TARGET COSTING

 Historical Background
 Target costing is especially important during
particularly competitive times, as during an
economic recession, when many firms
struggle for survival.
 It originated in Japan in the 1970s, it came
to being as a result of recognition that
customers were demanding more diversity
in products that they bought and the life
cycle of the products were getting shorter.
 As such, it meant that new products
had to be designed more frequently.
 Companies realized that the larger
proportion of costs were committed
in the design stage of the product
and hence the design stage become
critical for the company to make
profit.
PURPOSE

 Target costing is a method that is employed

to manage costs and profits.
 It involves setting a target or objective for
the maximum of a product /service and
working out now to achieve this target.
 It is used for business strategy and
marketing strategy in particular by
companies who operate in a competitive
environment and where new products are
continuously being introduced.
 For companies to achieve these, they
need to:
 Continually improve their existing
products or design new ones.
 Sell their products at a competitive
price just like competitors or slightly
below competitors.
 Make a profit.
 NB in order to make a profit,
companies need to make the product at
a cost below the expected sale price.
TARGET COSTING AND NEW PRODUCT DEVELOPMENT

 It is mainly used for new product

development; this is due to the fact that
whenever a new product is designed and
developed for a competitive market, a
company needs to know what maximum
cost to be placed on a new product so that
it will sell at a profit.
 Keeping the cost of the product within the
target level is the major factor in controlling
its design and development.
 New product design and development
 Setting target cost
 $
 Target selling price xxxx
 Less target margin xxx
 Target cost xx


 The reason that target costing is used for new products is the
opportunities for cutting costs to meet target costs since it is
from the design stage and development that all production
processes are set up.

TARGET COSTING METHOD
 The principles of target costing can be
summarized as:
 Target costing is based on the idea that
when a new product is developed ,a
company will have a reasonable idea
about:
 i) The price at which it will sell the
product.

 ii) The sales volume that will be able
to achieve for the products over its
product life.

 iii) Their may be need to estimate

capital investments, incremental
fixed costs such as marketing costs
and additional salaries
 Taking estimates of sales volumes,
capital investments, incremental
costs over the life of the product, it
then becomes easier to ascertain the
target cost.
 The target cost for the product might
be the maximum cost for the product
that will provide at a least a required
return on the investment.

 Implementing a target costing
approach involves five steps:
 1. Determine the market price.
 2. Determine the desired profit.
 3. Calculate the target cost at market
price less desired profit.
 4. Use value engineering to identify
ways to reduce product cost.
 5. Use kaizen costing and operational
control to further reduce costs
ELEMENTS IN ESTIMATES COST AND TARGET COST

 It is difficult to measure the cost of a

product that has not yet been created
and the cost must include such items
as raw material wastage, direct labour
idle time which is expected to occur in
normal circumstances.
 Raw material
 The target cost should allow for expected
wastage rates/wastage in the process.
 The price of raw material should also
allow for any possible increase up to the
time when the new product development
is completed.
 Estimating price of raw materials can be
difficult in inflation times when prices are
subject to large price increases within
short periods.
 Labour
 Target cost should allow for any expected idle
time that occurs during the manufacturing of the
product.
 Production Overheads
 target cost could be a target marginal cost or full
cost.
 Production overheads, in some cases make up a
large portion of the total manufacturing cost and
as such target cost should be based on full cost.
 NB Activity based costing can be employed to absorb costs
rather than the traditional methods.
 Example
 The textile and Clothing Department
has designed a new product, the
Graduation Gown; it currently
estimates that in the current market,
the product could be sold for $70.00 a
unit.
 A gross profit margin of 30% on the
selling price would be required to
cover administration, marketing
overheads and also make an
acceptable level of profit.
 A cost estimation study has
produced the following estimate of
production cost for the Graduation
Gown .
 Cost item
 I. Direct material m1--- $9/unit
 Direct material m2 each unit would
require 3kgs of material m2 but there
will be a loss in production of 10% of
the material used.
 Material m2 cost $1.80 per kg. Direct
labour –each unit of Graduation
Gown will require 0,5hours of direct
labour time.

