Target Costing explains how to derive the target cost, explains the difficulties of using target costing and suggests how a target cost gap might be closed.
Target costing involves “setting a target cost for a product, having identified a target selling price and a required profit margin.”
a) Derive a target cost in manufacturing and service industries.
Formula: Target Cost = Sales Price – Required Profit
The target cost is the cost at which a product or service must be sold to achieve a desired profit.
Example: Smart Energy is considering launching a portable water heater. Based on market analysis, the sales price of similar products is $100. Smart Energy aims to make a gross profit of 50% of the selling price of its profits. Therefore, the target cost is:
Target Cost = Sales Price – Required Profit = $100 – $50 = $50
b) Explain the difficulties of using target costing in service industries.
Target costing is difficult to use in service industries because of the “characteristics and information” requirements of service businesses. Examples of services are transportation, pensions and financial advice, car maintenance and entertainment.
The main characteristics of services are (IIVPT):
- Intangibility – no physical or material attributes
- e.g. Bus service – transportation from point A to point B
- Inseparability/ Simultaneity – service does not exist until it is needed
- e.g. Bus service – does not exist until someone catches the bus
- Variability/ Heterogeneity – services vary and are not always consistent
- e.g. Bus service – bus might be on time today but late tomorrow
- Perishability – services are purchased for a period of time
- e.g. Bus service – bus ride is an hour
- No Transfer of Ownership – purchase of the service does not mean you own it
- e.g. Bus service – you don’t own the bus or the company when you pay a fare
It is difficult to identify a target cost for a service because of these characteristics.
c) Suggest how a target cost gap might be closed.
During manufacturing the “currently-attainable cost may be higher than the target cost.” The target cost gap is the “estimated cost less the target cost.”
Target Cost Gap = Estimated Cost – Target Cost
There are several techniques that can be used to close the target cost gap:
- Reduce the number of components being used to create the product
- Use cheaper staff and/ or reduce labour costs
- Use standard components
- Use new and more efficient technology
- Train staff to be more efficient
- Cut out non-value added activities
- Use different materials
If the projected cost exceeds the target cost, the next step is to reduce the cost from the current estimated amount down to the target cost.
- BPP’s ACCA F5 Performance Management Study Text
- ACCA F5 Syllabus and Study Guide
- Open Tuition’s ACCA F5 Performance Management Study Materials
- Acowtancy Free ACCA F5 Course