Target costing estimates product cost by subtracting a desired profit margin from a competitive market price. As the target cost makes reference to the competitive market, it is fundamentally customer-focused and an important concept for new product development.

What is it?

Target costing is part of a product development process. It starts with understanding the wants and needs of customer segments across targeted competitive markets, and the prices they're willing to pay for the product and its variants. The business must specify the margin it needs to get the maximum tenable cost for the product and its variants. The margin needs to be sustainable across the product's full expected lifecycle.

Because target costing encompasses a business' full costs, it applies to its full value chain. So, at one end of the value chain, customer value must be expressed in terms of the value the product and its variants generate for customers. At the other end of the value chain, it incorporates how the business will collaborate with its suppliers to generate this value. As target costing has an all-encompassing role, it is multidisciplinary, multifunctional and integral to the business model that generates value for customers. It's as much a change of culture as a change in process. The role of the management accountant is to partner with all the disciplines involved and to understand the impact of decisions on customers. So, it's not just about minimising product costs, but doing so while maintaining or enhancing quality for the customer.

Competitive markets are full of uncertainty. Since the process applies to the product's full lifecycle in competitive markets, businesses will need to continually revise a product's value proposition and price. This is bound to affect the product's target cost over time. So, target costing is an ongoing process that needs continuous improvement effort.

What benefits does the process provide?

  • Assures that profitability targets for a product portfolio are achievable
  • Improves sales prospects, since product development is focused on customer needs and wants
  • Improves profitability of product variants
  • Reduces the cost and effort of managing a profitable product lifecycle
  • Reduces reliance on costly post-production product revisions to meet customer needs and wants
  • Market and customer-led, rather than business capability-led
  • Extends customer centricity beyond sales to all functions in the business.

Implementing target costing? Questions to consider

  • Have we segmented our prospect and customer base by their wants and needs?
  • Have we aligned existing products with customer segments?
  • Have we made the case for adopting target costing in our strategy?
  • Do our leaders champion the target costing cause?
  • Have we put in place the resources to facilitate implementation?
  • Are key people inspired to embrace target costing or is there resistance to change?
Actions to take / Dos Actions to avoid / Don'ts
  • Communicate the need for target costing.
  • Lead the change - leaders must champion the need.
  • Provide target costing training to key functional people.
  • Recruit functional target-costing champions to form a multidisciplinary target costing centre of excellence.
  • Ensure all new product development projects are controlled by the target costing centre of excellence.
  • Ensure all existing product variant development projects are controlled by the target costing centre of excellence.
  • Provide the resources needed for success by the centre of excellence.
  • Product developers must own costs - not just product quality and speed to market. Incentives must reflect this.
  • Sales and marketing must accept the inevitability of trade-offs; endless variant development to satisfy customers' every need diminishes returns.
  • Don't make it the sole preserve of the management accountant.
  • Avoid the project mindset - target costing is a process.
  • Avoid cost being the only target. Target costing is about quality (from the customer's perspective), speed to market and cost - not just cost.
  • Don't be subjective. Quality and value is what the customer says it is.