What is Target Costing?
Target costing is the technique where the management decides on a target cost for the products or services and uses it as the basis of pricing and costing decisions.
It must be noted that target costing is not considered very practical and useful for service-based industries where the primary cost is mainly labour.
Deciding on a target cost is quite a complex process for management. It requires a lot of judgement, research and assumptions.
The company first conducts thorough market research for the product.
The company needs to estimate the product’s quality and perceived value and also perform a competitive analysis. This helps the company decide how much can be charged for the product in the current market.
The next step is that the company adjusts the appropriate markup or margin from the projected or estimated price of the product.
The result will be the target cost, which is the cost that the company should incur in producing the product.
If the actual expected cost is higher than this target cost, the company will either have to increase the selling price, reduce the profit, or adjust the design and quality of the product to reduce the cost.
If none of these options is feasible, the company might discard or cease producing the product.
Therefore, this technique is closely associated with lifecycle costing and is usually applied at the design and planning stage of new products.
Example
Suppose a company designs a new product and estimates the total per-unit cost will be $15 per unit. The breakup of this unit cost is as follows:
Direct material |
$4 |
Direct labour |
$3 |
Other direct expenses |
$2 |
TOTAL DIRECT VARIABLE COST |
$9 |
Non-production variable costs |
$2 |
TOTAL VARIABLE COST |
$11 |
Non-production fixed costs |
$4 |
TOTAL COST |
$15 |
The company has conducted detailed market research and estimates it can charge $20 per unit for the product.
Let us see if it is feasible for the company to produce and sell this new product, assuming the following desired markup or margin:
1. Full cost plus markup of 10%
We know that markup is charged on cost, so here, the cost represents 100%, whereas the price will represent: cost (100%) + markup (10%) = 110%.
Therefore, the target cost based on the target selling price of the product will be $20 x 100%/110% = $18.18.
In this case, the company’s estimated cost is lower than the target cost by: $18.18 – $15 = $3.18.
2. Margin of 30%
We know that margin is charged on sales, so here, the selling price represents 100%, and the cost will represent: selling price (100%) – profit (30%) = 70%.
Therefore, the target cost based on the target selling price of the product will be $20 x 70% = $14.
In this case, the company’s estimated cost is higher than the target cost by: $15 – $14 = $1.
The company will have to close this cost gap by either lowering the profit (for example, switching to the policy stated in option (1) above) or increasing the price it will charge to the customers.