Module 20Module 20

Pricing and Pricing and

Related Related DecisionsDecisions

The Value ChainThe Value Chain The set of value-producing activities that The set of value-producing activities that

stretches from basic raw materials to the stretches from basic raw materials to the final consumerfinal consumer Each product or service has a separate Each product or service has a separate

value chainvalue chain All entities along the value chain depend All entities along the value chain depend

on the final customer’s perception of the on the final customer’s perception of the value and cost of a product or servicevalue and cost of a product or service

Three Levels of the Value Three Levels of the Value ChainChain

The value chain for the paperboard cartons The value chain for the paperboard cartons used to package beverages shows three used to package beverages shows three levels with each successive level showing levels with each successive level showing more detail. Who does what activities best?more detail. Who does what activities best?

Value Chain PerspectiveValue Chain Perspective Core competencies: Where do we fit Core competencies: Where do we fit

in the chain & what are we in the chain & what are we bestbest at? at? Relationships with suppliers & Relationships with suppliers &

customers becomes an integrated customers becomes an integrated partnership (data & vision)partnership (data & vision)

Considers the full cost, including Considers the full cost, including customer use…customer use…

Meet together to improve product Meet together to improve product value, processes and reduce costsvalue, processes and reduce costs Fewer suppliersFewer suppliers Some shared managementSome shared management

Supplier-Buyer Supplier-Buyer Partnership Partnership ExampleExample

Ford Motor Co. partners with selected Ford Motor Co. partners with selected suppliers who meet quality tests. They share suppliers who meet quality tests. They share production data, engineering design, and production data, engineering design, and some training. Must meet delivery of quality, some training. Must meet delivery of quality, time, and cost. time, and cost.

Industrial Molding Corp. (Lubbock) provides Industrial Molding Corp. (Lubbock) provides plastic components for Ford (and 20 other plastic components for Ford (and 20 other companies).companies).

Source: Hirsch, Steve. E-Management - Suppliers Become Closer Partners© International Trade Centre, International Trade Forum, Issue 3/2005.

The Pricing DecisionThe Pricing Decision

Important and complex decision for Important and complex decision for managementmanagement

Directly affects the salability and Directly affects the salability and profitability of individual products or profitability of individual products or servicesservices

Two pricing theoriesTwo pricing theories Economic approachesEconomic approaches Cost-based approachesCost-based approaches

Economic Approaches to Economic Approaches to PricingPricing Based on cost and revenue functionsBased on cost and revenue functions

Marginal revenueMarginal revenue The varying increment in total revenue derived from the The varying increment in total revenue derived from the

sale of an additional unitsale of an additional unit Marginal costMarginal cost

The varying increment in total cost required to produce and The varying increment in total cost required to produce and sell an additional unit of productsell an additional unit of product

Expand production until marginal revenue = marginal Expand production until marginal revenue = marginal cost cost For 1 company Expand to MC = Price For 1 company Expand to MC = Price

http://upload.wikimedia.org/wikipedia/commons/1/17/Profit_max_marginal_small.svghttp://upload.wikimedia.org/wikipedia/commons/1/17/Profit_max_marginal_small.svg

Entire market clears when production expands and price Entire market clears when production expands and price decreases to MC decreases to MC http://upload.wikimedia.org/wikipedia/commons/7/7a/Supply-and-demand.svg

Marginal revenues often unknown—just a guess. Marginal revenues often unknown—just a guess.

Cost-Based Approaches to Cost-Based Approaches to PricingPricing

Cost has traditionally been the most Cost has traditionally been the most important consideration in pricing important consideration in pricing because because Cost data are available.Cost data are available.

Feasible for setting prices in a short period of Feasible for setting prices in a short period of time time

Cost-based prices are defensible.Cost-based prices are defensible. Managers can argue prices represent a fair Managers can argue prices represent a fair

profitprofit Revenues must exceeds costs if the firm is Revenues must exceeds costs if the firm is

to remain in business. to remain in business. Long run selling prices must exceed the full costsLong run selling prices must exceed the full costs

Cost-Based Pricing Cost-Based Pricing in Single-Product in Single-Product

CompaniesCompanies

Example Lawn Chopper mows lawns and has an annual facilities cost totaling $30,000. Each lawn mowed costs $10. Management desires to achieve an annual profit of $40,000 at an annual volume of 5,000 lawns.

Known data are entered into a profit formulaKnown data are entered into a profit formula

Profit = Total revenues – Total costs$40,000 = (Price × 5,000) – ($30,000 + [$10 × 5,000])

Price = $24 per lawn

Then, will the customers pay $24 per week to have their lawns mowed?

