Target pricing definition
/What is Target Pricing?
Target pricing is the process of estimating a competitive price in the marketplace and applying a firm's standard profit margin to that price in order to arrive at the maximum cost that a new product can have. A design team then tries to create a product with the requisite features within the pre-set cost constraint. If the team cannot complete the product within the cost constraint, the project is terminated. By taking this approach, a firm can assure itself of earning a reasonable profit across its product line, without being burdened by any low-profitability products. However, if the standard profit margin is set too high, it may not be possible to develop very many products within the cost constraint.
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Example of Target Pricing
Scuba Corporation wants to use target pricing principles to design and sell a high-end scuba regulator. The steps it follows are noted below.
Step 1. Competitor analysis. The company reviews the other regulators being offered on the market, and notes that the typical high-end regulator costs between $800 and $1,200. They are all made of titanium, because it does not corrode in sea water.
Step 2. Determine target net selling price. The company decides to price its product in the middle of the range, which is $1,000 after deducting for sales discounts.
Step 3. Determine target cost. The company deducts its standard 40% profit margin from the net selling price to arrive at a desired cost of $600 per regulator sold.
Step 4. Conduct cost analysis. At an expected unit volume of 5,000 regulators per year, the company concludes that it can manufacture the titanium regulator, with all necessary features, for $700. This initial analysis reveals that the design team needs to reduce the cost by $100 in order to have a viable product.
Step 5. Reduce costs. The company takes several steps to reduce costs. First, it negotiates with a titanium supplier to reduce the cost by $60 per unit. In addition, the manufacturing staff alters the production process to eliminate $30 of labor from each unit. Finally, the team revises the design of the purge feature on the regulator to save another $10. These changes reduce the overall cost of the design by $100, allowing the company to earn its target profit of 40% per unit sold.
Step 6. Monitor the product. The company rolls out the new regulator product. A cost accountant assigned to the product routinely reports back to management regarding the costs being incurred and margins earned on it over time. In addition, the cost accountant reports on any other cost-savings opportunities as they arise.
In short, Scuba Corporation has employed the target pricing concept to develop a new product that will generate a return that matches the firm’s target profit. If it had been unable to develop the regulator with an adequate margin, the design team would have parked the idea; it might review it at a later date, to see if costs have declined sufficiently to make the product a viable concept.