About this episode

Pricing is one of the biggest decisions we make in business. Charge too little and we damage profit. Charge too much and customers may walk away. Target costing gives us a different way to think about price, cost, value and margin.

In this episode, we explain how to price using target costing and why it works differently from traditional cost-plus pricing. We look at market price, desired profit margin, target cost, cost gaps, product design, waste reduction, and how better cost control can help us protect profit without sacrificing quality.

What you’ll learn in this episode

• What target costing means in practical business terms.
• How target costing differs from traditional cost-plus pricing.
• Why customer expectations and market price matter.
• How to calculate a target cost from price and profit margin.
• Why many costs are locked in at the design stage.
• How to identify and close a cost gap.
• Why cost reduction should not damage quality.

What is target costing?

Target costing is a pricing and cost control method that starts with the market. Instead of asking, “What does this product cost us to make?” we begin by asking, “What price is the customer prepared to pay?”

Once we know the market price, we deduct the profit margin we want to achieve. What remains is the target cost. That target cost then becomes the cost limit the business needs to work towards.

This makes target costing a customer-led approach. It forces us to think about value, design, efficiency, cost control and profit before the product is fully made.

Traditional costing versus target costing

Traditional costing, often called cost-plus pricing, starts with cost. We calculate the cost of labour, materials, production, support and overheads. Then we add a desired profit margin to arrive at a selling price.

Target costing works in the opposite direction. We start with the price customers are willing to pay, subtract the profit margin we need, and then work out what the product should cost.

If you want to understand the traditional approach in more detail, our episode on Understanding cost based pricing is a useful comparison.

Why target costing matters

Target costing matters because pricing is not just about adding a margin to whatever the costs happen to be. If costs are too high, the business may lose competitiveness, reduce profit, or struggle to sell at a price the market accepts.

One powerful idea in this episode is that many costs are locked in early, especially during design and planning. Once a product has been designed, sourced and built into production, it can be much harder to reduce costs later.

Target costing encourages us to challenge costs before they happen. That means we can think about materials, design, processes, production methods and customer value from the start.

How target costing works

The episode breaks target costing into a practical process. The method is simple in principle, even though applying it properly takes research, discipline and teamwork.

Step 1: Set the market price

First, we work out the price customers may be prepared to pay. This can involve market research, customer conversations, competitor checks, testing, and understanding the value the product offers.

Step 2: Decide the required profit margin

Next, we decide the profit margin we need. This may be a percentage of the selling price or a fixed amount per unit. The margin must support the wider business, not just one product.

Step 3: Calculate the target cost

We then subtract the required profit margin from the selling price. The result is the target cost. This tells us what the product should cost if we want to achieve the desired margin.

Step 4: Estimate the actual product cost

After that, we estimate what the product is likely to cost across its life cycle. This may include materials, labour, production, support, distribution, and other relevant costs.

Step 5: Close the cost gap

If the estimated cost is higher than the target cost, we have a cost gap. The business then needs to close that gap by improving design, reducing waste, changing processes, reviewing materials, or removing features that do not add value for the customer.

A simple target costing example

The episode uses a clear example. If the market price is $25 and the required profit margin is $5, the target cost is $20.

If the actual estimated cost is $22, there is a $2 cost gap. The business then needs to reduce costs by $2 without damaging quality or customer value.

This is where target costing becomes more than a pricing method. It becomes a way to improve cost control, challenge waste and protect profit. For more on the link between costs and profit, listen to Knowing Your Costs Makes You Money.

Benefits of target costing

• It starts with what customers are prepared to pay.
• It protects profit margin from the beginning.
• It encourages cost control before production begins.
• It helps reduce waste and unnecessary features.
• It supports better pricing decisions.
• It keeps quality and customer value in focus.
• It can improve competitiveness when used properly.

Challenges of target costing

Target costing is not perfect for every business or every product. It can require more research, more planning, and more attention to the full production life cycle.

It may also feel more complex than traditional cost-plus pricing. That is because we need to understand the market, customer expectations, desired margins, production costs, and design choices before finalising the product.

However, that discipline can be valuable. It helps us avoid accepting costs simply because they already exist. Instead, we challenge costs before they become locked into the business.

