Target Costing Approach to Pricing:

Learning Objective of the Article: 1. Define and explain target costing. 2. Compute the target cost for a new product or service. What are advantages and disadvantages of target costing approach. In traditional costing system it is presumed that a product has already been developed, has been costed, and is ready to be marketed as soon as a price is set. In many cases, the sequence of events is just the reverse. That is, the company already knows what price should be charged, and the problem is to develop a product that can be marketed profitably at the desired price. Even in this situation, where the normal sequence of events is reversed, cost is still a crucial factor. The company can use an approach called target costing. 1. Definition and Explanation of Target Costing 2. Reasons for Using Target Costing Technique 3. Example of Target Costing Process 4. Advantages and Disadvantages of Target Costing

Definition, Explanation and Formula of Target Costing:

Target costing is the process of determining the maximum allowable cost for a new product and then developing a prototype that can be profitably made for that maximum target cost figure. A number of companies--primarily in Japan--use target costing, including Compaq, Culp, Cummins Engine, Daihatsu Motors, DaimlerChrysler, Ford, Isuzu Motors, ITT, NEC, and Toyota etc. The target costing for a product is calculated by starting with the product's anticipated selling price and then deducting the desired profit. Following formula or equation further explains this concept: Target Cost = Anticipated selling price Desired profit The product development team is then given the responsibility of designing the product so that it can be made for no more than the target cost. Following set of activities further explains the concept of target costing technique: TARGET COSTING PROCESS DIAGRAM Determine Customer Wants and Price Sensitivity

Planned Selling Price is Set


Target Cost is Determined As: Selling Price Less Desired Profit

Teams of Employees from Various Areas and Trusted Vendors Simultaneously

Design Product Determine Manufacturing Process Determine Necessary Raw Materials

Costs are Considered Throughout this Process. The Process Requires Trade-offs to Meet Target Costs

Once Target Cost is Achieved the Manufacturing Begins and Product is Sold

Reasons for Using Target Costing Technique:

The target costing approach was developed in recognition of two important characteristics of markets and costs. The first is that many companies have less control over price than they would like to think. The market (i.e., supply and demand) really determines prices, and a company that attempts to ignore this does so at its peril. Therefore, the anticipated market price is taken as a given in target costing. The second observation is that most of the cost of a product is determined in the design stage. Once a product has been designed and has gone into production, not much can be done to significantly reduce its cost. Most of the opportunities to reduce cost come from designing the product so that it is simple to make, uses inexpensive parts, and is robust and reliable. If the company has little control over market price and little control over cost once the product has gone into production, then it follows that the major opportunities for affecting profit come in the design stage where valuable features that customers are willing to pay for can be added and where most of the costs are really determined. So that it is where the effort is concentrated--in designing and developing the product. The difference between target costing and other approaches to product development is profound. Instead of designing the product and then finding out how much it costs, the target cost is set first and then the product is designed so that the target cost is attained.

Example of Target Costing:

To provide a simple numerical example of target costing, assume the following situations:

Handy Appliance Company feels that there is a market niche for a hand mixer with certain new features. Surveying the features and prices of hand mixers already in the market, the marketing department believes that a price of $30 would be about right for the new mixer. At that price, marketing estimates that 40,000 of new mixers could be sold annually. To design, develop, and produce these new mixers, an investment of $2,000,000 would be required. The company desires a 15% return on investment (ROI). Given these data, the target cost to manufacture, sell, distribute, and service one mixer is $22.50 as calculated below: Projected sales (40,000 mixers $30 per mixer ) Less desired profit (15% $2,000,000) Target cost for 40,000 mixers Target cost per mixer ($9,00,000 / 40,000 mixer) $1,200,000 300,000 -----------$9,00,000 ======= $22.50

This $22.5 target cost would be broken into target cost for the various functions: manufacturing, marketing, distribution, after-sales service, and so on. Each functional area would be responsible for keeping its actual costs within target.

