TARGET COSTING
Traditional Costing Perception Target Costing Perception
Production Cost Competitive market Selling Price
Add Desired Profit Desired Profit
Selling Price Target Cost
It involves setting a target cost by subtracting a desired profit margin
from a target selling price.
Target Cost = Selling Price – Desired Profit Margin
Test your understanding
[Link] target selling price of a product is $100, and the desired
profit margin is $[Link] the target cost
[Link] Target selling price of a product is $200, the desired profit
margin is $[Link] the target cost
[Link] Co’s target selling price is $500 per unit, the company
is expecting a 10% return from their investment of $150000. They
are planning to sell 100 units, calculate the target cost
Q4. One plus co’s target selling price is $1200 per unit. They
require a profit of 12% from their investments of $ [Link] the
estimated sales are 200 units, calculate the target cost
1
Cost Gap
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.
Q) Nokia's target cost for a product is $25 per unit, calculate the cost
gap if the actual cost is $20
Methods to reduce the cost gap
1. Value analysis: It is a technique used to reduce or eliminate cost by
removing non-value elements from a product, Types of value:
2. Value engineering – reducing Cost at the engineering phase
3. Switching to alternate suppliers without compromising quality
4. Outsourcing: Outsourcing is the business practice of hiring a party
outside a company to perform services or create goods traditionally
performed in-house by the company's employees and staff.
5. Using standardized components wherever possible
6. Acquiring new more efficient technology
7. Training staff
2
Traditional Approach
1. Developing the idea
2. Designing the product
3. production
4. Find the cost of the product
5. Add the Desired Profit and set the selling price
Limitations
• It ignores the price that the customer willing to pay
• It ignores the price charged by competitors for a similar
product
• Ignores cost control
Service industry
A service industry provides people with intangible products or
services and completes tasks that are useful to customers, clients,
businesses or the general public.
Education, Health care, Hospitality, Media and entertainment
3
Target Costing in Service Industries
Hence, although target costing can be used in service industries, it
may face several problems: -
It is very difficult to determine a market-driven price for
services provided
The introduction of new services occurs far less frequently than
in a manufacturing company.
The major cost in the service industry is salaries. Bought-in
materials are usually low when compared to salaries. It is very
difficult to reduce the cost of salaries!
Characteristics of the Service Industry
Intangibility (of what is provided to and valued by individual
customers).
Perishability (the inability to store the service);
Inseperable/Simultaneity (production and consumption of the
service coinciding);
Heterogeneity (Describes the uniqueness of service offering,
also known as variability);
No transfer of ownership.
MARGIN MARK UP
Selling price * (100% - Margin) Selling Price / (100% + Mark
up%)
Test Your Understanding
Apple Company decided their selling price as $96 Per unit, Calculate
target cost if they require a profit
1. Margin of 20%
2. Mark up of 20%
4
Question Practise
1) The selling price of Product X is set at $550 for each unit and sales
for the coming year are expected to be 800 units.
A return of 30% on the investment of $500,000 in Product X will
be required in the coming year.
What is the target cost for each unit of Product X (to two
decimal places
2) Which of the following statements about target costing is NOT
true?
A. Target costing is better suited to assembly-orientated
industries than service industries that have a large fixed cost
base.
B. Costs may be reduced in target costing by removing product
features that do not add value.
C. A target cost gap is the difference between the target cost for a
product and its projected cost.
D. Products should be discontinued if there is a target cost gap.
3) Elimination of target cost gap is most likely to be successful at:
Production Stage
Design Stage
Marketing Stage
Budgeting Stage
4) The estimated Cost level is $ 120 and the Target cost for a Product
‘X’ is $ 100.
The following is the cost break-up for the current estimated cost level:
5
Material Cost: $45 (the company may use material of ‘P’ quality which
will cost $30, the same material is being utilized by other competitors
in the market)
Salaries Cost: $25
Overheads: $20 (of which $5 is to enhance the product design to make
it superior to the product offered by the competitor)
Distribution Cost: $20
Packaging Cost: $10
Calculate the best Target Cost for Product ‘X’ after reducing the Cost
Gap
100
105
120
115
5) A ______ is a cost estimate derived by subtracting a desired profit
margin from a competitive market price.
Target cost
None of the choices
Variable cost
Fixed cost
6) Where a gap exists between the current estimated cost levels and
the target cost, it is essential that this gap be closed. Efforts to close
a target cost gap are most likely to be successful at the design stage.
It is far easier to ‘design out’ cost during the pre-production phase
than to ‘control out’ cost during the production phase.
False
True
6
Lifecycle Costing
Life cycle costing aims to cost a product, service, customer or project
over its entire life cycle to maximise the return over the total life
while minimizing costs.
Lifecycle cost mainly includes:
Research and development expenditure
Cost of purchasing technical data
Training costs
Production costs
Distribution costs
Marketing and advertising cost
Inventory costs
Retirement and disposal costs, and many more
Every product goes through a life cycle
7
1. Development - The product has a research and development
stage where costs are incurred but no revenue is generated.
During this stage, a high level of setup costs will be incurred,
including research and development, product design, and building
of production facilities.
2. Introduction - The product is introduced to the market. Potential
customers will be unaware of the product or service, and the
organization may have to spend further on advertising to bring
the product or service to the attention of the market. Therefore,
this stage will involve extensive marketing and promotion costs.
