Target and life cycle costing - Cost commitment over product...

Learning Outcomes

After reading this article, you will be able to explain the concepts of target and life cycle costing, distinguish between traditional and modern approaches to cost management, and describe how cost commitment occurs throughout the product life cycle. You will be able to apply these principles to exam scenarios, especially regarding controlling costs at the earliest stages of product development and aligning them with company objectives.

ACCA Advanced Performance Management (APM) Syllabus

For ACCA Advanced Performance Management (APM), you are required to understand not only how costs are planned and controlled across a product's life, but also how early design and pricing decisions impact future profitability and organizational strategy. In your revision, focus on:

• Explaining the principles and objectives of target costing and life cycle costing
• Comparing target costing with conventional cost-plus methods
• Assessing when costs become committed, and the importance of early-stage cost management
• Evaluating the implications of product design on long-term costs
• Recommending strategies to manage costs throughout a product’s life cycle

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which phase of the product life cycle commits the highest percentage of total product cost?
   1. Introduction
   2. Design and development
   3. Production
   4. Decline
2. What is the main goal of target costing?
   1. Reduce quality to lower costs
   2. Set prices by adding a standard profit margin to cost
   3. Achieve a desired profit margin by designing products that can be produced within the target cost
   4. Maximize short-term profits through aggressive cost-cutting

3. True or false? The majority of a product’s total life cycle costs are determined after production begins.

4. List two actions managers can take at the design stage to help meet target costs.

Introduction

Effective cost management is critical for organizational performance. Approaches such as target and life cycle costing recognize that most costs are determined before production even begins. Early decisions on product design and features will “commit” a large proportion of the costs that will be incurred during manufacture and after-sales service. This article discusses how organizations can use these costing techniques to ensure that products are profitable throughout their lives by managing costs as early as possible.

Key Term: target costing
A cost management technique that sets a planned cost by subtracting a required profit margin from a competitive market price. Product design and processes are then developed to meet this cost.

Key Term: life cycle costing
A method that tracks and manages all costs and revenues related to a product from initial concept to withdrawal, aiming for profitability over the whole life span.

THE LINK BETWEEN PRODUCT DESIGN AND COST COMMITMENT

In traditional costing, production and post-production phases receive the greatest attention for cost control. However, research shows that decisions made at the earliest stages—especially design—commit the majority of a product’s total costs. Once a product moves from design to production, the flexibility to influence cost is dramatically reduced.

Key Term: cost commitment
The point at which decisions made lock in (commit) resources to be spent, making those costs unavoidable by later changes.

How Product Life Cycle Affects Cost Management

A typical product life cycle consists of:

• Design and development
• Introduction
• Growth
• Maturity
• Decline/Withdrawal

Studies estimate that up to 85% of total product costs are committed by the end of the design stage. This means that actions taken after the design phase, such as efficiency improvements in production, can only affect a small proportion of total costs.

Why Early Decisions Are Critical

• Features or materials specified at the design stage may dictate expensive manufacturing methods.
• Choices about product complexity directly impact costs such as warranty claims and after-sales support.
• Making changes to designs after production has started is expensive and usually ineffective at achieving significant cost reductions.

TARGET COSTING IN PRACTICE

Target costing reverses the traditional approach of “design-then-cost.” Instead, the organization starts with the maximum price customers are willing to pay, deducts a required profit margin, and sets a target cost for product development.

Target Costing Process

1. Determine market price – What will customers pay for a product with the desired features?
2. Subtract required profit – The company decides on an acceptable profit margin.
3. Set the target cost – Target Cost = Market Price – Required Profit
4. Design to cost – The product must be engineered so total cost does not exceed the target.

If initial cost estimates exceed the target, design changes, process improvements, or negotiations with suppliers are needed to close the “cost gap.”

Key Term: cost gap
The difference between the estimated cost of a proposed design and the allowable target cost.

