By Kenneth Boyd, Lita Epstein, Mark P. Holtzman, Frimette Kass-Shraibman, Maire Loughran, Vijay S. Sampath, John A. Tracy, Tage C. Tracy, Jill Gilbert Welytok

Many industries use price points — special “magic” price levels that customers expect to pay. You’ve probably seen these prices in the store: $99.99, $26.99, $19.95, and so on. Understanding customer expectations and competitor pricing, manufacturers design products specifically so that the products can be produced and sold at the magic price points.

Although traditionally you first design the product and then set the price, target costing requires you to set the price before you design the product. After you know the price, you can engineer the product so that its cost is low enough to ensure that you earn the expected profit margin.

Done right, target costing avoids problems caused by products that are priced too high for consumers or are too expensive to make. It engineers the price, the profit margin, and the cost right into the product.

Calculating your target cost

With target costing, the company starts with market price and markup and uses that information to figure out the product’s cost and specifications. (In contrast, cost-plus pricing starts with the product cost and desired profit and uses that information to set the price.)

To figure out the target cost, subtract the desired profit from the market price:

Market price – Desired profit = Target cost

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For example, suppose you head to a big-box store to buy a new desktop computer, and you’re determined to pay no more than $750 plus tax. You discover four different desktop models, priced at $599.99, $749.99, $999.99, and $1,299.99. You take the $749.99 model, because you want the best computer you can get for $750 or less.

Assume that the store sets prices so that gross profit equals 10.51 percent of the company’s sales price. An inventory item that sells for $100 typically includes gross profit worth $100 x 0.1051 = $10.51, costing the company $100.00 – $10.51 = $89.49. Gross profit is defined as sales less cost of sales.

The company’s desired profit on your computer model equals $749.99 x 0.1051 = $78.82. Plug it into the formula:

Market price – Desired profit = $749.99 – $78.82 = $671.17

The math indicates that the store should pay $671.17 for computers that it can sell for $749.99.

Target costing works both for retailers (like that big-box store) and for manufacturers (such as the maker of your new computer). Therefore, after the store determines that it’s willing to pay $671.17 for these computers, the maker needs to figure out how to make computers with all the right bells and whistles that it can sell for $671.17.

The computer maker works to earn a 22.7-percent profit margin on sales. Therefore, the company’s desired profit equals $671.17 x 22.7 percent = $152.36:

Market price – Desired profit = $671.17 – $152.36 = $518.81

After subtracting desired profit of $152.36 from its expected sales price of $671.17, the computer maker works out that it needs to engineer and produce computers that cost $518.81. Armed with this knowledge, the engineers pick and choose various specifications and features to cook up a computer that costs exactly this amount.

Knowing when to use target costing

Target costing works especially well for companies whose products aren’t well differentiated (such as electronic accessories and economy automobiles), where price is often a key consideration for customers selecting which brand to buy. This technique ensures that the company can sell a competitive product with all the features — and the price — that customers expect.