Target cost is is the process the entity desire to incur in order to earn specific amount profit from market price. The whole process of computing target cost is known as target costing.
Target costing begin by specifying a product an organization wishes to sell. This will involve extensive customer analysis, considering which features customer value and which they do not. Ideally only those features valued by customer will be included in product design.
The second process in establishing target cost is to determine the price of the product. This will take into account competitors products and the market condition expected at the time that the product will be launched. Hence the heavy emphasis is placed on external analysis before any consideration is made of internal cost of the product.
After determining the product price the entity must decide on the desired margin and deduct the margin to have the target cost. The margin established may be gross or net margin. The entity will need to meet this target cost if the desired margin (profit) is to be met.
After production of the prototype the cost of product is established and compared to target cost established.
If actual cost of product (prototype) can not be achieved (is more than target cost) the short fall is called cost gap. This gap is is closed by some form of cost reduction such as changing of materials, redesigning the product and so forth. cost gap must be eliminated to enable the entity to achieve desired margin (profit).