Target pricing - a challenge for purchasing.

INTRODUCTION - A NEW APPROACH TO PRICING

Long known for their uncomplicated approaches to business situations, the Japanese have developed a strategy for price determination that could have significant ramifications in the area of pricing. Artistic in its simplicity and uncomplicated in structure, it provides the buyer with a challenge in obtaining a price reduction, and at the same time tying that reduction into the overall pricing strategy of his or her firm. In turn, the supplier is placed in a position of justifying the price in a way that maintains product integrity while reducing waste in the product and the processes that produced it.

The method, known as target pricing, illustrates the concept that price reduction is an integrated effort. It is not only a design engineering effort or a manufacturing effort, but also a purchasing effort. Coordinated activities, all focused on the same target, bring about the desired price reduction.

Target pricing itself is simple. In determining the target price, marketing computes the price it believes is necessary to achieve the desired share of market. That price becomes the target. Once the target price is set, the normal operating profit for the item is subtracted from the target price. This remainder becomes the target cost. The organization now focuses on reaching that target cost. Each functional area is responsible for a proportional segment of the cost reduction. This means company-wide cost reduction in all areas of the buyer's firm. It translates to:

1. Design to cost, on the part of design engineering

2. Manufacture to cost, on the part of production

3. Purchase to cost, on the part of purchasing

The targets given each of these areas are relative to the price reduction that marketing wishes to achieve for the product. If the purchased material cost component is 40 percent of the price of the current model and a 10 percent price reduction is ordered, then purchasing has the target of reducing the purchased material cost component to 36 percent. Any reduction in excess of the four percentage points simply adds to profit. The greater the spread between cost and price, the greater is the opportunity to use price as a competitive weapon.

There are sizable ancillary benefits that flow from adopting this approach. They include:

* Clear targets for the size of price reductions needed from a supplier

* The ability to assess the reduction's contribution to the overall pricing goal of the company

* The ability to compute and document purchasing's contribution on a product by product basis

Target pricing also creates a unique operating environment for both the buyer and the supplier. It provides an ideal opportunity to quantify cost savings by the application of such programs as early supplier involvement (ESI), quality function deployment (QFD), and value analysis (VA). Instead of being conceptual and abstract, interaction with suppliers and key company personnel takes on concrete meaning when there is an actual target price to achieve. This is not theory, but the practical application of a simple concept with far-reaching strategic ramifications for both the buyer and the supplier.[1]

TARGET PRICING'S OPERATING ENVIRONMENT IN JAPAN

Target pricing was developed in Japan, where securing market share has been a higher order priority than short-term product profits.[2] In the long term, enhanced market share will lead to long-term profits. After reaching the goal of market share, and perhaps leadership in the market, the price may be increased to raise the return on investment to the desired level. Constant improvement (Kaizen) activities will also result in cost reduction.

Those suppliers who are contributors via cost reduction, and partners in the growth of the customer company, can look forward to increased growth as the market share target is reached. This may not evolve into a single sourcing situation, however, because many Japanese firms also "hedge their bets" with dual sourcing and information sharing between the suppliers.[3]

In Japan, buyer-seller relationships differ considerably from those in the United States.[4] These differences account in part for the relative ease of implementing the concept. Egalitarianism between buyer and seller in the purchasing relationship does not exist in Japanese transactions. The seller is subservient to the buyer, and customer satisfaction does not have the same meaning as in the United States. While distinctly not equals, the loyalty of the buyer to the supplier, however, engenders a significant degree of stability in the relationship. The supplier is a willing partner. It is definitely a long-term relationship that may take decades to develop fully. This cohesiveness is an ingredient of target pricing. The effort of convincing the supplier of the need to reduce price is made somewhat easier in an atmosphere where loyalty to the customer is paramount.

Usually by the time market share is achieved, the competition is either eliminated or substantially curtailed. Once market dominance is achieved, pricing can be adjusted accordingly.

The Japanese have learned to "put the ball in the supplier's court." Guaranteed the normal margin, in either percentage or dollars, the supplier's …