I'm Karl Ulrich, I'm a professor at the Wharton School.

And this session is on target costing and channel economics.

In order to achieve financial sustainability as a new business,

the entrepreneur has to be able to satisfy this basic expression.

Quantity times price minus cost must be greater than the fixed costs.

Put simply, quantity Q, the number of units you sell per unit time,

times the difference between the price you get for the product and

the cost you pay for the product.

That quantity has to cover your fixed cost of being in business,

the cost you incur per unit time.

What we're going to do in this module is to give a better sense of how

you actually calculate these numbers and how you come up with a system,

with a business model that's financially sustainable.

Now, the basic logic behind this is, we're going to set price based on the market,

based on the other products that are in the market, and

what your competitors are doing.

We're then going to work backwards from price.

In order to set a cost target, and then we're going to check the cost of goods,

that is our own cost structure against that cost target in order to be sure

that our business is financially sustainable.

Let me work through an example for you.

I want to talk about the Belle-V bottle opener and Belle-V is a kitchen

accessories company, of which, I'm one of the co-founders.

And so this is one of our products.

And these are luxury goods, so

the Belle-V bottle opener sells for $50 in the retail store.

And I want to now work through the logic around that price and

around the target cost that we knew we had to be able to hit in the factory

in order to be able to make this business work.

Now in order to walk through that logic,

I want to walk through the supply chain, or the sequence of supply actions,

that get this bottle opener from the factory to you.

Let's start with the factory.

This is a photograph of a factory in Taiwan.

Actually, it's a factory for another of my products, but

very similar to the factory where the bottle-opener is made, and

that factory produces that bottle opener to our specifications.

Once the factory is produce the batch of openers, those openers are shipped to

the United States, and they're shipped via container ships.

So this image shows a container ship being loaded with shipping containers.

The shipping containers are those metal boxes that you've seen on

the back of rail cars, or on the highway on the backs of trucks.

They measure 40 feet long by 8 feet tall by 8 feet wide.

They actually do use imperial units, feet, to measure that.

But in rough terms, that would be about 13 meters long,

about 3 meters tall and about 3 meters wide.

So those shipping containers are then loaded onto ships as shown here.

And then they're transported, in our case, from China to a port in the Untied States,

in our case to Long Beach California, which is shown here.

So this is the container yard where those goods get unloaded.

From there, they go to our distribution warehouse, also located in California,

and then finally, they're shipped to the retailer.

So here is shown a kitchen goods retailer that would

carry the Belle-V bottle opener.

And so, as we think about target costing, we really have to work back

from the price this product would sell for in the store, all the way back

to what the cost must be at the factory in order for that system to work.

Let me walk you through the arithmetic on how to do that.

I mentioned that the retail price is $50, and we've treated elsewhere

the setting of retail prices, but in some, they're based on the market forces.

In effect, what is the customer willing to pay and

what are the competitive offerings in the marketplace?

So in our case, the bottle opener sells for

$50 because it's intended as a premium gift item sold in museum stores and

design boutiques, where there are lots of $50 items.

And so $50 does not seem a ridiculously high price for

our beautifully designed object, like that bottle opener, that could serve as a gift.

So that logic about where the $50 comes from,

I'm not going to treat in this session.

I'm just going to take that as a given, that the $50 is the retail price.

Now if you think about it, that's the price the consumer will pay for

the product.

But the consumer isn't giving us, the brand owner, that $50.

Instead, they're paying the retail store that $50.

And in order for the retail store to be in business

the retailer has to buy it from us for quite a bit less than $50.

In our case, the retailer margin, that is the difference between

the price the consumer pays and the price the retailer pays us, is 50%.

And so the retailer buys the product from us for $25.

Now we have to work back from the price we get, which is $25,

to what our target cost would be.

Now to do that we need to think about what our target gross margin is.

We, as the manufacturer, or probably more accurately we,

as the brand owner, what is our target gross margin.

Let's just for

the sake of argument say that our target gross margin is 40% that is on average.

We want to be able to make about 40% of our revenue in terms of gross margin.

What that suggest is that we need to pay no

more than 60% of $25, or $15.

$15 would be the maximum cost of goods for

us to have the product in our hands, ready to deliver to the retailer.

For us to be able to sustain a supply chain, that gives us 40%

gross margin and gives our retailer 50% gross margin.

So working back from $50, $50 is the retail price the consumer pays,

$25 is the wholesale price the retailer pays us.

And in order for us to be able to sustain a 40% gross margin,

we must pay no more than $15 to have that product in our warehouse in California.

I want to now dive in on two additional points.

One is, where that gross margin comes from and

how you actually calculate the gross margin.

And the other is to talk about what's in cost of goods.

That is, what has to be included in that $15 in order for this all to work.

So let's first start with gross margin.

Gross Margin is defined as the price minus the cost, divided by the price.

And this is always taken from the perspective of the entity that's

selling the product.

So, if we take, as an example,

the museum store that is selling our product to the consumer.

Their price, minus their cost, divided by their price, will give the gross margin.

And so for instance, using the numbers in this example,

$50 is the price they offer to the customer, $28 is the cost they paid to us.

So 50 minus 28 is $22.

That divided by the retail price, or divided by 50, gives us 44%.

So that would be an example of a retail margin calculation of 44%.

Now it just gave in the example that the retailer buys it from us for $25.

That would give a gross margin of 50%.

50- 25 divided by 50 would be 50%.

And so depending on what those different parameters are, the price and

the cost you get different gross margins.

Now I want to just identify a difference in

terminology that's sometimes used in retailing.

Some retailers and some manufacturers will use the term mark up.

Which is related but different from margin.

More specifically, mark up is defined as the price divided by the cost minus one.

And so, let me give a numerical example that I think will

help make that a little more clear If price is $50, and

if my cost is $28 then my mark up is 79%.

Let me just walk through that arithmetic.

50 divided by 28 is 1.79.

That means I'm selling the product for

1.79 times what I buy it for, 50 is 1.79 times 28.

If I subtract 1 from that then what I get is a mark up of 79%.

And the way to think about that, is the retailer takes the price that he or

she buys the product for, and marks it up by a value of 79% of his or her cost.

Now, that obviously is closely related to gross margin, but

they give very different numerical values.

And so I want you to keep them straight and

to make sure you're talking about gross margin and not mark up, or mark up and

not gross margin, when you're having a conversation about these numbers.

Mark up is related to gross margin by the following expression.

Gross margin divided by 1 minus gross margin is equal to mark up.

So that's how they're related parametrically.