The upcoming discussion will update you about the difference between traditional costing and target costing. Traditionally, manufacturers would make use of the cost-plus approach to estimate the product price. This will be followed by the design of the product. Vendors will then be contacted to identify the total costs of the components which are required by the design and engineering departments.
Finally, cost components are summed up and a selling price is set based on the costs. If the management and the marketing department think that the price and cost are too high, the product design and engineering process will be repeated till an acceptable cost is reached, after which, production will begin.
Subtracting the desired profit margin set by the management from the predicted selling price, maximum target cost is arrived at.
This target cost is then compared to an expected product cost and if it is higher than the expected product cost, the company has several options. This is carried out by all the members of the planning team the suppliers, design, engineering, and production and marketing department who will investigate the need and cost of each component. All the members will work together instead of going through various departments sequentially to reduce cost.
When the target cost is reached, standards can be set and product will then enter the manufacturing phase. Secondly, the management might consider accepting a less-than-desired profit margin.
This will depend on the numerical difference between expected cost and target cost. If the target cost is slightly higher than the expected cost, a slightly lower profit margin will be feasible.
However, if the difference is too great and there is no way for the company to earn the profit margin that it desires, its third alternative would be to abandon that particular product. In short, target costing can be viewed as a system of profit planning and cost management that is customer focused, price led, design centered and cross functional. In brief the use of target costing forces managers to change their way of thinking with regard to the relationship among cost, selling price and profitability.
The traditional mindset has been that a product is developed, production cost is identified and measured, a selling price is set, and either profits or losses will result. However, in target costing, a product is developed, a selling price and desired profit are determined and maximum allowable cost is derived. This makes cost dependent on selling prices.To login with Google, please enable popups.
Log in. Get started today! Cohe Midterm. Edit a Copy. Study these flashcards. Lauren F. Which of the following statements about fee-for-service reimbursement is incorrect? Payment may be based on the number of covered lives. The balance sheet is affected by changes in the. In Januarywhen the salaries were paid, the effect of the transaction was to:. True or False: Providers accepting capitated contracts need to receive a per member per month premium sufficient to cover medical costs, administrative costs, and a reserve to protect against medical losses that exceed actuarial estimates.
True or False: Pricing analysis should only consider the most likely scenario using the best available estimates of input variables such as utilization and variable costs.
True or False: The price set for a service could affect the volume of that service; therefore, pricing decisions should consider the effects of both prices and volumes on profits. Assume a governmental payer reimburses Mercy Hospital at a rate that covers only 60 percent of the cost of providing one inpatient day.
In contrast, Mercy Hospital negotiates with private insurers for a rate that covers greater than percent of the cost of providing one inpatient day.Learning Objective of the Article:.
In traditional costing system it is presumed that a product has already been developed, has been costed, and is ready to be marketed as soon as a price is set. In many cases, the sequence of events is just the reverse. That is, the company already knows what price should be charged, and the problem is to develop a product that can be marketed profitably at the desired price. Even in this situation, where the normal sequence of events is reversed, cost is still a crucial factor.
The company can use an approach called 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. Following formula or equation further explains this concept:.
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:. 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.Dumb Reason The US Lost A $1.4 Billion Aircraft
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.
To provide a simple numerical example of target costingassume the following situations:. Handy Appliance Company feels that there is a market niche for a hand mixer with certain new features. At that price, marketing estimates that 40, of new mixers could be sold annually.
Each functional area would be responsible for keeping its actual costs within target. Target costing has the following main advantages or benefits:. Target costing approach has the following main disadvantages or limitations:. After repeating this process a number of times, the final blueprint is drawn up and turned over to the production department.
In the first several months of production, the target costs will ordinarily not be achieved due to problems in getting a new model into production.Target costing is a systematic approach to establishing product cost goals based on market driven standards. Target costing begins with identifying customer needs and calculating an acceptable target sales price for the product. Working backward from the sales price, companies establish an acceptable target profit and calculate the target cost as follows:.
Target Costing is different from standard costing. The target cost is normally less than the current cost. Thus, managers must try to reduce costs from the design and manufacture of the product. Target costing tries to reduce costs as shown in Exhibit The bar at the left in Exhibit The bar at the right shows that the market price is expected to decline in the future.
The target cost is estimated as the difference between the expected market price and the desired profit. To reduce the costs in target costing, the following analysis needs to be made.
