Traditional (or cost-plus) costing and target costing are the most commonly used methods for pricing goods and services. The two methods share some similarities and also exhibit some differences. Businesses choose the method that is most appropriate for their market, product mix and position in an industry.
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Traditional or cost-plus costing has been around for many decades, much longer than target costing. Most businesses prefer it. Target costing was developed in the 1960s by market and cost researchers working for Toyota. Target costing is still most widely practised in and most closely associated with Japan. Many of Japan's leading manufacturers, such as Nissan, Toshiba and Toyota, are known for their devotion to target costing.
Traditional costing involves first determining the total cost of the product (adding together direct, indirect and fixed costs of the total production run, then calculating a per-unit cost and adding an amount for expected profit (called the profit margin). In target costing, the profit margin is subtracted from a set market price to determine a target cost. Then the production procedures are centred around this cost. Essentially, target costing goes in the opposite direction of traditional costing.
Each method has benefits. Businesses like traditional costing for its simplicity. Little data is required initially for cost-plus pricing, and later adjustments to the price can be made more easily than with target costing. Target costing is praised for its efficiency and focus on keeping costs low.
Drawbacks of traditional costing include its tendency to underestimate costs and overestimate profits, leading to wasteful spending and unprofitable products. It is also criticised for inefficiency. Target costing is criticised for its complexity and rigidity. It requires much more attention to the production life cycle. Traditional costing is better suited to process-oriented businesses that use continuous production. Target costing is better suited to assembly-oriented businesses, such as car manufacturing.
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