Strategic cost management - Target costing and value enginee...

Learning Outcomes

After studying this article, you will understand how target costing aligns product costs with customer value and market constraints. You’ll be able to define target cost, explain the target costing process, identify why a cost gap arises and methods to close it, and discuss the role of value engineering. You’ll also appreciate challenges of applying target costing in service industries and recognise benefits for performance management.

ACCA Performance Management (PM) Syllabus

For ACCA Performance Management (PM), you are required to understand how modern cost management techniques drive organisational competitiveness. This article supports exam success by covering key syllabus requirements:

• Identify and derive a target cost in manufacturing and service settings
• Explain difficulties in applying target costing in services
• Suggest strategies to close a cost gap
• Apply and discuss the use of value engineering/analysis
• Evaluate practical implications of target costing for performance management

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. Target costing reverses the logic of cost-plus pricing. Which of the following is the primary first step in target costing?
   1. Calculate the unit cost based on design
   2. Set a competitive market selling price
   3. Add required profit margin to cost
   4. Analyse the value of features
2. If the target cost calculated is lower than the current estimated cost, what is the resulting difference called?
   1. Learning curve gap
   2. Value added margin
   3. Cost gap
   4. Residual margin

3. True or false? Value engineering is only carried out after a product is fully developed and about to be launched.

4. Briefly state two ways a company can attempt to close a target cost gap.

Introduction

Many organisations face fierce competitive pressure that prevents them from simply raising prices when costs increase. In highly competitive, price-sensitive markets, management must find ways to produce goods and services at costs that allow them to generate profit at market-driven prices. Target costing has been developed to address this challenge, ensuring that products are designed and produced so that their planned costs do not exceed the level customers are willing to pay, minus the required profit.

Value engineering, an essential part of this process, is used to redesign products or services in order to reduce costs while retaining the features that customers demand.

Key Term: target cost
A planned maximum cost for a product or service, calculated by subtracting the required profit margin from a competitive market price.

TARGET COSTING: THE CUSTOMER-DRIVEN APPROACH

The Need for Target Costing

Traditional cost-plus pricing works by determining cost and then adding a margin. However, in markets where prices are determined by competition and customer expectations, this approach may price products out of the market.

Target costing begins not with cost or design but with what customers are willing to pay. The logic is simple: if the product can’t be produced at a cost that allows both an acceptable selling price and required profit, it shouldn’t be made—or the design must change.

Key Term: target costing
A cost management technique where the target cost is set by subtracting a desired profit from a projected market price. Product design and production must then be structured to meet the target cost.

The Target Costing Process

The steps in target costing are:

1. Determine the market price: Assess what customers are likely to pay for a product, considering competitor offerings and perceived product value.
2. Deduct required profit: Subtract the required operating profit to derive the allowable cost.
3. Estimate current expected cost: Calculate what it would actually cost to make the product as currently designed.
4. Calculate the cost gap: Compare the current estimated cost with the target cost.
5. Close the gap: Use value engineering and other methods to reduce cost to, or below, the target.

Key Term: cost gap
The difference between a product’s estimated actual cost and its target cost, representing the amount by which cost must be reduced for the product to achieve the required profit at the target price.

ANALYSING AND CLOSING THE COST GAP

If a cost gap exists—that is, estimated cost exceeds the target cost—action must be taken before launching the product.

Techniques to close the gap include:

• Redesigning or simplifying product features (without reducing customer value)
• Sourcing cheaper materials (provided quality remains satisfactory)
• Using more efficient production methods
• Increasing predicted production volume to access economies of scale
• Re-examining supply chain arrangements

Raising the selling price is rarely an option, as this is set by the market.

Key Term: value engineering
A structured approach assessing all product functions and features to find the most cost-effective ways to deliver customer value, often through design modifications or process improvement.

Key Term: value analysis
The systematic review of existing products with the goal of identifying cost-reduction opportunities while maintaining required quality and functionality.

