This term refers to the amount of money a company decides to spend on any given product. It could be either establishing a price for a particular item, or setting the production cost for their product. The concept of targeting costs is based on LSS principles, and it can provide benefits to both the company’s profits and its customers.
This is a potentially powerful tool, but it requires a great deal of understanding of how and when to use it. To gain that understanding, we’ll talk about the concept of targeting costs, how it works, benefits, and some best practices.
Overview: What is a cost target?
This is a tool used to identify the lowest cost at which a product can be produced, sold and shipped without losing money. It should be calculated by adding an appropriate mark-up on the variable costs (costs that vary with output) and then the fixed costs (the overhead costs) are added on top of it to achieve the profit goals for a particular project or product line.
The basic concept of targeting costs is that the price of a product or service should be equal to its cost, plus a reasonable profit. In other words, the customer will pay for what it takes to go from raw materials to a finished product. This differs from traditional costing methods, where companies add in profit as an additional charge on top of the overall cost.
3 benefits of cost targets
Better than your target is an ideal cost, which is a budget for the cost of the product, but there are three main benefits of setting the target cost. It’s worth noting that many other benefits are dependent upon reducing the costs of products.
1. It will reduce the costs of your products
Companies that want to make better products will strive to reduce costs by reducing waste and rework.
2. Reducing the costs of products improves product quality
The lower the cost of production, the higher the profit margin. The profit margin can be used to improve product quality or other factors such as employee pay. This will make employees feel valued and keep them motivated.
3. A lower cost of production makes products more affordable to consumers
This allows for a greater customer base and can lead to higher sales.
While quality is the primary focus in many companies, there are times when quality might be sacrificed for other reasons. In order to reduce costs, there are several ways a company can cut corners and still produce an acceptable product.
Why are cost targets important to understand?
This concept is an important KPI for three reasons.
First, it shows how efficient you are at hitting your budget, which can be one of the most important ways to improve profitability. If you are constantly over budget, then you can look at the underlying drivers to find ways to reduce costs. If you are consistently under budget, then you may need to raise your estimates for future projects or make changes in your cost structure.
Second, it can be a good target for profit margin because it gives you a measure of how much profit is required per unit of revenue. This will allow you to assess whether your pricing strategy is working, or if there are other opportunities that may be available.
Third, knowing your targeted costs will help you understand which channels are most important for your business (e.g. marketing channels). For example, if you know that Facebook ads are twice as expensive as Google AdWords, then you will allocate more of your budget to Google AdWords.
An industry example of cost targets
An industry example can be found in the dairy raw materials industry. The amount of milk produced is determined by the number of cows in Wisconsin, and the price that farmers receive for their milk is determined by a complex regulatory formula.
What’s interesting about this market is that it’s a price taker; it has no power over what the price will be. It’s a pure commodity. However, dairy manufacturers have a great deal of control over their costs. This is because they control where their milk comes from and how much they pay for it.
That’s the reason some of them have been able to price their products competitively, while others have not. It’s because they know how to manage their costs and pass those savings on to consumers.
3 best practices when thinking about cost targets
One of the first things to do when launching a new product is to put together a budget. Targets for costs should be set in order to meet the needs of the business and market, and there are some best practices to keep in mind.
1. Allocate a percentage of revenue for each area of cost
Set an appropriate margin for each product. Be aware of timing considerations and planning requirements, as well as accounting practices to be used in the budget. The company must then consider all areas of costs: direct and indirect materials, labor, marketing and sales, distribution, administration, and overhead. Each area is reviewed in detail to ensure that the best course of action is being followed.
2. Analyze what will work for your business, and how much it will cost
This is essential in identifying which products, processes, or services are the most profitable for you or your company. It helps you understand which operations are making money and which ones aren’t. It also allows you to see what your competitors are doing in order to keep up with them.
3. Understand what’s possible, and what you can’t afford
Many organizations have a hard time properly implementing these tools because of an inability to identify what’s possible and what can’t be afforded. Before you can set targets for costs, you need to understand how much money is in your current budget, and how much money is being spent on a given process. Once you know how much money is available to spend, you can set realistic and attainable targets.
Frequently Asked Questions (FAQs) about cost targets
One of the biggest reasons businesses fail is because they don’t know how to control their costs. If you have a budget to work with, then things like these three questions can be of great help.
What is your target cost per unit?
Before you can decide what to cut, you must first establish what it costs you to make each product or service. You can use this number as the benchmark for all of your other decisions.
Can we eliminate any items from every production process?
This is where you will find most of your savings. After determining your cost per unit, go through every production process and determine if you can eliminate any items. If you cannot eliminate an item, then see if you can make it cheaper by changing the materials or suppliers.
Can we consolidate our product lines?
If your company makes multiple products or services, you should look at each one individually to see if there are ways to reduce costs by eliminating any unnecessary steps in the production process.
Can cost targets benefit all companies?
While the LSS concept is an important tool that can be beneficial to companies, it’s also important to note that not all businesses can effectively apply this method. For example, if your business has a high level of uncertainty or variance in its processes, you may need to take a different approach when setting targets. Explore our website to learn more about how LSS can help your company reduce costs and increase profits.