Implementing Target Pricing and Target Costing

We use the Provalue example to illustrate the four steps in developing target prices and target costs.

Step 1: DEVELOP A PRODUCT THAT SATISFIES THE NEEDS OF POTENTIAL CUSTOMERS. Astel’s managers use customer feedback and information about competitors’ products to change product features and designs of Provalue in 2020. Their market research indicates that customers do not value Provalue’s extra features, such as special audio elements and designs that make the PC run faster. Instead, customers want Astel to redesign Provalue into a basic, reliable and low-priced PC.
Step 2: CHOOSE A TARGET PRICE. Competitors are expected to lower the prices of PCs to $850. Astel’s managers want to respond aggressively by reducing the price of Provalue by 20%, from $1,000 to $800 per unit. At this lower price, the marketing manager forecasts an increase in annual sales from 150,000 to 200,000 units.
Step 3: DERIVE A TARGET COST PER UNIT BY SUBTRACTING TARGET OPERATING INCOME PER UNIT FROM THE TARGET PRICE. Target operating income per unit is the operating income that a company aims to earn per unit of a product or service sold. Target cost per unit is the estimated long-run cost per unit of a product or service that enables the company to achieve its target operating income per unit when selling at the target price.^* Target cost per unit is the target price minus target operating income per unit. It is often lower than the existing full cost of the product. Target cost per unit is really just that—a target—something the company must strive to achieve.
To earn the target return on capital, Astel needs to earn 10% target operating income per unit on the 200,000 units of Provalue it plans to sell.

Total target revenue	$= $ 800 per unit \times 200,000 units = $160,000,000$
Total target operating income	$= 10 % \times $ 160,000,000 = $ 16,000,000$
Target operating income per unit	$= $ 16,000,000 \div 200,000 units = $ 80 per unit$
Target cost per unit	$= Target price - Target operating income per unit$
	$= $ 800 per unit - $ 80 per unit = $ 720 per unit$
Total current full costs of Provalue	$inline style equals text $ end text 135 , 000 , 000$ (from Exhibit 14-3)
Current full cost per unit of Provalue	$= $ 135,000,000 \div 150,000 units = $ 900 per unit$

Provalue’s $720 target cost per unit is $180 below its current unit cost of $900. To achieve the target cost, Astel must attempt to reduce costs in all parts of the value chain, from R&D to customer service.
Target costs include all future costs, variable costs as well as costs that are fixed in the short run, because in the long run a company’s prices and revenues must exceed its total costs if it is to remain in business. In contrast, for short-run pricing or one-time-only special-order decisions, managers only consider costs that vary in the short run.

Concepts in Action

Zara Uses Target Pricing to Become the World’s Largest Fashion Retailer^*

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In recent years, fast fashion has taken the apparel world by storm. Quickly designed and manufactured to respond to the latest fashion trends, fast fashion retailers work to ensure their store shelves are always stocked with the trendiest clothes at affordable prices. At Zara, many of the items you see in stores today will have been designed as little as 2 weeks before. This has allowed Zara’s parent company, Inditex SA, to become the world’s largest fashion retailer by sales. In 2017, Zara sold nearly $20 billion worth of the 18,000 fast-fashion designs on its racks in 2,251 stores in 50 countries. How did this happen? Aggressive target pricing, coupled with a unique business model focused on speed to market and reducing unnecessary costs.

Every day, more than 200 designers located at Zara headquarters in Spain collect information about the decisions made by customers in each of the chain’s stores. When Zara decides to produce an item, an in-house team of designers, production managers, and logisticians establish its price and how many will be made. Unlike most fashion retailers who focus only on their spring and fall collections, Zara changes its inventory every 15 days or so. They produce items in small batches, which allows more than 60% of its garments to be manufactured in Spain and nearby countries in a matter of days. This is critical for Zara, because all garments are shipped directly to stores from its headquarters, meaning it does not use warehouses to store excess inventory. This means that Zara has much lower inventories than its rivals, and therefore lower inventory costs and less need to discount unsold goods. On average, only 15–20% of Zara items are marked down, compared to 45% for competitor H&M. When a Zara store needs more inventory of a particular item, it notifies managers at headquarters and the process begins anew.

This model inspires customers to spend their money differently. In Zara, every purchase is an impulse buy; that trendy leather jacket in the window is likely to be gone in a matter of days. As a result, Zara customers typically visit stores four or five times more often than customers of more traditional fashion retailers.

Step 4: 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. The Concepts in Action: Zara Uses Target Pricing to Become the World’s Largest Fashion Retailer describes Zara’s approach to target pricing and target costing.