The Target Pricing Controversy
PurchTips edition #148
Are You Using Or Misusing Target Pricing?
Target pricing has both supporters and opponents among purchasing experts. With target pricing, it is neither right nor wrong to provide target pricing to suppliers. You just need to do so in the right context.
Target pricing works well when:
- You are buying a custom product that is manufactured to your specifications
- The material costs and labor hours can be clearly identified
- The primary materials are not commonly subject to volatile commodity pricing fluctuations
- The buying organization understands the costs
- Labor represents a significant enough portion of total cost so that the buyer can factor in aggressive productivity improvements in the target price
Let me elaborate a bit more on points #4 and 5. In many cases, buyers purchase a variety of items and can't be technical experts for every category. As such, they need to get quotes from suppliers to know what their price will be. In these cases, target pricing should not be used.
When buyers do have expertise in a category, they know what the costs will be prior to getting quotes. So they can set a target price for their suppliers rather than the supplier telling them what the price will be.
Of course, buyers want a low price. The key to getting one is factoring in labor productivity improvements for the supplier. Let's look at some numbers.
Let's say that material costs $400.00 per unit, labor hours required per unit are 8, labor typically costs $50 per hour, overhead in the industry is typically 10% of material and labor, and profit is typically 10% of material and labor. Doing the math, the price would be $960. The supplier sees this as $880 cost, $80 profit.
You want the supplier to take advantage of the "learning curve" - the more you do something, the faster you'll do it. So, let's say by the end of production, you expect the supplier's labor hours to decrease to 6 hours per unit. Starting at 8 hours and ending at 6 hours will give you an average of 7 hours of labor per unit. If you base labor costs on 7 hours instead of 8, the price would be $900.
With a target price of $900, you'll likely get pushback from suppliers claiming that there is barely any profit since their costs are $880. That's a reason that target pricing is controversial: suppliers think that it's about setting prices such that they can't make a profit.
But when you communicate that you expect productivity improvements from your supplier; that their profit margin still represents 10% of materials and labor (or whatever is typical for the industry); and that if they beat the productivity targets they increase their profit margin, target pricing is perceived as much more reasonable. So use target pricing in the right context. Used otherwise (e.g., for a volatile commodity), it will fail and fuel the controversy.
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