Strategic Cost Management
Target costing
Part A: Discussion of basic theories including (i) definition
of target cost and target costing, (ii) process and steps of computation of
target cost, and (iii) applications of target costing.
Part B: Three Illustrations with Solutions.
Part A
Introduction
Target
costing is an approach to determine a product's life-cycle cost which
should be sufficient to develop specified functionality and quality, while
ensuring its desired profit. It involves setting
a target cost by subtracting a desired profit margin from a competitive market
price. A target cost is
the maximum amount of cost that can be incurred on a product ensuring that the
firm can still earn the required profit margin from that product at a particular
selling price. Target costing decomposes the target cost from
product level to component level. Through this decomposition target costing
spreads the competitive pressure faced by the company to product's designers
and suppliers. Target costing consists of cost planning in the design phase of
production as well as cost control throughout the resulting product life cycle.
The cardinal rule of target costing is to never exceed the target cost.
However, the focus of target costing is not to minimize costs, but to achieve a
desired level of cost reduction determined by the target costing process.
Definition
Target costing is defined as "a disciplined
process for determining and achieving a full-stream cost at which a proposed
product with specified functionality, performance, and quality must be produced
in order to generate the desired profitability at the product’s anticipated
selling price over a specified period of time in the future.” This definition encompasses the following two
principal concepts:
1.
Products should be based on an accurate assessment of the wants and
needs of customers in different market segments, and
2.
Cost targets should be what result after a sustainable profit margin is
subtracted from what customers are willing to pay at the time of product
introduction and afterwards.
From
the above definition it can be said that,
|
Target cost of a product = |
|
Competitive market price of the product –
Desired profit margin from the product |
The
fundamental objective of target costing is to manage the business to be
profitable in a highly competitive marketplace. In effect, target costing is a
proactive cost planning, cost management and cost reduction practice whereby
costs are planned and managed out of a product and business early in the design
and development cycle, rather than during the later stages of product
development and production.
History
Target
costing was developed independently in both USA and Japan in different time
periods. Target costing was adopted earlier by American companies to reduce
cost and improve productivity, such as Ford Motor from 1900s, American Motors
from 1950s-1960s. Although the ideas of target costing were also applied by a
number of other American companies including Boeing, Caterpillar, Northern
Telecom, few of them apply target costing as comprehensively and intensively as
top Japanese companies such as Nissan, Toyota, Nippondenso. Target costing
emerged from Japan from 1960s to early 1970s with the particular effort of
Japanese automobile industry, including Toyota and Nissan. It did not receive
global attention until late 1980s to 1990s when some authors such as Monden
(1992), Sakurai (1989), Tanaka (1993), and Cooper (1992) described the way that
Japanese companies applied target costing to thrive in their business (IMA
1994). With superior implementation systems, Japanese manufacturers are more
successful than the American companies in developing target costing. Traditional
cost-plus pricing strategy has been impeding the productivity and profitability
for a long time. As a new strategy, target costing is replacing traditional
cost-plus pricing strategy by maximizing customer satisfaction by accepted
level of quality and functionality while minimizing costs.
Process of target costing
The process of target costing can be divided
into three sections: the first section involves
in market-driven
target costing, which focuses on studying market conditions to
identify a product's allowable cost in order to meet the company's long-term
profit at expected selling price; the second
section involves in product-level target costing, which includes
performing cost reduction strategies with the product designer's effort and
creativity to identify the product-level target cost; the
third section is component-level target costing which decomposes
the production cost to functional and component levels to transmit cost responsibility
to suppliers.
Market-driven target costing
Market driven target costing is the first section in
the target costing process which focuses on studying market conditions and determining
the company's profit margin in order to identify the allowable cost of a
product. Market driven costing can go through 5
steps as follows:
1. Establish company's long-term sales and profit
objective;
