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Yu-Lee, R. T. 2002. Target costing: What you see is not what you get. Journal of Cost Management (July/August): 23-28.

Summary by Adebola Shokunbi
Master of Accountancy Program
University of South Florida, Fall 2004

Capacity Related Main Page | Target Costing Main Page

The purpose of this article is to reveal that conventional target costing relies on two incorrect assumptions about cost dynamics. The author proposes that target costing benefits can be realized by using a four-step process, in which capacity management and an understanding of the relevant cost dynamics translates information down to the bottom-line benefits.

Introduction

Target costing involves the identification of an ideal cost for a product based on various factors, including anticipated sales volumes and prices together with the desired margins for the product. The target cost is achieved through the cooperation of engineering, accounting, and sometimes, procurement groups within the organization, to improve processes and purchase more cost-effective components.

Yu-Lee states that “target costing is a great concept on paper.” Organizations can focus specifically on the manufacturing of the product and the pools of costs being allocated to the product cost to merely attempt to reduce the overall cost. The author asserts that target costing does not work in its original form, because the following two underlying assumptions are incorrect.

1. Product cost is a valid concept and the analysis of product costs reflect the cost dynamics of the bottom line.

2. Efficiencies lead to cost reductions.

These two assumptions suggest that target costing as used will decrease costs on paper but have little, if any, effect on the bottom line.

The author suggests that target costing becomes a useful approach within a specified context, when it is combined with value engineering and design-for-manufacturing techniques. This combination of techniques can eventually increase the organization’s capacity. However, capacity dynamics must be understood clearly; managers making decisions must have a clear understanding of the organization’s cost dynamics; decisions must be shifted away from the product level to the organizational level, to eliminate the inconsistencies that lead to the problems found with product costs; and finally, organizations must take action based on the information and the organization’s capabilities.

The Basic Target Costing Assumptions are Incorrect

While the objective of target costing is to identify how much it would cost to produce and make certain that the target cost is met through changes or improvements, product costs are notoriously difficult to determine or manage, even with the best information. Furthermore, efficiency does not automatically lead to cost savings. Thus, the idea that a product cost can be determined and managed through efficient operations is fundamentally unattainable.

Product Cost and the Bottom-Line Dynamics

Product cost is determined by allocating various costs to the number of products that are created. However, cost allocations do not reflect how the costs affect the bottom line and can lead not only to erroneous results, but also to totally incorrect cost dynamics in some cases. Allocation requires that a pool of costs be assigned to the cost of a specific product creating a ratio:

Dollars ÷ Units = Cost per Unit

1. Based on the ratio, if more products are made, the cost per unit decreases, but in reality, the opposite occurs. As more products are made, costs increase because of higher material consumption. Labor costs might remain constant, assuming greater efficiency; otherwise, they might increase. All in all, cost functions are increasing functions that can never decrease with increasing levels of work. While costs can be managed to increase at slower rates, they will not decrease as more units are produced.

2. If the time spent on a product decreases, as suggested by activity based costing, one might assume that the product cost decreases. This is linear logic, but often incorrect because salaries are fixed.

Managers and accountants who manipulate product costs under the assumption that changes in the time allocation will reduce the cost of a product, deceive themselves into believing that the products’ “decreased” costs will improve the bottom line. Essentially, target cost dynamics are inconsistent with bottom-line cost dynamics.

Efficiencies and Cost Reduction

More often than not, the assumption that efficiencies automatically lead to cost reduction is false. Organizations benefit from efficiencies only by actually realigning asset levels (for example, fewer machines), by reducing pay rates or the number of employees, or by acquiring profitable new businesses that use capacities freed up by improvement efforts.

Capacity costs represent what something costs, regardless of how it is used. Increasing the efficiency of a worker, machine, or the materials consumed will not reduce their costs. Instead, an increase in efficiency allows for more output, which may lead to more sales and a reduced rate of cost increase. It also increases the available capacity, so that more work can be done.

Increased Output vs. Reduction in the Rate of Cost Increases

Efficiency shows up as additional capacity rather than showing up as cost savings. With additional capacity, managers now have choices: increase output, reduce input, or do nothing.

Increased Output

With the same resources as input, the organization is capable of more output, and this increased output leads to the “potential” for more sales. (“Potential” is used because making a product does not necessarily lead to a one-to-one correlation with increased sales).

