-THIS DOCUMENT INCLUDES ALL THE CONCEPTUAL RELATED KNOWLEDGE. - INCLUDES EXAMPLES & NUMERICALS - TARGET COSTING FOR A COMPANY

1. TARGET COSTING
Cost Reduction is the achievement of real and permanent reduction in unit cost of products
manufactured. It, therefore, continuously attempts to achieve genuine savings in cost of production
distributing, selling and administration. It does not accept a standard or budge t. It rather challenges
the standards/budgets continuously to make improvement in them. It attempts to excavate, the
potential savings buried in the standards by continuous and planned efforts.Cost Control relax that
dynamic approach, it usually dealt with variances leaving the standards intact.
Target Costing – Origin
It emerged in Japan in 1960s as the response to difficult market conditions. A
proliferation of consumer and industrial products of western firms were overcrowding
the market in an Asia, Japanese companies were also experiencing shortage of resources
and skills needed for the development of new concepts, tools and techniques, which
were required to achieve parity with the toughest western competitors in-terms of
quality, cost and productivity.
In Japan, target costing is widely practiced in more than 80% of the companies in the
assembly industries and more than 60% of companies in processing industries.
Concept of Target Costing:
Target costing is a systematic approach to establishing product cost goals based on market
driven standards. It is a strategic management process for reducing costs at the early stages of
product planning and design. Target costing begins with identifying customer needs and
calculating an acceptable target sales price for the product.
Working backward from the sales price, companies establish an acceptable target profit and
calculate the target cost as follows:
Target Cost = Expected selling price – Desired profit
Target Costing is different from standard costing. While target costs are determined by market
driven standards (target sales price – target profit = target cost), standard costs are determined
by design – driven standards with less emphasis on what the market will pay (engineered costs
+ desired markup = desired sales price).
The target cost is normally less than the current cost. Thus, managers must try to reduce costs
from the design and manufacture of the product. The planned cost reduction is sometimes
referred to as the cost “drift.”

3. Target costing has been described as a process that occurs in a competitive
environment, in which cost minimization is an important component of profitability. This newer
approach of product costing may take into account initial design and engineering costs, as well as
manufacturing costs, plus the costs of distribution, sales and services.
It can be defined as “a structured approach to determining the cost at which a
proposed product with specified functionality and quality must be produced, to
generate a desired level of profitability at its anticipated selling price” .
A critical aspect of this definition is that it emphasizes that target costing is much more
than a management accounting technique. Rather, it is an important part of a
comprehensive management process aimed at helping an organization to survive in an
increasingly competitive environment. In this sense the term “target costing” is a misnomer: it
is not a product costing system, but rather a management technique aimed at reducing a
product’s life-cycle costs.
In Target costing, we first determine what price we think the consumer will pay for our
product. We then determine how much of a profit margin we expect and subtract that from
the final price. The remaining amount left is what is available as a budget to be used to
create the product.

4. Definition of Target Costing:
Target costing can be defined as “a structured approach for determining the cost at
which a proposed product with specified functionality and quality must be
produced to generate a desired level of profitability at its anticipated selling
price”. A critical aspect of this definition is that it lays emphasis on the fact that target costing
is much more than a management accounting technique.
Rather, it is an important part of a comprehensive management process aimed at helping a firm
to survive in an increasingly competitive environment. Target costing is a management
technique aimed at reducing a product’s life-cycle costs. A general concept of target costing is
discussed here.
Target Costing is a disciplined process for determining and realizing a total cost at which a
proposed product with specified functionality must be produced to generate the desired
profitability at its anticipated selling price in the future. CIMA defines target cost as “a product
cost estimate derived from a competitive market price”
Target Costing is a disciplined process that uses data and information in a logical series of steps
to determine and achieve a target cost for the product. In addition, the price and cost are for

5. specified product functionality, which is determined from understanding the needs of the
customer and the willingness of the customer to pay for each function.
Target costing is a formal process that attempts to match a proposed product’s
features (benefits) with a viable market price that achieves the company’s
profitability goals by:
(a) Determining a price point (or range of prices) for an approximate combination of features
and benefits.
(b) Subtracting a desired profit from the market price to determine the maximum bearable level
of costs.
(c) Iterating the product design—eliminating or reducing unnecessary attributes with costs that
can’t be recovered in higher prices—until the cost target is met.
(d) Revising the market price for the redesigned product in view of changed market conditions.
Having two of the world’s best selling cars, the Camry and the Corolla, as well as a number of other
popular models, Toyota is among the world’s most successful automakers. The reason for Toyota’s
success is that it is able to consistently produce high-quality cars with attractive features at competitive
prices. Target costing, a method Toyota pioneered in the 1960s, is one method it uses to achieve high
quality and desirable features at a competitive price. Target costing is a design approach in which cost
management plays a large part, as we will see in this chapter.

