The concept behind target costing is based on the realization that the bulk of all product costs are predetermined before a product ever reaches the production floor. This is because the types of materials used are determined during the design stage, as are the types of production methods used to shape and assemble the parts into a completed product. Consequently, the cost-reduction focus of any company that designs its own products should be to closely review the costs of products while they are still in the design stage, and do everything possible to keep those costs to a minimum.
Target costing can have a startlingly large positive impact on profitability, depending on the commitment of management to its use, the constant involvement of accountants in all phases of a product’s life cycle, and the type of strategy that a company follows.
Target costing improves profitability in two ways:
- One is that because it places such a detailed and continuing emphasis on product costs throughout the life cycle of every product, it is very unlikely that a company will experience runaway costs; also, the management team will be completely aware of costing issues, since it receives regular reports pertaining to costs from the cost accounting members of all design teams.
- The second way in which it improves profitability is through the precise targeting of the correct prices at which the company feels it can field a profitable product in the marketplace that will sell in a robust manner. This is opposed to the more common cost-plus approach, under which a company builds a product, then determines its cost, tacks on a profit, and then does not understand why its resoundingly high price does not attract any buyers.
Thus, target costing results in not only better cost control, but also better price control. Target costing is really part of a larger concept called concurrent engineering, which requires participants from many departments to work together in project teams, rather than having separate departments handle new product designs only after they have been handed off from the preceding department in the design chain.
Clustering representatives from many departments together in a single design team can be quite a struggle, especially for older companies that have a history of conflict between departments. Consequently, only the most involved and prolonged support by all members of the senior management group will ensure that target costing, and the greater concept of concurrent engineering, will result in significant profitability improvements. The review of product costs under the target costing methodology is not reserved for just the period up to the completion of design work on a new product.
On the contrary, there are always opportunities to control costs after the design phase is completed, though the opportunities are smaller than during the design phase. Accordingly, accountants should not be pulled from a design team once the final drawings have left the engineering department. Instead, the accountants should regularly monitor actual component costs and compare them against planned costs, warning management whenever significant adverse variances arise.
Also, they should take a lead role in the continuing review of supplier costs to see whether these can be reduced, perhaps by visiting supplier facilities, as well as constantly reviewing existing product designs to see whether they can be improved, and by targeting waste or spoilage on the production floor for elimination. Therefore, the accounting staff must be involved in all phases of a product’s life cycle if a company is to realize the fullest extent of profitability improvements from target costing.
An issue that can get in the way of profitability is a company’s type of strategy. If it is constantly issuing a stream of new products, or if it’s existing product line is subject to severe pricing pressure, then it must make target costing a central part of its strategy, so that the correct price points are used for products and actual costs match those that were originally planned. However, there are other strategies, such as growth by geographical expansion of the current product line (as is practiced by retail stores), or growth by acquisition, where there is no particular need for target costing—these companies make their money in other ways than by a focused concentration on product features and costs. For them, there may still be a limited role for target costing, but it will be severely bounded by the reduced need for new products.
Further worth reading: