What is target costing?

Definition

Target costing is a systematic way to set product price. It considers the current market price and desired profit to set production cost.

It considers the following three elements in the process of target costing.

The product’s market price (It’s obtained by doing market research).
Desired profit (The management of the company sets it)
Cost of making (It’s calculated by deducting desired profit from market price)

Target costing formula

Target cost = market price of the product – desired profit.

The process of setting prices in the target costing starts with market research. During market research, the business managers and marketing department is expected to gather information related to the product price in the market. In fact, it’s the first step towards setting prices by using the target market.

The second stage is related to determining operational profitability. It’s dependent on internal business management. If their profit ambition is higher, they set a higher desired profit and vice versa.

The third stage is cost calculation. It’s a simple mathematical calculation where desired profit is deducted from the expected selling prices.

As a result, we get target cost – this is the cost that needs to be maintained by the business production department. It will help ensure that the business gains desired or targeted profitability.

Example of target costing

You start a manufacturing business and want to target product-A. Target costing can be applied in three following three stages.

You go to market and visit different vendors to get an idea about the product-A price. And you find that the price of product A is $100. It gives an idea that if you manufacture product A, it can be sold at this price.
Your desire that $20 should be profit per unit of product-A.
In this last step, need to deduct desired ($20) profit from the market price ($100). It can be like $80 ($100-$20). It’s the price that you need to manufacture a product with. Hence, it our examples, $80 is target cost.

Advantages of target costing

Following are some of the advantages of target costing.

It’s a proactive method of costing. It means you have clear financial goals regarding production and sale of the goods.
It helps understand if there is a need to improve processes and bring innovation to achieve cost targets.
The market factor is incorporated into the business operations. Hence, It’s a more practical and logical approach.
New market opportunities can be explored with this pricing method. In fact, it’s the most logical method to do business with the new product.
The business can easily decide if they should adopt a cost or quality-oriented approach. For instance, if the target price is lower, the business needs to cut the price and ensure production. On the other hand, if the target price is higher, the business can produce higher quality products.

Disadvantages of target costing

Following are some of the disadvantages of using target costing.

It might result in an excessive burden to control the cost. For instance, an existing supplier may be enjoying economies of scale due to strong roots. Hence, they may be able to supply the cheap product. So, you need to make some manual adjustments to the product’s market price.
An attempt to control cost may lead to quality compromise as the manager might use cheap material and technology to keep the cost under control.
The cost of production is dependent on the production volume. So, if the company fails to accurately predict correct demand, it might have to suffer losses.