The method involves subtracting a desired profit margin from a competitive market price to arrive at an allowable production cost. For example, if a product can be sold for $100 in the market, and the company requires a 20% profit margin ($20), then the maximum allowable cost to manufacture the product is $80. This establishes a cost objective that the company must achieve.
This strategic approach is vital for businesses seeking to remain competitive in price-sensitive markets. By focusing on the desired selling price first, organizations are forced to innovate and control expenses throughout the product development and production processes. This approach gained prominence as businesses faced increased global competition and the need to deliver value to customers while maintaining profitability.