How does target costing work

Thus, management has to control its costs to boost its profit margin. So, we can say that target costing includes cost planning at the product designing stage and continues throughout the lifecycle of a product research, engineering, production, and marketing.

In simple words, the target costing is estimating the cost of a product by subtracting a profit margin that the company wants from the competitive market price of the product. Or, target costing determines the cost that is necessary to produce a product of a specific quality to ensure or attain a particular profit margin. For example, Company A approaches Company B to make a customized product.

Company B has the specifications and needs to quote a price to Company A. Company B will review similar products in the market to decide how much should be the selling price. Then, it chooses the profit that it desires, and thus comes up with a target cost. As this approach takes into account competition, it is customer-focused and is a crucial part of new product development. In several industries, there is so much competition that the supply and demand factors dictate the selling prices.

Producers in such industries have little or no control over the selling price. Hence, their only option is to reduce their cost to maintain their profit margin. It is where target costing comes into play. It allows the management to proactively use cost planning, cost management, and cost reduction measures. Such measures assist the management in planning and calculating costs early in the product life cycle, i.

Step 7: Determine the current cost of producing the new product, based on available resources and conditions. Step 8: Set a cost reduction target in order to reduce the current cost to the target cost. Brainstorm and analyze the alternatives to identify the opportunity to reduce cost through consideration of multiple concepts.

Step Achieve cost reduction and target profit by effective implementation of cost reduction decisions. Close down the gap between the current cost of the product and the target cost determined in step 6.

Step Focus on further possibilities of cost reduction i. Measure the results and maintain management focus on upcoming possibilities of cost reduction as part of a continuous improvement program.

In addition to the above, each toy utilizes 1. Using the target costing technique, KMC can determine whether its cost structure is within the target cost or not. Since the current cost structure of the company is not within the target cost, it must strive to work towards cost reduction. The currently expected cost is Rs. Final thoughts. Target costing is not just a product costing system, but rather a management technique that seeks to reduce the total cost of a product over the entire life-cycle with the help of productivity, value engineering, and efficiency at the research and design phase.

If any organization continuously releases a stream of new products, or if its existing product line is subject to severe pricing pressure, it should make target costing a central part of its cost strategy. Save my name, email, and website in this browser for the next time I comment. Share the article :. It may be necessary to later drop a product feature if the team decides that it cannot provide the feature while still meeting its target cost. At the end of this process, the team has a good idea of the target price at which it can sell the proposed product with a certain set of features, and how it must alter the price if it drops some features from the product.

Calculate maximum cost. The company provides the design team with a mandated gross margin that the proposed product must earn. By subtracting the mandated gross margin from the projected product price, the team can easily determine the maximum target cost that the product must achieve before it can be allowed into production. Engineer the product. The engineers and procurement personnel on the team now take the leading role in creating the product. The procurement staff is particularly important if the product has a high proportion of purchased parts; they must determine component pricing based on the necessary quality, delivery, and quantity levels expected for the product.

They may also be involved in outsourcing parts, if this results in lower costs. The engineers must design the product to meet the cost target, which will likely include a number of design iterations to see which combination of revised features and design considerations results in the lowest cost.

Ongoing activities. Once a product design is finalized and approved, the team is reconstituted to include fewer designers and more industrial engineers. The team now enters into a new phase of reducing production costs, which continues for the life of the product. For example, cost reductions may come from waste reductions in production known as kaizen costing , or from planned supplier cost reductions.

These ongoing cost reductions yield enough additional gross margin for the company to further reduce the price of the product over time, in response to increases in the level of competition.

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. 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.

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. 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.

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. The organization can conduct a trial production in small scale to ensure target profit margin , target cost, and product performances.