Target Costing | Managerial Accounting
In this video we're going to discuss target costing, so target costing is a pricing strategy, and it's, an alternative to cost plus pricing. So if you're not familiar the way cost plus pricing works is you say, look, it cost us 40 to make this product. And we mark up all our products by 25, so we're going to sell this product for fifty dollars. And then every time we sell a product. We will make a ten dollar profit per unit. The way target costing works is you set the price first, and you determine the maximum.
Allowable cost to make that product. And then you go. And you design the product in such a way that you are not going to exceed the maximum allowable cost. This is related to the concept of value engineering from designing the product from the very beginning. You make sure we are not going to exceed the target cost.
For example, let's say that we said, the expected selling price of our product is going to be sixty dollars. Okay, we're going to sell it for sixty dollars a unit and our target profit is we. Want a target profit of fifteen dollars on every unit that we sell, then our target cost would be 45 a unit. In other words, we are going to design this product in such a way that it does not cost more than 45 dollars a unit to make okay. If it goes more than 45 dollars, then we are not going to achieve our target profit. We have failed. Okay.
So we set the price first. And then we say, okay, what's our target profit that we want that tells us our target cost. And we need to somehow get either at 45 or. Below 45 in order for this to be a success. Now, in contrast, so cost plus pricing. The idea is that we're going to say, look, let's build the product first. And then once we built the product and see what it costs.
Then we'll figure out the price based on the cost we'll just take the cost, and we'll mark it up, but with target costing what target cost. You say, look here. The price is just fixed. The price is whatever it is.
In this case we said, 60, but whatever the price is we fixed it. And we say, okay. Now. We're going to build the product so that the cost is low enough to achieve the profit that we want to achieve which in this example, was 15.
So you know, right up front. What the price is going to be, and you're trying to meet this target cost. And so when you're doing this, when you're designing the product, you are trying to avoid over engineering. And that means building in features that the customer isn't necessarily going to value and want to pay extra for okay. So its target costing is very different.Then cost plus pricing, you're trying to make sure that no matter what happens you come in below that maximum allowable cost.
So let's do an example, let's say, your company is going to introduce a new product you're going to do an ultra light hiking backpack, and you're going to compete with the CDT pack that is made by the company LA. Okay. So LA is a real company, and they make the CDT pack, and they sell it for as of the time of this video 145 to buy one of these CDT packs that's, a picture right. There so your firm let's just say that they want to compete on price, so they're, not going to have any better features or anything than this than the CDT pack. They just want to have a similar pack that is cheaper. So customers will just buy it because it's cheaper. So they say, okay, so let's say, your marketing team.
You talk to the marketing team, and you say, uh, okay, well, what should be the price? What are we? And they said, look at a price point of 140 that's, where we feel comfortable we're going to. Undercut so the CDT is 145 we're going to go with 140 that's, just what's going to happen. And we think we're going to sell 5 000 of these backpacks. So you say, okay, well, what is our target profit?
We can think about that. Well, if we're let's just say that there's going to take an investment of 300 000 in order to launch this new product line, you could think of that as working capital tied up, whatever, however, you want to think about it and let's say that the required rate of return is 20 for our. Company where did I come up with that number I'm, just saying that that's, uh, that's, what your company has decided that it wants 20 return on any projects. So basically, you say, 20 times, 300, 000 they're, wanting to make a 60 000 profit on this.
Okay. Now, the maximum allowable cost. The target cost in this situation is going to be 640 thousand dollars. If you divide that by 5, 000 packs, which is what we said, they think they're going to sell be 128 a pack.
But let me go through each step and walk you through. This so you completely understand this first, we said, look, what do we think we're going to do in sales here based on the price? Remember we set the price first we're, not going to build the product and figure out how much it costs. And then later go and set the price. Okay.
So in this case, we say, well is 140 that's going to be our price per unit 5, 000 packs so that's going to be 700 000 in terms of revenue. Now so that's. This is our sales here, 700 000.
Now, the desired profit. I already told you so 300,000 of capital, a 20 rate of return. So basically our company is saying, look, if we do this, we want to have a profit of at least 60 000.
So if we're going to do 700 000 in sales, and we want to have at least 60 000 profit. That means the target cost. The maximum allowable cost is 640 000.
So that's, where I get this number up here, 640 000, just our sales, minus the profit that's going to back out what the cost can be. If the cost is more than 640 000. Then it has failed. We are not going to achieve our. Desired level of profit. Okay. So let's say, the cost comes in at 690 000 or something like that we're, not going to achieve a 60 000.
Profit, it's, not going to happen. So here's. Another way of thinking about it. Instead of just thinking 640 000, if we divide that. So we said, we're going to sell 5. 000 packs. Okay.
So if you divide the 640 000, total cost by 5000. You get the target cost on a per-unit basis, which is 128. So let me just tie all this together. We are saying look we're going to sell this pack for.140 a unit that's the price. So we need to design this backpack in such a way that it does not cost more than 128 dollars per backpack to make in order to achieve our desired return, our desired level of profit.