 However, it is expected that there

would unavoidable idle time equal to
5% of total labour time paid at $19
per hour.
 Production overheads –it is expected
that production overheads will be
absorbed to production cost at a rate of
$60 per direct labour hour for each
labour hour worked (overheads are not
absorbed into cost of idle time)
 Required
 To calculate:
 i) Expected cost per Graduation Gown .
 ii) Target cost for Graduation Gown .
 Iii) The size of the cost gap
EXAMPLE 2
 E and E Ltd. manufacture a range of electronics
products.
 Technical staff recently developed a design for a
new type of in-car music player which can be used
to play CDs, digital downloads, and cassette tapes.
 The board of the company has asked the
marketing, financial, and production directors to
evaluate the design before a decision is made as to
whether to begin production of the music player.

 The marketing director has suggested that
$900 would be a suitable selling price for the
music player and that 60 000 units per
annum would be sold at this price. Variable
selling costs would amount to $220 per unit
sold.
 The financial director has estimated that the
new capital equipment required in order to
manufacture the music player would cost
$30,000,000.
 The company requires an annual return on
investment (ROI) of 8% on all capital
investments.
 The production director has not yet
finalized her estimate of the cost of
manufacturing the music player.
 However she has commented that the
design has certain features which are
likely to add to the complexity and cost
of the manufacturing process without
significantly enhancing the
attractiveness of the product to
potential customers.
 REQUIRED:
 (a) Using the data provided above, calculate the
target cost of manufacturing the music player, and
explain fully the significance of this figure.
(10 marks)
 (b) Assume now that the production director has
estimated the cost of manufacturing the music
player (using the recently-developed design) at
$650 per unit and has suggested that the company
should accept a reduced ROI if necessary.
 Calculate the ROI if this suggestion is accepted
and comment on the production director’s
suggestion. (7 marks)
 c) It is often stated that target costing
is most likely to be effective when
products are still at the design stage
(i.e., before any production begins) and
when comprehensive information about
cost driver rates is available from the
company’s accounting system.
 Explain why this is so. (8 marks)
 Closing the cost gap
 Common methods of closing the gap are:
 To redesign products to make use of
common processes and components
that is already used in the manufacture of
other products by the company.
 To discuss with key suppliers on the
methods of reducing material costs.
 To eliminate non value added activities or
non value added features of the product
design.
 To train staff in more efficient
techniques .improvement in these
reduces costs.
 To achieve economies of scale
(buying and producing in bulk.
 To achieve cost reduction as a result
of the learning curve effect that is
through experience curve effect.
Benefits of Target Costing
Target costing can be beneficial because it
• Increases customer satisfaction, as design
is focused on customer values.
• Reduces costs, through more effective and
efficient design.
• Helps the firm achieve desired profitability
on new or redesigned products.
•
Can decrease the total time required for
product development, through
improved coordination of design,
manufacturing, and marketing
managers.
• Can help provide a competitive edge in
times of economic recession.
• Can improve overall product quality, as
the design is carefully developed and
manufacturing issues are considered
explicitly in the design phase.
 Limitations
 It is sometimes unrealistic hence
unachievable targets are set.
 May demotivate workers if they fail
to meet their targets.
ACTIVITY BASED COSTING

 It is a costing approach that analyses all activities to identify what

drives costs incurred that is what causes costs to increase.
 The major ideas behind ABC are:
 Activities cause costs—these activities include ordering materials,
handling, dispatching etc
 It believes that it is the products that create demand for the activities.
 Costs are assigned to products on the basis of the product’s
consumption of the activities.
 Cost driver
 This is a factor that directly influences cost over a relevant range
of activity. This could be number of orders, number of production
runs, number of dispatches, labour hours and machine hours.

 Cost Pool
 This is a bucket in which costs are accumulated that relate to the
single activities.
 Steps in Activity Based Costing

 Identify an organisation’s major activities.

 Identify the cost drivers for each major activity for example:
 Activity cost driver
 Ordering number of orders made
 Material handling number of material movements
 Production scheduling production runs
 Dispatching number of dispatches etc
 Collect the cost associated with each activity into cost pools.
 Charge the activity cost to products on the basis of the number of activity depending
on the product’s demand for activities.