- THE MARKET-BASED APPROACH ASK: Given what our customers want and how competitors will react to what we do, what price should we change?
- THE COST-BASED APPROACH ASK: Given what it costs us to make this product, what price should we change that will recoup our costs and achieve a target return on investment?
Markets and Pricing
Companies operate in different markets which affect the approach they will use for pricing:
- Companies operating in COMPETITIVE MARKETS use the market-based approach. Companies in these markets must accept the prices set by the market (good or services provided by competitors are very similar)
- Companies operating in LESS-COMPETITIVE MARKETS offer products or services that differ from each other and can use either the market-based or costs-based approach as the starting point for pricing decisions.
- Remember, both approaches consider customers, competitors and costs. Only the starting points differ.
- Managers should always keep in mind market forces regardless of which pricing approach they use.
- Companies operating in markets that are NOT COMPETITIVE favor cost-based approaches because these companies do not need to respond or react to competitors’ prices.
Understanding the Market Environment
Before setting prices under any approach, managers need to understand customers and competitors for three reasons:
- Lower-cost competitors continually restrain prices
- Products have shorter lives, which leaves some companies less time and opportunity to recover from pricing mistakes, loss of market share and loss of profitability.
- Customers are more knowledgeable because they have easy access to price and other information online and demand high-quality products at low prices
Market-based Approach: Target Costing for Target Pricing
Starts with a target price which is the estimated price for a product or service that potential customers are willing to pay. The target price is estimated based on
- An understanding of customers’ perceived value for a product or service
- How competitors will price competing products or services
Implementing Target Pricing and Target Costing
There are five steps we follow to implement target pricing and target costing:
- Develop a product that satisfied the needs of potential customers
- Choose a target price
- Derive a target cost per unit by subtracting target operating income per unit from the target price
- Perform cost analysis
- Perform value engineering to achieve target cost
Value engineering is a systematic evaluation of all aspects of the value chain, with the objective of reducing costs and achieving a quality level that satisfies customers. Value engineering entails improvements in product designs, changes in materials specifications and modifications in process methods. To implement value engineering, managers must distinguish value-added activities and costs from non-value-added activities and costs.
Here we have a graphical view of cost incurrence and locked-in costs
The bottom curve plots the cumulative cost per unit incurred in difference business functions of the value chain. The top curve plots cumulative locked-in costs. Total cumulative cost per unit for both curves is $900 but as you can see, there is wide divergence between the locked-in costs and costs incurred.
Possible Undesirable Effects of Value Engineering and Target Costing
Unless managed properly, value engineering and target costing can have undesirable effects:
- Employees may feel frustrated if they fail to attain targets
- The cross-functional team may add too many features just to accommodate the different wishes of team members
- A product may be in development for a long time as the team repeatedly evaluates alternative designs
- Organizational conflicts may develop as the burden of cutting costs falls unequally on different business functions in the company’s value chain.
Avoid Possible Undesirable Effects
To avoid those possible undesirable effect, target-costing efforts should always:
- Encourage employee participation and celebrate small improvements toward achieving the target cost
- Focus on the customer
- Pay attention to schedules
- Set cost-cutting targets for all value-chain functions to encourage a culture of teamwork and cooperation
Antitrust Laws and Pricing Decisions
There are laws that impact our pricing decisions. Price discrimination is illegal if the intent is to lessen or prevent competition. Predatory pricing occurs when a company deliberately prices below its costs in an effort to drive competitors out of the market and restrict supply, then raise prices rather than enlarge demand.