Definition
Target Costing is a pricing approach that involves determining the cost at which a product must be manufactured to meet a desired profit margin, based on the price customers are willing to pay. It effectively aligns product costs, pricing, and profit goals to maintain market competitiveness and ensure profitability.
Four Stages of Target Costing
- Identify the Target Price: Determine the price customers are willing to pay through market research, analysis of competitors’ products, and pricing strategies.
- Identify the Target Cost: Subtract the desired profit margin from the target price to establish the target cost.
- Forecast the Actual Cost: Estimate the actual cost of manufacturing the product.
- Achieve the Target Cost: Adjust the product design, materials, or manufacturing processes to lower costs to meet the target cost. If the cost cannot be reduced to the target, reconsider manufacturing the product.
Examples
-
Sony:
- Target Price: $500 based on competitor pricing and market expectations.
- Desired Profit Margin: 20%, equating to $100 profit.
- Target Cost: $400 ($500 - $100).
- If the forecasted cost is $450, Sony must reduce costs by optimizing design or production to reach $400.
-
Automobile Industry:
- Target Price: $25,000 for a new model.
- Desired Profit Margin: 15%, equating to $3,750 profit.
- Target Cost: $21,250 ($25,000 - $3,750).
- Forecasted cost is $23,000, so the company redesigns components or improves manufacturing efficiency to reduce costs by $1,750 to meet the target cost.
Frequently Asked Questions (FAQs)
What is the main benefit of target costing?
Target costing ensures that products are developed within cost constraints to achieve desired profitability while remaining competitive in the market.
How is target cost calculated?
Target cost is calculated by subtracting the desired profit margin from the target price.
Can target costing be used for services?
Yes, target costing can be applied to services by identifying the service cost that allows for competitive pricing and desired profit margins.
How does target costing impact product design?
Target costing often requires adjustments in product design to reduce cost while maintaining essential features and quality.
What happens if the actual cost cannot be reduced to the target cost?
If the actual cost cannot be reduced to the target cost, the product may not be manufactured, or the company may reconsider its pricing strategy.
Related Terms
Cost-Plus Pricing
A pricing strategy where the selling price is determined by adding a specific markup to a product’s unit cost. Unlike target costing, cost-plus pricing starts with cost and adds desired profit.
Market Research
The process of gathering and analyzing information about consumers’ needs, preferences, and behaviors, often used to determine target prices in target costing.
Profit Margin
The percentage of revenue that exceeds the costs of production, used to calculate target costs in target costing.
Lean Manufacturing
A production approach focused on minimizing waste and maximizing efficiency, often employed to achieve target costs by improving manufacturing processes.
Online References
- Investopedia on Target Costing
- Harvard Business Review on Pricing Strategies
- ACCA Global on Target Costing
Suggested Books for Further Studies
- “Target Costing and Value Engineering” by Robin Cooper and Regine Slagmulder
- “Cost Management: Strategies for Business Decisions” by Ronald Hilton
- “Activity-Based Costing and Management” by Robert Kaplan and Robin Cooper
Accounting Basics: “Target Costing” Fundamentals Quiz
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