An Overview Of Target Costing

AN OVERVIEW OF TARGET COSTING

Introduction

Many managers often underestimate the power of target costing as a serious competitive tool. When general managers read the word "costing", they naturally assume it is a topic for their finance or accounting staff. They miss the fact that target costing is really a systematic profit and cost management process.

What Is Target Costing?

CAM-I defines target costing as the maximum amount of cost that can be incurred on a product and still earn the required profit margin from that product. This is captured by the equation

Target Cost = Price – Profit

At first sight the equation appears to reverse the familiar cost plus price equal profit that many firms use. However, behind the inversion of the equation are two very powerful ideas; (1) market price and profit margins are exogenous variables beyond the control of an organization’s management; and (2) customer and financial markets drive cost planning and not the other way around. Target costing, therefore, is a market driven system in which the needs of the customer and the likely reaction of competitors drive product and profit planning.

Target costing has six key principles:1

1. Price-led costing. Market prices are used to determine allowable or target costs.

2. Focus on customers. Customer requirements for quality, cost, and time are simultaneously incorporated in product and process decisions and guide cost analysis. The value (to the customer) of any features and functionality built into the product must be greater than the cost of providing those features and functionality.

3. Focus on design. Cost control is emphasized at the product and process design stage. Therefore, engineering changes must occur before production begins, resulting in lower costs and reduced “time-to-market” for new products.

4. Cross-functional teams. Cross-functional product and process teams are responsible for the entire product from initial concept through final production.

5. Value-chain involvement. All members of the value chain, e.g., suppliers, distributors, service providers, and customers, are included in the target costing process.

6. Life cycle cost reduction. Total life-cycle costs are minimized for both the producer and

1 These principles are adopted from, S. Ansari, J. Bell, and the CAM-I Target Cost Core Group, Target Costing, The Next Frontier in Strategic Cost Management, (Irwin/McGraw-Hill, 1997).

2

the customer. Life-cycle costs include purchase price, operating costs, maintenance, and distribution costs.

The Target Costing Process

To maximize cost control and enhance profit improvement, most companies set relatively aggressive targets. The process begins when top management establishes a target cost for a new product (e.