Managerial Accounting -Target Costing
Target costing is the reverse of Target Pricing. Usually, a manufacturer would start with a target price which is set by adding a profit margin to the actual cost. If it is not easy to sell at that price, the manufacturer would resort to Target Costing which goes in reverse order: Market price for similar product is taken as a base, desired profit is deducted from this to arrive at a target cost. Later, ways and means are found to meet the target by eliminating any extra feature, reducing non-value added activities and overall investments.
Target costing is particularly popular among Japanese firms such as Toyota, Nissan, Toshiba and Daihatsu Motors. The growing demand for a vareity of products has forced the companies to focus on cost reduction while improving the product to the taste and aspiration of their customers.
What is target costing?
A formal definition is given by Katherine Radeka
Target costing is an approach to managing product costs and gross margins that works backward from the price a customer will pay for a specific product with a specific feature set, sets product cost targets based on that product’s expected gross margin and then manages the development process to achieve the targets.
This is different from how many companies approach product costs, where the teams may set targets based on historical data and prediction, and then set the price by adding a specific percentage of margin.
In the video-presentation, target costing has been well explained.
Major influence on pricing decisions
There are four major influences which govern the prices of products:
- Cutomer demand - Usually customer demand high quality proudcts but are unwilling to pay high prices.
- Action of Competitors- sometime, a competitor may resort to distressing selling reducing its costs to a point which barely covers the variable costs, leaving a small margin to meet fixed costs. But this could only be for a short period of time.
- Costs (Both manufacturing and non-manufacturing). It is a major factor in the long run but in in the short run, demand and supply set price specially in unbranded goods.
- Political legal and image related issues. Some prices are set by governments in basic foods and other necessirties. A price ceiing is a government imposed maximum price for a product while a price flooring is the minimum price usually for the farmers. The government regulate the price through importing when there is a shortage and purchasing when there is a surplus.
Benefit of target cost can be summarized as follows:
- increased overall profitability,
- reduced manufacturing costs,
- meets or exceeds customers expectation for the product,
- savings in raw materials costs due to Just-in-time inventory,
- results in product features and functions that customers value,
- reduction in design changes after production begins, short product life cycles.
The following is a step-by-step approach to seting a target cost:
- Ascertain the price which a customer is willing to pay. This calls for a short survey of the market and asking for prices of products which the company wants to produce such as 39" LCD TV which is already being sold by Sony, Samsung, Toshiba and Panasonic.
- Deduct a target profit margin from the market price to determine target costs. The profit margin would be set keeping in view cost of capital or desired rate or return or target profit based on ROI or opportunity costs.
- Estimate the actual cost of the product with the help of a cross functional team.
- If actual cost exceeds the target cost, investigate ways of driving down the actual cost to target cost.
The aim of target costing is mainly to reduce cost which can be achieved by some measures:
- Elimination of non-value added activities - A well defined production process reduces wait to minimum. This is turn shorten the operating cycle and a company is able to bring in the market it produc earlier than its competitors. On the other hand, it save money through lesser investments in stocks.
- Another area is un-necessary movement of work-in-process within the plant. Through a suitable layout, the internal transport can be brought to a minimum. The options are product layout, process layout, fixed layout and cellurer layout.
- Teardown analysis is a useful which studies the product marketed by the competitors.
- Value engineering is opposite of teardown as the companyis own products are brought under scrutiny. Any feature or element for which a customer is not willing to pay is eliminated.
The aim is to improve proces, design and at the same time to reduce cost to offer a good competition to the other player in the market.
A challenging task before any manufacturer is pricing of the products and services. A variety of factors affect pricing decisions like demand, market competition, cost-structure and government regulations.
Target costing is a tool to arrive at cost which a customer is willing to pay. It is a disciplined process that uses data and information in a logical series of steps to determine and achieve a target cost for the product.