Management Accounting · Cost reductions and value enhancement

Target Costing and Kaizen Costing Explained

Updated 11 October 2026 · Fact-checked

Target costing starts with the price the market will pay, subtracts the profit you want, and leaves a target cost. Cost gap = estimated cost − target cost. Kaizen costing cuts costs through small, continuous improvements during production. Target costing works at the design stage; kaizen works after launch.

Understand Cost Reduction Tools: Target Costing and Kaizen

Most firms set price by adding profit to cost. Target costing reverses this. The market decides the price. The firm decides the profit it needs. What remains is the most the product can cost. If the design costs more than that, the firm must find savings before it launches.

The gap between the current estimated cost and the target cost is the cost gap. Teams close it by redesigning the product, using cheaper materials or parts, simplifying processes, or negotiating with suppliers. Value engineering is a common way to do this. It removes cost without cutting the features customers value. Target costing is mainly used at the design and planning stage, when most of a product's cost is still being decided.

Kaizen is a Japanese word meaning continuous improvement. Kaizen costing applies it to production. After launch, the firm sets small cost-reduction targets for each period, for example a 1% cut in cost per unit each month. Employees on the shop floor suggest and make many small changes. Over time the savings add up.

Compare kaizen costing with standard costing. Standard costing sets a fixed standard and measures variances against it. It assumes the current method is acceptable. Kaizen costing treats the standard as a starting point to beat. Each new, lower cost becomes the next target.

Both tools aim at cost reduction, not just cost control. Cost control keeps spending in line with a plan. Cost reduction lowers the planned cost itself. Related ideas you may meet are value analysis, value engineering and life cycle costing.

Key formulas to remember

Target cost: Target cost = Target selling price − Target profit; If profit is given as a margin on selling price, target profit = price × margin %. If it is a mark-up on cost, work from cost instead: cost = price ÷ (1 + mark-up).
Cost gap: Cost gap = Estimated cost − Target cost; A positive gap means the product is too expensive and savings are needed. Zero or negative means the target is met.
Kaizen cost target: New target cost = Previous cost × (1 − reduction %); Applied each period. Reductions compound, so two 2% cuts are not a 4% cut.
Target costing vs kaizen: Target costing: design stage. Kaizen: production stage.; Learn this contrast, as it is the most common exam point.

How to solve Cost Reduction Tools: Target Costing and Kaizen questions

Use this order for any numerical or written question on target costing and kaizen.

1Identify the stage. Design or planning points to target costing. Existing production and small ongoing savings point to kaizen.
2Find the target selling price the market will accept. Do not start from cost.
3Find the required profit. Check whether it is a percentage of selling price or a mark-up on cost.
4Calculate target cost = price − profit. Do this per unit unless told otherwise.
5Calculate cost gap = estimated cost − target cost. Note the sign.
6For kaizen, apply the stated reduction percentage to the previous period's cost, one period at a time.
7If asked how to close the gap, give practical actions: redesign, cheaper materials, fewer components, supplier negotiation, simpler processes, without lowering valued quality.
8Check the answer: is the unit correct and does the result make sense?

Quickest way: Price, profit, cost, gap in four lines

When to use it: Use for number-entry and multiple-choice questions where you need the target cost or the cost gap quickly.

Write price. Write profit beneath it. Subtract to get target cost.
Write estimated cost. Subtract target cost to get the gap.
For margin on price: profit = price × %. For mark-up on cost: target cost = price ÷ (1 + %).
For kaizen over several periods, multiply by (1 − %) each period. Do not add the percentages.

Common mistakes in Cost Reduction Tools: Target Costing and Kaizen

Adding profit to cost to get the price.
Cost-plus pricing is the habit from earlier study.
Fix: In target costing the price comes first. Always compute price − profit.
Treating a mark-up on cost as a margin on price.
Both are stated as percentages of profit and look alike.
Fix: Read the wording. Margin is on selling price. Mark-up is on cost, so divide price by (1 + mark-up).
Getting the cost gap the wrong way round.
Students subtract in whichever order feels natural.
Fix: Use estimated cost − target cost. A positive result means savings are needed.
Adding kaizen reductions instead of compounding them.
Percentages seem easy to add.
Fix: Apply each period's reduction to the previous period's cost.
Saying kaizen costing and standard costing are the same.
Both set cost targets.
Fix: Standard costing holds a fixed standard and reports variances. Kaizen costing keeps lowering the target through continuous improvement.

Worked examples

Example 1

A company plans a new product. Market research shows customers will pay $50 per unit. The company requires a profit margin of 20% on selling price. The current design has an estimated cost of $44 per unit. Calculate the target cost and the cost gap.

Show the solution

Target profit = $50 × 20% = $10.
Target cost = $50 − $10 = $40.
Cost gap = $44 − $40 = $4.

Answer: Target cost is $40 per unit. The cost gap is $4 per unit, so savings of $4 per unit are needed.

Example 2

A factory's cost per unit is $80 at the start of month 1. It uses kaizen costing with a target reduction of 2% per month, applied to the previous month's cost. Calculate the target cost per unit at the end of month 2.

Show the solution

Month 1 target = $80 × 0.98 = $78.40.
Month 2 target = $78.40 × 0.98 = $76.832.
Round to $76.83.

Answer: The target cost per unit at the end of month 2 is $76.83 (not $76.80, which would come from adding 4%).

Exam tips

Check first whether the question is about design stage (target costing) or ongoing production (kaizen).
Underline whether profit is a margin on selling price or a mark-up on cost before calculating.
For multiple-response questions on cost reduction tools, remember that target costing and kaizen both reduce cost, but standard costing mainly controls it.
In number-entry questions, check the unit asked for and the rounding instructions.
If asked how to close a cost gap, choose actions that do not reduce features customers value.

Practice questions from Cost reductions and value enhancement

Cost Reduction Tools: Target Costing and Kaizen in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Cost Reduction Tools: Target Costing and Kaizen: frequently asked questions

What is target costing with an example?

Target costing sets the cost from the market price. If customers pay $50 and you need a $10 profit, the target cost is $40. If the design costs $44, you must find $4 of savings per unit.

How do you calculate the cost gap in target costing?

Cost gap = estimated cost − target cost. A positive result shows how much cost must be removed. It is usually calculated per unit.

What is the difference between kaizen costing and standard costing?

Standard costing sets a fixed standard and measures variances against it. Kaizen costing aims for continuous small reductions, so the target keeps falling. Kaizen focuses on improvement, standard costing on control.

When is target costing used?

It is used mainly at the design and planning stage, before production begins. This is when most of a product's cost can still be changed. Kaizen is used later, during production.