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Vojislav Marjanovic Assistant-beginner Faculty of Economics 34 000 Kragujevac, Serbia and Montenegro
Abstract: Target costing approach considers the situation when a company is deciding whether to develop and market a new product. In evaluation the feasibility of the new product, management must determine both the price it can charge and the expected cost. As it is supposed, both the market conditions and actions of management can affect the price and the cost of the new product. The degree to which management actions can affect the price and cost determines the most effective approach to use for pricing and cost management purposes. In these circumstances target costing is a very effective management tool for making cost reductions a key focus throughout the life of a product. A desired, or target cost is set before creating or even designing the product. The target cost is based on the products predicted price and the companys desired profit. Managers must then try to reduce and control costs so that the products cost does not exceed its target cost.

The Target costing concept (jap. Mokuhyou Genkakeisan) was developed in the Japanese enterprises with the basic purpose for the Cost Management while it is connected with the long range planning system. Target costing has found its basic appliance in high technology industrial branches producing complex products such as car and electronic industry. By reason of this fact, Target Costing approach is very suitable in mass production because even the insignificant changes in the production process could have huge influence on the total success of the enterprise. Considering all important facts, it could be said that the basic points of the Target costing process are: Public relations and market research, Costs influence in the research and construction phase, Constant conducting the total Life Cycle during the construction of the specific product type. Target costing is most effective at reducing cost during the product design phase when the vast majority of costs are committed. For example, the costs of

resource such as new machinery, materials, parts, and even future refinements are largely determined by the design of the product and the associated production processes. It is not easy to reduce these costs once production begins. So, the emphasis of target costing is on proactive, up-front planning throughout every activity of the new product development process.


In the beginning of seventies has been already proven in the study of British Aerospace that 80-90% of the production costs had been established before the first unit production. Considering these facts, the vast majority of enterprises (at firs in Japan) have concluded that the methods for cost reducing are settled in the development and the construction phase. Costs

Developing Influence

Bringing into market Life cycle Exhibit 1 Establishment, development and influence of the costs in the product Life cycle In the Exhibit 1 is shown, that in the Life cycle the influence costs curve rises up while the establishing costs curve falls down. The production costs decrease in the production phase and the next Life cycle phases indeed, but the establishing costs are for the most part set (at about 85%) and the their influence is insignificant. In this point could be used two the most important cost management tools. Using target costing approach we could determine the target costs at the

beginning of product creating process. Generating these costs we also need to take in the consideration cash-flow in order to determine to lowest profit level it could be reached. Generally speaking, target costing and life cycle are the most important modern cost management tools for cost reduction. This long range orientation was absent in the traditional cost management orientation.

TARGET COSTING APPROACH The ideal Target costing approach could be presented as in exhibit 2.

Target price

Target profit

Allowable costs

Product profile

Cost distribution

Yes Target costs

Drifting costs = Allowable costs

Estimated costs Drifting costs

No Taken steps to reduce Drifting costs

Exhibit 2 Target costing approach As shown in the Exhibit 2, target costing approach should follow next steps: Product profile determination; Target price determination;

Allowable costs determination; Drifting costs determination; Redesign or design products and processes to achieve the cost-reduction target

Product profile determination. In order to be determined product profiles should be proceeded essential market and customer research. For this establishing is often Conjoint Measurement approach suggested. The specificity of this approach consists of questions and suggestions about possible product design that will be made to one customer group. This group should evaluate expected product profiles and functions with specific measurements, for instance: Proposed functions Surface Quality Production time Product reliability

Proposed measurements (40, 50, 60 m 2 ) (high, average, low) (10, 14, 18 days) (2 000, 1 8000, 1 6000 MTbF * )

- Mean time between failures

On the basis of the proposed functions and measurements, the customer group evaluates the product profiles and utilities. The percentage evaluation of utilities from the customer group for each function will be then collected and divided with the number of product utilities: Proposed functions Surface Quality Production time Product reliability Product utilities (0,5; 0,3; 0,0) (0,93; 0,53; 0,0) (0,2; 0,15; 0,0) (0,9; 0,72; 0,0)

Target price determination. The target price is what competitors are likely to charge and what customers are wiling to pay for the product. This is expected market price. Here must be respected one principle: Which is the price level for the proposed product by which the customer is willing to buy another product? The customer is likely to buy another product if he total expected value of the offered product is on the lower level than by the another product. This level can be determined using simple price linear function, for the proposed function quality. The first step would be establishing price linear function for the changes of expected value which is shown in exhibit 3.

