What is Target Costing?

S7-SA7-0422

Grade Level:

Class 12

AI/ML, Physics, Biotechnology, FinTech, EVs, Space Technology, Climate Science, Blockchain, Medicine, Engineering, Law, Economics

Definition

What is it?

Target costing is a smart way for companies to decide how much a product should cost before they even make it. Instead of calculating cost and then setting a price, they first set a selling price based on what customers are willing to pay, then subtract the profit they want, and the leftover amount is the 'target cost' they must achieve.

Simple Example

Quick Example

Imagine you want to buy a new smartphone, and you're willing to pay ₹15,000. A phone company decides they want to make a profit of ₹3,000 on each phone. So, they set their 'target cost' for making that phone at ₹15,000 - ₹3,000 = ₹12,000. Now, their engineers and designers must find a way to build the phone for ₹12,000 or less.

Worked Example

Step-by-Step

Let's say a company wants to launch a new eco-friendly scooter.

Step 1: Market research shows customers are willing to pay ₹80,000 for this scooter.
---Step 2: The company decides they want to earn a profit margin of 20% on the selling price. So, profit = 20% of ₹80,000 = (20/100) * ₹80,000 = ₹16,000.
---Step 3: Now, they calculate the Target Cost. Target Cost = Selling Price - Desired Profit.
---Step 4: Target Cost = ₹80,000 - ₹16,000 = ₹64,000.
---Step 5: The design and production teams must now figure out how to manufacture this scooter for ₹64,000 or less.

Answer: The target cost for the eco-friendly scooter is ₹64,000.

Why It Matters

Target costing is crucial for companies in FinTech, EVs, and Biotechnology to stay competitive and profitable. Engineers design products within these cost limits, while economists analyze market prices to set realistic targets. This approach helps create innovative products that customers can actually afford, making careers in product development and financial analysis exciting.

Common Mistakes

MISTAKE: Thinking target costing is about adding profit to actual cost. | CORRECTION: Target costing starts with the selling price and desired profit to arrive at the maximum allowable cost.

MISTAKE: Believing target cost is just a guess. | CORRECTION: Target cost is calculated based on thorough market research (what customers will pay) and the company's profit goals, making it a strategic decision.

MISTAKE: Assuming target costing is only for big companies. | CORRECTION: While complex, the principle of setting a price first and then managing costs can be applied by any business, even a small chai stall owner deciding how much to spend on ingredients to sell a cup for ₹10.

Practice Questions

Try It Yourself

QUESTION: A company wants to sell a new gaming console for ₹25,000. They aim for a profit of ₹5,000 per console. What is the target cost? | ANSWER: Target Cost = ₹25,000 - ₹5,000 = ₹20,000.

QUESTION: A startup is developing a smart home device. Market research suggests a selling price of ₹4,000. If the company wants to achieve a 30% profit margin on the selling price, what should be their target cost? | ANSWER: Desired Profit = 30% of ₹4,000 = ₹1,200. Target Cost = ₹4,000 - ₹1,200 = ₹2,800.

QUESTION: A clothing brand plans to launch a new line of T-shirts. They estimate the market will bear a price of ₹600 per T-shirt. Their current production cost is ₹450 per T-shirt, but they want to achieve a 25% profit margin on the selling price. Calculate their target cost. Is their current production cost above or below the target cost? | ANSWER: Desired Profit = 25% of ₹600 = ₹150. Target Cost = ₹600 - ₹150 = ₹450. Their current production cost of ₹450 is exactly equal to the target cost.

MCQ

Quick Quiz

Which of the following best describes the starting point of target costing?

The company's current production cost

The desired profit margin

The market selling price that customers are willing to pay

The total raw material cost

The Correct Answer Is:

Target costing begins with determining what customers are willing to pay for a product (the market selling price). From this, the desired profit is subtracted to arrive at the target cost.

Real World Connection

In the Real World

Companies like Tata Motors use target costing when designing electric vehicles (EVs). They first decide what price point will attract customers for a new EV model. Then, knowing their desired profit, they calculate the maximum cost they can incur to manufacture it. This drives their engineering teams to innovate and find cost-effective materials and production methods, ensuring their EVs are both affordable and profitable.

Key Vocabulary

Key Terms

SELLING PRICE: The price at which a product is sold to customers | DESIRED PROFIT: The amount of money a company wants to earn from each product sold | TARGET COST: The maximum allowable cost to produce a product while achieving the desired profit at a specific selling price | MARKET RESEARCH: Studying customer preferences and willingness to pay for a product

What's Next

What to Learn Next

Next, you should explore 'Cost-Plus Pricing.' It's another common pricing strategy, but it works in the opposite way to target costing. Understanding both will give you a complete picture of how companies set prices and manage their finances. Keep up the great work!