Target Costing
1 Introduction
This chapter covers two of the three value management techniques the syllabus names under P2A3 — “Apply value management techniques to manage costs and improve value creation”: target costing (A3a) and value chain analysis (A3b). The third, life cycle costing (A3c), is chapter 4.
Target costing is a proactive cost reduction system, well suited to a globally competitive environment, and it contributes with life cycle costing to long-term profitability.
A very common traditional approach to setting a selling price is to calculate a cost per unit and add a mark-up or a margin. That ensures the price covers the cost of the item and returns a profit on each unit sold. Its problem is that the resulting price may be higher than customers will accept, so the product does not sell in sufficient numbers — and it gives the business no incentive to reduce cost at all, since any cost is recovered by definition.
Rather than deriving its own selling price, target costing accepts the price the market sets and then designs products and processes that can be sold profitably at it, by achieving a target cost.
Most of the work of meeting a target cost is done at the early product development stages. That is the crucial point about it as a cost control technique: a change made at design stage eliminates the cost and also prevents it from being locked in before production begins. Value engineering and functional analysis (section 5) are the methods used to find design changes that reduce cost without reducing the value the customer places on the product.
If the target cost cannot be achieved, production may not go ahead at all.
The reversal
Traditional: cost + required profit = selling price. Target costing: market selling price − required profit = the maximum cost the business can allow itself. The arithmetic is trivial; the change is in which number is given and which is derived.
2 Target costing
This recording works Examples 1 to 3 and covers sections 2 to 5. Its account of why target costing exists is the argument in section 1: “if you simply get the cost and add on a profit margin, the danger is you end up with a selling price which is more than the competition … also there's no incentive on us to try and cut costs”.
Notice. The recording does not reach section 6. Value chain analysis is a named syllabus topic (P2A3b) with no recorded coverage in this paper at all. Note also that the tutor calls the examples “exercises” throughout; they are numbered identically.
2.1 The steps
Determine the market selling price for the product — the target selling price.
Determine the profit required, as a required margin or mark-up percentage. There is no rule here: every company sets its own objective, and the question will tell you what it is.
Calculate the maximum cost per unit that will achieve the required profit at that selling price — the target cost.
Compare the estimated or actual cost with the target cost.
Take action to close any target cost gap, where the estimated cost exceeds the target cost.
Target cost = Target selling price − Required profit
Target cost from a margin
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.
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Target cost from a return on investment
Hewlett plc is about to launch a new product on which it requires a pre-tax return on investment of 30% per annum.
Buildings and equipment needed for production will cost $5,000,000.
The expected sales are 40,000 units per annum at a selling price of $67.50 per unit.
Calculate the target cost.
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2.2 The target cost gap
Once the target cost has been determined it is compared with the estimated cost of production. The excess of the estimated cost over the target cost is the target cost gap, and closing it becomes the focus of the design work.
Target cost gap = Estimated cost − Target cost
2.3 Closing the target cost gap
Methods of closing the gap fall into two groups, and they are not equally good.
Approach | Examples | Comment |
Conventional cost reduction | Buy materials more cheaply; negotiate labour rates; improve productivity so that each unit takes less time; improve efficiency through better working practices, lean manufacturing and continuous improvement. | Available, and worth doing, but limited. Most of these cost reductions are also available to competitors. |
Design out the cost | Remove non-value-adding features, or make them optional extras the customer pays for separately; substitute materials that the customer does not value differently; reduce dimensions or component counts where the customer will not notice; simplify assembly. | This is the method target costing exists for, and it is only available before production begins. The test is always whether the change affects the value the customer places on the product. |
Methods of closing the gap must not reduce quality. If the product ends up worse than the competition, the market selling price the whole calculation started from is no longer achievable, and the target cost was computed from a price that no longer exists.
Target costing at Rollo
Rollo plc are a car manufacturer who face intense competition from other automotive manufacturers in their industry. They are considering production of a small hatchback car, which will be known as the Rolla.
All Rollo's key competitors produce a small hatchback model aimed at the same market segment. The selling price of these cars averages $10,000 each regardless of manufacturer.
The cost of producing the Rolla has been estimated at $9,750.
Rollo's shareholders require a mark-up of 25% on all retail car sales.
