Target costing is a system under which a company plans in advance for the price points, product costs, and margins that it wants to achieve for a new product. If it cannot manufacture a product at these planned levels, then it cancels the design project entirely. With target costing, a management team has a powerful tool for continually monitoring products from the moment they enter the design phase and onward throughout their product life cycles. It is considered one of the most important tools for achieving consistent profitability in a manufacturing environment.
The primary steps in the target costing process are:
The design team uses one of the following approaches to more tightly focus its cost reduction efforts:
Of these methods, companies are more likely to use the first approach if they are looking for a routine upgrade to an existing product, and the second approach if they want to achieve a significant cost reduction or break away from the existing design.
What if the project team simply cannot meet the target cost? Rather than completing the design process and creating a product with a substandard profit margin, the correct response is to stop the development process and move on to other projects instead. This does not mean that management allows its project teams to struggle on for months or years before finally giving up. Instead, they must come within a set percentage of the cost target on various milestone dates, with each successive milestone requirement coming closer to the final target cost. Milestones may occur on specific dates, or when key completion steps are reached in the design process, such as at the end of each design iteration.
Though management may cancel a design project that cannot meet its cost goals, this does not mean that the project will be permanently shelved. Instead, management should review old projects at least once a year to see if the circumstances have changed sufficiently for them to possibly become viable again. A more precise review approach is to have each project team formulate a set of variables that should initiate a product review if a trigger point is reached (such as a decline in the price of a commodity that is used in the product design). If any of these trigger points are reached, the projects are immediately brought to the attention of management to see if they should be revived. Such a revival should take into consideration any changes in the market prices of comparable products since the project was last examined.
Target costing is most applicable to companies that compete by continually issuing a stream of new or upgraded products into the marketplace (such as consumer goods). For them, target costing is a key survival tool. Conversely, target costing is less necessary for those companies that have a small number of legacy products that require minimal updates, and for which long-term profitability is more closely associated with market penetration and geographical coverage (such as soft drinks).
The target costing concept has limited application in a services business where labor comprises the primary cost.
Target costing is an excellent tool for planning a suite of products that have high levels of profitability. This is opposed to the much more common approach of creating a product that is based on the engineering department’s view of what the product should be like, and then struggling with costs that are too high in comparison to the market price.