Advantages and Disadvantages of Target Costing Approach:

Target costing has the following main advantages or benefits: 1. Proactive approach to cost management. 2. Orients organizations towards customers. 3. Breaks down barriers between departments. 4. Implementation enhances employee awareness and empowerment. 5. Foster partnerships with suppliers. 6. Minimize non value-added activities. 7. Encourages selection of lowest cost value added activities. 8. Reduced time to market. Target costing approach has the following main disadvantages or limitations: 1. Effective implementation and use requires the development of detailed cost data. 2. its implementation requires willingness to cooperate 3. Requires many meetings for coordination 4. May reduce the quality of products due to the use of cheep components which may be of inferior quality. In Business | Target Costing Approach--An Iterative Process:

Target costing Technique is widely used in Japan. In the automobile industry, the target cost for a new model is decomposed into target costs for each of the elements of the car-down to a target cost for each of the individual parts. The designers draft a trial blueprint, and a check is made to see if the estimated cost of the car is within reasonable distance of the target cost. If not, design changes are made, and a new trial blueprint is drawn up. This process continues until there is sufficient confidence in the design to make a prototype car according to the trial blueprint. If there is still a gap between the target cost and estimated cost, the design of the car will be further modified. After repeating this process a number of times, the final blueprint is drawn up and turned over to the production department. In the first several months of production, the target costs will ordinarily not be achieved due to problems in getting a new model into production. However after that initial period, target costs are compared to actual costs and discrepancies between the two are investigated with the aim of eliminating the discrepancies and achieving target costs.

Time and Material Pricing in Service Companies:

Learning Objective of the Article: 1. Define and explain time and material pricing. 2. Calculate and use billing rates used in time and materials pricing. Contents: 1. Definition and explanation of time and material pricing. 2. Time component 3. Material component 4. Example

Definition and Explanation of Time and Materials Pricing:

Some companies--particularly in service industries-- use a variation of cost plus pricing called time and material pricing. Under this method, two pricing rates are established-one based on direct labor time and other based on the cost of direct materials used. This pricing method is used in repair shops, in printing shops, and by many professionals such as physicians and dentists. The time and material rates are usually market determined. In

other words, the rates are determined by the interplay of supply and demand and by competitive conditions in the industry. However, some companies set the rates using a process similar to the process followed in the absorption costing approach to cost plus pricing. In this case, the rates include allowances for selling, general and administrative expenses; other direct and indirect costs; and a desired profit. This page will show how the rates might be set using the cost-plus approach.

Time Component:
The time component is typically expressed as a rate per hour of labor. The rate is computed by adding together three elements: 1. The direct costs of the employee, including salary and fringe benefits. 2. A pro rata allowance for selling, general, and administrative expenses of the organization. 3. An allowance for a desired profit per hour of employee time. In some organizations (such as a repair shop), the same hourly rate will be charged regardless of which employee actually works on the job; in other organizations, the rate may vary by employee. For example, in a public accounting firm, the rate charged for a new assistant accountant's time will generally be less than the rate charged for an experienced senior accountant or for a partner.

Material Component:
The material component is determined by adding a material loading charge to the invoice price of any materials used on the job. The material loading charge is designed to cover the costs of ordering, handling, and carrying materials in stock, plus a profit margin on the materials themselves.

Example of Time and Material Pricing:

To provide a numerical example of time and material pricing, consider the following: Quality Auto Shop uses time and material pricing for all of its repair work. The following costs have been budgeted for the coming year: Repairs $300,000 40,000 18,000 57,280 720 36,000 8,400 91,600 Parts

Mechanics' wages Service manager--salary Parts manager--salary Clerical assistant--salary Retirement and insurance--16% of salary and wages Supplies Utilities Property taxes Depreciation Invoice cost of parts used

$36,000 15,000 8,160 540 20,800 1,900 37,600 400,000

Total budgeted cost The company expects to bill customers for 24,000 hours of repair time. A profit of $7 per hour of repair time is considered to be feasible, given the competitive conditions in the market. For parts, the competitive markup on the invoice cost of parts used is 15%. The following schedule shows the calculation of the billing rate and the material loading charge to be used over the next year. TIME AND MATERIALS PRICING Time Component: Repairs Per Total Hour* $300,000 48,000 -------348,000 Parts: Material Loading Charge Total Percent**

Cost of mechanics' time:

Mechanics' wages Retirement and insurance (16% of wages) Total cost For repairs--other cost of repair service. For parts--cost of ordering handling, and storing parts: Repairs service manager--salary Parts manager salary Clerical assistant salary Retirement and insurance (16% of salaries) Supplies Utilities Property taxes Depreciation Total cost Desired profit: 24,000 hours $7per hour 15% $400,000 Total amount to be billed

