Target Costing – A Quick Overview

Target costing is a management-accounting technique that flips the traditional approach to pricing on its head. Instead of working out what a product costs and then adding a margin, it starts with the price the market will bear and works backwards to the cost the product must hit. This guide explains what target costing is, how it works, the cost gap and how to close it, where it's used, and why it matters — in plain language. It's a core topic in management accounting, central to CIMA and ACCA study.

What is target costing?

Target costing is an approach in which a company determines the cost a product must be made for, by working backwards from a competitive market price and a required profit margin. The logic is captured in a simple formula:

Target cost = Target selling price − Required profit margin

The company first decides what price the market will accept (the target selling price) and what profit it needs, and the difference is the target cost — the maximum the product can cost to make while still being competitive and profitable. For example, if the market price for a product is £50 and the company wants a £15 profit per unit, the target cost is £35. The challenge then becomes designing and making the product to meet that £35 cost.

Target costing vs traditional cost-plus

This is the opposite of traditional cost-plus pricing, where a company works out the cost of a product and then adds a margin to set the price. The problem with cost-plus is that it assumes the company can charge whatever price covers its costs — which simply isn't true in competitive markets, where the price is set by what customers will pay and what rivals charge. Target costing accepts the market price as a given and makes cost the variable to be managed, which is far more realistic in competitive industries.

The cost gap — and how to close it

When a company first estimates what its proposed product will actually cost to make, that figure often exceeds the target cost. The difference is the cost gap:

Cost gap = Estimated current cost − Target cost

Closing this gap is the heart of target costing. It's done largely at the design stage — because that's where most of a product's costs are effectively locked in — through techniques such as value engineering (improving the design to reduce cost without sacrificing what customers value), simplifying the product, redesigning components, finding cheaper materials or suppliers, and improving the production process. The aim is to get the actual cost down to the target without harming the features customers care about.

Where target costing is used

Target costing is especially common in highly competitive, price-sensitive markets where companies have little ability to set their own prices — such as consumer electronics and the automotive industry. It's strongly associated with Japanese manufacturing, where companies like Toyota helped pioneer the approach as part of a wider drive for efficiency. It works best for products designed and launched in volume, where there's genuine scope to influence cost at the design stage before production begins.

Why target costing matters

Target costing matters because it builds cost discipline and market awareness into product development from the very start. By focusing on cost at the design stage — where it can most effectively be influenced — and by anchoring everything to what the market will actually pay, it helps companies bring profitable, competitively-priced products to market. For management accountants, it's an important, practical technique that links cost management directly to strategy and the end customer.

Frequently asked questions

What is target costing?

A technique where a company sets the cost a product must be made for by working backwards from a competitive market price and required profit margin: target cost = target selling price − required profit.

How does target costing differ from cost-plus pricing?

Cost-plus works out cost then adds a margin to set the price; target costing accepts the market price as given and manages cost down to fit. Target costing is more realistic in competitive markets.

What is the cost gap?

The difference between the estimated current cost of making a product and its target cost. Closing the gap — mainly at the design stage through value engineering — is the core of target costing.

Where is target costing used?

Especially in competitive, price-sensitive markets such as consumer electronics and automotive, where companies can't set their own prices. It's strongly associated with Japanese manufacturing and lean production.

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