Many companies face pressure from customers and competitors to keep prices low. Customers threaten to stop buying or to patronize competitors if the company raises prices. These companies may also face rising costs, reducing their profit on each item they sell. These companies pursue different tactics to in order to increase their profits. Some companies use a strategy of target costing to increase their profits without affecting price. These companies receive several benefits from using this approach.
Target costing involves a reverse analysis of the product, starting with the selling price. The company considers the projected price for each unit and its desired profit on the item. The company subtracts the desired profit from the selling price to determine the target cost per unit. The company assembles representatives from various departments to participate on a team to achieve the target cost. The team leader starts with the current cost information and calculates the amount of cost that it needs to eliminate. Together, the team comes up with ideas for reducing costs and reaching the target.
One benefit of target costing falls on the side of proactively focusing on cost. By pursuing a strategy of target costing, the team aims to reduce the product cost before the company starts losing money. This reduces total losses incurred by the company. The alternative approach, less beneficial, is reacting to customer pressures and focusing on cost reduction after the company starts losing money.
Another benefit of target costing is the improved processes that result from the team’s efforts. Target costing teams consider material costs, labor requirements and processes. Teams often discover inefficiencies in current processes and recommend improvements that increase efficiency and reduce costs. These improvements apply to the product being targeted as well as other products using the same process. By improving processes, the company reduces costs in other product lines as well.
Target costing teams require employees from different departments to collaborate on finding ways to reduce the product cost. These employees learn about the activities that occur in other departments and how their own actions affect others. These employees gain an appreciation for the big picture of the business and build relationships that transfer to future projects.