Target Costing

How Does the Target Costing Strategy Work?

The target costing strategy is one method utilized by companies to determine the price at which to sell a particular product or service to customers in their end market.

Conceptually, target costing is akin to setting a desired profit margin and then back-solving the price point at which a product must be sold at.

By setting a market-driven price and working backwards to manage costs, target costing—also referred to as target pricing—aims to ensure that each product sold generates the desired profit margin.

However, the effectiveness of target costing is contingent on managing costs to meet internally set profitability targets and implementing initiatives to create long-term sustainable value (and optimize profitability) to improve the odds of thriving in a competitive market environment.

The overarching objective is to establish a price point that covers costs, ensures profitability, and aligns with the perceived value from the perspective of customers, while still remaining competitive in the target end market(s).

Unlike cost-plus pricing, which focuses primarily on internal costs, target costing places much more emphasis on external market factors and customer value perception.

The initial step to estimating the price point to offer a product in a given market is to analyze the competitive landscape, market conditions, and most importantly, the market price.

The competitive market price reflects the price at which competitors selling comparable product offerings decided to set their prices at, which is usually expressed as a range (or average).

Based on the data set containing the range used to determine the competitive market price, further analysis is required to understand the underlying factors that contribute toward the variance between the prices of each product on a more granular basis.

Therefore, the product features, the competitor (and branding), and the pricing dynamics surrounding the specific product must be grasped, at a bare minimum.

For example, a market leader that offers a full suite of products on a subscription-basis employing a growth and customer acquisition strategy oriented around capitalizing on upselling and cross-sell opportunities might trim their product prices (i.e. technique to get the customer’s “foot in the door”).

Given those circumstances, a company on the verge of releasing a competing product must recognize the distinctions at the product-level (and revenue model), and decide using their best judgment on whether their target price should be either higher or lower, which is based on the target profit margin.

In other words, the unit economics of a product must be sufficiently profitable, or else the right decision could be to abandon or redesign the product (i.e. improve features to differentiate, granting them the option to alter the price).

How to Calculate Target Cost

The target profit margin is subtracted from the market price, resulting in the target cost, which is the main factor that dictates if the unit economics of a product are economically feasible (or align with internal strategic objectives).

The estimation of the market-derived target price requires a thorough understanding of the market (and competitive landscape), the company’s desired profitability on a per-unit basis, and the estimated costs attributable to the production process of the product on hand.

With that said, the target costing process kicks-off with conducting extensive market research to determine a competitive price point, or target selling price, that aligns with customer value perceptions.

The target selling price serves as the starting point to obtain the selling price under the target costing approach. From that point onward, the company establishes the profit margin they aim to achieve per product sale (i.e. customer conversion), which is derived by subtracting the target selling price from the desired profit margin to arrive at the target cost.

The target cost represents the maximum parameter (i.e. the “ceiling”) at which the company can spend in total on activities that pertain to producing and delivering the product, while still achieving their profitability goals.

Once the target cost is determined, the company conducts a comprehensive analysis of their current production costs, taking into account all relevant expenses such as materials, labor, overhead, and distribution.

If the current production cost exceeds the target cost, the company must identify opportunities for cost reduction and optimization, like process improvements, supplier negotiations, product design changes, or other cost-saving initiatives.

The intent here is to align the actual production cost with the target cost, ensuring that the product can be profitably sold at the desired market price.

Finally, the company implements the pricing strategy, launching the product at the determined price point. Continuous monitoring of sales volumes, customer feedback, and production costs is crucial to ensure ongoing profitability and make any necessary adjustments.

Therefore, the step-by-step process in calculating the implied selling price per the target pricing strategy are as follows:

• Step 1 ➝ Conduct Thorough Market Research to Determine a Competitive Selling Price
• Step 2 ➝ Establish the Desired Profit Margin for the Product
• Step 3 ➝ Calculate the Target Cost by Subtracting the Desired Profit Margin from the Target Selling Price
• Step 4 ➝ Analyze Current Production Costs and Identify Opportunities for Cost Reduction
• Step 5 ➝ Implement the Pricing Strategy and Continuously Monitor Performance

Target Costing Formula

The formula to calculate the selling price under the target costing method subtracts the desired profit margin from the target selling price.

However, the more practical method to compute the target cost is to multiply the target selling price by one subtracted by the desired profit margin.

From a modeling perspective, the latter approach is more useful for purposes of performing scenario analysis in Excel to analyze the incremental impact each variable has on the target price.

By setting clear profit margin targets and working backwards to determine the allowable costs, analysts can assess the feasibility and potential value creation of a product or business strategy.

Sensitivity analysis must be performed to evaluate the impact of changes in market prices or cost assumptions on overall profitability and value.

However, profitability can be affected if market conditions shift or the company fails to meet the target price.

If the market price declines, the company must either find additional cost reductions or accept a narrower profit margin. Likewise, if costs rise beyond anticipated levels, the profitability of the company can quickly erode via margin compression (i.e. reduction in the profit margin).

To maintain profitability in the face of changing market conditions and unpredictable developments, continuous monitoring and adjustment are necessary to adapt in real-time, which is a broader, yet critical component to cost optimization, irrespective of the pricing strategy employed.

If the target cost is deemed attainable, the product’s go-to-market (GTM) strategy moves forward and is offered to consumers at that target price point.

If not, however, the company must strategize on potential tactics to redesign and improve the product itself, or to reduce the direct costs, assuming the product idea is not outright abandoned.

Target Costing Calculation Example

To illustrate the practical application of the target costing process, suppose a consumer electronics company is preparing to launch a new tablet device in fall 2024.

The consumer electronics company starts by conducting extensive market research to understand the competitive landscape and consumer preferences in the tablet market, which includes analyzing the prices of competing products, their respective product features, and value propositions to collect data on the market demand and consumer willingness to pay for certain tablet attributes.

Based on the research and market insights retrieved, the new tablet must be priced between $300 and $400.

Within that stated range, we’ll assume that consumers perceive the most value around the $350 price point for a tablet with the company’s planned features and specifications.

The company decides to set the target selling price for their new tablet right at $350, because that price positioning aligns with consumer value perceptions at present and allows the company to compete effectively against other offerings by competitors in the market.

• Target Selling Price = $350.00

With the target selling price set, the subsequent step is for the company to determine its desired profit margin, which after much review, management aims for a 30% profit margin per sale on the new tablet.

• Desired Profit Margin = 30.0%

With the target selling price and desired profit margin established, the company inserts the two assumptions into the target cost formula to arrive at an estimated target cost of $245.

• Target Cost = $350 — ($350 × 30%) = $245.00