Welcome to Target Costing!
Welcome to this chapter on Target Costing. As part of your studies in "Managing the costs of creating value," this is a crucial topic. In the traditional world, businesses often built a product, added a profit margin, and hoped customers would pay the price. But in today’s competitive world, the market dictates the price. Target costing turns the traditional approach on its head. Instead of asking "What will it cost to make this?", we ask "What can we afford to spend to make this?"
Don't worry if this seems a bit backwards at first—by the end of these notes, you'll see why it's a powerful tool for creating value.
1. What is Target Costing?
Target costing is a proactive cost management tool used during the design and development stage of a product's life cycle. It ensures that a product is designed to be profitable from the very beginning.
In the P2 syllabus, it's vital to remember that target costing is market-driven. We look at what the customer is willing to pay first, and then work backwards.
Traditional Costing vs. Target Costing
The Traditional Approach (Cost-Plus):
Estimated Cost + Profit Margin = Selling Price
Problem: If the market thinks the price is too high, you won't sell anything!
The Target Costing Approach:
Target Selling Price - Target Profit Margin = Target Cost
Analogy: Imagine you are making a smartphone.
Traditional: You spend \$500 making it, add \$100 profit, and try to sell it for \$600. If customers only want to pay \$450, you are in trouble.
Target Costing: You see that customers will pay \$450. You need a \$50 profit. Therefore, you must find a way to manufacture it for \$400. You design the phone specifically to hit that \$400 mark.
Quick Review: Target costing happens before production begins. It is much easier to "design out" costs than to try and "cut" costs once the factory is already running!
2. The Target Costing Process
Closing the gap between what a product might cost and what it must cost is the heart of this chapter. Here are the steps:
Step 1: Determine the Target Selling Price
This is based on market research, competitor prices, and the value customers perceive in the product's features.
Step 2: Determine the Target Profit Margin
This is usually set by management based on the company’s required Return on Sales or specific financial objectives.
Step 3: Calculate the Target Cost
Use the formula: \( Target Cost = Target Selling Price - Target Profit \)
Step 4: Estimate the Current Cost
Based on current designs and processes, what would it cost to make this product today?
Step 5: Identify the "Cost Gap"
The Cost Gap is the difference between what we want it to cost (Target Cost) and what we think it will cost (Estimated Cost).
\( Cost Gap = Estimated Cost - Target Cost \)
Step 6: Close the Gap
This is where the hard work happens. The team must find ways to reduce the estimated cost until it meets the target cost without sacrificing the quality the customer expects.
Key Takeaway: The goal is always to eliminate the Cost Gap before production starts.
3. How to Close the Cost Gap
Closing the gap isn't just about using cheaper materials; it’s about being smart. Here are the main techniques mentioned in the P2 curriculum:
Value Engineering (VE): This involves looking at the product at the design stage to see if any components can be simplified, standardized, or removed without reducing the value to the customer.
Example: Using the same type of screw across five different products to get a bulk discount.
Value Analysis (VA): Similar to VE, but often applied to existing products. It asks: "Does this feature add enough value to justify its cost?"
Functional Analysis: We look at the functions the customer wants (e.g., "the phone must take clear photos") rather than the components. We then allocate costs to those functions. If a function costs 40% of the budget but customers only value it at 10%, that’s where we cut costs!
Other methods to close the gap:
• Reducing the number of components.
• Using standard parts instead of custom-made ones.
• Negotiating better prices with suppliers.
• Improving production efficiency (Lean manufacturing).
• Training staff to reduce waste.
Did you know? Most of a product's costs (often up to 80%) are "locked in" during the design stage. That's why target costing focuses so heavily on design.
4. Target Costing in Service Industries
Target costing isn't just for making widgets; it applies to services (like an airline or a consultancy) too. However, services have unique challenges:
• Intangibility: It’s harder to define the "components" of a service.
• Perishability: You can't store a service in a warehouse (e.g., an empty seat on a flight).
• Inseparability: The service is created and consumed at the same time.
• Variability: Every customer experience might be slightly different.
To use target costing in services, focus on the processes and the time taken. If the target cost for a hair transplant is \$3,000, the clinic must analyze the cost of the surgeon's time, the clinic space, and the materials used to ensure they stay within that limit.
5. Benefits and Challenges
Benefits:
• It forces the company to be customer-focused.
• It encourages different departments (Design, Engineering, Marketing, Finance) to work together early on.
• it reduces the risk of launching a product that no one can afford.
Challenges:
• It can be very time-consuming at the start.
• It requires excellent communication between departments.
• It can put a lot of pressure on staff to meet difficult cost targets, which might lead to stress or "corner-cutting."
6. Common Pitfalls to Avoid (Student Tips)
Mistake 1: Subtracting profit from cost. Remember the formula! You subtract profit from the Selling Price to find the Target Cost.
Mistake 2: Forgetting quality. If you close the cost gap by making the product "cheap and nasty," customers won't pay the target price anyway. You must maintain Value.
Mistake 3: Thinking it's only for new products. While best for new designs, it can be used for redesigns of existing products too.
Memory Aid: The "T-P-S" Rule
To remember the formula, think: Total Price System.
Target Price - Profit = Spending limit (Target Cost).
Key Takeaway Summary: Target costing is a market-driven approach that determines the allowable cost of a product by subtracting the required profit from the market price. It focuses on the design stage to eliminate cost gaps through value engineering and functional analysis.