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.
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.)
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: