Chapter 8
Evaluating Your Costs
In-a-Rush TipThe Ideas Behind “Target Costing” and “Target Engineering”
The traditional cost-plus calculation gives way to a more market-oriented, price-minus calculation. The amount customers are willing to pay for a product that fulfills their requirements is determined first. Based on this information, the highest acceptable price is calculated, and the target margin is deducted from that price. The result is the maximum cost allowable for this product. The traditional idea of “How much will the product cost?” is replaced with “How much can the product cost?”
Butscher and Laker (2000)
JUMP had a new basketball sneaker with several advanced features and a modified cushioning technology. The cost of the sneaker was $40. Adding the target margin of 100 percent resulted in a price to the dealer of $80. Adding the dealer’s margin of 50 percent on top of that led to a market price of $120, which put this sneaker in the upper price range with the most expensive models from Adidas, Nike, and Reebok. Expected sales in this price category were thin.
. . . JUMP decided to reevaluate the new shoe using the target-costing approach. It was discovered that the target segments preferred a less elaborate shoe. The maximum acceptable price for such a shoe was determined to be $99, just under the $100 price step, which positioned the JUMP sneaker at a slight price premium to most other basketball sneakers price in the $70-$90 range. The new features the JUMP sneaker had justified this price premium. Deducting the 50% dealer margin led to a price to the dealer of $66. Deducting the 100% target margin from that price resulted in a target cost for the sneaker of $33, which was $7 lower than the current cost. JUMP was able to slash the cost to $33 by slightly redesigning the sneaker to lower the production cost and by optimizing transportation from the Asian production plan to the distribution centers globally. It launched the sneaker nine months after the original target date. (Butscher and Laker, 2000)
It was a success, but not as big as it could have been if it made the target date and could have been promoted at the Dream Team Olympics in Atlanta. That could have happened, had they started with target costing.
Types of Costs
There are three different types of costs to analyze for this section of the book:
Let’s look at each type.
Sunk Costs
Sunk costs are those costs needed to launch a company—or a new product. They include costs such as establishing a new dealer network, researching the new industry, researching new competitors, preparing financial and sales projections, etc.
There are tax implications (the IRS requires some of these costs to be capitalized, not expensed) as to what you classify as sunk costs.
For the purposes of setting prices only, consider sunk costs to be those up to manufacturing and selling costs. In other words, sunk costs are what you spend setting up the company and procedures so you can then either start manufacturing and/or start selling.
Overhead Costs
Overhead costs are those ongoing costs that will not go away if you change the products or services you are offering. They are divided into two groups and include costs such as:
- Administrative costs
- Rent
- Utilities
- Salary and benefits of positions that would not go away if you changed what you sell. These include the CEO, CFO, CIO, administrative assistants, and other administrators.
- Sales-related management costs (not specific to any product or service)
- These include the chief marketing officer’s (CMO’s) salary and benefits, plus any overall research or marketing services and/or databases you buy that aren’t specific to one product or service you offer.
Direct Costs
Direct costs are those that are directly required for manufacture of or provision of specific products or services. Examples include:
- Blank t-shirts and colored inks, if you sell imprinted t-shirts. And salary and benefits for any employees who work imprinting the t-shirts.
- Attorney costs, if you run a legal firm.
- Hair stylist expenses (employees plus shampoos, conditioners, etc.) if you run a hair salon.
- Writer fees (or salaries), photo fees, printing expenses, and postage/delivery fees to mail issues if you have a magazine, newspaper, or newsletter.
The Hardest Part of Calculating Costs
The most difficult aspect of calculating your costs is deciding what amount of your sunk costs and/or overhead costs to add in when calculating your total costs for a product.
There are a few methods of calculating your total costs for pricing purposes:
- What are your direct costs per unit?
- How many other products/services are you offering that can carry part of the overhead?
- Is the upside for this product/service worth it contributing less-than-optimal dollars to overhead for some time at its introduction?
If your price at least covers direct costs, the company is making at least some money that can be applied to overhead.
Let’s look at an example:
- Your direct costs for this product are $12 per unit.
- Let’s assume your “fully loaded” costs are $20 per unit. (This covers a percentage of overhead applied to each unit based on total overhead costs divided by the number of units of this and other products you expect to sell.)
- Then let’s assume your previous market analysis shows competitor products that are equivalent to yours are selling for $19 per unit.
- Should you go ahead with the launch?
Over the long haul, you need to make more than enough to cover your overhead. So if you think this is the total upside for this product and it won’t aid you in other ways to be described below, then no—launching it wouldn’t be smart.
However, it will be contributing $9 per unit sold to overhead. So if you don’t launch it, you lose $9 on each non-sale toward overhead.
Reasons for Launching a Product that Doesn’t Cover Overhead
You may well wish to launch a product where the price does cover direct costs but doesn’t cover all the indirect (overhead) costs. Here are some valid reasons:
- It’s an entry into an industry that is attractive to you.
- It’s an entry product that will bring in customers, many of which will upgrade to your higher margin products/services.
- It’s a product that requires additional products with a higher margin. For example:
- Pricing razors cheap because the profit margins on the blades are higher.
- Low prices on an iPhone or Kindle, when you make your high profit margins from app and book sales.
- It’s a product that has little value until a critical mass of people have one (e.g., fax machines).
- You anticipate initial market resistance to your innovative product, so you’re pricing low until innovators can spread the word about how great it is. And you have add-on products with higher margins for buyers.
Your Assignment