Target Costing
A pricing strategy businesses can employ to achieve consistent profitability.
What is Target Costing?
Target costing is a pricing strategy businesses can employ to achieve consistent profitability. It operates by the company brainstorming and planning the price of the product, how much the product will cost, and the margins the firm wants to hit before production.
Next, the company sets a maximum allowable cost for a product, meaning that the company will not pay for any production cost over this set price. So if a product cannot be manufactured within the price range set by the company, then the whole design will be scraped.
Target costing is an alternative to cost-plus pricing. Cost-plus pricing operates by looking at the product's manufacturing cost and marking the product to sell by a certain percentage. The difference between the specific-percentage markup and manufacturing cost is one’s profit.
It is a powerful tool for management teams to constantly monitor products from the beginning of their design process to the end of their product life cycle. This leaves firms with a key tool to achieve consistent profitability in a manufacturing environment.
Using this method, firms can maximize profitability. They can see from the beginning which products will generate the most money and which products will have slim margins.
The products with high profitability opportunities will be the ones the firm decides to develop.
As the product matures throughout its life cycle, the firm can continue using the cost targeted from this strategy to ensure that the products are still profitable. If they aren’t, the firm will need to cut more costs again.
This differs from the common approach, where a firm will create the product before setting an optimal price point. After creating the product, they deal with the manufacturing costs and decide the selling point.
Key Takeaways
- Target costing is a pricing strategy used by companies to manage costs and achieve desired profit margins.
- Target costing involves determining the allowable cost of a product based on its market-driven selling price and desired profit margin.
- This costing technique involves cross-functional collaboration and continuous improvement to achieve cost targets without compromising quality.
- Target costing helps control and reduce costs throughout the product lifecycle. By aligning costs with market-driven prices, it focuses on maintaining desired profit margins.
Steps of Target Costing
This costing can be a helpful strategy for companies trying to maximize profitability when launching a new line of products.
The strategy attempts to maximize a firm’s profitability and cut costs by following the steps below:
Step 1: Conducting Market Research
The first step is to determine and research the marketplace where the firm wants to launch the product. Through this initial market research, firms can see what works and what doesn’t, what is currently missing in the market, and what consumers crave.
Firms can get a pretty good idea of the elements that will be featured on the product due to what is demanded in the market. Through these features, the firm can get a ballpark estimate of the cost needed to manufacture the product and brainstorm a target price to sell at.
Step 2: Determine the Maximum Price
The next step is for the firm to supply the design team with a mandated gross margin that the suggested product must generate.
The firm can then easily calculate the maximum target cost the product needs to achieve before it is produced by subtracting the mandated gross margin from the proposed product price.
Step 3: Design and Engineer the Product
This is the process stage where the design team starts making a tangible product. The team tasked with this must be tired of staying below the maximum price while creating a high-quality product.
Trying to stay under the maximum price may take multiple attempts. The team may have to try different combinations of different parts until they reach the cheapest, highest-quality product they can manufacture.
Note
If the firm skips out on quality and only focuses on the price, then consumers won’t buy the product or recommend it to their peers. This will automatically result in lower profitability.
Step 4: Ongoing Responsibilities
After this point, the product is created and launched into the marketplace. The firm's next steps are to continue to drive the production cost down and increase the profit margin.
Firms accomplish this by adding more industrial engineers to the team and removing some of the designers. This process continues for the rest of the product’s life.
Why Target Costing?
In highly competitive industries, like FMCG (Fast Moving Consumer Goods), prices are influenced and determined by the economic market forces of supply and demand.
These industries offer firms limited or no pricing power, indicating firms cannot influence the price of the products they sell.
This means that firms only control the cost of the products they make. So lowering the production cost and creating higher margins will be one of the only ways to increase profits.
Note
The main reason a firm would use target costing is to empower management to utilize cost planning, cost management, and cost reduction practices, where production costs are calculated early in the design and development cycle.
When using this pricing strategy, firms become price-takers. This means that the market determines the price of the product, and the firm has very little influence on the price of its products.
When using it, companies should use two different approaches depending on the circumstance and stage of product development they’re in. The two stages are:
1. Link to Components
This is the method a firm usually uses to upgrade an existing product. Link to Components means that the design team will achieve its goal of reducing cost by reducing the prices of the different product components.
Link to Components results in gradual cost reductions of components from previous product iterations.
Firms will usually apply this method when trying to upgrade one of their products and reduce the cost but want to keep the skeleton of the product intact.
Note
Using this method won’t reduce costs much, but the product will likely be successful, and the turnaround of producing the new iteration will be relatively short.
2. Link to Features
This method will likely be implemented when a firm is trying to cut high costs or create a new product design.
Using this method, the product team will allocate the cost reduction goal among the different product designs. This results in attention being removed from any product design feature integrated from the preceding model.
Using this approach tends to result in a more radical cost reduction, but on the other hand, the approach requires more time and carries a greater risk of product failure.
Factors Affecting Target Costing
The costing process is broadly influenced by attributes such as a company’s product strategy for quality, functionality, and price change over time. Some of these factors play a big role in driving a company’s approach to it.
The three factors that affect it are as follows.
1. What affects cost-based strategies at a market level?
These factors deal with the competition in the market and the kind of customers the market is competing to capture.
If competitors in the market are producing similar products, firms may look to different strategies that help them plan out a way to keep their costs low and drive the most profit.
Since the products in the market will be similar, firms will want to maximize their profits as much as possible. However, they can only do this by cutting costs, and it would be very hard to increase the revenue because of the competition.
Note
Other factors like customer satisfaction with the products in the market and the knowledge of new features affect pricing/costing strategies.
If firms know that their products will require new features to compete in the market, they may choose to implement target costing.
2. What affects cost-based strategies at a product level
The different business strategies and features that firms elect to implement into their future products will affect how they handle cutting costs.
Different strategies, such as the number of products a firm plans on producing and their efficiency in producing these products, influence a firm's decision to use a target costing strategy.
When firms elect to produce more products, they usually implement it rather than other cost-based strategies. However, if the product needs regular changes or updates, the firms may also elect to implement this strategy as it could help cut costs the most efficiently.
Note
Different characteristics of the firm's product can affect the pricing strategy too. If the product is relatively complex and requires a lot of capital, firms may elect to implement target costing.
3. What affects cost-based strategies at a component level
Supplier-Base strategy is a big factor affecting the cost-based strategies at a component level because it allows the firm to understand its limitations on different features implemented in the product.
The extent of the company’s horizontal integration, the firm's power over its suppliers, and the relationship between the two parties are essential when looking at a component-level basis.
The degree of horizontal integration will illuminate the costs of components sourced externally. If the firm has buying power over its supplier, it can dictate the pricing of the components it buys, making costing an effective option.
Note
When firms and suppliers have a strong relationship, the components' costs become more predictable, leading to effective target costing.
Target Costing FAQs
There are many benefits when firms use target costing as their pricing strategy. First, it shows the management team’s commitment to improving and producing new variations of products to gain competitive advantages in the market.
The customer can feel that the product offered is of more value since the product is manufactured to the consumer's expectation, and so is the cost.
As companies improve their production process given time and more resources using this method, they achieve economies of scale. With the company's approach guided by designing and manufacturing cost-effective products, the product becomes market-driven.
This costing can create unrealistic expectations about production when the estimated cost is too low. When firms fail to estimate the proper quantity needed, it may lead to a loss of business when they cannot sell all the products it produces.
Firms that continually produce new or upgraded products benefit from a target pricing strategy. The pricing strategy can be essential for them to remain in the competition.
On the other hand, target pricing isn’t as necessary for firms that sell legacy products and don’t release many updates. For these firms, long-term profitability is tied to market penetration and geographical coverage.
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