Value 0,93


Value 0,93 DI = 0,4 0,7 0,5


0,53 D high average enough CU 1 000 1 100 1 300

DI Difference between utility values 0,4 = 2 000 CU CU Currency unit D - Distinction Exhibit 3. Price linear function for the changes of expected value Considering the previous exhibit, the linear function for the price difference between 9 000 and 1 350 CU could be presented as follows: y(p)=2 000 p y = Quantity p = Price (1)

Maximizing the function of the total Income (I) it is possible to determine the optimized relation between quantity and price: I(p) = p y = p (2 000 p) = 2 000 p p 2 (2) The maximum of the price income function can be reached when the function takes total value zero: I(p) = 2 000 2 p = 0 p = 1 000 CU (3) On the price level of 1 000 CU the price income function reaches follow quantity: y(1 000) = 2 000 = 1 000 pieces. Allowable costs determination. Considering the results of the price income function it is possible to determine the maximum level of allowable costs in the broader sense: Total income (1 000 CU 1 000 pieces) 1 000 000 CU target profit (10%) 100 000 CU = allowable costs (broader sense) 900 000 CU

The allowable costs in the broader sense represent all production costs considering market and competition situation in order to reach target profit. These costs must be reduced by subtracting all common costs that relate governance, marketing, sale, research and development. Allowable costs broader sense Total costs Budget Governance Marketing/Sale Development = Production Exhibit 4. Crossing from the total allowable costs to the distributed allowable costs Subtracting the common costs from the total allowable costs represents as the main result the distributed allowable costs. allowable costs (broader sense) common costs = allowable costs (straighter sense) 900 000 CU 400 000 CU 500 000 CU Functions Components Distribution of cost Parts straighter sense Unit costs

Drifting costs determination. After determination the allowable costs that may not be broken, it is necessary to be estimated the costs of the eventual production. In this step is very important to determine the percentage part of all product components in the total amount of costs. In this example the proposed component costs and their percentage parts are shown as follows:

Magnet Electronic cabinet System components Montage/Installation Total costs of product

drifting costs (per unit) 310 CU 270 CU 120 CU 300 CU 1 000 CU

Partial costs 31 % 27 % 12 % 30 % 100 %

Redesign or design products and processes to achieve the cost-reduction target. In this phase must be determined components/functions-matrix in order to be established redesign or improvement process. This matrix should comprise percentage information about that by which components are the specified functions proceeded. Surface (50 m 2 ) Quality (high) Production time (14 days) Product reliability (1 800 MTbF) Total utility of the product Functions Components Magnet Electronic cabinet System components Montage/installatio n Partial utilities of functions Surface Quality Utilities 0,30 0,93 0,15 0,72 2,10 Production time Partial utilities 15% 41% 10% 34% 100% Product reliabilit y 15% 9% 10% Partial utilities of components 45% 19% 16% 20% 34% 100%


20% 10% 6% 5% 41% 10% 10%

5% 15%

Exhibit 5. Components/Functions matrix Redesign or design products and processes to achieve the cost-reduction target are completed with target costing costs controlling diagram. This diagram comprises target costing indexes determined by the next relation:
T arg et cos ting index % Partial utilities % Partial cos ts


Partial utilities Magnet Electronic cabinet System components Montage/Installation Partial costs too expensive 40 15% 41% 10%

Partial costs 31 % 27 % 12 %


30 %

Target costing index 0,48 1,52 0,83 1,13

Magnet 30

Electronic cabinet

20 Montage/Installation


too simple System components





Partial utilities

Exhibit 6. Target costing costs controlling diagram When the specified product components are located out of target costing zone (Magnet, Electronic cabinet), the management of enterprise should consider some possibilities for cost reducing (Magnet), or product improvement (Electronic cabinet).

The traditional approach for deriving standard costs is a bottom-up technique. Usually, the manager who will be held responsible for meeting the standard submits an initial estimate, which is reviewed and ratified by industrial engineers, controllers, and high-level managers. Sometimes industrial engineering submits the initial estimate of the standard. In all cases, setting and revising standards involve assembling specialized knowledge from various individuals in the firm. The standard cost of each factor input is estimated and the standard cost of the complete product is built up from the sum of these individual standard costs. Target costing is a top-down approach conducted during new product planning. It starts with the long-run price (often estimated by the marketing department) required to achieve a desired market share. From this price, the required return on investment (profit) is subtracted to derive a total target product cost. Or, Target cost = Target price Target profit. This total target cost is then broken down into subcomponent cost, including selling and distribution cost. These subcomponent costs become the targets or standards to be achieved if the firm is to meet its goals for market penetration and return on capital. The target costs become part of the performance evaluation system. For many products, once the product is designed, most of opportunities to reduce the cost of the product are gone. The only way to reduce the costs is to redesign the product. Unlike traditional cost control systems, which do not control costs until production begins, target costing requires aggressive cost management during planning, product design, and production. Target costing focuses managements attention on cost control during the critical design stage when most costs are controllable.

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