Pricing decision for customized products or services is easy, it is a single customer with the pricing decision being based on direct negotiations with the customer for a known quantity, But for non-customized products, it needs full detailed plan of pricing decision, for example pricing of a shoe in show factory, is a non-customized product.
Customized Products: Sales of a single quantity (Or low quantity) to A single customer
Non-Customized Products: Sales of a thousands quantity (Or high quantity) to A unknown quantity of customers
A market leader must make a pricing decision, normally for large and unknown volumes, of a single product that is sold to thousands of different customers. To apply cost-plus pricing in this situation an estimate is required of sales volume to determine a unit cost, which will determine the cost-plus selling price.
This circular process occurs because we are now faced with two unknowns that have a cause-and-effect relationship, namely selling price and sales volume. in this situation it is recommended that cost-plus selling prices are estimated for a range of potential sales volumes. Consider the information presented in Example as below ( case ): (Please click on photo to zoom)
You will see that the Auckland Company has produced estimates of total costs for a range of activity levels instead of adding a percentage profit margin the Auckland Company has added a fixed lump sum target profit contribution of t2 million. The information presented indicates to management the sales volumes, and their accompanying selling prices, that are required to generate the required profit contribution.
The unit cost calculation indicates the break-even selling price at each sales volume that is required to cover the cost of the resources committed at that particular volume.
Management must assess the likelihood of selling the specified volumes at the designated prices and choose the price that they consider has the highest probability of generating at least the specified sales volume. if none of the sales volumes are likely to be achieved at the designated selling prices management must consider how demand can be stimulated and or costs reduced to make the product viable. if neither of these, or other strategies, are successful the product should not be launched. The final decision must be based on management judgement and knowledge of the market The situation presented in Example 5.1 represents the most extreme example of the lack of market data for making a pricing decision. if we reconsider the pricing decision faced by the company it is likely that similar products are already marketed and information may be available relating to their market shares and sales volumes Assuming
that Auckland's product is differentiated from other similar products, a relative comparison should be possible of its strengths and weaknesses and whether customers would be prepared to pay a price in excess of the prices of similar products. it is therefore possible that Auckland may be able to undertake market research to obtain rough approximations of demand levels at a range of potential selling prices. Let us assume that Auckland adopts this approach, and apart from this, the facts are the same as those given in above Example (Case A).
Now look at Case B in above example, The demand estimates are given for a range of selling prices. in addition the projected costs, sales revenues and profit contribution are shown. You can see that profits are maximized at a selling price of £80. The information also shows the effect of pursuing other pricing policies. For example, a lower selling price of 170 might be selected to discourage competition and ensure that a larger share of the market is obtained in the future.
Instead of using the cost-plus pricing approach described in above example (Case A) whereby cost is used as the starting point to determine the selling price, target costing is the reverse of this process. With target costing the starting point is the determination of the target selling price. Next a standard or desired profit margin is deducted to get a target cost for the product. The aim is to ensure that the future cost will not be higher than the target cost.
The stages involved in target costing can be summarized as follows:
Stage 1: determine the target price that customers will be prepared to pay for the product
Stage 2: deduct a target profit margin from the target price to determine the target cost
Stage 3: estimate the actual cost of the product;
Stage 4: if estimated actual cost exceeds the target cost investigate ways of driving down the actual cost to the target cost.
The first stage requires market research to determine the customers' perceived value of the product, its differentiation value relative to competing products and the price of competing products, The target prof it margin depends on the planned return on investment for the organization as a whole and profit as a percentage of sales. This is then decomposed into a target profit for each product that is then deducted from the target price to give the target cost. The target cost is compared with the predicted actual cost. if the predicted actual cost is above the target cost intensive efforts are made to close the gap.
Product designers focus on modifying the design of the product so that it becomes cheaper to produce. Manufacturing engineers also concentrate on methods of improving production processes and efficiency.
The aim is to drive the predicted actual cost down to the target cost but if the target cost cannot be achieved at the pre-production stage the product may still be launched if management are confident that the process of continuous improvement will enable the target cost to be achieved early in the product's life if this is not possible the product will
not be launched. The major attraction of target costing is that marketing factors and customer research provide the basis for determining selling price whereas cost tends to be the dominant factor with cost-plus pricing A further attraction is that the approach requires the collaboration of product designers, production engineers, marketing and finance staff whose focus is on managing costs at the product design stage. At this stage costs can be most effectively managed because a decision committing the firm to incur costs will not have been made. Target costing is most suited for setting prices for non-customized and high sales volume products, lt is also an important mechanism for managing the cost of future products.