Key Term: value analysis
The process of evaluating the function and cost of features/components to eliminate or modify those that do not add value from the customer's viewpoint.

Worked Example 1.1

A company wants to launch a new kitchen appliance. Customer research sets a maximum market price of $150, and management requires a profit margin of $30 per unit. Early design proposals estimate the cost per unit at $135. What steps should be taken?

Answer:
The target cost is $120 ($150 price – $30 profit). The projected design cost is $135, resulting in a cost gap of $15. The design team must review product features, materials, and processes to close the gap without sacrificing critical performance attributes, possibly through value analysis or supplier negotiations.

LIFE CYCLE COSTING AND TOTAL COST MANAGEMENT

While target costing focuses on meeting cost objectives at the design and launch stages, life cycle costing considers all costs incurred throughout a product’s entire existence, not just production costs.

This includes:

• Research and development
• Design and engineering
• Manufacturing
• Marketing and distribution
• Operation and support (e.g., warranty, repairs)
• End-of-life disposal

This approach prevents organizations from focusing only on minimizing production costs while ignoring significant pre- and post-production costs, which can undermine profitability.

Worked Example 1.2

A company develops a product with the following projected costs and revenues over its planned 5-year life:

• Development: $2m
• Production (Year 1–5): $8m
• Marketing and distribution: $3m
• End-of-life disposal: $1m
• Total sales revenue: $18m

What information does life cycle costing provide the management team?

Answer:
Life cycle costing reveals the product’s total cost ($14m) and compares it to total projected revenue ($18m), giving a total profit of $4m over the life cycle. It highlights the significance of non-production costs and allows managers to adjust pricing or design decisions early if profitability is threatened.

MANAGING COSTS ACROSS THE LIFE CYCLE

Organizations aiming for long-term profitability must consider all committed costs, not just those that are easily visible in accounting reports. Actions that support effective life cycle cost management include:

• Involving cross-functional teams (design, engineering, procurement, production, marketing) at the concept stage
• Employing value analysis to eliminate non-essential features or material costs
• Forecasting and including hidden costs such as future disposal or environmental obligations in early calculations
• Negotiating supplier contracts that support total cost targets, not just unit price

Key Term: cross-functional team
A group made up of representatives from multiple departments, working together to optimize products and processes.

COST COMMITMENT TIMELINE

The timing of cost commitment is essential. Below is a typical pattern (percentages are illustrative):

• By the end of design: 80–90% of total cost committed
• By start of production: 95% committed
• During manufacturing: Only 5–10% of cost is still controllable

Worked Example 1.3

A manager waits until production to reduce costs but finds little progress. Why?

Answer:
Because nearly all significant costs were committed during design and development. Opportunities to achieve large savings at production stage are limited; efforts should focus on earlier phases.

Exam Warning

In exam scenarios, watch for mismanagement where teams seek savings only after production starts. Comment on why this approach is usually doomed to result in minimal cost reductions, due to high cost commitment in earlier phases.

Revision Tip

When asked about cost control, always identify which stages allow the greatest influence over total cost and recommend early-stage involvement of cost management.

Summary

Target and life cycle costing ask “How much should a product cost over its entire life, and how do we ensure this?” Most costs are locked in by early decisions, so proactive management at the design stage—using cross-functional input, value analysis, and focus on whole-of-life costs—is essential. Traditional cost-cutting after launch is ineffective. Organizations should integrate cost and value thinking from the outset to achieve sustained profitability and competitive advantage.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the principle and process of target costing
• Describe the concept of life cycle costing and its scope
• Identify when most costs are committed during a product’s life cycle
• Apply the concept of cost gap and value analysis in managing design costs
• Recognize the limited effectiveness of post-production cost-reduction efforts
• Advise on strategies to manage and control costs during early stages for long-term profitability

Key Terms and Concepts

• target costing
• life cycle costing
• cost commitment
• cost gap
• value analysis
• cross-functional team