The upcoming discussion will update you about the difference between traditional costing and target costing.
Traditionally, manufacturers would make use of the cost-plus approach to estimate the product price. A starting point for them would be to conduct market research to determine its market segment’s preferences and hence its product’s characteristics that will meet the customer’s needs. This will be followed by the design of the product. Next manufacturer’s process is determined.
Vendors will then be contacted to identify the total costs of the components which are required by the design and engineering departments. Finally, cost components are summed up and a selling price is set based on the costs.
If the management and the marketing department think that the price and cost are too high, the product design and engineering process will be repeated till an acceptable cost is reached, after which, production will begin.
In contrast, target costing derives an “allowable” product cost by first carrying out market research to predict what the market segment is willing to pay for the desired product with specific characteristics. Subtracting the desired profit margin set by the management from the predicted selling price, maximum target cost is arrived at.
This target cost is then compared to an expected product cost and if it is higher than the expected product cost, the company has several options. First, to lower costs, the product design and/or the engineering process can be changed.
This is carried out by all the members of the planning team (the suppliers, design, engineering, and production and marketing department) who will investigate the need and cost of each component.
All the members will work together instead of going through various departments sequentially to reduce cost. When the target cost is reached, standards can be set and product will then enter the manufacturing phase.
Secondly, the management might consider accepting a less-than-desired profit margin. This will depend on the numerical difference between expected cost and target cost. If the target cost is slightly higher than the expected cost, a slightly lower profit margin will be feasible.
However, if the difference is too great and there is no way for the company to earn the profit margin that it desires, its third alternative would be to abandon that particular product. In short, target costing can be viewed as a system of profit planning and cost management that is customer focused, price led, design centered and cross functional.
In brief the use of target costing forces managers to change their way of thinking with regard to the relationship among cost, selling price and profitability.
The traditional mindset has been that a product is developed, production cost is identified and measured, a selling price is set, and either profits or losses will result. However, in target costing, a product is developed, a selling price and desired profit are determined and maximum allowable cost is derived. This makes cost dependent on selling prices.