Target Costing: a tool for Strategic performance Management
Article by John Currie – Examiner in Professional 2 Strategic Performance Management
Target costing versus cost-plus pricing
The basic principle of target costing is that the cost of producing and distributing a product must
not exceed: (competitively realistic selling price minus acceptable profit margin). For example, if
the product can be sold for €20 and a profit margin of €7 is required then the manufacturer
cannot afford to spend more than €13 producing and distributing it. The amount of this required
profit is likely to depend on how much capital has been invested in production and distribution
facilities for the product. The logic behind target costing is essentially the reverse of the logic in
cost-plus pricing. The logical error in cost-plus pricing is the idea that cost can be taken as a
“given” and that a required profit margin can be added to arrive at a “fair” selling price.
In reality, the issue is not whether a proposed selling price is “fair” but rather whether it is
competitively realistic and strategically appropriate. A price derived on a cost-plus basis takes
no account of customers’ willingness and ability to pay that price. Customers’ incomes, price
sensitivity of demand, competitors’ prices for comparable products of similar functionality, and
the market positioning of the product are all important variables which must be consciously
considered as part of a strategic approach to pricing. Yet cost-plus pricing recognises none of
these factors. Target costing, by contrast, provides a means of taking explicit note of these
factors and provides a framework for an integrated strategic approach to pricing and cost
management. It is worth noting that, while target costing is often thought of as a cost reduction
technique, some of its best-known users are companies which operate in high-cost economies
such as Japan and Switzerland. This is partly because cost savings...