Target costing is an integral part of a strategic profit management system. Target costing determines an estimate for the selling price of a new product, at which the firm can capture the required share of the market. It is important that the firm reduces this figure to a firms desired level of profit, and also with regards to the rate of return required on new capital investment and working capital requirements.
The deduction of required profit from the proposed selling price will produce a target price that must be met in order to ensure that the desired rate of return is obtained. The main theme of target costing is, therefore, what a product should cost in order to achieve the desired level of return.
Target costing will necessitate comparison of current estimated cost levels against the target level. This must be achieved if the desired levels of profitability, and hence return on investment, are to be achieved. Where a gap exists between the current estimated cost levels and the target cost, it is essential that this gap is closed.
Target costing overview: