The Institute of Finance Management

Department Accounting and Finance

Lecture Notes
Management Accounting
Targeting Costing
Instructor: Dr Zawadi Ally

Learning Objectives
After studying this chapter, readers will be able to understand
• Explain what is meant by the term ‘target cost’
• Derive a target cost in manufacturing and service industries
• Explain the difficulties of using target costing in service industries
• Describe the target cost gap
• Suggest how a target cost gap might be closed

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1.1 Introduction
Target costing is a technique which developed in the early 1970s in Japan’s manufacturing
industry as consumer demand for more diversified products and shorter product life cycles made
the development and planning stages of new products more important. At the same time
increased automation and decreased labour costs made standard costing less important as the
main method of cost management within manufacturing companies.

It began with the recognition that customers were demanding more diversity in the products that they
bought, and the life cycles of products were getting shorter. This meant that new products had to be
designed more frequently to meet customer demands

A target cost involves setting ‘a product cost estimate by subtracting a desired profit margin from
a competitive market price. Sakurai (1989) defines target costing 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, marketing, and accounting departments’.
A target cost is the allowable amount of cost that can be incurred on a product and still earn the
required profit from that product

It important to manage costs before products have been produced because nearly 80% of the
costs of many products are committed at the design stage. Therefore, the best opportunity to
reduce costs is during design and not after a product is being manufactured.
Target costing occurs within the product development cycle. This means it starts when a product
is in its concept stages and ends when a product has been released for manufacturing

Target Costing

Target costing involves setting a target cost by subtracting a desired profit margin from a
competitive market price.

Target costing is used mainly for new product development. This is because whenever a new
product is designed and developed for a competitive market, a company needs to know what the
maximum cost of the new product must be so that it will sell at a profit.

1.2 The steps involve in deriving a target cost

There are a number of steps in the process of deriving target costing,
1. Estimate a selling price for a new product that considers how much competitors are charging
and how much customers are willing to pay. This selling price will enable a firm to capture a
required share of the market.
2. Reduce this figure by the firm’s required level of profit.
3. Produce a target cost figure for product designers to meet.
4. Reduce costs to provide a product that meets that target cost

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1.3 Steps in the implementation of the target costing process.
Step 1: Determine a product specification of which an adequate sales volume is estimated.
Step 2: Set a selling price at which the organization will be able to achieve a desired market share.
Step 3: Estimate the required profit based on return on sales or return on investment.
Step 4: Calculate the target cost = target selling price – target profit
Step 5: Compile an estimated cost for the product based on the anticipated design specification and
current cost levels.
Step 6: Calculate target cost gap = estimated cost – target cost.
Step 7: Make efforts to close the gap. This is more likely to be successful if efforts are made to design
out costs prior to production, rather than to control out costs during the production phase.
Step 8: Negotiate with the customer before making the decision about whether to go ahead with the
project.

1.4 Closing the target cost gap

Once an overall target cost has been established for the product, it is necessary to identify the gap
between the target cost and the estimate of the cost to build the product based on current
processes, suppliers, productivity levels and materials. The gap gives an estimate of the excess
cost which must be taken out of the new product.

It should be noted that, the target cost gap is established in step 4 of the target costing process. It
is the difference between what an organization thinks it can currently make a product for, and
what it needs to make it for, in order to make a required profit

Target cost gap = Estimated product cost – Target cost

Hence: The alternative product designs should be examined for potential areas of cost reduction
that will not compromise the quality of the products.
This process is known as ‘value analysis’. Attention should be focused more on reducing the
costs of features perceived by the customer not to add value.

1.5 Key characteristics of successful target costing

• Target costing focuses on the customer: Customer requirements for quality, cost and time are
incorporated into the product decisions and guide the analysis of costs.
• Emphasis on cost reduction at early stages in product development: Target costing starts at
the earliest stage in new product development. This often means initial designs are simplified
before manufacture, resulting in lower costs and time-to-market once the design is finalized.
• Consideration of the whole product life-cycle: In order to ensure that total costs are
minimized for both the producer and the customer, successful target costing examines the full
life-cycle cost of the product
• A multidisciplinary process: target costing is the multidisciplinary nature of the process and
the importance of the involvement of all functions in the analysis and decision-making.
Responsibility for achieving targets must also be shared across functions.
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1.6 Target costing in service organizations
Target costing is as relevant to the service sector as the manufacturing sector. There are some
ways in which target costing can be applied to service-oriented businesses. For service
businesses the focus is the service delivery system. Although, the key issues – understanding the
needs of the market, customers and users, and ensuring satisfactory financial performance at a
given cost or price which does not exceed the target cost – remain.

