Target Costing

Target costing involves setting a target cost by subtracting a desired profit margin from a competitive market price. To complete effectively, organizations must continually redesign their products (or services) in order to shorten product life cycles. The planning,development and design stage of a product is therefore critical to an organization’s cost management process. Considering possible cost reductions at this stage of a product’s life cycle (rather than during the production process) is now one of the most important issues facing management accountants in industry. Here are some examples of decisions made at the design stage which impact on the cost of a product.
- The number of different components
- Whether the components are standard or not
- The ease of changing over tools
Japanese companies have developed target costing as a response to the problem of controlling and reducing costs over the product life cycle.

Implementing target costing
In ‘product costing/pricing strategy’ (ACCA Students Newsletter, August 1999), one of the examiners provided a useful summary of the steps in the implementation of the target costing process.
Step 1 - Determine a product specification of which an adequate sales volume is estimated.
Step 2 - Set a selling price at which the organization will be able to achieve a desired market share.
Step 3 - Estimate the required profit based on return on sales or return on investment.
Step 4 - Calculate the target cost = target selling price – target profit.
Step 5 - Compile an estimated cost for the product based on the anticipated design specification and current cost levels.
Step 6 - Calculate target cost gap = estimated cost – target cost.
Step 7 - Make efforts to close the gap. This is more likely to be successful if efforts are made to ‘design out’ costs prior to production, rather than to ‘control out’ costs during the production phase.
Step 8 - Negotiate with the customer before making the decision about whether to go ahead with the project.