Target costing

Target Costing

Target costing is a pricing method used by firms. It is defined as “a cost management tool for reducing the overall cost of a product over its entire life-cycle with the help of production, engineering, research and design”. A target cost is the maximum amount of cost that can be incurred on a product and with it the firm can still earn the required profit margin from that product at a particular selling price.

Target costing is a system under which a company plans in advance for the price points, product costs, and margins that it wants to achieve for a new product. If it cannot manufacture a product at these planned levels, then it cancels the design project entirely. With target costing, a management team has a powerful tool for continually monitoring products from the moment they enter the design phase and onward throughout their product life cycles. It is considered one of the most important tools for achieving consistent profitability in a manufacturing environment.

What is target costing

Target costing involves setting a target cost by subtracting a desired profit margin from a competitive market price.

A lengthy but complete definition is “Target Costing is a disciplined process for determining and achieving a full-stream cost at which a proposed product with specified functionality, performance, and quality must be produced in order to generate the desired profitability at the product’s anticipated selling price over a specified period of time in the future.”

This definition encompasses the principal concepts: products should be based on an accurate assessment of the wants and needs of customers in different market segments, and cost targets should be what result after a sustainable profit margin is subtracted from what customers are willing to pay at the time of product introduction and afterwards. These concepts are supported by the four basic steps of Target Costing:

• Define the Product
• Set the Price and Cost Targets
• Achieve the Targets
• Maintain Competitive Costs.

Objectives of Target Costing

The fundamental objective of target costing is to enable management to manage the business to be profitable in a very competitive marketplace. In effect, target costing is a proactive cost planning, cost management, and cost reduction practice whereby costs are planned and managed out of a product and business early in the design and development cycle, rather than during the later stages of product development and production.

The primary steps in the target costing process are:

1. Conduct research: The first step is to review the marketplace in which the company wants to sell products. The design team needs to determine the set of product features that customers are most likely to buy, and the amount they will pay for those features.

2. Calculate maximum cost: The company provides the design team with a mandated gross margin that the proposed product must earn. By subtracting the mandated gross margin from the projected product price, the team can easily determine the maximum target cost that the product must achieve before it can be allowed into production.

3. Engineer the product: The engineers and procurement personnel on the team now take the leading role in creating the product. The procurement staff is particularly important if the product has a high proportion of purchased parts; they must determine component pricing based on the necessary quality, delivery, and quantity levels expected for the product.

4. Ongoing activities: Once a product design is finalized and approved, the team is reconstituted to include fewer designers and more industrial engineers. The team now enters into a new phase of reducing production costs, which continues for the life of the product. For example, cost reductions may come from waste reductions in production (known as kaizen costing), or from planned supplier cost reductions. These ongoing cost reductions yield enough additional gross margin for the company to further reduce the price of the product over time, in response to increases in the level of competition.

Target costing is most applicable to companies that compete by continually issuing a stream of new or upgraded products into the marketplace (such as consumer goods). For them, target costing is a key survival tool. Conversely, target costing is less necessary for those companies that have a small number of legacy products that require minimal updates, and for which long-term profitability is more closely associated with market penetration and geographical coverage (such as soft drinks).

The target costing concept has limited application in a services business where labor comprises the primary cost.