$14.5

40,000 18,000 9,280 720 36,000 8,400 91,600 -------204,000 -------168,000 $36,000 15,000 8,160 540 20,800 1,900 37,600 --------120,000 --------

8.50

30%

7.00 15% ------45% ====

60,000 ------------------$720,000 $30.00 $180,000 ====== ===== ======

*Based on 24,000 hours **Based on $400,000 invoice cost of parts. The charge for ordering, handling, and storing
parts, for example, is computed as follows: $120,000 cost / $400,000 invoice cost = 30% Note that the billing rate, or time component, is $30 per hour of repair time and the material loading charge is 45% of the invoice cost of parts used. Using these rates, a repair job that requires 4.5 hours of mechanics time and $200 in parts would be billed as follows:

Labor time: 4.5 hours $30 per hour Parts used: Invoice cost Material loading charge: 45% $200 Total price of the job

$135 $200 90 --------

290 -----$425 =====

Rather than using labor hours as the basis for calculating the time rate, a machine shop, a printing shop, or a similar organization might use machine-hours. This method of setting prices is a variation of the absorption costing approach. As such, it is not surprising that is suffers from the same problem. Customers may not be willing to pay the rates that have been computed. If actual business is less that the forecasted 24,000 hours and $400,000 worth of parts, the profit objectives will not be met and the company may not even break even.

Price Elasticity of Demand-Economists' Approach to

Pricing:
Learning Objective of the Article: 1. Define and explain the term "Price elasticity of demand". 2. Calculate profit maximizing price of a product of service using the price elasticity of demand and variable cost. If a company raises the price of a product, unit sales ordinarily falls. Because of this, pricing is a delicate balancing act in which the benefits of higher revenues per unit are traded-off against the lower volume that results from charging higher prices. The sensitivity of unit sales to changes in prices is called the price elasticity of demand. 1. Definition and explanation of price elasticity of demand 2. Formula of Price elasticity of demand 3. Profit maximizing price

Elasticity of Demand--Definition and Explanation:

A product's price elasticity should be a key element in setting its price. The price elasticity of demand measures the degree to which the unit sales of a product or service are affected by a change in price. Demand for a product is said to be inelastic if a change in price has little effect on the number of units sold. The demand for designer perfumes sold by trained

personnel at cosmetic counters in department stores is relatively inelastic. Lowering prices on these luxury goods has little effect on sales volume; factors other than price are more important in generating sales. On the other hand, demand for a product is said to be elastic if a change in price has a substantial effect on the volume of units sold. An example of a product whose demand is elastic is gasoline. If a gas station raises its prices for gasoline, there will usually be a substantial drop in volume as customers seek lower prices elsewhere. Price elasticity is very important in determining prices. Managers should set higher markups over cost where customers are relatively insensitive to price (i.e., demand is inelastic) and lower markups where customers are relatively sensitive to price (i.e., demand is elastic). This principle is followed in departmental stores. Merchandise sold in the bargain basement has a much lower markup than merchandise sold elsewhere in the store because customers who shop in the bargain basement are much more sensitive to price i.e., demand is elastic.

Formula and Example of Price Elasticity of Demand:

Price elasticity of demand for a product or service can be estimated using the following formula: [Price Elasticity of Demand = In(1+ % Change in quantity sold) / In(1 + % Change in price)]
The term In( ) is the natural log function. You can compute natural log of any number using the LN or lnx key on your calculator. For example, ln(0.85) = 0.1625 This formula assumes that the price elasticity of demand is constant. This occurs when the relationship between the selling price, P, and the unit sales, q, can be expressed in the following form: ln(q) = a + elasticity of demand ln(p). Even if this is not precisely true, the formula provides a useful way to estimate a product's real price elasticity.

For example, suppose that the managers of Nature's Garden Inc. believe that every 10% increase in the selling price of their apple-almond shampoo will result in a 15% decrease in the number of bottles of shampoo sold. The Calculation of the price elasticity of demand for this product would be as follows: Price elasticity of Demand = In(1 + ( (0.15)) / In(1 + (1.10)) In(0.85) / In(1.10) = 1.71
The estimated change in unit sales should take into account competitor's responses to a price change.

