Target costing is a cost management technique used in accounting and finance that focuses on determining the optimal cost of a product during the design and development phase. It involves setting a target price for a product and then working backward to determine the allowable cost, taking into consideration desired profit margins. The main goal of target costing is to minimize costs while ensuring product quality and maintaining competitiveness in the market.
Importance of target costing:
- Cost control: Target costing promotes cost control by actively managing costs during the product development stage rather than after production has begun.
- Competitive pricing: By focusing on cost management early in the process, companies can price their products competitively and maintain market share.
- Improved profitability: Target costing helps businesses achieve desired profit margins by identifying cost reduction opportunities and ensuring cost-efficient production.
- Enhanced product quality: The approach encourages innovation and value engineering, resulting in products that meet or exceed customer expectations while maintaining cost efficiency.
- Cross-functional collaboration: Target costing involves coordination between various departments, fostering communication and teamwork across the organization.
Types of target costing:
- Component-level target costing: Focused on individual components of a product, seeking cost reductions and improvements in specific parts.
- System-level target costing: Takes a broader approach by examining the costs of an entire system or assembly to identify opportunities for cost reduction and efficiency improvements.
Formula on target costing:
Target Cost = Target Selling Price – Desired Profit Margin
Examples of target costing:
- Automotive industry: Car manufacturers use target costing to develop vehicles at an optimal cost while meeting customer expectations for quality, safety, and performance.
- Electronics industry: Companies producing smartphones, tablets, and other consumer electronics use target costing to offer feature-rich devices at competitive prices.
- Consumer goods: Manufacturers of appliances, furniture, and other household items apply target costing principles to deliver high-quality products at prices customers are willing to pay.
Issues and limitations of target costing:
- Inaccurate cost estimates: Target costing relies on accurate cost projections, which can be challenging to obtain, especially for new or innovative products.
- Reduced flexibility: Strict adherence to cost targets may limit the flexibility to make changes in response to changing market conditions or customer preferences.
- Overemphasis on cost: Focusing too much on cost reduction could lead to sacrificing product quality, functionality, or customer satisfaction.
- Organizational resistance: Implementing target costing may face resistance from employees or departments reluctant to change established processes and practices.
- Time-consuming process: Target costing requires significant time and resources, which can be a challenge for organizations with tight deadlines or limited resources.