Target Costing is a strategic pricing technique used by businesses in which the desired selling price of a product is set, and then the costs associated with making that product are reduced to meet that target selling price.
Target costing is based on the idea that, as opposed to the conventional method of setting prices based on incurred costs, a product’s price should be determined by customer demand and market conditions. It entails determining a target cost that will allow the desired profit margins to be achieved by working backwards from the desired selling price.
Target costing aims to produce a product that satisfies customer expectations at a price that is competitive and still yields the desired profit margins for the company. Target costing helps avoid the need for significant price reductions or quality compromises later on by focusing on cost reduction in the early stages of product development.
In highly competitive and price-sensitive industries like consumer electronics, automotive, and fast-moving consumer goods (FMCG), target costing is frequently employed. To achieve cost-effective and customer-focused product development, it promotes cross-functional collaboration between various departments, including design, engineering, marketing, and finance.
Objectives of Target Costing
The objectives of target costing, then, are twofold: 1) To ensure that products are priced competitively in order to maximize sales; and
2) To reduce production costs as much as possible in order to improve profitability.
One of the main objectives of target costing is to enable management to use proactive cost planning, cost management, and cost reduction practice.
In this, costs are planned and managed out of a product and business, early in the design and development cycle, instead of during the later stages of product development and production.
It obviously applies to the new product, but can also be applied to product modification or succeeding generations of products. It might also be used for the existing product, but costs are more difficult to reduce once a product is developed and designed.
Target costing is as much a significant business philosophy as it is a process to plan, manage and reduce cost.
- It emphasises understanding the market and competition.
- It focuses on customer requirements in terms of quality, functions, and delivery, as well as price.
- It recognises the necessity to balance the trade-offs across the organisation and establishes teams to address them early in the development cycle; and
- It has, at its core, the fundamental objective to make money, to be able to reinvest, grow and increase value.
Broadly speaking, a target costing system has three objectives:
- To lower the cost of new products so that the required profit level is ensured.
- The new products meet the levels of quality, delivery timing and prices requirement by the
- To motivate all the employees of the firm to achieve the target profit during new product development by making target costing a company-wide profit management activity.
- For any system to be effective in an organization’s decision-making, workers from relevant departments must collaborate in order to leverage their creativity and accomplish goals. In other words, the business requires a non-conflicting and sensible framework for reaching an agreement and making decisions.
There are a number of ways in which businesses can go about achieving these objectives. One common approach is to design products in such a way that they use fewer materials and require less labour to produce. Another approach is to source cheaper materials or negotiate better terms with suppliers. However, the most effective way to achieve cost reduction through Target Costing is by reducing the number of components in a product. This can be achieved by using fewer materials or by making parts that are more basic and less complex.