Target costing

What Is Target Costing?

Target costing is a strategic management accounting technique where a company determines the maximum allowable cost for a new product by working backward from its market-driven selling price and desired profit margin. Instead of calculating costs and then setting a price, this approach establishes a target price based on what customers are willing to pay and then designs the product to meet that cost. This proactive approach aims to ensure profitability from the outset of product development, fostering a disciplined approach to cost management throughout the entire product life cycle.

History and Origin

The concept of target costing emerged in Japan during the 1960s, gaining significant prominence in the 1980s as Japanese companies sought to enhance their competitiveness in global markets. While rudimentary forms of working backward from a price goal existed earlier—such as at Ford in the early 20th century and with the Volkswagen Beetle in the 1930s—the full-fledged target costing approach as we know it today blossomed after World War II.

A³³, ³⁴ key pioneer in formalizing target costing was Toyota, which adopted and refined the methodology as part of its lean manufacturing philosophy. Kn³⁰, ³¹, ³²own in Japan as "genka kikaku," the system integrated value engineering to systematically reduce costs during the design and planning phases. Th²⁸, ²⁹is early emphasis on cost reduction at the design stage, rather than reactive cost control during production, allowed companies like Toyota to deliver high-quality products at competitive prices, setting a new standard for global manufacturing. Th²⁷e University of Akron provides further historical context on Japanese target costing.

#²⁶# Key Takeaways

• Target costing starts with a market-determined selling price and desired profit margin to calculate a "target cost."
• It is a proactive approach to cost reduction and product design, emphasizing profitability from the initial development stages.
• Cross-functional teams are crucial for successful implementation, involving marketing, engineering, production, and accounting.
• The primary goal is to ensure a product meets customer expectations for features and quality while remaining profitable at its market-acceptable price.
• It encourages innovation in design and production processes to achieve cost targets rather than simply cutting corners.

Formula and Calculation

The fundamental formula for calculating target cost is straightforward:

[
\text{Target Cost} = \text{Target Selling Price} - \text{Desired Profit Margin}
]

Here:

• Target Selling Price refers to the price at which the company expects to sell the product in the market, determined by extensive market research and competitive analysis.
• Desired Profit Margin is the specific amount of profit per unit or percentage of sales the company aims to achieve from the product. This margin is crucial for overall financial planning and meeting organizational profit goals.

For example, if a company determines a market price of $100 for a product and aims for a $20 profit margin, the target cost would be $80. The company must then ensure that the total of its fixed costs and variable costs per unit does not exceed $80.

Interpreting the Target Costing

Interpreting target costing involves understanding its implications for product design, manufacturing, and overall business strategy. The target cost is not merely an accounting figure; it serves as a strict guideline that dictates product features, material selection, and production processes. If the estimated cost of producing a product (based on current designs and processes) exceeds the target cost, a "cost gap" exists. Ma²⁵nagement and cross-functional teams must then identify ways to close this gap through innovation, efficiency improvements, or redesigns, rather than compromising the desired profit margin or market price. This continuous focus on meeting the target cost ensures that new products are inherently competitive and profitable from their inception, aligning product attributes with customer willingness to pay.

Hypothetical Example

Consider "InnovateTech," a company planning to launch a new smart home device. Through extensive market research, InnovateTech determines that customers are willing to pay $150 for a device with the desired features. The company's management accounting department sets a desired profit margin of 25% of the selling price for new products to meet its financial goals.

Using the target costing formula:
Target Selling Price = $150
Desired Profit Margin = 25% of $150 = $37.50

Target Cost = $150 - $37.50 = $112.50

Now, the engineering and production teams at InnovateTech are tasked with designing and manufacturing the smart home device such that its total cost per unit does not exceed $112.50. This means evaluating every component, manufacturing process, and supply chain management decision against this target. If initial design estimates suggest a cost of $125, the teams must collaborate to identify areas for cost reduction, perhaps by sourcing cheaper components, optimizing assembly processes, or simplifying non-essential features, until the $112.50 target cost is achieved. If the cost gap cannot be closed, the project may be re-evaluated or even canceled to prevent launching an unprofitable product.