6. Using target costing, a company designs a product to achieve a desired profit while satisfying the
customer’s expectations for quality and product features. The balancing of costs, features, and quality
takes place throughout the design, manufacturing, sale, and service of the car but has the strongest infl
uence in the fi rst phase, design. When design alternatives are being examined and selected, Toyota has
the maximum fl exibility for choosing options that affect manufacturing and all other product costs such
as customer service and warranty work.
Once the design is complete and manufacturing has begun, the cost consequences of the choice of
features and manufacturing methods are set until the next model change. As a result, the development
of a good, cost-effective design is critical. Target costing places a strong focus on using the design
process to improve the product and reduce its cost. For example, in the redesign of the Camry, Toyota
made the running lamps part of the headlamp assembly and made the grill part of the bumper, which
saves time and materials in manufacturing and produces a more crash-resistant bumper—a win/win for
Toyota and the car buyer.
Target costing is the first of four costing methods we study in the chapter. The others are the theory of
constraints, life-cycle costing, and strategic pricing. The common element of all four methods is that
they are involved with the entire product life cycle. While once managers focused only on
manufacturing costs, they now look at costs upstream (before manufacturing) and downstream (after
manufacturing) in the product life cycle to get a comprehensive analysis of product cost and profi
tability ( Exhibit 10.1 ).

7. For example, in target costing we consider the role of product design (an upstream activity) in reducing
costs in the manufacturing and downstream phases of the life cycle. Then, we see how the theory of
constraints is used in the manufacturing phase to reduce manufacturing costs and to speed up delivery
downstream. Then we look at life-cycle costing, which provides a comprehensive evaluation of the profi
tability of the different products, including costs throughout the product life cycle. Finally, strategic
pricing uses life-cycle concepts in pricing decisions. Strategic pricing takes two important and very
different views of the product life cycle.
The cost life cycle is the sequence of activities within the fi rm that begins with research and
development followed by design, manufacturing (or providing the service), marketing/ distribution, and
customer service. It is the life cycle of the product or service from the viewpoint of costs incurred. The
cost life cycle is illustrated in Exhibit 10.1. 1
The sales life cycle is the sequence of phases in the product’s or service’s life in the market from the
introduction of the product or service to the market, the growth in sales, and fi nally maturity, decline,
and withdrawal from the market. Sales are at fi rst small, peak in the maturity phase, and decline
thereafter, as illustrated in Exhibit 10.2 . Both the sales and the cost views of the product life cycle are
important in strategic pricing.

8. Three methods are commonly used by manufacturing fi rms, where new product development,
manufacturing speed, and effi ciency are important. The three methods are target costing, the theory of
constraints, and life-cycle costing. Because a product with physical characteristics is involved,
applications in manufacturing fi rms are more intuitive and easily understood. However, each method
can also be used in service fi rms. For example, a local government could use the theory of constraints to
speed the process of billing residents for water services (and to reduce the processing cost) or to speed
the operations for processing and depositing the collections from these residents.
Why Target Costing?
In industries such as FMCG (Fast Moving Consumer Goods), construction,
healthcare, and energy, competition is so intense that prices are
determined by supply and demand in the market. Producers can’t
effectively control selling prices. They can only control, to some extent, their
costs, so management’s focus is on influencing every component of
product, service, or operational costs.

9. The key objective of target costing is to enable management to use
proactive cost planning, cost management, and cost reduction practices
where costs are planned and calculated early in the design and
development cycle, rather than during the later stages of product
development and production.
Key Features of Target Costing:
• The price of the product is determined by market conditions. The company is a price
taker rather than a price maker.
• The minimum required profit margin is already included in the target selling price.
• It is part of management’s strategy to focus on cost reduction and effective cost
management.
• Product design, specifications, and customer expectations are already built-in while
formulating the total selling price.
• The difference between the current cost and the target cost is the “cost
reduction,” which management wants to achieve.
• A team is formed to integrate activities such as designing, purchasing, manufacturing,
marketing, etc., to find and achieve the target cost.
FOR EXAMPLE,

10. Explain how to use target costing to facilitate strategic
management?

11. Henry Ford’s thinking would fi t well in today’s corporate boardrooms, where global competition,
increased customer expectations, and competitive pricing in many industries have forced fi rms to look
for ways to reduce costs year after year at the same time producing products with increased levels of
quality and functionality. Ford is describing a technique called target costing, in which the fi rm
determines the allowable (i.e., “target”) cost for the product or service, given a competitive market
price, so the fi rm can earn a desired profi t:
Target cost = Competitive price - Desired profit
The fi rm has two options for reducing costs to a target cost level:
1. By integrating new manufacturing technology, using advanced cost management techniques
such as activity-based costing, and seeking higher productivity.
2. By redesigning the product or service. This method is benefi cial for many fi rms because it
recognizes that design decisions account for much of total product life cycle costs. By careful
attention to design, signifi cant reductions in total cost are possible.
Many fi rms employ both options:
efforts to achieve increased productivity gains and target costing to determine low-cost design.
Some managers argue that, unlike programs for productivity improvement, target costing
provides a more distinct goal, a specifi c cost level. Because the goal is more defi nite, it appears
more achievable and therefore more motivating.
Many auto manufacturers, software developers, and other consumer product manufacturers
must also determine in the design process the number and types of features to include in
periodic updates of a product using cost and market considerations. Target costing, based on
analysis of functionality/cost trade-offs, is an appropriate management tool for these fi rms.
With its positioning in the early, upstream phases of the cost life cycle, target costing can clearly
help a fi rm reduce total costs (see Exhibit 10.3 ).

