Target Costing: Principles, the Target Cost and the Cost Gap

A company that waits until a product is designed, tooled and built to find out what it costs has already lost the argument. By then most of the cost is fixed in the design, and the market price is whatever customers will pay. Target costing turns the order round.

It starts with the price the market will accept, takes away the profit the company needs, and what is left is the most the product may cost. Designers and buyers are then asked to meet that figure.

This topic explains where target costing comes from, its principles and steps, how to calculate the target cost from a target price and margin or from a required return on investment, how to estimate the product’s expected cost, and how to find the cost gap. It builds on the topic comparing ABC with traditional costing, because activity based costing helps estimate overhead in a design.

The next topic covers how to manage a target cost gap and the problems of using target costing in services.

Principles, uses and the process

Target costing began in Japan in the 1970s. Customers were asking for more variety, and product life cycles were shortening, so new products had to be designed more often. Companies realised that a large proportion of the cost of a product is committed at the design stage, before manufacture begins. The design stage therefore decides whether a product can be made at a cost that earns a profit.

Target costing is a method of strategic management of costs and profits. It sets a target, the maximum cost of a product or service, and then works out how to meet it. It is used by companies in competitive markets where new products appear continually.

To compete successfully such a company must improve existing products or design new ones continually, sell at a competitive price (the same as competitors or lower), and make a profit. To make a profit it must make the product for less than the expected selling price.

Target costing and new product development

Target costing is used mainly for new products. For a product under development the company decides the price it wants to charge to win a target share of the market. It decides the profit it wants, to give the return it needs on its investment. Subtracting gives the target cost: the cost at which the product must be made and sold to earn the target profit at the market price.

Keeping the cost within the target is then a main control on the design.

1. Target selling price
2. Less: target profit margin
3. Equals: target cost, the maximum cost to meet or exceed the target profit.

The reason for using it on new products is that opportunities for cutting cost are much greater during design than after development has finished and the production process is set up. A first design usually aims to meet customers’ needs better than rivals do, and it may cost too much.

The cost of the design is compared with the target cost, and if it is higher there is a cost gap.

The steps

1. Research the target market and design the product to meet customers’ needs.
2. Set the target price and the maximum cost, with the desired profit.
3. Determine the target profit for the product.
4. Design features that will meet the maximum cost, with engineers and others working together.
5. Monitor actual product costs and adjust to achieve the target profit.

The principles

• Price-led costing: the price comes from the market, and cost is worked back from it.
• Customer focus: customers are involved so that the product delivers the value they want.
• Product design focus: effective design with innovation.
• Process design focus: lean manufacturing and continuous improvement.
• Cross-functional teamwork: collaboration across departments.
• Value chain approach: relationships from suppliers to consumers are integrated.
• Life cycle costing principles: costs are looked at over the whole life for sustainable practice.

Finding the target cost and the expected cost

There are two ways to find the target cost. The usual exam method deducts a target profit margin from a target selling price. The fuller method starts from the estimated sales volumes over the product’s life, the capital investment needed and any extra fixed costs. Finds the maximum cost that still gives at least the minimum required return on investment.

The expected cost of a design is hard to estimate because the product does not yet exist, so the estimate must be realistic and include items that will occur in practice:

• Raw materials. Allow for the expected wastage or loss in processing, and for possible price rises before development ends. Prices of volatile materials such as commodities are hard to forecast.
• Direct labour. Allow for the expected unavoidable idle time, usually the normal level in the company’s production. Labour is paid for idle time, so the paid hours are higher than the active hours.
• Production overhead. Overhead is often a large share of cost, so the target cost is usually a full cost, including overhead. If ABC is used, the design can limit the use of activities that drive cost, for example by cutting materials movements or inspections. Overhead is not absorbed into idle time when the question says so.

The cost gap is the estimated cost less the target cost. It must be closed by making the product more cheaply without losing features that give customers value: simplify the design or process, or use a cheaper material without loss of value. Management should then make sure the product is developed and the production method put in place so that the target cost is actually reached.

Layouts for target cost calculations

1. Target cost = target selling price − target profit. If the margin is a percentage of selling price, target cost = price × (1 − margin %).
2. Material with loss = quantity needed ÷ (1 − loss %) × price. The loss is a percentage of the input.
3. Labour with idle time = active hours ÷ (1 − idle %) × rate, when idle time is a percentage of the time paid.
4. Overhead = rate per active hour × active hours (unless told to absorb on paid hours).
5. Estimated cost = materials + labour + overhead. Cost gap = estimated cost − target cost.
6. Return method. Required annual profit = required return % × capital invested. Profit per unit = required profit ÷ annual units. Target cost per unit = price − profit per unit. Target variable cost = target cost − fixed cost per unit.

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

Worked examples

1. Material M2.
   Input needed 1.5 ÷ 0.96 = 1.5625 kg
   1.5625 × 600 = ₦937.50.
2. Labour.
   Hours paid 0.6 ÷ 0.90 = 0.6667
   × 1,500 = ₦1,000.
3. Overhead.
   0.6 × 2,400 = ₦1,440.
4. Expected cost.
   900 + 937.50 + 1,000 + 1,440 = ₦4,277.50.
5. Target cost.
   4,800 × (1 − 0.25) = ₦3,600.
6. Cost gap.
   4,277.50 − 3,600 = ₦677.50 a unit, or 15.8% of the expected cost.
7. Comment. The design is too costly. The team should look first at the largest items, overhead and labour, and at design changes that cut activity, for example fewer components and set-ups, before looking at price.

1. Required annual profit.
   20% × ₦60m = ₦12m.
2. Profit per unit.
   ₦12,000,000 ÷ 20,000 = ₦600.
3. Target cost per unit.
   6,000 − 600 = ₦5,400, including fixed costs.
4. Fixed cost per unit.
   ₦16,000,000 ÷ 20,000 = ₦800.
5. Target variable cost.
   5,400 − 800 = ₦4,600 a unit.
6. Comment. If the sales volume proves lower, the fixed cost per unit rises and the target variable cost must fall, so the volume estimate should be tested.

Expect variants: the margin on cost instead of price, loss stated as a percentage of output, overhead absorbed on paid hours, or several cost elements to be reduced by given percentages.

Common mistakes

• Calculating cost plus profit. Target costing works backwards from the price.
• Applying the margin to cost instead of selling price when the question says selling price.
• Forgetting wastage and idle time. Loss is a percentage of input; idle time of time paid. Divide by one minus the percentage.
• Absorbing overhead on idle time when the question says not to.
• Cutting value to close the gap. Savings must not reduce what the customer values.
• Using it for existing products only. Its power is at the design stage.

Quick revision

• Target cost = target price − target profit. Cost gap = estimated cost − target cost.
• Japan, 1970s; for new products; most cost committed in design.
• Principles: price-led, customer focus, product and process design, cross-functional teams, value chain, life cycle.
• Estimate: materials with loss, labour with idle time, overhead (ABC may help).
• Return method: required profit = return % × capital; subtract fixed cost per unit for target variable cost.

How the marks are earned

• Explain: the idea, the reason for design-stage use and the principles, one mark per point.
• Calculate: a mark for each cost element, the target cost, the gap, with allowances shown.
• Advise: how to close the gap without losing value.

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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