Target Costing Formula
The core formula is Target Cost = Target Selling Price − Target Profit. The target selling price represents the expected market price, while target profit represents the amount the business intends to earn from each unit.
For example, assume a company expects a product to sell for $250 and requires a target profit of $75 per unit. The calculation is: $250 − $75 = $175. Therefore, $175 is the maximum target cost for producing and delivering one unit while achieving the required profit.
The target cost can then be divided among materials, labor, manufacturing overhead, logistics, sourcing, packaging, and other relevant cost elements. Finance and product teams can use these component targets to evaluate whether the proposed product design supports the intended margin.
How Target Costing Works
Target costing usually begins with market research and product planning. The business estimates a realistic selling price based on customer value, competitive products, positioning, and expected demand. Management then establishes the desired profit level and derives the allowable cost.
Cross-functional teams compare the allowable cost with the estimated cost of the proposed design. If the estimated cost exceeds the target, teams investigate design alternatives, materials, sourcing options, manufacturing methods, packaging, and other cost drivers. The objective is to achieve the required functionality and quality within the target cost.
- Market price: Establish the expected selling price for the product or service.
- Profit requirement: Determine the desired profit per unit or required margin.
- Allowable cost: Calculate the maximum cost that supports the financial objective.
- Cost analysis: Break the target into major components and identify cost drivers.
- Design and sourcing decisions: Adjust specifications, materials, suppliers, and processes to meet the target.
Target Costing and Costing Methods
Target costing differs from conventional cost-plus pricing because the desired selling price and profit are established before the allowable cost is finalized. The resulting target becomes a design and operating constraint rather than simply a measurement made after production.
Traditional costing approaches can still provide useful information within this framework. Full Costing considers the complete set of relevant costs associated with a product or service and can provide a broader baseline for comparing estimated costs with the target.
Process Costing is relevant when production involves standardized, continuous, or repetitive processes. Its cost information can help identify the manufacturing cost components that need to remain within the target for high-volume products.
Applications in Procurement and ERP Planning
Target costing has a direct connection with procurement because purchased materials and services can represent a significant portion of the allowable product cost. Procurement teams can use target component costs when evaluating suppliers, negotiating commercial terms, and selecting sourcing strategies.
ERP configuration also matters because target-cost information may need to connect product structures, purchasing data, inventory records, and financial reporting. During ERP integration or migration, finance teams should ensure that cost classifications remain consistent with the organization's chart of accounts and management-reporting requirements.
When an organization is evaluating whether its ERP environment can support increasingly detailed product-cost and profitability workflows, resources such as When to Move from Free ERP to Paid can provide context for assessing ERP capability, integration requirements, and finance-process expansion.
Benefits and Management Decisions
Target costing gives management a forward-looking framework for protecting profitability during product development. Because cost objectives are established before production begins, teams can evaluate design and sourcing choices in relation to their expected financial impact.
The method can support decisions about product specifications, supplier selection, make-or-buy alternatives, production processes, packaging, and market positioning. It can also improve communication between finance, engineering, procurement, merchandising, and operations because each function can work toward a defined cost objective.
Target costing should be distinguished from Target Interest, which is a separate finance term concerned with interest-related targets rather than product cost management.
Best Practices for Target Costing
Successful target costing requires reliable market assumptions, realistic profit objectives, accurate cost estimates, and continuous collaboration among the functions that influence product economics. The target should be reviewed when major changes occur in product specifications, supplier pricing, market conditions, or production assumptions.
- Base target prices on credible market and customer information.
- Set profit objectives that align with broader business performance goals.
- Break total target cost into actionable material, labor, overhead, and sourcing components.
- Involve procurement and operations early because supplier and process decisions can materially affect achievable cost.
- Compare estimated, target, and actual costs to identify opportunities for continuous improvement.
- Maintain consistent cost classifications across operational and financial systems.
Summary
Target Costing starts with an expected selling price and desired profit to determine the maximum allowable product cost. Its formula, Target Cost = Target Selling Price − Target Profit, provides a clear financial objective for product design, sourcing, production, and procurement decisions. By connecting market expectations with cost planning, the method helps businesses manage product profitability before costs become embedded in operations.