Definition: The target cost of a product is the expected selling price of the product minus the desired profit from selling it. In other words, target cost is really a measure of how low costs need to be to make a certain profit.
What Does Target Cost Mean?
In a job order production system or job order manufacturing, a company manufacturers custom products on a limited basis. This process starts when a customer or client brings a custom order to a manufacturer.
Example
Take guitar manufacturing for example. A guitarist comes into Gibson Guitar Company and wants Gibson to make him a completely custom guitar. Gibson will look at the order and first determine if they can produce it. If Gibson decides they can make the custom guitar, they then have to set a selling price. To determine the right selling price, Gibson has to look at the target cost.
Gibson has to look at how much it will cost to produce this guitar and how much it can sell the guitar for. Then Gibson can figure out how much profit it will make on the sale. Here’s the simple target cost formula.
If this profit isn’t enough, Gibson has two options. It can either raise the selling price or figure out how to make the guitar cheaper. As with most retail sales, raising the price is not always an option. Some customers might decide to buy a guitar from some other company. In that case, Gibson has to reengineer its custom guitar and see how it can lower the production costs in order to raise the profit to an adequate level.