Cost-Based Pricing in Cost-Based Pricing in Multiple-Product Multiple-Product

CompaniesCompanies Desired profits are obtained for entire Desired profits are obtained for entire

companycompany Standard procedures are established for Standard procedures are established for

determining initial selling prices of each determining initial selling prices of each productproduct Typically includeTypically include

Cost assigned to the product or servicesCost assigned to the product or services Plus a markup to cover unassigned costs Plus a markup to cover unassigned costs

and to provide a profitand to provide a profit

Pricing Bases in Pricing Bases in Multiple-Product Multiple-Product

CompaniesCompanies Possible cost bases for markups:Possible cost bases for markups:

Variable production costsVariable production costs Variable production, selling, and Variable production, selling, and

administrative costsadministrative costs Full manufacturing costs Full manufacturing costs

Markup on Cost BaseMarkup on Cost Base

General approach to developing a markup General approach to developing a markup is to recognize that the markup must be is to recognize that the markup must be large enough to provide for costs not large enough to provide for costs not included in the base, plus a profitincluded in the base, plus a profit

Markup on cost base =Markup on cost base =

Costs not included in the base + Desired profit

Costs included in the base

Variable Cost Basis Variable Cost Basis ExampleExample

Lawn Chopper has total assets of $320,000. Lawn Chopper has total assets of $320,000. Management desires an annual return of 12.5% Management desires an annual return of 12.5% on total assets. Fixed costs and expenses total on total assets. Fixed costs and expenses total $30,000, and variable costs and expenses total $30,000, and variable costs and expenses total $50,000. Estimated variable costs per unit equals $50,000. Estimated variable costs per unit equals $10.$10.

Markup on Variable CostsMarkup on Variable Costs

Desired annual profit = 12.5% × $320,000 = $40,000

$30,000 + $40,000$50,000 = 140% of VC

Selling price = $10 + ($10 × 1.40) = $24.00

Full Production Cost Full Production Cost Basis Basis ExampleExample

Lawn Chopper’s fixed costs and expenses total $30,000, of which Lawn Chopper’s fixed costs and expenses total $30,000, of which $10,000 are selling and administrative costs. Total variable costs $10,000 are selling and administrative costs. Total variable costs and expenses total $50,000, with $5,000 of this amount selling and and expenses total $50,000, with $5,000 of this amount selling and administrative costs. Estimated variable costs per unit equal $10 administrative costs. Estimated variable costs per unit equal $10 (with $1 of this selling and administrative costs). Full production (with $1 of this selling and administrative costs). Full production cost = $20,000 + $45,000 = $65,000 or $13 for each of the 5,000 cost = $20,000 + $45,000 = $65,000 or $13 for each of the 5,000 units. Desired profit is still $40,000.units. Desired profit is still $40,000.

Selling price = $13 + ($13 × 84.6%) = $24.00

Markup on Full Production CostMarkup on Full Production Cost

$10,000 + $5,000 + $40,000$20,000 + $45,000

= 84.6%

Critique of Cost-Based Critique of Cost-Based PricingPricing

If cost-based pricing does not have accurate If cost-based pricing does not have accurate cost assignments, some products could be cost assignments, some products could be priced too high and others too low. priced too high and others too low.

Cost-based pricing assumes goods or Cost-based pricing assumes goods or services are relatively scarce and, generally, services are relatively scarce and, generally, customers who want a product are willing to customers who want a product are willing to pay the price.pay the price.

Target Costing & ProductTarget Costing & Product Starts with determining what customers are willing to pay for a Starts with determining what customers are willing to pay for a

product or serviceproduct or service Then subtracts a desired profit on sales to determine the Then subtracts a desired profit on sales to determine the

allowable cost of the product or service allowable cost of the product or service Team must design a product that meets customer price, Team must design a product that meets customer price,

function, and quality requirements while providing the desired function, and quality requirements while providing the desired profitprofit

Save cost by designing the Save cost by designing the target product target product that will eventually that will eventually be in the market after competitors have responded.be in the market after competitors have responded.

Target Costing Requirements

Requires cost information Detailed information on the cost of

alternatives activities is needed Allows decision makers to select design and

production alternatives that are fast & cost effective

Requires coordination with all involved Need a basic understanding of the overall

processes required to bring a product to market

Should appreciate cost consequences Must respect, cooperate, and communicate

with other team members

Pros and Cons of Target Costing

Product Life Cycles

Time

Sal

es R

even

ue

Decline

Growth

Start-u

p

Maturity

Sales level off. Price pressure increases. Price reductions could be needed.

Sales level off. Price pressure increases. Price reductions could be needed.

Sales decline as product becomes obsolete. Significant price cuts needed to sell inventories.

Sales decline as product becomes obsolete. Significant price cuts needed to sell inventories.

Products with a relatively long life go through 4 stages during their life

cycle

Sales are low. Often selling prices are high. Customers are affluent trendsetters.

Sales are low. Often selling prices are high. Customers are affluent trendsetters.

Sales increase as product gains acceptance. Selling prices often remain high. Customers are loyal. Low competition.

Sales increase as product gains acceptance. Selling prices often remain high. Customers are loyal. Low competition.

Life Cycle Costs

Life cycle costs include all costs associated with a product or service ranging from Cost incurred with initial

conception Design Pre-production Production After production support

Cost management aided by target costing

Commitment and Expenditures

Commitments and expenditures of organizations for high-technology products with relatively short product lives

Commitments and expenditures of organizations for high-technology products with relatively short product lives

Kaizen Costing A costing approach focused on

continuous improvement Calls for establishing cost reduction

targets for products or services Begins where target costing leaves off Often found in companies that have

adopted a lean production philosophy

Successful companies often use Kaizen to avoid

complacency.

Successful companies often use Kaizen to avoid

complacency.

Benchmarking A systematic approach to identifying

best practices to help an organization take action to improve performance

Typically deals with Target costs for a product, service or

operation Customer satisfaction Quality Inventory levels Inventory turnover Cycle time Productivity