Target costing is defined as a management technique that helps the company to decide the prices by estimating market condition. It includes cost planning in the initial designing stage and also the cost control that exists throughout the lifecycle of a product.
Although the primary role of target costing is not to surpass target cost, it does not remove its focus which is not to decrease costs but to achieve cost reduction by process of target costing.
Target cost is an accounting approach that measures the cost of a product that is necessary to develop a certain quality and functionality for ensuring the desired profit figure.
This cost management tool is used by the company through design, research, engineering, production, and marketing to reap better profits in this competitive market.
Understanding target costing
The costs are planned in the early phase of a new product by understanding the market thoroughly. It intends to satisfy the growing needs and requirements of a consumer about price, features, and quality of a product.
Target costing is estimated as the expected selling price of a product minus the desired profit from selling the product. A target cost is the highest amount of cost that the product incurs but the beauty of it is that the product can still manage to earn a profit at a specific selling price.
It is easy to break the target cost from the product to the component level with the help of target costing. This will spread the competitive pressure to the suppliers and designers instead of just the business entity.
The objective of target costing is to help the organization in cost reduction, management, and planning at the initial designing stage rather than at the later stage of production and development.
Process of target costing
- Identifying customer needs
- Planning selling price as per the needs
- Identifying the target cost
- Keep the price in consideration after identifying suppliers and fixing the manufacturing process
- Compare sample product with the target and start production for product launch
Examples of target costing
Target costing can be explained with the help of a simple example. Armstrong needed a customized bicycle, and he approached one of his favorite manufacturers David for it. After noting down the exact specifications of his client, David now has to quote the selling price.
He looks at the order and first determines the cost that will be needed to manufacture the bicycle and then at what price he can sell it. It now becomes easy for him to determine the estimated profit on the product.
The actual formula for target cost is expected selling price minus the desired profit. Suppose the first is 100,000 Rs and the second is Rs 10,000. Now it becomes easier to get the target cost that is
Target cost = desired selling price – expected profit
Target cost = 100000 – 10000
Target cost = 90,000
If David thinks that the desired profit is not enough, he can either increase the selling price or try to minimize the cost.
10 Features of target costing
The important features are as follows-
- The organization is not a price maker instead is defined as the price taker as it is the market conditions that determine the product prices, not just the company alone. It has to make several changes as per the prevalent conditions then.
- When the company estimates the selling price, it always figures in expectation of its customers, specification and product design
- The target selling price was estimated based on sales forecasting method
- Target costing is an important strategy adopted by the business entity for putting their onus on cost management and cost reduction.
- The onus was on earning the least amount of target profit at any cost from every product
- The organization always include the minimum amount of profit in the target selling price
- The management wants to achieve cost reduction with the help of target costing
- The management keeps a team handy to include factors like marketing, manufacturing, and purchasing to achieve the desired target cost.
- It is considered an important part of the design and launch of a new product
- The level of cost reduction was estimated as the difference between current and target cost
Objectives of target costing
The objectives of target costing are-
- Decreasing the costs to ensure the required profit level of new products
- Meeting the set standards of the market for new products in terms of price, delivery time and quality levels
- Motivating employees to achieve target profit during the development of new products
Advantages of target costing
The advantages of target costing are described below-
- Helps to utilize the fresh opportunities in the market so that it can convert it into savings.
- It strengthens manufacturing strategies
- Reduces the cost of products to significant numbers
- Molds the management’s approach of manufacturing and designing into the market-driven move.
- The target costing is a powerful tool that is capable of improving the operations of a business entity and creating further economies of scale.
- Helps to give more value to the customer, and this encourages customer loyalty towards the brand
- It makes sure about the planning and schedule of production and marketing
- Target costing encourages employee participation and commitment to quality production
- It encourages innovation of product to gain competitive advantages
- Helps the management to find new opportunities
- Minimizes the period of the development cycle of a product
Disadvantages of target costing
The disadvantages are as follows-
- The process of development becomes very long as the designing team makes several alterations that meet the target cost
- Cutting costs can affect the employee’s morale
- It becomes difficult to reach a consensus as numerous players are involved in the decision making
- If the estimated cost is low, it creates an unnecessary burden on the production team
- Sometimes an organization chose to opt for inferior quality and design to achieve required target costing
- Mistakes in target costing can lead to financial loss for the company
Steps involved in target costing
The following steps are involved in target costing
1. Market research
The organization conducts market research to understand and determine the wants of a customer. This helps in making viable changes in the existing product as well as in designing new products about the perceptions and expectations of the customer
2. Identifying the market
The information collected via market research proves a blessing for the business entity. It informs about the types of products prevalent in the market, level of competition it can face, number of rival companies that it will have to handle and the prices at which the products are already available in the market.
It is also vital to get an estimate of the amount which a customer considers affordable pricing so that it can make its adjustments.
3. Product features
Gaining information about the preference of a customer is a tedious process as their wants and needs may vary from one to another. The organization takes into account the average requirement and converts them into a tangible entity called a product.
Now it needs target costing to follow the needed path for its growth and prosperity
4. Product design
The organization designs a product that it considers suitable for the prevalent market conditions by analyzing needs of the customer, prevalent marker forces, models adopted by rival companies, relevant technology, process capabilities, design alternatives, and service requirements.
5. Determine cost, margin, and price
It is the market survey that determines the target selling price of a product. The business entities also add standard margin in the target selling price.
6. Value engineering process
Carry out a value engineering process if you are interested in reaching the target cost.
7. Improve designs
The organization can conduct a trial production in small scale to ensure target profit margin, target cost, and product performances. It ends when you find the match between target cost and product design.
8. Formal approval
The top management receives a detailed report about the design of a particular product, costs to be incurred, and elements of cost and production process for a formal approval so that the company can say yes to commercial production.
9. Maintaining accounts
It is vital to maintain separate accounts for each product design so that you can verify whether total expenses exceed the target cost for any product.
10. Implementing target costing
The organization acquires the necessary information in relation to the expenses that have incurred for every design and that too separately. It keeps a close watch so that it can nudge the total cost within the target cost.