Target Costing

As a totally new product and its industry develop, it starts to compete based on its new technology, concept, and/or service. Competitors emerge and the basis for competition evolves to other areas such as cycle time, quality, or reliability. As an industry becomes mature, the basis of competition typically moves to price. Profit margins shrink. Companies begin focusing on cost reduction. However, the cost structure for existing products is largely locked in and cost reduction activities have limited impact. As companies begin to realize that the majority of a product's costs are committed based on decisions made during the development of a product, the focus shifts to actions that can be taken during the product development phase.

Until recently, engineers have focused on satisfying a customer's requirements. Most development personnel have viewed a product's cost as a dependent variable, that is, the result of the decisions made about a products' function, features and performance capabilities. Because a product's costs are often not assessed until later in the development cycle, it is common for product costs to be higher than desired.

The long-term financial success of any business depends on whether its prices exceed its costs and are adequate to finance growth, provide for reinvestment, and yield a satisfactory return to its stakeholders. As competition increases, and supply exceeds demand, market forces influence prices significantly. To achieve a sufficient margin over its costs, a company must manage those costs relative to the prices the market allows or the price the firm sets to achieve certain market penetration objectives. In the context of these characteristics, the practice of target costing has evolved. Effective management of cost makes an organization more strong, more stable and helps in improving the potential of a business. The organization calls for a system that would monitor the full economic impact of the business, on resource acquisition and consumption.

Target costing is defined as "a cost management tool for reducing the overall cost of a product over its entire life cycle with the help of the production, engineering, R&D." Target costing process starts with determining market-based prices based on market and competitive conditions and then subtract the required margin to determine the product or service level target costs. Such aggregate level target costs can be useful in designing value delivery processes and in determining the relative cost contribution of people, process and technology elements in such a manner to achieve target cost before costs are incurred.

Target costing is fundamentally a different approach. It is based on three premises: (i) orienting products to customer affordability or market-driven pricing, (ii) treating product cost as an independent variable during the definition of a product's requirements, and (iii) proactively working to achieve target cost during product and process development. It is a profit and cost management system that helps a company to achieve market and financial success by planning the portfolio of services, and designing the products, processes and related cost structures that provide value to customers.

Target costing is a customer-oriented technique that is widely used by Japanese companies and which has recently been adopted by companies in Europe and the USA. The target costing process is a logical outgrowth of determining the causes of cost and seeking ways to reduce or eliminate those costs before production costs were incurred, while simultaneously looking to improve quality and customer satisfaction.

Illustration 8

A company XYZ Ltd. has the production capacity of 1,00,000 units and currently selling 40,000 units at Rs.100 per unit. The demand can make fluctuations in the selling prices and it has been observed that demand increases in two folds with every reduction of Rs.10 in selling price. Find out the target cost at full capacity if profit margin on sales is taken as 30%.

Solution

Target cost   = Rs.80 - (25% of 80)

                     = Rs.80 - Rs.20 = Rs.60.

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