Target costing
Target costing is a cost management approach that works backward from what the market will pay to determine allowable product costs. Rather than designing a product and then calculating what it costs, target costing establishes the cost target first, then designs and sources to meet that target. This market-driven approach ensures products can be profitable before development proceeds too far.
Examples
Consumer electronics pricing: Market research indicates consumers will pay $199 for a new product category. After required margins, the target cost is $110. Engineering and procurement work together to design a product that delivers competitive features within this cost ceiling.
Automotive component targets: An automaker sets target costs for each vehicle system based on competitive pricing requirements. Tier-one suppliers must meet these targets to win business, driving them to innovate and optimize their designs and processes.
New market entry: A company entering a price-sensitive market calculates that products must cost under $50 to compete. This target drives design decisions from the beginning, preventing development of products the market won't accept.
Definition
Target costing originated in Japan, particularly at Toyota, as part of lean product development practices. It reverses the traditional cost-plus approach where products are designed and then priced to cover costs plus margin, which can produce products the market won't accept.
The target cost calculation starts with market price (what customers will pay), subtracts required profit margin, yielding the allowable cost that becomes the development target. This target is then allocated to components and systems, creating cost targets throughout the BOM.
Achieving target costs requires collaboration across functions. Design engineering makes choices that enable cost targets. Procurement sources competitively and works with suppliers on cost reduction. Manufacturing develops efficient processes. All functions share responsibility for the cost outcome.
Target costing creates tension between cost and functionality. When initial designs exceed targets, the team must find ways to reduce costs or make cases for feature reduction. This discipline prevents over-engineering and ensures market viability.
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