What is Target costing? – An overview and application
Target costing is a specialized technique that estimates a product’s cost by deducting the desired profit margin from a competitive market price. As target cost makes reference to the competitive market, it is essentially customer-focused and an important concept for new product development.
Meaning
Target costing is defined as “a structured approach in determining the cost at which a proposed product with specified functionality and quality must be produced, to generate a desired level of profitability at its anticipated selling price.”
This technique was originated in Japan in the 1970s. It aims at profit planning.
It is a strategic profit management device to continuously control costs and manage profit throughout a product’s life cycle. ‘Target costing’ initiates cost management at the earliest stages of product development and applies it throughout the product life cycle by systematically engaging the entire value chain. Thus, it is capable to take into account initial design and engineering costs, as well as costs of production, distribution, sales, and services.
How does target costing work?
In the product inception stage, the selling price and desired profit are set after considering the operational strategies and profit plans. For a decision to enter a market, prices of the competitors’ products and services are also given due consideration.
Under this technique, the necessary target cost is arrived at from the below mentioned formula:
Target cost = Planned Selling Price – Required Profit
The target cost becomes the residual sum.
Target costing is almost the exact opposite of cost-plus margin modeling, in which a business manufactures a product with absolutely no regard to its cost structure. After the product is built, they add a profit margin on top to arrive at the final selling price.
When we do target costing, we first figure out what price we think our customers will pay for our product. We then determine how much of a profit margin we anticipate and deduct it from the final price. The remaining amount is what is available as a budget to be used for the creation of the product.
Thus, target costing recognizes the factors that the traditional cost-plus pricing model ignores, such as:
- The price charged by the competitor
- The price which the customer is ready to pay
- Cost control
If it is found that a product cannot generate the desired profit, it will not be produced as such and aspects of the product would be redesigned or modified until the target is met.
Value analysis and value engineering may also be used in the planning and product inception stages so that innovative and cost-effective product features may be identified. Target costing continues to be used to control costs over the product’s entire lifecycle.
Once the initial start-up stages are over, target costs will then be set through short-term budgets. Therefore, all costs including both variable and fixed overheads are controlled and are expected to reduce on a regular (monthly) basis.
Hence, target costing is seen as an integral part of the design and introduction of new products. Rather than just being a tool for cost reduction and cost management, it is part of an overall profit management process. It helps an organization to survive, even in an increasingly competitive environment.
Advantages of target costing
Some of the primary advantages offered by target costing are:
Innovation: It reinforces top-to-bottom commitment towards process & product innovation, and is aimed at identifying issues to be addressed.
Competitive advantage: It allows a business to gain a competitive edge over its competitors in the industry. The firm which realistically meets its cost reduction targets will prosper in the long-run.
Market-driven management: Target costing helps a company in designing and manufacturing products that meet the price required for market success. It not only defines value by what customers are demanding but also by what they are willing to pay for.
It allows teams to make intelligent trade-offs between features, functionality, and cost by engaging and educating customers, resulting in designs that are better suited to the quality and price expectations of customers.
A proactive approach to cost management: Target costing ensures that there is proper planning well ahead of actual production and marketing.
Awareness and empowerment: The implementation of target costing increases employee awareness and empowerment. It also fosters partnership with suppliers.
Improvement in profitability: It increases profitability through precise targeting of the correct prices at which a company believes it can field a profitable product in the marketplace that will sell in a robust manner. This is in contrast to the more common cost-plus model, in which a company builds a product, calculates its cost, adds on a profit, and then wonders why its exorbitant price does not attract buyers. As a result, target costing not only aids in cost control but also assists in price control.
What is the process of target costing?
Target costing is a method of determining the price points, product costs, and margins that a company wants to achieve for a new product ahead of time. If it is unable to produce a product at these planned levels, the design project is canceled altogether.
With target costing, a management team has a strong tool for continually monitoring products from the time they enter the design phase and moving onward throughout their product life cycles. It is regarded as one of the most significant tools for achieving consistent profitability in a manufacturing environment.
The steps involved in the process of target costing include the following:
Step 1: Re-orient a culture of thinking and attitude so that whenever a product is developed, priority can be given to market-driven prices and customer needs rather than just technical requirements.
Step 2: Identify the market requirements as regards design, utility, and need for a new product or improvements of an existing product.
