Setting inappropriate prices may not be the primary reason that companies are forced to close up shop, but it's as good a reason as any. Set prices too high, and customers walk. Set prices too low, and your business may be forced to shutter its windows and close its doors. To set prices that enable you to earn a decent profit and at the same time not drive your customers away, you might use the target-costing or cost-plus pricing strategies.
Using the target-costing pricing strategy, you set a competitive and strategically appropriate sales price and then subtract the desired profit from this sales price to determine your product’s maximum acceptable production costs. You set a reasonable sales price after considering customers’ salaries, competitors’ pricing schemes and other pricing variables. In turn, your desired profit may be the industry average for similar products or the historical return your company has earned for similar products. The allowable cost is the maximum cost you can incur to achieve the required profit. For example, assume that your company plans to introduce a new line of chairs. You plan to sell a chair for $850 and earn a $300 profit margin, which means your production, distribution and sales costs must be $550 or less.
When implementing the target-costing pricing strategy, you must recognize that to achieve the desired profits, your company must focus on controlling costs because this strategy doesn’t pass costs on to customers in terms of higher prices. Because the unit price and profit is set when this pricing model is used, there is no wiggle room for fluctuations in costs. Due to such cost restrictions, inter-departmental cooperation is essential to achieving production goals with the limited budget. In addition, innovative product and supply chain design may evolve to accommodate the cost commitments that are made during the design phase of product development. Also, the focus of a product’s design tends to be the product features that customers have confirmed they are willing to pay for rather than features the company assumes the customer may want.
The cost-plus pricing strategy ensures that a price is set that will cover the costs of a product or service as well as earn a profit. A company using cost-plus pricing calculates a selling price by first determining the total cost of a product or service. To do so, you add together the direct materials cost, the direct labor costs, the fixed and variable overhead costs, and sales and distribution costs. To obtain the unit cost, you divide the total costs by the number of units. You then add the desired per unit profit to the unit cost to equal the product’s unit price. For example, once again assume that your company is introducing a new line of chairs. The per-unit production and distribution costs are $550 per chair, which includes $250 labor, $150 materials and $150 in fixed and variable overhead. If your company’s typical mark-up is 55 percent above cost, the selling price will be $850.
Simple in its application, the cost-plus pricing method allows you to pass all costs to your customer, regardless of the product or service. The model ignores market and customer data and sets a price based on costs, which best ensures you will recoup those costs and make a profit. The more efficient companies will have lower costs to pass on to the customers, which enables these companies to lower their product prices and remain competitive in the market.