Traditionally, manufacturers would make use of the cost-plus approach to estimate the product price. A starting point for them would be to conduct market research to determine its market segment’s preferences and hence, its products’ characteristics that will meet the customer’s needs. This will be followed by the design of the product. Next, the manufacturer’s process is determined. Vendors will then be contacted to identify the total cost components which are required by the design and engineering departments.
Finally, cost components are summed up, and a selling price is set based on the costs. If the management and the market department think an acceptable cost is reached, after which, production will begin.
In contrast, target costing derives an “allowable” product cost by first carrying out market research to predict what the market segment is willing to pay for the desired product with the specific characteristics. Subtracting the desired profit margin set by the management from the predicted selling price, the maximum target cost is arrived at. This target cost is then compared to an expected product cost, and if it is higher than the expected product cost, the company has several options.
First, to decrease costs, the product design and/or the engineering process might be altered. This is carried out by all the members of the planning team (the suppliers, design, engineering, and production and marketing department) who will analyse the necessity and cost of each component. The entire member will work collectively instead of passing through several departments sequentially to minimise costs.
When the desired cost is attained, standards may be defined and the product will then begin the manufacturing phase. Secondly, the management could contemplate accepting a smaller –than desired profit margin. This will rely on the numerical difference between projected cost and goal cost. If the goal cost is somewhat higher than the projected cost, a slightly smaller profit margin will be achievable.
However, if the difference is too great and there is no way for the company to earn the profit margin that is desired, its third alternative would be to abandon that particular product. In short, Target costing can be viewed as a system of profit planning and cost management that cost management that is customer-focused, price-led, design centred and cross-functional.
In brief, the use of target costing forces managers to change their way of thinking with regard to the relationship between cost, selling price, and profitability. The traditional mindset has been that a product is developed, the production cost is identified and measured, a selling price is set, and either profits or losses will result.
However, in target costing, a product is developed, a selling price and desired profit are determined, and the maximum allowable cost is derived. This makes cost dependent on selling prices