What is the Target Cost?
Target Cost refers to the total cost of the product after deducting a certain percentage of profit from the selling price and is mathematically expressed as expected selling price – desired profit required to survive in the business. In this type of cost, the company is a price taker rather than price maker in the system.
- The desired profit is already included in the target selling price of the product and is a management strategy to control the costing.
- We can define it as a difference between the current cost and the targeted cost of the product, which the company management wants to achieve in the long run to boost profitability.
- It is a handy tool used in management accounting to analyze the cost and fix the same, considering the internal and external factors.
- In industries such as FMCG, construction, healthcare, energy, the prices of the commodities are dependent upon the demand and supply of the same hence the management cannot control the selling price of the product due to intense competition. Thus they can only control the cost at their level, keeping the profit margin well within the company benchmarks.
Types of Target Cost
This cost we can divide into the below mentioned three types:
- Market Driving Costing: Base upon the market conditions and the expected selling price of the product;
- Product Level Costing: Targets are set to individual products rather than the entire portfolio.
- Component Level Target: It refers to the functional and supplier level targets of the company.
Target Costing Formula
Examples of Target Costing
ABC ltd is a big player in the food and beverage sector which sells food to the public at $100 per packet. The company is desiring to achieve a 20% profit on its sales. What will be the target cost of the product?
In the above example, the total profit marginProfit MarginProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. of the product would be $100*20% = $20. Hence to achieve $20 on the sale of one product, the company needs to sell the products at $80 ( $100- $20), which is the target cost of the product year. Since the total cost is $80, the management needs to sum-up all the internal costs to reach the $80 figure. And accordingly, allocate more importance to the activities which directly contribute to the product and lesser significance to insignificant contributors. E.g., admin charges, printing charges, etc. that company can control, thus restricting the total cost to go up.
Suppose ABC ltd is a grocery company and sells it grocery at $1000 per piece. Its profits are 20%. Hence the cost works out to be $800. The company has recently received a subsidy from the government, which it needs to pass on to its customers. The subsidy amount is $200 per piece. The company sells 10,000 units annually. Work out the target cost?
In the above, e.g., since the company has received a subsidy of $200, this would be subtracted from the selling price to arrive at the new selling price, i.e., $1000 – $200 = $ 800. The Company will keep the profit % the same as earlier, i.e., 20% = $160. Hence the new target cost for the company would be $800-$160 = $ 640; however, to earn the same revenue as before, the company will have to sell more units in the current.
Earlier revenue = $1000*10,000 = $1,000,000,000. To achieve the same revenue, the company now needs to sell 15,625 units to achieve the same revenue. If the company fails to achieve this sales target, it would be in a loss, and the entire exercise will go on a toss.
- Process Improvements: It shows the ability and the intention of the management to improve the processes and inject product innovation as well.
- Customer Expectation: The product created is as per the expectations of the customer, which enables the management to align the cost in the most effective manner.
- Economies of Scale: It helps companies to create economies of scale in the long run since, as the cost efficiency improves the financial performance also increases.
- Market Opportunities: It also helps creates new market opportunities in the market by lowering the cost as compared to its competitors.
- Efficient Management: It improves management efficiency as well.
- Rely on Final Selling Price: This entire costing base upon the fixation of the selling price of the product. An error in estimating the selling price may result in a failure as the whole of the marketing strategy.
- Low Estimation of Selling Price: By fixing a lower selling price of the product, it will bring a burden on the total costing and also on the production department.
- Inferior Technology: Sometimes, it may happen that to reach the targeted cost, the management may compromise on the technology and inferior methods to keep the price in control, which may, in turn, go against the company.
- Ascertaining Quantity: While ascertaining the target cost, the company management must keep in mind the quantity they need to sell to achieve the desired result at the end. If the company is unable to sell these many units, it will suffer massive losses, which will push the cost upwards.
Target costing is a useful tool used in management accounting to control the cost of the products, and also the desired profits require to survive the business in the long run.
This article has been a guide to what is target cost and its definition. Here we discuss the formula and three types of target costing along with the examples, advantages, and disadvantages. You can learn more from the following articles –