#²⁴# Practical Applications

Target costing is widely applied across various industries, particularly those characterized by intense competition and price-sensitive markets. Manufacturing sectors, such as automotive, electronics, and fast-moving consumer goods (FMCG), frequently use target costing. Fo²², ²³r instance, companies like Sony employ target costing to remain competitive in the consumer electronics market by designing products that meet customer demands at prices they are willing to pay. Th²¹is proactive pricing strategy is a cornerstone of achieving competitive advantage in crowded marketplaces.

B²⁰eyond product development, target costing informs strategic decisions by embedding market realities into the core of a company's operational planning. It encourages cross-functional collaboration, breaking down departmental silos to ensure that all aspects of a product—from design to procurement to manufacturing—are aligned with the target cost. This i¹⁸, ¹⁹ntegration often leads to innovative solutions that improve efficiency and reduce waste. The website Business Case Studies highlights how companies utilize target costing to deliver competitive products.

Li¹⁷mitations and Criticisms

Despite its benefits, target costing presents several limitations and criticisms that companies must consider. One significant challenge is the difficulty in accurately estimating target costs, especially for innovative products lacking historical data. Inaccu¹⁶rate predictions of market conditions, customer behavior, or competitive dynamics can lead to setting unrealistic target costs, which may force companies into impossible cost reduction scenarios.

Anoth¹⁵er concern is the potential for quality compromise. When under pressure to meet aggressive cost targets, companies might resort to using cheaper materials, simplifying designs excessively, or cutting corners on quality control, which can ultimately harm customer satisfaction and brand reputation. This f¹⁴ocus on cost can also strain production processes, potentially leading to rushed decisions or unsafe working conditions.

Furth¹³ermore, implementing target costing successfully demands significant organizational resources, sophisticated cost accounting systems, and strong cross-functional collaboration, which some companies may lack. Some c¹²ritics argue that an overemphasis on cost targets might stifle innovation if designers are solely focused on cost rather than exploring novel, potentially higher-cost, but highly valuable features. The Ag¹¹riculture Institute discusses these limitations in more detail.

Ta¹⁰rget Costing vs. Cost-Plus Pricing

Target costing and cost-plus pricing represent fundamentally different approaches to product pricing and cost management.

The primary difference lies in their starting points. Cost-plus pricing calculates the total cost of producing a product and then adds a predetermined markup percentage to arrive at the selling price. This method is simpler but risks setting a price that the market will not bear, potentially leading to lost sales or reduced market share. In contrast, target costing begins with the market-acceptable price, forcing companies to design and engineer products within a predefined cost constraint to ensure profitability. This market-driven approach is particularly effective in highly competitive environments where companies are price-takers rather than price-setters.

FA⁹Qs

What industries commonly use target costing?

Target costing is widely used in industries with intense competition and price-sensitive markets, such as automotive, consumer electronics, and fast-moving consumer goods (FMCG). It is also prevalent in heavy industries like construction and energy.

I⁷, ⁸s target costing only for new products?

While target costing is primarily applied during the design and development phase of new products, its principles of continuous cost management and improvement can be applied throughout a product's entire product life cycle. It can also be used for significant redesigns or updates to existing products.

H⁵, ⁶ow does target costing benefit customers?

Target costing inherently focuses on customer value. By starting with the price customers are willing to pay and the features they desire, companies are compelled to design products that meet customer needs and expectations at an affordable price. This often leads to products that offer better value for money and enhanced customer satisfaction.

W³, ⁴hat is a "cost gap" in target costing?

A "cost gap" occurs when the current or estimated cost of producing a product is higher than the calculated target cost. This gap signifies that the product, as currently designed or manufactured, would not achieve the desired profit margin at its target selling price. Identifying and closing this gap is a crucial step in the target costing process, often requiring significant cost reduction efforts and design adjustments.¹, ²