Target Costing as a Strategic Tool

Faced with increasing global competition, many firms are finding that cost-based pricing is becoming a relic of the past, whereas price-based or target costing is emerging as a key strategic tool. Consistent with the notion of price-based costing, several authors have argued that target costing is a superior approach to cost reduction and control when compared with typical standard-cost systems. Although many credit the Japanese with popularizing this technique, the idea and its early applications were evident in the philosophy of the Ford Motor Company in the early 1900s.1 Today, as firms outside Japan start to integrate target costing into their management systems, there is little consensus on the technique’s exact definition or when its use is most beneficial.

The logic of target costing is simple. The target cost is a financial goal for the full cost of a product, derived from estimates of selling price and desired profit. In a target-costing framework, product selling price is constrained by the marketplace and is determined by analysis along the entire industry value chain and across all functions in the firm. Top management sets the desired level of profit on the basis of firm strategy and financial goals. In many cases, the target profitability is based on desired return on assets or return on sales.2 In contrast with cost-based pricing, product cost does not drive the estimated selling price. Instead, the target cost is the goal that a firm must achieve to meet its strategic objectives.

Common to most target-cost applications is a process that starts with competitive end-use market prices as the basis for determining acceptable manufacturing costs and a belief that large-scale cost planning and reduction must occur early in the product life cycle. Several authors, in fact, assume that target costing is applicable only early in the product life cycle (i.e., during product specification and design).

For example, Cooper states: “The purpose of target costing is to identify the production cost for a proposed product such that the product, when sold, generates the desired profit margin. The focus of target costing is to reduce the cost of a product through changes in its design. It is therefore applied during the design phase of a product’s life cycle.