 Hello and welcome to this session. This is Professor Farhat in which we will discuss target costing. This topic is typically covered in cost accounting, managerial accounting, as well as the CPA exam. If you want to see additional lectures like this one, please visit my website farhatlectures.com. You will also find additional resources to supplement your courses or to study for the CPA exam. So when do we use target costing? Target costing is used when we are a price takers. What is a price taker? Price takers means we don't have an option. In other words, we don't set our own price. Why not? Because we are not selling a unique product. Well, it means our product is in the market that we are selling and everyone is competing on price. For example, when Apple came out with their first iPhone, Apple was a price setter, not a price taker. What do we mean by price setter? So price taker versus a price setter. Price setter means the company, Apple could have did not have to look for someone else to determine the selling price of the phone. They can set the price. Why? Because their product is unique. Here we are dealing with not unique product. Therefore, we are price takers. If we're not selling something unique, then we have competition. So what happened under those circumstances? We're going to look at the selling price. We're going to look at how much revenue we can generate by the market. Well, mainly by our selling price. Then we're going to set our desired profit motion. How much profit do we want to make? So simply put, it's a simple formula that you have to be familiar with. And basically, you have a target price. Wherever your price is, then you subtract your desired profit. How much profit you want to make, you'll get to your cost. Now, you could rearrange this formula. You can say cost plus profit equal to price. It doesn't matter. So let's assume, you know, you can sell something for 300. You'd like to make $30 in profit. Therefore, it should cost you to make $270. Now, what happened if you cannot manufacture this item for $270? Well, if you can't do so, you have to accept the lower profit because you can only sell it for 30. Or try to differentiate your product. So this way, maybe you can increase the selling price if you can. Or re-engineer the production process to lower the cost. But basically, this is what you have to do. The best way to illustrate this target constant is to work a couple of quick examples to see how this simple concept... Well, it's simple once you have it down. Market research indicates that a new product can sell well in the market at $21. So this is basically the selling price, $21. The company desired an operating profit of 20%. So remember, the selling price would include the cost and the profit. What do I mean by this? So simply put, your selling price should equal to the cost plus the profit, because the selling should recover your cost and give you some profit. Here, the selling price is $21. What we are saying, the $21 should give you your cost plus your profit. What we are saying here is, your profit, our target profit should be 20% of the cost. So we could replace profit by 0.2 of cost. This is what our profit is, 0.2 of cost. Well, let's complete this simple algebra. $21 equal to 1 cost plus 1.2 cost equal 1.2 cost. Now if you want to isolate cost, well, we can say cost equal to... We're going to divide both ends by 1.2, 1.2. So now we isolate cost, cost equal to $21 divided by 1.2. Now we can find our cost. So let's go ahead and compute this. $21 divided by 1.2, that's going to give us $17.50. Therefore, our cost is $17.50. So our cost is $17.50. Therefore, the profit is the difference, whatever the difference is. So what is our profit? So minus 21. So our profit is $3.50. What does... Sorry, I shouldn't have done this. So what does $3.50, 3.5 represent of 17.5? It represents 20%. Therefore, it's exactly what we did. We wanted our profit to be 20% of our cost. So hopefully this make sense. Let's take a look at another example. Let's take a look at another example. Market research indicate that our headphones would sell well in the market for a price of $149. Good. So we know the price that we can sell it for. The company desire an operating profit of 25% of cost. So how much what's the highest acceptable manufacturing cost would be willing to produce this product? So remember, we have $149 in total. It's going to cover our cost and it's going to cover our profit. Now, what do we know about this $149? We know if we take the selling price, it should equal to our cost, which is we don't know, plus it should give us 0.25 of the profit. Well, this is cost, let me do cost plus profit. $149 should give us cost plus profit. $149 equal to cost. Again, the profit is what? The profit is 0.25 of cost. Now $149 equal to $1.25 cost. Now if we divide $1.25 by both sides of the equation, we're going to get $149 divided by $1.25, $1.25. Let me just erase this and make it a little bit higher here. So $149 divided by $1.25 equal to the cost. Now again, we can do the same thing and figure out what is our cost. So our cost is $149 divided by $1.25. Our cost is $119.20. Again, the cost is $119.2 and the profit is, let's see, $119.2. I'm going to take the difference with $149. The profit is $29.80. Simply put, what does that mean? It means the, so if it's going to cost us more than $119.20. So simply put, when we manufacture those headphones, whether we are incurring variable costs such as, if we are incurring direct material, direct labor, a variable, manufacturing overhead, manufacturing overhead, when we do this, it should not per unit. We want it to cost us no more than $119.20. This is what we're saying. So the cost should not be higher than $119.20. If it's lower, it's great. If it's lower, if this is, let's assume this is $1.10, then guess what? If we can sell it for $149, our profit will go up. If you like this recording, please like it and share it. For additional recordings for managerial, as well as cost accounting CPA lectures, I strongly suggest you check out my website, foreheadlectures.com for additional resources. Good luck, study hard, and most importantly, stay safe.