Question

Heartland Fabrication is a steel fabricator that has grown significantly over the last 10 years. Heartland's core business comes through government work, especially in fulfilling military contracts.

These military contracts are primarily based on a cost-plus model. Heartland has developed a detailed process-based costing system, which they have relied upon for several years. As they determine product costs, they add a profit margin and submit bids.

Recently, two of Heartland's lightweight steel products have gained traction in the agricultural industry. Strategically, Heartland has determined to put significant resources into gaining traction in the agricultural market. The market is very competitive but also has a high volume, and if Heartland could gain a foothold it would mean significant growth.

However, because of the competitive nature of the market, Heartland will need to move to a target pricing model.

For this discussion:

• What initial activities would Heartland need to perform in order to determine a target price?
• What factors may affect profit margin in a move from cost-plus pricing to target pricing?
• What are the advantages and disadvantages in a target pricing model?
• Explain value engineering and how this might play a role in the transition from a cost-plus model to a target pricing model.

Answer 1

(1): In case of target pricing a company plans in advance for the price points, product costs, and margins that it wants to achieve for a new product. Here Heartland Fabrication was using the cost-plus pricing model and in order to switch to target pricing model it will have to perform certain initial activities. First of all it will have to determine a price point for its products that is competitive in the new agricultural industry that it is planning to gain traction in. After that it will have to determine the desired profit that it is willing to make and in fact wants to make through the sale of its products. So the company will have to determine its target cost by deducting the desired profit from the desired price. Another important activity that it will need to perform is to engineer and manufacture the product in a manner so that the desired target cost is achieved.

(2): In a move from cost plus pricing to target pricing the first factor that will affect profit margin is the relationship between price and demand. In case of cost plus pricing the price of the product was determined without taking into consideration the impact of price movements on demand. Moreover the focus will have to shift to the value of the product. This is because at the end of the day the buyers are concerned only if the purchase being done by them is adding value for them or not. In case of target pricing the selling price is already fixed in advance and this is the opposite of the cost plus pricing method. Thus it is in fact considering customer value and demand and hence by reducing costs it is able to lead the business to profitability.

(3): The advantages are that it generates a tangible willingness on the part of a company’s management to improve its processes and to innovate. This helps the company to gain competitive advantage in a sustainable basis. Another advantage is that buyers and customers feel more valued and hence this can translate into incremental sales in the long run. Lastly it most probably leads to higher profits for the business as the target cost is determined from the selling price.

In terms of disadvantages it constraints the business to design its product around meeting the target cost. This sometimes pushes the managers to cut corners and they do this by making use of inferior technology, inferior materials etc. all with the objective of lowering the target cost. This dilutes the quality of the product substantially.

(4): Value engineering is a systematic approach to provide value in a product or a service. It can also be regarded as a systematic and tangible approach that is used for the purpose of cost reduction.

Value engineering can play an important and significant role in the transition from a cost-plus model to a target pricing model. This is because in case of target pricing the focus is on what the market is willing to pay. Value engineering helps in achieving desired target cost levels. In case the desired target cost levels are not achieved then the business can use value engineering to reevaluate the product features and price in other to arrive at a desired target cost.