Contrôle Interne Avancé-HEC Lausanne- 2007/2008 1 Thème 6 Pricing Decisions and Cost Management

Contrôle Interne Avancé-HEC Lausanne-2007/2008

1

Thème 6

Pricing Decisions

and

Cost Management


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Pricing and Business

How companies price a product or service ultimately depends on the demand and supply for it,

Three influences on demand and supply:1. Customers,

2. Competitors,

3. Costs.


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Influences on Demand and Supply

1. Customers – influence price through their effect on the demand for a product or service, based on factors such as quality and product features,

2. Competitors – influence price through their pricing schemes, product features, and production volume,

3. Costs – influence prices because they affect supply (the lower the cost, the greater the quantity a firm is willing to supply).


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Time Horizons and Pricing Short-run pricing decisions have a time horizon of

less than one year and include decisions such as: Pricing a one-time-only special order with no long-run

implications, Adjusting product mix and output volume in a competitive

market.

Long-run pricing decisions have a time horizon of one year or longer and include decisions such as: Pricing a product in a major market where there is some

leeway in setting price.


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Differences Affecting Pricing:Long Run vs. Short Run

1. Costs that are often irrelevant for short-run policy decisions, such as fixed costs that cannot be changed, are generally relevant in the long run because costs can be altered in the long run.

2. Profit margins in long-run pricing decisions are often set to earn a reasonable return on investment – prices are decreased when demand is weak and increased when demand is strong.


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Alternative Long-Run Pricing Approaches

Market-Based: price charged is based on what customers want and how competitors react,

Cost-Based: price charged is based on what it costs to produce, coupled with the ability to recoup the costs and still achieve a required rate of return.


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Markets and Pricing

Competitive Markets – use the market-based approach,

Less-Competitive Markets – can use either the market-based or cost-based approach,

Noncompetitive Markets – use cost-based approaches.


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Market-Based Approach

Starts with a target price,Target Price – estimated price for a

product or service that potential customers will pay,

Estimated on customers’ perceived value for a product or service and how competitors will price competing products or services.


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Focusedon design.

Considerationgiven to the

entirevalue chain.

Focusedsimultaneously

on profit andcost planning.

Driven by the customer.

Target costing is aimed at the earliest stagesof new product and service development.

The Target Costing Process


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Conceptdevelopment

Planningand market

analysis

Productiondesign and

valueengineering

Productionand

continuousimprovement

Targetprice

Profitmargin

Targetcost

Establishing theTarget Price

Attaining theTarget Cost

Components of the Target Costing Process


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Develop productsthat satisfy

customer needs.

Set target price usingcompetitors’ prices andcustomers’ perceived

value for product.

Target price – Profit margin = Target cost

Use value engineeringto find least costly

combination of resourcesto meet customer needs.

Developing target prices and targetcosts requires four steps:

Developing target prices and targetcosts requires four steps:

Components of theTarget Costing Process


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Involve entire valuechain in reducing

costs while satisfyingcustomer needs.

An understanding ofrelationships betweenprocess componentsand costs is critical.

A product’s functional characteristics to thecustomer are emphasized.

A primary objective is reducingdevelopment time.

ABC is used todetermine changes

that will reduce costs.

Characteristics of theTarget Costing Process


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Understanding the Market Environment

Understanding customers and competitors is important because:

1. Competition from lower cost producers has meant that prices cannot be increased,

2. Products are on the market for shorter periods of time, leaving less time and opportunity to recover from pricing mistakes,

3. Customers have become more knowledgeable and demand quality products at reasonable prices.


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Five Steps in Developing Target Prices and Target Costs

1. Develop a product that satisfies the needs of potential customers,

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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Value Engineering

Value Engineering is a systematic evaluation of all aspects of the value chain, with the objective of reducing costs while improving quality and satisfying customer needs,

Managers must distinguish value-added activities from non-value-added activities.


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Value Engineering Terminology

Value-Added Activities – an activity that, if eliminated, would reduce the actual or perceived value or utility (usefulness) customers obtain from using the product or service,

Non-Value-Added Activities – an activity that, if eliminated, would not reduce the actual or perceived value or utility customers obtain from using the product or service. It is an activity the customer is unwilling to pay for.


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Analysis andClassification

Activities

Value- and Non-value-Added Activities

Non-value-Added

Activities

Reduce orEliminate

Value-Added

Activities

Continually Evaluate

and Improve


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Value-added activitiesenhance the value of productsand services in the eyes of the customer while meetinggoals of the business.

Designing to customer specification.

Processing for just-in-time delivery to customers.

Competent customer service.

Value-added activitiesenhance the value of productsand services in the eyes of the customer while meetinggoals of the business.

Designing to customer specification.

