Management Accounting 101: Strategic Cost Management - Target Costing, Target Price Desired Profit Target Cost Value Engineering

What This Is

Target Costing is a management accounting technique used to set prices and costs for products or services. It involves setting a target price, desired profit, and then calculating the target cost. This approach helps managers make informed decisions about product pricing, production, and resource allocation. For example, Toyota uses Target Costing to set prices for its vehicles, taking into account the desired profit margin and production costs.

Key Frameworks & Metrics

• Target Cost = Target Price - Desired Profit – sets a target cost for a product or service, considering the desired profit margin.
• Value Engineering = Target Cost - Actual Cost – identifies areas for cost reduction and process improvement.
• Contribution Margin = Sales - Variable Costs – measures the amount of revenue available to cover fixed costs and generate profit.
• Contribution Margin Ratio = Contribution Margin / Sales – indicates the proportion of sales revenue available to cover fixed costs and generate profit.
• Break-Even Point (units) = Fixed Costs / Contribution Margin per Unit – tells you how many units must be sold to cover all costs.
• Economic Value Added (EVA) = NOPAT - (Capital Invested × WACC) – measures true economic profit after charging for the cost of capital.
• Value Chain Analysis – examines the activities and processes that create value for customers and stakeholders.
• Activity-Based Costing (ABC) – assigns costs to products or services based on the activities and resources consumed.

Step-by-Step Process

1. Identify the target market and customer needs: Determine the target price and desired profit margin based on market research and customer feedback.
2. Analyze the value chain: Examine the activities and processes that create value for customers and stakeholders.
3. Calculate the target cost: Set the target cost based on the target price, desired profit margin, and value chain analysis.
4. Identify areas for cost reduction: Use value engineering to identify areas for cost reduction and process improvement.
5. Implement cost reduction initiatives: Implement the cost reduction initiatives identified in step 4.
6. Monitor and adjust: Continuously monitor and adjust the target cost and pricing strategy as market conditions and customer needs change.

Common Mistakes

• Mistake: Treating all costs as relevant when using Target Costing.
• Correction: Only consider relevant costs that impact the target cost and pricing strategy.
• Mistake: Ignoring qualitative factors in make-or-buy decisions.
• Correction: Consider both quantitative and qualitative factors when making make-or-buy decisions.
• Mistake: Using ROI alone without considering residual income or EVA.
• Correction: Use a combination of ROI, residual income, and EVA to evaluate investment opportunities.

Decision-Making Tips

• When faced with a make-or-buy decision, always isolate avoidable costs and consider strategic, not just quantitative, factors.
• When evaluating investment opportunities, use a combination of ROI, residual income, and EVA to ensure a comprehensive analysis.
• When implementing cost reduction initiatives, focus on activities and processes that create the most value for customers and stakeholders.

Quick Practice Scenario

A company uses ABC to calculate the per-unit cost of a product that consumes 10 setups and 5 design changes. The product has a fixed cost of $10,000 and a variable cost of $5 per unit. Using ABC, calculate the per-unit cost.

Answer: $5.50 per unit (=$10,000 / 1,800 units + $5 per unit)

Explanation: The per-unit cost is calculated by dividing the fixed cost by the total number of units produced, and then adding the variable cost per unit.

Last-Minute Cram Sheet

• Target Cost = Target Price - Desired Profit
• Value Engineering = Target Cost - Actual Cost
• Contribution Margin = Sales - Variable Costs
• Contribution Margin Ratio = Contribution Margin / Sales
• Break-Even Point (units) = Fixed Costs / Contribution Margin per Unit
• EVA = NOPAT - (Capital Invested × WACC)
• Value Chain Analysis examines the activities and processes that create value for customers and stakeholders.
• ABC assigns costs to products or services based on the activities and resources consumed.
• 'Fixed costs' are only fixed in the short run within a relevant range – outside that range, they can change.
• ROI alone is not sufficient to evaluate investment opportunities – use a combination of ROI, residual income, and EVA.