Cost and Management Accounting: Target Costing

 



Target costing may form part of a question comparing its use to other costing techniques or it may form an entire question including calculation of a target cost.

 

Target Costing involves setting a target cost by subtracting a desired profit margin from a competitive market price.

 

Target Costing involves setting a target cost by subtracting a desired profit margin from a competitive market price.

 

Target Cost is an estimate of product cost which is determined by subtracting a desired profit margin from a competitive market price. This target cost may by less than the planned initial product cost but it is expected to be achieved by the time the product reaches the maturity stage of the product life cycle.

 

Need of Target Costing:

 

To compete effectively, organizations must continually redesign their products or services. in order to shorten product life cycles. The planning, development and design stage of a product is therefore critical to an organization's cost management process. Considering possible cost reductions at this stage of a product life cycle, is now one of the most important issue facing management accountants in industry.

 

Following are some examples of decisions made at the design stage which impact on the cost of a product:

 

The number of different components

Whether the components are standard or not

The ease of changing over tools

 

Japanese companies have developed target costing as a response to the problem of controlling and reducing costs over the product life cycle

 

Implementing Target Costing...

 

In 'product costing/pricing strategy' (ACCA Students Newsletter, August 1999) one of the examiners provided a useful summary of the steps in the implementation of the target costing process:

 

STEP 1 Determine a product specification of which an adequate sales volume is estimated

 

STEP 2 Set a selling price at which the organization will be able to achieve a desired market share

 

STEP 3 Estimate the required profit based on return on sales or return on investment

 

STEP 4 Calculate the target cost = target selling price - target profit

 

STEP 5 Compile an estimated cost for the product based on the anticipated design specification and current cost level.

 

STEP 6 Calculate target cost gap = estimated cost - target cost

 

STEP 7 Make efforts to close the gap. This is more likely to be successful if efforts are made to 'design out' costs prior to production rather than to 'control out' costs during the production phase.

 

STEP 8 Negotiate with the customer before making the decision about whether to go ahead with the project.

Source: ACCA Study Text Paper F5, Performance Management