Skills to Develop
- Understand how to use cost-plus pricing and target costing to establish prices.
The previous section focuses on using differential analysis to assess pricing for special orders. Organizations also use other approaches to establish prices, such as cost-plus pricing and target costing. We cover these two approaches next.
Questions: Companies that produce custom products, such as homes or landscaping for commercial buildings, often have a difficult time determining a reasonable market price. Prices for these products can be determined using cost-plus pricing. How is cost-plus pricing used to arrive at a reasonable price?
Cost-plus pricing10 starts with an estimate of the costs incurred to build a product or provide a service, and a certain profit percentage is added to establish the price. For example, a defense contractor working with the government assumes the cost to build a new fighter jet is $60 million. As there is no open market price for this product, the contractor must come up with an approach to establishing the price that does not rely on market pricing. Based on industry-wide standards and negotiations with the government, the contractor requests a 10 percent markup on cost. If the government accepts this proposal, the contractor will receive $66 million for each plane delivered [$66 million = $60 million + ($60 million × 10 percent)].
The concept of cost-plus pricing sounds simple. However, the difficulty is in determining which costs should be included. Are only variable product costs included? Should fixed manufacturing overhead be included? What about selling costs? The answers to these questions depend on the negotiations between buyer and seller, and should be clearly defined in the agreement. When using cost-plus pricing, it is important to establish in advance which costs are to be included for pricing purposes.
Question: Organizations are constantly trying to find ways to become more efficient and reduce costs. However, once manufacturing firms design a product and begin production, it is difficult to make significant changes that will reduce costs. How can target costing help with this issue?
Target costing11 is an approach that mitigates cost efficiency problems associated with introducing new products by integrating the product design, desired price, desired profit, and desired cost into one process beginning at the product development stage. Target costing has four steps:
Step 1. Design a product that provides the features and price demanded by customers.
Step 2. Determine the company’s desired profit.
Step 3. Derive the target cost by subtracting the desired profit (from step 2) from the desired price (from step 1).
Step 4. Engineer the product to achieve the target cost (from step 3). If the desired target cost cannot be achieved, the company must go back to step 1 and reevaluate the features and price.
For example, suppose Hewlett-Packard designs a laser printer with features that customers have requested and wants to sell it for $240; this is Step 1. Management requires a profit equal to 40 percent of the selling price, or $96 (= $240 × 40 percent); this is Step 2. The target cost is $144 (= $240 − $96); this is Step 3. The product engineers must now design this product in detail to achieve or beat the target cost of $144; this is Step 4.
Cost-plus pricing starts with an estimate of the costs incurred to build a product, and a certain profit percentage is added to establish the price. Companies often use this method when it is difficult to determine a reasonable market price. Target costing integrates the product design, desired price, desired profit, and desired cost into one process beginning at the product development stage.
REVIEW PROBLEM 7.7
Suppose Nike, Inc., has developed a new shoe that can be sold for $140 a pair. Management requires a profit equal to 60 percent of the selling price. Determine the target cost of this product.
The target cost of $56 is found by subtracting the target profit from the target selling price. This calculation is as follows.
- An approach to establishing prices that starts with an estimate of the costs incurred to build a product, and a certain profit percentage is added to establish the price.
- An approach to pricing that integrates the product design, desired price, desired profit, and desired cost into one process beginning at the product development stage.