Target Costing

What is Target Costing?

Target costing is the method which company sets the production cost by deducting profit margin from the target selling price. Company uses this strategy by setting the selling price, determine desirable profit, and calculate the target cost. Target Cost is the remaining balance after deducting profit from selling price. It is the maximum cost which the company can go for otherwise they should not produce the product.

In order to use this method, total costs must be equal or less the target cost otherwise it will impact profit margin or selling price. The target costs include variable cost, fixed cost, and manufacturing overhead costs. The desirable profit is the expected return from the shareholder.

We use this strategy in a competitive market because it is hard to increase the selling price due to its elasticity. A small change in price will have a massive impact on sale volume.

The company set the target cost, which includes all the costs, at the minimum level. To maintain the target profit margin, the company needs to reduce total cost.

Target Costing Formula

To calculate the target costing, we simply use the following formula:

Alternative Formula

If the profit margin base on the selling price:

Target Cost = Selling price – (Selling price x Profit %)

If the profit margin base on cost:

Target Cost = Selling Price / (1 + Profit %)

We usually design the target costing at the planning stage of productions. After that we regularly compare the target cost with the actual production cost. If the actual cost is higher than target cost, it will require our investigation in order to find the solutions to close the gap. If the result is the other way round, we are good to go; no action required.

Conduct market research: We need to conduct market research on the product we intend to produce. We need to look at competitors’ selling price as well as customers’ behavior of how much they are willing to pay. Additionally, we should try to find out which products feature customer need so that we can fill the gap in the market.

Target costing Process

In order to determine the target costing, we need to follow below processes:

 –    Set selling price: We need to set a specific selling price which aligns with the market and customers. It can be a benchmark from the market and competitors.

–    Set target profit: We need to follow our company target profit that decided by top management. 

–    Calculate target cost: Calculate target cost by deducting the target profit from selling price, which set in the previous step.

–    Calculate cost gap: Cost gap occurs when the actual cost is higher than the target cost. So, during production, we need to compare the exact cost and target cost.

–    Take action to close the cost gap: We need to analyze the production cost from the beginning to the end to find the root causes. The gap usually results from an inefficient process that requires improvement. In this case, we need to keep monitoring this process over time.

Target Costing Example

Company ABC produces tumbler for a very competitive market, due to the similarity with many other suppliers. After conducting market research, the average price is $10 per unit. It is not willing to increase its selling price because it is hard to differentiate from other products in the market.

Base on ABC’s policy, the profit margin should not be less than 15% of the selling price.

So the target costing would be:

$10 – ($10 *15%) = $8.5

The production manager has calculated the variable cost as below:

•     Direct Materials: $3 per unit
•     Direct Labors: $5 per unit
•     Overhead Cost: $ 1 per unit

Total cost equal to $ 9 per unit

The production manager has conducted a meeting with relevant departments to find a way to reduce all variable costs to $8.5. As a result, ABC will be able to save $1 per unit from direct labor due to the learning curve after one month. Moreover, the purchasing department will be able to get a bulk discount from suppliers when they buy more than 10,000 units. In conclusion, ABC decides to produce this tumbler.

Every month, ABC needs to compare the actual cost and target cost; any variance needs to investigate and find a solution.

Type of Cost	Target	Actual	Variance
Direct Materials	3	3	0
Direct Labors	4.5	5	0.5
Overhead Cost	1	1	0
Total Cost	8.5	9	0.5

After investigation, the production manager found that the reason for the labor cost gap is due to the workers are still in the learning curve. Hence, he expects that this cost will decrease in next month.

Principle of Target Costing

Target costing is a modern costing concept which needs to work backward from the selling price to total cost. These are the principle of target costing:

• Price led costing: the cost of production will change depending on the selling price, as we can see in the formula. It will be very tough for the company for the low selling product, as the cost will low too. So the company needs to save material, labor, and overhead to achieve the target cost.
• Focus on the customer: customers are the key person whom the company needs to satisfy otherwise, they will not purchase our product. Customers require both quality and low price, so the company needs to make sure that their price is suitable for the market with great quality.
• Focus on process and design: The company needs to reverse engineering by setting the target (product) and define the process later. The engineering team must design products and processes to save the cost and minimize the negative impact on quality.
• Cross-functional: All departments need to work together in order to prevent conflict during operation. Moreover, they are the responsible people who need to work on the product.
• Value Chain Involvement: Besides internal departments, we need to consider other members such as suppliers, shipping lines, distributors, and the retail store. We need to negotiate the term and conditions to find the best partners to achieve the target.

Advantages of Target Costing

Advantages of target costing include:

• Process Improvement
• Encourage innovation
• Encourage competitively
• Best value product for customer

Process Improvement

This method shows the company’s commitment toward process improvement to compete in the same industry. Management needs to improve its process with fewer resources without sacrificing products’ quality.

Encourage Innovation

Target costing pushes the company to initiate new ideas that are more effective and efficient. Some companies may include robots into production which can achieve significant cost saving. For example, Tesla had included robots in its car production process. As a result, the Model 3 body line is now 95% automated, including the transfer, loading, and welding.

Encourage Competitive

By using market prices, we already compete with other competitors. We show no intention to set a higher price than our competitors. At the same time, we still maintain the target profit for our shareholders. To achieve the target price and target margin, we only have one choice which is cost deduction. As the company operate in accordance with market change (price change), it is more suitable for a competitive market.

Best Value Product for Customers

With target costing, the company will try to reduce nonvalue features from the products as they will not impair the product’s quality. Those features only incur the cost for the company without providing value to customers. By doing so, customers will receive the product with the best value for money. 

Disadvantages of Target Costing

Even with many benefits, target costing still has its own disadvantages and limitations including:

• Low budget design
• Depend on market price
• Cheaper material or technology
• Unrealistic production cost
• Failure of proper estimation of the quantity

Low Budget Design

Due to the requirement of the product’s cost, the design team will find it difficult to do their work. They have to work closely with other departments to ensure that the product is within the cost range. They have to limit their creativity if it leads to an increase of cost.

Depend on Market Price

As we get the target cost from using the market price less margin, if there’s an error with market price, the whole system will fail. We usually have to rely on market price that we receive from market research, so any problem with the research will impact our costing. Some products are similar but have different features, so it will inappropriate for us to use their selling price.

Cheaper Material or Technology

Some companies may consider low-quality material which results in low-quality products to customers. The company purchases outdated equipment to save cost, but it impacts in long term as we stuck with them for a few years ( fixed asset useful life).

Unrealistic production cost, the estimated cost is too low

To achieve the target cost, the design team may come with a very tight budget for production. As a result, it is very aggressive for the production team. The target cost would not meet if there’s a small adverse variance. The team would need to eliminate any mistake or error to finish the work perfectly which would only happen on paper.

Failure of Proper estimation of the quantity

Even though we can achieve the target cost, we may not be profitable if the sale quantity does not meet the budget. The profit margin cannot cover the total fixed cost.