Target Costing
If a company can produce for the target cost (or less), it will meet its profit goal. If it cannot
achieve its target cost, it will fail to produce the desired profits.
In a competitive market, a company generally establishes and uses a target cost as follows:
1. It chooses the market segment it wants to compete in; that is, its market niche. For
example, it may choose between selling luxury goods or economy goods to focus its
efforts on one segment or the other.
2. Next, it does market research to determine the features that its products should have and
the target price for a product with those features. This target price is the price that the
company believes would place it in the best position for its target audience (its
customers).
3. It determines its target cost by setting a desired profit. The difference between the market
price and the desired profit is the target cost of the product. (Illustration 9.2 showed this
calculation.)
4. It assembles a team of employees with expertise in a variety of areas (production and
operations, marketing, and finance). The team’s task is to design and develop a product
that can meet quality specifications without costing more than the target cost.
The target cost includes all the product and period costs that are necessary to make and market
the product or service.
Total Cost-Plus Pricing
As discussed, in a competitive product environment, the price of a product is set by the market.
In order to achieve its desired profit, the company focuses on achieving a target cost.
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In a less competitive environment, companies have a greater ability to set the product
price.
Commonly, when a company sets a product price, it does so as a function of, or relative
to, the cost of the product or service. This is referred to as total cost-plus pricing.
Under total cost-plus pricing, a company first determines a cost base and then adds a
markup to the cost base to determine the target selling price.
If the cost base includes all the costs required to produce and sell the product, then the markup
represents the desired profit.
Assuming that the company desires a 20% ROI and that it has invested $1 million.
Limitations of Total Cost-Plus Pricing
This cost model does not consider the demand side. That is, will customers pay the price
Thinkmore calculated for its video camera pen?
Sales volume plays a large role in determining per-unit costs. The lower the sales volume, for
example, the higher the price Thinkmore must charge to meet its desired ROI.
Absorption Cost-Plus Pricing
The absorption cost-plus pricing approach defines the cost base as the manufacturing cost.
Both the variable and fixed selling and administrative costs are excluded from this cost base.
1. A company’s cost accounting system provides absorption cost information most easily.
Because absorption cost data already exists in general ledger accounts, it is cost-effective
to use them for pricing.
2. Basing the cost-plus formula on only variable costs could encourage managers to set too
low a price to boost sales. There is the fear that if only variable costs are used, managers
will substitute them for total costs, and this can lead to repeated price-cutting.
3. The absorption cost or total cost is the easiest basis to defend when prices need to be
justified to all interested parties—managers, customers, and governments.
Variable Cost-Plus Pricing
Under variable cost-plus pricing, the cost base consists of all of the variable costs associated
with a product, including the variable selling and administrative costs.
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Because fixed costs are not included in the base, the markup must cover fixed costs
(manufacturing, as well as selling and administrative) and the target ROI.
Variable cost-plus pricing is more useful for making short-term decisions because it
considers variable-cost and fixed-cost behaviour patterns separately.
The major disadvantage of variable-cost pricing is that managers may set the price too low and
consequently fail to cover their fixed costs. In the long run, failure to cover fixed costs will lead
to losses. As a result, companies that use variable-cost pricing must use higher markups to make
sure that the price they set will give a fair return.
Under any of the three approaches we have looked at (total cost, absorption cost, and variable
cost), the company will reach its desired ROI only if it reaches the budgeted sales volume for the
period.
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None of these approaches guarantees a profit or a desired ROI.
Achieving a desired ROI is the result of many factors, and some of these are beyond the
company’s control, such as market conditions, political and legal issues, customers’
tastes, and competitors’ actions.
Time-and-Material Pricing
Another variation on cost-plus pricing is called time-and-material pricing.
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Under this approach, the company sets two pricing rates: one for the labor used on a job
and another for the material.
The labor rate includes direct labor time and other employee costs.
The material charge is based on the cost of direct parts and materials used and a material
loading charge for related overhead costs.
Time-and-material pricing is widely used in service industries, especially professional firms such
as public accounting, law, engineering, and consulting firms, as well as construction companies,
repair shops, and printers.
Using time-and-material pricing involves three steps:
1. Calculate the per-hour labor charge.
2. Calculate the charge for obtaining and holding materials.
3. Calculate the charges for a particular job.
The marina budgets 5,000 hours of repair time in 2022, and it desires a profit margin of $8 per
hour of labor.
The marina multiplies this rate of $38.20 by the number of hours of labor used on any job to
determine the labor charge for that job.
Calculate the material loading charge.
