How is a selling price for any product calculated? The norm for price calculation in any business is generally like this: Calculate all the costs relating to the production or procurement of a product; add up the desired profit margin and arrive at a selling price.
But, in some industries or business, the price is fixed in a slightly different manner. Here, the price is determined first and then the cost is arrived at keeping in mind the desired rate of return. This method of price determination is known as Target Pricing. We will understand more about it in a discussion that follows.
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What is Target Pricing?
In target pricing, the selling price for a product is determined first. Based on the insights from the marketing department and other market intelligence data, the most competitive price that the customers would be willing to pay is fixed as a selling price.
Now, the desired profit margin is deducted from this selling price to arrive at a cost within which the production department would have to produce the product or procurement department would have to procure the product.
For example, ABC Ltd. is in the business of manufacturing prom dresses for high school girls. The average price at which the prom dresses sell in the market is $100. So, ABC Ltd. also fixes the selling price of $120 for its up-scale range of prom dresses.
Now, the desired markup is 25% on selling price. So the profit margin is $30 per dress. Hence, the cost price within which the manufacturing department would have to manufacture every single dress will be $90 ($120-$30). In order for that product line to be profitable, ABC Ltd. has to ensure that its total cost per unit doesn’t exceed $90. And the lower is able to bring down the cost per unit; higher will be its profit per dress. Target pricing can overcome the limitations of Cost-plus pricing.
Which industries follow Target Pricing?
The industries where the competition is intense and demand is price elastic have to follow target pricing in order to be competitive in the market. Price elastic demand means the level of demand changes in accordance with the changes in prices. If price increases, demand decreases, and vice versa.
Thus, in order to counter the negative outcome of fall in demand, the business has to quote a price that’s acceptable in the market. Target pricing was particularly made popular by Japanese motor companies such as Toyota and Nissan.
Advantages of Target Pricing
- It is a dynamic method of price determination that takes into account and responds to market factors of demand and supply while determining the selling price.
- It results in higher profitability for business by way of reducing cost as the selling price is already fixed in advance.
- It provides the opportunities to promote efficient and optimum utilization of resources within the company. It leads to creative and permanent ways of bringing down the cost of the product and leads to permanent technological and economic gains for the company.
- It leads to the availability of value-added products and services to the customers. Many-a-times, the company passes on the benefits of cost reduction to the customers and hence they are able to enjoy better products at lower prices.
- As a result of a proactive approach to fixing the price, the business is better equipped to predict and respond to market changes. Coordination amongst its various departments such as production, marketing, design, and engineering enables it to form a cohesive strategy in the event of any major shift in trends.
Disadvantages of Target Pricing
- Target pricing relies on estimating the final selling price of the product correctly. Any error on this front may cause the entire marketing strategy to fail.
- Estimating too low a price and then accordingly fixing very rigid constraints on cost may place the unrealistic burden on the production department.
- Sometimes, in order to achieve a narrow-minded goal of reducing cost, the organization may resort to using cheaper technology or materials or faulty designs which may not confer any advantages in the long run on the company or the customers.
- While estimating a selling price and cost, the company has to work out the quantity it desires to sell at those prices in order to achieve a markup. If the business fails to sell that many numbers of units, it is bound to suffer losses.