Required:
Using traditional mark-up pricing, calculate the expected selling price of a Rolla, and explain what will happen if production goes ahead at this point.
Calculate a target cost and a target cost gap, and briefly explain what each of these represents.
Suggest three ways in which Rollo could take steps to meet this cost, without affecting the quality or the usefulness of the product.
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3 Kaizen costing
Kaizen is the Japanese word for continuous improvement. Applied to costing, it means cost reductions achieved through small incremental improvements on an ongoing basis, rather than through large radical change.
Kaizen costing occurs during the manufacturing stage and empowers all workers to find continual small cost reductions which together reduce overall cost.
Target costing | Kaizen costing | |
When | At the design stage, before production begins | During manufacture, continuously |
Size of reduction | Large — the whole target cost gap | Small, incremental, cumulative |
Mechanism | Design changes that prevent cost being locked in | Worker-led improvements to how the work is done |
Relationship to the target | Sets the target | Grinds towards it, or beyond it, afterwards |
A company may go ahead with production even though the product does not quite meet its target cost, on the basis that kaizen costing and other improvements will achieve the remaining reduction over the longer term. Chapter 2 sets kaizen against business process re-engineering, which is the opposite approach to the same problem.
4 Using technology to reduce costs
Software such as CAD (computer aided design) has become inexpensive and in some cases free to use.
Innovations such as 3D printing have reduced the cost of prototyping, testing and refinement — which is exactly where target costing does its work.
Digital products such as music, games and other media can be produced at a fraction of the former cost.
Advertising and marketing costs are reduced through social media and pay-per-click, which target customers more precisely and reduce wasted spend.
5 Value analysis, value engineering and functional analysis
5.1 What they are
Both value analysis and value engineering seek to understand value as the customer or user of the product perceives it. The aim is to identify cost-effective changes to the product's composition or design that will not reduce that perceived value.
What is sought is a modification that reduces cost while the customer's assessment of the product is enhanced or unchanged — without affecting its quality, reliability or functionality.
Applies to | When it is used | |
Value analysis | An existing product | After production has begun — the design is already fixed and the question is what can be taken out of it |
Value engineering | A product not yet produced | During design — which is where target costing does its work, so this is the technique target costing relies on |
5.2 Aspects of value
Aspect of value | What it means to the customer |
Cost value | What the item costs the customer to acquire and to own |
Exchange value | What it could be resold for later — significant for cars, property and equipment |
Use value | What it actually does, and how much the customer needs it done |
Esteem value | The prestige, brand or status attached to owning it, independent of what it does |
The four are the checklist for a value analysis. A feature that adds to none of them is a candidate for removal; a feature that adds to esteem value is one to leave alone even though it does nothing useful.
5.3 Functional analysis
Functional analysis examines the product as the customer perceives it and considers the value and the cost of each function the product performs. The aim is to understand the values placed on those functions and, where possible, to develop cost-effective alternative ways of providing them without reducing the customer's perception of worth.
It extends beyond products to services, to organisational structure and to other applications of cost control. For example, installing a tea machine may be a cost-effective alternative to employing canteen staff to serve tea: the function — fresh tea available on demand — is still delivered, by a cheaper method.
6 Value chain analysis
Value chain analysis is not value analysis. Section 5's value analysis looks inside one product and asks which of its features the customer values. Value chain analysis looks at the whole set of activities the business performs to create that product, and asks which of them create value and what each of them costs. The names are similar, the techniques are not, and the syllabus lists value chain analysis as its own component outcome (P2A3b) with its own topics: “components of the value chain” and “profitability along the value chain”.
6.1 The components of the value chain
Porter's value chain divides everything a business does into nine activities: five primary activities that create and deliver the product, and four support activities that make the primary activities possible. What is left when the cost of performing all nine is deducted from what the customer will pay is the margin.
