Target Costing: Meaning and Applications Advantages

Target Costing: Meaning and Applications Advantages

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Chanchal
Chanchal Aggarwal
Senior Executive Content
Updated on Feb 13, 2024 09:45 IST

Target costing is a cost management approach used in businesses to determine the desired cost of a product based on market conditions and customer expectations. It involves setting a target cost for a product and then working to achieve that cost through design, production, and other processes, while still maintaining the desired level of quality and profitability.

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In today’s competitive business landscape, companies are constantly searching for ways to reduce costs. Along, with maintaining the quality of their products or services. One approach that has gained popularity in recent years is target costing. This customer-focused cost management strategy involves setting a target cost for a product or service based on customer needs and desired profit margins. Also, designing and producing the product or service within that target cost. By focusing on meeting customer needs while keeping costs under control, target costing can help businesses achieve long-term success in the market.

What is Target Costing?

Target costing is a cost management strategy that is used by businesses to determine the maximum cost. They use what they can afford to incur for a product or service based on the price that customers are willing to pay. The goal of target costing is to ensure that a company can earn a desired profit margin by designing and producing products or services. Also, they can be sold at a price that is attractive to customers while keeping the costs of production within the target cost.

To implement target costing, a company will typically start by determining the target selling price of the product or service. The target selling price is the price that the company believes customers will be willing to pay for the product or service. Once the target selling price is determined, the company will then subtract the desired profit margin from the target selling price to arrive at the target cost.

Target cost = Selling price – Desired profit margin

The target cost represents the maximum amount that the company can spend to produce the product or service while still earning the desired profit margin. If the estimated cost of production exceeds the target cost, the company will need to find ways to reduce costs, such as through process improvements, materials substitutions, or design changes.

By using target costing, companies can focus on designing and producing products or services that meet customer needs while also ensuring that they are profitable. This can help companies to remain competitive in their respective markets and to achieve long-term success.

Example of Target Costing

A company wants to produce a new product that it plans to sell for $100. The company wants to earn a profit margin of 30% on the sale of each product. This means that the target cost of the product should be $70.

Target cost = Selling price – Desired profit margin

= $100 – ($100 x 30%)

= $100 – $30

Target cost = $70

To achieve the target cost of $70, the company works with different departments to identify ways to reduce costs. For example, it might find ways to reduce the cost of raw materials, or it might streamline the production process to reduce labour costs. By designing and producing the product within the target cost of $70, the company can earn its desired profit margin of 30% and remain competitive in the market.

Applications of Target Costing

Target costing can be applied in various industries, including:

Automotive Industry: Automotive companies use target costing to design and produce cars within a certain target cost while ensuring high-quality standards. For example, Toyota is known for using this method to reduce costs and offer high-quality cars at competitive prices.

Consumer Electronics Industry: Companies in this industry use this costing method to develop and produce electronic devices such as smartphones, laptops, and tablets. By designing products within a target cost, companies can offer competitive prices and maintain profitability.

Apparel Industry: Fashion companies use target costing to manage costs while producing high-quality clothing items. By designing clothing items within a target cost, companies can offer affordable prices to customers without compromising on quality.

Food and Beverage Industry: Companies in this industry use target costing to develop and produce food and beverage products within a certain target cost. For example, Coca-Cola uses target costing to develop new beverage products that meet customer needs while also being produced at a target cost.

Construction Industry: Construction companies use this method to manage costs while building homes, commercial buildings, and infrastructure projects. Companies can remain competitive and profitable by designing and building within a target cost.

Advantages of Target Costing

Customer Satisfaction

This method focuses on meeting customer needs and designing products or services that are attractive to customers. By meeting customer needs, businesses can increase customer satisfaction and loyalty.

Improved Profitability

It helps businesses to achieve their desired profit margins by designing and producing products or services that can be sold at a price that is attractive to customers while keeping the costs of production within the target cost.

Early Identification of Cost Issues

It involves the early involvement of different departments in the product development process. This allows businesses to identify cost issues early on and find ways to reduce costs before they become a problem.

Better Collaboration

Target costing requires cross-functional collaboration among different departments, which helps to improve communication and collaboration within the organization.

Cost Reduction

This costing method encourages businesses to identify opportunities for cost reduction and implement changes to reduce costs. This can lead to significant cost savings over time.

Improved Competitiveness

By designing and producing products or services that are both cost-effective and attractive to customers. Businesses can improve their competitiveness in the market.

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Disadvantages of Target Costing

Time-consuming: Target costing requires significant time and resources to implement. It involves cross-functional collaboration, continuous monitoring, and ongoing cost-reduction efforts, which can be time-consuming and costly.

Limited applicability: It may not be applicable to all businesses or products. It is most effective for products with high sales volumes and significant cost components.

Limited focus on quality: It is primarily focused on cost reduction and profitability. It leads to a narrow focus on product quality. This could lead to quality issues in the product, which could negatively impact customer satisfaction and loyalty.

Supplier dependency: This method requires close collaboration with suppliers, which could lead to a dependence on them for cost reduction. This could impact the company’s ability to negotiate with suppliers.

Inflexibility: It requires a clear target cost to be set early in the product development process. This could limit flexibility in the design and development of the product. This could impact its ability to meet changing customer needs or market demands.

FAQs

What is target costing?

Target costing is a cost management method used to determine the maximum allowable cost for a product based on its expected selling price and desired profit margin.

How does target costing differ from traditional costing?

Traditional costing assigns costs based on historical data, while target costing starts with the desired selling price and works backward to establish a cost that ensures profitability.

What is the key objective of target costing?

The primary goal of target costing is to design and produce products at a cost that meets customer expectations and market conditions while maintaining profitability for the company.

What are the main steps involved in implementing target costing?

Target costing typically involves four key steps: setting a target cost, conducting cost gap analysis, redesigning products or processes, and continuously monitoring and adjusting costs to achieve the target.

About the Author
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Chanchal Aggarwal
Senior Executive Content

Chanchal is a creative and enthusiastic content creator who enjoys writing research-driven, audience-specific and engaging content. Her curiosity for learning and exploring makes her a suitable writer for a variety ... Read Full Bio