Target costing is a cost management tool used during product planning and design. Its core concept is price-led costing: the target cost is derived externally from market conditions, not internally from production capabilities. It represents the maximum cost the company can incur while still earning its required profit margin. Achieving this target demands cross-functional teamwork involving design, engineering, procurement, and production to eliminate waste and inefficiencies. It emphasizes cost avoidance rather than cost control, meaning costs are designed out before production begins. This reverses the traditional cost-plus mindset, embedding profitability into the product’s very DNA from inception.
Objectives of Target Costing:
1. To Control Product Cost
The main objective of target costing is to control the cost of a product before production begins. The target cost is determined by deducting the desired profit from the expected market price. Management then designs the product and production process within this cost limit. This approach helps prevent unnecessary costs from becoming part of the product. Early cost control is more effective than trying to reduce costs after production has already started. Therefore, target costing encourages systematic cost management from the product planning stage.
2. To Achieve Desired Profit
Target costing aims to ensure that the organisation earns its desired level of profit. The target cost is calculated using the formula:
Target Cost = Target Selling Price − Desired Profit
Once the target cost is established, product design, materials, production methods and other activities are planned accordingly. This ensures that the desired profit is considered before production rather than being treated simply as the difference between selling price and actual cost. Thus, target costing supports planned and controlled profitability.
3. To Meet Customer Requirements
Target costing focuses strongly on customer needs, preferences and expectations. The target selling price is generally determined after considering what customers are willing to pay and the value they expect from the product. The organisation then designs the product to provide the required features and quality within the target cost. This helps ensure that cost reduction does not unnecessarily compromise customer value. Therefore, target costing aims to balance customer expectations, product quality, selling price and profitability.
4. To Improve Product Design
An important objective of target costing is to encourage efficient product design. A significant portion of product cost is determined during the design stage. Target costing requires designers, engineers, production managers and cost accountants to work together to develop a product that meets customer requirements at the target cost. Unnecessary features, expensive materials and inefficient design elements can be identified and modified. This approach helps reduce future production costs and improves the overall economic efficiency of the product.
5. To Reduce Costs
Target costing aims to identify and eliminate unnecessary costs while maintaining the required quality and functionality of the product. Management examines materials, components, production methods, labour requirements, packaging and other activities to find opportunities for cost reduction. Techniques such as value engineering and value analysis may be used for this purpose. Cost reduction is planned before production starts, making it easier and less disruptive than reducing costs after the product has entered the market.
6. To Increase Competitiveness
Target costing helps organisations remain competitive by allowing them to develop products at prices acceptable to customers while maintaining desired profitability. In competitive markets, organisations may have limited freedom to increase selling prices. Therefore, controlling product cost becomes essential. Target costing helps management design products that provide appropriate value at competitive prices. This enables the organisation to respond effectively to competitors, changing customer expectations and market conditions while protecting its profit margin.
7. To Improve Value for Money
Target costing aims to provide customers with the best possible value for money. It does not simply focus on reducing costs; instead, it seeks to achieve the required product quality and functionality at the lowest reasonable cost. Management evaluates each product feature and component to determine whether it contributes sufficient value to the customer. Unnecessary costs can then be removed without reducing important benefits. Thus, target costing balances cost, quality, functionality and customer value.
8. To Encourage Teamwork
Target costing promotes cooperation among different departments involved in product development. Marketing, design, engineering, purchasing, production, finance and cost accounting teams work together to achieve the target cost. Each department contributes its knowledge to identify cost reduction opportunities and improve product value. This cross functional approach helps avoid decisions being made independently by individual departments. It also improves communication and coordination throughout the product development process, supporting the successful achievement of cost and profitability objectives.
9. To Improve Resource Utilisation
Target costing aims to ensure efficient utilisation of resources such as materials, labour, machinery and production facilities. During product development, management examines alternative materials, components and production methods to determine the most economical combination. Wasteful activities and unnecessary resource consumption can be identified and eliminated. Better resource utilisation reduces product cost while maintaining the required quality and functionality. Therefore, target costing contributes to improved operational efficiency and helps organisations achieve their planned cost and profit objectives.
10. To Support Long Term Profitability
Target costing focuses on controlling costs throughout the product life cycle, from product planning and design to production and eventual withdrawal from the market. By controlling costs at an early stage and continuously seeking improvements, the organisation can protect its profit margin over the long term. It also helps management respond to changes in customer expectations, technology and competition. Thus, target costing is not merely a short term cost reduction technique but a strategic approach for maintaining sustainable profitability.
