Target costing refers to the process by which a business plans the costs of its new product, the price selling points, and the margins it will make on each sale. Target costing enables the management team to monitor the products continuously from the moment they enter the design phase through their life cycle. The product's design will be scrapped if manufacturing a product at the plant's specified levels is not possible.
Did you know? The firm's operations will get more efficient as time goes on, leading to the creation of a scale of economics due to target costing.
What Exactly Does Target Costing Mean?
So what is target costing? Target costing is a structural approach which allows a business to plan ahead for the price points, product costs, and margins it hopes to achieve for a new product.
This cost is then used to determine the target cost for the product. Target costing meaning may also be considered a method for managing costs associated with manufacturing i.e a product's total price throughout its life cycle. It is done using research and development, and requires engineering skills.
In the target cost definition, the anticipated cost for the specific product will contribute to the survival of the production system. It allows the product to stay competitive in the market for the most significant amount of time.
The Target Costing Process
The following will explain the significant phases involved in the target costing process.
Research the Marketplace
Conducting research is the first stage, followed by a study of the marketplace where the organisation wishes to carry out the product sale.
The design team is responsible for deciding which product features will be included in the final product. These product features should be the ones that consumers want to purchase because they are the ones who will be paying for those features.
The design team needs to understand the potential value of each feature for future decisions. It will impact the product's price if they remove one or more elements or take away features one at a time. It may be necessary to remove a feature from the product if the team concludes that it cannot fulfil that function while maintaining the desired profitability level.
At the end of the procedure, the designing team will have good information about the price. It is the target at which it can sell the proposed product with specific features. It also involves modifying the price if there is any withdrawal of the features from the product. In other words, the team will have a good idea of the price at which it can sell the product, proposed with particular features.
Examine and Determine the Expenses
The second stage is to determine the expense that might be incurred. The company will communicate the gross margin requirements imposed on the presented product to the design team. The design team can calculate the target cost at the maximum that the product should attain before it is authorised to be produced. It can be done by deducting the gross margin mandated from the estimated product price and then subtracting it.
Introduction of Engineers and Procurement Staff
The third phase is product engineering. The procurement staff and engineers on the team take the lead position in the product design. If there is a high proportion of purchased parts for the product, the staff of the procurement department is essential.
They are responsible for determining the component's pricing, which depends on the delivery quality and the quantity levels anticipated for the product. They may also participate in outsourcing components if it leads to cheaper costs. The engineer is responsible for the product design and design to meet the target cost. Product design for meeting the target cost should include the previous versions of the design for using the combinations of revised features to achieve the target cost.
The Activities After Product Design
The continuing activities are the fourth phase. After the product design has been accepted and finished, the team will consist of designers and other engineers with industrial experience. This step occurs once the product's plan has been approved and finalised. The group will then move into a new phase of the manufacturing process, which will include fewer steps but will remain continuous throughout the product's lifetime. This continual cost reduction will result in a gross margin sufficient for the organisation to cut the product's price.
What Are Some of the Benefits of Using Target Costing?
Here are some advantages of target costing:
- Target costing will demonstrate the management's devotion to the improvement process and the innovation of the product to acquire benefits in the marketplace.
- Because the product is generated based on the customer's expectations, the cost is likewise based on those expectations. This is how the value of the consumer is fulfilled via target costing. The customer's expectations directly influence both the product and the cost.
- The organisation's strategy for production, and the design of the product itself, will ultimately be determined by the market's demands.
- Opportunities for the new market might be converted into genuine savings to maximise monetary value rather than focus on reducing expenses to their absolute minimum.
Disadvantages of Target Costing
Target costing has both advantages and disadvantages of target costing, and here are some of its drawbacks:
- Any miscalculation in target costing, which depends on the estimation of the product's final selling price, could lead to the failure of the entire marketing strategy.
- The business can use less expensive technology or materials to meet the target cost, which is ultimately unfavourable and even turns out to be the worst disadvantage.
- Target costing can place an unreasonably heavy strain on the production line when the predicted cost is too low.
- A loss may result when the company doesn't sell all of the quantity it produces due to improper quantity assessment.
Example of Target Costing
With the assistance of target costing examples, we should be able to clarify the idea of target costing.
John needs a personalised cycle, so he went to one of the manufacturers by the name of Lewis, for assistance. After writing down the requirements that the client desired, the manufacturer Lewis must now prepare a price proposal for the product before selling it.
He examines the order that has been made, calculates the cost necessary for the construction of the bicycle, and then estimates the price at which he can sell the cycle. It will make determining the product for which an estimate has been provided much easier for him.
The formula for determining the target cost is the anticipated selling price reduced by the intended amount of profit.
Target Cost = Projected Selling Price - Desired Profit
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If the first is ₹10,000 and the second is ₹1,000, then calculating the target cost using the method will be simple today since the first number is already known.
Target cost is equal to Desired Selling Price - Estimated Profit.
That comes to a target cost of ₹10,000 – ₹1000 = ₹9000.
If John believes that the profit sought will not be enough, he may now attempt to increase the price of selling items to reduce his overall costs.
Functions of Target Costing
Market circumstances decide the product price, and the organisation manages it, rather than setting it. The target selling price includes a minimal profit margin. Target costing is a method that focuses on cost reduction and efficient cost management. The customer expectations are considered when finalising the total selling price. The disparity between the target and present costs is why management wishes to reduce it. A team will integrate buying, production, and marketing processes to get the desired cost. Sales forecasting will estimate the intended selling price.
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Organisations use the target costing approach to control and reduce costs. Each product's focus is on maximising profit at whatever cost. In the traditional system, pricing choices are based on standard and competitive factors like dependability and quality. Target costing must replace the old strategy for cost reduction. It is because fast-growing businesses take a market-focused approach to workplace choices. Target costing determines if a new product or service can be sold and its design produced at a profit.
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