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Managerial Accounting -Target Costing

Updated on May 1, 2012

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:

  1. Cutomer demand - Usually customer demand high quality proudcts but are unwilling to pay high prices.
  2. 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.
  3. 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.
  4. 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:

  1. 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.
  2. 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.
  3. Estimate the actual cost of the product with the help of a cross functional team.
  4. 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.

SUMMARY

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. 

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    • Rufi Shahzada profile image

      Rufi Shahzada 7 years ago from Karachi

      Dear Sir,

      Thanks a lot, I have gained another Milestone with a perfect TARGET COSTING article. Hopefully It is now embedded in my mind forever. You have made things so simple and precise...

      Once Again Thank You!

      Rufi Shahzada

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      thanks

    • profile image

      Syed Kabeer Ehsan 7 years ago

      Dear Teacher

      The best thing is using simple language, which really help me to understand the concept of TARGET COSTING.

      Thanque Sir.

    • TEERATHMAHESHWARI profile image

      TEERATHMAHESHWARI 7 years ago from karachi

      dear sir

      i have alredy study about target costing but my concept was not clear but after reading this article i have clear picture about managerial accounting.

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      Thanks Kabeer and Teerath for your comments.

    • profile image

      Sana Rao 7 years ago

      Dear Sir,

      hope u r fine by the grace of Allah,thanks for sharing the important topic but i need to ask is target costing is imp in every field and it is helpful or not?

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      Generally a company would like to set its own price based on cost plus markup to earn a reasonal profit. But because of competition, it may not be possible. Therefor, it resorts to target costing. Of course it is important and helpful.

    • profile image

      Accounting firm 7 years ago

      More good informations thanks for helping me out. Always a pleasure to see information that is useful, thanks again

      http://www.kpmgaccountingfirm.info

    • profile image

      Mubashir 7 years ago

      Dear Sir,

      Plz tell me whether target costing is applied in manufacturing industries of Pakistan?

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      I will have to contact Institute of Cost & Management Accountants of Pakistan for this. In the meanwhile, you may also get in touch with them, their email is: research@icmap.com.pk

    • Ez Kay profile image

      Ez Kay 6 years ago

      Perfect and excellent managerial skills which i lond be looking for.Thank you for making things easy for me by publishing it here for my usage.

    • hafeezrm profile image
      Author

      hafeezrm 6 years ago from Pakistan

      Thanks Ez Kay for your nice comments.

    • profile image

      hari 5 years ago

      what is target costing in accounts and marketing subjects?

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks Hari for reading my article. Target Costing help the marketing people to compete in the market. If a product is selling for US$ 10 they would ask their management to form a team of engineers, cost accountants and marketing executives to find out ways and means of cutting their present costs to bring to a level where it satisfy the following equation:

      Market price minus desired profit margin= target cost

      10 - 2 = 8

      Replying to your query, I may say that there is no difference in the concept of target costing whether it is used in accounts or marketing subjects.

    • profile image

      Nusrat Nasima 5 years ago

      It is really very helpful to me.Thanks

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks Nusrat Nasima for your comments.

    • profile image

      soroush 5 years ago

      hi Mr.hafeezrm

      im study accounting in a iran and i want to know about target accounting

      what is a target accounting?thankyou if you help me

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Dear Soroush,

      Never heard of target accounting. If you mean target costing, you may read this article again.

    • profile image

      lala 5 years ago

      hi sir, i need your help.. what are the example of non-value added elements in target costing?

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      @Lala It is given in this article which is repeated: non-value added elements are: wait, inspection, storage, internal transport, recall, rework and wastage.

    • profile image

      lala 5 years ago

      thanks sir.I just realized after I posted the comment.

      By the way,I have 1 more question..what are the example of value added elements in target costing?

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      @Lala Value added is any addition or improvement which would enhance market of the product or service in the eyes of customers. In other words, customer is willing to pay more than the cost.

      In target costing, we take price from market, deduct our profit margin, say 20%, from this price and try to cover necessary costs with the remaining (80%). If this works out well, we have already charged more that what we have incurred. The profit margin is value added is on raw materials, labor and overhead costs.

    • profile image

      lala 5 years ago

      thank u sir...u are really help me to understand this target costing.

      Thanks a lot..!

    • profile image

      Jenny 5 years ago

      Would target costing be appplicable in a pharmaceutical company?

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Yes Jenny. Target costing would be applicable in pharmaceutical companies.

    • profile image

      joan 4 years ago

      this is good. can you recommend online accounting books that would give more information for study purposes. thanx

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