1

Chapter 12

Pricing and Cost Management

2

Players in Pricing

Customers Competitors (heterogeneous oligopoly)

Pricing Strategies passive

adapt price to competitors‘ will not induce competitive action compete by quality, service, and differentiation cost Management should ensure profitability

aggressive based on cost leadership position attempt to increase market share induces retaliation by competitors shakeout of weak competitors target: quasi-monopoly position

3

Time Horizon of Pricing Decisions

short-run bottom price: incremental cost But: beware of side effects:

Is it really additional business??? one-time customer could compete with „our“ other

customers‘ business and undercut their prices (Cannibalization)

Relevant costs of the bidding decision should include revenues lost on sales to existing customers (Opportunity costs)

long-run bottom price: cost of resources used for the respective object estimated by using ABC but: Competition on the product market may require

reduction of the current cost level long-run prices should always be market-based

exception: sometimes government contracts neglecting market reaction foregoes profit potential

4

Target Price and Target Cost

Target price is part of the product concept it is designed with the product using marketing research

methods (conjoint measurement) Conjoint measurement uses experiments to figure out

customers‘ willingness to pay for the product depending on its features

Target Cost the allowable cost that leaves a target profit margin based on predicted product life cycle sales volume at the

target price price and sales volume may change over the product life

cycle according to expected dynamics target profit then has to be determined as the net present

value of the Product all over the life cycle hard to estimate

5

Simultaneous Engineering

Specify product concept that satisfies the needs

of the target market segment Choose a target price, estimate sales level at this price

Product design and design of productive system processes equipment supply chain

are developed simultaneously. Objective: find a solution that is viable under competition and

yields a positive net present value given the company‘s cost of capital i.e. its risk-adjusted rate of return sometimes if not usually, the required rate of return is set above

the market rate why?: the returns from the products must cover average

development costs of unsuccessful products.

6

Target rate of return

assuming constant price and sales volume or considering an average over the product life cycle :

rS = Target return on sales:

target cost = (1 rS) target price markup = rS / (1 rS)

rI = Target return on investment rI can be derived from capital market data: „required rate of

return“ on the capital market

rS = rI / turnover rate

turnover rate = additional sales / additional investment

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Example

A company has invested 100,000$ in assets to produce a certain product.

The investors‘ required rate of return rI = 10%

Full costs of production per unit of the 1,000 units produced is 150$.

What is the markup rate needed to earn the required return on Investment?

What is the target return on sales?

8

Value-Added vs. Nonvalue-Added Costs

A value-added cost is a cost that customers perceiveas adding value, or utility, to a product or service

A nonvalue-added cost is a cost that customers do not perceive as adding value, or utility, to a product or service. Cost of expediting Rework Repair

Value-added costs of processes, however, should be defined from the company‘s point of view it may be quite profitable to keep units in stock while this

does not add to customer value; however it saves other costs

9

How to determine the allowable costs of a component

Target costing helps to determine what the allowable costs of each component of a product are

Start from the allowable costs of the product Proceed in three Steps:

Identify how different functions of the product (attributes) affect the customers’ willingness to pay

Determine to what extent a component contributes to a specified function or attitude

Taking step one and two into consideration to determine the allowable cost of each component

Problem: Interaction effects between features

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Cost Incurrence andLocked-in Costs

R&D andDesign Manufacturing Mkt., Dist.,

& Cust. Svc.

Value-ChainFunctions

Cu

mu

lati

ve C

osts

per

Un

it

Locked-in Cost Curve

Cost-Incurrence

Curve

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Cost Incurrence and Locked-in Costs

At the end of the design stage, direct materials,direct manufacturing labor, and many

manufacturing, marketing, distribution,and customer-service costs are all locked in.

When a sizable fraction of the costs are locked inat the design stage, the focus of value engineeringis on making innovations and modifying designs

at the product design stage.

12

Excursion: Interdependence of products

A company produces two different products, x1 and x2

The number of units that can be sold in the market can be described using the following functions:

x1 = 400 – 2p1 – (+) p2

x2 = 200 – 4p2 –(+) p1

Variable costs are k1 = 2 and k2 = 4

Which kind of interdependence is expressed by – (+)?

How many units should be produced of each product to maximize profit in either situation?

