Management Accounting

Target Costing

We have discussed earlier in this book that one of the main reasons for calculating total cost of a product/ service is to establish a price for it. Many organisations produce a product, establish the total cost and then add a mark-up to set a price for their products.

Well – that’s what used to happen but not anymore in many sectors. After globalisation in 2005, the competition has become fierce in the business world. Same (or similar) product can be bought from many different suppliers with competing prices. In the current environment, producers need to establish the prices for their product/services which a market is willing to pay before they even produce it. If the market is unwilling to pay the price set and required by the business then the business will have three choices

1-Reduce the mark-up on the product

2-Abandon the idea/product

3-Reduce the production cost of the product

In most of the cases, organisations have a standard mark-up which they will add on their products/services. The management would not be willing to reduce the mark-up to reduce the price as this will divert their time from the products which may already be generating desired mark-up. There could be other future products/ideas which can fetch the desired mark-up.

For big companies like Uniliver or Tesco, abandoning a product may not be an issue but for some companies like Airbus, Apple, Audi or tesla it can be a major issue. For such companies abandoning a product may mean leaving a whole sector for competitors who can steal company’s market share in other products consequently. An example is Ford which is forced to sell electric vehicle at a loss as it does not want Tesla to monopolise this sector.

If the management, decides to go ahead with the project, then they will work backwords (from a set price to the required cost rather than from a set cost to the required price) to reduce the cost of the product to a level where the product can be sold at the price which a market is willing to pay and desired profit is also achievable. This approach is called Target Costing.

In some cases, small adjustments in the product may reduce the cost to the desired level. This may involve reducing the weight, volume, size and/or functionality of the product minutely which consumer will not notice.

There is another option available to the management to reduce production cost before deep diving into Target Costing which is outsourcing the production of the product. Many countries where cost of production is too high due to factors like high labour cost, rent, rates and insurance etc are producing products in the developing countries including China, Vietnam, Thailand, India, Bangladesh and Pakistan etc. However, it is not always possible to outsource due to issues like unavailability of technical skills in the developing countries, protection of patents, company policies etc.

Target costing approach pushes management out of the box to find the solutions to reduce the production cost. As we have discussed in chapter 2 of this book, variable costs are the one which can be reduced in the short term so the management focus will be on material and labour costs which are two most prominent types of variable costs.

Reducing the cost of material:

Most obvious solution would be going back to the supplier and renegotiating the prices of the raw materials. Many profitable businesses get negligent in this area as there is no genuine push to decrease the prices of the inputs. However, if management knows they need to reduce the cost of the raw material, say by 15%, they will try hard to get this reduction from their supplier. If current suppliers agree to reduce the prices then the problem is solved. Otherwise the business will be forced to look for other suppliers in the market.

Finding new suppliers may bring more opportunities for the business, not only for the product in question but also for other products. Existing suppliers may have been arranged a long time ago and the business may not have looked harder for better prices elsewhere.

To arrange new suppliers, the business will require quotations from all the suppliers in the market. The competitive pricing may bring higher savings than required which will be beneficial for the business and the product will generate even higher return.

However, it is not always possible to find new suppliers for some raw materials due to limited competition and suppliers in the market. For example, electronic industry is facing chip shortage after covid-19 pandemic and there are not enough suppliers to meet the demand. The raw material may not be available from other parties due to copyrights of the raw material.

Another solution would be to use the raw material of a reduced quality if it will not have a significant effect on the saleability of the product. For example, there are many touch screen tablets in the market which use lower quality raw materials including the touch screens to compete in the market. However, lower quality material has an adverse impact on the quality of the product (an obvious one), increased raw material wastage, quality inspections, product rejection rate and product returns. Therefore, a decision to reduce raw material quality should not be taken lightly. Poor quality material also increases labour cost as labour finds it harder to work with cheap quality material and more production is needed due to higher rejection rate.

Reducing the Cost of labour:

Many businesses have their own production facilities now in the developing countries to enjoy the benefits of cheap labour. This is different than outsourcing as outsourcing involves hiring another business to produce for you. If the business already has overseas production facility then it must have already been included in the original costing, therefore, this solution does not apply in this situation.

However, if a business does not have overseas facility then this could be considered if the new product is expected to be sold in large quantities. This will be a huge decision which must be evaluated properly using various decision-making techniques which management accounting offers. This could reduce the production cost significantly not only for the proposed product but also for existing and future products. However, a post-Covid phenomenon is increased in the shipping costs which has five-folded in some cases. This is a point which goes against outsourcing and overseas production. Many US and European companies have already started thinking about returning to in-house production as excessive shipping costs have made overseas production not worthwhile.

Another option to reduce labour cost is to use semi-skilled or low skilled labour instead of skilled labour which can reduce the cost of production. Although, this option increases material wastage, for some industries it has proven successful option to reduce the costs. In my student life I was working in a factory in West London producing CDs and DVDs for Hollywood movies. The students were working at the minimum wage while the permanent staff was getting three times more pay for the same work as they were considered skilled due to their experience at the factory. That factory closed down few years later anyway due to changes in the industry and competition from overseas.

Labour cost can also be decreased by negotiating with labour unions. If a business is facing fierce competition which is threatening its existence, labour union may be willing to accept reduce pay which can reduce the costs of its products. Many businesses reduced staff pay during pandemic to reduce the costs for their survival.

This article is written by Raja Mizan who is a senior lecturer in accounting & finance in a UK university. He is an ACCA member and also runs his own accountancy practice RMR Accountants & Business Advisors.

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