Skip to content

Strategic Cost Management · Target Costing

How to Calculate Target Price, Target Cost and Cost Gap

Updated 11 October 2026 · Fact-checked

Target costing starts from the market. Target price is what customers will pay. Subtract the desired profit to get the allowable cost. Compare it with the current (drifting) cost to find the cost gap. The gap is the saving you must achieve through design and process changes, usually through value engineering.

Understand Setting Target Price, Profit and Cost Gap

Traditional costing works forward: you add up cost, add a margin, and call the result the selling price. Target costing works backward. The market decides the price, the firm decides the profit it needs, and cost is whatever is left. If the product cannot be made at that cost, the firm must redesign it or drop it.

The chain has four numbers. Target selling price is the price at which the firm expects to win its planned share of the market. Target profit is the margin the firm needs, set as a percentage of selling price, as a return on investment, or as a fixed amount per unit. Allowable cost is target price minus target profit.

The fourth number is the cost you can actually achieve today. The drifting cost (also called the current or estimated cost) is what the product costs with the present design and processes. It is called drifting because, left alone, costs tend to drift upwards.

The cost gap is drifting cost minus allowable cost. A positive gap means the product is too costly and you must close it. A zero or negative gap means the product already meets the target.

In practice, the allowable cost may be too tough to hit at once. Management often sets a target cost that sits between the drifting cost and the allowable cost. Then the gap to close in the first round is drifting cost minus target cost. Read each question to see which cost it asks you to compare with. The margin base matters too: a margin on sales and a mark-up on cost give different answers.

Key rules to remember

Target profit (on sales)
Target profit = Target selling price × Desired profit % on sales
Use this when the margin is given as a percentage of selling price.
Allowable cost
Allowable cost = Target selling price − Target profit
Also equals Target price × (1 − margin % on sales).
Target price from cost plus mark-up (check)
Price = Cost × (1 + mark-up %)
Only for converting a mark-up on cost into a margin on sales. Mark-up m on cost equals margin m ÷ (1 + m) on sales.
Cost gap
Cost gap = Drifting (current) cost − Allowable (or target) cost
Positive means the cost must be reduced. State which benchmark you used.
Target profit from ROI
Target profit = Capital employed × Required return %
Divide by units to get profit per unit. Use the same period for profit and units.
Gap as a percentage
Gap % = Cost gap ÷ Drifting cost × 100
Shows how much of the current cost must be cut.

How to solve Setting Target Price, Profit and Cost Gap questions

Use this order for any question on target price, profit and cost gap. It keeps the margin base and the benchmark clear.

  1. 1Find the target selling price. It may be given, or you may need to read it from market data such as a competitor's price or a price that gives the planned volume.
  2. 2Find the target profit. Check the base: percentage of sales, mark-up on cost, return on capital, or a fixed rupee amount per unit.
  3. 3Compute the allowable cost as target price minus target profit. Work per unit unless the question asks for totals.
  4. 4Compute the drifting cost per unit from the data given. Add all manufacturing, selling and other costs the question includes. Leave out any cost it tells you to exclude.
  5. 5Compute the cost gap as drifting cost minus allowable cost. If a separate target cost is given, also compute the gap against it.
  6. 6Break the gap into cost components if asked. Spread the reduction by component, for example in proportion to current cost, or as management directs.
  7. 7State the decision in a line. Say whether the product is viable, the size of the gap in rupees and percent, and what must be done to close it.

Quickest way: Three-line cost gap check

When to use it: Use when the question gives price, margin and current cost and asks for allowable cost or cost gap.

  1. Write: Price − Profit = Allowable cost. Fill in the numbers per unit.
  2. Write: Drifting cost − Allowable cost = Gap. Check the sign.
  3. Write the gap percentage and one decision line. Do a quick reverse check: allowable cost plus profit should equal price.

Common mistakes in Setting Target Price, Profit and Cost Gap

  • Treating a margin on cost as a margin on sales

    The words 'profit of 20%' sound the same, but the base changes the answer.

    Fix: Read the base. If it is on cost, price = cost × 1.20. If it is on sales, allowable cost = price × 0.80. Convert if the question mixes the two.

  • Subtracting in the wrong direction for the cost gap

    Students subtract allowable from drifting out of habit in one question and reverse it in the next.

    Fix: Always write drifting cost first. A positive answer means cost must fall.

  • Confusing allowable cost with target cost

    Many textbooks use both words loosely.

    Fix: Allowable cost is price minus required profit. Target cost is the achievable goal management sets, which may be higher than allowable cost. Follow the question's labels and state your assumption.