1.6 Advantages of target costing

A primary reason why firms use target costing is to plan or project the costs of products before
they are introduced, and to ensure that low-margin products are not introduced which do not
bring sufficient returns
However, there are additional purposes for which companies have introduced target costing
which vary from company to company which include the followings

• Target costing is more flexible than traditional standard costing, so targets can change/reduce
from time to time
• Target costing takes into account the competitive market and the price customers are
prepared to pay. Hence target costing focus on external rather than traditional standard
costing focus on internal costs only
• Target costing is flexible for cost reduction and control while Standard costs are too rigid for
cost reduction and control
• Targeting costing is used as a cost reduction technique, unlike standard costing, should
incorporate a learning effect
• Target costing usually involves other techniques, such as value analysis and value
engineering, which should simplify production methods and reduce costs
• Target costing is a tool which can be used to control decisions such as design specifications
and production techniques
• Staff can be highly motivated by target costing if used correctly. It helps to break down any
artificial functional barriers as staff at all levels and in all functions are involved
• To encourage a focus on the customer: Target costing is, by nature, market-driven. It
therefore stimulates behaviour which is customer-focused and encourages all functions
within the company to respond to market demand and competitive trends rather than internal
performance indicators
• The discipline of target costing and the detailed review of costs can reveal more general
managerial problems
• Targeting costing is a driver for cost improvement

1.7 Difference between target costing and cost plus pricing

Target Costing Cost Plus Pricing
Competitive market considerations drive cost Market considerations not part of cost planning
planning
Prices determine costs. Costs determine price.
Design is key to cost reduction Waste and inefficiency is focus of cost
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 reduction efforts
Customer input guides cost reduction Cost reduction is not customer driven.
Supplier involved early. Suppliers involved after product designed
Uses cross-functional teams to manage costs Cost accountants are responsible for cost
reduction.
Minimizes cost of ownership to customer Minimizes initial price paid by customer.
Involves the value chain in cost planning. Little or no involvement of value chain in cost
planning

1,8 Comprehensive Example

A company has designed a new product. BXM. It currently estimates that in the current market,
the product could be sold for Shs 700 per unit. A gross profit margin of at least 30% on the
selling price would be required, to cover administration and marketing overheads and to make an
acceptable level of profit.

A cost estimation study has produced the following estimate of production cost for BXM
Cost item
Direct material X Shs 90 per unit
Direct material Y Each unit of product BXM will require three kgs of material X, but
there will be loss in production of 10% of the material used. Material
Y costs Shs 18 per kg..
Direct labour Each unit of product BXM will require 0.50 hours of direct labour
time. However it is expected that there will be unavoidable idle time
equal to 5% of the total labour time paid for. Labour is paid Shs 190
per hour.
Production overheads It is expected that production overheads will be absorbed into
product costs at the rate of Shs 600 per direct labour hour, for each
active hour worked. (Overheads are not absorbed into the cost of
idle time.)

REQUIRED:

Calculate:
(a) The expected cost of Product BXM;
(b) The target cost for BXM;
(c) The size of the cost gap.

Solution:

(a) Expected cost per unit Shs Shs

Direct material X 90
Direct material Y: 3 kgs x 100/90 x shs 18 60
Direct labour: 0.5 hours x 100/95 x shs 190 100
Production overheads: 0.5 hours x Shs 600 300

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Expected full cost per unit 550
(b) Target cost
Sales price 700
Minimum gross profit margin (30% x Shs 700) (210)
Target cost 490
(c) Cost gap 60

The company needs to identify ways of closing this cost gap.

1.9 Closing the Target Cost Gap

Target costs are rarely achievable immediately and ways must be found to reduce costs and close
the cost gap
• To re-design products to make use of common processes and components that are already
used in the manufacture of other products by the company.
• To discuss with key suppliers methods of reducing materials costs. Target costing involves
the entire ‘value chain’ from original suppliers of raw materials to the customer for the end-
product, and negotiations and collaborations with suppliers might be an appropriate method
of finding important reductions in cost.
• To eliminate non value-added activities or non-value added features of the product
design. Something is ‘non-value added’ if it fails to add anything of value for the customer.
The cost of non-value-added product features or activities can therefore be saved without any
loss of value for the customer. Value analysis may be used to systematically examine all
aspects of a product cost to provide the product at the required quality at the lowest possible
cost.
• To train staff in more efficient techniques and working methods. Improvements in
efficiency will reduce costs.
• To achieve economies of scale. Producing in larger quantities will reduce unit costs because
fixed overhead costs will be spread over a larger quantity of products. However, production
in larger quantities is of no benefit unless sales demand can be increased by the same
amount.
• To achieve cost reductions as a result of the learning curve or, more likely, the experience
curve effect. The learning curve is most likely to exist in a labour-intensive environment.
It results in cost savings as labour becomes more familiar with performing a new and
complex task. The experience curve effect relates to cost savings made in costs other than
labour costs as the company becomes more familiar with the production of a new product.
For example, management of the process and marketing may become more efficient as the
company gains experience of making and selling the product