What Is Target Costing? Definition, Process, and Examples

Target costing is a proactive management approach focusing on product development and cost control. It establishes a maximum allowable cost for a product based on its market selling price and a desired profit margin. This method differs from traditional cost-plus pricing, where costs are determined first, and a profit margin is then added to set the price. Instead, target costing reverses this sequence, ensuring profitability from the outset in a competitive market.

This framework guides design and production teams to achieve specific cost objectives before manufacturing begins. It integrates various functions, including marketing, engineering, and production, to align product features with cost constraints. The goal is to meet customer expectations for quality and functionality while adhering to predefined cost targets. This strategic alignment helps companies remain competitive and profitable by controlling expenses from the product’s initial conception.

Understanding Target Costing

This approach begins by analyzing customer needs and market conditions to determine a competitive selling price for a new product or service. Companies evaluate what customers are willing to pay for specific features and quality levels. This ensures products are designed with market viability.

The core objective is to achieve a predetermined profit margin at this market-driven selling price. Target costing subtracts the desired profit from the anticipated selling price to arrive at the maximum allowable cost. This “target cost” becomes the ceiling for all design, development, and production expenses.

This method is relevant in competitive industries where pricing power is limited. Companies cannot simply pass on increasing costs to consumers without risking market share. Adopting target costing allows businesses to proactively manage expenses, ensuring products are desirable to customers and profitable. It shifts cost management from a reactive exercise to a forward-looking, integrated process.

Key Elements of Target Costing

Target Price

The target price represents the anticipated selling price of a product in the market. This price is derived from market research, competitor analysis, and an understanding of customer perceived value. It reflects what customers are willing to pay for a product that meets their needs and quality expectations. This figure is the first step, as all subsequent cost calculations depend on it.

Desired Profit Margin

The desired profit margin is the profit a company aims to earn from selling a product. This margin is set based on the company’s financial objectives, return on investment targets, and industry benchmarks. It represents the minimum acceptable profit necessary for the business to be sustainable and grow. This margin ensures the product contributes adequately to the company’s profitability.

Target Cost

The target cost is the maximum allowable cost for a product to achieve the desired profit margin at the target selling price. For example, if a product’s target price is $100 and the desired profit margin is $20, then the target cost is $80. This figure serves as a non-negotiable ceiling for design, manufacturing, and other product-related expenses.

Cost Gap

The cost gap is the difference between the current estimated cost of producing a product and its calculated target cost. If the current estimated cost is higher than the target cost, a cost gap exists, indicating that cost reduction efforts are necessary. For instance, if the target cost is $80 but the initial design estimates suggest a cost of $95, there is a $15 cost gap that must be closed. This gap highlights the amount of cost reduction required for the product to be viable.

The Target Costing Process

The process begins with market research and the determination of the target price. Teams analyze customer preferences, competitor offerings, and prevailing market prices to establish a realistic selling price for the new product. This initial step grounds the entire process in market realities, ensuring the product’s commercial viability.

Next, the desired profit margin is set, aligning with the company’s strategic financial goals. This margin reflects the profitability required for the product to contribute positively to the business’s overall success. Management considers factors such as return on investment, capital structure, and shareholder expectations.

Then, the target cost is established. This figure becomes the maximum allowable cost for designing, manufacturing, and delivering the product. It acts as a strict constraint that guides all subsequent engineering and production decisions.

Current cost analysis and cost gap identification represent a diagnostic stage. Engineers and designers estimate the actual cost of producing the product based on initial designs and existing processes. This estimated cost is then compared against the target cost to identify any discrepancy. Recognizing this gap quantifies the exact amount of cost reduction needed.

Subsequent stages focus on cost reduction activities to close the identified cost gap. Value engineering is often employed, analyzing product functions to achieve them at the lowest possible cost without sacrificing quality or performance. Process innovation, supply chain management, and design for manufacturing and assembly are also utilized. For example, renegotiating supplier contracts for raw materials or redesigning components to use less expensive materials or simpler production techniques can significantly reduce costs.

The final stage involves achieving the target cost and implementing continuous improvement measures. Once the product is designed and produced within the target cost, the focus shifts to maintaining and further reducing costs through ongoing efficiency improvements. This includes monitoring production processes, feedback from customers, and exploring new technologies. The goal is to ensure long-term profitability and competitiveness in the market.