Target Costing Vs.. Cost-Plus in Pricing by Cam Merritt, Demand Media A business makes a profit when the price it charges customers for its goods or services exceeds the cost of producing those goods or services. Target costing and cost-plus pricing are two well-recognized methods of managing the relationship between cost and price, but they approach the equation from opposite directions. Ads by Google Pay Per Click Advertising Reach the Right Customers Online. Sign Up for Google Towards Today. Www. Google. Com/Towards Cost vs.. Price Consumers often use the terms “cost” and “price” interchangeably, but to a easiness person, these are fundamentally different concepts. Price is what your business charges its customers. Cost is the expense your business incurs to provide the goods or services that customers are paying for. In short, cost is what the business owner pays, price is what the business owner receives, and the larger the difference between the two, the larger the profit.
Cost-Plus Pricing Cost-plus pricing is the simplest and most intuitive method of setting a price. A business adds up the total cost of producing an item, tacks on a markup for its profit, and the result is the selling price. For example, assume your business makes shoes. Each pair requires $10 worth of materials, two hours’ worth of labor at $12. 50 an hour, and $5 in fixed costs such as rent and utilities. The cost of producing each pair is $40. If your business’ policy is to mark up items 25 percent over cost, you’d set the price at $50.
Related Reading: Advantages and Disadvantages of Marginal Cost-Plus Pricing Cost-Plus Pros and Cons The primary advantages of the cost-plus method are simplicity and predictability. A key disadvantage is that it sets a price without taking into consideration how that price will affect demand. The price it sets could be either too low or too high. A strict cost-plus policy may also discourage efficiency or even punish it. Since all costs get passed directly to the customer, there may be no incentive to save money in the production process.
At the same time, a business that finds ways to operate more efficiently might wind up passing cost savings to customers in the form of a lower price rather than keeping them as profit, even when those customers are perfectly happy with the price they’re paying. Target Costing While the cost-plus method uses cost to determine price, target costing works he other way around. It uses price to determine cost. In target costing, a business starts by determining how much it wants to charge for a product.
It then subtracts its desired profit from that price to arrive at the maximum cost it can afford to pay to produce that product. For example, assume again your business makes shoes, and you want to introduce a new line. Your assessment of the market tells you that you shouldn’t charge more than $60 per pair. If you desire a markup of 25 percent over cost, then you must be able to produce each pair for $48 or less. Target Costing Pros and Cons Target costing recognizes that a business doesn’t have total control over pricing; price is limited by what the market will pay.