Final answer:
Target costing is a method used to manage costs based on a competitive market price to ensure profitability. It involves setting a selling price, subtracting desired profit, and targeting the resultant cost during product development to stay profitable. Firms must optimize costs to maintain profitability at given market prices.
Step-by-step explanation:
Target costing is a pricing method used by firms to manage costs and ensure profitability in a competitive marketplace. It determines the desired cost for a product based upon a given competitive price such that the product will yield a sufficient profit margin. In essence, the firm starts with a target selling price, subtracts the desired profit margin, and then aims to create a product that meets this remaining cost structure.
The process of setting prices using target costing involves understanding the cost of production and the desired profit which together, shape the price that a firm sets for its product. In a perfectly competitive market, a firm is considered a price taker and must adapt to the prevailing market price, optimizing cost structures to remain profitable while meeting this given price. In such markets, total revenue is calculated as the price multiplied by the quantity sold, and highest profit is determined by comparing this total revenue with total costs.
For example, if a firm determines that the market price for their product is $28, they would calculate their total revenue based on this price and the number of items sold, continually adjusting the cost structure to maximize profits while adhering to the market price.