Question

Class: ACCT-301 --> WEEK 7: CAPITAL BUDGETING

What is the target cost, and how is it determined?

Answer 1

Target cost means determination of the lowest cost for a particular product which will fetch desired profit. It is used by the management to survive under the increasing competitive environment (e.g. price war).

It is determined by reducing desired profit from expected selling price of the product.

i.e. Target Cost = Expected Selling Price (-) Desired Profit

Under Target costing, selling price is fixed based on product specifications, quality and the customers requirements, expectations and price of identical/ substitute products in market. Also target product volumes needs to be considered since there is a relation between price and volume.

Example:

ABC Ltd. is a company operating into FMCG industry. It sells toiletries through its own distribution channels to consumers. It can charge maximum USD 10 per unit. If the company wants to earn minimum of 5% profit margin, calculate target cost per unit.

Solution:

Desired Profit = Expected Selling Price * Desired Profit margin

= 10 * 5%

= USD 0.5 per unit

Target Cost = Expected Selling Price (-) Desired Profit

= 10 - 0.5

= USD 9.5 per unit