Value analysis attempts to assess the value placed on various product functions by customers. If the price customers are willing to pay for a particular function is less than its cost, the function is a candidate for elimination.
Both reverse engineering and value analysis focus on product design to achieve cost reductions. The processes used to produce and market the product are also sources of potential cost reduction. Thus, redesigning processes to improve their efficiency can also contribute to achieving the needed cost reductions. Target costing sets the target cost by first determining the price at which a product can be sold in the marketplace.
Subtracting the target profit margin from this target price yields the target cost, that is, the cost at which the product must be manufactured. Notice that in a target costing approach, the price is set first, and then the target product cost is determined. This is opposite from the order in which the product cost and selling price are determined under traditional cost-plus pricing. What products do they want? What features are important?
How much are they willing to pay for a certain level of product quality? Management needs to aggressively seek customer feedback, and then products must be designed to satisfy customer demand and be sold at a price they are willing to pay.
In short, the target costing approach is market driven. Design engineering is a key element in target costing. Engineers must design a product from the ground up so that it can be produced at its target cost. This design activity includes specifying the raw materials and components to be used as well as the labour, machinery, and other elements of the production process.
In short, a product must be designed for manufacturability. Every aspect of the production process must be examined to make sure that the product is produced as efficiently as possible. Manufacturing a product at or below its target cost requires the involvement of people from many different functions in an organisation: market research, sales, design engineering, procurement, production engineering, production scheduling, material handling and cost management.
Individuals from all these diverse areas of expertise can make key contributions to the target costing process. Moreover, a cross-functional team is not a set of specialists who contribute their expertise and then leave; they are responsible for the entire product. These include the costs of product planning and concept design, preliminary design, detailed design and testing, production, distribution and customer service.
Sometimes the projected cost of a new product is above the target cost.Target costing is an approach to determine a product's life-cycle cost which should be sufficient to develop specified functionality and quality, while ensuring its desired profit. It involves setting a target cost by subtracting a desired profit margin from a competitive market price.
Target costing decomposes the target cost from product level to component level. Through this decomposition, target costing spreads the competitive pressure faced by the company to product's designers and suppliers.
Target costing consists of cost planning in the design phase of production as well as cost control throughout the resulting product life cycle. The cardinal rule of target costing is to never exceed the target cost. However, the focus of target costing is not to minimize costs, but to achieve a desired level of cost reduction determined by the target costing process.
The fundamental objective of target costing is to manage the business to be profitable in a highly competitive marketplace. In effect, target costing is a proactive cost planning, cost managementand cost reduction practice whereby costs are planned and managed out of a product and business early in the design and development cycle, rather than during the later stages of product development and production. Target costing was developed independently in both USA and Japan in different time periods.
Although the ideas of target costing were also applied by a number of other American companies including BoeingCaterpillarNorthern Telecomfew of them apply target costing as comprehensively and intensively as top Japanese companies such as NissanToyotaNippondenso. It did not receive global attention until late s to s when some authors such as Monden Sakurai Tanaka and Cooper  described the way that Japanese companies applied target costing to thrive in their business IMA With superior implementation systems, Japanese manufacturers are more successful than the American companies in developing target costing.
The process of target costing can be divided into three sections: the first section involves in market-driven target costing, which focuses on studying market conditions to identify a product's allowable cost in order to meet the company's long-term profit at expected selling price; the second section involves performing cost reduction strategies with the product designer's effort and creativity to identify the product-level target cost; the third section is component-level target cost which decomposes the production cost to functional and component levels to transmit cost responsibility to suppliers.
Market driven target costing is the first section in the target costing process which focuses on studying market conditions and determining the company's profit margin in order to identify the allowable cost of a product. Market driven costing can go through 5 steps including: establish company's long-term sales and profit objective; develop the mix of products; identify target selling price for each product; identify profit margin for each product; and calculate allowable cost of each product.
Company's long-term sales and profit objectives are developed from an extensive analysis of relevant information relating to customers, market and products. Only realistic plans are accepted to proceed to the next step.
Product mix is designed carefully to ensure that it satisfies many customers, but also does not contain too many products to confuse customers. Company may use simulation to explore the impact of overall profit objective to different product mixes and determine the most feasible product mix. Target selling price, target profit margin and allowable cost are identified for each product.
