The purpose of this article is to describe target costing and show how ABC data can help suppliers and product designers translate product features into future product costs.

INTRODUCTION

Companies need to be equipped with accurate cost modeling techniques in order to manage their costs and assure an acceptable profit margin.  As competition increases, new-product innovations must outpace product obsolescence.  Most of a product’s costs are determined during the product design stage.  Managing the cost of a product already in production can be achieved only by minimizing unfavorable cost variances from the product’s standard cost and by applying process improvements.  After a new product is launched, the potential to reduce costs from the product’s perspective rapidly falls as indicated in the graphic illustration below.  Costs must be managed early on in a product’s life.  Target costing and ABC data can be used to achieve this.

WHAT IS TARGET COSTING?

Target costing is a cost modeling technique that determines what price consumers are willing to pay for a product, and then works backwards to determine profit margins and allowable costs.  This planned target cost becomes a calculated number that the operating costs cannot exceed once the product design is released.  Therefore, target costing is applied at the beginning of a product’s life cycle during the concept and design phase.  This technique is in contrast to the traditional cost-plus markup method that is commonly used by manufacturers.  It is easier and much less expensive to design costs out of a product rather than figure out how to eliminate them after the product is in production (See the graphic illustration above).   

TARGET COSTING STEPS

1.  Determine target selling price – As the first step, the company determines what the market is willing to pay for a product.  Three main players are taken into consideration: customers, competitors, and a company’s senior management.  The company must understand the customer’s perceived value of a product as well as their attitude for purchasing products. The company must take into account competitors alternative and substitute products. This is because customers are shoppers and will shop around for the best price and value. Senior management must define and adjust strategies to meet the company’s objectives. 

2.  Determine target profit margin – Profit margins must be set to satisfy the expectations of both the company and its investors. Two approaches can be used to determine the desired profit margin:  baseline experiences and capital budgeting using lifecycle analysis. 

3.  Calculate the allowable product cost – The maximum allowable product cost is calculated as the net difference between the target selling price and the target profit margin. In order for target costing to work, the maximum allowable product cost must not be exceeded. If the maximum allowable product cost is exceeded there will be undesirable outcomes.  First, the company will increase the price of the product in order to maintain the desired profit margin.  This will decrease sales volume and the optimal sales-price combination will not be achieved.  Second, investors will be dissatisfied. See the illustration below for a graphic view of the target costing concept.

TARGET COSTING AND ABC DATA

Target costing places pressure in a feed-forward mode meaning workers must strive for a more economical design.  In contrast, traditional costing places pressure in a feedback mode meaning workers need to achieve more effective and efficient production processes. Traditional managerial accounting uses ABC data to provide feedback. ABC data can also be used to provide feed-forward data that can be used for target costing. ABC provides data on cost centers, which product-related costs are traced to. ABC uses activity-driver quantity measures to transmit a component’s usage on the equipment costs. ABC data can be used to cost the components that comprise a product.  This is known as feature-based costing. In feature-based costing, the driver is now thought of as a feature equivalent, rather than based on another measure such as time. It is a conversion of the time measure to make the component into the types of features that require the time.  These feature-based costs can be used to project costs of a proposed new product, hence making it useful for target costing.

EXAMPLE

The following example shows how ABC data can be used to project the costs of a proposed product component.

Circuit board A requires 60 holes to be punched in it and three passes through a treatment device.  Each hole-punch takes 6 minutes and each board-treatment takes 12 minutes.  For the month of June, the hole-punching machine cost $100,000 and processed 8,000 minutes worth of boards or $12.50 per minute ($100,000 / 8,000 minutes) as the activity-driver rate.  The board-treatment machine incurred a cost of $400,000, and had 40,000 minutes of board work, or $10.00 per minute ($400,000 / 40,000 minutes.  Board A’s hole-punching standard is 6 minutes.  Board A’s board-treatment standard requires 12 minutes.  If the board had only these two components, the board would cost without any indirect support costs $195.00 as show in the table. 

Assume that 80,000 holes are punched in a month.  Thus, each hole costs $1.25 ($100,000 / 80,000 holes).  Presume there were 10,000 boards passed through the board-treatment machine for the 40,000 minutes.  That equates to $40.00 for each board-pass ($400,000 / 10,000 board-passes).  Now board A can be recalculated based on feature quantities rather than time as seen in the table below. 

A proposed new circuit board B requires 30 holes punched and 4 passes through the treatment machine. As shown in the table, the cost of board B using feature-based costing would be $197.50. The difference between ABC and feature-based costing is that the activity-driver rate is based on a component feature, not time.  Feature-based costing data can be used to project the cost of the proposed new board B, as computed in the table.

*Example adapted from Cokins.

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