Target Costing

Target costing is a way of deriving a target cost to set production managers and is best viewed as the opposite of cost-plus pricing.

Problems with cost-plus pricing

In a traditional cost-plus pricing system,

• The cost of the item is established first.
• A profit per unit is added.
• This results in the selling price. 

However, cost-­plus pricing ignores the following:

• The price that customers are willing to pay ­
• The price charged by competitors for similar products ­
• Cost control

Target costing

A firm could address the problems discussed above through the implementation of target costing:

(1) The first step is to establish a competitive market price. The company would consider how much customers are willing to pay and how much competitors are charging for similar products. 

(2) Determine the required profit  

(3) A target cost is arrived at by deducting the required profit from the selling price

(4) Steps must then be taken to close the target cost gap from the current cost per unit if higher.

Closing the target cost gap

The target cost gap is established in step 4 of the target costing process.

Target cost gap = Estimated product cost – Target cost

It is the difference between what an organisation thinks it can currently make a product for, and what it needs to make it for, in order to make a required profit.Alternative product designs should be examined for potential areas of cost reduction that will not compromise the quality of the products.

Questions that that a manufacturer may ask in order to close the gap include: 

• Can any materials be eliminated, e.g. cut down on packing materials?
• Can a cheaper material be substituted without affecting quality?
• Can labour savings be made without compromising quality, for example, by using lower skilled workers?
• Can productivity be improved, for example, by improving motivation?
• Can production volume be increased to achieve economies of scale?
• Could cost savings be made by reviewing the supply chain?
• Can part ­assembled components be bought in to save on assembly time?
• Can the incidence of the cost drivers be reduced?
• Is there some degree of overlap between the product ­related fixed costs that could be eliminated by combining service departments or resources?

A key aspect of this is to understand which features of the product are essential to customer perceived quality and which are not. This process is known as ‘value analysis’. Attention should be focused more on reducing the costs of features perceived by the customer not to add value.

Target costing in service organisations

Target costing is as relevant to the service sector as the manufacturing sector. Key issues are similar in both: the needs of the market need to be identified and understood as well as its customers and users; and financial performance at a given cost or price (which does not exceed the target cost when resources are limited) needs to be ensured.

For example, if a firm of accountants was asked to bid for a new client contract, the partners or managers would probably have an idea of what kind of price is likely to win the contract. If staff costs are billed out at twice their hourly salary cost, say, this would help to determine a staff budget for the contract. It would then be necessary to work out the hours needed and play around with the mix of juniors / senior staff to get to that target cost.

There are ways in which target costing can be applied to service­-oriented businesses, and the focus of target costing shifts from the product to the service delivery system.

Target Costing in the NHS

In 2005, the National Audit Office and the Audit Commission identified the need for improvements in financial skills to meet the challenges facing the health service, as first­class financial management has a vital role in delivering improvements to patients. A number of healthcare providers in the United States had recently made significant improvements to patient care and resource utilisation by adopting approaches used in manufacturing businesses, including target costing principles, which is thought to have contributed towards significant benefits in improved quality of care, decreased mortality and cost reduction.

Target costing was thought of as a better method of costing services, in order to help NHS Trusts and hospitals to meet their financial responsibility to at least break­even, by ensuring that services are delivered within budgeted costs. Therefore, a move towards a new method of funding services was initiated, with NHS Trusts being paid a pre­set national tariff for each service they provide, rather than a price based on their own costs.

Take the example of Mrs Smith, who suffers from a medical condition requiring hospital care. She is booked into Guy’s St Thomas’s hospital NHS Foundation Trust for a procedure this month. Lambeth PCT is the responsible commissioner for Mrs Smith’s care, because she is registered with a GP practice there. The national tariff for the procedure amounts to £3,236, adjusted by two daily long stay payments at £740 a day.Therefore, the reimbursement from Lambeth PCT to St Guy’s hospital for the procedure would amount to a total of £3,976.

It was hoped that target costing, with targets related to the national tariff and coupled with an emphasis on value­for­money performance indicators , might provide a discipline within which Trusts could manage costs to improve efficiency. In a case like Mrs Smith’s, a target cost would hopefully encourage the hospital to perform the operation within this costs and promote better scheduling, use of cheaper drugs, etc.

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