Cost management plays a decisive role in determining profitability, pricing strategy, and long-term competitiveness. Organisations rely on costing methods not only to calculate product costs but also to guide managerial decisions. Among the most discussed approaches are the traditional costing approach and the target costing method. While both aim to control costs and support pricing decisions, they differ significantly in philosophy, timing, and strategic orientation.
In this post, we will discuss in detail the key differences between traditional costing and target costing approaches and their application.
Concept and Basic Approach
Traditional costing follows a cost-plus philosophy. Under this method, a firm first calculates the total cost of producing a product by accumulating direct materials, direct labour, and overheads. After determining the cost, the business adds a desired profit margin to arrive at the selling price. This approach assumes that the market will accept the calculated price.
Target costing adopts a market-driven philosophy. The process begins with the expected market price, which customers are willing to pay. Management then deducts the desired profit margin to determine the target cost. The organisation must design and produce the product within this cost limit. The emphasis shifts from calculating costs after production to managing and reducing costs before production begins.
Timing of Cost Control
One of the most critical differences lies in the timing of cost control. Traditional costing focuses on cost control during and after the production process. Managers identify variances between actual and standard costs and take corrective action retrospectively. This reactive approach limits the scope for meaningful cost reduction, especially once product design and production processes are fixed.
Target costing emphasises proactive cost management at the design and planning stage. Research indicates that up to 80 per cent of a product’s lifecycle cost becomes locked in during the design phase. By addressing costs early, target costing allows firms to influence materials, technology, and processes before they become rigid. This early intervention significantly enhances cost efficiency.
Role of the Market and Customers
Traditional costing pays limited attention to market conditions and customer expectations. Pricing decisions rely heavily on internal cost structures rather than external demand. As a result, products priced under traditional costing may struggle in highly competitive markets where customers compare alternatives closely.
Target costing places customers at the centre of cost planning. Market research, competitor analysis, and customer value perception determine the acceptable selling price. Cost targets then align with these market realities. This customer-oriented approach ensures that products remain competitive while still achieving profitability objectives.
Focus on Cost Reduction
Under traditional costing, cost reduction often occurs through incremental efficiency improvements, such as reducing wastage or improving labour productivity. These efforts usually take place after production has started, limiting their overall impact.
Target costing treats cost reduction as a strategic, cross-functional exercise. Design engineers, procurement teams, production managers, and marketers collaborate to eliminate non-value-adding features and processes. Techniques such as value engineering play a central role in achieving target costs without compromising quality or functionality. This holistic focus results in deeper and more sustainable cost savings.
Impact on Product Design and Innovation
Traditional costing exerts minimal influence on product design. Designers often focus on technical feasibility and functionality, while cost considerations emerge later. This separation can lead to products that meet technical standards but exceed acceptable cost levels.
Target costing integrates cost considerations directly into product design. Design choices, component selection, and manufacturing methods must align with cost targets from the outset. Far from stifling innovation, this constraint often encourages creative solutions that deliver value at lower cost. Firms learn to innovate within defined financial boundaries.
Profit Planning and Risk
Profit planning under traditional costing remains uncertain because selling prices depend on cost structures that may not align with market conditions. If customers reject the price, firms may face margin erosion or inventory build-up.
Target costing improves profit certainty by locking in the desired profit margin at the planning stage. Since the target cost derives from the market price minus profit, achieving the target cost ensures profitability. This approach reduces pricing risk and supports more predictable financial outcomes.
Suitability and Business Environment
Traditional costing suits stable environments with limited competition and predictable cost behaviour. Public sector organisations or firms with regulated pricing often rely on this method due to its simplicity and compliance orientation.
Target costing suits dynamic and competitive markets where price pressure remains intense. Manufacturing firms in consumer electronics, automotive, and fast-moving consumer goods sectors widely adopt target costing to remain competitive. The method aligns well with globalised markets where customers have multiple alternatives.
Conclusion
Target costing is considered a tool of financial management. With the help of this method, an organisation can plan and control its operating costs and determine its financial performance. With the help of target costing, you can make better decisions regarding your business and its products. Today, many organisations face difficulty in getting profits with low returns on investment. If you want to increase the level of revenue, you can use the target costing method. For those who are struggling to get their business, financial growth and profitability, it is better that they know more about the target costing method.
