This Issue - Icwai

Target Cost
COST COST ACCOUNTING
ACCOUNTING
ACCOUNTING
The long term financial success of any business
depends on whether its prices exceed its costs
by enough to finance growth, provide for
reinvestment, and yield a satisfactory return to its
stakeholders. As competition increases, and supply
exceeds demand, market forces influence prices
significantly more. To achieve a sufficient margin over
its costs, a company must manage those costs relative
to the prices the market allows or the price the firm sets
to achieve certain market penetration objectives. The
problem that firms face is that the prices are set by the
market forces and the shareholders decide profits.
Therefore firms have no other option but to set the cost
and have to achieve that cost. In the context of these
characteristics, the practice of target costing has
evolved.
Target costing is a fundamentally different way to
look at the relationship of prices and costs. The basic
target equation of “Price—Profit Margin = Cost”
means that prices are driven and set either by
competitive market forces or by the firm as it
aggressively lowers its prices to increase market
penetration; that profit margins are established such
that the firm can make money; and that allowable
costs are derived from price and margin. This method
was pioneered by Toyota in the 1960s to achieve high
quality and desirable features at a competitive price.
Target costing is a design approach in which a
company designs a product to achieve a desired profit
while satisfying the customers expectations for quality
and product features. The target costing (TC) practice
(genka-kikaku in Japanese) seeks to bridge the gap
between the cost determined through market research
(i.e., what the customer is willing to pay) and the cost
at which the firm can supply its product, given the
firm’s technology and the state of its accumulated
knowledge, without compromising its profitability.
The balancing of costs, features and quality takes place
throughout the design, manufacturing, sale and
service though it target costing has the strongest
influence during the design phase as the cost
consequences of manufacturing method and features
selected are mostly determined during the design
phase of the product.
Integrating Target Costing with
Supply Chain Management : A
Strategic Perspective
Rajat Gera*
Barnali Chaklader**
The Target Costing approach is illustrated in
Equation I.
The allowable cost is the total product cost which
the firm has to achieve and is dictated by consumer
willingness to pay and market competition.
(Target Cost) = (Selling Price) — (Profit Margin)
Equation I
The desired profit margin is driven by corporate
strategic profit planning. In reality, the allowable cost
might not be achievable in the short run, and the target
cost is revised upward. The target cost estimate is first
determined based on the best estimate of the future
product’s costs and compared with the target cost,
and the gap constitutes the subject of the costreduction
program. The excess of the estimated cost
over the target cost is reduced by management tools
like value engineering. For example, the current cost
estimates of the final product may be INR 100,000
while the target cost determined through market
research and strategic analysis may be INR 80,000
which leads to a target cost reduction of Rs 20,000 ie
20%. The same is achieved by decomposing the gap
into cost reduction targets for various business
functions. Each function then redesigns its component
of the product or re-engineers the manufacturing and/
or logistics process (i.e., JIT = just-in-time) to achieve
the desired target cost estimate. The redesigning
process is called value engineering, which is basically
concerned with looking for alternatives to designing
product with the same or greater level of quality/
functionality while reducing the cost. The process
undergoes numerous iterations before the final
product can be produced within the targeted cost.
Supply Chain Management (SCM) : is a logistics
network which consists of suppliers, manufacturing
centers, warehouses, distribution centers and retail
outlets as well as raw materials, work-in-process
inventory and finished goods that flow between the
facilities. SCM is also defined as a set of approaches
utilized to efficiently integrate suppliers, manufac-
* Associate Professor (Marketing), Institute of Management
Technology, Ghaziabad
** Associate Professor (Finance and Accounting), Institute
of Management Technology, Ghaziabad
The Management Accountant |September 2011 763