Do you have a systematic method of calculating costs or is it handled only intuitively?
Ideally, the prices of products and services that the company brings to the market should be in line with what the customer can pay for the value they have incorporated.
Most price calculation systems start from the calculation of costs.
Then they add a profit margin and from there they determine the sale price.
But this does not often coincide with the value that the customer is willing to pay. The solution? Target Costing combined with ABCosting.
Why combine Target Costing with ABCosting?
Target Costing is a technique that can help determine the price-earnings-cost structure that the market is willing to pay for your product or service. ABCosting is the ideal complement to understand how costs originate and achieve the values that are determined by Target Costing.
How do those who know?
In Japan, cost management is in the hands of engineers, not accountants. Unlike many other countries, the Japanese production system takes costs as a symptom, not a cause or a problem. They use costs to identify the production problems underlying this information. And as an opportunity for improvement.
Target Costing begins with identifying what the customer is willing or able to pay for. Sometimes when there is a market leader, the leader's price must be taken as a reference.
So the first step is to determine the price that the market is willing to pay, calculated independently of costs, for a product or service that meets the characteristics of quality and functionality that the market demands.
After taking the price as a data, Target Costing requires the definition of the margin that the manufacturer or service provider is seeking to obtain.
Finally, the cost is determined according to the following formula:
Costs = Market Price - Planned Profit
On the contrary, in Western economies this calculation follows the opposite path. The company calculates the cost of the good or service according to the characteristics that it must have and to this adds the expected profit. The sum of both determines the price, according to the following formula
Costs + Planned Profit = Market Price
The Advantages of Target Costing
The advantages of using Target Costing are great and lie in the fact that costs can be better managed in the design stage of the product or service and thus influence the design engineers so that the product is defined at an acceptable cost by the market.
Thus, costs are accepted from the very beginning of the product's life cycle, avoiding the subsequent costly reengineering necessary to adapt it to market conditions.
In other words, the Target Costing technique makes costs the adjustment variable and therefore the concept that production or service delivery systems must adjust.
On the contrary, the traditional cost calculation system starts from these as data and leaves the market price as the adjustment variable to be determined. The problems with this method of calculation is that when the market price does not adapt to what customers can or want to pay, then reprocessing and reengineering must be applied to modify and adapt the cost of the product or service to market conditions.
This constitutes an endless spiral, as reengineering is expensive and ends up adding costs to the entire process.
Also, product reengineering doesn't always have a happy ending; generally the costs that can be reduced are marginal.
In Japan, for example, the manufacturer's relationship with its suppliers is different from the West.
The manufacturer does not ask for a price for a certain product or service, but informs its supplier of the price it can pay and will only accept from the supplier the products or services it requires (with strict control of its specifications) at the given price. Thus, the entire value chain is adjusted to the price defined as acceptable by the market.
In the West, the usual thing is to call several suppliers and ask for a price quote, selecting the one that offers the best conditions. But again we see that the concept is different since the final price is left as an adjustment variable and not costs.
Target Costing + ABCosting = the perfect formula
In this context, ABCosting appears as an invaluable ally when adopting Target Costing techniques.
ABCosting offers the most detailed and complete information on costs, their way of consuming resources and their reciprocal allocation between activities.
By working with the system of drivers or cost inducers, ABCosting provides powerful information about what are the causes that induce costs and how they flow through all departments and areas of the company to products and services.
ABCosting brings out the cost formation mechanism like no other system does.
Not surprisingly, companies are rapidly adopting these techniques to reduce the margin of error when determining the prices of their products and services.
