(b) As Lumsden has discovered, to compete effectively in today's competitive environment, organisations must continually redesign their products with the result that product life cycles are becoming much shorter. The planning, development and design stage of a product is therefore critical to an organisation's cost management process. Cost reduction at this stage of a product's life cycle, rather than during the production process, is critical.
Target costing
A target cost is an estimate of a product cost derived by subtracting a desired profit margin from a competitive market price. This may be less than the planned initial product cost but ways will be sought to close the gap between the two. Target costing (or target cost management) therefore requires managers to change the way they think about the relationship between cost, price and profit.
Stages of the target costing process
The target costing process involves three main stages.
(1) Analyse the external environment to ascertain what customers require and what competitors are producing. Specify the product's target market share.
(2) Using the resulting information, develop the product in an atmosphere of continuous improvement using value engineering techniques and close collaboration with suppliers, to enhance the product (in terms of service, quality, durability and so on) and reduce costs.
(3) Once the product has been developed, set a selling price (using market research, functional analysis and so on) to capture the target market share.
Benefits of target costing
Selling price is set with reference to the market place not as an internal mechanism. This ensures the product will be competitively priced and should achieve predicted volumes. Cost plus pricing may result in too high a price where sales volumes are not achieved.
When a product is first manufactured, its target cost may be well below its currently-attainable cost, which is determined by current technology and processes. Target costing therefore assists in cost reduction. Management should therefore set benchmarks for improvement towards the target cost, by improving technologies and processes (reducing the number of components, training, cutting out non-value-added activities and so on).
As the lifecycle of Lumsden’s products are short target costing is a very useful tool to ensure that the design costs etc can be recovered and that the products launched will make the desired returns. Any loss making products would be prevented from being launched when it is realised that product cannot be made for its target cost. |