Process of Target Costing:
1. Market Research
The target costing process begins with studying the market, customers and competitors. Management collects information about customer needs, preferences, purchasing behaviour and expected product features. Competitors’ prices and product offerings are also analysed. This information helps the organisation understand the value customers expect and the price they are likely to accept. Since target costing is market oriented, accurate market research provides the foundation for determining the target selling price and designing a product that can compete effectively while satisfying customer requirements.
2. Determination of Target Selling Price
After studying market conditions, the organisation determines the target selling price of the proposed product. The price is influenced by customer expectations, competitors’ prices, product features, expected demand and overall market conditions. The organisation generally has limited control over the market price in highly competitive markets. Therefore, the selling price must be realistic and acceptable to customers. The target selling price becomes the starting point for calculating the maximum cost that the organisation can incur while still achieving its desired profit.
3. Determination of Desired Profit
The organisation next determines the desired profit margin for the product. The desired profit may be expressed as a percentage of the selling price or as a specific amount per unit. Management considers factors such as corporate profit objectives, investment requirements, market conditions and expected return. The desired profit is deducted from the target selling price to determine the maximum allowable product cost. This ensures that the profit objective is incorporated into product planning before production begins.
4. Calculation of Target Cost
Target cost is calculated by subtracting the desired profit from the target selling price.
Target Cost = Target Selling Price − Desired Profit
For example, if the expected selling price is ₹1,000 and the desired profit is ₹200, the target cost will be ₹800. This ₹800 represents the maximum cost that the organisation should incur to produce and sell the product while achieving the desired profit. The target cost becomes the cost benchmark for product design, material selection, production planning and other cost reduction activities.
5. Determination of Estimated Current Cost
After calculating the target cost, management estimates the current or expected cost of producing the product based on the existing design, materials, production methods and available technology. This estimated cost represents what the product is likely to cost if developed using current methods. Costs may include materials, labour, manufacturing overheads, distribution expenses and other relevant costs. Comparing estimated current cost with target cost helps management determine whether a cost reduction effort is necessary before production begins.
6. Determination of Target Cost Gap
The difference between the estimated current cost and the target cost is known as the target cost gap.
Target Cost Gap = Estimated Current Cost − Target Cost
For example, if the estimated current cost is ₹900 and the target cost is ₹800, the cost gap is ₹100. This indicates that the organisation must reduce the expected cost by ₹100 per unit. Identifying the cost gap helps management determine the extent of cost reduction required and provides a clear cost reduction objective for the product development team.
7. Value Engineering
Value engineering is an important part of target costing used to reduce unnecessary costs without reducing essential product quality or functionality. Engineers, designers and cost accountants examine each component and feature of the product. They identify alternative materials, designs, production methods and suppliers that can provide the required function at a lower cost. The objective is not simply to make the product cheaper but to achieve the required customer value at the target cost. Value engineering helps eliminate unnecessary features and production costs.
8. Cross Functional Teamwork
Target costing requires cooperation among various departments such as marketing, design, engineering, purchasing, production, finance and accounting. A cross functional team evaluates product features, costs, materials, production methods and customer requirements. Each department contributes specialised knowledge to achieve the target cost. For example, purchasing may identify cheaper suppliers, while engineering may suggest an alternative design. This teamwork ensures that cost reduction decisions are considered from different perspectives and that the final product satisfies customer expectations while remaining financially viable.
9. Supplier Involvement
Suppliers can play an important role in achieving the target cost because purchased materials and components may represent a significant portion of product cost. The organisation may work with suppliers to identify lower cost materials, improve component design, reduce wastage and negotiate better purchasing arrangements. Suppliers may also suggest alternative technologies or production methods. Early supplier involvement helps reduce procurement costs without compromising required quality. It also strengthens coordination between the organisation and its suppliers during product development.
10. Continuous Cost Reduction
Target costing does not end once the product is launched. Organisations continue to monitor actual costs and search for further improvements throughout the product life cycle. Changes in technology, material prices, production methods and customer requirements may create new cost reduction opportunities. Management compares actual performance with the target cost and takes corrective action where necessary. Continuous improvement helps maintain the desired profit margin, improve efficiency and ensure that the product remains competitive throughout its market life.
