Definition
Target cost is a financial metric used in cost management and product planning. It is calculated by subtracting the desired profit margin from a competitive market price. The result is the maximum cost a company should expend to produce a product or service while still maintaining profitability.
Key Takeaways
- Target Cost is a pricing method used in business, and it is an estimate of cost-based on a proposed future product or service. This estimation aims to keep costs low while still achieving the desired profit margin.
- In the process of Target Costing, understanding the customer’s expectation of price is a fundamental component. Businesses need to reverse engineer their production process to meet the price demand and still maintain profitability.
- Lastly, the entire organization’s collaboration is vital in Target Costing. Design, production, and marketing departments must work together to analyze and reduce costs at each phase, without compromising quality or value.
Importance
Target cost is a critical concept in finance and business as it is a proactive method that allows businesses to maintain profitability and remain competitive.
It is a strategic approach to cost management, where companies identify the potential selling price of a product and then subtract the desired profit margin, giving them the target cost.
This approach ensures pricing is competitive while still guaranteeing profitability.
By focusing on controlling production costs to meet this target cost, businesses can closely monitor expenses, improve operational efficiency, and mitigate financial risks.
Therefore, understanding and implementing target cost is integral to financial planning and overall business success.
Explanation
Target cost is a financial metric primarily used by companies to promote cost efficiency and effectiveness and to bolster profitability. The purpose of applying target cost is to manage the business costs in accordance with the market conditions and customer needs.
It enables businesses to predetermine a cost based on consumer’s willingness to pay for a product or service. By calculating target cost, a company can figure out the potential savings it can achieve.
Therefore, it assists in accurately pricing a product to meet the profit requirements while also maintaining competitiveness. Moreover, target costing is utilized as a systematic process to maintain cost control and reduce total costs throughout the product lifecycle, from design to development, manufacturing, and distribution.
It further fosters innovation and creativity, as it forces businesses to rethink processes, materials, and functions to meet cost targets without compromising product quality or customer satisfaction. Ultimately, target cost is a proactive approach used to maintain profitability and stay competitive in the ever-changing marketplace.
Examples of Target Cost
Automobile Manufacturing: In the competitive auto industry, car manufacturers might apply target costing. For instance, if a car company wants to release a new model, they will study the market to determine what consumers are willing to pay for a car with the desired features. If the expected retail price is $20,000, that becomes the target cost. They’ll then subtract their desired profit margin to set a production cost goal. This helps them to make efficient design and manufacturing decisions to stay within the limit.
Electronics Industry: A great example of target costing can be seen in the production of smartphones. Electronics companies know that consumers have a lot of choices and price plays a significant role in their decisions. For example, if a company aims to introduce a new smartphone into the market at a price of $500 and they want a profit margin of $150 per unit, they need to ensure the manufacturing cost doesn’t exceed $
This ensures they can compete effectively in the market while still making a profit.
Fast Food Industry: Fast food chains often use target costing when adding new items to their menu. The company will first determine a target price at which the new menu item should be sold, based on market research and competitive analysis. Then, they’ll subtract the desired profit for each unit to determine the target cost. For example, if a new sandwich should be priced at $4 to stay competitive, and the desired profit is $2 per sandwich, the target cost for making the sandwich would be $
This helps in determining the ingredients and preparation method that will keep costs within the target range.
FAQs on Target Cost
What is Target Cost?
The target cost of a product is the estimated total cost of producing one unit of that product which will allow the company to earn the desired profit margin when it is sold at a certain price. It helps companies to control costs during the product development cycle and improve cost competitiveness of their products.
How is Target Cost calculated?
Target cost is generally derived by subtracting the desired profit margin from the target selling price of the product. The formula is: Target Cost = Target Selling Price – Desired Profit.
What is the purpose of Target Costing?
The main purpose of target costing is to understand and manage the business costs from early product development stages, and to ensure that the business will achieve a certain profit margin at a certain selling price.
What are the advantages of Target Costing?
Some advantages of target costing include: it encourages cost control and cost reduction, promotes focus on customers’ needs, fosters understanding of lifecycle costs, and enhances competitiveness of the company’s products.
Can Target Costing be used for service industry?
Yes, although target costing was originally developed for the manufacturing industry, its principles can also be applied to the service industry, especially in businesses where the focus is to deliver projects or services at a predefined cost.
Related Entrepreneurship Terms
- Cost Plus Pricing
- Cost Management
- Cost Estimation
- Market Price
- Variance Analysis
Sources for More Information
- Investopedia: A comprehensive online resource for finance and investment terminology and news.
- Accounting Tools: Provides a plethora of information about all things related to accounting, including finance terms.
- Corporate Finance Institute: A provider of online financial analyst certification programs and ongoing education resources.
- Project Management Institute: Offers resources and research relating to project management, which often includes financial aspects like target costing.
