Target costing is a very powerful tool that seeks to ensure profitability of a
company’s products and services. In short, target costing is used to evaluate
the design and functionality of products and services that will support a given
level of profitability. Target costing is oftentimes used in the R&D phase
of new products and services, and can, if effectively used, act as the cornerstone
of profitable product development.
The process of Target Costing contains several steps, which are listed below.
1. Determining the target profit and target cost
The first step of target costing is to determine the target profit level. The
calculation is relatively simple, and a simple example is given below.
Profit = Selling price – Production Costs
1.000$ = 2.500$ - Production Costs
Production Cost = 1.500 $
Therefore, to reach the target profit, the cost of the product must not exceed
2. Perform functional cost analysis
During this step engineers are developing the functionality
of the product, and develop the “Bill of Material” (BOM) for the
product and create the identifies the workload required for producing the product.
The cost of the materials, labor cost and potential overheads are added together
to an estimated cost price, of the product. If the cost is not in line with
the target cost, the cost must be lowered in the design and/or workload. The
design will undergo changes in its functionality and design until the target
cost level is reached.
The redesigning of the product to fit the target cost should not result in
a product, that will not satisfy the customer, and that will not be demanded
by the market. If cost savings cannot be obtained in the product re-design,
the product could be seen a unprofitable product, that will not be able to meet
market demands and expected profit levels. Therefore, Target Costing must recognize
both the target cost and functionality, because revenues and profits will only
be actualized if customers are willing to pay for the functionality of the supplied
3. Close the design and release for production
If the newly developed product is satisfying target costs and customer demands,
the product is ready for its final production and distribution to customers.
If the assumptions of potential selling price and cost levels holds true, the
company will generate the expected profit targeted in the initial stage the
target costing process.