Budget Targets as Performance Measures
Category : Budget Process Essays, Costing of Products
Budget Targets as Performance Measures
This paper discusses how effective are budget targets when used as performance measures. It gives the reader a clear explanation of the probable issues raised by the effectiveness of the used of budget targets as performance measures. It also includes considerable evidence of research into the said topic. A conclusion, which can be found at the last part of the paper, is drawn on the key findings to come up with the final judgment regarding the said topic.
A budget is an intelligently prepared estimate of future business conditions. In a business concern, such an estimate must include the income, probable costs, and expenses. Budgets are designed to assist management in the coordination of the selling, production, and administrative functions of the business. Budgetary control system is the term applied to a carefully worked-out plan covering the coordination of all these functions, as well as the continuous study and comparison of the actual operating figures with the budgeted figures to interpret the reasons for discrepancies.
Since business conditions vary, so is the budgets prepared for them. The basic principle of forecasting for control is the same for all businesses. In a small organization, the task of the preparation of a budget is in the hands of the accountant. In larger organizations, the budget preparation will be further supervised by a budget director. It must be emphasized that the budget is an instrument of control. It can be used by management in the determination of the amount of the deviations form plans and its possible causes. If there is a negative controllable cause, management should act to remove it. That is the meaning of control via budgets. The most important thing here is the comparison of the actual with the planned results, since this comparison reflects the operating conditions of the business.
Target costing is defined as a technique for profit management. It aims on ensuring that future products bring-in sufficient profits that enables the firm in achieving its long-term profits plans. This objective can only be made possible if these two conditions are met: (1) products are designed to satisfy the demands of the firm’s customers; and (2) it is manufactured at a sufficiently low cost. The cost at which the product must be manufactured is first identified in the target costing systems. This is to know if it enables the achievement of the profit objective. Then a disciplined environment is created afterwards to help ensure the achievement of the target cost.
Most target costing processes contain three distinct steps. These are market-driven costing, product-level target costing, and component-level target costing.
It is normal for a firm to face competitive pressures in the market place. However, there exists the need of transmission of these pressures to its product designers and suppliers. Therefore, market-driven costing is used for this purpose. This is done by subtracting the target profit margin from the target-selling price to determine the product’s allowable cost.
The market is the one who sets the allowable cost. Therefore, it does not incorporate the capabilities of the firm nor its suppliers. Setting the target cost equivalent to the allowable cost risks setting unachievable targets. Consequently, the effectiveness of the target costing is being reduced. For that reason, in the step of product-level target costing, product-level target costs are more often set higher than the allowable costs. These product-level target costs are determined in order for them to be achieved, only if the product designers expend considerable effort on designing costs out of the future products. The objective here is to create intense but realistic pressure on the product designers in reducing costs.
On the other hand, equivalent pressure should also be created on the firm’s suppliers. Therefore, component-level target costing is needed. This type of costing is used to focus supplier creativity on the reduction of the costs of their supplies’ components. At the heart of this step lies the establishment of the price that the firm is wiling to pay for each of the externally acquired components of their new product. In this way, the buyer is able to establish the selling prices of its suppliers. However, these prices must be realistic. In addition, it must also allow the suppliers to make adequate returns in case they also expend considerable efforts on designing costs out of their products. These three major steps are more often contained in most target costing systems. The only thing that makes them different by firm is the way these steps are being undertaken.
Key Principles of Target Costing
Target costing is based on six key principles. First is the price-led costing. In here, market prices are used to determine allowable or target costs. Target costs are calculated using a formula similar to this: market price --- required profit margin = target cost.
The second principle is based on the focus on customers. Customer requirements for quality, cost, and time are simultaneously incorporated in decisions on product and process. It also serves as a guide to the cost analysis. The value (to the customer) of any features and functionality built into the product must exceed the cost of providing those features and functionality.
Third is the focus on design. Cost control is emphasized at the stage of product and process design. Therefore, engineering changes must occur prior to the start of the production. This will result to lower costs and reduced “time-to-market” for new products.
Fourth is the cross-functional involvement. In here, the one responsible for the entire product, from initial concept through final production, is the cross-functional product and process teams.
Fifth principle is the involvement of the members of the value-chain. All members of the value chain, such as the suppliers, distributors, service providers, as well as the customers, are included in the target costing process.
The last principle is on the orientation of a life cycle. Total life-cycle costs are minimized for both the producer and the customer. This includes the purchase price, operating costs, as well as the maintenance and distribution costs.
