Pricing decisions

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Pricing Decisions Pricing Decisions EMBA 5411 Budgeting and Pricing

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marketing managment

Transcript of Pricing decisions

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Pricing DecisionsPricing DecisionsEMBA 5411

Budgeting and Pricing

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Pricing External sales- outside

Target costing Cost plus pricing Variable cost pricing Time and material pricing

Internal-within the company among divisions Negotiated transfer prices Cost based transfer prices Market based transfer prices Effect of outsourcing on transfer prices Transfers between divisions in different countries

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Profit MaximizationEconomic Theory

The quantity demanded is a function of the price that is charged

Generally, the higher the price, the lower the quantity demanded

Pricing Management should set the price that provides

the greatest amount of profit

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Quantity made

and soldper month

Determining the Profit-Maximizing Price and QuantityDollars

per unit

Demand

Marginalrevenue

q*

p*

Marginalcost

Profit is maximized where marginal cost equals

marginal revenue, resultingin price p* and quantity q*.

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Determining the Profit-Maximizing Price and Quantity

Total revenueDollars Total cost

Total profit at the profit-maximizingquantity and price,

q* and p*.

Quantity made

and soldper month

q*

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Price Elasticity

The impact ofprice changes on

sales volume

Demand is elastic ifa price increase has alarge negative impact

on sales volume.

Demand is inelastic ifa price increase has

little or no impact on sales volume.

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Who determines the price?

Price takers- when there is a competitive market and the company has no influence on price Once competition enters the market, the price of a

product becomes squeezed between the cost of the product and the lowest price of a competitor.

Price makers- companies that influence the price

• Organizations that choose to compete by offering innovative products and services have a more difficult pricing decision because there is no existing price for the new product or service.

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Influences on Price Customer demand Competitors’ behavior/prices/actions Costs Regulatory environment – legal, political

and image related

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Pricing approaches Cost plus mark-up

Variable – contribution margin approach, contribution margin( reflecting mark-up) should cover desired return on investment, all fixed costs

Absorption – common- mark-up covers all expenses except cost of goods sold plus the desired return on investment

Target costing – price is known, desired return on investment is known, price is known = determine the maximum cost per unit

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Product Life Cycle

http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf

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Life Cycle Costing Life cycle costs are the total costs

estimated to be incurred in the design, development, production, operation, maintenance, support, and final disposition of a product/system over its anticipated useful life span (Barringer and Weber, 1996).

The best balance among cost elements is achieved when the total LCC is minimized (Barringer and Weber, 1996).

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Cost-plus Pricing Cost + mark-up = price Mark-up = cost x desired % return

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Which cost? Variable manufacturing costPrice= vari.man. costs + markup% * var.man.costMark-up should cover the remaining costs and

provide for the desired profit, i.e. variable selling and all fixed costs

Desired profit = desired % return * investment

itproducednumberofuntperunitman

fitdesiredprotsfixedsellingmarkup

*cos..var

cos.var%

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Which costs? Total variable costs

Variable manufacturing and selling costs

Price= variable costs + markup %* variable costs

itproducednumberofuntperunitiable

fitdesiredprotsfixedmarkup

*cosvar

cos%

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Which costs? Absorption – manufacturing costs Unit manufacturing costs – both variable

and fixed

Price= unit manuf. cost + markup %* unit manufacturing cost

itproducednumberofuntunitmanuf

fitdesiredproensesadmsellingandmarkup

*cos.

exp.%

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Which costs? Absorption – total costs

Total costs – manufacturing and selling and administrative –fixed (direct or allocated, variable costs)

Price= unit cost + markup %* unit cost

itproducednumberofuntunit

fitdesiredpromarkup

*cos%

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Example - PricingAnnual production 480 unitsUnit costs:

Variable manufacturing cost $ 400Applied fixed manufacturing cost $ 250Absorption manufacturing cost $ 650Variable selling costs $ 50Allocated and direct fixed selling and administrative costs

