The following conversation took place between Cedrick James, vice-president of marketing, and Lee Wright, controller of Gem Computer Company:
Cedrick: I am really excited about our new computer coming out. I think it will be a real market success.
Lee: I’m really glad you think so. I know that our price is one variable that will determine if it’s a success. If our price is too high, our competitors will be the ones with the market success.
Cedrick: 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?
Lee: Well, there’s the rub. The product cost looks as if it’s going to come in at around $2,400. With a 25% markup, that will give us a selling price of $3,000.
Cedrick: I see your concern. That’s a little high. Our research indicates that computer prices are dropping by about 20% per year and that this type of computer should be selling for around $2,500 when we release it to the market.
Lee: I’m not sure what to do.
Cedrick: Let me see if I can help. How much of the $2,400 is fixed cost?
Lee: About $400.
Cedrick: 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 $400, the new price with a 25% markup would be right at $2,500. Boy, I was really worried for a minute there. I knew something wasn’t right.
a. If you were Lee, how would you respond to Cedrick’s solution to the pricing problem?
b. How might target costing be used to help solve this pricing dilemma?