Pricing using Target Costing is this weeks video-blog theme.
Costs are reduced by as much as 25% to 30% under target costing, compared to traditional cost plus pricing. Above all your focus is on understanding and knowing your market conditions from day one. This gives you more chances of success. Cost control is more effective than traditional costing methods. However, the implementation cost of target costing is higher and requires a culture shift. Moreover, it is more time consuming than traditional methods as not always easy to find a suitable price.
Traditional Costing versus Target Costing
Traditional cost-plus costing and target costing are commonly used for pricing goods and services. The two methods share similarities but also differences. Choose the method that is relevant for your market, product mix and industry position.
Traditional or cost-plus costing has been around for much longer than target costing. Target costing was developed in the 1960s by market and cost researchers working for Toyota.
How Target Costing works
Traditional costing involves firstly calculating the total cost of the product. This involves
- Firstly, add direct, indirect and fixed costs of the total production run.
- Secondly, calculate a per-unit cost and add an amount for expected profit margin.
In target costing, the profit margin is taken off from a set market price to give a target cost.
Each method has its benefits.
- Businesses like traditional costing for its simplicity
- Little data is required initially for cost-plus pricing
- Moreover price adjustments can be made later than with target costing
- Target costing is praised for its efficiency and focus on keeping costs low
- Traditional costing underestimates costs and overestimates profits. This leads to wasteful spending and unprofitable products
- Pricing using target costing is more complex and rigid. It requires much more attention to the production life cycle.
Target costing is a modern technique of cost control. It is a reverse costing technique, your selling price is based on knowing your market and customers. Your desired profit margin is deducted from the target selling price.
In the traditional system the budget is prepared and then production starts. From the calculated cost your target profit is taken off and a selling price is given.
Estimate your target cost by taking off your target profit margin from your competitive market price. Target costing does not focus on finding what a new product does cost. It focuses on finding what a new product should cost.
Cost reduction must not affect quality. If quality is damaged your target costing plan will fail.
Target costing process
Pricing using Target Costing is summarised below.
- Firstly: Estimate your target selling price for your product
- Secondly: Estimate your desired profit margin.
- Thirdly: Calculate your Target cost – this is target selling price minus target margin.
- Fourthly: Calculate the estimated cost of the product and compare it with your target cost.
- Finally: The difference is your cost gap that needs to be closed.
For example, your product selling price is $25 and your target profit margin is $5. Your target cost would be $25-$5 = $20. If the real cost of the product was $22, there is a cost gap $20-$22 = -$2. This cost gap of $2 must be reduced as the selling price is less than the real cost of the product.
Moreover, talking about Pricing using Target Costing is to inform, inspire and educate you to get closer to your numbers. Above all you can improve your financial understanding and well-being. Plus make more profit, save tax and time, and your money mindset. How wonderful is that?
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