How to Calculate Target Cost: Formula and Process

Target costing is a strategic approach to cost management that begins with a market-driven selling price and then subtracts a desired profit margin to arrive at a maximum allowable cost for a product or service. This method builds profitability into the product from its inception. It helps businesses align product development with market realities and financial objectives, fostering proactive cost control. By focusing on customer value and competitive pricing, target costing guides design and production teams to achieve cost efficiency and meet market demands.

Identifying the Target Selling Price

Determining the target selling price is the initial step in target costing, driven primarily by external market factors rather than internal costs. This price reflects what customers are willing to pay and what the competitive landscape dictates. Companies often engage in extensive market research for this. This research might involve surveys to gauge customer willingness to pay and perceived value, or techniques like conjoint analysis, which assesses how customers trade off price against product features.

Competitive analysis is another important aspect of setting the target selling price. Businesses examine the pricing strategies of direct and indirect competitors for similar products or services. This analysis includes understanding competitors’ value propositions, historical pricing trends, and promotional activities. Companies can use this information to identify market gaps and strategically position their product, whether as a premium offering or a more budget-friendly alternative. Demand forecasting, which predicts future sales, also helps ensure the chosen price point is sustainable given market demand and competitive pressures.

Establishing the Desired Profit Margin

Once the target selling price is established, the next step in target costing is to define the desired profit margin. This margin represents the profit a company aims to achieve from each unit sold after accounting for the target cost. It is carefully determined by considering internal and external factors that influence a company’s financial health and strategic goals.

Companies typically evaluate financial objectives, such as achieving a specific return on investment (ROI) or maintaining earnings per share. Industry benchmarks also provide valuable context, as typical profit margins can vary significantly across different sectors. For instance, software companies may expect higher margins due to lower production costs compared to manufacturing businesses. Factors like the cost of capital also influence the desired profit margin, as companies need to cover these expenses to ensure long-term viability. Ultimately, the desired profit margin reflects the minimum profitability required for the product to contribute positively to the company’s financial performance and growth.

The Target Cost Calculation Formula

With the target selling price and desired profit margin established, calculating the target cost is a straightforward application of a formula. The core equation is: Target Cost = Target Selling Price – Desired Profit Margin. This formula derives the maximum allowable cost for a product, ensuring that if sold at the predetermined market price and achieving the desired profit, the company meets its financial objectives.

For example, if market research indicates a product can sell for $100, and the company aims for a $30 profit margin per unit, the target cost would be $70. This $70 becomes the ceiling for all design, production, and delivery expenses. The calculation’s simplicity belies its strategic importance, as it reverses the traditional cost-plus pricing approach. Instead of adding a markup to an internal cost, target costing subtracts profit from a market-driven price, compelling teams to manage costs proactively from product development’s outset. The resulting target cost provides a clear financial goal for engineers, designers, and procurement professionals, guiding innovation and process streamlining to ensure the product remains profitable.