Target Costing

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TARGET COSTING “We tend to build up a model of the product, determine what it is going to cost and then ask whether we can sell it for that. The Japanese turn around. They say, “It’s got to sell for X. Let’s work backwards to make sure we can achieve it”. I’ve never seen this done by a U.S company with the same intensity - Robin Cooper − Professor, Harvard University In today’s rapidly changing business environment, product innovation is one of the keys to a company’s survival and competitivene
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    TARGET COSTING “We tend to build up a model of the product, determine what it is going to cost andthen ask whether we can sell it for that. The Japanese turn around. They say, “It’s gotto sell for X. Let’s work backwards to make sure we can achieve it”. I’ve never seenthis done by a U.S company with the same intensity - Robin Cooper  −  Professor, Harvard University   In today’s rapidly changing business environment, product innovation is one of the keys toa company’s survival and competitiveness. Manufacturers can no longer produce andmarket large volumes of standard products with a relatively stable market and technologicalclimate. There has been a shift toward unstable, rapidly changing markets andtechnologies. To implement market-driven management across the organisation,measurement and cost control systems must be designed to motivate the desiredconsumer-oriented behaviour. The strategies that determine the direction of productinnovation have become crucial to corporate management. Industrial marketers play amajor role in product innovation, and cost accounting must support this role. Costmanagement methods must help with the production of new products that meet customerdemands at the lowest cost, as well as with cost reduction of existing products byeliminating waste. Japan’s Competitive Thinking Triggers Target Costing One of the most influential changes in the practice of management to emerge is  kaizen - thephilosophy of continuous improvement. Originally a Japanese idea, it is being adoptedaround the world as an integral part of management strategy. A variation of this concept is that of ‘kaizen costing’, in which the emphasis is on gradualongoing cost reduction. Deriving from the thought of continuously improving costing,Japanese organisations are moving to a more radical approach referred to as target costing in a move to maintain the competitive edge.The Japanese believe that the key to achieving a competitive edge is simplicity. They arebeginning to realise there can be too much of a good thing, too much variety, too muchflexibility and even too much customer satisfaction. Organisations such as Nippondensowere cited as using target-costing principles to reduce its product range, increaseproductivity and profitability. Additional Japanese companies utilising target costing to seeka competitive edge include:   Isuzu MotorsToyota Motor CorporationNECSonySharpNissanTarget costing, although its concept is used throughout the product life cycle, is primarilyused and most effective in the product development and design stage. Born out of themarket-driven philosophy, target costing is based on the price-down, cost-down strategy,which has allowed companies to win considerable share of their respective markets.In companies where target costing is used, there seems to be a different culture andattitude. They place more emphasis on their relative position in the market and productleadership. Since more than 80% of product cost is already determined by the time productdesign and processing is complete, cost management must start (and done substantially) atthe design stage. What is Target Costing? There is no clear definition to target costing. Organisations that have implemented it havehad to apply their own unique approach to the concept. In essence, it is a philosophy inwhich product development is based on what the market will pay for it, not on what it hascost to produce. In other words, market price becomes the determinant of cost and not theother way around, as is the practice with most organisations.Target costing is a strategic management tool that seeks to reduce a product’s cost over itslifetime. Therefore, the target cost is not necessarily the cost to currently build the product.Target costing presumes interaction between cost accounting and the rest of the firm; well-executed, long-range profit planning; and a commitment to continuous cost reduction. Itsapplication in Japan has been well documented, but Western World firms also can use it tounderstand costs better and to enhance long-term profitability. Breaking the Corporate Western World Mindset Typically, Western World manufacturers have said: Here is my cost (Amount X). I have toreceive a certain profit contribution rate above that, so that consequently I must sell myproduct for this price (Amount Y or X/1-needed profit margin). Target costing reversesseveral decades of Western World pricing strategy by taking into account that ourcustomers do not care about our costs-only about their own. Our selling price is their cost,and there the customer’s concern ends.    Traditional Costing Before target costing is addressed further, it is necessary to understand the current statefor the majority of Western World firms. The traditional costing approach has themanagement accountant contributing only as a cost accountant, working with historicalinformation and subsequent to many significant decisions, which have already been made.The management accountant may then provide information that in today’s competitiveenvironment triggers an after-the-fact response, often too late to contribute cost savingsvalue to the company.In the traditional model of costing, costs are the driver. As costs increase, prices areincreased to sustain profit margins. Tried, but determined to not be so true, traditionalcosting abides by the following steps: Assess market needsEvaluate competing productsDevelop new productsDecide whether to make or buy products or componentsCalculate how much to invest in new processesSet up new processesManufacture new productsCost productsSet price The Process of Implementation - Target Costing into a New Product The target costing approach brings the management accountant into the process at theearly planning stage. The management accountant is contributing to the early decisions—should the company be making this kind of product? What constraints need to be appliedin the design stage? Is the market demand consistent with our projections? Can we achievethe determined return in this competitive of a market? Market Driven Selling Price - Desired Profit = Target Cost In the target costing model and opposed to the traditional method of costing, costs are notthe driver rather they are driven. The market sets the price, management sets the profitmargin, and the difference becomes the allowable cost—cost defined and constrained byprice realities and profit goals. New and increasingly necessary, target costing abides to thefollowing logical flow and procedures:    Establishing a Selling Price for the Product The target costing process begins by establishing a selling price, based on marketresearch, for the new product. From this target-selling price, the desired (target) profit issubtracted to determine the target cost. In all likelihood, this target is below the company’scurrent manufacturing cost. Teams from many departments then perform functional costanalysis in an attempt to reduce costs to a level in the acceptable range. If the current costestimate is at the target, the firm must decide whether or not to introduce the new product.If the current cost estimate is above the target, functional cost analysis is used to makechanges and prepare another cost estimate. Establishing a Target Profit for the Product Marketing plays a crucial role in the determination of the target cost. The starting point for atarget cost is the estimated selling price for the product determined by market analysis.Sales volume is also estimated and, from the total estimated sales revenue, the desiredprofit is subtracted. Management determines this desired profit margin in reference to thecompany’s long-term strategy. Retail prices and sales volumes are proposed by themarketing function based on its research and the company’s desired market share. Totalsales revenue for each new product over its life can now be estimated. The target profit,usually determined by using return on sales, is subtracted from the total sales revenue. Thetarget cost is now determined. Determine the Target Cost The target profit is subtracted from the target price to arrive at the target cost. Managementaccounting can play an important role in effectively determining target profits and targetcosts. Accountants can supply the information required to support marketing analysis for anew product and relate it to existing products. After the target cost is determined bysubtracting the target profit from the target price, functional cost analysis is used to achievethe target cost. Functional cost analysis is a group activity typically involving employeesfrom different departments (such as marketing, design, engineering, production,purchasing, and accounting) and is aimed at proposing alternatives for reducing overallproduct cost.This team-oriented approach requires that the employees of different departments bringtogether their knowledge and experience in the organisation to contribute to the costreduction process. Working with product designers, their motivation is not only to cut thenumber of parts but also to work toward the use of standard parts in designs that giveproducts desired functions at a lower cost. Perform Functional Cost Analysis and/or Value Engineering Functional cost analysis requires the preparation of a logical diagram for each function ofthe product. It should be noted that this is not a diagram of each part of the product since itis the functions of a product that determine its success in the market. Each function andsub-function of the product is defined to show the various operations of the product.
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