Target costing

What it means

Target costing is a method in which a company first sets the price the market is willing to pay, subtracts the desired profit, and the remainder becomes the target cost. Product design and production must then fit within that amount.

The method reverses the traditional logic of deriving price from a cost calculation plus a margin. In target costing the starting point is the customer and the competition, not the company's internal costs, which must adapt to the market.

It originated in the Japanese car industry and is most effective in the product development phase, when most future costs can still be influenced. Once production starts, costs are harder to cut and fall only gradually, for example through kaizen.

How it works in practice

The process starts with market research and defining the value proposition, meaning what the customer is willing to pay for. The target cost is derived from the target price and broken down by component, function or activity, and teams look for ways to stay within the limits.

Activity-based costing is often used to assign costs accurately to product functions. It reveals which parts of a product or service are expensive relative to the value they deliver to the customer and where it makes sense to look for savings.

The principle also works in services. An accounting firm that wants to offer a package for sole traders at a set monthly price calculates how much time and cost it can afford per client and shapes the scope of service, automation and workflows accordingly.

What to watch out for

If the target cost is unrealistically low, pressure to save may erode quality in ways the customer notices. The key is to save on things the customer does not value and keep those for which they choose the product.

The method requires cooperation between marketing, development, purchasing, production and finance. If only the finance department runs it without the others, it stays as numbers in a spreadsheet. With an aggressive penetration price, special care is needed to check that the target cost ensures long-term profitability.