Methodology of Target Costing:
1. Market Based Method
The market based method starts with the expected market price of the product. Management studies customer expectations, competitors’ prices, market demand and product features to determine a realistic selling price. The desired profit margin is then deducted from the target selling price to calculate the target cost. The organisation designs and produces the product within this cost limit. This method is particularly useful in highly competitive markets where the organisation has limited control over selling prices. It ensures that product cost is aligned with market expectations and desired profitability from the beginning.
2. Product Level Target Costing
Product level target costing determines the overall target cost of a product based on its expected selling price and desired profit. The product is examined as a complete unit, and management identifies the maximum cost that can be incurred while achieving the required profit. If the estimated cost exceeds the target cost, cost reduction measures are introduced. These may include redesigning the product, changing materials, improving production methods or negotiating with suppliers. This method ensures that the entire product remains financially viable while maintaining the required quality and customer value.
3. Component Level Target Costing
Under component level target costing, the total target cost of a product is divided among its individual components or parts. Each component is assigned a target cost based on its importance, functionality and contribution to customer value. Engineers and cost accountants then examine each component to identify opportunities for cost reduction. Alternative materials, designs or suppliers may be considered. This approach helps management control costs at a detailed level and prevents excessive costs in individual components from increasing the overall product cost.
4. Functional Level Target Costing
Functional level target costing focuses on the different functions performed by a product rather than simply examining its physical components. Each function is evaluated according to the value it provides to customers and the cost required to provide it. Functions that have low customer value but high cost are examined for possible modification or elimination. The objective is to maintain important functions at the lowest possible cost. This methodology is closely associated with value engineering and helps organisations achieve cost reduction without unnecessarily reducing product quality or usefulness.
5. Value Engineering Method
Value engineering is a systematic method used to achieve target cost while maintaining the required functionality and quality of a product. Each product feature and component is analysed to determine whether it provides sufficient value to the customer in relation to its cost. Engineers may consider alternative materials, simpler designs, improved production techniques or different components. Unnecessary costs are eliminated without affecting essential functions. Value engineering therefore focuses on improving the value to cost relationship and is one of the most important techniques used in target costing.
6. Kaizen Costing Method
Kaizen costing focuses on continuous cost reduction after the product has entered production. Unlike target costing, which mainly operates during product development, Kaizen costing works during the manufacturing stage. Employees and managers continuously identify small improvements in production methods, material usage, labour efficiency, quality and waste reduction. These improvements gradually reduce actual production costs. The objective is to maintain or improve the desired profit margin while ensuring that product quality remains satisfactory. Kaizen costing complements target costing by continuing cost reduction throughout the product life cycle.
7. Life Cycle Costing Approach
Life cycle costing considers costs incurred throughout the entire life of a product, from research and development to design, production, marketing, distribution, customer service and eventual withdrawal. Target costing can use this approach to ensure that decisions made during product development consider their long term cost consequences. A low initial production cost may not always mean a low total product cost if maintenance, warranty or after sales expenses are high. Therefore, life cycle costing helps management achieve an economically efficient product over its entire market life.
8. Cost Gap Analysis
Cost gap analysis compares the estimated current cost with the target cost to determine the amount of cost reduction required.
Cost Gap = Estimated Current Cost − Target Cost
If the estimated cost is higher than the target cost, management must identify ways to close the gap. Cost reduction may involve product redesign, material substitution, supplier negotiations, process improvements or elimination of unnecessary features. Cost gap analysis provides a clear numerical target for the product development team and helps monitor progress towards achieving the desired cost.
9. Cross Functional Method
The cross functional method involves cooperation between different departments such as marketing, engineering, production, purchasing, finance, accounting and research and development. Each department contributes specialised knowledge to achieve the target cost. Marketing provides information about customers and competitors, engineering focuses on product design, purchasing examines supplier costs and production evaluates manufacturing efficiency. This coordinated approach helps identify cost reduction opportunities from multiple perspectives. It also ensures that cost reduction decisions do not unnecessarily compromise product quality, customer requirements or production feasibility.
10. Supplier Based Method
The supplier based methodology involves suppliers directly in the target costing process. Suppliers are asked to contribute ideas for reducing the cost of materials, components and purchased parts while maintaining required quality. They may suggest alternative materials, improved component designs, efficient manufacturing methods or better purchasing arrangements. Early supplier involvement can reduce procurement costs and improve the overall cost structure of the product. This approach is particularly useful when purchased components represent a significant portion of total product cost. It also encourages long term cooperation between the organisation and its suppliers.
