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Definition of Target Costing with Example

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Last editedDec 20223 min read

Pricing strategy varies widely by industry and market conditions. For businesses selling consumer goods, the market can change rapidly along with the competition. It’s important that your price points evolve along with these swiftly moving goalposts, which is where a strategy like target costing comes in handy. In this guide, we’ll cover the definition of target costing as well as how to use it most effectively.

What is target costing?

While some costing methods use straightforward mathematical formulas, target costing is more complex. It looks at cost management on several levels, driven by the changing needs of market conditions. Target costing as a management system helps your business plan for a new product’s product costs, profit margins, and price points. It recognizes that while you won’t have full control over the selling price due to market conditions, you can control the costs instead. When the desired target cost isn’t achievable, the project is canceled because it simply won’t be profitable.

When to use target costing

There’s a time and a place to use a target costing strategy. In most cases, this system is used by businesses in fast moving consumer goods industries such as energy, healthcare, or construction. Competition is fierce in fields like these, with prices determined by market supply and demand rather than by producers. You won’t be able to control the selling price of energy, for example, but you can control the costs involved with bringing your product to market. In this situation, target costing makes sense.

Target costing is also used by businesses that bring a consistent stream of new products to market, ensuring that they’ll be profitable. Businesses that produce a small volume of staple products, such as high-end leather goods, wouldn’t use target costing. Instead, they’d use a pricing strategy tied to factors like geographical coverage or market penetration.

How to calculate target cost

The first step when determining how to calculate target cost is to use the following formula:

Target Cost = Selling Price – Profit Margin

It’s important to understand that with this strategy, product prices are determined by the market. You must determine a minimum profit margin required to bring this product to market, and factor this into the selling price. To maximize profit margins, managers can focus on reducing the cost of production and operations. When there’s a gap between your current cost and target cost, the target costing strategy will be involved finding ways to make purchasing, manufacturing, and marketing more efficient.

Your team will need to follow these steps to calculate target cost:

Research the marketplace thoroughly. Which product features are customers interested in? How much will they pay for these features? This will help you set a target price.
Figure out the minimum profit margin that the product needs to earn. Subtract the gross margin from the projected product price to find out the maximum target cost for production.
Design and manufacture the product according to these target costs. It’s important for the team to procure parts and change the design if necessary according to the budget, cutting costs to meet the target.

Target costing example

Imagine that Company ABC sells shampoo in a fast-paced competitive market. It needs to take consumer demand into account and determines that it can only charge $10 per unit. The company needs to take in a profit margin of 10% of the selling price to meet its financial targets. Within these parameters, it can use the following target costing equation:

Target profit margin = 10% of $10 or $1 per unit
Target cost = Selling price – Target profit margin ($10 - $1)

The target cost will therefore need to be $9 per unit, meaning it must be able to adjust its production and operating costs to meet this target. If it’s unable to do so, it won’t be able to produce this new shampoo and bring it to market.

There are plentiful ways for businesses to cut costs, both during production and during the sales process. For example, ecommerce and subscription businesses can cut down on the cost of chasing up on payments by using a streamlined payment solution like GoCardless. It allows businesses to take payments directly from customers’ bank accounts using direct debit, reducing late and failed payments for improved cash flow.

We can help

GoCardless is a global payments solution that helps you automate payment collection, cutting down on the amount of financial admin your team needs to deal with. Find out how GoCardless can help you with one-off or recurring payments.