Target costing
1 Introduction
An important reason for calculating the cost of the product or service is in order to decide on a selling price. There is a chapter later in these notes that covers pricing decisions in detail, but traditionally a very common approach to determining a selling price has been to take the cost and then add on a profit percentage.
One problem with this approach is that it can clearly result in a price that is unacceptable to customers and at the same time provides no direct incentive to cut costs.
Target costing is a more modern and more market driven approach.
2 Target costing
2.1 The steps involved are:
From research of the market determine a selling price at which the company expects to achieve the desired market share (the target selling price)
Determine the profit required (e.g. a required profit margin, or a required return on investment)
Calculate the maximum cost p.u. in order to achieve the required profit (the target cost)
Compare the estimated actual costs with the target cost. If the actual cost is higher than the target cost then look for ways of reducing costs. If no way can be found of meeting the target cost then the product should not be produced.
Packard plc are considering whether or not to launch a new product. The sales department have determined that a realistic selling price will be $20 per unit.
Packard have a requirement that all products generate a gross profit of 40% of selling price.
Calculate the target cost.
Hewlett plc is about to launch a new product on which it requires a pre-tax ROI of 30% p.a..
Buildings and equipment needed for production will cost $5,000,000.
The expected sales are 40,000 units p.a. at a selling price of $67.50 p.u..
Calculate the target cost.
3 The use of the target cost
Once the target cost has been determined, it will be compared with the estimated actual cost of production. The excess of the actual cost over the target cost is known as the target cost gap, and the company will then be looking for ways of closing this gap.
The selling price comes from the market, so raising it is not a way of closing a cost gap — that is a favourite wrong answer. The gap is closed by taking cost out of the product, or by the company accepting a lower return than it first required.
4 Possible ways of attempting to close the target cost gap
5 Target costing in service industries
It is much more difficult to use target costing in service industries due to the characteristics of service businesses.
5.1 The five major characteristics that distinguish services from manufacturing are:
Intangibility
Inseparability / Simultaneity
Variability / heterogeneity
Perishability
No transfer of ownership
Target costing
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