2. Develop the mix of products;
3. Identify target selling price for each product;
4. Identify profit margin for each product; and
5. Calculate allowable cost of each product.
Company's
long-term sales and profit objectives are developed from an extensive analysis
of relevant information relating to customers, market and products. Only
realistic plans are accepted to proceed to the next step. Product mix is
designed carefully to ensure that it satisfies many customers, but also does
not contain too many products to confuse customers. Company may use simulation
to explore the impact of overall profit objective to different product mixes
and determine the most feasible product mix. Target selling price, target
profit margin and allowable cost are identified for each product. Target
selling price need to consider to the expected market condition at the time
launching the product. Internal factors such as product's functionality and
profit objective, and external factors such as company's image or expected
price of competitive products will influence target selling price. Company's
long-term profit plan and life-cycle cost are considered when determining
target profit margin. Firms might set up target profit margin based on either
actual profit margin of previous products or target profit margin of product
line. Simulation for overall group profitability can help to make sure achieving
group target. Subtracting target profit margin from target selling price
results in allowable cost for each product. Allowable cost is the cost that can
spend on the product to ensure meeting profit target if selling it at target
price. It is the signal about the magnitude of cost saving that team need to
achieve.
Product-level target costing
Following
the completion of market-driven costing, the next task of the target costing
process is product-level target costing. Product-level target costing concentrates
on designing products that satisfy the company's customers at the allowable
cost. To achieve this goal, product-level
target costing is typically divided into three steps as shown below.
The first step is to set a product-level target cost. Since the
allowable cost is simply obtained from external conditions without considering
the design capabilities of the company as well as the realistic cost for
manufacturing, it may not be always achievable in practice. Thus, it is
necessary to adjust the unachievable allowable cost to an achievable target
cost that the cost increase should be reduced with great effort. The second step is to discipline this target
cost process, including monitoring the relationship between the target cost and
the estimated product cost at any point during the design process, applying the
cardinal rule so that the total target costs at the component-level does not
exceed the target cost of the product, and allowing exceptions for products
violating the cardinal rule. For a product exception to the cardinal rule, two
analyses are often performed after the launch of the product. One involves
reviewing the design process to find out why the target cost was unachieved.
The other is an immediate effort to reduce the excessive cost to ensure that
the period of violation is as short as possible. Once the target cost-reduction
objective is identified, the product-level target costing comes to the final step, finding ways to achieve it.
Engineering methods such as value engineering (VE), design for manufacture and
assembly (DFMA), and quality function deployment (QFD) are commonly adopted in
this step.
Component-level target costing
Value engineering (VE), also known as value analysis (VA), plays a
crucial role in the target costing process, particularly at the product level
and the component level. VE not only attempts to reduce costs, but also aims to
improve the functionality and quality of products. There are a variety of
practical VE strategies, including zero-look, first-look and second-look VE
approaches, as well as teardown approaches.
Summary Steps in Target Costing
The steps in Target Costing are:
|
Step 1 |
Identify the market requirements as regards
design, utility and need for a new product or improvements of existing
product. |
|
Step 2 |
Set Target Selling Price based on customer
expectations and sales forecasts. |
|
Step 3 |
Set Target Production Volumes based on
relationships between price and volume. |
|
Step 4 |
Establish Target Profit Margin for each
product, based on the company’s long term profit objectives, projected volumes, and course of action, etc. |
|
Step 5 |
Set Target Cost (or Allowable cost) per unit, for
each product. Target cost = Target selling price less Target profit margin. |
|
Step 6 |
Determine Current Cost of producing the new
product, based on
available resources and conditions. |
|
Step 7 |
Set cost reduction Target in order to reduce the
Current Cost to the Target Cost. |
|
Step 8 |
Analyze the Cost Reduction Target into various
components and identify cost reduction opportunities using Value Engineering
(VE) and Value Analysis (VA) and Activity Based Costing (ABC). |
|
Step 9 |
Achieve cost reduction and Target profit
by Effective Implementation of Cost Reduction decisions. |
|
Step 10 |
Focus on further possibilities of cost reduction
i.e. Continuous Improvement program. |
Regarding
the complexity of problems in the real world, implementing the target costing
process often relies on the computer simulation to reproduce stochastic
elements. For example, many firms use simulation to study the complex
relationship between selling prices and profit margins, the impact of
individual product decisions on overall group profitability, the right mix of
products to enhance overall profit, or other economic modelling to overcome
organizational inertia by getting the most productive reasoning. In addition,
simulation helps estimate results rapidly for dynamic process changes.
Factors affecting target costing
The
factors influencing the target costing process is broadly categorized based on
how a company's strategy for a product's quality, functionality and price
change over time. However, some factors play a specific role based on what
drives a company's approach to target costing.
