To determine the selling price of a product, the cost-plus pricing method is used most commonly. To put it simply, it adds up materials, labor, overhead costs, and finally puts in a desired profit margin on top. In other words, cost-plus pricing is centered on questions like “How much will our product cost?” and “How do we adjust the existing pricing structures so that we achieve the profit goal under any circumstances?”
Target costing follows a rather different approach. In the first place, it does not matter how much the product will cost. Instead, target costing focuses on consumer demand and asks questions like “What is the highest price our customers are willing to pay?”
It is little wonder that target costing originated in the 1970s in the Japanese manufacturing industry—a slightly tumbling industry at that time, challenged by fierce competition, ever-shorter product lifecycles, as well as consumer demand for more diversity. The then familiar procedure of designing innovative new products—no matter what the product price (the customer base would pay for it later on anyway)—could not be taken for granted any longer. Development and planning stages of new products eventually became more important to achieve competitive market prices.
The advantages of target costing
Target costing is not just a method of cost control; it’s also a management tool that involves all disciplines and is aimed at reducing each product’s overall cost over its entire lifecycle. In that process, target costs are defined as calculated maximum costs that can be incurred on the product after a desired profit margin has already been subtracted, so that eventually the product can still be sold at a competitive market price.
Competitive Market Price – Profit Margin = Target Costs
In most cases, the process of target costing starts even before the proper production stages begin; usually it comes into effect in the design phase. That is especially important given that the major amount of final product costs (up to 80%) is determined in the design stage when the product’s components and main functions are specified. Later on, those costs can hardly be squeezed; they are effectively fixed. Given that target costing manages costs from the design stage, it maximizes the potential for cost savings.
This leads us directly to another advantage: customer orientation. Target costing opposes product development solely based on the engineering department’s view. Since target costing is a market-driven approach, it guides all functions within the organization to respond to competitive trends as well as customer requirements for product quality, costs, or product functions and features. Extensive market research ensures that all consumer requests and their specific price sensitivities are met.
That proceeding also allows for major product changes before prototyping or even production stages—at much lower monetary and temporal capacities. Say, if the company’s marketing team finds out that potential customers do not need one of the product’s (expensive) main features after production has already started and the product has been finally launched, hard times might lie ahead. Changes made in the initial design stage instead result in lower costs and better matching of customers’ expectations, eventually leading to products being launched at attractive prices and leading to greater market success.
Furthermore, target costing defines a multidisciplinary process that involves mostly all of the organization’s functions that play important roles in cost analysis as well as decision-making. Just to name the essential ones:
- Engineering (identifying cost savings without crucially curbing product functionality)
- Purchasing (working in close partnership with the company’s supply chain to save costs on the components or raw materials bought)
- Sales & Distribution (conducting market research, measuring the specific value of components and features in relation to the customer base, establishing competitive market prices)
- Finance / Management Accounting (determining specific cost targets, reporting and monitoring possible gaps between actual costs and target costs, coordinating the overall target costing processes)
- Manufacturing (making improvements in manufacturing procedures, eventually leading to decreasing costs)
The primary steps in the target costing process
Step 1: Market research—finding a competitive market price
Since customer requirements in globalized and highly competitive markets play an ever-bigger role, the process of “dreaming up products, bringing them into the production stage, adding a specific mark-up to the production costs and finally hoping those products become longsellers” no longer works. The organization rather has to determine customer behavior, satisfaction and demand:
- Are there different types of consumers within the market, and in which dimensions do potential sales volumes range?
- Which key features do potential customers demand and how much are they willing to pay for those?
- Are there any competitors and what are their main differences relating to product range and handling of the market?
- Does our product include components or features that consumers do not value, and hence do not want to pay for?
After extensive market research, the research team should have a much better picture of the value of individual features and the impact of dropping one feature (or not) on selling prices. Eventually they can define a competitive market price—or target price—for their product.
