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CHAPTER 2B: TARGET COSTING

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OVERVIEW
What will you learn?

TARGET COSTING

I. Overview of target costing

II. Closing a target cost gap

III. Target costing in service industry

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I. OVERVIEW OF TARGET COSTING

1. What is target costing?

Under traditional costing method: To sell product or service, target costing

1. Firstly, cost is always determined method is used. Under this method:
2. Secondly, expected profit is set 1. Firstly, selling price is set based on
3. Finally, selling price is formed market price
2. Secondly, identify required profit
But this method is no longer suitable in margin
competitive market. 3. Finally, target cost is formed

Traditionally Target costing

Step 1: Step 1: Identify

Identify cost selling price
Step 3: Step 3:
Determine Determine
selling price target cost
Step 2: Step 2: Set
Set expected profit expected profit
(% mark-up cost) (% mark-up cost)

Note: There is a difference between a mark-up and a margin

• A mark-up is the profit expressed as a percentage of cost (cost is 100%)
• A margin is the profit expressed as a percentage of the sales price (sales is 100%)
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I. OVERVIEW OF TARGET COSTING

1. What is target costing?

Thus, target costing was born.

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

Target cost is the cost at which a product must be produced and sold in order to
achieve the required amount of profit at the target selling price.

When a product is first planned, its estimated cost will often be higher than its target
cost.

The aim of target costing is then to find ways of closing this target cost gap and
producing and selling the product at the target cost.

Achieving a target cost will usually require some redesigning of the product and the
removal of unnecessary costs. Target costing therefore encourages a business to
examine its processes and costs carefully.
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I. OVERVIEW OF TARGET COSTING

2. Implementing target costing

Target costing is carried out through 7 steps:

1 Define product specification and estimate sales volume (if any)

2 Decide a target selling price

3 Estimate required profit based on profit margins or return on investment

4 Calculate target cost = Target selling price (step 2) - Target profit (step 3)

Estimate cost for the product based on the product specification and
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current cost levels

6 Calculate target cost gap = Estimated cost (step 5) - Target cost (step 4)

7 Make efforts to close the cost gap (see section II)

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I. OVERVIEW OF TARGET COSTING

2. Implementing target costing

Example 1 (Question)

SAP Co produces rabbit hutches. It is about to launch a new top of the range
hutch which it believes can be sold for $125. SAP Co demands a margin of 25% on
sales.
Cost information for the new hutch is as follows:
• Timber: The hutch needs 10 metres (m) of good quality planed timber. SAP
Co can acquire this at a cost of $48
• Felt roofing material: 2m2 are required. Roofing material costs $17.50/m2
• Wire: 1m of wire is needed at a cost of $1.50 per metre
• Labour: 2 hours are required. Labour is paid at a rate of $7/hour
• Variable overhead: These will be incurred at a rate of $1.50 per labour hour.
Required: Calculate the target cost gap of the new product.
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I. OVERVIEW OF TARGET COSTING

2. Implementing target costing

Example 1 (Answer)

Step 1: Define product specification and estimate sales volume (if any)
Product is rabbit hutch, which is made from timber, felt and wire.
Sales volume: no information is mentioned in the question.

Step 2: Decide a target selling price

Target selling price is $125

Step 3: Estimate required profit based on profit margins or return on

investment
Profit is required at a margin 25% on sales.
So, target profit = 25% x $125 = $31.25

Step 4: Calculate target cost

Target cost = Target selling price (step 2) - Target profit (step 3)
= $125 - $31.25 = $93.75
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I. OVERVIEW OF TARGET COSTING

2. Implementing target costing

Example 1 (Answer)

Step 5: Estimate cost for the product based on the product specification and
current cost levels

Estimated costs $
Timber 48.0
Felt roofing material [17.5 x $2] 35.0
Wire [1 x $1.5] 1.5
Labour [2 x $7] 14.0
Variable overhead [2 x $1.5] 3.0
Total 101.5

Step 6: Calculate target cost gap

Target cost gap = Estimated cost (step 5) - Target cost (step 4)
= $101.5 - $93.75 = $7.75
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II. CLOSING A TARGET COST GAP

Value analysis
To close a target cost gap, it is important to understand which features of the product
are essential for customers and to maintain product quality. This is known as value
analysis.

