(a) Deriving a target price and cost in a manufacturing company

Step 1: A product is developed that is perceived to be needed by customers and therefore will attract adequate sales volumes.

Step 2: A target price is then set based on the customers’ perceived value of the product. This will therefore be a market based price.

Step 3: The required target operating profit per unit is then calculated. This may be based on either return on sales or return on investment.

Step 4: The target cost is derived by subtracting the target profit from the target price.

Step 5: If there is a cost gap, attempts will be made to close the gap. Techniques such as value engineering may be performed, which looks at every aspect of the value chain business functions, with an objective of reducing costs while satisfying customer needs.

Step 6: Negotiation with customers may take place before deciding whether to go ahead with the project.

(b)

Four characteristics of services

–  Spontaneity: unlike goods, a service is consumed at the exact same time as it is made available. No service exists until it is being experienced by the consumer.

–  Heterogeneity/variability: services involve people and, because people are all different, the service received may vary depending on which person performs it. Standardisation is expected by the customer but it is difficult to maintain.

–  Intangibility: unlike goods, services cannot be physically touched.

–  Perishability: unused capacity cannot be stored for future use.

(Also acceptable characteristics are that ‘No transfer of ownership takes place when a service is provided’ and ‘service industries rely heavily on their staff, who often have face-to-face contact with the customer, and represent the organisation’s brand’.)

(c) Deriving target costs

(i) For services under the ‘payment by results’ scheme

The obvious target price is the pre-set tariff that is paid to the trust for each service. This is known with certainty and since the trust is a not for profit organisation, there will be no need to deduct any profit margin from the tariff. Problems may arise because of the fact that it is already known that costs sometimes exceed the pre-set tariff. These issues are discussed in (d).

(ii) For transplant and heart operations

For these operations, the trust is paid on the basis of its actual costs incurred. However, since the trust only has a restricted budget for such services, it is still important that it keeps costs under control. The target cost could be based on the average cost of these services when performed in the past, or the minimum cost that it has managed to provide such services on before, in order to encourage cost savings. It is important that quality is not affected, however.

(d) Difficulties for the Sickham UHS Trust in using target costing

The main difficulties for the trust are as follows:

It is difficult to find a precise definition for some of the services

In order for target costing to be useful, it is necessary to define the service being provided. Whilst the introduction of the pre-set tariff will make this more easy for some services, as this definition can be used, for other services not covered by the tariff, definition could be difficult.

It is difficult to decide on the correct target cost for services

For the pre-set tariff services, the obvious target cost would be the pre-set tariff. However, bearing in mind that the Trust knows that some services can be provided at less than this and some services cannot be provided at this price at all, one has to question whether it is right to use this as the target cost. A target cost which is unachievable could be demotivational for staff and one which is easily met will not provide an incentive to keep costs down.

As regards the other operations, the target can be set at a level which is both achievable but feasible, so this should result in less of an issue.

It would be difficult to use target costing for new services

The private sector initially developed the use of target costing in the service sector with the intention that it should only be used for new services rather than existing ones. Considering the work that a hospital performs particularly, it would be difficult to establish target costs when there is no comparative data available, unless other hospitals have already provided services and the information can be obtained from them.

The costing systems at the Sickham UHS Trust are poor

If costs are to be analysed in depth, the analysis must be based on accurate and timely costing systems, which do not appear to currently exist at the Sickham UHS Trust. A large part of the hospitals’ costs for services are going to be overhead costs and these need to be allocated to services on a consistent basis. This is not currently happening.

Note: Only three difficulties were required.