Set Price, Then Figure Target Cost
Don Quixote tried to convince us that “what costs little is valued less.” That may be true with respect to diamond rings and meals in classy restaurants, but it doesn’t hold water among most business owners and their customers. Indeed competitive pricing is essential to success in today’s marketplaces. But what price is the right price?
Q. My company is about to introduce a new product and I’m struggling with the issue of price. What’s the best way to determine what to charge?
A. In bygone days when competition wasn’t as keen, most price decisions were based on standard costing. A product’s material, labor and overhead components were carefully calculated, added, and topped off with a share of administrative costs and a desired profit margin.
This additive technique worked well when markets weren’t as efficient and responsive as they are now. You might still get away with this approach in situations where you have an exclusive product niche or really lazy competitors. But, by and large, building up costs to determine price doesn’t cut it any more.
Most progressive businesses use a “target costing” approach. This moves the decision perspective from your bookkeeper’s office to the marketplace. Here you start with the necessary selling price, deduct your desired profit, and - viola - you have your target cost.
If the cost you estimated is greater than this target cost, you’ll have to either go back to the drawing board and redesign your product to reduce associated expenses or completely re-examine your original decision to offer the product.
Of course, an estimate of unit price is only part of the equation. You’ll also have to guesstimate market share and sales volume to determine the product’s ability to absorb overhead and a reasonable share of general administrative costs. This means you’ll have to carefully assess existing and potential competition, your intended customers’ price sensitivities, and general market conditions.
The beauty of target costing is that it is a “before-the-act” indicator that can keep you from getting in a lot of trouble. By looking only at costs and desired profits, it’s possible to go to market with a product or service that is priced unreasonably and doomed to failure. This can cost dearly in terms of market image, out-of-pocket cash, and institutional ego.
If you are fortunate enough to be able to conclude that your costs are out of line before you go to market, it’s possible that adjustments can be made to resolve the problem. You might re-design your product to use less expensive parts, components or materials. You might change your initial “make-or-buy” decisions and find cheaper alternatives by outsourcing or by producing vendor-supplied items yourself.
You can also re-examine your production processes in search of ways to introduce cost-reducing efficiencies. You might even opt to eliminate some non-essential product features or refinements.
Your goal, of course is to reduce total costs to a point where your desired pricing and profit objectives are attainable.
This technique works for both products and services.
Q. I’m a single mom and pretty talented when it comes to desk-top publishing. I’m thinking about making my services available, part time, to a number of companies. It looks like my best option is to work as a freelance independent contractor rather than as a part-time employee of each firm. Is that true?
A. Unfortunately, as far as the IRS is concerned, this decision is not always in your hands. Your status and your related tax benefits and obligations are determined by the conditions of your employment. The IRS uses an extensive list of criteria to determine your status.
If you are going to be free to set your own hours, work where you wish, and use your own computer, you probably can qualify as an independent contractor. To be sure, get IRS publication No. 937, Employment Taxes, which lists the relevant criteria it uses.
As an employee, group health insurance would probably be less expensive and your employer would pay half of your Social Security payroll tax. You’d also be eligible for unemployment compensation.
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