1. Estimates its total annual costs for purchasing, receiving, handling, and storing materials.
2. Divides this amount by the total estimated cost of parts and materials.
3. Adds a desired profit margin on the materials themselves.
The marina estimates that the total invoice cost of parts and materials used in 2022 will be
$120,000. The marina desires a 20% profit margin on the invoice cost of parts and materials.
The marina’s material loading charge on any job is 43.50% multiplied by the cost of materials
used on the job. For example, if the marina used $100 in parts, the additional material loading
charge would be $43.50.
Calculate charges for a particular job.
1. The labor charge,
2. The charge for the materials,
3. The material loading charge.
Lake Holiday Marina estimates the job will require 50 hours of labor and $3,600 in parts and
materials.
Included in the $7,076 price quotation for the boat repair and refurbishment are charges for labor
costs, overhead costs, materials costs, materials handling and storage costs, and a profit margin
on both labor and parts.
Transfer Pricing for Internal Sales
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A division within a vertically integrated company normally transfers goods or services to
other divisions within the same company, as well as making sales to customers outside
the company.
When companies transfer goods internally, the price they use to record the transfer
between the two divisions is the transfer price.
The price charged for intermediate goods is the cost of goods sold to the buying division
(assembly division) and revenue to the selling division (manufacturing division).
A high transfer price results in high revenue for the selling division and high costs for the
buying division.
A low transfer price has the reverse outcome and therefore affects the selling division’s
performance.
Thus, transfer prices can be a point of serious disagreement for division managers and can lead
to actions that benefit a division but hurt the company.
A firm’s transfer pricing policy should accomplish three objectives:
1. Promote goal congruence. The policy should motivate division managers to choose
actions that maximize company earnings as a whole and it should allow each division
manager to make decisions that maximize his or her own division’s earnings.
2. Maintain divisional autonomy. Top management should not interfere with the decisionmaking process of division managers.
3. Provide accurate performance evaluation. The policy should make it possible to
accurately evaluate the division managers involved in the transfer.
Key elements in this approach are:
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The minimum price that the selling division is willing to accept and the maximum price
that the buying division is willing to pay.
For the selling division, the minimum price is the price that it needs to charge the buying
division so that the selling division would not be better off if it sold the product to an
outside buyer.
For the buying division, the maximum price is determined by the outside market.
Therefore, the maximum price is how much the buying division would have to pay an
outside seller for the product.
When minimum and maximum prices are known, the division managers can decide if a
transfer should occur.
Goods should be transferred internally if the selling division’s minimum price is less than
or equal to the buying division’s maximum price.
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The above information indicates that the assembly division has a contribution margin per
unit of $90 and the manufacturing division has a contribution margin of $35.
The total contribution margin per bicycle is $125 ($90 + $35) for the Aerobic Bicycle
Company as a whole.
Minimum transfer price—no excess capacity
If the transfer price is charged at $130, according to the general approach, the company achieves
goal congruence.
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The manufacturing division is willing to transfer its products to the assembly division at
the price of $130, which is equal to the external market price.
The assembly division is willing to buy the bicycle components from the internal division
because the assembly division will have a contribution margin of $90 on each bicycle
component purchased from the manufacturing division ($290 sales price minus the $70 of
variable assembly costs and the transfer price of $130).
Thus, the total contribution margin per unit is $125 ($90 + $35) for the Aerobic Bicycle
Company.
Minimum transfer price – excess capacity
If the transfer price is charged at $95, according to the general approach, Aerobic Bicycle
Company achieves goal congruence because the total contribution margin per unit is still $125
($125 + $0) for the company.
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It is in the company’s best interest for the bicycle components to be purchased internally
from the manufacturing division if the variable cost to produce and transfer the bicycle
components is less than the outside price of $130.
In this situation, it is beneficial for the assembly division to buy the bicycle components
from the manufacturing division because it will have a contribution margin that is greater
than $90 on the components for each bicycle that it purchases from the manufacturing
division ($290 sales price minus the $70 of variable assembly costs and the transfer price
up to a maximum market price of $130).
Transfer-Pricing Approaches
In the minimum transfer price formula, variable cost is defined as the variable cost of units
sold internally.
This cost-based transfer system is a bad deal for the sole division, because it reports no profit
on the transfer of 10,000 soles to the boot division.
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If the sole division had sold the 10,000 soles externally, it would have made $70,000
[10,000 × ($18 − $11)].
The boot division, on the other hand, is delighted, as its contribution margin per unit
increases from $38 to $44, or $6 more per boot.
Overall, because of this transfer price, Alberta Boot Company loses $10,000 (10,000 units ×
$1). The sole division lost a contribution margin per unit of $7, and the boot division
experienced only a $6 increase in its contribution margin per unit.