12. Japanese industry and a growing number of fi rms worldwide are using target costing. Toyota; Honda
Motor Company; Boeing; Intel, Inc.; and many others use target costing. Many firms fi nd it diffi cult to
compete successfully on cost leadership or differentiation alone; they must compete on both price and
functionality. Target costing is a very useful way to manage the needed trade-off between functionality
and cost.
Implementing a target costing approach involves five steps:
1. Determine the market price.
2. Determine the desired profi t.
3. Calculate the target cost at market price less desired profi t.
4. Use value engineering to identify ways to reduce product cost.
5. Use kaizen costing and operational control to further reduce costs.
The fi rst three steps require little additional explanation. However, the determination of
desired profi t can be done in a variety of ways. A common way is to set a desired per unit profi
t. This approach means that, if the product’s price falls and target costs fall proportionally, then
profi ts will remain the same after the price change, assuming the fi rm meets the new price and
sales in units does not change. Another approach is to set the desired profi t as a percentage of
sales dollars. The section on pricing at the end of this chapter gives some additional examples of
pricing methods. The following sections explain the fourth and fi fth steps: the use of value
engineering, kaizen costing, and operational control.
Target costing for target pricing
An important form of market-based price is the target price. A target price is the estimated
price for a product (or service) that potential customers will be willing to pay. This estimate is
based on an understanding of customers’ perceived value for a product and competitors’
responses. A target operating profit per unit is the operating profit that a company wants to
earn on each unit of a product (or service) sold. The target price leads to a target cost. A target
cost per unit is the estimated long-run cost per unit of a product (or service) that, when sold at
the target price, enables the company to achieve the target operating profit per unit. Target cost
per unit is derived by subtracting the target operating profit per unit from the target price.
What relevant costs should we include in the target cost calculations? All costs, both variable
and fixed. Why? Because in the long run, a company’s prices and revenues must recover all its
costs. If not, the company’s best alternative is to shut down. Relative to the shutting-down
alternative, all costs, whether fixed or variable, are relevant.
Target cost per unit is often lower than the existing full product cost per unit. To achieve the
target cost per unit and the target operating profit per unit, the organisation must improve its
products and processes. Target costing is widely used among diferent industries around the

13. world. General Motors, Renault, Toyota, Daimler-Chrysler, Fiat and Volvo in the motor vehicle
industry, and Siemens, Panasonic, Sharp and HP in the electronics and personal computer
industries, are examples of companies that use target pricing and target costing
We illustrate the above steps for target pricing and target costing using the Astel Computer
Step 1: Product planning for Provalue Astel is in the process of planning design modifications for
Provalue. Astel is very concerned about severe price competition from several competitors.
Step 2: Target price of Provalue Astel expects its competitors to lower the prices of PCs that
compete against Provalue by 15%. Astel’s management believes that it must respond
aggressively by reducing Provalue’s price by 20%, from €1000 per unit to €800 per unit. At this
lower price, Astel’s marketing manager forecasts an increase in annual sales from 150 000 to
200 000 units.
Step 3: Target cost per unit of Provalue Astel’s management wants a 10% target operating profit
on sales revenues.
• Total target sales revenues = €800 × 200 000 units = €160 000 000
• Total target operating profit = 10% × €160 000 000 = €16 000 000
• Target operating profit per unit = €16 000 000 ÷ 200 000 units = €80 per unit
• Target cost per unit = Target price – Target operating profit per unit
= €800 – €80 = €720
• Total current costs of Provalue = €135 000 000
• Current cost per unit of Provalue = €135 000 000 ÷ 150 000 units = €900 per unit
The target cost per unit of €720 is substantially lower than Provalue’s existing unit cost of €900.
The goal is to find ways to reduce the cost per unit of Provalue by €180, from €900 to €720. The
challenge in step 4 is to achieve the target cost through value engineering.
Step 4: Value engineering for Provalue An important element of Astel’s value engineering is
determining the kind of low-end PC that will meet the needs of potential customers. For
example, the existing Provalue design accommodates various upgrades that can make the PC
run faster and perform calculations more quickly. It also comes with special audio features. An
essential first step in the value-engineering process is to determine whether potential
customers are willing to pay the price for these features. Customer feedback indicates that
customers do not value Provalue’s extra features. They want Astel to redesign Provalue into a
no-frills PC and sell it at a much lower price. Value engineering at Astel then proceeds with
cross-functional teams consisting of marketing managers, product designers, manufacturing
engineers and production supervisors making suggestions for design improvements and process
modifications. Cost accountants estimate the savings in costs that would result from the
proposed changes.
Managers often find the distinction between value-added and non-value-added activities and
costs introduced in Chapter 2 useful in value engineering. A value-added cost is a cost that

14. customers perceive as adding value, or utility (usefulness), to a product or service. Determining
value-added costs requires identifying attributes that customers perceive to be important. For
Provalue, these attributes include the PC’s features and its price. Activities undertaken within
the company (such as the manufacturing line) influence the attributes that customers value.
Astel assesses whether each activity adds value or not. Activities and the costs of these activities
do not always fall neatly into value-added or non-value-added categories. Some costs fall in the
grey area in between, and include both value-added and non-value-added components. The
following classification typifies value-added and non-value-added categories in a manufacturing
organisation:
KEY PRINCIPLES
According to Hilton, target costing involves seven key
principles listed as follows:
1. Price-Led Costing:
Target costing sets the target cost by first determining the price at which a product can
be sold in the marketplace. Subtracting the target profit margin from this target price
yields the target cost, that is, the cost at which the product must be manufactured.
Notice that in a target costing approach, the price is set first, and then the target product
cost is determined. This is opposite from the order in which the product cost and selling
price are determined under traditional cost-plus pricing.

