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.

Characteristics of Target Pricing

The key characteristics of target pricing are as follows:

  • Market-driven pricing. In target pricing, the selling price is determined by analyzing market demand, competitor pricing, and customer willingness to pay. The concept emphasizes aligning the product price with customer perceptions of value.

  • Customer-centric approach. Target pricing focuses on delivering products or services that meet customer needs at a price point they find acceptable.

  • Backward cost calculation. The target cost is derived by subtracting the desired profit margin from the target selling price. This encourages cost management to achieve profitability rather than pricing based on production costs.

  • Emphasis on cost control. Target pricing encourages continuous improvement and innovation in production processes to reduce costs and meet target cost goals.

  • Competitive focus. Target pricing takes into account competitor pricing and market conditions to ensure the product remains competitive.

  • Profit-oriented. Target pricing ensures that products are priced to achieve a predetermined profit margin.

  • Iterative process. Target pricing is an ongoing process that may involve revisiting designs, materials, or processes to align with cost objectives.

  • Focus on product design. Target pricing drives decisions about materials, components, and production methods to achieve cost objectives without compromising quality

By emphasizing market-driven pricing, customer value, and efficient cost management, the target pricing concept helps organizations strike a balance between competitiveness and profitability.

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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.

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