How to Find and Achieve Your Target Cost

Target costing is a management approach that starts with a market-driven price to manage product costs. It reverses the traditional cost-plus pricing model, which sets a price after determining costs and adding a profit margin. Instead, target costing establishes a desired selling price based on market conditions, then subtracts the desired profit margin to find the maximum allowable product cost. This proactive method ensures profitability, especially in highly competitive markets where companies have limited control over selling prices.

Setting the Target Price

Determining the target price is the first step in target costing, driven by market forces. Businesses conduct market research to understand customer demand, preferences, and willingness to pay for product features. Research involves surveys, focus groups, and analysis of consumer behavior to gauge perceived value.

Competitive analysis is also a component where businesses assess competitor pricing, product offerings, market share, and strategies. Understanding the competitive landscape helps position a product effectively and identify an attractive, sustainable price point. The target price is thus a reflection of market realities and customer expectations, rather than internal cost structures.

Defining the Desired Profit

After establishing a market-driven target price, companies define the profit they aim to achieve from each product or service. This margin is influenced by internal and external factors. Companies consider financial goals, such as return on investment (ROI) targets for new product development.

Shareholder expectations and strategic objectives also play a role in setting this margin. For instance, a company might aim for a higher margin in a new, less competitive market, or accept a lower margin to gain market share in a competitive industry. The desired profit ensures the product contributes adequately to the company’s financial health and long-term sustainability.

Computing the Target Cost

The target cost is calculated from the target price and the desired profit margin. The formula is straightforward: Target Cost = Target Price – Desired Profit. This calculation yields the maximum cost a company can incur to produce a product while achieving its financial objectives given the market price.

For example, if market research indicates a product can sell for $50 and the company desires a $15 profit per unit, the target cost is $35. This means the product’s design, materials, and manufacturing processes must ensure costs do not exceed $35 per unit. If the estimated actual cost exceeds this figure, the project may require re-evaluation or cancellation to avoid unprofitability.

Strategies for Cost Achievement

Achieving the calculated target cost requires a proactive, multidisciplinary approach focused on cost reduction throughout the product lifecycle. Value engineering systematically analyzes product functions to achieve desired performance at the lowest possible cost without compromising quality. This involves evaluating trade-offs between features and cost, and exploring material substitutions or design modifications that reduce expenses.

Process re-engineering streamlines workflows by identifying and eliminating inefficiencies, non-value-added activities, or production bottlenecks. This involves implementing lean principles to optimize manufacturing and reduce waste. Supply chain optimization focuses on collaborating with suppliers to secure better pricing, negotiate favorable terms, and explore alternative sourcing options for materials and components.

Design for Manufacturability and Assembly (DFMA) is another technique where product design is optimized from the outset to simplify manufacturing and assembly, reducing production costs. Cross-functional teams, including representatives from marketing, engineering, procurement, production, and finance, collaborate. These teams identify cost-saving opportunities and ensure design and production decisions align with the target cost.

Ongoing Cost Management

Target costing is an ongoing process, not a one-time calculation, requiring continuous monitoring and adjustment throughout a product’s lifecycle. Regular performance reviews compare actual costs against established target costs. This includes analyzing variances and identifying areas where costs deviate from the target, prompting corrective actions.

Feedback loops from production teams, suppliers, and customers provide insights for continuous improvement and cost reduction efforts. Fostering a cost-conscious culture ensures all departments align with the objective of meeting or exceeding cost targets. This iterative process, often incorporating principles like Kaizen costing, allows businesses to adapt to changing market conditions and maintain profitability over time.