Cost Reduction Techniques under Target Costing:
1. Value Engineering (VE) / Value Analysis
Value Engineering is the core technique of target costing, involving systematic examination of every product component and process to eliminate unnecessary costs without compromising quality, function, or customer value. Cross-functional teams analyze each part’s function versus its cost, asking whether the function can be achieved more cheaply, eliminated, or combined with another part. VE targets both “avoidable” costs (unnecessary features) and “necessary” costs (optimized through better design or materials). It’s applied primarily during the design stage, since most costs are locked in early. This technique drives the gap-closing process between estimated cost and target cost, making it the most widely used tool in target costing implementation.
2. Functional Analysis
Functional analysis breaks down a product into its individual functions (e.g., a car door provides “access,” “sealing,” “aesthetics”) and evaluates the cost contribution and customer-perceived value of each function separately. Costs are then reallocated so that spending is proportionate to the value customers place on each function—over-engineered, low-value functions get cost reduced or removed, while high-value functions retain investment. This ensures resources aren’t wasted on features customers don’t value while critical functions remain robust. Functional analysis works alongside value engineering, providing the diagnostic framework that identifies where cost-cutting opportunities exist without eroding the product’s competitive market appeal or perceived quality.
3. Component/Parts Standardization
Standardization involves using common, interchangeable parts across multiple products or product variants instead of designing unique components for each. This reduces design costs, tooling costs, and inventory holding costs, while enabling bulk purchasing discounts through higher volume per component. Standardized parts also simplify manufacturing processes, reduce training needs for workers, and lower quality-control complexity since fewer unique parts require inspection. Automobile and electronics manufacturers commonly use shared platforms or modular components across models to achieve significant cost savings. This technique is particularly powerful in target costing because it directly reduces both direct material costs and indirect overheads tied to complexity and variety.
4. Value Chain Analysis / Value Chain Reconfiguration
This technique examines the entire chain of activities—from raw material sourcing through production, distribution, marketing, and after-sales service—to identify where costs can be reduced or activities restructured for greater efficiency. It may involve renegotiating supplier contracts, relocating production, outsourcing non-core activities, or integrating processes to eliminate redundant steps. Unlike value engineering which focuses on the product itself, value chain analysis looks outward at organizational and inter-organizational cost drivers. It helps identify whether cost advantages lie in vertical integration or outsourcing, and supports decisions about which activities the firm should perform in-house versus rely on external partners to achieve the target cost.
5. Design for Manufacturing and Assembly (DFMA)
DFMA is a technique that redesigns products to simplify manufacturing and assembly processes, reducing the number of parts, assembly steps, and specialized tooling required. Fewer parts mean lower material costs, reduced assembly labor time, fewer quality defects, and simpler supply chain management. DFMA principles include designing parts that can be assembled in a single direction, using self-locating features, and minimizing fasteners. Because assembly and manufacturing complexity directly drive labor and overhead costs, DFMA is a powerful lever for closing the cost gap in target costing. It’s typically applied early in product development, working hand-in-hand with value engineering teams.
6. Kaizen Costing (Continuous Improvement)
While target costing focuses on cost reduction during the design/planning stage, Kaizen costing extends cost reduction efforts into the manufacturing/production stage through small, continuous, incremental improvements. Once a product reaches production, further large-scale redesign is costly, so Kaizen relies on shop-floor suggestions, waste elimination (Muda), process tweaks, and efficiency gains achieved gradually by workers and supervisors. Annual kaizen cost-reduction targets are often set as a percentage of current costs. This technique complements target costing by ensuring cost discipline doesn’t stop once a product launches, but continues throughout its lifecycle, sustaining competitiveness and profitability over time.
7. Overhead Cost Reduction / Activity-Based Management
This technique applies Activity-Based Costing insights to identify and eliminate non-value-adding activities that drive overhead costs, such as excess handling, inspection, or storage. By analyzing cost drivers behind support functions (procurement, quality control, logistics), management can streamline processes, reduce batch sizes, improve layout efficiency, or automate repetitive tasks. Since overheads often form a significant and growing proportion of total product cost in modern manufacturing, controlling them is essential to achieving the target cost. This technique ensures that cost reduction isn’t limited to direct materials and labor but extends comprehensively across all indirect costs contributing to the final product cost.
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