Part a 3 Target Costing

8/13/2019 Part a 3 Target Costing

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Part A 3 Target costing

The starting points for pricing decisions can be:

a) Market based

b) Cost based

The market based approach to pricing starts with the question - Given what ourcustomer wants and how our competitors react to what we do, what price shoud wecharge to ensure that we achieve our desired eve of market share !or our desiredeve of operating profit etc)"

The cost based approach starts b# asking - $hat does it cost us to make thisproduct and hence what price shoud we ask that wi recoup our costs and producea desired profit"%

&oth approaches share techniques and requirements for information, but the startingpoint is different and the focus is different'

Target costing for target pricing

This is a particuar form of the market-based approach'

Terminoog#:

The target cost computed from the above e(ercise wi often be beow the actua fucost per unit' To achieve the target cost a compan# wi have to improve its productsand processes'

Target costing is wide# used in man# different industries: Genera Motors,Mercedes, To#ota, iat and *ovo in the motor industr#+ iemens, anasonic, harpand Compaq in the eectronics industr#'

Target price

The estimated price for a product or service that a potential customer will bewilling to pay (based on an understanding of customers perceived value for aproduct and competitors responses)

Target operating profit per unitThe operating profit that a company wishes to earn on each unit of a product orservice sold.

Target costThe difference between the two above!


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Implementing target pricing and costing:

This is a summar# of the process:

Step 1: .eveop a product that satisfies the needs of potentia customers'

Step 2: Cacuate a target price and target operating profit per unit, based onmarket information as above'

Step 3: .erive the target cost and compare with e(isting cost !target cost gap)'

Step 4: erform vaue engineering to achieve the necessar# cost reduction'

*aue engineering can resut in:

o /mprovements in product design

o Changes in materia specification

o Modifications in process methods

etc

Closing the target cost gap

Target cost gap 0 estimated cost ess target cost

1se cheaper materias

1se different materias

Train staff to be more efficient

1se ower grade of abour

2cquire more efficient machiner#etc

/ have incuded a itte case stud# that ma# hep e(pain target costing3

Value engineeringis a s#stematic evauation of a aspects of the vaue chainbusiness functions, with the ob4ective of reducing costs whie satisf#ing customerneeds'


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Coerdrie !td

Target Costing

/n recent months 5ohn Thiste, the compan#6s management accountant had met onsevera occasions with teve 2mbrose the M. and discussion had focused onissues as fu cost pricing, activit# based costing, standard costing and aspects ofbudgetar# contro'

teve informs 5ohn of various ideas he has for increasing the compan#6s productrange and the concept of pricing returns to the agenda'

5ohn mentions that he has recent# read some research b# 7emet 7ergeth, 8orthCaroina 1niversit#, on Target Costing and fees that the technique coud be appiedat Coverdrive'

teve wishes to e(pore the idea and asks 5ohn to prepare a paper for the seniormanagement team6s ne(t meeting'

"ohn#s $otes

Target Costing

Much iterature cites 5apanese companies deveoping and using target costing+

To#ota, 7onda and 8issan are such e(ampes' /n the 1 Caterpiar and Chr#serare e(ampes where economic benefits of the technique have been noteworth#'

Traditional Pricing and Costing

u cost pricing has been the mode used b# man# businesses in the past'tandards and standard costing technique was used to determine a product6s cost ofabour and materia, overhead was absorbed, a share of seing distribution andadministration cost was added to achieve a product6s tota cost' rice was then setb# adding a desired profit margin'

This additive mode worked we and was appropriate when markets were essefficient and responsive as the# are toda#'

/f the price was acceptabe in the market it was on# e(perienced when the productwas actua# introduced to potentia customers' This coud resut in the price beingeither too high or too ow and therefore technique was deveoped that preventspricing error and aids faster more focused product deveopment'


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Target Costing

9Target costing describes a process of first assessing a target price and thendesigning a product to meet this price6 !7ergeth)'

/t is part of a tota cost management s#stem which moves awa# from traditionaaccounting to manageria accounting and moves decision making from anaccountants perspective to the market pace'

