Strategic Cost Management · Target Costing

Target Costing Concept and Process Explained

Updated 11 October 2026 · Fact-checked

Target costing is a market-driven method. You start with the price customers will pay, subtract the profit the firm needs, and the result is the target cost: Target Cost = Target Price − Target Profit. If the current cost is higher, the gap must be closed by redesign and cost reduction before launch.

Understand Target Costing Concept and Process

Most firms used to work out cost first, add a markup, and hope the market accepted the price. That is cost-plus pricing. It works only when the firm has little competition. If customers will not pay the price, the firm is stuck with the cost it has already built in.

Target costing reverses the order. The market sets the price. The firm decides the profit it must earn. What is left is the most the product can cost. The cost is a limit set before the product is made, not a figure found after.

The key idea is that most of a product's cost is locked in at the design stage. So target costing works mainly during planning and design. Teams from design, production, purchasing, marketing and accounts work together to find a design that meets the cost limit while still giving customers the features they value.

The process runs in a sequence. You study the market and fix a target selling price. You fix a target profit, often as a percentage of selling price or as a return on investment. You find the target cost by subtraction. You compare it with the estimated current cost. The difference is the cost gap, which the team must close using value engineering, supplier negotiation and process improvement.

If the gap cannot be closed, the firm should drop or redesign the product rather than launch it at a loss. The process continues after launch through continuous cost reduction (kaizen).

Key rules to remember

Target cost: Target Cost = Target Selling Price − Target Profit; Price comes from the market. Cost is the balancing figure.
Target profit on sales: Target Profit = Target Selling Price × Required profit margin %; If the profit is given as a markup on cost, convert it to a margin on selling price first. A 25% markup on cost equals 20% on selling price.
Target profit on investment: Target Profit = Capital employed × Required return %; Divide by the number of units to get profit per unit.
Cost gap: Cost Gap = Estimated Current Cost − Target Cost; A positive gap means cost must be reduced. Zero or negative means the target is met.
Cost-plus price: Selling Price = Cost + Markup; Traditional approach. Target costing uses Cost = Price − Profit.

How to solve Target Costing Concept and Process questions

Use this order for any numerical or theory question on target costing.

1Identify the target selling price. Use the market or competitor price given in the question. If price is given to be cut or changed, use the new price.
2Find the target profit per unit. Check whether it is a percentage of sales, a markup on cost, or a return on capital employed.
3Convert the profit to a per-unit rupee figure on a selling-price basis.
4Calculate Target Cost = Target Price − Target Profit.
5Work out the estimated current cost per unit, adding up all components given (material, labour, overhead).
6Compute the cost gap = Current Cost − Target Cost.
7If asked, suggest ways to close the gap: value engineering, cheaper materials, design simplification, supplier negotiation.
8State a clear conclusion: whether the product can be launched, redesigned or dropped.

Quickest way: Price minus profit, then compare

When to use it: Use this for MCQs and for the first part of any numerical question when time is short.

Write the price and the profit as rupees per unit.
Subtract to get the target cost.
Subtract the target cost from the current cost to get the gap.
For a markup on cost, divide: profit on price = markup ÷ (100 + markup).
Check the sign of the gap and write one line of conclusion.

Common mistakes in Target Costing Concept and Process

Adding a markup to cost to find the price.
Students are used to cost-plus pricing and apply it by habit.
Fix: Start from the price. In target costing, cost is derived: Price − Profit.
Treating a markup on cost as a margin on sales.
The words 'profit 25%' are read without checking the base.
Fix: Read the base. If it is on cost, convert: 25% on cost is 25 ÷ 125 = 20% of selling price.
Reporting the target cost as the cost gap.
Two similar figures appear and the question wording is rushed.
Fix: The gap is Current Cost − Target Cost. It is the amount to be removed, not the target itself.
Saying target costing is done after production starts.
Students confuse it with ordinary cost control or standard costing.
Fix: State that it works mainly at the planning and design stage, where most cost gets committed, and continues with kaizen afterwards.
Ending a numerical answer without a decision.
Students stop after computing the gap.
Fix: Add a recommendation: launch, redesign to close the gap, or drop the product.

Worked examples

Example 1

Bharat Appliances plans a mixer-grinder. The market will accept a price of ₹4,000 per unit. The company needs a profit of 20% on selling price. The estimated current cost is ₹3,400 per unit. Find the target cost and the cost gap, and advise.

Show the solution

Target price = ₹4,000.
Target profit = 20% × ₹4,000 = ₹800.
Target cost = ₹4,000 − ₹800 = ₹3,200.
Cost gap = ₹3,400 − ₹3,200 = ₹200 per unit.
The gap is ₹200 ÷ ₹3,400 = 5.88% of current cost.

Answer: Target cost is ₹3,200 per unit and the cost gap is ₹200 per unit. The firm should use value engineering and supplier negotiation to cut ₹200 before launch. If it cannot, the product should be redesigned or dropped.

Example 2

Kaveri Motors currently sets price as cost plus 25% markup on cost. A new scooter costs ₹80,000 per unit, so the cost-plus price is ₹1,00,000. Competitors sell similar scooters at ₹90,000. Kaveri wants the same profit percentage on sales as under its current policy. Using target costing, find the target cost and the cost gap.

Show the solution

Current profit on price = ₹1,00,000 − ₹80,000 = ₹20,000, which is 20% of selling price (25 ÷ 125 = 20%).
Target price = ₹90,000, set by the market.
Target profit = 20% × ₹90,000 = ₹18,000.
Target cost = ₹90,000 − ₹18,000 = ₹72,000.
Cost gap = ₹80,000 − ₹72,000 = ₹8,000 per unit.

Answer: Target cost is ₹72,000 per unit. Cost must fall by ₹8,000 per unit, which is 10% of current cost. Cost-plus would have priced the scooter ₹10,000 above the market and lost sales.

Exam tips

In a numerical, show the three lines separately: target price, target profit, target cost. Marks are given for each line.
Check whether profit is on cost or on sales before computing anything. Examiners often set this trap.
When asked to compare with cost-plus pricing, write the direction of logic for each: cost-plus is cost → price, target costing is price → cost.
End every case answer with a recommendation and one or two practical cost-reduction actions.
In MCQs, remember target cost is a ceiling set before launch, not a historical cost.

Practice questions from Target Costing

Target Costing Concept and Process in other exams

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

Target Costing Concept and Process: frequently asked questions

What is the formula for target costing?

Target Cost = Target Selling Price − Target Profit. The price comes from the market, and the profit from the firm's required return or margin. The target cost is what remains.

How is target costing different from cost-plus pricing?

Cost-plus pricing starts with cost and adds a markup to get the price. Target costing starts with the market price and subtracts the required profit to get the allowed cost. The first is internally driven, the second market driven.

What are the steps in the target costing process?

Fix the target price from the market, set the target profit, compute the target cost, compare it with the current estimated cost to find the gap, and close the gap through value engineering and other cost reduction. Then keep reducing cost after launch.

What happens if the cost gap cannot be closed?

The firm should redesign the product, change features, or drop it. Launching with a gap would give a profit below the target or a loss.