Target selling price need to consider to the expected market condition at the time launching the product. Internal factors such as product's functionality and profit objective, and external factors such as company's image or expected price of competitive products will influence target selling price. Company's long-term profit plan and life-cycle cost are considered when determining target profit margin.
Firms might set up target profit margin based on either actual profit margin of previous products or target profit margin of product line. Simulation for overall group profitability can help to make sure achieving group target.Target costing is a system under which a company plans in advance for the price pointsproduct costs, and margins that it wants to achieve for a new product. If it cannot manufacture a product at these planned levels, then it cancels the design project entirely.
Target Costing: Concept and 7 Key Principles
With target costing, a management team has a powerful tool for continually monitoring products from the moment they enter the design phase and onward throughout their product life cycles. It is considered one of the most important tools for achieving consistent profitability in a manufacturing environment. Conduct research. The first step is to review the marketplace in which the company wants to sell products.
The design team needs to determine the set of product features that customers are most likely to buy, and the amount they will pay for those features. The team must learn about the perceived value of individual features, in case they later need to determine what impact there will be on the product price if they drop one or more features. It may be necessary to later drop a product feature if the team decides that it cannot provide the feature while still meeting its target cost.
At the end of this process, the team has a good idea of the target price at which it can sell the proposed product with a certain set of features, and how it must alter the price if it drops some features from the product. Calculate maximum cost. The company provides the design team with a mandated gross margin that the proposed product must earn.
By subtracting the mandated gross margin from the projected product price, the team can easily determine the maximum target cost that the product must achieve before it can be allowed into production. Engineer the product. The engineers and procurement personnel on the team now take the leading role in creating the product. The procurement staff is particularly important if the product has a high proportion of purchased parts; they must determine component pricing based on the necessary quality, delivery, and quantity levels expected for the product.
They may also be involved in outsourcing parts, if this results in lower costs. The engineers must design the product to meet the cost target, which will likely include a number of design iterations to see which combination of revised features and design considerations results in the lowest cost.
Ongoing activities. Once a product design is finalized and approved, the team is reconstituted to include fewer designers and more industrial engineers. The team now enters into a new phase of reducing production costs, which continues for the life of the product.
Target Costing: Definition, Objectives and Advantages
For example, cost reductions may come from waste reductions in production known as kaizen costingor from planned supplier cost reductions. These ongoing cost reductions yield enough additional gross margin for the company to further reduce the price of the product over time, in response to increases in the level of competition. The design team uses one of the following approaches to more tightly focus its cost reduction efforts:.
Tied to components. The design team allocates the cost reduction goal among the various product components. This approach tends to result in incremental cost reductions to the same components that were used in the last iteration of the product. This approach is commonly used when a company is simply trying to refresh an existing product with a new version, and wants to retain the same underlying product structure.
The cost reductions achieved through this approach tend to be relatively low, but also result in a high rate of product success, as well as a fairly short design period.
Tied to features. The product team allocates the cost reduction goal among various product features, which focuses attention away from any product designs that may have been inherited from the preceding model. This approach tends to achieve more radical cost reductions and design changesbut also requires more time to design, and also runs a greater risk of product failure or at least greater warranty costs.Question 1.
Accurate cost estimates are required by strategic management for all except: Points : 2. Question 2. The use of a relationship of total factory overhead to direct labor hours is said to be valid only within the relevant range, which means: Points : 2. Question 5. High operating leverage represents increased risk associated with relatively: Points : 2. Question 6. The difference between sales price per unit and variable cost per unit is the: Points : 2.
Question 7. Income taxes have the following effect on the breakeven point calculation: Points : 2. They may increase or decrease the breakeven point, depending on the cost structure of the organization.
Question A budgeting system that has, in effect, a budget for a set number of periods i. The act of encouraging non-value-adding actions on the part of management in order to improve indicated performance is referred to as: Points : 2. All of the following represent alternative approaches to the traditional budget-preparation process except which one? Points : 2. Thompson Refrigerators Inc. To do so, the company must forecast its total overhead cost. The actual machine hours and total overhead cost are presented below for the past six months.
Brownsville Novelty Store prepared the following budget information for the month of May:. The store had 1, gallons on hand at the beginning of March, and expects to have 1, gallons on hand at the end of March. What is the budgeted number of gallons to be sold during March?