Chapter 12 -Pricing Decisions and Cost Management

5/27/2018 Chapter 12 -Pricing Decisions and Cost Management

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Chapter Twelve

Pricing Decisions and CostManagement


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Short-run and long-run pricing decisions

Target costing

Cost incurrence and locked-in costs

Cost-plus costing

Life-cycle budgeting and costing

Non-costs factors in setting price Anti-trust laws

Learning Objectives


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The Five Forces Affect Pricing


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Influences on Supply and Demand

1. Customers - by establishing demand level

Based on factors such as quality and product features

2. Competitors/Potential Entrants/Substitutes - by

establishing alternatives

Through pricing schemes, product features, and

production volume

3. Suppliers by affecting costs and supply

The lower the cost, the greater the supply


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StrategicPositioning Affects Pricing

Cost Leadership:Outperform competitors by producing at the lowest cost,

consistent with the quality demanded by the consumer

Differentiation:

Create value for the customer through product

innovation, product features, customer service, etc. for

which the customer is willing to pay


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Short-Term Pricing

Less than one year:

One time special order with no long-run implications

Adjusting product mix and output volume in a competitive

market

Many costs are irrelevant in short-term pricing

Fixed costs - price above contribution margin

R&D, design, etc. will not change in the short run


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Costing and Pricingfor the Short Run Example

Lomas Corporation operates a plant with

a monthly capacity of 500,000 cases

of tomato sauce.

Lomas is presently producing

300,000 cases per month.

Del Valle has asked Lomas and two other

companies to bid on supplying 150,000

cases each month for the next four months.


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Cost Per Case

Variable manufacturing $38Variable marketing and distribution 13

Fixed manufacturing 14

Fixed marketing and distribution 15Total $80


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If Lomas makes the extra 150,000 cases, the existing

total fixed manufacturing overhead ($4,200,000 per

month) would continue, plus an additional $165,000

of fixed overhead will be incurred per month.

Total fixed marketing and distribution

costs will not change.

What price should Lomas bid?


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Relevant Costs

Variable manufacturing $38.00

Fixed manufacturing 1.10

Total $39.10

$165,000 150,000 = $1.10

Any bid above $39.10 will improve

Lomass profitability in the short run.


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Suppose that Lomas believes that Del Valle

will sell the tomato sauce in Lomass currentmarkets but at a lower price than Lomas.

Relevant costs

should include revenues lost on salesto existing customers.


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Long-Term Pricing

One year or longer Pricing a product in a major market where there is some

leeway in setting price

Fixed costs are relevant, since they can be managed in thelong run

Set Profit margins to earn areasonable return on

investment Lower prices when demand is weak and increase them

when demand is strong


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Long-Term Pricing Optimization


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Long-Term Pricing Approaches

Cost-based

Base price on production costs

Plus a required rate of returnMarket-based

Base price on customers demand and competitor reaction


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Markets and Pricing

Competitive markets market-based approach

Commodities such as oil, steel, etc.

Less-competitive markets either market-based or cost-

based approach

Professional services, high end automobiles, etc.

Usually look at costs first

Often comes down to bidding or negotiation

Noncompetitive markets cost-based approach

Maximize margins constrained by customer limits


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Costing and Pricingfor the Long Run Example

Latisha Computer Corporation manufactures

two brands of computers: Simple Computer (SC)

and Complex Computer (CC).

Latisha uses a long-run time horizon to price

Complex Computer (CC).


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Direct materials costs vary with the

number of units produced.

Direct manufacturing labor costs vary

with direct manufacturing labor hours.

Ordering and receiving, testing and

inspection, and rework costs vary

with their chosen cost drivers.


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Ordering: $78 per order

Testing: $ 2 per inspection hour

Rework: $38 per unit reworked

Cost per Unit

Direct materials $450.00

Direct labor:

3.50 hours @ $19 per hour 66.50

Total $516.50


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Number of orders placed: 17,000

Number of testing hours: 3,000,000

Number of units reworked: 8,000

The direct fixed costs of machines used

exclusively for the manufacture of

Complex Computer total $7,000,000.

What is the cost of producing 100,000

units of Complex Computer?


