2.4 The implications of using target costing on pricing, cost control and performance management

　　Pricing

　　§ Target costing forces product/service designers to ‘think outside the box’ and identify new and imaginative ways in which costs can be reduced in order to meet the target cost.

　　§ This approach can result in substantial cost saving being identified, thereby enabling prices to be set at levels that are very competitive but still generate a profit. A policy of penetration pricing can then be pursued with a view to substantial market share being captured.

　　§ Target costing is usually considered superior to cost plus pricing as it considers the demand for a product or service. As long as the estimates for demand at the target price are accurate and costs are controlled then an organisation will achieve its required return on investment.

　　Cost control and performance management

　　§ Target costing has a potentially major positive impact on cost control since it seeks to change the accounting mindset from one of recording costs to one of reducing costs in order that the cost target can be met.

　　The requirement to meet a target cost can generate new ideas and new ways of working which in turn can generate substantial cost savings and facilitate a more proactive approach to cost control.

　　§ Performance management is also potentially enhanced since the setting of a target cost requires a business to identify how costs can be managed down to the target cost level. This may involve product/service redesign and new ways of working (e.g. outsourcing, greater use of the internet etc.).

　　Test your understanding 7

　　LMN Ltd makes and sells two products, X and Y. Both products are manufactured through two consecutive processes assembly and finishing. Raw material is input at the commencement of the assembly process. An ABC approach is used in the absorption of product specific conversion costs.

　　The following estimated information is available for the period ending 31 December 20x5:

　　Product XProduct Y

　　Production/sales (units)12,0007,200

　　Selling price per unit$75$90

　　Direct material cost per unit$20$20

　　ABC variable conversion cost per unit

　　- assembly$20$28

　　- finishing$12$24

　　Product-specific fixed costs$170,000$90,000

　　Company fixed costs$50,000

　　LMN Ltd uses a minimum contribution/sales (C/S) ratio target of 25% when assessing the viability of a product. In addition, management wish to achieve an overall net profit margin of 12% on sales in this period in order to meet return on capital targets.

　　Explain how target costing may be used in achieving the required returns and suggest specific areas of investigation.