What is Target Costing - Features, Advantages & Methodology

source: corporatefinanceinstitute

Target costing can help you plan a line of profitable products. This is in contrast to the much more typical strategy, which entails designing a product based on the conception of an engineering department. This conception primarily includes what the product should look like and then dealing with excessively high costs in relation to the product's selling price.

Keep reading to learn about this in detail.

It is a system that helps a business to plan for the product costs, price points,  and margins it aims to achieve for a new product. However, if it cannot produce a product at these anticipated levels, it completely abandons the design effort. A management team has a potent tool for continuously monitoring products with target costing from the beginning of the design phase through the rest of their product life cycles.

A company uses target costing during the following scenarios:

• When a business wishes to establish a product price that will fetch profit, then target costing is used as an effective method.
• Target costing system is also used when a company needs to undergo cost planning and cost management to plan and calculate costs in initial stages of product development.
• A company may also use target costing to practise cost reducing methods.

Furthermore, target costing has three primary utilisations. These are discussed below: 

• To make new items more affordable so that the necessary profit level may be guaranteed.
• The new items satisfy market demands for quality, the timing of delivery, and price.
• By making target costing a business-wide profit management activity, it can inspire all firm personnel to hit the target profit during new product development.

Because of the fierce competition in some sectors, such as FMCG, healthcare, construction, and energy, prices are set by market forces like supply and demand. Also, selling prices cannot be efficiently managed by producers. Hence, the management focuses on influencing every element of product, service, or operational expenses because they can only somewhat control their costs. 

However, target costing's primary goal is empowering the management to employ target costing techniques like proactive cost planning, cost management, and cost reduction. This includes expenses estimated and planned for earlier in the development and design cycle rather than later in the production and product development process.

A few of the critical features of Target Costing include the following:

• It is a component of the management process used for cost management and cost reduction.
• It strongly emphasised achieving the goal profit margin for each product at all costs.
• The target selling price is determined as part of the target costing process using various sales forecasting methods.
• It highly values the customer's opinions, the market's state, and profitability.
• Since there is a correlation between price and volume, fixing the selling price is based on setting the desired production quantities.
• The desired selling price includes the necessary profit margin.
• The amount of cost reduction is the difference between the present cost and the desired cost.
• When determining the target selling price, the product's quality, design parameters, and customer needs and expectations are all taken into account.
• The target cost is the amount that falls between the target selling price and the necessary profit margin.
• It is a crucial component of new product introduction and product design.
• The components of the product's existing cost are used to guide the cost reduction programme. 
• Target cost is broken down into different components. Each component is carefully examined to identify opportunities and determine the potential scope of cost reduction. In this regard, value engineering (VE), often known as value analysis, examines each component (VA). 

Besides this, there are several advantages and disadvantages of target costing.  These are detailed below

Three primary advantages of target costing include the following – 

• Tracking Manufacturing Costs

Target costing recognises the significance that customers place on your goods or services. Using this data, you may evaluate your production procedures to determine whether your existing set-up enables you to sell your goods or services at that pricing while still generating a profit. 

Also, you can evaluate your manufacturing process to find areas where you can cut costs to reach your targeted manufacturing cost for the target if a target costing analysis reveals an inadequate profit at a specific price point.

• Ensuring the Capability of Profit

Target costing can be valuable for determining a price if you need to generate a specific profit on your product or service to make it a viable offering. Moreover, it enables you to identify a sale price that satisfies your requirements for profitability. This also allows you to only proceed with projects that have the potential to provide your desired level of profit.

• Staying Customer-Focused

As target costing is based on the product's price on the purchaser's expected pricing, it can also assist your business in maintaining a customer-focused mindset. Customers are more likely to remain involved if they believe your business values them. Customers may also purchase goods for reasonable prices thanks to target costing.

A few disadvantages of target costing – 

• A target costing error, which depends on an assumption of the product's eventual selling price, could spell the end of the marketing plan as a whole.
• To achieve the desired cost, the company may employ less expensive technology or materials, which is eventually unfavourable and even ends up being the greatest disadvantage.
• Target costing might stress the manufacturing line excessively when the estimated cost is too low.
• A loss could follow when a corporation produces more than it can sell because of inaccurate quantity estimation.

The methodology for target costing can be explained in four primary steps:

1. Research Market Conditions

Examine the market before you launch your goods or service. It's crucial to comprehend who your potential clients are, what they seek, and how much money they can spend. You can use pieces of valuable information you receive from this to further your calculations and produce more precise estimates.

2. Establish the Target Price

Decide on the optimal selling price for your good or service. In this regard, several factors might vary depending on the market, industry, and corporate objectives that determine a target price.

For instance, a product marketed to wealthy consumers may be worth a higher price. In contrast, a business looking to promote brand awareness may set a lower price point to boost overall sales and establish a loyal client base.

3. Determine Your Profit Margin

To achieve your financial objectives, determine the product or service's target profitability. Your optimal profit margin depends on various circumstances, like your sale price. Your financial capabilities, your firm's short- and long-term goals, and any financial commitments for the organisation are all crucial factors to consider.

4. Calculate the Target Cost

Subtract your intended sale price from your targeted profit margin for each transaction. Your target cost is the value that is produced. To achieve your desired profit margins, this is the acceptable financial cost to generate one sale of the product at the target price.

Hence, target costing is most useful for businesses that compete by releasing a steady stream of new or improved products onto the market. However, target costing is less necessary for organisations with a small number of legacy goods that require little updating. This is because long-term profitability is more strongly related to market penetration and regional coverage (such as soft drinks).