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Direct material and labor $51,650,000

Direct fixed costs 7,000,000Ordering (17,000 $78) 1,326,000

Testing (3,000,000 $2) 6,000,000

Rework (8,000

$38) 304,000Total $66,280,000

$66,280,000 100,000 units = $662.80/unit


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Market-Based Pricing

Must understanding customers and competitors:

Competition from lower cost producers limits ability

to increase prices

Commodity products must turn over quickly, leaving

little room to recover from pricing mistakes

Customers demand quality products at reasonable

prices


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Market-Based Pricing

Start with a targetprice

Estimated price that potential customers will pay

Based on customers perceived value

Or how competitors will price competing products or

services


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Target Pricing/Target Costing

1. Develop a product that satisfies potential customer

needs

2. Choose a target price

3. Derive a target cost per unit:

Target price per unit minus target operating

income per unit

4. Perform cost analysis

5. Perform value engineering to achieve target cost


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Implementing Target Pricingand Target Costing

Latishas management wants a 15% target

operating income on sales revenues of CC.

Target sales revenue is $750 per unit.

What is the target cost per unit?

$750 .15 = $112.50, $750 $112.50 = $637.50

Current full cost per unit of CC is $662.80


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Product

Design

Research

and

Development

Value Engineering

Securing raw

materials andother resources

Production

Marketing

Distribution

Customer

Service


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Value Engineering

A systematic evaluation of the value chain

Reduce costs while improving quality and satisfying

customer needs

Distinguish value-addedactivities and costs from non-

value-addedactivities and costs


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Value Engineering Terminology

Value-added costs

If eliminated, would reduce the value to customers

Non-value-added costs

If eliminated, would notreduce value to customers

A cost the customer is unwilling to pay for

Gray area Many costs fit between the two extremes

e.g., preventative maintenance


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Value Engineering Terminology

Cost incurrence

The point in time when a resource is consumed (or

benefit foregone)

Locked-in costs (designed-in costs)

Have not yet been incurred but, based on decisions that

have already been made, will be incurred in the future


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Cost Incurrenceand Locked-In Costs Graph


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Problems with Value Engineering andTarget Costing

Employee frustration with failed targets

A cross-functional team may over-engineer, to

accommodate the wishes of team members

A product development may require a long time as

alternative designs are repeatedly evaluated

Risk of organizational conflict

The burden of cost cutting falls unequally on different

business functions


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Value Engineering and Target Costing

http://www.forbes.com/sites/joannmuller/2013/01/13/

new-corvette-is-a-sign-of-the-times-at-gm/


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Cost-Based (Cost-Plus) Pricing

Add a markup to the cost base to determine a prospective

selling price

Usually, it is only a starting point in the price-setting

process

The markup is somewhat flexible, based partially on

customers and competitors


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Forms of Cost-Plus Pricing

Setting a target rate of return on investment

The target annual operating return that an organization

aims to achieve, divided by invested capital

Selecting the cost bases for the cost-plus calculation:

Variable manufacturing cost

Variable cost

Manufacturing cost

Full cost


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Common Business Practice

Most firms use full cost for their cost-based pricing basis,

because:

It allows for full recovery of all costs

It allows for price stability

It is simple


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Cost-Plus Pricing

Assume that Latishas engineers

have redesigned CC into CCI ata new cost of $637.50.

The company desires a 20% markup

on the full unit cost.What is the prospective selling price?


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Cost-Plus Pricing

Cost base: $637.50

Markup component: (637.50 .20) 127.50

Prospective selling price: $765.00


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Life-Cycle Budgeting and Costing

Estimating the revenues and individual value-chain costs

attributable to each product

From initial R&D to final customer service and

support

Until services are no long offered on that product

(orphaned)


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Important Considerations forLife-Cycle Budgeting

Non-production costs are significant

Development period for R&D and design is long and

costly

Many costs are locked in at the R&D and design stages,

even if R&D and design costs are themselves small

Lif C l B d i


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Life Cycle Budgeting


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Other Important Considerations inPricing Decisions

Price discrimination

Charging different customers different prices for the

same product or service

Illegal if the implication is to limit competition

Peak-load pricing

Charging a higher price for the same product or servicewhen demand approaches the production capacity limit


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The Legal Dimension ofPrice Setting

Price discrimination

Predatory pricing is deliberately lowering prices

below costs in an effort to drive competitors out of

the market and restrict supply, and then raising

prices


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Dumping

A non-U.S. firm sells a product in the United States at a

price below the market value in the country where it isproduced

This lower price materially injures or threatens to

materially injure an industry in the United States


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Collusive pricing

Companies conspire in their pricing and production

decisions to achieve a price above the competitive priceand so restrain trade

Chapter 12 -Pricing Decisions and Cost Management

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