to be able to reinvest, grow and increase value.

Broadly speaking, a target costing system has three objectives:

a. To lower the costs of new products so that the required profit level can be ensured.

b. The new products meet the levels of quality, delivery timing and price required by the market.

c. To motivate all company employees to achieve the target profit during new product development by making target costing a companywide profit management activity.

For any system to be effective in supporting decision making in an organization, the staff from the relevant departments must come together in order to tap their creativity so as to achieve goals. In other words, the company requires a non-conflicting and rational system for consensus building and decision-making.



5. Target Costing Process
:

Just as there is no single definition of target costing, there is no single target costing process.

Nevertheless, all companies share a series of general steps:

a. Establishing the target price in the context of market needs and competition;

b. Establishing the target profit margin;

c. Determining the allowable cost that must be achieved; this cost should motivate all personnel to achieve;

d. Calculating the probable cost of current products and processes; and finally,

e. Establishing the target amount by which current costs must be reduced.

Once the target cost has been calculated, companies take the following steps to achieve it:

a. Establishing a cross functional team, which is involved in the implementation process from the earliest design stages,

b. Using tools such as value engineering in the design process; and

c. Pursuing cost reductions using “kaizen costing” once production has started.

A number of techniques and tools facilitate an effective and efficient costing process. Three externally oriented analyses market assessment tools, industry and competitive analysis and reverse engineering provide a firm with a foundation for defining the proposed new product and establishing its price.

The determination of the target profit margin relies heavily on the comprehensive and detailed financial planning and statement analysis. Every firm has relationship between prices, volumes and revenues; costs and investments, in the aggregate and for specific product lines and individual products. The management team should explore other tools like value engineering and quality function deployment.



6. Advantages of Target Costing
:

Main advantages of target costing are:

a. It reinforces top to bottom commitment to process and product innovation to achieve some competitive advantages.

b. It helps to create a company’s market-driven management for designing and manufacturing products that meet the price required for the market success.

c. It uses management control system to support and reinforce manufacturing strategies, and to identify market opportunities that can be converted into real saving to achieve the best value for money rather than simply achieving the lowest cost.

d. Assures that products are better matched to their customers’ needs.

e. Aligns the costs of features with customers’ willingness to pay for them.

f. Reduces the development cycle of a product.

g. Reduces the costs of products significantly.

h. Increases the teamwork among all internal organizations associated with conceiving, marketing, planning, developing, manufacturing, selling, distributing and installing a product.

i. Engages customers and suppliers to design the right product and to more effectively integrate the entire supply chain.




7. Reasons for the Late Development of Target Costing
:

Although target costing emerged more than 30 years ago, yet only in 1990’s this system came into notice. Main reasons for late popularity of target costing could possibly be that target costing focuses heavily on new product development and Japanese companies which practice the system most are very secretive about their new products/activities.

Also, popularity of Japanese Just-in-time inventory system had dominated the attention of industry in 1980’s and, therefore, target costing got the second seat.



8. Problems with Target Costing
:

Talk with customers about a new product concept, find out which features they like and don’t like, and find out how much they would pay. Subtract an acceptable profit margin, and you’re left with the target cost of the product. Now all you have to do is get everyone inside and outside the company to adhere to this number. It sounds simple enough.

It is easier said than done. Yet, target costing-a cost-management process imported from Japan—is helping a few dozen companies in the United States gain an edge by having them listen harder to customers to gauge the right product or service price.

Boeing, Eastman Kodak, and Honda of America, for example, as well as pioneers Daimler Chrysler and Caterpillar, have implemented the strategy, reversing the way they traditionally design, price, and sell new products.

Companies that have implemented the cost-management strategy insist they have boosted profitability. But, although virtually the entire Japanese manufacturing sector has gone the target-costing route since its inception in the 1970s, it hasn’t exactly taken root here in India.

Target Costing has a few problems that one should be aware of and guard against. These problems are as follows:

a. The development of the process can be lengthened to a considerable extent since the design team may require a number of design iterations before it can devise low cost product that meets the target cost and margin criteria. This occurrence is most common when the project manager is unwilling to discontinue a design project that cannot meet its costing goals within a reasonable time frame.

Usually, If there is no evidence, it is better to either drop a project or at least shelve it for a short time and then try again, on the belief that new cost reduction methods or less expensive materials will be available in the near future that will make the target cost an achievable one.

b. A large amount of mandatory cost cutting can result in finger pointing in various parts of the company; especially if employees in one area feel they are being called on to provide a disproportionately large part of the saving.

For example the industrial staff will not be happy if it is required to completely alter the production layout in order to generate cost saving, while the purchase staff is not required to make any cost reductions through supplier negotiations. Avoiding this problem requires strong interpersonal and negotiation skills on the part of the project manager.

c. A design team having representatives from the number of departments can sometimes make it more difficult to reach a consensus on the proper design because there are too many opinions regarding design issues.

For every problem area outlined above the proper solution is retaining strong control over the design team, which calls for a good team leader. This person must have a very good knowledge of the design process, good interpersonal skills, and a commitment to staying within both time and cost budgets for a design project.


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