The selling prices computed under cost-plus pricing are prospective prices. Suppose Astel’s initial product design results in a $750 full cost estimate for Provalue II. Assuming a 12% markup, Astel sets a prospective price of In the competitive personal computer market, customer and competitor reactions to this price may force Astel to reduce the markup percentage and lower the price to, say, $800. Astel may then want to redesign Provalue II to reduce the full cost to $720 per unit, as in our example, and achieve a markup close to 12% at the price of $800. The eventual design and cost-plus price must balance cost, markup, and customer reactions.
The target-pricing approach reduces the need to go back and forth among prospective cost-plus prices, customer reactions, and design modifications. In contrast to cost-plus pricing, the target pricing approach first determines product characteristics and a target price on the basis of customer preferences and expected competitor responses and then computes a target cost.
Companies that provide many distinctive products and services to their customers, such as accountants, management consultants, and lawyers, usually use cost-plus pricing. Each job that professional service firms do for their clients is unique. They set prices based on hourly cost-plus billing rates of partners, managers, and associates. These prices are, however, lowered in competitive situations. Professional service firms also take a multiple-year client perspective when deciding prices because clients prefer to work with the same firm over multiple periods. Certified public accountants, for example, sometimes charge a client a low price initially to get the account and then recover the lower profits or losses in the initial years by charging higher prices in later years.
Service companies such as home repair services, automobile repair services, and architectural firms use a cost-plus pricing method called the time-and-materials method. Individual jobs are priced based on materials and labor time. The price charged for materials equals the cost of materials plus a markup. The price charged for labor represents the cost of labor plus a markup. That is, the price charged for each direct cost item includes its own markup. Companies choose the markups to recover overhead costs and to earn a profit.