Practical steps for using target costing

• Research what customers are prepared to pay.
• Understand the value your product or service delivers.
• Set a realistic profit margin before production starts.
• Calculate the target cost from price minus profit margin.
• Estimate the actual cost over the product life cycle.
• Identify any cost gap between actual cost and target cost.
• Review design, materials, processes and waste.
• Reduce costs without reducing quality or customer value.
• Choose the pricing method that fits your market, customers and product mix.

Related episodes

• How to price your products or services
• Understanding cost based pricing
• Knowing Your Costs Makes You Money

Key takeaway

Target costing helps us price with the customer, market and profit margin in mind. Instead of accepting costs after they happen, we work backwards from the selling price and design the product around the cost the business can afford.

The aim is not to cut corners. The aim is to remove waste, challenge unnecessary costs, protect quality, and improve profit margins. When we understand the target cost, we can make better decisions before the product reaches the customer.

If pricing, costs, or margins feel unclear, visit ihatenumbers.co.uk or listen to the related episodes above to build more confidence with your numbers.

Plan it, Do it, Profit.

“Target costing asks what your product should cost, not just what it does cost.”

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Episode Timecodes

• 00:00 – Why pricing products is such a big business question
• 00:43 – Introducing target costing and cost reduction
• 01:27 – Traditional costing and cost-plus pricing explained
• 02:16 – Background to target costing and Japanese manufacturers
• 03:00 – How target costing differs from traditional costing
• 04:02 – Benefits and drawbacks of each costing method
• 05:09 – Target costing as cost control in reverse
• 06:54 – The five-step target costing process
• 07:44 – Example: price, profit margin and target cost
• 08:04 – Closing the cost gap without damaging quality

About the Podcast

The I Hate Numbers podcast helps business owners understand accounting, tax, finance, profit, cash flow, and business planning in a practical way. We simplify financial topics so you can make better decisions and feel more confident with your numbers.

You can also watch more practical finance and tax support on the I Hate Numbers YouTube channel, or listen and follow on Apple Podcasts.

Further Support

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https://www.ihatenumbers.co.uk/i-hate-numbers-book/

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🌐 Website

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How much should you charge for your products? That's a question that's occupied the minds of millions of business owners over the century. There are many answers to that question, and one such answer is to apply something called target costing, and target costing is the theme of this week's podcast on I Hate Numbers.

You are listening to the I Hate Numbers Podcast with Mahmood Reza. The I Hate Numbers podcast mission is to help your business survive and thrive by you better understanding and connecting with your numbers. Number love and care is what it's about. Tune in every week. Now, here's your host, Mahmood Reza.

Hi folks. Welcome to another weekly episode of I Hate Numbers, the podcast that has as part of its mission to help you increase your financial awareness, improve your money mindset, help you make more profit, save tax and time. What's not to love about that? Let's crack on with the podcast. Now, it's generally observed under target costing that costs you have in your business can be reduced by as much as 25 to 30%.

That's some saving, and that's compared to using traditional costing techniques. Target costing bases its price on what the customer is prepared to pay. It ignores the cost to begin with, and it ultimately ends up figuring out how much your product should cost you as opposed to how much your product does cost you.

Let me expand that in more detail. Now, under traditional or cost plus costing, what happens is we figure out the cost of making the product, we take into account the cost of labor, the cost of materials, we take into account the production cost, the support cost, to work out, to manufacture that product, work out an average unit cost, add on an expected profit

element, the profit margin, and we arrive at the base price that we charge to our customers. Target costing, on the other hand, ignores that approach and even though target costing has some similarities with traditional or cost-plus costing, it also has some marked differences. Remember, ultimately, folks, choose the pricing option, the pricing strategy that best fits your market, your customers, your mix, your position in your industry.

And remember, pricing is a tool that you use in your toolkit depending on what your expectations and requirements actually are. Now, traditional costing to give you some background has been around for much longer than target costing. Target costing is considered very much the new kid on the block, and by new kid on the block,

it's been with us since the 1960s. Target costing was developed way back in the 1960s by market and cost researchers working for that big well-known Japanese car manufacturer Toyota. Target costing is still most widely practiced in and mostly connected with Japan. Many Japan's leading manufacturers such as Nissan, Toshiba, Toyota are still known for their devotion

and admiration of target costing. Let's explore the methodology behind it. Now, traditional costing involves, first of all, as we said, figuring out the total cost of the product, taking into account all the direct, indirect, and fixed costs of the production, figuring out an average unit cost, and then adding an amount for that, that gives you the profit. In target costing,

however, the profit margin that we require is taken away, is subtracted from a determined market price to give us our target cost. That target price, that target cost, by the way, is figured out by talking to our consumers, talking to our clients, asking them based on the attributes of what we are delivering, what price are they prepared to pay.

