2.2

Target Costing

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

2.4

Implementing Target Costing

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.

2.5

Case

Swedish retailer Ikea continues to dominate the home furniture market with more than 300 stores across 35 countries at the end of 2009. The "Ikea concept" as defined on the company website www.ikea.com is "based on offering a wide range of well designed functional home furnishing products at prices so low as many people as possible will be able to afford them."

Ikea is widely known for pricing products at 30-50% below the price charged by competitors. Extracts from the website outline how the company has successfully employed a strategy of target pricing:

"While most retailers use design to justify a higher price, IKEA designers work in exactly the opposite way. Instead they use design to secure the lowest possible price. IKEA designers design every IKEA product starting with a functional need and a price. Then they use their vast knowledge of innovative, low-cost manufacturing processes to create functional products, often coordinated in style. Then large volumes are purchased to push prices down even further.

Most IKEA products are also designed to be transported in flat packs and assembled at the customer's home. This lowers the price by minimising transportation and storage costs. In this way, the IKEA Concept uses design to ensure that IKEA products can be purchased and enjoyed by as many people as possible."

3.1.1

Example 1

A company has designed a new product. NP8. It currently estimates that in the current market, the product could be sold for $70 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 NP8.

Required:

Calculate:
(a)     the expected cost of Product NP8;
(b)    the target cost for NP8;
(c)     the size of the cost gap.

Solution:

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

3.2.2

Commend methods of closing the target cost gap

(a)       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.
(b)       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.
(c)       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.
(d)       To train staff in more efficient techniques and working methods. Improvements in efficiency will reduce costs.
(e)       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.
(f)        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 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.

3.3.1

Benefits of Target Costing

(a)       The organisation will have an early external focus to its product development. Businesses have to compete with others (competitors) and an early consideration of this will tend to make them more successful. Traditional approaches (by calculating the cost and then adding a margin to get a selling price) are often far too internally driven.
(b)       Only those features that are of value to customers will be included in the product design. Target costing at an early stage considers carefully the product that is intended. Features that are unlikely to be valued by the customer will be excluded. This is often insufficiently considered in cost plus methodologies.
(c)       Cost control will begin much earlier in the process. If it is clear at the design stage that a cost gap exists then more can be done to close it by the design team. Traditionally, cost control takes place at the ‘cost incurring’ stage, which is often far too late to make a significant impact on a product that is too expensive to make.
(d)       Costs per unit are often lower under a target costing environment. This enhances profitability. Target costing has been shown to reduce product cost by between 20% and 40% depending on product and market conditions. In traditional cost plus systems an organisation may not be fully aware of the constraints in the external environment until after the production has started. Cost reduction at this point is much more difficult as many of the costs are ‘designed in’ to the product.
(e)       It is often argued that target costing reduces the time taken to get a product to market. Under traditional methodologies there are often lengthy delays whilst a team goes ‘back to the drawing board’. Target costing, because it has an early external focus, tends to help get things right first time and this reduces the time to market.

Total production overhead

Total assembly labour hours

$

Month 1

620,000

19,000

Month 2

700,000

23,000