13

Life-Cycle Budgeting

The product life cycle spans the time fromoriginal research and development, through

sales, to when customer support is no longer offered for that product.

A life-cycle budget estimates revenues andcosts of a product over its entire life.

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Costs beyond the market phase of the PLC

Nonproduction Costs less visible on a product-by-product basis. When nonproduction costs are significant, identifying

these costs by product is essential for target pricing, target costing, value engineering, and cost management.

Development Costs When a high percentage of total life-cycle costs are

incurred before any production begins and before any revenues are received, it is crucial for the company to have as accurate a set of revenue and cost predictions for the product as possible.

Costs after the end of the PLC disposal costs design for remanufacturing

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Price Discrimination Laws

They apply to manufacturers, not service providers. Price discrimination

under the U.S. Robinson-Patman Act, a manufacturer cannot price-discriminate between two customers if the intent is to lessen or prevent competition for customers.

Price discrimination is permissible if differences in prices can be justified by differences in costs.

Predatory pricing occurs when the predator company charges a price that is below an

appropriate measure of its costs, and the predator company has a reasonable prospect of recovering in

the future the money it lost by pricing below cost. Most courts in the United States have defined the “appropriate

measure of costs” as the short-run marginal and average variable costs.

Dumping occurs when a non-U.S. company sells a product in the United States at a price

below the market value in the country of its creation, and its action injures an industry in the United States.

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Price Discrimination Laws

Collusive pricing occurs whencompanies in an industry conspire in their pricing and output decisions to achieve a price above the competitive price.

Assignments for Chapter 12:

12-17 (5%) 12-27 (8%) 12-19 (5%) 12-29 (=11.12-30) (8%) 12-23 (8%), 12-31 (new in 11th ed.)(5%), 12-33 (=11.12-28) (8%)

12-25 (5%), 12-35 (new in 11th ed.)(10%)

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Quiz

1.       Short-run pricing decisions include

a.       pricing a main product in a major market

b.       considering all costs in the value-chain of business functions.

c.       adjusting product mix and volume in a competitive market while maintaining a stable price if demand fluctuates from strong to weak.

d.       pricing for a special order with no long-term implications.

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Quiz

2. Pritchard Company manufactures a product that has a variable cost of $30 per unit. Fixed costs total $1,500,000, allocated on the basis of the number of units produced. Selling price is computed by adding a 20% markup to full cost. How much should the selling price be per unit for 300,000 units?

a. $49 b. $43.75 c. $42 d. $35

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Quiz

 3.       The first step in implementing target pricing and target costing is

a.       choosing a target price.b.       determining a target cost.c.       developing a product that satisfies

needs of potential customers.d.       performing value engineering.

 

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Quiz

 4.       The best opportunity for cost reduction is

a.       during the manufacturing phase of the value chain.

b.       during the product/process design phase of the value chain.

c.       during the marketing phase of the value chain.

d.       during the distribution phase of the value chain.

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Quiz

The following data apply to questions 5 and 6. Each month, Haddon Company has $275,000 total

manufacturing costs (20% fixed) and $125,000 distribution and marketing costs (36% fixed). Haddon’s monthly sales are $500,000.

 5.       The markup percentage on full cost to arrive at the

target (existing) selling price isa. 25%. b. 75%. c. 80%. d. 20%.

6.       The markup percentage on variable costs to arrive at the existing (target) selling price is

a. 20%. b. 40%. c. 80%. d. 66 %.

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Quiz

7.       The price of movie tickets for opening day and the few days following compared to the price six months later is an example of

a.       price gouging.b.       peak-load pricing.c.       dumping.d.       demand elasticity.

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Quiz

 8.       Which of these do antitrust laws on pricing not cover?

a.       Collusive pricingb.       Dumpingc.       Peak-load pricingd.       Predatory pricing

 

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12-17 (data in million $)

Offer: 3000 units @ $85; capacity: 300 000 units < max demand Sales manager would accept flat sales commission: $6,0001. effect on operating income if accepted?2. Accept?

Revenues (200,000 units @ $100 (average))

variable costs

direct materials ($35 per unit)

direct manufacturing labor ($10 per unit)

variable manufacturing overhead ($5 per unit)

sales commissions (15% of revenues)

other variable costs ($5 per unit)

total variable costs

Contribution margin

Fixed costs

Operating Income

7

2

1

3

1

20

14

  6

  5

  1

25

12-27 (in $1 000)

capacity: 1 500 crates; relevant range of fixed costs: 500 to 1500 crates.

