Target cost
A target cost is a cost estimate derived by subtracting desired profit margin from a competitive market price.
In effect it the opposite of conventional ‘cost plus pricing’ and is sometimes referred to as ‘price minus costing’.
It may be used in both manufacturing and service industries.
The main theme behind target costing is thus not finding what a new product does cost but what it should or needs to cost. The firm can then focus on which costs can be reduced and which can not to see whether such a target cost is achievable. Obviously cost reductions must be seen in the context of quality concerns as well. This will involve product comparisons with the competitors used to set the competitive market price in the first place.
Illustrative 4 targeting costs Real world users:
§ Sony
§ Toyota
§ Swiss watchmakers – Swatch.
Test your understanding 6
Briefly identify the implications for a profit-orientated organisation if it chooses to use cost plus pricing.
2.2 Deriving a target cost
Steps
1 Estimate a selling price for a new product that will enable a firm to capture a required share of the market.
2 Reduce this figure by the firm’s required level of profit. This could take into account the return required on any new investment and on working capital requirements or could involve a target margin on sales.
3 Produce a target cost figure for product designers to meet.
4 Reduce costs to provide a product that meets that target cost.
Illustration 5 – Targeting costs
Katy Inc, a toy manufacturer, is about to launch a new type of bicycle on which it requires a Return on Investment of 30%.
