KENNETH C HOLMES
APPLIED MANAGEMENT ACCOUNTING
PROFESSOR: JASON CADE
FEBRUARY 2, 2015
PHASE 2: GROUP PROJECT
A brief history:
Target costing started back in World War II when material shortages forced U.S.
manufacturers to build the most function into products with the lowest cost, and became known
as value engineering. After the war, most U.S. manufacturers reverted back to the traditional way
of manufacturing, but Japan adopted the concept and expanded it into target costing in the
1960’s. The process became a long-term, customer-driven, price-led, profit planning system.
Today, 80 to 85 percent of Japanese manufacturers use target costing (Leahy, 1998).
Traditional costing:
Traditional costing designs the product, determines the cost, and then sets the price. It
assumes the product has been developed, the costs have been determined, and the product is
ready to market as soon as the price is set. This process does not work in most case and the
process is usually reversed.
Target costing:
Target costing first determines the market price, then subtracts the target profit to arrive
at the target cost, then develops a prototype that can be profitably made for that maximum target
cost.
Industries that would use target costing:
Industries most likely to use target costing are those that compete by continually
producing new and updated product for the market place, typically consumer goods including:
household appliances, consumer electronics, automobiles, industrial machinery and vehicles, as
well as a suite of products with a high profit margin.
Industries not applicable for target costing:
Industries least applicable for target costing are industries that produce a small number of
products (legacy products) requiring minimal or no updating, and for which their long-term
profitability is connected more to their market share or penetration and geographic coverage.
These products would include: soft drinks, snack foods, household cleaners, automotive cleaning
products, etc.
Firms currently using target costing:
Firms currently using target costing include: Boeing, Canon, Compaq, Culp, Cummins
Engine, Daihatsu Motors, Daimler Chrysler, Isuzu Motors, ITT, Komatsu Limited, NEC, Nissan,
Olympus, Optical Company Ltd., Sony, Topcon Corporation, Toshiba and Toyota.
How and when EEC could use target costing:
Since target costing is used for products that required constant updating, as well as new
products, the tech industry fits the definition. Since EEC manufactures tech products including:
memory chips, tablets, laptops, desktops, PDA’s, smart phones, and any electronic device that
uses computer memory chips and parts, their product line would work very well with target
costing.
Target Costing formula: Starts with the product’s anticipated selling price and then deducting
the desired profit.
Target Cost = Anticipated selling price – Desired profit
Steps for Target Costing:
1. The product team conducts market research regarding the customer wants including:
products, features and price their willing to pay. Determine what features are most
essential, least essential, and their impact on the price. Based on the research, the team
will have a definitive idea of the target price and the features they can offer at the target
price.
2. Calculate maximum cost: the team must set the selling price based on required gross
profit and maximum cost to manufacture.
3. Determine target cost = projected selling price – mandated gross profit.
4. The product team including product designers, engineers and vendor reps, is responsible
for designing the product for no more than the target cost. The team designs the product,
determines all manufacturing costs, and all necessary raw materials. They must consider
component quality, delivery, and cost for the quality. Outsourcing or modifications
(tradeoffs) may be necessary to bring costs down to the target cost.
5. Once the design is finalized and approved, the team is reassembled with fewer designers
and more engineers. They are now responsible for reducing the production costs for the
life of the product, and those reductions are expected to yield additional gross profit and
further reduce the price over time, all to maintain a competitive edge.
6. If the product cannot be produced for the desired cost, it can be shelved and looked at
again at a later date (usually 1 year).
7. A more precise review approach is to have each project team determine a trigger point
that would initiate a product review, which would include a decrease in the price of a
commodity used in the product design, and any changes in the market prices of
comparable products. If any of the trigger points are reached, the project would
immediately be brought to management’s attention to determine if the project should be
revived.
Cost reduction methods:
Costs tied to components. With this method cost reductions are allocated among the
product components. This approach usually results in incremental cost reductions to the same
components used in previous designs, and is usually used to perform a routine upgrade to an
existing product. The cost reductions achieved are usually low, but results in a high product
success rate and a short design period.
Costs tied to features. With this method cost reductions are allocated among the product
features, and focuses on redesigning the preceding model. This approach usually results in more
radical design changes and cost reductions, it requires more time and risk, but results in greater
cost reduction or a completely new design.
Reasons for using Target Costing:
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Target costing recognizes companies have less control over price than they think.
It recognizes supply and demand, and market price, are crucial to staying in business.
It recognizes the cost factors and that the opportunity for cost reduction is in the design
stage, it is the stage where modifications can be made and where the effort should be
concentrated.
It recognizes the product needs to be simple to make, use cost effective parts, and
reliable.
It understands costs cannot be reduced once the product has been designed and
manufactured.
