Linear Performance Pricing
Most companies lack a sound, objective basis for defining target prices. The linear performance pricing strategy is one way to identify a technical cost driver crucial for the product price of a sourcing category, which can then serve as the basis of objective target prices.
In the case of simple components where the crucial cost driver is evident (for example, weight) a straightforward “rule-of-three” calculation is sufficient to determine the target price. Simple steel parts and products sold by the yard/meter are good examples.
At first sight the method may appear straightforward; however, the devil is in the details—the crucial cost driver is not always so easy to identify. Then there are cases in which the cost effect is far from clear. In the case of a casting, for example, both the weight and also the cross-section area of the mold can be relevant cost drivers.
The challenge is to pick the crucial cost driver out of all the possible ones. An appropriate method for this is simple correlation analysis. The result indicates the strength of the correlation between the cost driver and the price. The cost driver with the highest correlation to the price is the relevant one. After identifying the relevant cost driver with the aid of correlation analysis, the target price can then be determined, again using a rule-of-three calculation.
To be able to use linear performance pricing, however, there must be only one relevant cost driver, which usually means that the item concerned has to be relatively simple. Simple parts that contain a large proportion of raw material, such as simple castings, crude steel, or copper wire, for example, are highly suited to this method. More complex parts, such as those involving various process steps, are not suited to linear performance pricing.