Question

6. Why do firms use target costing? How are target costs established?

Answer 1

Target costing can be defined as “a structured approach for determining the cost at which a proposed product with specified functionality and quality must be produced to generate a desired level of profitability at its anticipated selling price”. A critical aspect of this definition is that it lays emphasis on the fact that target costing is much more than a management accounting technique.

Rather, it is an important part of a comprehensive management process aimed at helping a firm to survive in an increasingly competitive environment. Target costing is a management technique aimed at reducing a product’s life-cycle costs. A general concept of target costing is discussed here.

Objectives of Target Costing:

The fundamental objective of target costing is to enable management to use proactive cost planning, cost management and cost reduction practices whereby, costs are planned and managed out of a product and business, early in the design and development cycle, rather to an during the later stages of product development and production.

Broadly speaking, a target costing system has three objectives:

a. To lower the costs of new products so that the required profit level can be ensured.

b. The new products meet the levels of quality, delivery timing and price required by the market.

c. To motivate all company employees to achieve the target profit during new product development by making target costing a companywide profit management activity.

Advantages of Target Costing:

a. It helps to create a company’s market-driven management for designing and manufacturing products that meet the price required for the market success.

b. Assures that products are better matched to their customers’ needs.

c Reduces the development cycle of a product.

d. Reduces the costs of products significantly.

e. It reinforces top to bottom commitment to process and product innovation to achieve some competitive advantages.

Problems with Target Costing:

a. A large amount of mandatory cost cutting can result in finger pointing in various parts of the company; especially if employees in one area feel they are being called on to provide a disproportionately large part of the saving.

b. A design team having representatives from the number of departments can sometimes make it more difficult to reach a consensus on the proper design because there are too many opinions regarding design issues.

c. The development of the process can be lengthened to a considerable extent since the design team may require a number of design iterations before it can devise low cost product that meets the target cost and margin criteria. This occurrence is most common when the project manager is unwilling to discontinue a design project that cannot meet its costing goals within a reasonable time frame.

establishment of target costing-

Target costing was developed independently in both USA and Japan in different time periods.Target costing was adopted earlier by American companies to reduce cost and improve productivity, such as Ford Motor from 1900s, American Motors from 1950s-1960s. Although the ideas of target costing were also applied by a number of other American companies including Boeing, Caterpillar, Northern Telecom, few of them apply target costing as comprehensively and intensively as top Japanese companies such as Nissan, Toyota, Nippondenso.Target costing emerged from Japan from 1960s to early 1970s with the particular effort of Japanese automobile industry, including Toyota and Nissan. It did not receive global attention until late 1980s to 1990s when some authors such as Monden (1992),Sakurai (1989),Tanaka (1993),and Cooper (1992)described the way that Japanese companies applied target costing to thrive in their business (IMA 1994). With superior implementation system, Japanese manufacturers is more successful than the American companies in developing target costing.Traditional cost-plus pricing strategy has been impeding the productivity and profitability for a long time.As a new strategy, target costing is replacing traditional cost-plus pricing strategy by maximizing customer satisfaction by accepted level of quality and functionality while minimizing costs.