So, it's definitely a market research, a market-orientated approach. The production procedures are then lasered in, are centered on this cost, and target costing goes in the opposite direction of traditional costing. Now, each method that we've mentioned here, traditional costing and target costing, both have their benefits.

Businesses do like the simplicity of traditional costing. We require relatively small amounts of information initially for cost-plus-pricing, and later on, we can make more adjustments to the price and tweak it much more easily than target costing. Target costing has at the top of its recommendations, its efficiency and focus on keeping costs low.

Now, as with all methods, there are drawbacks. The drawbacks of traditional costing is the tendency to underestimate costs and overestimate profits. Wasteful spending and unprofitable products become a result. Also, we create that climate that we accept costs, we don't challenge them as much, and one well-known fact is that in designing a product, most of the costs are locked in at the design phase.

So, going forward, once we’ve introduced our product into our production schedules, we're making that product, it becomes very difficult to actually reduce the cost significantly. Target costing has criticisms. It's criticised for its complexity, its rigidity, and it requires much more attention to the production life cycle.

Traditional costing is suited, however, to process-orientated businesses that use continuous production. Very much ones, there's a repetition, assembly-based orientated businesses, ones that such as car manufacturing, are very well suited to target costing. Now, target costing is not just about selling prices, but it's a modern method of cost control, it’s costing in reverse.

The selling price is determined by reading the market environment, the customer expectations, and then deducting a desired profit margin from the selling price. Towards the end of this podcast, I'm going to go through a five-step approach as to how target costing works in practice. In the traditional system,

we, first of all, calculate the budget, we then start the production, and once we've calculated the production, the total cost is calculated, and from this cost, we work out the desired profit margin. Any differences between the actual and expected cost is calculated as a variation and a variance. Now, a target cost is a cost estimate derived by taking off a desired profit margin from your market price,

and your market price is considered to be a competitive one, it is customer-orientated. In some circles, target costing is referred to as price minus costing. Target costing is much shorter in shorthand. Now, target costing doesn't focus on finding out what a new product does cost. Instead, it focuses on finding out what a new product should cost. Quite a distinction between those two.

Any cost reductions have got to be done in such a way that quality is unaffected, because once you go down that quality-damaging route, then your target costing plan will immediately fail. And the last part of this podcast, I'm going to go through this five-step process that one adopts to go through target costing.

Step one, figure out, calculate your selling price at which your product could be sold. Again, market research, asking the client, doing some desk-based research, getting out there and doing some testing, conversations with your customers is absolutely essential. Having got a figure for your target selling price, based on your product attributes, based on the value that you're going to deliver to that customer, you then work out what your desired, required profit margin is.

Typically, this could be expressed as a percentage of selling price or maybe a flat currency figure. Deduct your profit margin from the selling price to arrive at your target cost. Once you've got your target cost, you then consider, over the life cycle of that product, what's the estimated cost of the product, and compare it with your target cost.

It's likely in the last step, you're going to get a cost gap, and that's the cost gap that needs to be closed. Let me throw some numbers into the mix. So, for example, you've determined that a price of a product you wish to sell is going to be $25. You require a profit margin of $5, therefore your target cost will be $20.

That's the 25 less the 5. Now, you calculate the actual cost of the product comes out to be $22, so, therefore, you've got a $2 cost gap. This $2 cost gap is what you've got to reduce. Now, you could do things by examining the product, removing aspects of that product, which don't add any value to the customer experience, but actually still have a component of cost.

You can look at your production processes to see if there are any efficiencies that can be made in how you produce that product. You look at the design phase, and your culture is about challenging costs before you've actually incurred them. Folks, I hope you found this podcast useful. I'd love it if you could share some feedback, give me some comments on them, what you found on them.

If you check out the show notes, I'm going to give you a couple of links also to some further information you can explore and podcasts on the whole world of costs. Until next week, have a fantastic week. We hope you enjoyed this episode and appreciate you taking the time to listen to the show. We hope you got some value.

If you did, then we'd love it if you shared the episode. We look forward to you joining us next week for another I Hate Numbers episode.