MA - More cost accounting techniques

Target Costing

Target costing is concerned with calculating the target cost of a product, with the target cost being the cost that
an organisation is aiming for.

The target selling price of a product (which is the same as the optimum selling price) is the price that makes
customers interested in buying the product at a price that they are willing to pay.

Once the target selling price has been established, it can be used to determine the target cost of the product:

Selling price = Cost of product + Profit margin

There are two ways of calculating a product’s profit margin:

1) Cost plus pricing method. This method involves adding a profit margin to the cost of the product which is
equivalent to a percentage of the costs involved in manufacturing the product.

Selling price = Cost of product + Profit margin (% of cost of product)

Selling price
Total costs =
(1 + Profit margin)

2) The second method involves the profit margin being a percentage of the selling price.

Selling price = Cost of product + Profit margin (% of selling price of product)

Total costs = Selling price x (1 - Profit margin)

Organisations must have a clear idea of how much profit they want to earn from each product in order to be able
to work out the target cost from the target selling price.

Example 1:

A company has established the target price of a product to be $1,000. The company wishes to keep a margin of
20% on sales. Calculate the target cost.

Solution:
If the term ‘margin on sales’ is used, always assume the selling price to be 100%. If the selling price is 100% and
the margin is 20%, the cost must be 80%.

Target cost = ($1,000 / 100) x 80

Target cost = $800

Example 2:

A company has established the target price of a product to be $1,000. The company wishes to keep a markup of
20% on cost. Calculate the target cost.

Solution:

If the term ‘markup on cost’ is used, always assume the cost to be 100%. If the cost is 100% and the markup is
20%, the selling price must be 120%.

Target cost = ($1,000 / 120) x 100

Target cost = $833.33