Strategic Cost Management · Target Costing

Value Engineering and Cost Reduction in Target Costing

Updated 11 October 2026 · Fact-checked

Value engineering is a pre-production technique that studies each function of a product and redesigns it to cut cost without reducing the value the customer gets. In target costing, you use it to close the gap between estimated cost and target cost: find the gap, analyse functions, then choose design changes that remove cost.

Understand Value Engineering and Cost Reduction Techniques

In target costing, the selling price comes from the market. Target cost = target price − target profit. Often the cost estimate for the current design is higher than this target. The difference is the cost gap. Value engineering (VE) is the main tool to close it.

VE looks at the product as a set of functions, not as a set of parts. A function is what the product does for the customer, for example 'keeps food cold' or 'looks premium'. Each function is split into basic functions (the reason the product exists) and secondary functions (support or appeal). You then ask what each function costs and what it is worth to the customer.

The key idea is that cost should follow value. If a function costs far more than the customer values it, you redesign it, use a cheaper material, simplify it or remove it. If a function is valued highly but gets little spend, you may keep or even add to it. The aim is lower cost at the same or better value, not just cheaper.

Value engineering vs value analysis. Both use the same functional approach. Value engineering is applied at the design and planning stage, before production starts, so it fits target costing. Value analysis is applied to an existing product already in production, to remove unnecessary cost. Target costing relies mainly on VE, because most cost is locked in at design.

Other cost reduction routes sit beside VE: negotiating with suppliers, involving suppliers in design, standardising parts, reducing the number of components, improving the production process, and cutting waste. Remember that cost reduction means lowering unit cost without harming quality or function, while cost cutting may damage them.

Key rules to remember

Target cost: Target cost = Target selling price − Target profit; Target profit may be given as a margin on price or on cost. Read the base carefully.
Cost gap (cost reduction required): Cost gap = Estimated (current) cost − Target cost; This is the amount VE and other methods must remove per unit or in total.
Value index: Value index = Function's share of customer value (%) ÷ Function's share of cost (%); Below 1 means over-costed, so look for savings. Above 1 means under-costed relative to its value. Near 1 is balanced.
Target cost of a function: Function target cost = Function's value weight × Overall target cost; Compare with the function's current cost to find the reduction needed for that function.
Value (concept): Value = Function (benefit to customer) ÷ Cost; VE raises value by keeping function and lowering cost, or by raising function at the same cost.

How to solve Value Engineering and Cost Reduction Techniques questions

Use this order for any numerical or descriptive question on VE in target costing.

1Compute the target cost: target price less target profit. Check whether profit is on sales or on cost.
2Compute the cost gap: current estimated cost less target cost.
3List the product's functions and assign customer value weights (percentages) from the data given.
4Work out each function's share of current cost and its value index (value share ÷ cost share).
5Compute each function's target cost (value weight × target cost) and the reduction needed (current cost − function target cost).
6Rank the functions: the lowest value index or largest reduction is the first place to look for design changes.
7Suggest specific actions (material change, fewer parts, simpler design, supplier input) and check they do not cut valued function.
8State the result: total reduction achieved against the gap, any shortfall, and a clear recommendation.

Quickest way: Function table method

When to use it: Use it when the question gives function-wise cost and customer importance and asks which functions to re-engineer or how much to cut.

Write a table with columns: function, current cost, cost %, value %, target cost, reduction.
Fill cost % and target cost first (value % × target cost).
Reduction = current cost − target cost for each function. A negative figure means the function is under-costed.
Mark the highest positive reductions as priorities and total them against the cost gap.
Write two lines of recommendation tied to the numbers.

Common mistakes in Value Engineering and Cost Reduction Techniques

Treating value engineering and value analysis as the same thing.
Both use functional analysis, so the difference in timing is overlooked.
Fix: Say that VE applies before production at design stage and VA applies to products already in production. Link VE to target costing.
Calculating the target cost wrongly when profit is stated as a percentage of cost.
Students deduct the percentage from price directly.
Fix: If profit is x% on cost, cost = price ÷ (1 + x). If it is x% on price, cost = price × (1 − x).
Cutting cost on functions the customer values highly.
Students chase the biggest cost line instead of the lowest value index.
Fix: Judge each function by cost share against value share. Protect high-value functions, cut over-costed ones.
Reading the value index upside down.
The ratio can be written either way and the direction is forgotten.
Fix: Use value share ÷ cost share. Below 1 means cost exceeds value, so reduce cost.
Ending with numbers and no recommendation.
Students stop once the table is complete.
Fix: Always state which changes you recommend, whether the gap is closed and what to do about any shortfall.
Confusing cost reduction with cost cutting.
Both lower spend, so they seem alike.
Fix: Cost reduction keeps quality and function. Cost cutting may harm them, and target costing does not accept that.

