Target Costing

Setting targets for costs according to market conditions

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 brought about by 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 no or little 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

 

Target Costing

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, and hence producers can’t control selling prices. They can only control the costs, so management’s focus is to influence every component of the 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.

 

Target Costing

 

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 strategy wherein the focus is 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 the target cost.

 

Advantages of Target Costing:

  • It shows management’s commitment to process improvements and product innovation to gain competitive advantage.
  • 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.
  • 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.

 

Example:

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.

 

Solution:

Target Profit Margin = 10% of 20 = $2 per unit

Target Cost = Selling Price – Profit Margin ($20 – $2)

Target Cost = $18 per unit

 

Download the Free Template

Enter your name and email in the form below and download the free template now!

Target Costing Template

Download the free Excel template now to advance your finance knowledge!

 

Related Reading

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.

If You’re interested in advancing your career in corporate finance, these articles will help you on your way:

Free Accounting Courses

Learn accounting fundamentals and how to read financial statements with CFI's free online accounting classes. These courses will give the confidence you need to perform world-class financial analyst work. Start now!  

Building confidence in your accounting skills is easy with CFI courses! Enroll now for FREE to start advancing your career!