Value analysis involves examining the factors which affect the cost of a product or
service, so as to come up with ways of achieving the intended purpose most
economically at the required standards of quality and reliability.

Value can be viewed from a number of different perspectives:

Cost value Exchange value Use value Esteem value

The cost of The market value The purposes it The prestige the
producing and of the product or fulfils (performance, customer attaches
selling an item service reliability) to the product

Value analysis seeks

• to refine the design of the product to reduce unit cost
• to provide the same use value at the lowest cost
• to maintain or enhance the esteem value of a product at the lowest cost
The aim of value analysis is to reduce cost without compromising other aspects of value.
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II. CLOSING A TARGET COST GAP

Techniques can be used to improve production processes
Management can then set benchmarks for improvement towards the target cost, by
improving production technologies and processes, such as:

Reduce the number of components

Use cheaper staff (where this does not affect quality)

Use standard components wherever possible

Acquire new, more efficient technology

Training staff in more efficient techniques

Cut out non-value added activities

Use different materials (identified through activity analysis that is an analysis of

how much is being spent on particular activities)
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II. CLOSING A TARGET COST GAP

Techniques can be used to improve production processes

Example 2 (Question)

SAP Co produces rabbit hutches. It is about to launch a new top of the range
hutch which it believes can be sold for $125. SAP Co demands a margin of 25% on
sales.

Cost information for the new hutch is as follows:

• Timber: The hutch needs 10 metres (m) of good quality planed timber. SAP
Co can acquire this at a cost of $48
• Felt roofing material: 2m2 are required. Roofing material costs $17.50/m2
• Wire: 1m of wire is needed at a cost of $1.50 per metre
• Labour: 2 hours are required. Labour is paid at a rate of $7/hour
• Variable overhead: These will be incurred at a rate of $1.50 per labour hour.

Required:
From Example 1 result, target cost gap = $7.75
Recommend appropriate strategies for House Co to close the cost gap.
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II. CLOSING A TARGET COST GAP

Techniques can be used to improve production processes

Example 2 (Answer)

As above mention, raising the selling price is not an appropriate strategy for
closing the cost gap.

As rabbit hutch is a top new product, its quality depends on main material and
skill labour. Thus, there is a risk that using lower quality timber and labour
would be likely to reduce the quality of the finished product and so would not be
suitable strategies here.

SAP Co could consider some following strategies:

• Make the hutch smaller
• Make the window bigger which helps to increase the proportion of wire
and reduce the proportion of wood
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III. TARGET COSTING IN SERVICE INDUSTRIES

Services industries and problems with target costing

Services are any activity or benefit that one party can offer to another that is essentially
intangible and does not result in the ownership of anything. Its production may or may not be
tied to a physical product.

Unlike manufacturing, service industries have the following characteristics which make cost and
performance measurement more difficult:

Characteristic Explanation Problem with target costing

Some of the features of service cannot be

Unlike goods, there are no properly specified, so it is difficult to know
substantial material or physical what a customer receive exactly
Intangibility
aspects to a service: no taste, When services do not have any material
feel, visible presence, and so on content, it is not possible to reduce costs
to a target level by reducing material costs

Services are created at the same

Inseparability
time as they are consumed

When services are variable, it is possible

It is difficult to maintain
to calculate an estimated average cost,
Variability consistency in the standard of
but this is not specific and so not ideal for
service offered
target costing

Perishability Services are innately perishable

As service has no physical

No transfer of
aspects, it cannot transfer
ownership
ownership as goods or property