15. Market prices are used to determine allowable—or target—costs. Target costs are calculated
using a formula similar to the following: market price – required profit margin = target cost
2. Focus on the Customer:
To be successful at target costing, management must listen to the company’s customers.
What products do they want? What features are important? How much are they willing
to pay for a certain level of product quality? Management needs to aggressively seek
customer feedback, and then products must be designed to satisfy customer demand
and be sold at a price they are willing to pay. In short, the target costing approach is
market driven.
Customer requirements for quality, cost, and time are simultaneously incorporated in product and
process decisions and guide cost analysis. The value (to the customer) of any features and
functionality built into the product must be greater than the cost of providing those features and
functionality
3. Focus on Product Design:
Design engineering is a key element in target costing. Engineers must design a product
from the ground up so that it can be produced at its target cost. This design activity
includes specifying the raw materials and components to be used as well as the labour,
machinery, and other elements of the production process. In short, a product must be
designed for manufacturability.
Cost control is emphasized at the product and process design stage. Therefore, engineering
changes must occur before production begins, resulting in lower costs and reduced “time-to-
market” for new products.
4. Focus on Process Design:
Every aspect of the production process must be examined to make sure that the product
is produced as efficiently as possible. The use of touch labour, technology, global
sourcing in procurement and every aspect of the production process must be designed
with the product’s target cost in mind.
5. Cross-Functional Teams:
Manufacturing a product at or below its target cost requires the involvement of people
from many different functions in an organisation: market research, sales, design
engineering, procurement, production engineering, production scheduling, material
handling and cost management. Individuals from all these diverse areas of expertise can
make key contributions to the target costing process. Moreover, a cross-functional team
is not a set of specialists who contribute their expertise and then leave; they are
responsible for the entire product.

16. Cross-functional product and process teams are responsible for the entire product from initial
concept through final production.
6. Life-Cycle Costs:
In specifying a product’s target cost, analysts must be careful to incorporate all of the
product’s life-cycle costs. These include the costs of product planning and concept
design, preliminary design, detailed design and testing, production, distribution and
customer service. Traditional cost-accounting systems have tended to focus only on the
production phase and have not paid enough attention to the product’s other life-cycle
costs.
Total life-cycle costs are minimized for both the producer and the customer. Life-cycle costs
include purchase price, operating costs, maintenance, and distribution costs.
7. Value-Chain Orientation:
Sometimes the projected cost of a new product is above the target cost. Then efforts are
made to eliminate non-value-added costs to bring the projected cost down. In some
cases, a close look at the company’s entire value chain can help managers identify
opportunities for cost reduction.
Target costing is a common practice in Japan where markets are extremely competitive.
The market determines the price of products and there is a little opportunity for the
individual organisations to set prices. Therefore, controlling cost is extremely important.
All members of the value chain—e.g., suppliers, distributors, service providers, and customers—
are included in the target costing process.
VOICE OF THE CUSTOMER
The best practice companies actively solicit input from the customer on design issues.
While this practice is no different from those of many other companies, these
companies take it a step further—they examine whether or not their customers are
willing to pay for the design innovations. If the cost of the innovation is greater than its
value to the customer, the innovation should be abandoned. We found numerous
examples of “value analysis” during the site visits.
For example:
◆ One of Boeing’s customers requested heated floors. Before target costing, The
Boeing Company was inclined to provide almost whatever the customer wanted without
regard to cost. The company now prices airplane options separately. When this

17. particular customer learned that the price for heated floors was more than $1 million, it
reconsidered its request.
◆ DaimlerChrysler used value analysis to evaluate many of the options that are
available for its vehicles. After considering the tradeoff between cost and customer
value for several lighting options, one of the platform teams decided to provide lighting
for interior controls but forgo under-the-hood lighting.
◆ Continental Teves went beyond its direct customers to learn from the automobile
consumer. It discovered that once vehicle purchasers were educated on the use of anti-
lock brake systems (ABS) and the resulting safety benefits, they were more interested in
purchasing ABS as an option for their vehicle. To leverage this discovery, Continental
built a trailer that serves as a “mobile exhibit” to teach the public about ABS. One
section of the trailer has a foot pedal simulator that allows the consumer to feel the
“pulsating” motion of the pedal when he or she applies ABS brakes.
PRODUCT DEVELOPMENT
The product development process at The Boeing Company has changed markedly in
recent years. The characteristics of new airplanes are dependent upon the size of the
market (potential sales volume), the number of seats required, and customer choices
with regard to technological requirements. Before target costing was introduced,
engineers tended to design “engineering marvels” with little regard to cost. These
airplanes had hundreds of customer-specific product features, most of which were not
transferable from one customer to the next. Boeing now tries to minimize unique
customer requirements and incorporate changes that will provide value to a large
customer base. Through target costing, the costs associated with adding new
components or changing aircraft configurations, such as moving kitchen galleys to new
locations on the airplane, are much more visible. Any changes that are incorporated into
a new airplane must satisfy a life-cycle-based business case. In other words, customers
must be willing to pay for the incremental, nonrecurring costs of the change.
Furthermore, many of the technological advancements are expensive to implement on a
“piecemeal” basis. Therefore, as technology improves, some strategic advancements are
incorporated into existing models, and others are held “in a drawer” until a new family
of airplanes is developed (such as the new Boeing 777). For example, the product
development team recently learned that a competitor had developed a common cockpit
design for its airplanes. This new design will be evaluated using the above criteria, as it is
expected to save money for both the manufacturer (fewer new cockpit components to
design and manufacture) and the customer (lower training costs and fewer component
parts to inventory).