Target Costing as a Valuable Tool
Target costing is a valuable tool and philosophy in supporting the overall efforts of an organization in remaining its competitiveness with regards to cost, while being able to meet the customer’s demands, all at the same time. Yet it is not a stand-alone effort. It involves the process that, if carried out by cross-functional teams, together with other value-adding processes, will be in its most effective manner of execution. This might include early supplier involvement, value analysis, and value engineering.
Target costing is also a tool worth investigating for any for-profit organization facing high profit and competitive pressure. The reasons for firms on why they decide to use target costing can be broadly defined. These are due to the need of increasing competitiveness, the desire to increase suppliers’ cooperation, and the goal involving the suppliers in their new product or service development process to leverage some of their supplier’s expertise. Additionally, there are also cost management reasons for performing target costing. This includes the improvement of their understanding of their own, as well as the supplier’s cost structures, improving internal cost management as well as cost monitoring, and increasing cost accountability.
Target costing is also best performed in cross-disciplinary teams, with suppliers as their team members. The integration of target costing success into the performance objectives of each team member is essential to the effectiveness of this cross-functional team.
Accountability for results is another critical issue to the long-term success of target costing. One way to create accountability is through holding of regular meetings that discusses the progress throughout the development cycle of the new product or service. Top management is involved in the said meetings. They undergo a clearer analysis of the comparisons made between the current estimate costs and the target costs. All gaps must be explained, with a corresponding plan in closing the said gaps. A tiered-team approach is said to be an effective technique in the management and implementation of target costing. In this approach, a higher-level team oversees the entire project. They are supported by other teams who actually execute and implement the target costing process within the organization and the supply base. A representative from the supply management participates on both of these teams.
In order to achieve target cost goals, organizations have undertaken various activities, ranging from minimal to extensive efforts. Among the less extensive efforts are the use of factual data in negotiating with suppliers and the sharing of long-term strategies to gain cooperation from suppliers. On the other hand, the more extensive methods have broader implications. These include the feature trade-off, the change of specifications, materials, and of design. In general, these efforts require team coordination. Close working relationships among the supply management, design/R&D, manufacturing, and marketing, if possible, are important in case there is a change in any feature performance or appearance. If the desired target cost was not achieved, the project may be cancelled or delayed.
Target costing is not only useful for components and unique raw materials. It may be also used for standard raw materials, packaging materials, services, outsourcing, tooling and capital. The potential impact of the purchased item must be high enough to offset the cost and effort related to target costing. Still target costing has the potential for widespread use.
Target costing is useful beyond new product or service development. There are evidences in case studies where organizations also use target costing for the improvement of their existing products or services. Some of them even specified their use of target costing for non-production items or for internally used items, instead for the reselling of a certain product or service. Target costing is used in monitoring actual supplier and total cost performance against targets, for encouraging the continued competitiveness of suppliers, as well as the organization’s products or services, as the market matures. In other words, target costing is also used with existing products and services in order to provide a scale for cost performance of both suppliers and the internal supply management function.
Target costing can also be used effectively for the purchase of high dollar services, especially if the services can be tied back to a product or service that will be resold. Take this as an example; one organization indicated that it utilizes target costing for the purpose of purchasing services that support new product development. These items are a relevant part of the new product costs and needs to be budgeted and attributed to that product. Just remember these conditions: (1) it should be high-dollar expenses; and (2) it should be allocated back to the product.
Those who use target costing are pleased with its results. They even intend to use it continually (and even increase its use). Among the benefits of target costing are improved supplier relationships as well as their involvement, the presence of teamwork, smooth the progress of new product and new service development process, supports cost management, and advancement of other internal improvements within an organization.
An integrated, institutionalized target costing effort is described as a resource-intensive process. It demands team effort, with the involvement of the supply management, marketing, accounting, research or design, and manufacturing. It also requires the building of supplier relationships in order to obtain the benefits of early supplier involvement and design participation. One critical success factor is the top management support. This enables the accessibility of time and creates an internal reward structure that supports target costing across all disciplines within the organization. Target costing becomes an essential part of the new product and service development process, as well as an ongoing approach for the monitoring and improvement of the costs of existing products and services.
There are numerous ways of the application of target costing within an organization. At one side, it is a supply chain-wide effort that includes value engineering, value analysis, and early supplier involvement. However, not all organizations have the resources and the company-wide support necessary to the success of an integrated, institutionalized target costing. As a result, at the other extreme, target costing can be used by a single department to benchmark performance, work with suppliers on improvements, and communicate cost targets to suppliers and within the organization. This can serve as a starting point for the growth of target costing efforts, as well as its benefits throughout the organization.