What is Target Costing?
Target costing is not just a method of costing, but rather a management technique wherein prices are determined by market conditions, taking into account several factors, such as homogeneous products, level of competition, no/low switching costs for the end customer, etc. When these factors come into the picture, management wants to control the costs, as they have little or no control over the selling price.
CIMA defines target cost as “a product cost estimate derived from a competitive market price.”
Target Costing = Selling Price – Profit Margin
Why Target Costing?
In industries such as FMCG, construction, healthcare, and energy, competition is so intense that prices are determined by supply and demand in the market. Producers can’t effectively control selling prices. They can only control, to some extent, their costs, so management’s focus is on influencing every component of product, service, or operational costs.
The key objective of target costing is to enable management to use proactive cost planning, cost management, and cost reduction practices where costs are planned and calculated early in the design and development cycle, rather than during the later stages of product development and production.
Key Features of Target Costing:
- The price of the product is determined by market conditions. The company is a price taker rather than a price maker.
- The minimum required profit margin is already included in the target selling price.
- It is part of management’s strategy to focus on cost reduction and effective cost management.
- Product design, specifications, and customer expectations are already built-in while formulating the total selling price.
- The difference between the current cost and the target cost is the “cost reduction,” which management wants to achieve.
- A team is formed to integrate activities such as designing, purchasing, manufacturing, marketing, etc., to find and achieve the target cost.
Advantages of Target Costing:
- It shows management’s commitment to process improvements and product innovation to gain competitive advantages.
- The product is created from the expectation of the customer and, hence, cost is also based on similar lines. Thus, the customer feels more value is delivered.
- With the passage of time, the company’s operations improve drastically, creating economies of scale.
- The company’s approach to designing and manufacturing products becomes market-driven.
- New market opportunities can be converted into real savings to achieve the best value for money rather than to simply realize the lowest cost.
ABC Inc. is a big FMCG player that operates in a very competitive market. It sells packaged food to end customers. ABC can only charge $20 per unit. If the company’s intended profit margin is 10% on the selling price, calculate the target cost per unit.
Target Profit Margin = 10% of 20 = $2 per unit
Target Cost = Selling Price – Profit Margin ($20 – $2)
Target Cost = $18 per unit
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We hope this has been a helpful guide to target costing. CFI is the official global provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification, designed to transform anyone into a world-class financial analyst.
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