18. VALUE ENGINEERING
Value engineering is used in target costing to reduce product cost by analyzing the tradeoffs
between different types of product functionality (different types of product features) and total
product cost. An important fi rst step in value engineering is to perform a consumer analysis
during the design stage of the new or revised product. The consumer analysis identifi es critical
consumer preferences that defi ne the desired functionality for the new product.
The type of value engineering used depends on the product’s functionality. For one group of
products—including automobiles, computer software, and many consumer electronic products
such as cameras and audio and video equipment—functionality can be added or deleted
relatively easily. These products have frequent new models or updates, and customer
preferences change frequently. The manufacturer in effect chooses the particular bundle of
features to include with each new model of the product. For automobiles, this can mean new
performance and new safety features; for computer software, it might mean the ability to
perform certain new tasks or analyses.
In contrast, for another group of products, the functionality must be designed into the product
rather than added on. These are best represented by specialized equipment and industrial
products such as construction equipment, heavy trucks, and specialized medical equipment. In
contrast to the fi rst group, customer preferences here are rather stable.
Target costing is more useful for products in the fi rst group because the fi rm has some
discretion about a larger number of features. A common type of value engineering employed in
these fi rms is functional analysis, a process of examining the performance and cost of each
major function or feature of the product. The objective of the analysis is to determine a desired
balance of functionality and cost. An overall desired level of performance achievement for each
function is obtained while keeping the cost of all functions below the target cost.
Benchmarking is often used at this step to determine which features give the fi rm a competitive
advantage. In a release of new software, for example, each desired feature of the updated
version is reviewed against the cost and time required for its development. The objective is an
overall bundle of features for the software that achieves the desired balance of meeting
customer preferences while keeping costs below targeted levels. In another example, auto
manufacturers must decide which performance and safety features to add to the new model.
This decision is based on consumer analysis and a functional analysis of the feature’s
contribution to consumer preferences compared to its cost. For instance, improved safety air
bags could be added, but target cost constraints could delay an improved sound system until a
later model year.
Typically, the total target is broken down into its various components, each component is

19. studied and opportunities for cost reductions are identified. These activities are often
referred to as Value Analysis (VA) and Value Engineering (VE).
Value Analysis1 is a planned, scientific approach to cost reduction which reviews the material
composition of a product and production design so that modifications and improvements can be
made which do not reduce the value of the product to the customer or to the user. Value
Engineering is the application of value analysis to new products. Value engineering relates closely
to target costing as it is cost avoidance or cost reduction before production. Value analysis is cost
avoidance or cost reduction of a product already in production; both adopt the same approach i.e. a
complete audit of the product.
Here are some of the issues that are dealt with during a Value Analysis/ Value Engineering
review:
▪ Can we eliminate functions from the production process?
This involves a detailed review of the entire manufacturing process and determine the
non- value added activities. By eliminating them, one can take their associated direct
or overhead costs out of the product cost. However, these functions were originally
put in for a reason, so the team must be careful to develop work-around steps that
eliminate one or more activities from the original set of functions and be sure enough
that eliminating these activities will not hamper the value- added activities in any
manner.

20. ▪ Can we minimize the design?
This involves the creation of a design that uses fewer parts or has fewer features.
This approach is based on the assumption that a minimal design is easier to
Can we eliminate
functions from the
production process?
Can we eliminate
some
durability or
reliability?
Can we minimize the
design?
Can we design the
product better for the
manufacturing process?
ValueAnalysis/
Engineering
Can we substitute
parts?
Can we combine
steps?
Canwetakesupplier’s
assistance?
Is there a better
way?

21. manufacture and assemble. Also, with fewer parts to purchase, less procurement
overhead is associated with the product. However, reducing a product to extremes,
perhaps from dozens of components to just a few molded or prefabricated parts, can
result in excessively high costs for these few remaining parts, since they may be so
complex or custom made in nature that it would be less expensive to settle for a few
extra standard parts that are more easily and cheaply obtained. Also, a proper trade-
off between price and quality is necessary in this context.
▪ Can we design the product better for the manufacturing process?
Also, known as design for manufacture and assembly, this involves the creation of a
product design that can be created in only a specific manner. For example, a toner
cartridge for a laser printer is designed so that it can be successfully inserted into the
printer only when the sides of the cartridge are correctly aligned with the printer
opening; all other attempts to insert the cartridge will fail. When used for the assembly
of an entire product, this approach ensures that a product is not incorrectly
manufactured or assembled, which would call for a costly disassembly or (even
worse) product recalls from customers who have already received defective goods.
▪ Is there a better way?
Though this step sounds rather vague, it really strikes at the core of the cost reduction
issue—the other value engineering steps previously mentioned focus on incremental
improvements to the existing design or production process, whereas this one is a mor
e general attempt to start from scratch and build a new product or process that is not
based in any way on preexisting ideas. Improvements resulting from this step lend to
have the largest favourable impact on cost reductions but can also be the most
difficult for the organization to adopt, especially if it has used other designs or
systems for the production of earlier models.
▪ Can we combine steps?
A detailed review of all the processes associated with a product sometimes reveals
that some steps can be consolidated, which may mean that one can be eliminated (as
noted earlier) or that several can be accomplished by one person, rather than having
people in widely disparate parts of the production process perform them. This is also
known as process centering. By combining steps in this manner, we can eliminate
some of the transfer and queue time from the production process, which in turn
reduces the chance that parts will be damaged during these transfers.
▪ Can we take supplier’s assistance?
Another approach to value engineering is to call on the services of a company’s
suppliers to assist in the cost reduction effort. These organizations are particularly
suited to contribute information concerning enhanced types of technology of materials,
since they may specialize in areas that a company has no information about. They
may have also conducted extensive value engineering for the components they
manufacture, resulting in advanced designs that a company may be able to
incorporate into its new products. Suppliers may have also redesigned their
production processes, or can be assisted by a company’s engineers in doing so,
producing cost reductions or decreased production waste that can be translated into
lower component costs for the company.

