Target costing differs from most of other costing methodologies [which are primarily concerned with the interpretation of costing data after it has already been incurred] in that it describes the costs that are expected to be incurred, and how this will impact product profitability levels. By describing costs in a proactive and future-oriented manner, managers can determine how they should alter product designs before they enter the manufacturing process in order to ensure that the company earns a reasonable profit on all new products. How should I implement target costing?, you asked. Follow the four effective Steps described below. Read on…
Steps to Take To Implement Target Costing
To use target costing methodology, a cost accountant is assigned to a new product design team, and asked to continually compile the projected cost of a product as it moves through the design process. Managers will use this information not only to make product alterations, but also to drop a product design if it cannot meet its cost targets.
There are four basic steps involved in target costing shown on below chart.
Step-1. Conduct Market Research
On fist step of target costing, the design team conducts market research to determine the price points that a company is most likely to achieve if it creates a product with a certain set of features. The research should include information about the perceived value of certain features on a product, so that the design team can add or subtract features from the design with a full knowledge of what these changes will probably do to the final price at which the product will be sold.
Step-2. Determine Margin and Cost Feasibility
The second step is to subtract from the prospective product price a gross margin that must be earned on the product; this can be a standard company-wide margin that must be earned on all new products, or perhaps a more specific one that management has imposed based on the perceived risk of the project. By subtracting the required margin from the expected price, we arrive at the maximum amount that the product can cost. This total cost figure drives the next step.
Step-3. Meet Margin target Through Value Engineering [Design Improvement]
On third step of target costing implementation process, the design team uses value engineering to drive down the cost of the product until it meets its overall cost target. Value engineering requires considerable attention to the elimination of production functions, a product design that is cheaper to manufacture, a planned reduction of product durability in order to cut costs, a reduced number of product features, less expensive component parts, and so on—in short, any activity that will lead to a reduced product cost. This process also requires the team to confirm costs with the suppliers of raw materials and outsourced parts, as well as the processing costs that will be incurred internally.
The cost accountant plays a key role at this stage, regularly summarizing costing information and relaying it not only to the team members, but to the managers who are reviewing the team’s progress. A standard procedure at this point is to force the team to come within a set percentage of its cost target at various milestones (such as being within 12% of the target after three months of design work, 6% after four months, and on target after five months); if the team cannot meet increasingly tighter costing targets, then the project will be canceled.
Step-4. Implement Continuous Improvement
Once those previous three design steps have been completed and a product has met its targeted cost level, the target costing effort is shifted into a different activity, which involves follow-on activities that will reduce costs even further after the product has entered its production phase.
This final step is used to create some excess gross margin over time, which allows the company to reduce the price of the product to respond to presumed increases in the level of competition. The sources of these cost reductions can be either through planned supplier cost reductions or through waste reductions in the production process (known as kaizen costing). The concepts of value engineering and kaizen costing can be used repeatedly to gradually reduce the cost of a product over time.
Once the design is released for production, kaizen costing could be used to further reduce costs in multiple stages until there are few additional reductions left to squeeze out of the original design. At this point, the design team uses value engineering to create a replacement Product B that incorporates additional cost savings [likely including the cost reduction experience gleaned from the kaizen costing stages used for Product A] that result in an even lower initial cost. Kaizen costing is then used once again to further reduce the cost of Product B, thereby keeping the cost reduction process moving in an ever-downward direction.