Target and life cycle costing - Value engineering and allowa...

Learning Outcomes

After reading this article, you will be able to explain and apply the concepts of target costing and life cycle costing within strategic cost management. You will understand how value engineering can help close cost gaps, how allowable cost is determined in competitive markets, and how these techniques support both planning and continuous cost management. You will also be equipped to analyze cost structures, identify cost gaps, and evaluate cost reduction opportunities in ACCA APM exam scenarios.

ACCA Advanced Performance Management (APM) Syllabus

For ACCA Advanced Performance Management (APM), you are required to understand strategic cost techniques and their application in product development and ongoing cost management. In particular, this article helps you cover:

• The application and purpose of target costing in new product development
• How allowable cost gaps are identified and managed
• The role of value engineering in achieving cost targets
• How life cycle costing supports long-term cost planning and decision-making
• The interrelationship between customer value, price setting, and cost control

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 of the following best describes an allowable cost gap?
   1. The budgeted profit for new products
   2. The difference between current estimated cost and target cost
   3. The minimum cost required to launch a product
   4. The difference between target cost and required profit margin

2. True or false? Value engineering is applied during the initial design phase to reduce costs of a product while preserving functionality and customer value.

3. Company Zeta plans to launch a product at a market price of $80, requires a 30% margin and has an estimated cost of $65. Calculate the target cost and the allowable cost gap.

4. Give one key reason why life cycle costing is important for evaluating the profitability of a new product.

Introduction

Cost management is a key concern for organisations facing competitive markets. Target costing and life cycle costing are strategic tools that help companies control costs from product development to withdrawal. Target costing begins with the market price and works backwards to determine the maximum cost a product can have to achieve the required profit. When actual or estimated costs are above this target, value engineering is used to close the cost gap without reducing product value to customers. Life cycle costing ensures that all costs across a product's entire life are captured, supporting better pricing and cost control. These techniques often work together, especially where product success depends on early cost management and sustained cost review throughout its life.

Key Term: target costing
Target costing is a method that establishes a product's allowable cost by subtracting the desired profit margin from the market-determined selling price.

Key Term: allowable cost gap
The allowable cost gap is the difference between the current estimated cost of a product and the cost allowed to meet the target profit at the market price.

Key Term: value engineering
Value engineering is a systematic approach used to analyse product design and production processes to reduce costs while maintaining or improving functionality and quality.

Key Term: life cycle costing
Life cycle costing involves estimating and managing the total costs of a product over its entire life, from development through to disposal.

TARGET COSTING: OVERVIEW

How Target Costing Works

Target costing is a proactive cost planning and management technique. The process begins by identifying the price at which a product can be sold in the market, based on customer willingness to pay and competition. The required profit margin is then subtracted to determine the target cost. If the estimated or current cost of the product exceeds this target, action must be taken to reduce costs to an allowable level before production begins.

Steps in target costing:

1. Identify likely market price.
2. Set the required profit margin.
3. Calculate the target cost (market price less profit).
4. Estimate the current or expected product cost.
5. Identify the allowable cost gap (if any).
6. Use value engineering and other methods to close the gap.

Key Term: allowable cost
Allowable cost is the maximum total cost a product can incur, ensuring the desired profit is achieved at the market price.

Allowable Cost Gaps

The existence of an allowable cost gap signals that the design or process is too expensive to meet profit objectives at the planned selling price. The gap must be narrowed using systematic cost reduction techniques, beginning with value engineering.

Worked Example 1.1

A company wants to launch a new gadget. The market price is $120. Management requires a 25% profit margin. The engineering team estimates the initial cost at $100 per unit. What is the target cost and the allowable cost gap?

Answer:
Required profit = 25% × $120 = $30
Target cost = $120 – $30 = $90
Allowable cost gap = Estimated cost ($100) – Target cost ($90) = $10
The team must find ways to reduce cost by $10 to meet the target.

