Target cost

From CEOpedia | Management online

Target cost is an economic category, meaning the value, expressed in money, of living labour and assets of a company used in a given period to manufacture products (S. Ahmeti,et all., 2013, p. 275-280). In other words, the target cost is the total amount in which a product must be manufactured to meet the needs of customers. A market-based target cost can be an excellent basis for establishing benchmarks, as it focuses on the future and requirements of customers and not on the company's internal design and technology capabilities (S. Ahmeti,et all., 2013, p.275-280). The target cost is the basis of the target cost method, which is a tool for strategic management accounting and strategic cost management, aimed at reducing the costs of a specific product throughout its life cycle. They are characterized by customer orientation, future orientation and interdisciplinary character. It is perceived as an instrument of strategic cost management. The decisive role is played by the product design phase. Costs are analysed throughout the product life cycle and compared with the customer's expectations of the product's functionality. It was established in the 1960s in Japan (S. Ahmeti,et all., 2013, p. 275).

Application

Target cost is used for cost control and mainly concerns the planning and design phase of the products to be introduced into production, as well as for product upgrades. The starting point is the sales price that can be achieved and includes the desired profit margin(W. Seidenschwarz, 2003, p. 437-453) . The purpose of the target cost calculation is to determine, through a gradual reduction, the amount of costs at which the product must be manufactured. Thus, it seeks to establish the costs to be incurred in order to make the product available to satisfy the needs of customers. A market-based target cost can be an excellent basis for establishing benchmarks, as it focuses on the future and requirements of the customers and not on the internal design and technology capabilities of the company (W. Seidenschwarz, 2003, p. 437).

Characteristics of target cost accounting

The following features are characteristic of this concept (R. Cooper 2002, p. 5-12):

  • The long-term achievement of a company's results is an objective for the cost orientation process,
  • decision variables occurring in the planning process carried out at the stage of product preparation are the parameters of the cost shaping process,
  • the subject of the cost shaping process are the assumed costs of the product,
  • Main assumptions in the target cost calculation,
  • The basic assumption in the cost calculation of the objective is that the planned result on the sale of the product and its planned market price remain unchanged, while the assumed costs of the product must be maintained at the level set by certain parameters (R. Cooper 2002, p. 5).

Comparison with other cost accounting concepts

The difference in the concept of target cost accounting from traditional cost accounting systems lies in the fact that (A. Lima,2016,  p. 11-25):

  • It allows for medium and long term cost impact of the product,
  • is integrated into the product life cycle,
  • is used to shape the production costs of products at the stage of their preparation,
  • is market-oriented and consumer-oriented,
  • takes into account human behaviour and enables the creation of an incentive system in companies,
  • it concerns the set-up costs of a product constituting a limit, an acceptable size guaranteeing the company's long-term viability,
  • The costs assumed for the product, its functional functions and components are explained using the cost function,
  • the cost of the product is the quantity explained by the market price and the expected long-term performance of the company (A. Lima,2016,  p. 25).

Examples of Target cost

  • An automotive manufacturer may set a target cost for a new car model at $30,000, which would include all costs associated with producing the car, such as labor, materials, and overhead. To achieve this cost, the manufacturer would need to negotiate with suppliers to reduce the cost of components, and find ways to reduce labor costs, such as increasing efficiency or automating certain processes.
  • A software development firm may set a target cost of $150,000 to develop a new software product. The firm would need to factor in the cost of labor, software licenses, hardware, and other costs associated with the project. They would need to negotiate with subcontractors and vendors to ensure they are able to meet their target cost.
  • A retail store may set a target cost for a new clothing line of $50 per item, which would include all costs associated with producing the item, such as labor, materials, and overhead. To achieve this cost, the store would need to negotiate with suppliers to reduce the cost of materials, optimize their production processes, and seek out cost-effective manufacturing solutions.

Advantages of Target cost

Target cost is an approach used in setting product prices and cost objectives that takes into account all the costs associated with a product design and development. Here are some advantages of using target cost:

  • It encourages innovation and cost reduction in product design and development, which can lead to improved profitability.
  • Target cost encourages designers and developers to consider the cost implications of their decisions early in the product design process.
  • It can help to eliminate waste and inefficiencies in the production process, resulting in lower costs and higher profits.
  • It provides a better understanding of the actual costs associated with a product, allowing companies to make more informed decisions on pricing and production.
  • Target cost can help to create a culture of cost-consciousness among a company's employees, leading to improved efficiency and profitability.

Limitations of Target cost

Target costing is a powerful tool for cost management, however, it has its limitations. These include:

  • Difficulty in predicting the future market. Target costing relies on predicting the future market for a product and its costs, which can be difficult to estimate accurately.
  • Difficulty in calculating the target cost. Setting a target cost requires significant research and data analysis, and can be complicated to calculate.
  • Difficulty in finding suppliers who can meet the target cost. It can be challenging to find suppliers who are able to meet the target cost.
  • Difficulty in controlling cost reduction. It can be difficult to control cost reduction once the target cost is set, as there are many factors that can affect the cost.
  • Difficulty in setting realistic target costs. It can be difficult to set realistic target costs when there are many variables involved in the cost calculation process.

Other approaches related to Target cost

Target costing is a cost management tool used to manage product costs by setting a target cost and working backward from the desired selling price to determine the cost at which the product must be produced. Other approaches related to target costing include:

  • Life Cycle Costing: A cost management tool that considers the total cost of ownership by taking into account the cost of purchasing, operating, and maintaining a product for its entire lifespan.
  • Throughput Accounting: A method of cost accounting which focuses on managing and optimizing the flow of products through the value chain.
  • Activity Based Costing: A system of costing which assigns indirect costs to activities based on the number of resources used in each activity.
  • Value Engineering: A structured approach to identify and eliminate unnecessary costs in a product or process.

In summary, target costing is a cost management tool used to control product costs, and there are other approaches related to it such as life cycle costing, throughput accounting, activity based costing, and value engineering.


Target cost — recommended articles
Step cost — Cycle time — Differential costing — Absorbed costs — Standard price — Designed quality — Cost avoidance — Master production schedule — Strategic cost management

References

Author: Rafal Maslyk

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