Question

Target Costing

The president of Houston Electronics was pleased with the company’s newest product, the HE Versatile CVD. The product is portable and can be attached to a computer to play or record computer programs or sound, attached to an amplifier to play or record music, or attached to a television to play or record TV programs. It can even be attached to a camcorder to record videos directly on compact disks rather than on tape. It also can be used with a headset to play or record sound. The proud president announced that this unique and innovative product would be an important factor in reestablishing the North American consumer electronics industry.

Based on development costs and predictions of sales volume, manufacturing costs, and distribution costs, the cost-based price of the HE Versatile CVD was determined to be $425. Following a market-skimming strategy, management set the initial selling price at $525. The marketing plan was to reduce the selling price by $50 during each of the first two years of the product’s life to obtain the highest contribution possible from each market segment.

The initial sales of the HE Versatile CVD were strong, and Houston Electronics found itself

adding second and third production shifts. Although these shifts were expensive, at a selling price of $525, the product had ample contribution margin to remain highly profitable. The president was talking with the company’s major investors about the desirability of obtaining financing for a major plant expansion when the bad news arrived. A foreign company had announced that it would shortly introduce a similar product that would incorporate new design features and sell for only $350. The president was shocked. “Why,” she remarked, “it costs us $375 to put a complete unit in the hands of customers.”

Required

How could the foreign competitor profitably sell a similar product for less than the manufacturing costs to Houston Electronics? What advice do you have for the president concerning the HE Versatile CVD? What advice would you have to help the company avoid similar problems in the future?

Answer 1

On analysis of the case study of Houston Electronics; following points can be observed:

• the product HE Versatile CVD was a novel product which did not have a competition.
• The development cost incurred were also included in the cost of the product.
• Houston Electronics has been following price skimming strategy.
• The product has a huge contribution margin thus as per the business plan of Houston Electronics, the selling price of the product will be reduced by $50 for two years.
• The new product that will be introduced will be selling at $350 which is way lesser than the calculated cost of Houston Electronics.

Answer to Part a) How could the foreign competitor profitably sell a similar product for less than the manufacturing costs to Houston Electronics

The attributable reasons can be explained as below:

• The pricing strategy of the competitor: The competitor is apparently following the strategy of market penetration. As it is evident that Houston Electronics has been enjoying a monopolistic market as it had the early mover advantage and thus there was no competition. Thus, to break into such a market, the competitor has to follow an aggressive pricing strategy like market penetration.
• The costing model of Houston Electronics: Houston Electronics is following absorption costing to arrive at the cost of $425. They have included all costs of development, manufacturing cost and distribution costs.
• Another point for such low cost of the competitors product could be the assumption that the conversion costs(Direct Labour costs) must've been substantially less than Houston Electronics.

Answer to Part B) What advice do you have for the president concerning the HE Versatile CVD?

Houston Electronics needs to change the costing method. The strategy seemed to be working well during the period when there was no competition. But considering the advent of a new competition in the market it is suggeted to switcg to those costing methods which focus more on the variable costs rather than the total costs.They should now be following the Target Costing .Target costing is a cost accounting approach in which companies set targets for costs based on the price prevalent in the market and the profit margin they want to earn. Keeping its costs below the relevant targets helps the companies to generate profit.

Target cost = Selling Price – Profit Margin

Advantage of this proposed method:

• It shows Houston Electronics management’s commitment to process improvements and product innovation to gain competitive advantages.
• The product is created from the expectation of the customer and, hence, cost is also based on similar lines. Thus, the customer feels more value is delivered.
• With the passage of time, the company’s operations improve drastically, creating economies of scale.
• The company’s approach to designing and manufacturing products becomes market-driven.
• New market opportunities can be converted into real savings to achieve the best value for money rather than to simply realize the lowest cost.

Answer to Part c) What advice would you have to help the company avoid similar problems in the future?

The organisation is working under a global competitve environment. It can not be expected to be operating in an isolated environment the threats from international competition would always be there. Following are the suggestions to help the company avoid similar problems in the future:

• SWOT analysis: Always carry out the analysis of the strenghts and weaknesses of the business. Also, the opportunities and threats in the business environment. In the current case, if the orgsnisation had conducted the threat analysis of the business environment, the current problem would not have been encountered.
• When there is a competition in the market, the best costing strategy would be target costing
• A six step approach would help the organisation to prevent problems in the future:

1. Know your local market:A great example is Google, which emerged from a university dorm to beat technology giants Microsoft and Yahoo at their own game. How? By focusing on what its users wanted: more relevant search results.

2. Focus on the client:Customer service often gets short shrift, but it can be a huge differentiator in almost any industry.

3. Be market-responsive: Although small local companies can more immediately respond to changes in their environment, they also need to stay close to customer needs and avoid making reactionary decisions.

4. Innovate to stay relevant:A marker of long-term business success is the ability to continuously innovate.

5. Develop strategic partnerships:Organisations with a strategic partnership will almost certainly be better placed to not only retain the qualities that made them successful in the first place, but (depending on the nature of the business) to value-add by offering customers access to the tools, technology, brands and services more often associated with larger competitors.

6. Play to your strengths:By staying connected to customers, being nimble and building strategic partnerships, they can even up the playing field and continue to dominate their local market.