12.2: Cost-Plus or Target Costing Decisions
Learning Outcomes
- Create a report outlining the data to support a cost-plus pricing or target costing decision
Cost-plus pricing , is when a company figures out their total cost of a product and adds the profit as a “mark-up” above the cost. If a company has a more unique item, that consumers are willing to pay a premium for, cost-plus pricing can be effective. These companies are called PRICE-MAKERS. They get to decide, based on the fact that their item can be differentiated from other products on the market, and priced based on this justification.
So, if a company’s cost to make a widget is $5.00 and they want a 50% profit, they will charge $7.50 for the widget calculated as follows:
We can also look at cost plus pricing like this:
Total Costs + Desired Profit = Desired Revenue
$5.00 + ($5.00 x 50%)= $7.50
Target costing , involves looking at what the company wants for a profit, the price for the product that the market will bear, and then determines how to potentially cut costs to reach the desired profit. Products with a lot of competition, or that are not unique, may need to be priced in this manner. These companies are called PRICE-TAKERS. They need to price based on a market average, or to meet the pricing that the market will bear, due to other substitute products being available at the same or lower prices.
So in our widget example, it would be calculated in this way:
This concept looks like this:
Revenue − Desired Target Profit = Costs
($7.50 − $2.50 = $5.00)
When we look at this process, the pressure is put on the buyers at the company to find the lowest priced components in order to lower costs and create the desired profit for the company.
There is a great deal of pressure to keep costs low and profits high. In a competitive market, it may not be possible to get the desired profit without competitively pricing the item and then lowering costs through an effective purchasing system.
Some items, such as the fuchsia Hupana Running Company high tops, won’t have that pressure, but what if you sell paper clips? People may not be willing to pay more for a paper clip no matter how much you spend on your components, right?
Picking how to price your products, cost-plus pricing or target pricing will depend on the market for your product and what price the consumers are willing to pay.
Practice Questions