Definition, Explanation and Formula of Target Costing:

Target costing is the process of determining the maximum allowable cost for a new product and then developing a prototype that can be profitably made for that maximum target cost figure. A number of companies--primarily in Japan--use target costing, including Compaq, Culp, Cummins Engine, Daihatsu Motors, DaimlerChrysler, Ford, Isuzu Motors, ITT, NEC, and Toyota etc. The target costing for a product is calculated by starting with the product's anticipated selling price and then deducting the desired profit. Following formula or equation further explains this concept: Target Cost = Anticipated selling price Desired profit The product development team is then given the responsibility of designing the product so that it can be made for no more than the target cost. Following set of activities further explains the concept of target costing technique: TARGET COSTING PROCESS DIAGRAM Determine Customer Wants and Price Sensitivity

Planned Selling Price is Set

Target Cost is Determined As: Selling Price Less Desired Profit

Teams of Employees from Various Areas and Trusted Vendors Simultaneously

Design Product Determine Manufacturing Process Determine Necessary Raw Materials

Costs are Considered Throughout this Process. The Process Requires Trade-offs to Meet Target Costs

Once Target Cost is Achieved the Manufacturing Begins and Product is Sold

Reasons for Using Target Costing Technique:

The target costing approach was developed in recognition of two important characteristics of markets and costs. The first is that many companies have less control over price than they would like to think. The market (i.e., supply and demand) really determines prices, and a company that attempts to ignore this does so at its peril. Therefore, the anticipated market price is taken as a given in target costing. The second observation is that most of the cost of a product is determined in the design stage. Once a product has been designed and has gone into production, not much can be done to significantly reduce its cost. Most of the opportunities to reduce cost come from designing the product so that it is simple to make, uses inexpensive parts, and is robust and reliable. If the company has little control over market price and little control over cost once the product has gone into production, then it follows that the major opportunities for affecting profit come in the design stage where valuable features that customers are willing to pay for can be added and where most of the costs are really determined. So that it is where the effort is concentrated--in designing and developing the product. The difference between target costing and other approaches to product development is profound. Instead of designing the product and then finding out how much it costs, the target cost is set first and then the product is designed so that the target cost is attained.

Example of Target Costing:

To provide a simple numerical example of target costing, assume the following situations: Handy Appliance Company feels that there is a market niche for a hand mixer with certain new features. Surveying the features and prices of hand mixers already in the market, the marketing department believes that a price of $30 would be about right for the new mixer. At that price, marketing estimates that 40,000 of new mixers could be sold annually. To design, develop, and produce these new mixers, an investment of $2,000,000 would be required. The company desires a 15% return on investment (ROI). Given these data, the target cost to manufacture, sell, distribute, and service one mixer is $22.50 as calculated below: Projected sales (40,000 mixers $30 per mixer ) Less desired profit (15% $2,000,000) Target cost for 40,000 mixers Target cost per mixer ($9,00,000 / 40,000 mixer) $1,200,000 300,000 -----------$9,00,000 ======= $22.50

This $22.5 target cost would be broken into target cost for the various functions: manufacturing, marketing, distribution, after-sales service, and so on. Each functional area would be responsible for keeping its actual costs within target.

Advantages and Disadvantages of Target Costing Approach:

Target costing has the following main advantages or benefits: 1. Proactive approach to cost management. 2. Orients organizations towards customers. 3. Breaks down barriers between departments. 4. Implementation enhances employee awareness and empowerment. 5. Foster partnerships with suppliers. 6. Minimize non value-added activities. 7. Encourages selection of lowest cost value added activities. 8. Reduced time to market. Target costing approach has the following main disadvantages or limitations: 1. Effective implementation and use requires the development of detailed cost data. 2. its implementation requires willingness to cooperate 3. Requires many meetings for coordination 4. May reduce the quality of products due to the use of cheep components which may be of inferior quality.