Processing for just-in-time delivery to customers.

Competent customer service.

I love them!

Value-Added Activities


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Non-value-added activitiesuse resources withoutproviding value to customers. Material and other inventory

storage. Moving parts and materials in

the factory. Waiting for work. Inspection. Creating scrap and rework. Product design without

customer input.

Non-value-added activitiesuse resources withoutproviding value to customers. Material and other inventory

storage. Moving parts and materials in

the factory. Waiting for work. Inspection. Creating scrap and rework. Product design without

customer input.

Get ridof them!

Non-value-Added Activities


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Example

In a recent survey of the soap box market by Boards and More’s Marketing and Planning Department, customers expressed dissatisfaction with currently available packaging. Further analysis revealed soap manufacturers believe the packaging is too heavy, increasing their shipping costs. Soap consumers are also unhappy with the ink used because, when the boxes get wet, the printing bleeds or rubs off.

A cross-functional, cross-organizational team is assembled to create a product to satisfy customer needs. Notice that two sets of customers, both in the value chain, are important: the soap manufacturer and the soap consumer. The product creation team consists of marketing, design engineering, accounting, and production engineering personnel from Boards and More and similar personnel from the printing firm and the soap company.

The charge to the team is to create new paperboard for the cardboard soap boxes that satisfies customers’ needs.


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Example

All members of the value chain should participate in new product creation: if the new cardboard created by Boards and More is of a lighter weight but cannot properly absorb ink, then the solution is not viable.

Similarly, if the cardboard is lightweight but its strength does not allow proper filling by the machinery at the soap manufacturer, then the solution is not feasible.

Finally, in addition to the design changes that Boards and More considers undertaking, other team members from the printing or soap companies may want to modify or change their processes to satisfy the ultimate customer, the soap consumer.


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Product function analysis

The requirements/functions table helps the design engineers to focus on product functions that can best meet the needs of the customers.


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Example

The ability to bend and cut the cardboard is very important for how easy the box is to pour, its weight, and its strength.

Unfortunately, the current technology in paperboard implies that, although lightweight cardboard is easier to bend and cut and is easier for the consumer to pour, it is not strong enough to meet the soap manufacturer’s requirements.

If the box could be made stronger while simultaneously maintaining light weight and high absorption, several consumer requirements could be met. Of course, the problem of the additional cost associated with the lighter weight paperboard must be considered.


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Example

The marketing members of the team must determine the target price consumers are willing to pay to gain the desired requirements. After market surveys, it becomes clear that soap consumers are unwilling to pay more than the current price for the desired requirements. The soap manufacturer is thus unwilling to increase the amount it pays to Boards and More for the printed soap boxes.


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Example

Additional investigation reveals competitors are about to release new packaging designed to solve some of these problems—plastic bottles. The plastic bottles are lightweight and strong and have labels that eliminate the printing problems.

Although this new packaging approach does not require a price increase, the head marketing and engineering managers at Boards and More are skeptical of its acceptance by soap consumers because of pouring problems. The narrow neck of the plastic jug causes the powdered soap to clump together as it pours, creating problems for the consumer. It is clear, however, that competitors are working to solve these problems.


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The design engineers, working with the accountants who have gathered ABC information, have come up with a potential solution to meet customer requirements

Example


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Example

The design engineers propose an initial target cost of $1.77. Lowering the wood fiber content of the paperboard and using microscopic plastic fibers that reduce weight and increase strength generates this initial target cost. The new mixture would require fewer pounds of pressure when being rolled but would require longer drying time and higher heat during drying. The paperboard would then be ready for printing.

However, the printing company determines the new paperboard would require new printing technology because of absorption problems created by the plastic fibers. The new paperboard would increase printing costs by $0.03 and the total cost by $0.05 per box ($1.72 to $1.77).


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Example

Because the initial target cost of $1.77 is too high to maintain previous margins, value engineering becomes critical. Cost must be driven out of the value chain or the proposed solution will not be acceptable. One piece of the value chain not yet considered is the bending and cutting used to create the box.

Boards and More approaches the supplier that bends and cuts the boxes before they are shipped to the soap manufacturer. Boards and More asks for a price cut of $0.03 from the current price because the bending and cutting process should be easier and less costly, and the supplier agrees.

Then Boards and More suggests splitting the remaining $0.02 of the total cost increase with the printer to achieve the target of $1.72, the price the soap producer is willing to pay. The printer agrees to the $0.01 reduction and Boards and More finds a way to cut $0.01 out of its heating and drying costs. Through value engineering across the value chain, suppliers and producers are able to arrive at the desired target cost.

Documents

Contrôle Interne Avancé-HEC Lausanne- 2007/2008 1 Thème 6 Pricing Decisions and Cost Management