Target CostingWhen raising prices isn't feasible

Generating profits is the primary purpose of running a business.

There are generally two ways to increase your business’s profit.

One is to increase its revenue.

This is usually done by increasing the sales price of the business’s products or increasing the asking price for services.

The other is to decrease the product or service costs.

For example, those that manufacture their own products find cheaper alternatives to the current rate of materials, labor, etc.

But sometimes, increasing a product’s sales price does more harm than good.

This is usually the case for products that are highly homogeneous and competitive.

For example, convenience stores.

Convenience stores sell almost the same products, with some specialty goods here and there.

But for those same products, the option to increase prices may mean a loss in customer patronage.

Since they can purchase the exact same product from another store for cheaper, they are more likely to get it from there.

Another case where the business cannot just whimsically decide on a product’s sales price is when it’s about to introduce a new product.

Sure, it’s a new product, but raise its price too high and no one will buy it.

Notice that you don’t see a new iPhone that sells for $10,000 or more?

No one would buy one at that price and Apple knows it.

It’s just too much for what the customer perceives as the product’s value.

In these cases where raising the price isn’t feasible, the only option is to deal with the costs if the business wants to raise its profitability.

One way to deal with costs is through a methodology referred to as target costing.

In this article, we will be learning about what target costing is, and when and how you can use it for your business.

What is Target Costing?

Target costing is a process in which a business plans the pricing, costing, and profit margins that it wants to achieve for a new product.

If it’s not feasible to manufacture the new product with such considerations, the business will cancel the design and development of the product entirely.

This is to ensure that the business only releases products that are sure to be profitable.

If used properly, target costing can be a great tool for ensuring the profitability of a product.

From the moment it enters the design phase up until its last days, the business can rely on target costing to monitor the product’s profitability.

This is especially useful if the business participates in an environment that is highly competitive.

Do note though that target costing is more than just a tool.

Rather, it is a more involved technique wherein a product’s sales price isn’t determined just by its product costs.

It considers a lot more factors such as market conditions, the level of competition, the value that the customer perceives, supply and demand, etc.

This is especially useful if the business has little to no control over the selling price of the product.

The business instead resorts to controlling the costs to the extent that it can.

Target costing provides a new view to designing a product.

It provides an alternative to the much more common approach where the design team dictates what the product should be like without much consideration as to the costs and current market conditions.

The design team might come up with a product that may have some nice specs, but the cost of producing it might be too high, and even worse, higher than what the customer is willing to pay for it.

Target costing ensures that scenarios like this don’t happen.

Why Target Costing?

In highly competitive industries where businesses have little to no control over the prices of products, the businesses will have to find other ways to ensure profits.

Raising the price is more or less off the table for these businesses.

As such, they will have to resort to controlling the costs to ensure profits.

Well, to the extent that they can.

Examples of such highly competitive industries include healthcare, construction, energy, and essential goods.

The price of the products within industries

Target costing enables a business to use plan a product’s cost even before production starts.

This is through proactive cost planning, cost management, and cost reduction practices.

A product’s costs are determined at the early stages (design and development) rather than at the later stages (product development and production).

This ensures that products that are not feasible cost-wise don’t proceed to the production phase.

The business only releases products that are sure to be profitable.

This is very important for businesses that have tight profit margins.

For these business, even a small increase in costs can mean drastic decreases in profits.

Of course, a decrease in costs doesn’t mean a decrease in the quality of the products.

Businesses need to be careful about this, especially for products where quality is an important factor.

The Benefits of Target Costing

Target costing provides the following benefits:

• Assures that the business only releases profitable products. This is done by only releasing products that can achieve the business’s desired profit margin even with all the considerations to costs, market demand, etc.
• A product is designed with the customer’s needs, specifications, and perceived value in mind. This may result in increased customer satisfaction as they may feel involved with the development of the product
• Related to the previous bullet point, target costing increases the business’s sales prospects; this is because the business’s product development focuses on the needs and wants of its customers
• Since costs are already considered at the earlier stages of the production process, target costing reduces reliance on post-production product revisions. These revisions can get costly very quick after all, and doing away with them can save the business some money
• As time passes, the business’s production process improves, which can lead to even more profit opportunities. For example, as operations become more efficient, the business can produce more products at the same level of cost – more products to sell at the same cost means more profits
• Target costing makes the business market-driven rather than capability-led. A business may introduce a game-changing product, but if there’s no market for it, it won’t sell. Target costing virtually removes the chance of such a scenario happening. It ensures that the products the business release have a market where they can be reliably sold

Limitations of Target Costing

While target costing provides many benefits, it still has its limitations.

For one, its effectiveness is highly dependent on the people that implement it.

If the team implementing it is not aligned with the target costing process, it probably won’t generate good results.

For example, the project manager continues with the development of a product even if research already shows that it won’t achieve the desired profit margin.

This goes against the process of target costing.

Target costing requires commitment.

When a business is only starting to adapt to target costing, there will be growing pains.

The process can take longer than desired as the design team may require many design iterations to finally come up with one that meets the desired cost levels and profit margins.

This lengthened process may scare away businesses that want to adapt to target costing.

Cost-cutting can also result in finger-pointing in various parts of the business.

This can cause discord and may lower employee morale.

This is especially true if one section of the business is being called on to provide a larger part of the saving.

For example, the production team will feel unhappy if they are required to make changes in the production process to save cots, while the sales team does not have to make any changes in their budget at all.

Target costing can only be as effective as the team implementing it.

As such, the business must make sure that everyone is on the same page when implementing target costing.