A modern cost technique (Target costing)
Target costing is a modern technique of cost control. It is a reverse costing technique in which selling price is determine by read the market environment and then the desire profit margin is deducted from the selling price.
Budget > Production > Total cost > Selling price > actual results > Variances
In the traditional system first the budget is prepared and then the production starts. After the production total cost is calculated. From the calculated cost the desire profit is deducted and a selling price is determined. The difference is notice by comparing the budgeted and actual results of cost which is know as variance.
A target cost is a cost estimate derived by deducting a desired profit margin from a competitive market price. It is the opposite of conventional cost plus pricing and is referred as price minus costing. Target costing does not focus on finding what a new product does cost, instead it focuses on finding what a new product should cost.
Cost reduction must be in a way that does not affect quality because if quality is damaged target costing plan will immediately fail.
Target costing process
A 5 step approach is adopted in order to carry out the target costing process.
Step # 1
Estimate a selling price at which a product could be sold.
Step # 2
Then estimate the desired profit margin.
Step # 3
Deduct the profit margin from the selling price to arrive at target cost.
Step # 4
Calculate the estimate cost of the product and compare it with target costing.
Step # 5
Difference is known know as the cost gap that needs to be closed.
For example, if the selling price of the product is $25 and the desired profit margin is $5. Then, the target cost would be $25-$5 = $20. The real cost of the product came out to be $22. Now, the cost gap calculated would be $20-$22 = -$2. This negative $2 or the cost gap of $2 needs to be reduce as the selling price is less than the real cost of the product.
It is vital to know that how can the cost gap be closed.
- Using substitute materials provided if it does not affect the quality of the product.
- Focusing on the alternative production designs/ production methods.
- Reviewing the entire supply chain.
- Focusing on the economies of scales. For example, bulk purchase discounts.
- Using cheap labour provided if it does not affect the quality of the product.
- Improving productivity by motivating the workforce.
In 2001-2002, there was a dynamic change in the automobile industry as Indus Motors, a Japanese company, got on the number one rank by replacing the General Motors. That time Mercedes faced a reduction in their sales. Having realised target costing was the technique, they had to adopt it.
Companies like Swiss Watch and Sony TV are the real world users of target costing.
It has been generally observed that costs are reduced by 25% to 30% under target costing as compare to the traditional costing techniques. Right from the start external environment is focused because there is a lot of market study required which helps to know the market conditions from the day one resulting into more chances of success. And also cost control is much more effective as compare to the traditional costing methods. However, The implementation cost of target costing can be high and it maybe more time consuming than traditional methods as it is not easy to identify a suitable price.
Target costing is difficult to apply in service industry due to the characteristics of service industries.
- Intangibility (Product can not be felt. For example, health, insurance)
- Heterogeneity (lack of consistency)
- Simultaneity ( Production and consumption is simultaneous; at that time only.)
- Perish ability (they cannot be stocked)
- No transfer of ownership
Similarly new services occurs rarely in service industries as compared to new products in the manufacturing industries.