【Answers】
1 Edward Limited
(a) Target costing process
Target costing begins by specifying a product an organisation wishes to sell. This will involve extensive customer analysis,
considering which features customers value and which they do not. Ideally only those features valued by customers will be
included in the product design.
The price at which the product can be sold at is then considered. This will take in to account the competitor products and
the market conditions expected at the time that the product will be launched. Hence a heavy emphasis is placed on external
analysis before any consideration is made of the internal cost of the product.
From the above price a desired margin is deducted. This can be a gross or a net margin. This leaves the cost target. An
organisation will need to meet this target if their desired margin is to be met.
Costs for the product are then calculated and compared to the cost target mentioned above.
If it appears that this cost cannot be achieved then the difference (shortfall) is called a cost gap. This gap would have to be
closed, by some form of cost reduction, if the desired margin is to be achieved.
(b) Benefits of adopting target costing
– The organisation will have an early external focus to its product development. Businesses have to compete with others
(competitors) and an early consideration of this will tend to make them more successful. Traditional approaches (by
calculating the cost and then adding a margin to get a selling price) are often far too internally driven.
– Only those features that are of value to customers will be included in the product design. Target costing at an early stage
considers carefully the product that is intended. Features that are unlikely to be valued by the customer will be excluded.
This is often insufficiently considered in cost plus methodologies.
– Cost control will begin much earlier in the process. If it is clear at the design stage that a cost gap exists then more can
be done to close it by the design team. Traditionally, cost control takes place at the ‘cost incurring’ stage, which is often
far too late to make a significant impact on a product that is too expensive to make.
– Costs per unit are often lower under a target costing environment. This enhances profitability. Target costing has been
shown to reduce product cost by between 20% and 40% depending on product and market conditions. In traditional
cost plus systems an organisation may not be fully aware of the constraints in the external environment until after the
production has started. Cost reduction at this point is much more difficult as many of the costs are ‘designed in’ to the
product.
– It is often argued that target costing reduces the time taken to get a product to market. Under traditional methodologies
there are often lengthy delays whilst a team goes ‘back to the drawing board’. Target costing, because it has an early
external focus, tends to help get things right first time and this reduces the time to market.
(c) Steps to reduce a cost gap
Review radio features
Remove features from the radio that add to cost but do not significantly add value to the product when viewed by the
customer. This should reduce cost but not the achievable selling price. This can be referred to as value engineering or value
analysis.
Team approach
Cost reduction works best when a team approach is adopted. Edward Limited should bring together members of the
marketing, design, assembly and distribution teams to allow discussion of methods to reduce costs. Open discussion and
brainstorming are useful approaches here.
Review the whole supplier chain
Each step in the supply chain should be reviewed, possibly with the aid of staff questionnaires, to identify areas of likely cost
savings. Areas which are identified by staff as being likely cost saving areas can then be focussed on by the team. For
example, the questionnaire might ask ‘are there more than five potential suppliers for this component?’ Clearly a ‘yes’ response
to this question will mean that there is the potential for tendering or price competition.
Components
Edward Limited should look at the significant costs involved in components. New suppliers could be sought or different
materials could be used. Care would be needed not to damage the perceived value of the product. Efficiency improvements
should also be possible by reducing waste or idle time that might exist. Avoid, where possible, non-standard parts in the
design.
Assembly workers
Productivity gains may be possible by changing working practices or by de-skilling the process. Automation is increasingly
common in assembly and manufacturing and Edward Limited should investigate what is possible here to reduce the costs.
The learning curve may ultimately help to close the cost gap by reducing labour costs per unit.
Clearly reducing the percentage of idle time will reduce product costs. Better management, smoother work flow and staff
incentives could all help here. Focusing on continuous improvement in production processes may help.
Overheads
Productivity increases would also help here by spreading fixed overheads over a greater number of units. Equally Edward
Limited should consider an activity based costing approach to its overhead allocation, this may reveal more favourable cost
allocations for the digital radio or ideas for reducing costs in the business.
(d) Cost per unit and cost gap calculation
Component 1 $ per unit
(4·10 +
$2,400
) 4·70 ––––––––––
4,000 units
Component 2
(
25
x 0·5 x
100 )
0·128 ––– –––
100 98
Material – other 8·10
Assembly labour
(
30
x $12·60/hr x
100 )
7·00 –– –––
60 90
Variable production overhead
(
30
x $20/hr) 10·00 ––
60
Fixed production overhead
(
30
x $12/hr) 6·00 ––
60
–––––––
Total cost 35·928
Desired cost
($44 x 0·8) 35·20
–––––––
Cost gap 0·728
–––––––
Working
1. Production overhead cost
Using a high low method
Extra overhead cost between month 1 and 2 $80,000
Extra assembly hours 4,000
Variable cost per hour $20/hr
Monthly fixed production overhead
$700,000 – (23,000 x $20/hr) $240,000
Annual fixed production overhead ($240,000 x 12) $2,880,000
FPO absorption rate
$2,880,000
= $12/hr
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