Factors influencing market-driven
costing
Intensity
of competition and nature of the customer affect market-driven costing. Competitors
introducing similar products have been shown to drive rival companies to expend
energy on implementing target costing systems such as in the case of Toyota and
Nissan or Apple and Google. The costing process is also affected by the level
of customer sophistication, changing requirements and the degree to which their
future requirements are known. The automotive and camera industry are prime
examples for how customers affect target costing based on their exact
requirements.
Factors influencing product-level
costing
Product strategy and product characteristics affect
product-level target costing. Characteristics of product strategy such as
number of products in line, rate of redesign operations and level of innovation
are shown to have an effect. Higher number of products has a direct correlation
with the benefits of target costing. Frequent redesigns lead to the
introduction of new products that have created better benefits to target
costing. It has to be noted that the value of historical information reduces
with greater innovation, thereby, reducing the benefits of product level target
costing.
The
degree of complexity of the product, level of investments required and the
duration of product development process make up the factors that affect the
target costing process based on product characteristics. Product viability is
determined by the aforementioned factors. In turn, the target costing process
is also modified to suit the different degrees of complexity required.
Factors influencing component-level
costing
Supplier-Base
strategy is the main factor that determines component-level target costing
because it is known to play a key role in the details a firm has about its
supplier capabilities. There are three characteristics that make up the
supplier-base strategy, including the degree of horizontal integration, power
over suppliers and nature of supplier relations. Horizontal integration
captures the fraction of product costs sourced externally. Cost pressures on
suppliers can drive target costing if the buying power of firms is high enough.
In turn, this may lead to better benefits. More cooperative supplier relations
have been shown to increase mutual benefits in terms of target costs
particularly at a component level.
Applications
Aside
from the application of target costing in the field of manufacturing, target
costing are also widely used in the following areas.
Energy
An
Energy Retrofit Loan Analysis Model has been developed using a Monte Carlo (MC)
Method for target costing in Energy Efficient buildings and construction. MC
method has been shown to be effective in determining the impact of financial
uncertainties in project performance.
Target
Value Design Decision Making Process (TVD-DMP) groups a set of energy
efficiency methods at different optimization levels to evaluate costs and
uncertainties involved in the energy efficiency processes. Some major design
parameters are specified using these methods including Facility Operation
Schedule, Orientation, Plug load, HVAC and Lighting systems.
The
entire process consists of three phases: initiation, definition and alignment.
Initiation stage involves developing a business case for energy efficiency
using target value design (TVD) training, organization and compensation. The
definition process involves defining and validating the case by tools such as
values analysis and bench marking processes to determine the allowable costs.
By setting targets and designing the design process to align with those
targets, TVD-DMP has been shown to achieve a high level of collaboration needed
for energy efficiency investments. This is done by using risk analysis tools,
pull planning and rapid estimating processes.
Healthcare
Target
costing and target value design have applications in building healthcare
facilities including critical components such as Neonatal Intensive Care Units (NICUs).
The process is influenced by unit locations, degree of comfort, number of
patients per room, type of supply location and access to nature. According to
National Vital Statistics Reports, 12.18% of 2009 births were premature and the
cost per infant was $51,600. This led to opportunities for NICUs to implement
target value design for deciding whether to build a single-family room or more
open-bay NICUs. This was achieved using set-based design analysis which
challenges the designer to generate multiple alternatives for the same
functionality. Designs are evaluated keeping in mind the requirements of the
various stakeholders in the NICU including nurses, doctors, family members and administrators.
Unlike linear point-based design, set-based design narrows options to the
optimal one by eliminating alternatives simultaneously defined by user
constraints.
Construction
About
15% construction project in Japan adopted target costing for their cost
planning and management as recognized by Jacomit (2008). In the U.S., target
costing research has been carried out within the framework of lean construction
as target value design (TVD) method and has been disseminated widely over
construction industry in recent years. Research has proven that if being
applied systematically, TVD can deliver a significant improvement in project
performance with average reduction of 15% in comparison with market cost. TVD
in construction project considers the final cost of project as a design
parameter, similar to the capacity and aesthetics requirements for the project.