22. A mix of all the value engineering steps noted above must be applied to each product
design to ensure that the maximum permissible cost is safely reached. Also, even if a
minimal amount of value engineering is needed to reach a cost goal, one should conduct
the full range of value engineering analysis anyway, since this can result in further cost
reductions that improve the margin of the product or allow management the option of
reducing the product ’s price, thereby creating a problem for competitors who sell higher-
priced products.
Design analysis is the common form of value engineering for products in the second group, industrial
and specialized products. The design team prepares several possible designs of the product, each having
similar features with different levels of performance and different costs. Benchmarking and value chain
analysis help guide the design team in preparing designs that are both low cost and competitive. The
design team works with cost management personnel to select the one design that best meets customer
preferences while not exceeding the target cost.
A useful comparison of different target costing and cost-reduction strategies in three Japanese fi
rms, based on the fi eld research of Robin Cooper, is illustrated in Exhibit 10.4 . Note that the
different market demands for functionality result in different cost-reduction approaches. Where
customers’ expectations for functionality are increasing, as for Nissan and Olympus, there is
more signifi cant use of target costing. In contrast, at Komatsu, the emphasis is on value
engineering and productivity improvement. Note also that fi rms such as Nissan, which use both
internal and external sourcing for parts and components, use target costing at both the product
level and the component level. The overall product-level target cost is achieved when targeted
costs for all components are achieved. 2
Other cost-reduction approaches include cost tables and group technology. Cost tables are
computer-based databases that include comprehensive information about the fi rm’s cost
drivers. Cost drivers include, for example, the size of the product, the materials used in its
manufacture, and the number of features. Firms that manufacture parts of different size from
the same design (pipe fi ttings, tools, and so on) use cost tables to show the difference in cost
for parts of different sizes and different types of materials.
Group technology is a method of identifying similarities in the parts of products a fi rm
manufactures so the same parts can be used in two or more products, thereby reducing costs.
Large manufacturers of diverse product lines, such as in the automobile industry, use group
technology in this way. A point of concern in the use of group technology is that it reduces
manufacturing costs but might increase service and warranty costs if a failed part is used in
many different models. The combination of group technology and total quality management
can, however, result in lower costs in both manufacturing and service/warranty.
An important part of value engineering is the use of advanced costing methods, such as ABC
costing, to accurately determine the product cost for each feature of the product, each function

23. of the product, or each design option that is being considered. ABC costing is particularly useful
for helping product designers, purchasing managers, manufacturing managers, and marketing
managers work together with a common understanding of the costs of different features and
options.
Concurrent engineering, or simultaneous engineering, is an important development
in the design of products that is replacing the traditional approach of product designers working
in isolation on specialized components of the overall design project. In contrast, concurrent
engineering relies on an integrated approach. The engineering/design process takes place
throughout the cost life cycle using cross-functional teams. Information is solicited from and
used at each phase of the value chain to improve the product design. For example, customer
feedback in the service phase is used directly in product design. Manufacturers such as Toyota
Motor Corp. and Moen Inc. are increasingly using product design in a very flexible manner by
continuously incorporating product improvements. Some experts argue that this approach has
saved firms as much as 20% of total product cost. Being able to identify, estimate, and track the
costs associated with providing each feature of the product, each function of the product, or
each design option that is being considered is an important part of value engineering.
Consequently, advanced costing methods, such as ABC, should probably play a role in the value
engineering process. The activity analysis component of ABC cost systems is particularly useful
for helping managers in product design, purchasing, manufacturing, and marketing gain a
common understanding of the costs of different features and options.