$ 100Total cost $ 800

Investment $ 600,000Desired profit 10% of investment $ 60,000Annual Fixed Manufacturing Costs $ 120,000Annual Fixed (allocated and direct) Selling and Administrative

Costs $ 48,000

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Cost Plus Pricing Versionsvariable manufacturing cost-plus-pricingVariable manufacturing cost $400

Total Variable Selling Costs ($50 x 480 units) $24,000mark -up % 131.25%markup $525Price = cost + markup $925

variable total cost-plus-pricingTotal variable cost per unit $450

mark -up % 105.56%markup $475Price = cost + markup $925

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Cost Plus Pricing Versionsabsorption manufacturing cost-plus-pricingmanufacturing cost per unit $650

Total variable selling costs $24,000mark -up % 42.31%markup $275Price = cost + markup $925

total absorption- cost-plus-pricingmanufacturing cost per unit $800

mark -up % 15.63%markup $125Price = cost + markup $925

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Time and Material Pricing Determine a charge for labor that includes

overhead Determine a charge for materials that

includes handling and storage costs Include a profit Sum = price Used in service companies mainly;

appropriate for construction companies as well

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ExampleInvestment $700,000.00Desired profit 10% of investment $70,000.00Annual labor hours 10,000Hourly charge to cover profit margin $7.00

Labor rate per hour $18.00Annual overhead costs:

Material handling and storage $40,000.00

Other overhead costs(supervision,utilities, insurance,and depreciation) $200,000.00

Annual cost of materials used in repair department $1,000,000.00

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Time and Material ChargesTime Charge per hour = hourly labor cost + annual overhead (excluding material overhead) / annual labor hours+ hourly charge to cover profit margin

= $18 + ($200,000 / 10,000 hours) + $7 = $ 45 per hour

Material Charge formulaMaterial cost incurred on job

+[material cost incurred on job *(material handling and storage costs /

annual cost of materials used in Repair department)] = material costs incurred on job +[material costs incurred on job

($40,000/$1,000,000)]=1.04 x material costs incurred on job

4% of material costs

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Example con’tJOB NO 101Labor hours 200cost of materials $8,000

total price of job 101material cost $8,000handling and storage $320 total material cost $8,320.00

Labor rate $45.00labor hours 200

$9,000.00TOTAL COST OF JOB 101 $17,320.00

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Internal Pricing – Transfer pricing issueTransfer Price is:

the internal price charged by one segment of a firm for a product or service supplied to another segment of the same firm

Such as: Internal charge paid by final assembly division for

components produced by other divisions Service fees to operating departments for

telecommunications, maintenance, and services by support services departments

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Effects of Transfer Prices Performance measurement: Reallocate total company profits among business segments Influence decision making by purchasing, production, marketing, and

investment managers

Rewards and punishments: Compensation for divisional managers

Partitioning decision rights: Disputes over determining transfer prices

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Ideal Transfer PricingIdeal transfer price would be Opportunity cost, or the value forgone by not using

the transferred product in its next best alternative use

Opportunity cost is the greater of variable production cost or revenue available if the product is sold outside of the firm

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Transfer Pricing Methods External market price

If external markets are comparable Variable cost of production

Exclude fixed costs which are unavoidable Full-cost of production

Average fixed and variable cost Negotiated prices

Depends on bargaining power of divisions

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Transfer Pricing Implementation

Disputes over transfer pricing occur frequently because transfer prices influence performance evaluation of managers

Internal accounting data are often used to set transfer prices, even when external market prices are available

Classifying costs as fixed or variable can influence transfer prices

determined by internal accounting data

To reduce transfer pricing disputes, firms may reorganize by combining interdependent segments or spinning off some segments as separate firms

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Transfer Pricing for International TaxationWhen products or services of a multinational firm are transferred between

segments located in countries with different tax rates, the firm attempts to set a transfer price that minimizes total income tax liability.

Segment in higher tax country:Reduce taxable income in that country by charging high prices on imports and low prices on exports.

Segment in lower tax country:Increase taxable income in that country by charging low prices on imports and high prices on exports.

Government tax regulators try to reduce transfer pricing manipulation.