12.1 Cost-Plus Pricing and Target Costing

Cost-plus pricing and target costing are two key pricing strategies in business. Cost-plus adds a markup to production costs, ensuring profit but potentially ignoring market factors. It's simple but can lead to over or underpricing.

Target costing starts with the market price and works backward to determine allowable costs. This approach aligns products with market expectations and drives innovation. It's more flexible and competitive, especially in price-sensitive industries.

Cost-Plus Pricing

Concept of cost-plus pricing

Top images from around the web for Concept of cost-plus pricing

• 

  13. Procurement Management – Project Management View original

  Is this image relevant?

• 

  11.10 Markup – Introduction to Marketing II 2e (MKTG 2005) View original

  Is this image relevant?

• 

  Production Cost | Boundless Economics View original

  Is this image relevant?

• 

  13. Procurement Management – Project Management View original

  Is this image relevant?

• 

  11.10 Markup – Introduction to Marketing II 2e (MKTG 2005) View original

  Is this image relevant?

1 of 3

Top images from around the web for Concept of cost-plus pricing

• 

  13. Procurement Management – Project Management View original

  Is this image relevant?

• 

  11.10 Markup – Introduction to Marketing II 2e (MKTG 2005) View original

  Is this image relevant?

• 

  Production Cost | Boundless Economics View original

  Is this image relevant?

• 

  13. Procurement Management – Project Management View original

  Is this image relevant?

• 

  11.10 Markup – Introduction to Marketing II 2e (MKTG 2005) View original

  Is this image relevant?

1 of 3

• Pricing strategy sets product price by adding markup percentage to total production cost
• Ensures all costs covered plus desired profit margin
• Widely used in manufacturing (automobiles), retail (clothing), and service industries (consulting)
• Particularly effective for government contracts, custom-made products (furniture), and industries with stable costs (utilities)

Calculation of cost-plus pricing

• Formula: $[Selling Price](https://www.fiveableKeyTerm:Selling_Price) = Total Cost + Markup$
• Process involves:
  1. Determine total production cost (materials, labor, overhead)
  2. Decide markup percentage based on industry standards and profit goals
  3. Apply markup to total cost to get final selling price
• Practical example:
  • Manufacturing cost of a chair: $80
  • Desired markup: 25%
  • Selling price: $80 + (25$80) = $100

Pros and cons of cost-plus pricing

• Advantages:
  • Simple to implement and understand
  • Guarantees cost recovery and consistent profit margins
  • Transparent pricing justification to customers
  • Useful for unique or custom products (specialized machinery)
• Disadvantages:
  • Disregards market demand and competitive landscape
  • Can lead to over or underpricing products
  • Lacks incentive for cost reduction or efficiency improvements
  • May result in missed sales opportunities due to inflexible pricing

Target Costing

Target costing approach in pricing

• Cost management method begins with desired market price, works backward to determine allowable costs
• Core principles:
  • Price determined by market research and customer willingness to pay
  • Product design focus to meet target cost
  • Cross-functional collaboration (design, engineering, marketing)
• Implementation process:
  1. Set target selling price based on market research
  2. Determine desired profit margin
  3. Calculate maximum allowable cost (target price minus desired profit)
  4. Design and develop product within cost constraints
• Crucial for maintaining competitiveness in price-sensitive markets (consumer electronics)

Target costing vs cost-plus pricing

• Fundamental differences:
  • Cost-plus: internally focused, cost-driven approach
  • Target costing: externally focused, market-driven strategy
• Market considerations:
  • Cost-plus may result in uncompetitive pricing
  • Target costing aligns with market expectations and competitor pricing
• Product development impact:
  • Cost-plus provides little motivation for cost reduction
  • Target costing drives innovation and efficiency in design and manufacturing
• Pricing flexibility:
  • Cost-plus follows rigid pricing structure
  • Target costing adapts to changing market conditions
• Long-term competitiveness:
  • Cost-plus may struggle in highly competitive markets (smartphones)
  • Target costing positions products better for market changes and consumer preferences