The following conversation took place between Juanita Jackson, vice president of

Question

The following conversation took place between Juanita Jackson, vice president of marketing, and Les Miles, controller of Diamond Computer Company:

Juanita: I am really excited about our new computer coming out. I think it will be a real market success.

Les: I'm really glad you think so. I know that our success will be determined by our price. If our price is too high, our competitors will be the ones with the market success.

Juanita: Don't worry about it. We'll just mark our product cost up by 25%, and it will all work out. I know we'll make money at those markups. By the way, what does the estimated product cost look like?

Les: Well, there's the rub. The product cost looks as if it's going to come in at around $1,200. With a 25% markup, that will give us a selling price of $1,500.

Juanita: I see your concern. That's a little high. Our research indicates that computer prices are dropping and that this type of computer should be selling for around $1,250 when we release it to the market.

Les: I'm not sure what to do.

Juanita: Let me see if I can help. How much of the $1,200 is fixed cost?

Les: About $200.

Juanita: There you go. The fixed cost is sunk. We don't need to consider it in our pricing decision. If we reduce the product cost by $200, the new price with a 25% markup would be right at $1,250. Boy, I was really worried for a minute there. I knew something wasn't right.

Explanation / Answer

If I was Les, I would have priced the product by considering only the variable costs and ignoring fixed costs since remain the same irrespective of the production. Hence, it would be pragmatic to price the product by adding a markup of 25% on variable costs I.e. $1,000+ 25% of $1,000= $1,250

Target costing is a technique where a target cost is determined by subtracting the profit margin from the competitive market price(CMP). In the given case, CMP is $1,250 and profit margin is 20% on selling price(25% on cost)

Thus target cost= 1,250- 20% of 1,250 = $1,000

The Diamond Computer company shall try and bring down the costs to $1,000

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