Many companies have difficulty understanding how traditional costing and target costing differ. These terms have their own specific meanings and purposes.
Traditional costing and target costing have some differences. This is so because traditional costing is a methodology that aims to collect information about the cost and use that information to estimate the cost of an organization’s products or services.
What is the Traditional Costing Approach?
Most companies rely on traditional costing to determine the financial statements. For example, a traditional company will calculate the cost of goods sold, income, expenses, and other factors to arrive at a sales or profit figure. This calculation is commonly referred to as traditional costing.
What is Target Costing Approach?
Target costing is a cost accounting method. It involves forecasting future financial performance and determining financials based on this forecast. This is the most important term that the two cost accounting methods have in common. The most common form of cost accounting, traditional costing, requires detailed analysis of past performance. This analysis is required so that projections of future financial performance can be accurate.
A target costing method is an approach to a cost analysis that aims to analyze cost data and use that data to set targets. Here, the organization must first know the process or activities they need to perform and the price of those processes and activities and then compare them with the expected prices to determine the cost of operations.
How do Traditional Costing and Target Costing Differ From Each Other?
The key difference between the two cost accounting methods is that the analysis behind target costing uses forecasts of future performance. This involves using the business’ past history of performance and financial performance to make predictions about future performance. It is important to note that traditional costing is just as important as target costing. Both methods are required to determine the financial performance of a company.
Traditionally, manufacturers would use the cost-plus approach to estimate the product price. A starting point for them would be to conduct market research to determine their market segment’s preferences and, hence, their 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 required by the design and engineering departments.
Finally, cost components are summed up, and a selling price is set based on the costs. Production will begin if the management and the market department think an acceptable cost has been reached.
In contrast, target costing derives an “allowable” product cost by first conducting market research to predict what the market segment is willing to pay for the desired product with specific characteristics. The maximum target cost is arrived at by subtracting the desired profit margin set by the management from the expected selling price. This target cost is then compared to a scheduled product cost, and if it is higher than the expected cost, the company has several options.
First, the product design and/or engineering process might be altered to decrease costs. All the planning team members (the suppliers, design, engineering, production, and marketing departments) will analyse the necessity and cost of each component. Each member will work collectively instead of passing through several departments sequentially to minimise expenses.
Standards may be defined when the desired cost is attained, and the product will begin the manufacturing phase. Secondly, the management could contemplate accepting a smaller-than-desired profit margin. This will rely on the numerical difference between the projected cost and the goal cost. A slightly smaller profit margin will be achievable if the goal cost is somewhat higher than the projected cost.
However, if the difference is too great and there is no way for the company to earn the desired profit margin, 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 is customer-focused, price-led, designed-centered, and cross-functional.
In brief, the use of target costing forces managers to change their way of thinking about 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, a product is developed at a target cost, a selling price and desired profit are determined, and the maximum allowable cost is derived. This makes the cost dependent on selling prices.
Target costing is considered a tool of financial management. With the help of this method, an organization 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 product. Today, many organizations 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.