Customers’ requirements as to the functionality and quality of a product are of paramount importance. The design specifications of the new product should be based on the tastes, preferences, and expectations of consumers. Competitor’s products as well as the need to have additional features over competitor’s products should also be taken into account. However, since charging a higher price may not be feasible in competitive markets, the need to offer better and improved products without a substantial increase in prices should be acknowledged.
Step 3: Set target selling price based on customer expectations and sales forecasts.
The target selling price is determined using various sales forecasting techniques. It is influenced by the offers of competitors, product utility, prices, volumes, and margins.
A firm must try to forecast the price-volume relationship with reasonable certainty. The target selling price is market-driven and should encompass a realistic reflection of the competitive environment.
Step 4: Set target production volumes based on relationships between price and volume. Determine the volume of product that would be produced at the established market-driven target price.
Step 5: Establish target profit margin for each product, based on the company’s long-term profit objectives, projected volumes, and course of action, etc.
Step 6: Set target cost (or allowable cost) per unit, for each product.
Target cost = Target selling price less Target profit margin
Target cost is determined by reducing the desired profit margin from the market-driven target price.
Establish a balance between target cost and market requirements; target cost must be seen in conjunction with the requirements of customers as identified under step 2 to lock the target cost.
Step 7: Determine the current cost of producing the new product, based on available resources and conditions.
Step 8: Set a cost reduction target in order to reduce the current cost to the target cost.
Step 9: Analyze the cost reduction target into various components and identify cost reduction opportunities using Value Engineering (VE), Value Analysis (VA), and Activity Based Costing (ABC)
Brainstorm and analyze the alternatives to identify the opportunity to reduce cost through consideration of multiple concepts. This should be done both for the product’s design & layout as well as its manufacturing process at each stage of the development cycle.
Step 10: Achieve cost reduction and target profit by effective implementation of cost reduction decisions
Close down the gap between the current cost of the product and the target cost determined in step 6.
Step 11: Focus on further possibilities of cost reduction i.e. continuous improvement program.
Measure the results and maintain management focus on upcoming possibilities of cost reduction as part of a continuous improvement program.
Example
Let’s take an example to understand the working and process of target costing. Suppose a toy manufacturing company (KMC) expects to successfully launch Toy “H” based on a Disney character. For this, KMC must pay a 15% royalty on the toy’s selling price to Disneyland.
KMC targets a selling price of Rs. 200 per toy and a profit of 25% on the selling price.
The company’s cost data forecast is as under:
| Cost data | INR (Details/toy) |
| Component 1 used in Toy H | 17 |
| Component 2 used in Toy H | 14 |
| Labor cost: 0.80 hr. @ Rs. 60 per hour | 48 |
| Product-specific overheads | 27 |
In addition to the above, each toy utilizes 1.2 kg of other materials, which are supplied at a price of Rs. 16 per kg along with a normal 4% sub-standard quality, which is not usable in the manufacture.
Using the target costing technique, KMC can determine whether its cost structure is within the target cost or not.
The target cost of Toy “H”
| Cost data | INR (Details/toy) |
| Target selling price | 200 |
| Less: Royalty to be paid @15% | 30 |
| Less: Desired profit margin @ 25% | 50 |
| The target cost of one product | 120 |
Cost Structure of Toy “H”
| Cost data | INR (Details/toy) |
| Component 1 used in Toy H | 17 |
| Component 2 used in Toy H | 14 |
| Labor cost: 0.80 hr. @ Rs. 60 per hour | 48 |
| Product-specific overheads | 27 |
| Other materials (1.2 kgs / 96% × Rs. 16) – {cost of 4% sub-standard quality is also accounted for} | 20 |
| Total Cost of Manufacturing | 126 |
Since the current cost structure of the company is not within the target cost, it must strive to work towards cost reduction.
The currently expected cost is Rs. 126 against the target cost of Rs. 120. Company KMC should make efforts to reduce the cost of Toy “H” by Rs. 6 to achieve a target selling price of Rs. 200. If the company manufactures its toys within the above target cost, it shall be able to realize the desired profit margin of 25%.
In this way, target costing (if applied carefully) can play a great role in achieving ongoing cost reductions of a product and help to reach the desired profit margins by sticking a company’s operations to its planned costs.
Final thoughts
Target costing is not just a product costing system, but rather a management technique that seeks to reduce the total cost of a product (over the entire life-cycle) with the help of productivity, value engineering, and efficiency at the research and design phase.
If any organization continuously releases a stream of new products, or if its existing product line is subject to severe pricing pressure, it should make target costing a central part of its cost strategy.
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