The Role of Value Engineering

Value engineering is central to the target costing process. It analyses each component, process, and feature of a product to identify cost savings without reducing product value for the customer. This may include:

• Redesigning parts for efficiency
• Using alternative, less costly materials
• Simplifying processes or assembly steps
• Eliminating non-essential product features

The focus is always on maintaining functionality required by the customer while achieving the target cost. Reductions that negatively impact perceived value or quality should be avoided.

Worked Example 1.2

XYZ Motors has a target cost for a car model of $15,000, but initial design costs come to $16,200. Through value engineering, the team suggests replacing a premium, seldom-used accessory with a standard model, saving $800 per unit, and standardising two components, saving another $600. Will this close the allowable cost gap?

Answer:
Cost savings = $800 + $600 = $1,400
New estimated cost = $16,200 – $1,400 = $14,800
Allowable cost gap closed: $15,000 target – $14,800 actual = $200 surplus. The actions have successfully closed the gap, and the car is now below target cost.

Exam Warning

When calculating target costs and allowable cost gaps, always check whether profit margin requirements refer to the selling price or cost, and apply percentages correctly. Misinterpretation leads to calculation errors.

LIFE CYCLE COSTING

Life cycle costing extends the view of product costs beyond the manufacturing phase, including pre-production (design and development) and post-sale (service, disposal) costs. This ensures all relevant costs are considered when making pricing, investment, and profitability decisions.

Why is life cycle costing important?

• Many products incur substantial costs before and after production, which traditional costing may ignore.
• Investment decisions made during design can have a large impact on future costs.
• Enables organisations to understand true profitability throughout a product’s life.

Key Term: life cycle cost gap
Life cycle cost gap is the difference between the total expected life cycle costs and the target life cycle cost aligned with strategic profit aims.

LINKING TARGET COSTING, VALUE ENGINEERING, AND LIFE CYCLE COSTING

In practice, target costing is most effective when applied early in product development, before major costs are committed. Life cycle costing supports this by capturing costs from "cradle to grave," helping to identify and prioritise cost reduction opportunities for both initial and ongoing expenditures. Value engineering serves as the main technique to bridge any cost gaps identified, and these tools work together to achieve cost competitiveness and profitability.

Worked Example 1.3

TechPro designs a new electronic device. The expected selling price is £300, management wants a 20% margin, and total estimated life cycle costs (development, production, warranty, end-of-life disposal) are £260 per unit. Should the project proceed, and what else should management consider?

Answer:
Required profit = 20% × £300 = £60
Target life cycle cost = £300 – £60 = £240
Cost gap = £260 – £240 = £20
The project currently does not meet the profitability objective. Management should carry out value engineering to reduce costs or consider product, feature, or process changes. If the gap cannot be closed, the project may not be viable.

WHEN TO APPLY TARGET AND LIFE CYCLE COST TECHNIQUES

Target costing is generally applied in markets with high competition and little control over price. Life cycle costing is valuable for products with long development, usage, or after-sales cost implications, such as capital equipment, vehicles, or high-tech products.

Revision Tip

Focus your calculations on the order: identify market price, subtract required profit, calculate target cost, compare to estimated cost, then identify and close any allowable cost gap.

Summary

Target costing ensures that cost planning is led by market realities and profit objectives, rather than historical cost plus margin. Value engineering is used whenever actual costs threaten to exceed the target, focusing on cost elimination without hurting value. Life cycle costing ensures all phases of a product's cost are measured, allowing for more informed profitability and investment decisions. The interplay of these tools helps organisations remain competitive, sustainable, and focused on value.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the process and rationale for target costing in new product development
• Calculate target cost, allowable cost gap, and interpret their meaning
• Describe how value engineering functions to bridge the allowable cost gap
• Apply life cycle costing to support long-term cost and profit assessment
• Link target costing, value engineering, and life cycle costing in strategic cost management
• Recognise when each tool is most appropriate in different business contexts

Key Terms and Concepts

• target costing
• allowable cost gap
• value engineering
• life cycle costing
• allowable cost
• life cycle cost gap