24. Target Costing and Kaizen
The fi fth step in target costing is to use Continuous Improvement (kaizen) and operational
control to further reduce costs. Kaizen occurs at the manufacturing stage where the effects of
value engineering and improved design are already in place; the role for cost reduction at this
phase is to develop new manufacturing methods (such as fl exible manufacturing systems) and
to use new management techniques such as operational control (Chapters 13, 14, and 15), total
quality management (Chapter 16), and the theory of constraints (next section) to further reduce
costs. Kaizen means continual improvement, that is, the ongoing search for new ways to reduce
costs in the manufacturing process of a product with a given design and functionality. Toyota
and a small number of other fi rms are leaders in the implementation of continuous
improvement. Toyota is using Kaizen to reduce manufacturing costs on its new hybrid vehicles,
so that it can bring down the premium it must now charge for these vehicles. Continuous
improvement can also mean enhancement of the product for a given cost, as noted in the
redesign of the Toyota minivan, the Sienna—the new model has a larger engine and a fi ve-
speed rather than a four-speed transmission.
Exhibit 10.5 shows the relationship between target costing and kaizen. Price is assumed to be
stable or decreasing over time for fi rms for which target costing is appropriate because of
intense competition on price, product quality and product functionality. These fi rms respond to
the competitive pressure by periodically redesigning their products using target costing to
simultaneously reduce the product price and improve their value. Consider the two points in
Exhibit 10.5 labeled fi rst and second target cost. The time period between product redesigns is

25. approximately the product’s sales life cycle. In the time between product redesigns, the fi rm
uses kaizen to reduce product cost in the manufacturing process by streamlining the supply
chain and improving both manufacturing methods and productivity programs. Thus, target
costing and kaizen are complementary methods used to continually reduce cost and improve
value.
An Illustration Using Quality Function
Deployment (QFD)
Quality function deployment (QFD) is the integration of value engineering, marketing
analysis, and target costing to assist in determining which components of the product
should be targeted for redesign or cost reduction. It helps designers and managers
break down the total product target cost into the components that make up the
product.
There are four steps in QFD:
1. Determine the customer’s purchasing criteria for this product and how these criteria are
ranked. Suppose the product is a power tool, a table saw. The customer criteria are
safety, performance, and economy.
2. Identify the components of the product and the manufacturing cost of each component.
For simplicity, assume the components of the table saw are the motor, the saw and the
frame. QFD in an actual application would generally use many more components and
more customer criteria.
3. Determine how components contribute to customer satisfaction. How much does the
motor contribute to the customer’s desired safety, performance, and economy? This is
done for all the components.
4. The fi nal step is to determine the importance index of each component, by combining
the information in steps one and three and then comparing this to the cost information
in step 2
Key characteristics of successful target costing
1. Focus on the customer
Target costing focuses on the customer. Customer requirements for quality, cost and time are
incorporated into the product decisions and guide the analysis of costs. Indeed target costing
forces companies to be specific about what customers want and the prices they are prepared to
pay (Cooper and Chew, 1996). Swenson et al (2003)7 identify as a feature of best practice in
target costing that companies actively solicit input from their customers on design issues to

26. examine whether or not customers are willing to pay for the design innovation and to ascertain
whether the cost exceeds the value to the customer, in which case the innovation is
abandoned.The process may also involve discussions with customers of different design options,
making trade-offs between cost and value.This is a key difference from other cost management
processes which tend to be disconnected from the value perceptions and requirements.
2. Emphasis on cost reduction at early stages in product development
Target costing starts at the earliest stage in new product development, indeed is embedded in
the development process, such that detailed financial analysis takes place from the outset and
engineering changes are made before production begins.This often means initial designs are
simplified before manufacture, resulting in lower costs and time-to-market once the design is
finalised.
3. Consideration of the whole product life-cycle
In order to ensure that total costs are minimised for both the producer and the customer,
successful target costing examines the full life-cycle cost of the product.This includes
consideration of the purchase price, operating costs, maintenance and distribution costs
(Swenson et al, 2003).
4. A multidisciplinary process
A characteristic mentioned in all literature on target costing is the multidisciplinary nature of the
process and the importance of the involvement of all functions in the analysis and decision-
making. Responsibility for achieving targets must also be shared across functions. In a study of
Toyota Australia’s target costing system, the International Federation of Accountants’ (IFAC)
Financial and Management Accounting Committee (now Professional Accountants in Business)8
highlighted the multi-disciplinary involvement in the cost management process and the vital
roles played by different functions:
● Finance — a co-ordinating role, managing the assignment of cost targets for individual
components and subsystems, performance reporting and monitoring performance
achievements across the business, and promoting target achievement and highlighting the need
for action when deviations occur.
● Sales planning and distribution – driving the formulation of the overall target cost. Purchasing
– looking for cost savings through the analysis of parts and components to be used in the new
product and working with suppliers to improve their cost base and to redesign parts.
● Engineering – using techniques such as value engineering to identify cost savings which can
be made whilst maintaining the functionality of the product.
● Manufacturing – looking for cost savings through improvements in the manufacturing
processes, either through continuous improvement or more long-term fundamental changes.
5. Team members understand their role and how it impacts
cost According to Gagne and Discenza (1995), the target costing teams which are the most
successful are those whose members have a basic understanding of how their work is translated

