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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
7
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
10
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
11
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.
14
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
15
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.
16
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%)
17
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.
18
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
19
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.
20
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.
21
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 %.
22
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.
23
Quiz
8. Which of these do antitrust laws on pricing not cover?
a. Collusive pricingb. Dumpingc. Peak-load pricingd. Predatory pricing
24
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
$100
60
40
30
10
26
12-19 (in 1 000$)
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)
27
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
28
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
29
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
30
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
31
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
32
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
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