Target costing is a method of determining the necessary cost of a product based on its market selling price and a required gross margin.
While a business may want to use cost plus pricing to set its selling price based on the cost of its product, in a competitive environment it is usually the market which determines the selling price.
The use of target costing is particularly important in industries where there is increasing competition and shorter lifecycles. The technique emphasizes the need for the business to manage its costs an early stage of product design and then launch them with appropriate features at a price to attract customers.
Target Costing Example Calculations
Suppose a business manufactures a product at a cost of 36 and wants to make a gross margin percentage of 55%.
For comparison purposes, we will first of all calculate the selling price using cost plus pricing before comparing this with the target costing method.
Using Cost Plus Pricing
Using cost plus pricing the business would simply set its selling price based on its cost and required gross margin. The selling price is calculated using the cost plus pricing formula as follows:
Selling price = Cost price / (1 - Gross margin %) Selling price = 36 / (1 - 55%) Selling price = 80
The starting point is the cost of the product which determines the selling price, as summarized in the diagram below.
|Cost 45% (36)||Gross margin 55% (44)|
|Selling price (80)|
This method is fine providing the business can sell its products at 80, however, most businesses operate in a competitive environment and the market itself determines the price.
Using Target Costing
Target costing takes a different approach. Faced with a market driven selling price, the business determines the target product cost needed in order to make a predetermined gross margin percentage.
Suppose the business in the example above can only sell its products at a price of 60. In this situation, the business must determine the cost at which it needs to manufacture its products to maintain its gross margin percentage of 55%.
Using the target costing formula, the cost is determined as follows:
Gross margin = Gross margin % x Selling price Gross margin = 55% x 60 = 33 Target cost = Selling price - Gross margin Target cost = 60 - 33 = 27
Alternatively, the target costing formula can be rearranged to the following:
In the above example, the calculation is as follows:
Target cost = Selling price x (1 - Gross margin %) Target cost = 60 x (1 - 55%) Target cost = 27
The starting point is always the selling price which is then used to determine the target cost, as shown in the diagram below.
|Selling price (60)|
|Cost 45% (27 )||Gross margin 55% (33)|
In this example, the target costing method shows that the business needs to set a target cost of 27. It must now engineer the product to satisfy customer requirements while ensuring that it is manufactured at the cost of 27 instead of the current cost of 36.
Closing the Target Costing Gap
In the above example, there is a gap between the target cost of 27 and the current cost of 36, this is referred to as the target costing gap. There are various methods and techniques which can be utilized to close this gap including the following.
- Reduce material costs by reducing the number of components needed in the manufacture of the product.
- Obtain access to more efficient technology.
- Reduce material costs by standardizing the components used in the product.
- Reduce labor costs by improving efficiency or reducing labor rates with cheaper staff.
- Reduce costs by changing the type and quality of materials used.
- Remove non-value added components and activities from the manufacturing process.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.