Target costing is a costing method that starts from the price a competitive market will pay for a product and works back to the cost, by subtracting the profit the business needs from that price. What is left is the target cost, a ceiling the product has to be designed and built inside, rather than an estimate of what it will happen to cost once it is built.
Target costing estimates product cost by subtracting a desired profit margin from a competitive market price, and because the target cost refers to the competitive market it is fundamentally customer focused and an important concept for new product development (AICPA and CIMA, Cost Transformation Target costing).
The Target Cost Formula
The target cost is the expected selling price less the profit the business requires on the product. Instead of starting with the cost and working to the selling price by adding on the expected margin, target costing starts with the selling price of a particular product and works back to the cost by removing the profit element, which means the company then has to find ways of not exceeding that cost (ACCA, Target costing and life-cycle costing).
ACCA’s short worked example runs the arithmetic. A company that normally expects a mark-up on cost of 50% and estimates that a new product will sell successfully at $12 has a maximum cost of production of $8 (ACCA, Target costing and life-cycle costing):
Cost 100% $8
+ Mark-up 50% $4
= Selling price 150% $12What It Replaces
Conventional costing works out the cost of producing a unit from the resources it consumes, adds a mark-up or gross profit percentage, and calls the result the selling price. Two flaws follow, and target costing is the answer to the first one. The product’s price is based on its cost, but nobody might want to buy at that price, because the product may carry features customers do not value and competitors’ products may be cheaper or offer better value (ACCA, Target costing and life-cycle costing). Under absorption costing or activity based costing, the number the mark-up sits on is still a cost the market never agreed to.
How the Gap Gets Closed
A target cost is rarely met by squeezing the factory after the design is fixed. Decisions made at the design stage set the features of the product, how to avoid over-design, the number of components, whether those components are standard or specialized, the complexity of machining and construction, what is made in-house and what is subcontracted, the quality, and the batch size (ACCA, Target costing and life-cycle costing). Understanding the cost drivers is how those decisions turn into money, since costs can be driven down by increasing batch size or by reducing the number of components stores has to handle.
Value engineering is the discipline that does the cutting. It aims to reduce costs by identifying the parts of a product or service that do not add value. Value here has two halves: use value, the ability of the product to do what it sets out to do, and esteem value, the status that ownership or use confers. The discipline is to maximize both while cutting cost (ACCA, Target costing and life-cycle costing). Perfume packaging is the example ACCA uses. A plain bottle would not damage what the perfume does, but it would damage what owning it says.
The timing is what makes the design stage decisive. By the end of the design phase approximately 80% of costs are committed, because the design largely dictates material, labor and machine costs, so haggling with suppliers afterwards moves a much smaller number than specifying fewer components would have (ACCA, Target costing and life-cycle costing).
What a Target Cost Leaves Out
Meeting the target cost per unit is not the same as making money on the product, and this is where a target cost tested only against manufacturing cost gives a false pass. The target cost is a ceiling on total cost per unit, so every cost the product causes has to be measured against it. ACCA’s second worked example makes the point with numbers, on a product expected to sell 10,000 units at $21.00 per unit at a mark-up of 40% (ACCA, Target costing and life-cycle costing):
Cost 100% $15 the target cost
+ Mark-up 40% $6
= Selling price 140% $21
Life-cycle cost per unit
Design and development $50,000
Manufacturing 10,000 x $10 $100,000
End of life $20,000
--------
Total $170,000
Per unit $170,000 / 10,000 $17At $17 the life cycle cost per unit sits above the $15 target cost, so the product is not worth making (ACCA, Target costing and life-cycle costing).
That is the second flaw in conventional costing, and target costing does not fix it on its own. The costs incorporated are current costs only, so research and development spending and close down costs sit outside them even though the product could not exist without them, and life cycle costing is what brings them back in (ACCA, Target costing and life-cycle costing).
Target Costing Inside a US CPA Firm
A firm that quotes a fixed monthly fee is already running the first half of this method, whether or not it calls it that. The price is set by what the market will pay, so the allowable cost of serving that client is the fee less the margin the firm needs, and every hour spent past that point comes out of the margin rather than out of the client.
The design-stage lesson is the half most firms skip. Scope, staffing mix, software and review depth are all decided before the engagement letter is signed, and they lock in most of what the work will cost, the same way a product design commits roughly 80% of costs before manufacturing starts (ACCA, Target costing and life-cycle costing). Renegotiating hours in March moves a much smaller number than scoping the engagement differently in November would have.
Common Questions
The direction. Cost plus pricing measures a cost first and derives a price from it, so the market gets a vote only after the price is set. Target costing takes the market price as the fixed input and derives the highest cost the product is allowed to reach, so the cost becomes the variable the design team has to work at.
No. A forecast predicts what something will cost. A target cost states what it may cost if the product is to earn its margin at a price the market has already been shown to accept, which is why the number is set before the design is finished rather than after.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a trial task lets a firm’s own reviewer grade real work before any client file moves.