TVD requires the project team to develop a target cost from the beginning. The project
team is expected not to design exceeding the target cost without the owner's
approval, and must use different skills to maintain this target cost. In some
cases, the cost can increase but the project team must commit to decrease and
must try their best to decrease without impacting on other functions of the
project.
Part B
Strategic Cost Management
Target Costing
Selected Problems
Illustration: 1
Bengal Manufacturing Company
sells its product at Rs 1,000 per unit. Due to competition, its competitors are
likely to reduce price by 15%. B wants to respond aggressively by cutting price
by 20% and expects that the present volume of 1, 50,000 units p.a. will increase
to 2, 00,000. B wants to earn a 10% target profit on sales based on following
estimates:
|
Particulars |
Existing (Rs) |
Target (Rs) |
|
D/M Cost p. u. |
400 |
385 |
|
D/L Cost p. u. |
55 |
50 |
|
Machine Cost p. u. |
70 |
60 |
|
Mfg Cost p. u. |
525 |
495 |
|
Mfg Overheads: |
|
|
|
No of orders (Rs 80 per order) |
22,500 |
21,250 |
|
Testing hours (Rs 2 per hour) |
45,00,000 |
30,00,000 |
|
Units reworked (Rs 100 per unit) |
12,000 |
13,000 |
Manufacturing overheads
are allocated using relevant cost drivers. Other operating costs for the
expected volume are estimated as follows:
|
|
Rs |
|
Research and
Design (p. u.) |
50 |
|
Marketing and
Customer Service (p. u.) |
130 |
|
|
180 |
Required:
(i)
Calculate target costs per unit and total target
costs for the proposed volume showing break up of different elements.
(ii) Prepare target
product profitability statement.
Illustration: 2
ABC Enterprises has
prepared a draft budget for the next year follows:
|
Quantity (units) |
10,000 |
|
|
(Rs) |
|
Sales price p. u. |
30 |
|
Variable
costs p. u.: |
|
|
Direct Materials |
8 |
|
Direct Labour |
6 |
|
Variable Overheads [Rs 0.50 × 2 hrs] |
1 |
|
Contribution p. u. |
15 |
|
Budgeted Total Contribution |
1,50,000 |
|
Budgeted Fixed Costs |
1,40,000 |
|
Budgeted Profit |
10,000 |
The Board of Directors
is dissatisfied with this budget, and asks working party to come up with
alternate budget with higher target profit figures.
The working party
reports back with the following suggestions that will lead to a budgeted profit
of Rs 25,000. The company should spend Rs
28,500 on advertising, & set the target sales price up to Rs 32 per unit.
It is expected that the sales volume will also rise, in spite of the
price rise, to 12,000 units.
In order to achieve the extra
production capacity, however, the workforce must be able to reduce the time
taken to make each unit of the product. It is proposed
to offer a pay and productivity deal in which the wage rate per hour is increased to Rs 4. The
hourly rate for variable overhead will be unaffected.
Ascertain the
target labour time required to achieve the target profit.
Illustration: 3
You are the manager
of a paper mill (M Ltd) and have recently come across a particular type of
paper, which is being sold at a substantially lower rate by another
company – ABC Ltd than the price charged by your own mill. The value chain for one tonne of such
paper for ABC Ltd is as follows:
ABC Ltd. → Merchant → Printer → Customer
ABC Ltd sells this
particular paper to the merchant at the rate of Rs 1,466 per tonne. ABC Ltd
pays for the freight which amounts to Rs 30 per tonne.
Average returns and
allowances amount to 4% of sales and approximately equal to Rs 60 per tonne.
The value chain of your
company, through which the paper reaches the ultimate customer, is similar to
that of ABC Ltd. However, your mill does not sell directly to the merchant, the
latter receiving the paper from a huge distribution centre maintained by your
company at Haryana. Shipment costs from the mill to the Distribution Centre amount
to Rs 11 per tonne while the operating costs in the Distribution Centre have
been estimated to be Rs 25 per tonne. The return on investments required by the
Distribution Centre for the investments made amount to an estimated Rs 58 per tonne.
You are required to
compute the “Target manufacturing cost per tonne” for this particular paper for
your company. You may assume that the return on the investment expected
by your company equals to Rs 120 per tonne of such paper.
Click here for Solution: 3 in PDF
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