What it means
Traditional cost plus pricing starts inside the business and works outwards: total the materials, labour and overhead, add a margin, and quote the result. That works only when customers happen to accept the answer, which in competitive markets they increasingly do not.
Target costing reverses the sequence. Market research establishes the price the product must sell at to win the volume the business wants, the required profit margin is deducted, and the difference becomes the target cost that engineering, procurement and operations must design towards.
The heavy lifting happens before production starts, because roughly 70% to 80% of a product's eventual cost is locked in at the design stage. Once tooling is bought and a specification is frozen, cost reduction becomes a matter of squeezing suppliers rather than rethinking the product.
Closing the gap between the current estimated cost and the target usually involves value engineering: simplifying assemblies, reducing part counts, substituting materials and questioning features customers do not value. Cross functional teams work through the design together rather than passing a cost problem down the line.
The main risk is quality erosion. If a target cost is set too aggressively, teams cut features or specifications that customers actually care about, and the resulting warranty claims and lost repeat sales cost more than the savings ever delivered.
In practice
Real-world examples.
Example
A furniture retailer commits to a $399 price point for a sofa range and works with its factory to design within an $270 cost ceiling. Two fabric options are dropped and the frame is redesigned to ship flat, which alone saves more than the freight budget assumed.
Example
A medical device firm sets a target cost for a disposable sensor based on what hospital procurement teams will pay per test. When the design cannot reach the target without compromising accuracy, the project is stopped before tooling is ordered, saving a much larger loss later.
Example
A car parts supplier bidding for a five year contract knows the customer's price will fall 3% a year. It builds a target cost path for each year and plans the specific engineering changes that will deliver each step, rather than hoping for savings.
Think of it
“Target costing designs products to hit a cost target-starting with price and working backward.
Formula
Calculation
Target cost = target selling price - required profit margin
A consumer appliance maker researches the market and concludes that a new kitchen blender must retail at $250 to compete effectively. Company policy requires a 30% margin on the selling price, so the required profit is $250 x 0.30 = $75.
Target cost = $250 - $75 = $175 per unit. The engineering team's first full estimate comes in at $205, leaving a gap of $205 - $175 = $30 per unit, which is 14.6% of the current cost.
Value engineering closes that gap: replacing a machined housing with a moulded one saves $18, consolidating two circuit boards into one saves $9, and a simpler carton saves $3, for a total of $30. The design is released at $175 and the product launches on price and margin as planned.Case study
Seen in the real world.
This case is illustrative and the company is fictional. Wrenfield Appliances, an invented maker of small kitchen equipment, developed products the way it always had: engineers designed the best machine they could, finance costed it, and sales were told what price was needed. Its newest toaster arrived with a required price of $89 in a market where competitors sold at $69.
Sales achieved a fraction of the forecast volume, and the product was discontinued after fourteen months at a loss. The fictional managing director introduced target costing for the next project, starting from a $69 price and a 32% margin requirement, which set a target cost of about $47.
Reaching it required three uncomfortable decisions: dropping a digital display customers rarely used, standardising the heating element across two product lines, and moving to a single supplier for the outer casing. The replacement product launched on target, and Wrenfield kept the approach for every subsequent range.
Watch out
Common mistakes.
- Setting the target price from internal opinion rather than genuine market evidence, which produces a target cost nobody has any reason to believe.
- Applying target costing only after the design is frozen, when most of the cost has already been committed and only supplier squeezing is left.
- Treating the target as a suggestion, so projects are approved with a known cost gap and a vague promise to close it later.
Questions
People also ask.
Does target costing work for services?
Yes, professional firms use it to design fixed price offerings by starting from what clients will pay and working back to the hours the delivery model can allow.
What if the target cost simply cannot be reached?
That is a valid and useful outcome, and stopping the project early is usually far cheaper than launching an unprofitable product.
Is target costing the same as cost cutting?
No, cost cutting removes spending from an existing operation, while target costing designs the cost out of a product before it exists.
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