For comparison purposes, the managers of Nature's Garden Inc. believe that another product, strawberry glycerin soap, will experience 20% drop in unit sales if its price is increased by 10%. (Purchasers of this product are more sensitive to price than the purchasers of the apple-almond shampoo). The calculation of the price elasticity of demand for the strawberry glycerin soap is:

Price elasticity of Demand = In(1 + ( (0.20)) / In(1 + (1.10)) In(0.80) / In(1.10) = 2.34 Both of these products, like other normal products, have a price elasticity that is less than 1. Not also that the price elasticity of demand for the strawberry glycerin soap is larger (in absolute value) that the price elasticity of demand for the apple-almond shampoo. The more sensitive customers are to price, the larger (in absolute value) in the price elasticity of demand. In other words, a larger (in absolute value) price elasticity of demand indicates a product whose demand is more elastic. The price elasticity of demand will be used to calculate selling price that maximizes the profits of the company.

Profit Maximizing Price:

Under certain conditions, it can be shown that the profit-maximizing price can be determined by marking up variable cost using the following formula: *[Profit-maximizing markup on variable cost = (Price elasticity of demand / 1 + Price elasticity of demand) 1] *The formula assumes that: The price elasticity of demand is constant. Total cost = Total fixed cost + Variable cost per unit q
The price of the product has no effect on the sales or costs of any other product. The formula can be derived using calculus.

Using the above markup is equivalent to setting the selling price using this formula: [Profit-maximizing price = (Price elasticity of demand / 1 + Price elasticity of demand) Variable cost per unit] The profit maximizing prices for two Nature's Garden products are computed below using these formulas: Apple-Almond Shampoo Price elasticity of demand Profit maximizing markup on variable cost (a) 1.71 Strawberry Glycerin Soap 2.34

( 1.71 / 1.71 + 1) ( 2.34 / 2.34 + 1) 1 1 2.41 1 = 1.41 or 141% 1.75 1 = 0.75 or 75% $0.40 0.30 -----------

Variable cost per unit--given (b) Markup, (a) (b)

$2.00 2.82 ------------

Profit maximizing price

$4.82 =======

$0.70 =======

Note that the 75% markup for the strawberry glycerin soap is lower that 140% markup for the apple almond shampoo. The reason for this is that the purchasers of strawberry glycerin soap are more sensitive to price than the purchasers of apple-almond shampoo. This could be because strawberry glycerin soap is a relatively common product with close substitutes available in nearly every grocery store. Caution is advised when using these formulas to establish a selling price. The assumptions underlying the formulas are probably not completely valid, and the estimate of the percentage change in unit sales that would result from a given percentage change in price is likely to be inexact. Nevertheless, the formulas can provide valuable clues regarding whether prices should be increased or decreased. Suppose, for example, that the strawberry glycerin soap is currently being sold for $0.60 per bar. The formula indicates that the profit maximizing price is $0.70 per bar. Rather than increasing the price by $0.10, it would be prudent to increase the price by a more modest amount to observe what happens to unit sales and to profits. The formula for the profit maximizing price also convey a very important lesson. The optimal selling price should depend on two factors--the variable cost per unit and how sensitive unit sales are to changes in price. In particular, fixed costs play no role in setting the optimal price. If the total fixed costs are the same whether the company charges $0.60 or $0.70, they cannot be relevant in the decision of which price to charge for the soap. Fixed costs are relevant when deciding whether to offer a product but are not relevant when deciding how much to charge for the period. Incidentally we can directly verify that an increase in selling price for the strawberry glycerin soap from the current price of $0.60 per bar is warranted, based just on the forecast that a 10% increase in selling price would lead to a 20% decrease in unit sales. Suppose, for example, that Nature's Garden is currently selling 200,000 bars of the soap per year at the price of $0.60 a bar. If the change in price has no effect on the company's fixed costs or on other products, the effect on profits of increasing the price by 10% can be computed as follows: Percent Price $0.60 200,000 $120,000 80,000 ---------$40,000 Higher Price $0.60 + (0.10 $0.60) = $0.66 200,000 (0.20 200,000) = 160,000 $105,600 64,000 ---------$41,600

Selling price Unit sales Sales Variable cost Contribution margin

=====

=====

Despite the apparent optimality of prices based on marking up variable costs according to the price elasticity of demand, surveys consistently reveal that most managers approach the pricing problem from a completely different perspective. They prefer to mark up some version of full, not variable, costs, and the markup is based on desired profits rather than on factors related to demand.