What is the formula for target pricing?

Deconstructing Target Pricing: A Formula for Profitable Product Development

Target pricing, a strategic approach to product costing, flips the traditional cost-plus pricing model on its head. Instead of determining a selling price based on production costs, target pricing starts with the desired market price and works backward to define the maximum allowable cost for profitability. This proactive method is crucial in highly competitive markets where price sensitivity is paramount.

The core concept hinges on understanding the market’s willingness to pay for a specific product or service. This understanding informs the target selling price, the price point at which the company aims to sell its product to achieve its market share and profit goals. This isn’t simply a guess; it’s based on thorough market research, competitive analysis, and a robust understanding of customer value.

Once the target selling price is established, the next step involves defining the desired profit margin. This represents the percentage of revenue the company wants to retain as profit after covering all costs. The desired profit margin is a crucial strategic decision reflecting the company’s overall financial objectives and risk tolerance. A higher profit margin means a lower allowable cost, requiring more efficient production and potentially impacting market competitiveness.

The formula for calculating the target cost is straightforward:

Target Cost = Target Selling Price – Desired Profit

Alternatively, and perhaps more commonly used, especially when dealing with a desired profit margin expressed as a percentage:

*Target Cost = Target Selling Price (1 – Desired Profit Margin)**

Where:

• Target Selling Price: The price at which the product will be sold to the customer.
• Desired Profit: The absolute monetary amount of profit the company wishes to make per unit.
• Desired Profit Margin: The percentage of the selling price that represents the desired profit.

Example:

Let’s say a company wants to sell a new widget. After thorough market research, they determine a target selling price of $50. They aim for a 20% profit margin. Using the second formula:

Target Cost = $50 (1 – 0.20) = $50 0.80 = $40

This means the maximum allowable cost to produce the widget is $40. Any cost exceeding $40 will result in the company failing to meet its desired profit margin at the target selling price.

Beyond the Formula:

The target pricing formula is just the starting point. Achieving the target cost requires a rigorous process of cost engineering and innovation. This involves:

• Value Engineering: Identifying areas where costs can be reduced without compromising product quality or functionality.
• Supply Chain Optimization: Negotiating better prices with suppliers and streamlining the procurement process.
• Process Improvement: Implementing more efficient manufacturing processes and reducing waste.
• Design for Manufacturing (DFM): Designing the product from the outset with manufacturing costs in mind.

Successfully employing target pricing demands a holistic approach. It requires a deep understanding of the market, a commitment to cost control, and a willingness to innovate throughout the product development lifecycle. It’s a powerful tool for ensuring profitability, but its effectiveness relies on accurate market analysis and the ability to meet the calculated target cost.

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