27. into numbers which represent the firm’s performance, using indicators which are meaningful to
them. In addition, the best team members are those who have rotated through several
departments, including design, purchasing and marketing before being assigned to a cost-
planning project, as broad backgrounds give team members a unique ability to spot and
implement ways to improve costs.
6. Involvement of the whole value/supply chain
A number of writers describe the importance of working with the company’s supply chain to
identify opportunities for cost savings. This is particularly important where a high proportion of
the total cost of a product is in purchased raw materials and components, and target costing
goals would be impossible to achieve without supplier involvement. Some companies view their
supply chains as part of an ‘extended enterprise’ where design and cost information is shared
and inter-company teams are established to meet cost reduction goals (Swenson et al, 2003).
Banham (2000)9 identifies getting suppliers to buy in to target costing as probably the most
difficult aspect of target costing as experienced by US companies implementing the
process.Amongst the methods used to achieve this are joint classes and team-building and
promises of shared savings.
7. An iterative process
Target costing is not an exact science and depends on credible data and sometimes difficult
judgements. It is also an iterative process where targets evolve as teams seek to balance
functionality, price, volumes, capital investment and costs (Cooper and Chew, 1996). However,
it is important the overall top-level target cost is regarded as an unalterable commitment and if
this cannot be met, the product cannot be launched.
8. Specific and real targets for improvement
Although the cost targets for individual components or processes evolve, once they are set, they
should not be changed.Also, as Cooper and Chew (1996) point out, targets must be more than
hypothetical, so that managers have an imperative to meet them in order to ensure the launch
of products.They should also be attainable, but require effort to meet them (Sakurai, 1989).
Benefits of Target Costing
Target costing can be benefi cial because
• it Increases customer satisfaction, as design is focused on customer values.
• Reduces costs, through more effective and effi cient design.
• Helps the fi rm achieve desired profi tability on new or redesigned products.

28. • Can decrease the total time required for product development, through improved coordination
of design, manufacturing, and marketing managers.
• Reduces “surprises” of the type, “We did not expect it to cost that much . . .”
• Can improve overall product quality, as the design is carefully developed and manufacturing
issues are considered explicitly in the design phase.
• Facilitates coordination of design, manufacturing, marketing, and cost management throughout
the product cost and sales life cycles
• Proactive approach to cost management.
• It reinforces top-to-bottom commitment to process and product innovation, and is aimed at
identifying issues to be resolved, in order to achieve some competitive advantage.
• Target costing starts with customer’s study or market study. It helps to create a company’s
competitive future with market-driven management for designing and manufacturing
products that meet the price required for market success.
• It uses management control systems to support and reinforce manufacturing strategies; and to
identify market opportunities that can be converted into real savings to achieve the best
value rather than simply the lowest cost.
• Target costing ensures proper planning well ahead of actual production and marketing.
• Implementation of Target Costing enhances employee awareness and empowerment.
• Foster partnership with suppliers.
• Minimize non-value-added activities.
• Encourages selection of lowest cost value added activities.
• Reduced time to market.
• Target Costing takes a market – driven approach towards cost, in which value is defined not
only by what customers demand but also by what they are willing to pay for. This strategy
introduces a discipline in which planning focus shifts to those costs that create value and
meet the needs of the customer. By involving and educating customers, target costing
provides a process that allows teams to make intelligent trade-offs between features,
functionality and cost, resulting in designs that are better suited to customer’s quality and
price expectations.
Problems with Target Costing
Though the target costing system results in clear, substantial benefits in most cases, it has
a few problems that one should be aware of and guard against. These problems are as
follows:
▪ The development process can be lengthened to a considerable extent since the design team
may require a number of design iterations before it can devise a sufficiently low-cost product
that meets the target cost and margin criteria. This occurrence is most common when the
project manager is unwilling to “pull the plug” on a design project that cannot meet its costing goals
within a reasonable time frame. Usually, if there is no evidence of rapid progress toward a

29. specific target cost within a relatively short period of time, it is better to either ditch a project
or at least shelve it for a short time and then try again, on the assumption that new cost
reduction methods or less expensive materials will be available in the near future that will
make the target cost an achievable one.
▪ A large amount of mandatory cost cutting can result in finger-pointing in various parts of the
company; especially if employees in one area feel they are being called on to provide a
disproportionately large part of the savings. For example, the industrial engineering staff will
not be happy if it is required to completely alter the production layout in order to generate cost
savings, while the purchase staff is not required to make any cost reductions through supplier
negotiations. Avoiding this problem requires strong interpersonal and negotiation skills on the
part of the project manager.
▪ Representatives from number of departments on the design team can sometimes make it more
difficult to reach a consensus on the proper design because there are too many opinions
regarding design issues. This is a major problem when there are particularly stubborn people
on the design team who are holding out for specific product features. Resolving out is difficult
and requires a strong team manager, as well as a long-term commitment on the part of a
company to weed out those who are not willing to act in the best interests of the team.
▪ Effective implementation and use requires the development of detailed cost data. This can be
really costly and may not be profitable for the company when a detailed cost-benefit analysis is
done.
▪ Use of target costing may reduce the quality of products due to the use of cheap components
which may be of inferior quality.
▪ For every problem area outlined have the dominant solution is retaining strong control over
the design teams, which calls for a good team leader. This person must have an exceptional
knowledge of the design process, good interpersonal skills, and a commitment to staying within
both time and cost budgets for a design project.
Conclusion
Target costing is an excellent tool for planning a suite of products that have high levels of
profitability. This is opposed to the much more common approach of creating a product that is
based on the engineering department’s view of what the product should be like, and then
struggling with costs that are too high in comparison to the market price. Target costing is a tool
for Cost Management which helps in reducing the cost of a product over its entire life-cycle.
Target costing induces those actions which management must take for establishing reasonable
target costs, developing methods to achieve these targets and developing the mechanisms to
test the cost effectiveness of various reduction efforts.