Target costing is a pricing method used by firms.

It is defined as "a cost management tool for

reducing the overall cost of a product over its entire life-cycle with the help of production,
engineering, research and design". A target cost is the maximum amount of cost that can be
incurred on a product and with it the firm can still earn the required profit margin from that
product at a particular selling price.

In the traditional cost-plus pricing method materials, labor and overhead costs are measured and
a desired profit is added to determine the selling price.

[edit] What is target costing?

Target costing involves setting a target cost by subtracting a desired profit margin from a
competitive market price.[1] [2]

A lengthy but complete definition is "Target Costing is a disciplined process for determining and
achieving a full-stream cost at which a proposed product with specified functionality,
performance, and quality must be produced in order to generate the desired profitability at the
product’s anticipated selling price over a specified period of time in the future." [3]

This definition encompasses the principal concepts: products should be based on an accurate
assessment of the wants and needs of customers in different market segments, and cost targets
should be what result after a sustainable profit margin is subtracted from what customers are
willing to pay at the time of product introduction and afterwards. These concepts are supported
by the four basic steps of Target Costing: (1) Define the Product (2) Set the Price and Cost
Targets (3) Achieve the Targets (4) Maintain Competitive Costs.

To compete effectively, organizations must continually redesign their products ( or services) in

order to shorten product life cycles. The planning, development and design stage of a product is
therefore critical to an organization's cost management process. Considering possible cost
reduction at this stage of a product's life cycle (rather than during the production process) is now
one of the most important issues facing management accountants in industry.

Here are some examples of decisions made at the design stage which impact on the cost of a
product.

1. The number of different components

2. Whether the components are standard or not
3. The ease of changing over stoo

Japanese companies have developed target costing as a response to the problem of controlling
and reducing costs over the product life cycle.
As a totally new product and its industry develops, it starts to compete based on its new
technology, concept, and/or service. Competitors emerge and the basis for competition evolves
to other areas such as cycle time, quality, or reliability. As an industry becomes mature, the basis
of competition typically moves to price. Profit margins shrink. Companies begin focusing on
cost reduction. However, the cost structure for existing products is largely locked in and cost
reduction activities have limited impact. As companies begin to realize that the majority of a
product's costs are committed based on decisions made during the development of a product, the
focus shifts to actions that can be taken during the product development phase.

Until recently, engineers have focused on satisfying a customer's requirements. Most

development personnel have viewed a product's cost as a dependent variable that is the result of
the decisions made about a products functions, features and performance capabilities. Because a
product's costs are often not assessed until later in the development cycle, it is common for
product costs to be higher than desired. This process is represented in Figure 1.

Target costing represents a fundamentally different approach. It is based on three premises: 1.)
orienting products to customer affordability or market-driven pricing, 2.) treating product cost as
an independent variable during the definition of a product's requirements, and 3.) proactively
working to achieve target cost during product and process development. This target costing
approach is represented in Figure 2.
Target costing builds upon a design-to-cost (DTC) approach with the focus on market-driven
target prices as a basis for establishing target costs. The target costing concept is similar to the
cost as an independent variable (CAIV) approach used by the U.S. Department of Defense and to
the price-to-win philosophy used by a number of companies pursuing contracts involving
development under contract.

The following ten steps are required to install a comprehensive target costing approach within an
organization.

1. Re-orient culture and attitudes. The first and most challenging step is re-orient thinking
toward market-driven pricing and prioritized customer needs rather than just technical
requirements as a basis for product development. This is a fundamental change from the
attitude in most organizations where cost is the result of the design rather than the
influencer of the design and that pricing is derived from building up a estimate of the cost
of manufacturing a product.
2. Establish a market-driven target price. A target price needs to be established based
upon market factors such as the company position in the market place (market share),
business and market penetration strategy, competition and competitive price response,
targeted market niche or price point, and elasticity of demand. If the company is
responding to a request for proposal/quotation, the target price is based on analysis of the
price to win considering customer affordability and competitive analysis.
3. Determine the target cost. Once the target price is established, a worksheet (see
example below) is used to calculate the target cost by subtracting the standard profit
margin, warranty reserves, and any uncontrollable corporate allocations. If a bid includes
non-recurring development costs, these are also subtracted. The target cost is allocated
down to lower level assemblies of subsystems in a manner consistent with the structure of
teams or individual designer responsibilities.
4. Balance target cost with requirements. Before the target cost is finalized, it must be
considered in conjunction with product requirements. The greatest opportunity to control
a product's costs is through proper setting of requirements or specifications. This requires
a careful understanding of the voice of the customer, use of conjoint analysis to
understand the value that customers place on particular product capabilities, and use of
techniques such as quality function deployment to help make these tradeoff's among
various product requirements including target cost.
5. Establish a target costing process and a team-based organization. A well-defined
process is required that integrates activities and tasks to support to support target costing.
This process needs to be based on early and proactive consideration of target costs and
incorporate tools and methodologies described subsequently. Further, a team-based
organization is required that integrates essential disciplines such as marketing,
engineering, manufacturing, purchasing, and finance. Responsibilities to support target
costing need to be clearly defined.
6. Brainstorm and analyze alternatives. The second most significant opportunity to
achieve cost reduction is through consideration of multiple concept and design
alternatives for both the product and its manufacturing and support processes at each
stage of the development cycle. These opportunities can be achieved when there is out-
of-the-box or creative consideration of alternatives coupled with structured analysis and
decision-making methods.
7. Establish product cost models to support decision-making. Product cost models and
cost tables provide the tools to evaluate the implications of concept and design
alternatives. In the early stages of development, these models are based on parametric
estimating or analogy techniques. Further on in the development cycle as the product and
process become more defined, these models are based on industrial engineering or
 bottom-up estimating techniques. The models need to be comprehensive to address all of
the proposed materials, fabrication processes, and assembly process and need to be
validated to insure reasonable accuracy. A target cost worksheet can be used to capture
the various elements of product cost, compare alternatives, as well as track changing
estimates against target cost over the development cycle.
8. Use tools to reduce costs. Use of tools and methodologies related to design for
manufacturability and assembly, design for inspection and test, modularity and part
standardization, and value analysis or function analysis. These methodologies will consist
of guidelines, databases, training, procedures, and supporting analytic tools.
9. Reduce indirect cost application. Since a significant portion of a product's costs
(typically 30-50%) are indirect, these costs must also be addressed. The enterprise must
examine these costs, re-engineer indirect business processes, and minimize non-value-
added costs. But in addition to these steps, development personnel generally lack an
understanding of the relationship of these costs to the product and process design
decisions that they make. Use of activity-based costing and an understanding of the
organization's cost drivers can provide a basis for understanding how design decisions
impact indirect costs and, as a result, allow their avoidance.
10. Measure results and maintain management focus. Current estimated costs need to be
tracked against target cost throughout development and the rate of closure monitored.
Management needs to focus attention of target cost achievement during design reviews
and phase-gate reviews to communicate the importance of target costing to the
organization
Target costing is defined as a cost management tool for reducing the overall cost of a
product over its product life cycle. Management utilizes this pricing technique to
meet both the demands of its customers as well as company profit goals.