6.2 The five primary activities
Primary activity | What it covers | Typical cost drivers |
Inbound logistics | Receiving, storing and distributing the inputs — goods inwards, materials handling, inventory control, supplier returns. | Deliveries received, inventory held, inspection frequency |
Operations | Transforming inputs into the finished product — machining, assembly, packaging, testing, plant maintenance. | Machine hours, batches and set-ups, defect and rework rates |
Outbound logistics | Storing the finished product and getting it to the buyer — warehousing, order processing, scheduling, delivery. | Orders despatched, delivery drops, storage volume |
Marketing and sales | Making the product available to buy and persuading buyers to buy it — advertising, promotion, sales force, channel selection, pricing. | Sales visits, campaigns, channel mix |
Service | Maintaining or enhancing the product's value after sale — installation, training, repair, spares, warranty work. | Warranty claims, service calls, spares held |
6.3 The four support activities
Support activity | What it covers |
Firm infrastructure | General management, planning, finance, accounting, legal, quality management. It supports the whole chain rather than any one activity — and the management accounting techniques in this paper live here. |
Human resource management | Recruiting, training, developing, rewarding and retaining people across every activity. |
Technology development | Product design, process engineering, research, and the information systems that run the chain. This is where a design change that removes cost from operations or from service is actually made. |
Procurement | The function of buying the inputs — not the inputs themselves, which sit in inbound logistics. Supplier selection, contracting, and the terms on which the business buys. |
6.4 Linkages
The activities are not independent, and the linkages between them are where most of the useful findings come from. Spending more in one activity frequently removes more cost from another:
Spending in technology development on a design that is easier to assemble removes cost from operations and from service.
Spending in procurement on supplier accreditation removes goods-inwards inspection from inbound logistics and rework from operations — which is the same argument as the cost of quality trade-off in chapter 2.
Cutting cost in outbound logistics by using a slower carrier can raise cost in marketing and sales and in service, because late delivery has to be dealt with somewhere.
A cost reduction judged inside a single activity will therefore often be wrong. The test is always the effect on the total cost of the chain, and on the price the customer will pay at the end of it.
6.5 The value system
The business's own chain sits inside a wider value system: the suppliers' value chains feed it, and the distributors' and the customers' value chains follow it. Competitive advantage can be found at the joins as well as inside the business — which is what a just-in-time supply relationship, a shared forecast, or a customer who collects the goods themselves is doing. Chapter 1's Example 4 is exactly that: Sam takes on the outbound logistics activity in exchange for a discount worth less than the cost it saves.
6.6 Profitability along the value chain
The second topic named under P2A3b is profitability along the value chain. The technique is the one chapter 1 uses for products, customers and channels: attribute the costs to the activity that causes them, then read the result.
Split the total cost of the business across the nine activities.
Express each as a cost per unit and as a percentage of the selling price, so that the shape of the chain is visible.
Compare against a competitor or a benchmark where one is available — an activity that costs twice what the industry spends on it is either a source of advantage or a source of waste, and the analysis tells you which by asking whether the customer pays more because of it.
Ask, activity by activity: does this create value the customer will pay for? Could it be done more cheaply, done differently, done by someone else in the value system, or not done at all?
Profitability along the value chain
Meridian plc makes a garden power tool. It sells 40,000 units a year at $300 each. Its total cost of $9,600,000 has been analysed across the value chain as follows.
Activity | $000 |
Inbound logistics | 720 |
Operations | 4,560 |
Outbound logistics | 1,080 |
Marketing and sales | 1,560 |
Service | 840 |
Support activities | 840 |
9,600 |
Required:
Calculate Meridian's margin in total, per unit, and as a percentage of revenue.
A specialist distributor has offered to take over the whole outbound logistics activity for a fee of $22 per unit delivered. Of Meridian's own outbound logistics cost, $760,000 would be avoided if the activity were outsourced; the remaining $320,000 is warehouse depreciation and apportioned central overhead which would continue. Advise Meridian.
Warranty repairs account for $700,000 of the service cost. A design change, developed within technology development at a cost of $180,000 a year, would reduce warranty repairs by 60%. Evaluate the proposal and comment on what it illustrates.
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Target costing starts at the market price, deducts the required profit and derives the maximum cost the business may allow itself; the shortfall against the estimated cost is the target cost gap, and it is closed mainly by designing cost out before production begins. Kaizen costing grinds cost down afterwards in small steps. Value analysis and value engineering ask which features of a product the customer values; functional analysis asks which functions, and whether they could be delivered another way. Value chain analysis is a different technique with a similar name: it splits the business into five primary and four support activities, costs each of them, and reads profitability along the chain — and its most valuable findings come from the linkages, where spending in one activity removes more cost from another.
7 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Target Costing
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