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Hit the bullseye with target costing
Developed in Japan in the 1960s, target costing has become an established cost management technique. But what does it involve?
Words Gill Myers, Evolve
For-profit organisations often strive to increase market share while at the same time achieving a set level of profit. There are several costing methods that can be utilised in this pursuit, but using target costing has the potential to add benefits such as improving efficiency, both in terms of production methods and resources, as well as internal co-ordination and co-operation.
Traditional costing
One of the easiest ways to understand target costing is by comparing it with traditional costing methods – be that marginal, absorption or activity-based. While there are differences in these methods – mainly to do with the treatment of fixed costs and the calculation of cost drivers – they all calculate the cost of producing a product and add a profit mark-up to calculate the selling price.
Target costing
By contrast, target costing works the other way round. It starts with the selling price and removes the profit element to calculate the cost. This is because it is a concept based on meeting consumer needs.
Traditional costing methods determine a selling price that will cover costs as long as estimated overhead predictions are accurate and budgeted sales achieved. However, they don’t take into consideration consumer behaviour and market forces; there might not be any demand for a product with the options/features supplied, or there may be demand that is already being met by competitors whose products are better value or cheaper. Target costing aims to eliminate these issues by considering them up front, as part of the process of planning and designing a product or service.
When target costing is appropriate
In order to use target costing, sufficient information needs to be available about a potential product or service: What features/options do consumers want? How much will they pay? What do competitors offer? How big is the market? As organisations have limited influence on consumers’ behaviour, competitors or the market, answering these questions can be challenging. However, trying to do so and doing it accurately is important because the first stage of target costing is to decide how much of the current market share an organisation wants to gain and the level of profit it wants to achieve as a percentage of its sales.
Stages of target costing
Example
An organisation wants to provide a new service which, after researching the current market, is expected to sell for £225. The average labour requirement is two hours and there are associated material costs of £50 per service. The company expects to be able to gain market share that equates to providing 10,000 services in the first year and requires a profit margin of 25%. Associated fixed costs are £250,000 per annum.
However, there is a shortage of experienced engineers qualified to provide the service, so target costing has been used to determine the maximum hourly rate that the company can afford to pay and retain the new service’s viability.
Unfortunately, the going market hourly rate is between £50 and £55 per hour. Therefore, ways to reduce costs but maintain quality must be found if the new service is to go ahead.
Meeting target cost
Finding ways to keep costs below the target is likely to be tasked to the team that initially researched and estimated the selling price, which should comprise of staff with a range of skills. This should not just be cost accountants but, for example, marketing, production and quality control professionals as well. The team will have already established the selling price and features combinations that are most likely to be desired by potential customers, so savings will have to be found in the processes and material costs. Value engineering is therefore often used because its objective is to ensure that new products and services are planned and designed for quality but at as low a cost as possible. This is done by analysing every part of the design to ensure it reduces costs while maximising value both in terms of its function (does the product/service do what it should?) and its esteem (the value placed on it by the consumer).
KEY TAKEAWAYS
Target costing can be understood as a market-driven approach. By anticipating consumer needs, understanding the market and assessing competition, organisations can plan and design viable products and services that have a realistic chance of being commercially successful. It is the opposite of traditional costing methods as it starts with the selling price from which profit is deducted to calculate the target cost. If necessary, ways are then found to not exceed that cost.
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