High prices may be changed to recoup these high development
costs.
3. Growth - The product gains a bigger market as demand builds up.
Sales revenues increase and the product begins to make a profit.
Marketing and promotion will continue through this stage. Unit
costs tend to fall as fixed costs are recovered over greater
volumes. Competition also increases and the company may need
to reduce prices to remain competitive.
4. Maturity - Eventually, the growth in demand for the product will
slow down and it will enter a period of relative maturity. It will
continue to be profitable. However, price competition and
product differentiation will start to erode profitability. The
product may be modified or improved, as a means of sustaining
its demand.
5. Decline - At some stage, the market will have bought enough of
the product and it will therefore reach 'saturation point'. Demand
will start to fall and prices will also fall. Eventually, it will become
a loss maker and this is the time when the organization should
decide to stop selling the product or service. During this stage,
the costs involved would be environmental cleanup, disposal, and
decommissioning.
8
Benefits of life cycle costing
To analyze product profitability over its entire lifecycle
Helps in
a)Increase sales
b)Reducing the cost
Better Decision-Making Ability
Forward-looking
Formula to Learn :
Lifecycle Cost Per Unit = Total Lifecycle Cost / Total Lifecycle Units
Q) Levis Company have a total lifecycle cost of $2500000 for their
product Swift. Calculate the lifecycle cost per unit if lifecycle units are
5000.
9
Variability/Behaviour
Fixed Cost
Semi-variable cost
Variable cost
Step cost
Fixed Cost
A fixed cost is an expense that does not change when sales or
production volumes increase or decrease
Variable Cost
Variable costs are any expenses that change based on how much a
company produces and sells Example: Direct materials, direct labour
10
Semi Variable Cost
Semi-variable costs are those that have both a fixed and a variable
component. Mixed costs are also known as semi-fixed or step costs
Example: Electricity, telephone
Step cost
Step cost refers to the cost that doesn't change to the changes in
activity levels but instead changes after a certain threshold is
crossed.
Example: Supervisor salary, Inspection cost
High low Method
The high-low method is used to calculate the variable and fixed cost
of a product or entity with mixed costs, The high-low method
involves taking the highest level of activity and the lowest level of
activity and comparing the total costs at each level
11
Question Practise
[Link] following statements relate to life-cycle costing: Which of
the statements is true?
It helps forecast a product’s profitability over its entire life.
It focuses on the production of monthly profit statements
throughout a product’s entire life.
It takes into account a product’s total costs over its entire life
[Link] of the following costs would be included to find the
lifecycle cost of a product?
(i) Planning and concept design costs
(ii) Testing costs
(iii) Production costs
(iv) Distribution and customer service
Q3. What is the name of the stage where costs are incurred but no
revenue is generated?
During this stage, a high level of setup costs will be incurred,
including research and development, product design and building
of production facilities.
a) Introduction
b) Research and Development
c) Maturity
d) Growth
12
[Link] following information relates to the expected cost of a new
product over its expected three-year life.
Year 0 Year 1 Year 2 Year 3
Units made and sold 25,000 100,000 75,000
R&D costs $850,000 $90,000
Production costs
Variable per unit $30 $25 $20
Fixed costs $500,000 $500,000 $500,000
Selling and distribution costs
Variable per unit $6 $5 $4
Fixed costs $700,000 $500,000 $300,000
Customer service costs
Variable per unit $4 $3 $2
What is the expected average life cycle cost per unit?
a $35.95
b $46.25
c $48.00
d $50.95
13
Question 5
Items Amount Amount
Activity Level 500 Units 1000 Units
Direct Materials $1500 $3000
Direct Labour $1000 $2000
Rent $4000 $4000
Administration $2500 $2500
Telephone Bill $1000 $1500
Electricity Bill $800 $1400
1)Total Cost for 1500 Units
2)Total Cost for 800 units
Question 7
Items 20X0 20X1
Activity Level 800 Units 1500 Units
Direct Materials $3200 $6000
Direct Labour $800 $1500
Rent $5000 $5000
Administration $3500 $3500
Telephone Bill $2600 $4000
Electricity Bill $2500 $2500
1. Total Cost for 1150 Units
2. Total Cost for 2000 units
14
Question 8
YEAR OUTPUT VOLUME TOTAL COST
20X1 25 750
20X2 40 900
20X3 55 1050
20X4 30 800
20X5 45 950
20X6 50 1000
What will be the total cost in 20X7, if the output is 58 units?
Question 9
Number of Machines Serviced Total Cost
2 110
4 140
6 170
8 200
10 230
12 230
Using the high-low method, estimate how much it will cost to service
16 machines annually
Question 10
Year Total call Cost
Jan 450 34250
Feb 900 68000
Mar 1200 90500
Apr 1100 83000
May 1050 79250
June 875 66125
What will the call cost in July be if calls totalling 950 hours are made?
15
High/Low Method: Stepped Fixed Costs
Question 10
An organisation wants to estimate the total cost of producing 4,000
units using the following information:
Number of units Total Cost
1000 9800
2000 14800
3000 20760
Fixed costs increase by 20% when the number of units produced is
more than 2,000.
Question 11
An organisation wishes to estimate the total cost of producing 800
units using the following information:
Number of units Total Cost
400 12000
500 13000
600 13400
The variable cost per unit decreases by 10% when the number of
units produced exceeds 550.
16