Question

3. Differentiate between “target costing approach to pricing” and “cost-plus pricing”.

Answer 1

Cost-Plus Pricing:-

Cost-plus pricing is the simplest 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 that a 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. So, a company uses a markup percentage that estimates a product price that covers full product costs and earns the required return on investment.

Price-makers typically use a cost-plus pricing approach. A price-marker is a company that can set its prices. Typically, the product is more unique and there is less competition. One of the most famous price-makers is Apple. Apple does not fit the traditional definition of a price-maker. There is a lot of competition in the cell phone, tablet, and computer markets and there are lots of similar products on the market. What makes Apple unique is its brand loyalty. Many Apple fans would never consider purchasing a non-Apple product. The customer believes that Apple’s products are unique, and therefore, would not consider the alternatives that are on the market. That allows Apple to charge higher prices for its products. Hence, cost-plus pricing approach is used by Price-makers.

Target Costing approach to pricing:-

While the cost-plus method uses cost to determine price, target costing works the 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 that business makes shoes, and it wants to introduce a new line. The 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. So, It estimates are based on customers' perceived value of the product.

Price-takers must use a target costing approach to pricing. A price-taker is a company that has little control over its prices. Typically, in such case the product is not unique and/or there is a lot of competition. Most commodities, like gasoline and milk, are price-takers. When searching for gasoline to fill up our cars, we typically look for the gas station with the lowest price. Target costing forces a company to look at its desired profit, the price the market will bare, and attempt to cut costs to achieve the profit desired. Hence, target costing to pricing approach is used by Price-takers.