Reduced Input vs. Reduction in the Rate of Cost Increases

Reducing the input may lead to reduced costs since what management does with the excess capacity determines whether there are cost savings. For instance, if the salaries of individuals or lease payments for equipment are still the responsibilities of the organization, no cost savings will result regardless of how unit cost is affected. With excess capacity, management might decide to dispose of whatever is not needed.

These bottom-line cost dynamics explain why target costing in its original form is ineffective. To obtain the potential benefits from target costing, a shift of focus away from product cost and toward overall organizational capability and profitability is needed.

The author asserts that in order to achieve bottom-line benefits from target costing, organizations should use a four-step process that translates the information that is usually gained in target costing into bottom-line benefits. "The four steps are:

1. Understanding what target costing enables.

2. Understanding capacity dynamics.

3. Understanding the cost dynamics associated with capacity decisions.

4. Acting on the opportunity" (p. 26).

Understanding What Target Costing Enables

Target costing enables two things:

1. "It positions the organization for the predictable use of capacity, when new products hit the market" (p. 27). What the target costing effort does best is allow for capacity to become the center of attention. Organizations should try to understand capacity so that operations and production planning can begin to focus on how to effectively use the capacity.

2. "It focuses the organization on efficient operations and the drivers that enable it" (p. 27). This increases available capacity by minimizing waste.

Understand Capacity Dynamics

Instead of focusing only on the cost reduction implications of improvements, engineers should instead focus on understanding the related capacity implications. This understanding will directly impact management’s ability to make decisions about what to do with available capacity.

Understanding Cost Dynamics

After target costing activities identify improvements and effect changes in capacity, "the organization has three ways to increase profitability:

1. Reduce people or space related capacity and, thereby reduce cost.

2. Increase output of products in demand and thereby, increase revenue.

3. Sell available capacity and, thereby increase revenue" (p. 27).

Act on Opportunities Presented

This rather obvious final step often presents as an enormous challenge for many organizations. Target costing techniques present companies with operational and financial performance improvements. It is the responsibility of managers to act on these improvements in order to achieve bottom-line value.

Conclusion

To achieve effectiveness from target costing, managers must be able to manage the capacity dynamics to produce opportunities for operational efficiencies and the improved financial performance that results from those changes.

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Related summaries:

Berliner, C., and J. A. Brimson, eds. 1988. Cost Management for Today's Advanced Manufacturing: The CAMI Conceptual Design. Boston: Harvard Business School Press. (Short Summary or Concepts.) (Longer Summary.)

Cokins, G. 2002. Integrating target costing and ABC. Journal of Cost Management (July/August): 13-22. (Summary).

Hiromoto, T. 1988. Another hidden edge: Japanese management accounting. Harvard Business Review (July-August): 22-25. (Summary).

Monden, Y. and J. Lee. 1993. How a Japanese auto maker reduces costs. Management Accounting (August): 22-26. (Summary).

Sakurai, M. 1989. Target costing and how to use it. Journal of Cost Management (Summer): 39-50. (Summary).

Schmelze, G., R. Geier and T. E. Buttross. 1996. Target costing at ITT Automotive. Management Accounting (December): 26-30. (Summary).

Tanaka, T. 1993. Target costing at Toyota. Journal of Cost Management (Spring): 4-11. (Summary).

Tanaka, T. 1994. Kaizen budgeting: Toyota's cost-control system under TQC. Journal of Cost Management (Fall): 56-62. (Summary).

For more on Explicit Cost Dynamics see:

Yu-Lee, R. T. 2003. Don't miss the bottom line with productivity increases. Industrial Management (January/February): 8-13. (Summary).

Yu-Lee, R. T. and C. Haun. 2006. Create bullet-proof value propositions. Industrial Management (May/June): 25-30. (Summary).

To Compare Explicit Cost Dynamics to The Theory of Constraints see:

Goldratt, E. M. 1990. What is this thing called Theory of Constraints. New York: North River Press. (Summary).

Goldratt, E. M. 1990. The Haystack Syndrome: Sifting Information Out of the Data Ocean. New York: North River Press. (Summary).

Goldratt, E. M. and J. Cox. 1986. The Goal: A Process of Ongoing Improvement. New York: North River Press. (Summary).