Coverdrive Ltd

Target Costing

In recent months John Thistle, the company’s management accountant had met
on several occasions with Steve Ambrose the MD and discussion had focused
on issues as full cost pricing, activity based costing, standard costing and
aspects of budgetary control.

Steve informs John of various ideas he has for increasing the company’s product
range and the concept of pricing returns to the agenda.

John mentions that he has recently read some research by Helmet Hergeth,
North Carolina University, on Target Costing and feels that the technique could
be applied at Coverdrive.

Steve wishes to explore the idea and asks John to prepare a paper for the senior
management team’s next meeting.

John’s Notes

• Target Costing

Much literature cites Japanese companies developing and using target costing;
Toyota, Honda and Nissan are such examples. In the US Caterpillar and
Chrysler are examples where economic benefits of the technique have been
noteworthy.

• Traditional Pricing and Costing

Full cost pricing has been the model used by many businesses in the past.
Standards and standard costing technique was used to determine a product’s
cost of labour and material, overhead was absorbed, a share of selling
distribution and administration cost was added to achieve a product’s total cost.
Price was then set by adding a desired profit margin.

This additive model worked well and was appropriate when markets were less
efficient and responsive as they are today.

If the price was acceptable in the market it was only experienced when the
product was actually introduced to potential customers. This could result in the
price being either too high or too low and therefore technique was developed that
prevents pricing error and aids faster more focused product development.

• Target Costing

‘Target costing describes a process of first assessing a target price and then
designing a product to meet this price’ (Hergeth).

It is part of a total cost management system which moves away from traditional
accounting to managerial accounting and moves decision making from an
accountants perspective to the market place.

TARGET COSTING
 It is a top down process:

• Setting Price
• Setting Profit
• Setting Cost

The process is interactive and comprises three phases: market level, product
level and component level (Cooper and Slagmulder 1999):

Market Level Strategy

Target Price
Target Profit
Target Cost

Product Level

Design product to meet

target cost

Component Level

Design components to meet

target cost

Supplier management

This can also be viewed as:

Understand Customer Need

Price Sensitivity Value of product

features

What What
Price Features

Set Profit

Set Target Cost

TARGET COSTING
 Target costing therefore builds upon a design to cost approach where the focus
is a market driven price as a basis for establishing target costs.

Hergeth states:

“The key element in target costing is the market orientation of the entire costing
and product development process. By introducing the market price as the focal
point of the analysis, target costing avoids problems of other costing approaches:

• Costing becomes a managerial tool to achieve successful product design

rather than documenting historical data.

• An economically relevant variable (price) becomes the driver of the

product development process rather than its output. This results in a market
and profit driven product development process rather.

• Due to its market orientation target costing can consider long-term

corporate strategies in the market. Variable costing and activity based
costing tend to focus more on short term goals.

• Due to its specific purpose target costing tends to provide decision

relevant data, while traditional absorption costing models tend to document
all cost, independent of the decision making relevance. “

• Application of Technique to Coverdrive

We would need to compare our original estimated cost of a product to target

cost.

If this was greater than target we would need to reconsider design and possibly
reduce associated expenses or examine our decision to offer the product.

This could involve re-examining processes to introduce cost reducing

efficiencies.

• Target Cost Profile

Product: Driver Supreme

Price / Cost Element % Per Unit

Factor Factor
£
Target Price 90.00
Profit Margin 20% 18.00
72.00
Selling, distribution and admin 10% 7.20
64.80
Overheads * 30% 19.44
Target Cost (Direct) £45.36

Labour and material applied

* on activity based costing technique
TARGET COSTING
 The target costing process integrates many activities and tasks. The target
costing team needs to be drawn from disciplines within the company to include:
finance, manufacturing, purchasing and marketing.

We need, as with our budgetary control mechanism, a participative approach to

target cost management.

• Conclusion

Although the technique in its simplest form is merely a model – target price
minus profit margin = target cost, todays highly competitive market place and
external environment can make the technique a strategic management tool. It
can be incorporated into our management accounting portfolio and provide the
company with economic value added and strategic benefit. It will allow us to
focus on the use of limited resources to maximise opportunity to achieve target
return on investment.

Readers are also referred to A Practical Guide to Target Costing by

Frank Robinson (a CIMA publication)

TARGET COSTING