Target Costing and Its Application

Target costing should be viewed as an integral part of a strategic profit management system.

The initial consideration in target costing is the determination of an estimate of the selling price for a new product which will enable a firm to capture its required share of the market. Then it is necessary to reduce this figure to reflect the firm’s desired level of profit, having regard to the rate of return required on new capital investment and working capital requirements.

The deduction of required profit from the proposed selling price will produce a target price that must be met in order to ensure that the desired rate of return is obtained.

Thus the main theme that underpins target costing can be seen to be 'what should a product cost in order to achieve the desired level of return’.

Target costing will necessitate comparison of current estimated cost levels against the target level which must be achieved if the desired levels of profitability, and hence return on investment, are to be achieved. Thus where a gap exists between the current estimated cost levels and the target cost, it is essential that this gap be closed.

Example:
The Marketing Director of Company A has estimated that sales volume amounting to 5% of the total market size can be achieved in year 1 if a selling price of £80 per unit is maintained throughout the year. The board of directors are in agreement that they wish to maintain a 5% share by volume, of the total market size in each of years 2–4.

The management of Company A should be cognisant of the fact that it is far easier to ‘design out’ cost during the pre-production phase than to ‘control out’ cost during the production phase. Thus cost reduction at this stage of a product’s life cycle is of critical significance to business success. A number of techniques may be employed in order to help in the achievement and maintenance of the desired level of target cost. Attention should be focused upon the identification of value added and non-value added activities with the aim of the elimination of the latter. The product should be developed in an atmosphere of ‘continuous improvement’. In this regard, Total Quality techniques such as the use of Quality circles may be used in attempting to find ways of achieving reductions in product cost.

Value engineering techniques can be used to evaluate necessary product features such as the quality of materials used. It is essential that a collaborative approach is used by the management of Company A and that all interested parties such as suppliers and customers are closely involved in order to engineer product enhancements at reduced cost.



**********