Value Engineering in Practice

Value engineering focuses cross-functional teams (including design, production, marketing, and finance) on finding lower-cost alternatives at all stages of pre-production, especially design and development. The objective is to prevent unnecessary costs being built in.

Worked Example 1.1

A company plans to launch a new kitchen appliance. Market research indicates customers are willing to pay $60 per unit. The required profit margin is $10 per unit. The initial design results in a predicted production cost of $56 per unit. What is the cost gap, and what should management do next?

Answer:

• Target cost = Selling price $60 – Profit $10 = $50 per unit
• Estimated cost = $56 per unit
• Cost gap = $56 – $50 = $6 per unit (adverse)
• Management must consider how to reduce cost by $6 per unit, such as redesigning the product or finding cheaper materials.

TARGET COSTING IN MANUFACTURING AND SERVICES

Target costing is widely used in manufacturing, especially where products are standardised and large production volumes can generate economies of scale. However, it can also be applied in service industries.

Challenges in service settings include:

• Intangibility of the service (harder to define “cost” per unit)
• Simultaneity of production and consumption (no inventory)
• Heterogeneity (services vary with delivery/person)
• Perishability (unused service capacity is lost)

Despite these difficulties, service organisations can still use target costing to manage resources, set budgets, and ensure services are delivered within market expectations.

Value Engineering and Target Costing: Practical Notes

• Timing: Value engineering should be employed before production starts, as most cost saving potential is lost once the design is finalised.
• Cross-functional teams: Effective value engineering requires input from all departments.

Worked Example 1.2

A mobile phone manufacturer finds that a competitor is selling a similar phone for $300, while their own current cost is $270 per phone. Management wants a 20% profit margin.

What is the maximum allowable cost, and does a cost gap exist?

Answer:

• Required profit = $300 × 20% = $60; Target cost = $300 - $60 = $240
• Current estimated cost = $270; Cost gap = $270 - $240 = $30
• The company must reduce costs by $30 per phone to launch profitably.

Exam Warning

Always set the target cost using a realistic market price as the starting point. Do not base calculations on what the company “wants” the price to be, or on historical costs. The exam may ask for the process rather than simply a calculation—explain steps clearly for full marks.

Value Analysis vs Value Engineering

• Value engineering – Focuses on cost reduction and function improvement during product design, before production.
• Value analysis – Applied to existing products and operations to identify further cost savings post-launch.

Key Term: functional analysis
Examines the specific functions a product or service must deliver, identifying multiple ways to achieve each at the lowest cost while retaining quality and value.

APPLICATIONS AND BENEFITS OF TARGET COSTING

Benefits include:

• Customer and market orientation—focuses design on customer-perceived value
• Encourages innovation in design and production methods
• Promotes early cost control, reducing need for corrective action after production starts
• Strengthens competitive position by ensuring costs do not exceed what customers will pay

Worked Example 1.3

A healthcare provider wants to offer a new package priced at $250, with an expected profit of $30 per package. Initial estimates show costs of $240 per package. What action should the provider take?

Answer:
Target cost = $220 ($250 – $30). Estimated cost is $240. Cost gap = $20 adverse. The provider should review service components, staff mix, technology use, and negotiate with suppliers to reduce costs by $20 before introducing the new package.

Summary

Target costing is a proactive approach to cost management, setting the allowable cost for products or services before development or launch. If there is a cost gap, teams use value engineering and critical analysis to reduce costs without sacrificing features that add value for the customer. This method is suitable for both manufacturing and services, helping organisations remain profitable when market prices are externally set.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the logic, steps, and purpose of target costing
• Identify and calculate a cost gap using target costing
• Describe the process and uses of value engineering and value analysis
• Discuss techniques to close a target cost gap in practice
• Recognise challenges of applying target costing to services
• Understand benefits of target costing for performance management

Key Terms and Concepts

• target cost
• target costing
• cost gap
• value engineering
• value analysis
• functional analysis