# Target Costing for Cost-Plus Pricing Companies Essay

JOURNAL ARTICLE OUTLINE

“Formula for success: Target Costing for Cost-Plus Pricing Companies,” Mohamed E. Bayou and Alan Reinstein, Journal of Cost Management, September/October 1997 pp. 30-34.

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The mechanism of cost-plus pricing involves the determination of the sales price in order to establish the target cost.

Organizations that employ the cost-plus pricing system have encountered major problems in implementing this approach.

This article recommends ways in which the cost-plus pricing companies can optimally utilize the target costing approach.

1.0 DEFINING TARGET COSTING AND COST PLUS PRICING

Cost-plus pricing system

§ Useful in companies that seek unique market positions by differentiating their products by from competitors.

§ Applied in price determination.

§ Two ways of determining the price-based on the actual cost plus a fixed fee and on the basis of the estimated cost, plus a fixed fee.

§ Cost pricing methods:

· Sales are determined by: Pi = Ci + rCi (Pi- sale price, Ci = unit cost , r= markup)

· Cost ranges from overall total cost, manufacturing cost, variable manufacturing cost to prime cost.

· Engineering target costing-The prime cost system where the direct material and labor cost are used as alternative basis for product pricing and applying target costing ,in this manner avoiding indirect variable and fixed costs allocation complications.

· Variable manufacturing overhead, direct materials and direct labor are the manufacturing costs used in this study as the general basis for target-costing applications.

· Fixed manufacturing costs are excluded from target costing since they represent significant funds that are committed for a long period of time and they cover an overall production capacity.

§ Targeting-costing system

· Has two commonly used methods:

i). The additive method focuses the target cost of a product and the cost of the components (Equation 1):

TCi = Ci1 + Ci2 + ……+ Cin I (TCi-Target cost, Ci1-cost 1, Ci2 = cost 2, Cin = cost n)

ii). The deductive method- the product’s profit is deducted from the given product’s sale price (Equation 2):

TCi = Pi-mi (TCi- target cost, Pi -sale price, mi- profit)

2.0 INTEGRATING TARGET COSTING AND COST-PLUS PRICING AND EVALUATING THE TARGET COSTING METHODS

Equation 4 is obtained by combining the target-costing deductive method and the cost pricing method, substituting the target cost for the unit cost: Pi = TCi + rTCi

Equation 5 combines the terms on the right-hand side of each equation when Pi is the product: Pi = TCi (1+r); r includes fixed manufacturing costs, administrative and marketing expenses and target profit.

The markup is thus measured as: r= (Ci¢ + Mi)/ (TCi (Qi)) [Ci¢ – costs of other TCi, Mi -Total profit, Qi –Quantity]

Equation 7is obtained by substituting the markup value in equation 5: Pi = TCi [1+ (Ci¢ + Mi)/TCi (Qi)]

Equation 7 is an interdependent variable system; the values reciprocally rely on each other for their determination.

The deductive method is recommended over the additive method since it connects the product’s target cost to the profit set by the top management and it fits within the mechanism of value of engineering which depends on this connection of costs to preset the profit targets.

3.0 COST-PLUS PRICING USING THE DEDUCTIVE METHOD AND CONCLUSION

Out of the five variables in equation 7, Mi is the most important followed by the target cost, Ci¢ .

Target costing through sensitivity analysis may well effectively determine the price (Pi) and the target cost (TCi).

Sensitivity analysis can help show the effect of various strategies and trade-off decisions that are taken before design engineers and product managers begin their value engineering and Kaizen (continuous improvement) activities.

Similarities caused by the interdependencies among the variables can be overcome by various alternatives using sensitive analysis.

Reference:

Bayou, E. M & Reinstein, A. (1997): Formula for Success: Target Costing for Cost-Plus Pricing Companies, Journal of Cost Management. Retrieved on 23rd February: http://benchiang19.com/article.doc

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