target costing

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Target costing is a process in which firms identify the quality and functionality needed to satisfy customers and what price they are willing to pay before designing the product. Products are only manufactured if the firm can control costs to meet the required price.
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Target Costing Example

In our target costing example, we examine a clothing manufacturer who would like to sell wool coats to price conscience customers. After conducting research for the target group, the firm determined that customers are willing to pay $39.99 for the wool coat. The firm needs to determine the target cost of manufacturing the coat; if they can meet customer quality requirements, while controlling costs in meeting the required price, they will  manufacture the coat. If they cannot, the firm will not produce the coat, abandoning the project. (See target costing formula below for the rest of the example.)
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Target Costing Formula

In our above example, we learned that a specific target market is willing to pay a retail price of $39.99 for a wool coat. To be profitable, the retailer needs a markup of 30% or .30. The firm or manufacturer requires a markup of  10%, or .10, to be profitable. Let’s plug our numbers into the target costing formula to determine the target cost of the wool coat:

Retailers Cost = Selling Price x (1.0 – markup percentage)

Target Cost = Price to retailer x (1.00 – manufacturers profit percentage)

Using the coat manufacturers example above, let’s calculate the target cost using the above formula:

Step 1: Determine the price point customers are willing to pay. In our example, our research shows the selected target customer is willing to pay $39.99 for a wool coat.

Step 2: What is the markup required by the retailer? In our example, we said the retailer needs a .30 (30%) markup to make money.

Step 3: Now, we’ll need to calculate the maximum price the retailer is willing to pay for the coat. We do this by taking the price the customer is willing to pay and subtracting the markup required by the retailer:

Retailers price = Selling Price x (1.00 – markup percentage)
Retailers price = $39.99 x (1.00 – .30)
39.99 – 0.70 = $27.99

Step 4: Profit required by firm/manufacturer. In our example, the required profit is .10 (10%)

Step 5: Target cost calculation

Target cost = Retailers price x (1.00 – firms profit requirement percentage)

Target cost = $27.99 x (1.00 – .10)
$27.99 x 0.90 = $25.19

Target Cost = $25.19

 

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