/t is a top down process:

etting riceo etting rofit

etting Cost

The process is interactive and comprises three phases: market eve, product eveand component eve !Cooper and agmuder ;;;):

Market


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This can aso be viewed as:

1nderstand Customer 8eed

rice ensitivit# *aue of product features

$hat $hat rice eatures

et rofit

et Target Cost

Target costing therefore buids upon a design to cost approach where the focus is amarket driven price as a basis for estabishing target costs'

7ergeth states:

The ke# eement in target costing is the market orientation of the entire costing andproduct deveopment process' introducing the market price as the foca point ofthe ana#sis, target costing avoids probems of other costing approaches:

Costing becomes a manageria too to achieve successfu product design rather

than documenting historica data'

2n economica# reevant variabe !price) becomes the driver of the product

deveopment process rather than its output' This resuts in a market and profitdriven product deveopment process rather'

.ue to its market orientation target costing can consider ong-term corporate

strategies in the market' *ariabe costing and activit# based costing tend to focusmore on short term goas'

.ue to its specific purpose target costing tends to provide decision reevant data,

whie traditiona absorption costing modes tend to document a cost,independent of the decision making reevance'


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Application of Techni%ue to Coerdrie

$e woud need to compare our origina estimated cost of a product to target cost'

/f this was greater than target we woud need to reconsider design and possib#

reduce associated e(penses or e(amine our decision to offer the product'

This coud invove re-e(amining processes to introduce cost reducing efficiencies'

Target Cost Profile

Product: &rier Supreme

Price ' Cost (lement ) Per *nit+actor +actor

,Target rice ;='==rofit Margin >=? @'==

A>'==eing, distribution and admin =? A'>=

B'@=Dverheads E F=? ;'

Target Cost !.irect) H'FB


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Target costing Illustration

2&C ==H'

roduct J roduct K

roductionsaes !units) >,=== A,>==eing price per unit AH ;=.irect materia cost per unit >= >=

2&C variabe conversion cost per unit:- assemb# >= >@- finishing > >

roduct specific fi(ed costs A=,=== ;=,===Compan# fi(ed costs H=,===

2&C H? when assessing the viabiit# of anew product' /n addition, management wish to achieve an overa net profit margin of

>? on saes in this period in order to meet return on capita targets'

N(pain how target costing ma# be used in achieving the required rates of return andsuggest specific areas of investigation'

EEC ratio 0 contribution to saes ratio 0 contribution O saes


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Solution

The information provided wi give the foowing estimated

product and compan# resuts:

- . Totaleing price AH ;=

*ariabe costs:

Materia !>=) !>=)

Conversion !F>) !H>)

Contribution >F @

C ratio F='BA? >='==?

Total for period

aes ;==,=== B@,=== ,H@,===Contribution >AB,=== >;,B==

roduct specific

fi(ed costs !A=,===)!;=,===

)

=B,=== F;,B== H,B==

Compan# fi(ed costs !H=,===)

;H,B==

8et profit margin B'@?

The compan# is faing considerab# short of its >? net profit margin target' /f saesquantities and prices are to remain constant, the costs must be reduced if the

required returns are to be made'

roduct K is faing short of its C ratio target' Cost reduction shoud therefore befocused on this product initia#' The compan# shoud aim to reduce theproduction cost of K in order to increase its contribution, giving a higher Cratio

pecific areas for consideration:

Can an# materia be eiminated !packaging for instance")

Can cheaper materia be substituted without osing quait#"

Can part-assembed components be used"

Can the incidence of cost drivers be reduced" Ntc


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(/ercise 1

.escribe how #ou coud use target costing in service industries, giving e(ampeswhere possibe'

(/ercise 2

Kou are the accountant of a compan# producing mountain bikes+ however saeshave dropped due to a fa in demand' Kou have noticed that man# companies havereduced the seing prices of their bikes and customers are moving awa# from #ourcompan# to #our competitors'

$rite a report to #our managing director e(paining target costing and how it coud

benefit #our compan#'

Part a 3 Target Costing

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