Target Costing Example

Description

Target costing is a cost management approach that is used by businesses to determine the optimal cost of a product or service based on the desired profit margin. It involves setting a target cost for a product or service and then working backwards to determine the necessary cost reductions in order to achieve that target. This method is widely used in industries such as manufacturing, retail, and services. In this article, we will discuss a real-life example of target costing and how it can benefit businesses.

• The Company: Our target costing example is based on a fictional company called XYZ Electronics. It is a leading manufacturer of consumer electronic products, known for its innovative and high-quality products.
• The Product: XYZ Electronics has recently launched a new smartphone model, the XYZ One. It is a mid-range smartphone with advanced features and specifications.
• The Market: The target market for the XYZ One is young professionals and tech-savvy individuals who are looking for a high-performance smartphone at an affordable price.

The XYZ One has received positive reviews from tech experts and has generated a lot of buzz in the market. However, the company soon realized that the production cost of the XYZ One was higher than expected, which would result in a higher retail price than its competitors. This could potentially affect the sales and market share of the product. In order to stay competitive and achieve their target profit margin, XYZ Electronics decided to implement target costing for the XYZ One.

Step 1: Set the Target Cost

The first step in target costing is to set the target cost for the product. This is the maximum cost that the company can incur while still generating the desired profit margin. In the case of XYZ One, the target cost was set at $300 per unit.

Step 2: Identify the Cost Drivers

The next step is to identify the cost drivers, i.e. the factors that contribute to the cost of the product. For the XYZ One, the cost drivers were identified as the components, labor, and overhead costs involved in the production process.

Step 3: Analyze and Reduce Costs

Once the cost drivers are identified, the company needs to analyze each cost component and find ways to reduce it. In the case of XYZ One, the company analyzed the cost of each component and identified areas where cost reduction was possible without compromising on the quality of the product. For example, they found a cheaper alternative for one of the components and negotiated lower labor costs with their suppliers.

Step 4: Implement Cost Reduction Strategies

After analyzing and identifying cost reduction opportunities, the company needs to implement these strategies. This could involve renegotiating contracts with suppliers, finding cheaper alternatives for components, or streamlining the production process to reduce labor costs. In the case of XYZ One, the company implemented all these strategies and was able to reduce the production cost to $270 per unit, achieving a cost reduction of $30 per unit.

Step 5: Monitor and Review

The final step in target costing is to continuously monitor and review the costs to ensure that the target cost is being met. In the case of XYZ One, the company set up a cost monitoring system to track the costs of each component and compare it with the target cost. Any deviations were immediately addressed to ensure that the target cost was not exceeded.

By implementing target costing, XYZ Electronics was able to reduce the production cost of the XYZ One and achieve their target cost of $300 per unit. This allowed them to price the product competitively and maintain their desired profit margin. As a result, the XYZ One became a popular choice among consumers and helped XYZ Electronics increase their market share.

In conclusion, target costing is an effective cost management approach that can benefit businesses in various industries. It allows companies to set competitive prices for their products or services while still achieving their desired profit margin. By following the steps outlined in this example, businesses can implement target costing and improve their cost efficiency, ultimately leading to increased profitability.