Managing the Target Cost Gap and Target Costing in Service Businesses

A cost gap is not a failure. It is the normal result of a first design, which is usually drawn to please customers, not to hit a cost. The skill lies in closing the gap without taking away what customers value, and doing it as a team, because the savings are spread across design, purchasing, production, distribution and after-sales service.

This topic explains how a cost gap is managed and the methods used to close it, the advantages of target costing and its effect on pricing, cost control and performance measurement, and how the method works, and where it struggles, in service businesses where overhead is the main cost. It builds on the target costing principles topic. The next topic introduces life cycle costing.

Managing a target cost gap

Target costs are rarely met at the first attempt, so ways must be found to cut cost. A multi-disciplinary approach is needed. The management accountant measures estimated costs, while ideas for reducing them come from the sales, manufacturing, engineering and purchasing departments, in product design, manufacturing processes, selling methods and purchase of raw materials. The common methods are:

• Redesign products to use common processes and components that the company already uses for other products.
• Work with key suppliers to reduce materials costs. Target costing involves the whole value chain, from original suppliers to the customer, so negotiation and collaboration with suppliers may give important savings.
• Eliminate non-value-added activities and features. Something is non-value-added if it adds nothing the customer values, so its cost can be saved without loss of value. Value analysis systematically examines all aspects of cost to provide the required quality at the lowest possible cost.
• Train staff in more efficient techniques and working methods, since greater efficiency reduces cost.
• Achieve economies of scale. Larger quantities spread fixed overhead over more units, but only help if sales demand grows by the same amount.

Advantages of target costing

• It improves understanding of product costs within the company.
• It recognises that the most effective way to reduce cost is to plan and control it from the design stage.
• It focuses the company on the final customer, because the concept of value matters: the target must be met without loss of value to the customer.
• It is multi-disciplinary and considers the whole supply chain, so it promotes co-operation between departments and with suppliers and customers.
• It can be used with value analysis, value engineering, just-in-time purchasing and production, total quality management and continuous improvement.

Implications for pricing, cost control and performance measurement

A company can fix a target selling price, for a new or existing product, to win market share or volume, and then work out the target cost.

With target costing, cost control and performance measurement change:

• cost savings are sought continuously over the life of the product
• responsibility for savings is shared, so if one department fails to deliver, others may find the saving
• staff are trained and empowered to find ways to cut cost while keeping quality

The method works best in a company with a culture of continuous improvement.

Target costing in service businesses

Target costing can be used for services as well as products, but services differ, and the differences matter:

• Some services are labour-intensive and direct materials are a small part of cost, so there is little to save on materials.
• Overhead is very high in many services, so effective target costing must focus on reducing overhead.
• One delivery system, using the same staff and assets, often provides several services. Adding or changing a service adds to the work and variety of the same employees, and may reduce the quality of existing services: a new service in a call centre can lengthen waiting times for callers.
• New services may be introduced without checking whether they are profitable. A restaurant may add menu items thinking the only extra cost is the food, but there are also purchasing, preparation and delivery costs, so new items may lose money.
• When one delivery system serves several services, most cost is allocated and apportioned overhead, so a consistent and fair method of attributing overhead to services is needed. Activity based costing helps.
• Not-for-profit bodies, such as a government health service providing free care, can use target costing for new services. But it is doubtful that the concepts of target price and target profit apply, so the basis for the target cost must be decided differently.

The system should therefore focus on quality of service and value to the customer.

Challenges in service industries, and how to meet them

• Cultural shift and resistance to change, from fear of job loss and uncertainty: training, orientation and workshops.
• Balancing cost reduction and value creation: clear customer-focused feedback so the industry stays customer-focused.
• Inaccurate market analysis and problems in cost estimation: good data mining and analysis to handle insufficient or very large data, and proper feedback.
• Interdepartmental coordination and complexity: clear lines of authority and departmental functions, and cross-functional teams.
• Unrealistic staff appraisal and ineffective measures: motivation of staff and effective performance measurement.

Layouts for gap and redesign questions

1. Target cost = price × (1 − margin %). Estimated cost = sum of cost elements per unit.
2. Cost gap = estimated cost − target cost.
3. Cost elements after a redesign: apply each change (a percentage cut, fewer hours, a lower failure rate) to its element; a failure cost is probability × cost of failure.
4. Residual gap = revised cost − target cost. Share of gap closed = savings ÷ original gap.
5. Service items: overhead per minute (or hour) × minutes used; add direct costs; compare with target.

Money is in naira per unit, figures are rounded once at the end, and percentages to one decimal place.

Worked examples

1. Target cost.
   80,000 × 0.75 = ₦60,000.
2. First design.
   Parts 36,000; labour 10 × 450 = 4,500; machine 12,000; quality 8 × 700 = 5,600; rework 8% × 9,000 = 720; distribution 8,000; warranty 10% × 14,000 = 1,400.
   Total ₦68,220.
   Gap 68,220 − 60,000 = ₦8,220.
3. Redesign.
   Parts 36,000 × 0.90 = 32,400; labour 8 × 450 = 3,600; machine 12,000; quality 6 × 700 = 4,200; rework 4% × 9,000 = 360; distribution 7,000; warranty 5% × 14,000 = 700.
   Total ₦60,260.
4. Savings.
   68,220 − 60,260 = ₦7,960, which is 96.8% of the gap.
5. Residual gap.
   60,260 − 60,000 = ₦260.
6. Comment. The redesign nearly closes the gap. The remaining ₦260 is less than 1% of the parts cost (₦324 would be 1%), so a small price concession from suppliers would close it. The team should confirm that the redesign keeps the features customers value.

1. Target cost.
   4,500 × 0.60 = ₦2,700.
2. Expected cost.
   Food 1,300; labour 0.25 × 1,600 = 400; overhead 8 × 150 = 1,200.
   Total ₦2,900.
3. Gap.
   2,900 − 2,700 = ₦200.
4. After redesign.
   Overhead 6 × 150 = 900, a saving of 300.
   Cost ₦2,600, which is ₦100 below the target.
5. Comment. Most of the cost is overhead, so the saving came from time in the kitchen, not from food. The kitchen’s total minutes are limited, so the restaurant should check that the new dish does not slow other orders, which would reduce service to existing customers.

Expect variants: several redesign changes at once, a price that must be set from a required return, overhead absorbed by an activity driver, or a question on a not-for-profit service where the target is a budget.

Common mistakes

• Closing the gap by cutting quality. Value to the customer must be kept.
• Giving a list of methods with no link to the business. Say which department would deliver each.
• Forgetting that service cost is mostly overhead and so looking for material savings.
• Failing to allocate overhead fairly across services that share one delivery system.
• Treating a failure rate as a cost per unit. Multiply the rate by the cost of the failure.
• Ignoring resistance to change when advising on adoption.

Quick revision

• Gap = estimated cost − target cost; close by redesign, suppliers, removing non-value-added items, training, scale.
• Advantages: cost understanding, planned from design, customer focus, co-operation, links to other methods.
• Implications: continuous saving, joint responsibility, empowered staff; needs a continuous improvement culture.
• Services: overhead-heavy, shared delivery systems, new services can harm old ones, fair overhead allocation needed, not-for-profit difficulty.
• Challenges: resistance to change, cost against value, estimation errors, coordination.

How the marks are earned

• Advise on closing a gap: each method with a business application, about one mark each.
• Discuss services: a feature of services and its effect on target costing.
• Calculate: each revised element, the new total, the residual gap.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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