Target Costing
A pricing-driven cost management approach where the acceptable cost of a product is determined by subtracting the desired profit margin from the market price.
What is Target Costing?
Target costing is a cost management strategy in which a company first determines the price at which a product can be sold in the market, then subtracts the desired profit margin to arrive at the target cost — the maximum allowable cost to manufacture the product. If the current estimated cost exceeds the target, the company works backward through product design, engineering, and supplier relationships to reduce costs to the target level. This approach, widely used in Japanese manufacturing (particularly by Toyota), reverses the traditional cost-plus pricing method. Target costing forces cross-functional teams to consider cost implications during the design phase, when cost reduction opportunities are greatest, rather than trying to cut costs after production begins.
Example
An automaker determines that the market will support a $25,000 selling price for a new compact car. With a desired 15% profit margin ($3,750), the target cost is $21,250. Engineers and designers then work with suppliers to redesign components, simplify assembly, and source materials to hit the $21,250 cost ceiling before production begins.