Target costing is particularly popular among Japanese firms such as Toyota, Nissan,
Toshiba and Daihatsu Motor in various industries such as automobile manufacturing,
electronics, machine tooling, and precision machine manufacturing. As Japanese
tastes became more diverse, assembly-oriented production grew in popularity. This
growing demand for a diverse range of products shortened product life cycles. With
shorter product life cycles more focus is placed on the costs occurring at each phase
(development, planning and design.)

Compared to traditional standard costing approaches in which an estimate of product,

general administrative, marketing, and distribution costs is taken into consideration,
target costing takes on a more proactive approach to pricing. Traditional costing
determines cost based on the design of goods, adds a markup and establishes a price.
In comparison, the marketplace directs target costing by first setting a selling price,
then subtracting target income and finally reaching a cost.

Traditionally, a cost figure is obtained, implemented and once found to be poorly

configured, sent back to management and engineers for reworking of production
processes and cutting of costs. In comparison, target costing utilizes costing
information and focuses on the best possible price up front, preventing wasted time on
after-the-fact discussions concerning design and re-engineering of the product.

The decision making process involves a cross functional team, in which employees
from various departments (Production, Engineering, R&D, Marketing, and
Accounting) are given the responsibility of determining an acceptable market price
and corresponding Return on Sales, as well as a feasible cost in which a given item
may be produced. In order to minimize costs, team members focus on eliminating
non-value-added costs of the process, improving product design and modifying
process methods.

Target costing, in particular, emphasizes the reduction of costs during the planning
and design stage of the product life cycle since the majority of product cost is
determined at this stage. In comparison to traditional product costing methods, target
costing allocates more of the total cost to the development stage, simultaneously
reducing costs during the production stage. A number of cost-engineering techniques
are used in the cost reduction process. Just-in-Time, Total Quality Control, Material
Requirements Planning and Value Engineering are among such methods promoted by
target costing.
With the increased popularity of assembly-oriented industries, Economic Order
Quantity analysis, a traditional means of keeping certain amounts of inventory on
hand, became less useful. Instead, many firms, realizing the dangers of housing high
inventory, turned to Just-In-Time and Material Requirements Planning. JIT and MRP
provided a great advantage to these companies that manufacture high variety, low-
volume products.

Value engineering involves the design of a product after gathering input from
employees and from various departments within a company, each offering a different
perspective on possible cost minimization tactics. Value engineering considers all
aspects of the value chain and frequently involves individuals outside of the company
such as suppliers in order to reach a decision that encompasses the most successful
combination of price and quality.

Total Quality Control is a Japanese process that initially developed in the United
States as a method of Quality Control. Inspection is the main issue that distinguishes
between the two. TQC incorporates QC (inspection) activities throughout a company,
rather than in isolation within specific departments.

Initially a project is either accepted or rejected based on marketability and cost and
profit data. Once a project is accepted, the engineering department constructs an
engineering development plan. This plan considers all aspects of product cost up-
front. Target profit is then subtracted from expected sales to reach an estimate of
allowable cost. In order to successfully reach this allowable cost, a great deal of effort
is required from each department to tighten overall cost. Individual processes are
evaluated in order to direct efforts toward the most valuable and feasible cost saving
areas.

The prevalence of assembly-oriented products along with shortened product life

cycles has contributed to the success of target costing. Many firms have turned to
target costing as a way of improving the price and quality of their products, creating a
benefit in terms of a company’s profits as well as increased customer satisfaction.
Target costing adds value to the production process by eliminating non-value added
activities, thus paving the way for decreased costs passed on to the consumer. Target
costing enables companies to ascertain a more realistic price as well as strengthen
competition among firms to offer quality products at lower costs.