  • Adding the profit to the allowable cost again

    Students forget that profit is already taken out of the price.

    Fix: Do a reverse check. Allowable cost plus target profit must return the target price.

  • Mixing total and per-unit figures

    Capital employed and total costs are given in totals, but price is per unit.

    Fix: Convert everything to per unit or everything to total before comparing. Write the unit beside every figure.

  • Stopping at the number without a conclusion

    Students treat it as a pure calculation.

    Fix: End with a recommendation: the gap, its percentage, and the step to close it, such as value engineering or dropping the product.

Worked examples

Example 1

Sunrise Appliances Ltd plans to launch a mixer-grinder. Market research shows customers will buy the planned volume at ₹4,000 per unit. The company needs a profit of 20% on selling price. The current design costs ₹3,500 per unit. Calculate the allowable cost, the cost gap and the gap as a percentage of the current cost. State what the company should do.

Show the solution
  1. Target selling price = ₹4,000 per unit.
  2. Target profit = 20% × ₹4,000 = ₹800 per unit.
  3. Allowable cost = ₹4,000 − ₹800 = ₹3,200 per unit.
  4. Drifting cost = ₹3,500 per unit.
  5. Cost gap = ₹3,500 − ₹3,200 = ₹300 per unit.
  6. Gap % = ₹300 ÷ ₹3,500 × 100 = 8.57% (approx).
  7. Check: ₹3,200 + ₹800 = ₹4,000, which matches the target price.

Answer: Allowable cost is ₹3,200 per unit. The cost gap is ₹300 per unit, about 8.57% of the current cost. The product is not yet viable. The company should use value engineering and supplier negotiation to cut ₹300 per unit before launch.

Example 2

Bharat Cycles Ltd is planning a new model. The competitive price is ₹9,000 per unit. The company has capital employed of ₹60,00,000 in this line and needs a 15% annual return on it. Planned sales are 2,000 units a year. The estimated cost per unit with the present design is ₹8,000. Management sets a target cost of ₹7,600 for the first round. Find (a) target profit per unit, (b) allowable cost, (c) the cost gap against allowable cost and (d) the gap to close in the first round.

Show the solution
  1. Required return in total = 15% × ₹60,00,000 = ₹9,00,000 per year.
  2. (a) Target profit per unit = ₹9,00,000 ÷ 2,000 = ₹450.
  3. (b) Allowable cost = ₹9,000 − ₹450 = ₹8,550 per unit.
  4. (c) Drifting cost is ₹8,000, which is below ₹8,550. Cost gap = ₹8,000 − ₹8,550 = −₹550. A negative gap means the current cost is already ₹550 below the allowable cost.
  5. (d) First-round gap = drifting cost − target cost = ₹8,000 − ₹7,600 = ₹400 per unit.
  6. Check: at ₹8,000 cost the profit is ₹1,000 per unit, which exceeds ₹450.

Answer: (a) ₹450 per unit. (b) ₹8,550 per unit. (c) The gap is −₹550, so the product already meets the allowable cost. (d) Management's stretch target requires a further reduction of ₹400 per unit in the first round. The product is viable even without it.

Exam tips

  • Write the chain as price, profit, allowable cost, drifting cost, gap, and fill in each line. Even if your arithmetic slips, you earn method marks.
  • Underline the margin base in the question: on sales, on cost, or on capital employed. This one word changes the answer.
  • In MCQs, check whether the question asks for allowable cost, target cost or cost gap. Wrong options are often the other two figures.
  • In written answers, finish with the gap in rupees and percent and one line on how to close it. Examiners look for a recommendation.
  • If the cost gap is negative, say so clearly. Do not force a positive number.

Practice questions from Target Costing

Setting Target Price, Profit and Cost Gap: frequently asked questions

What is the difference between allowable cost, target cost and drifting cost?

Allowable cost is target price minus required profit. Drifting cost is what the product costs now with the present design. Target cost is the goal management sets, which can sit between the two when the full allowable cost is too hard to reach at once.

How do you calculate the cost gap in target costing?

Cost gap = drifting cost − allowable cost (or target cost, if the question gives one). A positive figure is the saving the firm must make. If the figure is negative or zero, the product already meets the target.

How is target price decided?

It comes from the market, not from cost. The firm studies customers' willingness to pay and competitors' prices, then picks the price that gives its planned volume or share. Cost is then managed to fit that price.

What if the profit margin is given as a mark-up on cost?

Convert it first. With a mark-up of m on cost, cost = price ÷ (1 + m). For a 25% mark-up and a price of ₹1,000, the cost is ₹800 and the profit is ₹200, which is 20% on sales.