Instead of using the cost-plus pricing approach described in above example (Case A) whereby cost is used as the starting point to determine the selling price, target costing is the reverse of this process. With target costing the starting point is the determination of the target selling price. Next a standard or desired profit margin is deducted to get a target cost for the product. The aim is to ensure that the future cost will not be higher than the target cost.
Stages involved in target costing
- Stage 1: determine the target price that customers will be prepared to pay for the product
- Stage 2: deduct a target profit margin from the target price to determine the target cost
- Stage 3: estimate the actual cost of the product
- Stage 4: if estimated actual cost exceeds the target cost investigate ways of driving down the actual cost to the target cost.
The first stage requires market research to determine the customers’ perceived value of the product, its differentiation value relative to competing products and the price of competing products, The target prof it margin depends on the planned return on investment for the organization as a whole and profit as a percentage of sales. This is then decomposed into a target profit for each product that is then deducted from the target price to give the target cost. The target cost is compared with the predicted actual cost. if the predicted actual cost is above the target cost intensive efforts are made to close the gap.
Product designers focus on modifying the design of the product so that it becomes cheaper to produce. Manufacturing engineers also concentrate on methods of improving production processes and efficiency.
The aim is to drive the predicted actual cost down to the target cost but if the target cost cannot be achieved at the pre-production stage the product may still be launched if management are confident that the process of continuous improvement will enable the target cost to be achieved early in the product’s life if this is not possible the product will not be launched. The major attraction of target costing is that marketing factors and customer research provide the basis for determining selling price whereas cost tends to be the dominant factor with cost-plus pricing A further attraction is that the approach requires the collaboration of product designers, production engineers, marketing and finance staff whose focus is on managing costs at the product design stage. At this stage costs can be most effectively managed because a decision committing the firm to incur costs will not have been made. Target costing is most suited for setting prices for non-customized and high sales volume products, lt is also an important mechanism for managing the cost of future products.