Advantages of Target Costing:
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Target costing would help EEC achieve greater cost efficiency in manufacturing by
requiring the refinement of all processes, and cost structures.
It would provide EEC a proactive approach to cost management by creating products
based on cost.
It would help EEC be more customer-oriented by identifying the customer’s real needs,
increasing customer satisfaction.
It would break down EEC’s department barriers by making all departments valued
partners, including finance.
It would provide EEC employee’s a better understanding of cost objectives through
participation in setting quality, cost and time targets.
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The method would foster and enhances EEC partnerships with suppliers by including
them in the creation process, providing them a voice and input.
It encourages production of cost effective products by minimizing unnecessary features,
promoting necessary features, and spending research and development dollars where it
would have the greatest impact, on EEC’s products.
It would reduce EEC’s time to market, and help them become more competitive globally.
Disadvantages of Target Costing:
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It often requires the entire production process be designed based on the cost goal.
To be implemented and used effectively detailed cost data must be compiled.
It requires full departmental cooperation, and many meeting for coordination.
It can lead to cutting corners by using cheap materials, or poor workmanship to obtain the
cost goal, and in the process reduce the quality of the product below accepted standard.
How to approach the disadvantages:
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Since target costing requires the entire production process to be cost efficient, EEC could
think of this process as an opportunity to look for inefficiencies and correct them to be in
line with cost goals.
Since effective implementation and use requires the development of detailed cost data,
EEC would find the cost sheets essential in making designing and production easier and
faster.
Since target costing requires departmental cooperation and many meeting for
coordination, EEC could think of the process as an opportunity to break down the walls
and make each department a values partner, including finance.
Since target costing requires the use of cost efficient components, EEC should be mindful
of the quality they want to produce, and not use substandard components, or use poor
workmanship to meet the cost objective. If you have to use substandard components and
workmanship to meet the cost objective, the project should be shelved for a later date.
The differences between the processes:
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Target costing determines the target cost by establishing a market price and deducting the
target profit, then developing a prototype that can be profitably made for the target cost.
It is commonly used by industries that continually produce new and updated products.
Activity-Based costing assigns costs based on the resources used in the production
process, it is a direct approach for allocating overhead costs in the production process,
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and identifies indirect costs to products and services for each activity in the production
process. It is commonly used by industries that produce their products in batches.
Variable costing separates fixed costs from variable costs; expenses fixed costs as a
period cost, and only include variable costs in the product cost. It is commonly used for
manufacturing high volume products.
Full/absorption costing accumulates fixed and variable costs associated with a production
process: and then portions them out to individual products in inventory. It is used to
record the inventory value in financial statements. The fixed and variable costs are not
seen as expenses in the month they were paid, they actually remain in inventory as assets
until the inventory is sold, then the value is charged to cost of goods sold. GAAP and
IFRS require corporations use absorption costing to record the value of inventory in their
financial statements.
Life-Cycle costing specifically analyzes and interprets the accrual of costs over a
product’s life time. Products typically have a similar life-cycle time line with several mile
stones such as the product’s development, introduction, growth, maturity, and decline.
Life-cycle costing is able to track the costs that the product generates during these
periods. Generally, products tend to have high costs in their earlier phases including
development, introduction, and growth; as the product begins to peak in the maturity
phase and decline due to sales, costs tend to even out as the selling price drops; finally the
product is discontinued as the product’s life comes to an end.
CONCLUSION
After careful consideration, I believe Target costing is the best approach for EEC to use.
Each product is assigned a team that continually works on reducing the cost and updating the
product to keep it fresh. The process predetermines the price, profit, and cost, so all costs are
fixed, which would also account for all costs involved in the product, and not split them for
accounting purposes. Target costing also requires all facets of production to be efficient and
meet the cost requirement, and breaks down the department walls and makes all departments part
of the process (part of the team), including finance. Since EEC would obtain their product
variables from market research EEC would be more competitive in the industry.
The least likely method is Life-Cycle costing, since it is used for products that have a
long life expectancy including: soft drinks, snack foods, household and automotive cleaners, etc.
These products depend on market share, penetration, and geographic coverage. Life-Cycle
costing is not appropriate for the tech industry, products change too quickly and require for more
modifications than products with a long life-cycle.
REFERENCES
Farid, S. (2015). Target Costing Approach To Pricing. Retrieved from ,
Accounting4Management.com: www.accounting4management.com>Costing
Leahy, T. (1998, January 1). The Target Costing Bullseye, Part One of a Series/ BPM. Retrieved
from www.businessfinancemag.com./bpm/target-costing-bullseye-part-one-series
N.A. (2015). Target Costing. Retrieved from AccountingTools.com:
www.accountingtools.com/target-costing