Question

What is target costIng? Please provide an in-depth explanation of its benefits to an organization. More specifically, the aerospace industry.

Answer 1

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.^[1] A target cost is the maximum amount of cost that can be incurred on a product, however, the firm can still earn the required profit margin from that product at a particular selling 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.

Key Features of Target Costing:

• The price of the product is determined by market conditions. The company is a price taker rather than a price maker.
• The minimum required profit margin is already included in the target selling price.
• It is part of management strategy to focus on cost reduction and effective cost management.
• Product design, specifications, and customer expectations are already built in while formulating the total selling price.
• The difference between the current cost and the target cost is the “cost reduction,” which management wants to achieve.
• A team is formed to integrate activities such as designing, purchasing, manufacturing, marketing, etc. to find and achieve the target cost.

Target costing involves a reverse analysis of the product, starting with the selling price. The company considers the projected price for each unit and its desired profit on the item. The company subtracts the desired profit from the selling price to determine the target cost per unit. The company assembles representatives from various departments to participate on a team to achieve the target cost. The team leader starts with the current cost information and calculates the amount of cost that it needs to eliminate. Together, the team comes up with ideas for reducing costs and reaching the target.

Another benefit of target costing is the improved processes that result from the team’s efforts. Target costing teams consider material costs, labor requirements and processes. Teams often discover inefficiencies in current processes and recommend improvements that increase efficiency and reduce costs. These improvements apply to the product being targeted as well as other products using the same process. By improving processes, the company reduces costs in other product lines as well.

Target costing teams require employees from different departments to collaborate on finding ways to reduce the product cost. These employees learn about the activities that occur in other departments and how their own actions affect others. These employees gain an appreciation for the big picture of the business and build relationships that transfer to future projects.