Step 2: Capping production costs—calculation of target costs
After the target price has been decided on with a certain percentage of surcharge (potential profit margin) in mind, the target costs are set as follows:
Target Price – Profit Margin = Target or Allowable Costs
The organization has to find ways of achieving—which does not mean exceeding—those costs. In other words, it has to ensure a satisfying financial outcome at given costs, or rather, given prices. In contrast to the traditional cost-plus pricing approach, target costing does not start with consideration of the product costs and thereafter does not automatically lead to the selling price (after addition of a mark-up).
Step 3: Product engineering—keeping costs in sight
Based on the already executed market research, and using insights on customer requirements and product expectations, the engineering team has to determine the overall interaction of components and features to create a well-selling product. In that stage, it is also important to perform functional cost analyses for individual components and the production process.
The following decisions during the design or engineering stage can particularly affect product costs:
- Well-considered choices of product features, and the quantity as well as quality of necessary components
- Sole inclusion of the features that are highly valued by potential customers (to avoid over-design/over-engineering)
- Usage of either standardized or individually manufactured specialized components
- Deciding between make (in-house) or buy (via subcontractors)
- Taking advantage of economies of scale in production (e.g. variation of batch sizes)
Finally, there will be a cost estimate (or rather actual costs) for the product, which can be compared with the target costs.
Step 4: Achieving target costs—an iterative, ongoing process of closing the gap between actual and target costs
At the beginning of each product’s lifecycle, it is quite usual to have a few extra costs (that is, a gap between actual/estimate and target/allowable costs), which have to be taken out of the new product before production starts under full load.
Once the gap between actual and target costs has been identified, the organization normally has several options to close it. So, which one is best suited to reduce actual costs, but without cutting away too much value from the product (value based on customers’ wants and needs)?
The answer won’t work out at one go—it is likely to require several design or engineering iterations, difficult judgments as well as repeated cost analyses, until the combination of revised components or features goes along with the minimum loss of product esteem or value, and meets the cost target.
Changes in features normally allow for bigger reductions in costs compared with the switching of components—especially if the components’ suppliers benefit from market power, which finally leads to fixed quotation prices and less room for price cuts.
Compromises on quality, say, resulting from the use of cheaper, low-grade components, make the decision of customers—that is, whether to buy the product—less obvious. On the contrary, the cancellation of a feature might theoretically (if highly valued in consumers’ opinion) result in a straight “no-buy” because potential customers are no longer willing to pay the defined target price. However, such a scenario can be avoided by mainly concentrating on costs of the features that exceed their value to the customer (meaning that the feature can be abandoned smoothly).
Cancellation of substandard, unprofitable product development
What should be done if even after multiple product revisions, the cost target cannot be met, or target costs are only achievable with an inappropriate cutback of product features, or rather, usage of inferior components?
Generally, the company’s ultimate maxim should not be to launch the product anyhow—eventually poor products’ damaging influence on the organization’s entire reputation cannot be underestimated. But launching a product at the expense of squeezed profit margins is not a viable alternative either. The overall top-level profit margin as well as the level of determined target costs should be seen as irreversible commitment.
The correct response in such a situation is simply to stop the product development process and move on to other projects or innovations, whose cost estimates might be on target.
It is also advisable to make such management decisions concerning “product launch or cancellation” within a limited timeframe so that the project team does not struggle for months and waste resources before finally giving up. Setting several milestones for achieving target costs and monitoring their (maybe failed) completion make it easier to decide whether to slam the emergency brakes on that runaway project.
Besides, managements’ cancellation of projects that do not meet their target costs does not necessarily mean a death blow to those. Each of those projects should be reviewed at least once a year to see whether the overall circumstances have changed (e.g. a slump in commodity prices, making material costs less expensive).
Even a product that has achieved its targets and for which production has already started should not be disregarded henceforward. Actual costs need to be continuously monitored and managed against the targets, using standard budgeting/costing methods within the organization—taking actions on processes and cost structures if and where necessary.
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Must-read blog posts about management accounting and financial control—classical topics, as well as modern subjects, latest trends, and current challenges in the management accounting discipline. Aimed to inform, inspire, and entertain management accountants and anyone with a deeper interest in management accounting.