Target costing

Introduction to Target Costing

Target costing is a strategic cost management approach businesses use to determine the maximum allowable cost for a product or service based on the price customers are willing to pay. Unlike traditional cost-plus pricing methods, which set prices based on production costs plus a profit margin, target costing starts with the desired selling price. It works backward to determine the allowable fee.

This method aligns cost management with market demands and customer expectations, fostering competitiveness and profitability. By focusing on cost reduction and value engineering techniques, companies can ensure that their products or services meet customer needs while remaining profitable. Target costing is a dynamic process that involves continuous monitoring and adjustment to maintain competitiveness in evolving markets. It is crucial in strategic decision-making and product development, driving innovation and efficiency across industries.

Understanding Target Costing Process

The target costing process is a structured approach businesses use to set cost targets for products or services based on desired profit margins and market expectations. This process typically involves several key steps:

First and foremost, companies adopt a customer-centric approach. They analyze the market, identify customer needs and preferences, and determine the target selling price for the product or service. This ensures that the end-user’s needs are at the heart of the cost management process.

Next, they subtract the desired profit margin from the target selling price to calculate the allowable cost, representing the maximum cost the company can incur while still achieving its profit objectives.

Once the allowable cost is determined, companies assess the current price of production and identify areas where costs can be reduced or controlled through value engineering, process improvements, or sourcing strategies.

Throughout the process, companies are committed to continuous improvement. They monitor and adjust their cost reduction efforts to ensure alignment with target cost objectives while maintaining product quality and customer satisfaction. This commitment to ongoing improvement is a key driver of success in the target costing process.

By following the target costing process, companies can optimize their cost structures, enhance competitiveness, and maximize profitability in the marketplace.

Steps in Target Costing

The steps in target costing provide a systematic approach for businesses to determine the maximum allowable cost for a product or service while ensuring profitability and meeting customer expectations:

• Market Analysis and Customer Needs Assessment: Understand customer preferences, market trends, and competitive offerings to identify target market segments and their requirements.
• Setting the Target Selling Price: Based on market research and demand analysis, determine the price customers are willing to pay for the product or service.
• Estimating Product Costs and Value Engineering: Break down the product’s components and processes to calculate the cost of production. Explore value engineering techniques to identify opportunities for cost reduction without sacrificing product quality.
• Analyzing Cost Gaps and Reduction Strategies: Compare the estimated product costs with the target cost to identify gaps. Develop strategies to bridge these gaps through cost-reduction initiatives such as supplier negotiations, process optimization, or material substitutions.
• Implementing Cost Reduction Measures: Execute the identified strategies and monitor their effectiveness in achieving the target cost.
• Monitoring and Evaluating Cost Performance: Continuously monitor cost performance against target cost objectives and adjust strategies as needed to maintain market competitiveness and profitability.

Techniques and Tools in Target Costing

Techniques and tools in target costing are essential for businesses to manage costs and achieve target cost objectives effectively. Several methods and tools facilitate the target costing process:

1. Value Engineering and Value Analysis: Value engineering involves analyzing a product or service’s functions to identify cost-effective ways to achieve the desired functionality. Value analysis focuses on maximizing the value delivered to customers while minimizing costs.
2. Cost-Volume-Profit (CVP) Analysis: CVP analysis helps businesses understand the relationship between costs, sales volume, and profits. It assists in determining the breakeven point and evaluating the impact of changes in volume or pricing on profitability.
3. Life Cycle Costing: Life cycle costing considers the total costs associated with a product or service over its entire life cycle, including design, production, distribution, and disposal. It helps businesses make informed decisions about product development, pricing, and resource allocation.
4. Activity-Based Costing (ABC): ABC allocates costs to products or services based on the activities required to produce them. It provides a more accurate understanding of cost drivers and enables businesses to identify areas for cost reduction and process improvement.
5. Target Costing Software and Systems: Specialized software and systems automate target costing calculations, data analysis, and cost monitoring, streamlining the target costing process and enhancing efficiency and accuracy.

By leveraging these techniques and tools, businesses can effectively manage costs, optimize product profitability, and maintain competitiveness in the marketplace.

Target Costing in Practice

Target costing is a dynamic and iterative process that requires cross-functional collaboration and continuous monitoring to achieve desired cost objectives while meeting customer needs. Companies often follow these steps:

First, they conduct market research to understand customer preferences and competitive offerings, determining the target selling price.

Next, they estimate the allowable cost by subtracting the desired profit margin from the target selling price.

Then, cross-functional teams analyze the product’s design, manufacturing processes, and supply chain to identify opportunities for cost reduction through value engineering and process improvements.

Throughout the product development lifecycle, companies monitor cost performance against target costs, adjusting strategies to address cost gaps and maintain competitiveness.

By integrating target costing into their strategic decision-making processes, companies can optimize costs, enhance product profitability, and deliver value to customers, ensuring long-term success in the marketplace.

Core Concepts

• Target Costing Process: Structured approach involving market analysis, setting a target selling price, cost estimation, gap analysis, implementation, and continuous monitoring.
• Techniques and Tools: Value engineering, CVP analysis, life cycle costing, ABC, and specialized software streamline cost management and optimization efforts.
• Customer-Centric Approach: Market analysis and customer needs assessment to ensure alignment of target costing with customer preferences and market demands.
• Continuous Improvement: Ongoing monitoring, evaluation, and adjustment of cost reduction efforts to maintain competitiveness and achieve target cost objectives effectively.

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