Target costing in the budget

Target costing describes the costs that you expect to incur to create a new product, and how this will impact product profitability levels. By addressing costs before a product design has been finalized, you can alter the design before it enters the manufacturing process to ensure that you earn a reasonable profit. It is inherently impossible to determine the probable price point, costs, and gross margin of a product that is still in the development stage, since the target costing staff is still trying to determine whether the product can even be built.

If a company is considering developing a product line in a new area, it is very worthwhile to first estimate the unit costs being incurred by competitors, and therefore the profits they are likely earning. This information can be the initial basis for budgeting the cost of goods sold. The cost accountant assigned to each target costing team can update this information during the budgeting process with the latest cost estimates, as well as the most recent estimates of the prices at which new products will be sold. This continual level of feedback can be incorporated into each successive iteration of the budget model, to give management the best possible estimate of likely revenues, costs, and profits.

Also, if a target costing team decides that a target cost cannot be attained and elects to curtail further design work, this information should be immediately communicated to those responsible for maintaining the budget, so that the related budget information can be removed from the budget model.

The financial information related to new products is inherently more variable than the information associated with more established products. Consequently, it may be useful to separate new product revenues and costs from other information in the budget, so that management can clearly see that portion of the budget that may be at risk.

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