Target costing is an approach in which companies set targets for its costs based on the price prevalent in the market and the profit margin they want to earn. Keeping its costs below the relevant targets helps the company generate profit.
Target cost = selling price – profit margin
Profit margin may be based on cost or selling price.
In most of the industries competition is high which means that prices are determined by the interaction of market demand and supply which the market participants i.e. producers can’t change. However, they can control their costs. In target costing, companies leverage their ability to monitor and control their cost to generate a profit.
Target costing can be contrasted with cost-plus pricing, in which companies set price by adding a profit margin to whatever cost they incur. Target costing is a more effective approach because it emphasizes efficiency in order to keep costs low. Target costing is particularly useful in industries that have low profit margins and high competition.
Where the profit margin is based on selling price, target total cost can be calculated as follows:
Target cost = selling price – profit percentage × selling price
Where the profit margin is based on cost, target cost can be found as follows:
|Target cost =||selling price|
|1 + profit percentage|
Targets can be set for each individual cost component based on the standard costing.
D&D is a denim manufacturer that operates in a very competitive environment. It sells denim to different companies that manufacture and market jeans under their own brands. D&D can only charge $2 per metre. If the company’s intended profit margin is 15% on cost, calculate the target cost per unit. If 30% of the cost per metre of denim is related to direct materials, what’s the target cost per unit for direct materials.
D&D wants to earn a margin of 15% on cost, so the following formula shall be used to set the total target cost per unit.
|Target cost per unit =||selling price|
|1 + profit percentage|
|Target cost per unit =||$2 per metre||= $1.74|
|(1 + 15%)|
D&D has to keep its cost per unit below $1.74 in order to generate 15% profit margin on cost.
If 30% of the unit cost is related to direct materials, target cost for direct materials shall be $0.52 (0.3*$1.74).
If D&D wants to earn 15% on selling price, the total target cost per unit shall be worked out as follows:
Target cost per unit = $2 * (1 – 15%) = $1.70
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