Target costing is the practice by which companies set a cost for a product and stick to it. In this lesson, we’ll see how it is more common for companies to do this than you might think.
Definition of Target Costing
Have you ever wondered why whenever a new smartphone comes out that its price is never that different from an old one? For example, you can usually purchase, on a contract, a new top-rated smartphone for around $200. But wait, if technology is always getting cheaper, shouldn’t this number budge a little bit?
The fact is that it shouldn’t due to target costing. Target costing is the strategy to set a price point for a product and engineer it to that point. In doing so, profit is treated as any other cost. As such, the formula for target costing is that the sales cost of an item should be the anticipated profit plus the cost that has been targeted by the designers. By doing so, a company hopes to offer enough value to still attract customers, while still maintaining a profit. In this lesson, we’ll look at how it works, what happens when plans go far, and then see it played out in an example.
Target Costing Steps
There are four major steps when doing target costing. The first of these is simply to figure out what your market is like and what your potential customers expect from a product. A crucial point is to make sure you understand what each aspect costs. From there, you should figure out what the highest cost is that you’re willing to pay per device to manufacture them. Keep in mind to leave plenty of room for profit and overhead costs. From there, you create the product, keeping it within the budgetary lines. Finally, remember that many products see their cost lowered as the lifespan of the product continues. At this point, it is wise to try to reduce the production cost of the item to continue to make those price point reductions profitable.
Example of Target Costing
So let’s look at all this through the example of a smartphone. After all, goods that are frequently upgraded are the best to apply target costing to. So when a phone is first released, it has a price point of $200 plus any fees over the term of the contract. After all, you’re often paying for the phone across the term of the contract. For simplicity’s sake, we’ll call that $500 total. That means that in addition to the $200 up front, $300 is made over the course of the contract. Within a year, that phone is no longer the hottest thing out, so the price drops. By now you’re paying $400 total across the contract for the phone, as the supplier has normally cut the price to $100 dollars. Finally, after another year, the phone carrier is practically giving the phone away, with only your monthly bill paying $300 over the course of the two-year contract. At each point the company has to be sure that the phone is still profitable at whatever real cost it is being sold at.
Now, how do you make a profit off of that? Let’s say that the phone was engineered with a target cost of $250. That would mean that profit the first year was $250 per phone, while it dropped in the second year to $400 – $250, or $150. Finally, in the third year, when the phone sold for only $300, profit was only $50 per phone.
Target Costing ; Rejecting Projects
Speaking of phones, there are often plenty of features that people would like to see on their phone. For example, almost every smartphone can take pictures. This is because HD cameras were a value for the customer. That wasn’t always the case. Sure, they could have put HD cameras on phones, but the resulting phone would have been too expensive for people to buy. Instead, phone manufacturers waited until the price of the camera came down.
That’s a key part of target costing. If a project has costs that make it nonviable, companies simply step back from the project. They will come back to it every year or so to see if costs have decreased, but as a rule, they will not try to incorporate it until it is sure to add more value than it costs.
In this lesson, we look at the idea of target costing. Target costing is the idea of engineering a product around a price point, making sure to keep costs low and profits present. Target costing is useful in the formula for total price, which is that total price should equal the targeted cost plus profit. Smartphones offer a great example of target costing, as they not only are built to a price point but also have to have their manufacturing processes constantly adjusted to make sure that the product continues to make money. If a feature proves to be too expensive for now, it is often shelved and revisited once it is considered more feasible to do so.