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Target Costing

Target costing describes the costs that are expected to be incurred, to create a new product and how this will impact product profitability levels.  By describing costs in a proactive and future-oriented manner, managers can determine how they should alter product designs before they enter the manufacturing process in order to ensure that the company earns a reasonable profit on all new products.

Under the target costing methodology, a cost accountant is assigned to a new product design team, and asked to continually compile the projected cost of a product as it moves through the design process.  Managers will use this information not only to make product alterations, but also to drop a product design if it cannot meet its cost targets.

There are four basic steps involved in target costing, which are:

1. Price and value research. Conduct market research to determine the price points that a company is most likely to achieve if it creates a product with a certain set of features.  The research should include information about the perceived value of certain features on a product, so that the design team can add or subtract features from the design with a full knowledge of what these changes will probably do to the final price at which the product will be sold.
2. Maximum allowable cost calculation. Subtract from the prospective product price a gross margin that must be earned on the product.  By subtracting the required margin from the expected price, we arrive at the maximum amount that the product can cost.
3. Value engineering. Use value engineering to drive down the cost of the product until it meets its overall cost target.  Value engineering requires considerable attention to the elimination of production functions, a product design that is cheaper to manufacture, a planned reduction of product durability in order to cut costs, a reduced number of product features, less expensive component parts, and so on – in short, any activity that will lead to a reduced product cost.  A standard procedure is to force the team to come within a set percentage of its cost target at various milestones (such as being within 12% of the target after three months of design work, 6% after four months, and on target after five months); if the team cannot meet increasingly tighter costing targets, then the project is cancelled.
4. Follow-on activities. Once these design steps have been completed and a product has met its targeted cost level, the target costing effort is shifted into a different activity, which is follow-on activities that will reduce costs even further after the product has entered its production phase.  This final step is used to create some excess gross margin over time, which allows the company to reduce the price of the product to respond to presumed increases in the level of competition.  The sources of these cost reductions can be either through planned supplier cost reductions or through waste reductions in the production process (known as kaizen costing).

Podcast: A discussion of target costing is available on Episode 57 of the Accounting Best Practices podcast. Listen Now.