The sufficiency of target costing for evaluating production‐related decisions

Target costing is a cost management system designed to develop products with a level of profitability deemed adequate to justify their production. This paper examines whether production‐related decisions made with target costing consistently add economic value to the firm. A traditional target costing model is compared to one that incorporates the cost of capital. An analysis of the two models reveals that the traditional target costing model systematically underestimates the marginal cost of invested funds and overestimates the marginal cost of cash‐related production resources. A numerical example and graphical analysis demonstrate that a traditional target costing model can lead to accepting products that have a negative net present value, while rejecting products that have a positive net present value. Mathematical analysis of a traditional target costing model indicates that it is a systemic property of the model.