1. markup% of total variable costs

2. Offer: 200 crates @ $55 cash; $2000 cost of special packaging; customer disappears in six weeks. Accept?

3. If customer stays in business: Accept?

Revenues (1 000 crates @ $100)

CoGS ($20 000 fixed)

Gross margin

Marketing costs ($16 000 fixed)

OI

$100

  60

40

  30

10

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12-19 (in 1 000$)

1. classify: value-added/non-value-added/ grey area2. if 65% of cost in grey area is value-added: how much of total

cost is value-added/non-value-added?3. quality improvement and other cost Management measures:

change %ages in right-hand column

Materials and labor for servicing machine tools

rework costs

expediting costs caused by work delays

materials handling costs

materials procurement and inspection costs

preventive maintenance of equipment

breakdown maintenance of equipment

800

75

60

50

35

15

55

  -5%

-75% (a)

-75%

-25%

-20%

+50%

-40%

(b)

(c)

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12-29

Indirect Manufacturing Cost per Unit ofCost Pool Cost Driver Cost Driver

Materials handling Number of parts $ 0,80Assembly management Hours of assembly time $48,00Machine insertion of partsNo. of machine inserted parts $ 0,75Manual insertion of parts No. of manually inserted parts $ 1,90Quality testing Testing hours $35,00

Direct material cost per unit

Indirect ManufacturingCost Pool P-81 P-63 P-81 REV P-63 REV

Materials handling 90 50 75 42 partsAssembly management 2,8 1,8 2,0 1,5 assembly-hoursMachine insertion of parts 49 31 59 29 partsManual insertion of parts 41 19 16 13 partsQuality testing 1,2 1,0 1,2 0,9 testing-hours

Direct material cost per unit $400,50 $286,50 $385,00 $260,00

Quantity of Cost Driver Per Output Unit

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12-23

expected demand: 16 000 room nights capital invested: $960 000 target return: 25%

1. Price per room night?

2. a price decrease of 10% would increase demand by 10%; decrease price?

variable operating costs

fixed costs

salaries and wages

maintenance of building and pool

other operating and administration costs

total fixed costs

$3 per room-night

$175 000

37 000

  140 000

352 000

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12-31

Order: 5 000 violins @ full cost + maximum markup of 20%

1. minimum acceptable price2. price @ full cost (without administrative cost) + incr.

administrative cost + maximum markup of 20%3. take offer @ $33 per unit?

Assembly rate 4 violins per direct manufacturing labor hourVariable direct manufacturing labor cost$ 60 per direct manufacturing labor hourVariable overhead cost $ 20 per direct manufacturing labor hourFixed overhead cost $ 50 per direct manufacturing labor hourIncremental administrative costs $10.000

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12-33

bdgeted supply 80 000 hrs of labor variable costs $12 per hr. fixed costs: $240 000

1. cost plus price @20%?

2. optimal price if:

3. Comment

Price per hr. Demand (1000 hrs)

$16

17

18

19

20

120

100

80

70

60

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12-25

Production and sales

Life cycle costs

R&D and design

Manufacturing

variable cost per watch

variable cost per batch of 500 units

fixed costs

Marketing

variable cost per watch

fixed cost

Distribution

variable cost per batch of 160 units

fixed costs

Customer service cost per watch

400 000 units @ $40

$1 000 000

$15

$600

$1,800,000

$3.20

$1,000,000

$280

$720 000

$1.50

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12-35 

1. price $480, sales 4 000 units of either model. Which one should be chosen?

2. cost structures?3. Yellin‘s favorite model, when she leaves after year 2

and gets a bonus according to division OI?

Years 1 & 2R&D CostsDesign Costs

Years 3 to 6 Total Variable Cost Total Variable CostFixed Costs Per Package Fixed Costs Per Package

Production costs $100.000 $25 $100.000 $25 Marketing costs 70.000 24 90.000 40 Distribution costs 50.000 16 80.000 25 Customer service costs 80.000 30 100.000 50

GL1 GL2

$240.000 160.000

$150.000 75.000