Worked examples

Example 1

Sundaram Appliances plans a mixer-grinder to sell at ₹4,000. It needs a profit of 20% on selling price. The current design is estimated to cost ₹3,400 per unit. Function-wise data per unit is: Grinding – cost ₹1,360, customer value 40%; Durability – cost ₹1,020, customer value 35%; Appearance – cost ₹1,020, customer value 25%. Find the cost gap and the function-wise reduction needed, and recommend where to focus.

Show the solution

Target profit = 20% × ₹4,000 = ₹800.
Target cost = ₹4,000 − ₹800 = ₹3,200.
Cost gap = ₹3,400 − ₹3,200 = ₹200.
Function target costs: Grinding 40% × 3,200 = ₹1,280; Durability 35% × 3,200 = ₹1,120; Appearance 25% × 3,200 = ₹800.
Reductions: Grinding 1,360 − 1,280 = ₹80; Durability 1,020 − 1,120 = −₹100 (under-costed); Appearance 1,020 − 800 = ₹220.
Cost shares: Grinding 40%, Durability 30%, Appearance 30%. Value indices: Grinding 40 ÷ 40 = 1.00; Durability 35 ÷ 30 = 1.17; Appearance 25 ÷ 30 = 0.83.
Appearance has the lowest index and the largest reduction. Grinding needs a small cut. Durability is worth more than it is getting.

Answer: Target cost is ₹3,200 and the cost gap is ₹200. Focus first on Appearance (reduce ₹220, for example simpler finish or cheaper body material), and trim Grinding by ₹80. Durability can take ₹100 more spend. The net of 220 + 80 − 100 = ₹200 closes the gap exactly.

Example 2

Kaveri Plastics has a target cost of ₹600 per unit for a storage container. The estimate is ₹680. VE proposes: (i) replace the metal hinge with a moulded plastic hinge, saving ₹30; (ii) reduce parts from 12 to 9, saving ₹25; (iii) a premium glossy finish costing an extra ₹15 that customers do not value. Evaluate the proposals and recommend.

Show the solution

Cost gap = ₹680 − ₹600 = ₹80.
Proposal (i) saves ₹30, and the hinge's function is kept, so accept.
Proposal (ii) saves ₹25 through simplification, so accept if function is unaffected.
Proposal (iii) adds ₹15 for a feature customers do not value, so reject.
Savings from (i) and (ii) = 30 + 25 = ₹55. New estimated cost = ₹680 − ₹55 = ₹625.
Remaining gap = ₹625 − ₹600 = ₹25.

Answer: Accept (i) and (ii), and reject (iii). Estimated cost falls to ₹625, leaving a shortfall of ₹25 per unit. Close it by further functional analysis, supplier negotiation or process improvement, rather than lowering quality or the target profit.

Exam tips

In MCQs, the typical traps are the target cost with profit on cost versus on price, and the direction of the value index. Do the arithmetic slowly.
For descriptive questions, define VE, then give the steps: gap, functional analysis, design options, evaluation. Add an Indian example of a product.
Explain the VE versus VA difference in one clear line on timing. Examiners reward that precision.
In case questions, always finish with a recommendation and say how any remaining gap will be closed.
Show the function table. Even if one figure is wrong, method marks are earned by the layout.

Practice questions from Target Costing

Value Engineering and Cost Reduction Techniques: frequently asked questions

What is the difference between value engineering and value analysis?

Value engineering is applied to a new product at the design stage, before production. Value analysis is applied to a product already being made, to remove unnecessary cost. Both use functional analysis and aim to keep function while lowering cost.

What is functional analysis in target costing?

It breaks a product into the functions the customer wants and separates basic from secondary functions. You then compare what each function costs with how much customers value it. This shows where cost is out of line with value.

How do you reduce cost to reach the target cost?

Compute the cost gap, then use value engineering, simpler design, fewer parts, cheaper materials that keep function, supplier involvement and process improvement. Each change must be checked so that it does not reduce features customers value.

What if value engineering cannot close the whole cost gap?

Look for further savings through suppliers, process changes or waste reduction. If the gap remains, management may review the target price or profit, or drop the product. Do not cut quality to force the number.