Welcome to Target Costing!
Hello there! Welcome to one of the most practical and logical chapters in your Performance Management (PM) studies. If you have ever looked at a new gadget and thought, "How can they afford to sell this for only \$50 and still make money?" then you are already thinking like a manager using Target Costing.
\n\nIn this chapter, we are going to flip traditional accounting on its head. Instead of making something and then deciding the price, we decide the price first and then figure out how to make it cheaply enough. Don't worry if it sounds a bit backwards; by the end of these notes, it will make perfect sense!
\n\n1. Traditional Costing vs. Target Costing
\nTo understand target costing, we first need to look at the "old way" of doing things. In traditional Cost-Plus Pricing, companies would design a product, calculate how much it costs to make, and then add a profit margin on top to get the selling price.
\n\nThe Traditional Formula:
\n\( Cost + Profit = Selling Price \)
The Problem: In today’s competitive world, customers don't care what it cost you to make a product. If your competitors sell a similar phone for \$400, you can't sell yours for \$600 just because your factory is inefficient! This is where Target Costing comes in.
\n\nThe Target Costing Formula:
\n\( Selling Price - Target Profit = Target Cost \)
Key Difference: In target costing, the market sets the price, and the company sets the cost. It is a "proactive" approach rather than a "reactive" one.
\n\nQuick Review: The Mindset Shift
\nTraditional: "It cost me \$10 to make, I want \$2 profit, so I'll sell it for \$12."
Target: "The market will only pay \$12. I want \$2 profit, so I must find a way to make it for \$10."
2. The Steps in Target Costing
\nImplementing target costing follows a logical sequence. Think of this as your "To-Do List" for the exam:
\n\nStep 1: Determine the selling price.
\nResearch the market. What are competitors charging? What are customers willing to pay? This is your Target Selling Price.
Step 2: Decide on the required profit.
\nManagement decides how much profit they want to make per unit. This is often a percentage of the selling price or a required return on investment. This is your Target Profit.
Step 3: Calculate the Target Cost.
\nUse the formula: \( Target Selling Price - Target Profit = Target Cost \).
Step 4: Estimate the actual cost.
\nLook at your current designs and processes. How much would it actually cost to make this product right now? This is the Estimated Cost.
Step 5: Calculate the "Cost Gap".
\nIf your Estimated Cost is higher than your Target Cost, you have a Cost Gap. This is the amount you need to "cut" from your expenses before production begins.
3. Understanding the Target Cost Gap
\nThe Cost Gap is simply the difference between what the product will cost to make and what it should cost to make to hit your profit goals.
\n\nThe Formula:
\n\( Cost Gap = Estimated Cost - Target Cost \)
Example:
\nIf the market price for a coffee maker is \$50 and you want a profit of \$10, your Target Cost is \$40. If your engineers say it will cost \$45 to make, your Cost Gap is \$5.
Important Point: In the PM exam, you must remember that target costing happens at the design stage. You want to close the gap before you start the machines in the factory!
4. How to Close the Cost Gap
Closing the gap isn't just about "cutting costs." It’s about being smart. Here are the most common ways companies close the gap:
- Value Engineering: Looking at every component. Can we use a cheaper material that does the same job? Can we remove a feature that customers don't actually value?
- Standardization: Using the same screws, buttons, or screens across many different products to get "bulk buy" discounts.
- Reducing Complexity: Making the product easier to assemble so it takes less time (saving on labor costs).
- Supply Chain Management: Negotiating better prices with suppliers or finding more efficient ways to ship parts.
- Process Innovation: Using new technology or better training to reduce waste and errors (spoilage).
Did you know?
Many car manufacturers use the same chassis (the base frame) for five or six different car models. This is a classic target costing technique to save millions in design and manufacturing costs!
5. Target Costing in Service Industries
Target costing is easy to imagine for a physical product like a phone, but what about services like a hair salon or an accounting firm? It is harder here because services have unique characteristics (remember the "SHIP" acronym):
- Simultaneity/Inseparability: The service is created and used at the same time (e.g., a haircut). You can't "inspect" it for quality before the customer sees it.
- Heterogeneity: Every time the service is performed, it might be slightly different (different stylists, different moods).
- Intangibility: You can’t touch a "service." Customers often judge value based on the environment or the staff's attitude.
- Perishability: You can't store a service in a warehouse. If a hotel room is empty tonight, that revenue is gone forever.
How to apply it: Even with these challenges, service firms can use target costing by focusing on staff time (their biggest cost) and standardizing processes where possible (like a set menu at a restaurant).
6. Common Pitfalls and Key Takeaways
Don't worry if this seems tricky at first; just keep these common exam "traps" in mind:
Common Mistakes to Avoid:
1. Forgetting the "Gap": Some students calculate the target cost but forget to compare it to the estimated cost to find the gap.
2. Mixing up Mark-up and Margin: Read carefully! Is the profit 20% of cost (mark-up) or 20% of price (margin)?
3. Ignoring Quality: You can't just cut costs by making a rubbish product. If quality drops, customers won't pay the target price!
Summary Key Takeaways:
- Target Cost = Market Price - Desired Profit.
- Cost Gap = Estimated Cost - Target Cost.
- The focus is on the design stage.
- It is an externally driven method (based on the market).
- Closing the gap requires teamwork between designers, engineers, and accountants.
You've got this! Target costing is all about finding the balance between what the customer wants to pay and what you need to earn. Keep practicing those "Cost Gap" calculations!