Target costing is a very powerful tool that seeks to ensure profitability of a company’s products and services. In short, target costing is used to evaluate the design and functionality of products and services that will support a given level of profitability. Target costing is oftentimes used in the R&D phase of new products and services, and can, if effectively used, act as the cornerstone of profitable product development.

The process of Target Costing contains several steps, which are listed below.

1. Determining the target profit and target cost
The first step of target costing is to determine the target profit level. The calculation is relatively simple, and a simple example is given below.
Profit = Selling price – Production Costs
1.000$ = 2.500$ - Production Costs
Production Cost = 1.500 $

Therefore, to reach the target profit, the cost of the product must not exceed 1.500$.

2. Perform functional cost analysis
During this step engineers are developing the functionality of the product, and develop the “Bill of Material” (BOM) for the product and create the identifies the workload required for producing the product. The cost of the materials, labor cost and potential overheads are added together to an estimated cost price, of the product. If the cost is not in line with the target cost, the cost must be lowered in the design and/or workload. The design will undergo changes in its functionality and design until the target cost level is reached.

The redesigning of the product to fit the target cost should not result in a product, that will not satisfy the customer, and that will not be demanded by the market. If cost savings cannot be obtained in the product re-design, the product could be seen a unprofitable product, that will not be able to meet market demands and expected profit levels. Therefore, Target Costing must recognize both the target cost and functionality, because revenues and profits will only be actualized if customers are willing to pay for the functionality of the supplied product.

3. Close the design and release for production
If the newly developed product is satisfying target costs and customer demands, the product is ready for its final production and distribution to customers.

If the assumptions of potential selling price and cost levels holds true, the company will generate the expected profit targeted in the initial stage the target costing process.