Target Costing Essay

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Accounting

The T&M Company is investigating whether it should use target costing for its towels, especially as it moves into the Italian market. Management might be halfway insane for targeting a country for international expansion that is only going to pay 20% less than our current revenue per towel, but it is my job as to crunch the numbers and figure out how we can do that. One technique is target costing. Target costing begins with the revenue per unit that is expected, then takes into account the margin that we are targeting. What is left is the amount of that is budgeted for the production of the item in question (Arrington, n.d). Target costing is useful in a situation like this because it provides a target for the company. It is easier to earn the profits that we seek if we are able to know what the total production cost is that we need to have. So target costing is just the first step in the process, but it is important because it puts a firm number that the supply chain and production specialists can work towards.

Target costing is relevant in today's business environment because with almost every product there is a high level of competition. This competition, combined with the ease of access of information that consumers have -- they can comparison shop online -- means that increasingly companies are price takers. When companies were price setters, it was easier for them to avoid a technique like target costing, because they would simply pass costs onto the customers. Today, doing that in many lines of business will make the company uncompetitive and unable to win business. It is essential that any company is able to price its goods in line with the other competitors in the market. Target costing can be a powerful tool to help the company achieve that (WBS Group, n.d.)

The Italian Job

The company seeks to break into the Italian market, but feels that it needs to lower prices by 20% in order to do this. Margins are to remain the same, so the cost of production needs to be reduced by 20% of the selling price in order to achieve this objective. The company can do this any number of ways, all of which will be beneficial, because lowering the cost of production will also help it to enjoy higher margins in the U.S., where the selling price can remain at its present level. Some companies seek to lower costs through efficiency improvements, and other companies seek to bargain with their suppliers to get lower costs. In this case, the amount of money that needs to be cut from the production cost is quite high, so a variety of techniques might be required in order to meet the target.

The first step in this process is to understand what the target is. The current contribution margin is 80% for U.S. specialty stores. The price is 100,000 / 5000 = $20 per unit at the U.S. specialty stores, which implies that in Italy the selling price will be $16. The production costs per unit in the U.S. right now are $4. To maintain the 80% contribution margin at a price of $16, the new costs for specialty stores in Italy will need to be $3.20, which means that the per unit cost needs to be reduced by $0.80.

The target for unit sales will be 5000, same as the U.S. specialty store division. The income statement for the Italian specialty stores will therefore be as follows:

Towels and More Italian Division

For the year ended 12-31-20XX

Unit Sales

Sales

$80,000

Variable Production Cost

$16,000

Contribution Margin

$12.80/unit

Contribution

$64,000

Selling costs per unit

$11.52

Selling costs

57,600

Net Income

Management's instructions were to sell to specialty stores in Italy, and to sell the number unit number as are sold in the U.S. At specialty stores (5000 units).

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The above pro forma income statement illustrates what comes of that strategy. That is the strategy management requested but it is reasonable to investigate what might occur if another strategy was undertaken. There are other options besides specialty stores, though in Italy there really are not very many department stores, they can occasionally be found. It is assumed for this exercise that the department store and gift shop options are equally viable in Italy -- we will leave the international management decisions to the big brains in the corner office.

Gift shops stand out as being lucrative in terms of revenues, even though the shipments are smaller. The selling price is much higher at gift shops. If the company sought out this market in Italy and sold 5000 units, the income statement would be as follows:

Towels and More Italian Division

For the year ended 12-31-20XX

Unit Sales

Sales

$240,000

Variable Production Cost

$48.000

Contribution Margin

$38.4/unit

Contribution

$192,000

Selling costs per unit

$68.8

Selling costs

344,000

Net Income

(152,000)

What this shows is that the gift shops, despite having a much higher selling price, as actually a money-loser for the company. The cost of servicing the gift shops is much, much higher than the other two. While the specialty stores only turn a small profit (and lose money once production overhead is taken into account), gift shops are a big money loser for the company even before production overhead is taken into account. The profit maker is actually the department stores, which have very low service costs associated with them, but sell a relatively high volume. If the company enters Italy with only department stores and sells the same amount as U.S. specialty stores (5000 units), the income statement will look as follows:

Towels and More Italian Division

For the year ended 12-31-20XX

Unit Sales

Sales

$100,000

Variable Production Cost

$16,000

Contribution Margin

84%

Contribution

$84,000

Selling costs per unit

$0.24

Selling costs

$1,200

Net Income

$82,800

The best results are to sell to department stores, since these are the most profitable. The conclusions are clear. In order to maintain the net margin but reduce the selling price, T&M needs to focus on department store sales. The costs of serving department stores are substantially lower than serving other stores. If it is not possible for the company reduce costs on the production side -- and it might not be -- then the optimal approach is simply to focus on the department store business. Management has indicated a preference for specialty stores, but the reality is that they do not provide a strong margin. The net margin on the specialty stores is 8%, before taking production overhead into account. This means that the Italian division, in order to deliver an equivalent net margin to the U.S. division, needs to not sell at gift shops at all, but maintain 50% in department stores. A 50/50 split yields the following income statement:

Towels and More Italian Division

For the year ended 12-31-20XX

Unit Sales

Sales

$90,000

Variable Production Cost

$16,000

Contribution Margin

$14.8/unit

Contribution

$74,000

Selling costs per unit

$5.88

Selling costs

29,400

Net Income

44,600

This gives the company a net margin of 49.5%. A target of at least 10% department store sales would be advisable, but the company might wish to consider a much higher percentage than that as a target because there is very little profit in the specialty stores, due to the high costs associated with servicing these customers.

There are a few potential obstacles to this. First, the company has to win some customers. This might be easier with department stores than with non-department stores because you only have to win one or two customers. However, breaking into an established market is not always easy. As noted, Italy has fewer department stores than the.....

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