Lecture 6 Pricing

7/29/2019 Lecture 6 Pricing

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Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

CostAnalysis and

PricingDecisions

Topic 6(Chapter 15)


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Chapter Outline

Introduction Major influences on pricing decisions.

Pricing strategies

cost-plus pricing

target pricing

time and material pricing

Price Elasticity


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Major Influences on Pricing Decisions

Political, legal,& image issues

Competitors

PricingDecisions

Costs

Customerdemand


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Quantity madeand sold

per month

Determining the Profit-Maximizing Price and Quantity

Dollarsper unit

Demand

Marginalrevenue

q*

p*

Marginalcost

Profit is maximized wheremarginal cost equals

marginal revenue, resulting

in price p* and quantity q*.

15-4


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Pricing Strategies- Cost plus pricing

Direct material costs

Direct labour costs

Allocation of anygeneral &

administrative costs

Allocated productionoverhead

What is the priceto cover our costsand earn a profit?

Price = cost + (markup % cost)

Full cost of aproduct:

+

+

+


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Example 1 The per unit cost of making a product is as follows:

Manufacturing costsVariable cost $ 400

Fixed cost 250Full absorption manufacturing cost $ 650

Selling and administration costsVariable cost 50Fixed cost 100

Total cost $ 800

If the companys policy is to charge a mark-up of 25% on the

total (full) cost of the product, what is the price of the product?


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Example 1 The price of the product will be $1000 (800+25%of

800). Thus, the profit per unit is $200.

However, cost can be defined in many ways: Is your mark up going to be based on full absorption

manufacturing cost (sometimes referred to as totalmanufacturing cost) of $ 650? Or,

Price = 650 + 25% x 650

Is your mark up to be based on the total (full) cost of theproduct of $800? Or,

Are you going to consider only the variable costs (bothmanufacturing and selling and administration) of $450?


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Cost based pricing is popular because it issimple to use. However, there are variousdisadvantages

What are the

disadvantages?


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Disadvantages of cost based pricing: Demand and price

Cost based pricing to price the companys productsignores the relationship between prices and quantitysold

RMperunit

Quantity made& sold per

month

Demand


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Disadvantages of cost based pricing: Fixed costs

Fixed cost per unit decreases as activity level increases.

The problem with cost-driven pricing is that it is impossible to

determine a unit cost because unit cost changes with volume. This cost change occurs because a significant portion of costs

are "fixed" and must somehow be "allocated" to determine thefull unit cost.

Since these allocations depend on volume, unit cost is a moving

target.


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Example 2 From Example 1, assume that the capacity is

2000 units. Further, assume that all units

produced are sold. Thus, given the capacity of 2000 units, the total

manufacturing fixed cost is $500,000 and thetotal selling and administration fixed costs

is $200,000.


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Example 2 If production falls to 1000 units,

then unit manufacturing fixed cost will change to$500 (RM500,000/1000units)

unit selling and administration fixed costs willchange to $200 (RM200,000/1000 units)

Thus, the total cost per unit will change.


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Example 2 (contd) If the mark up percentage remains at 25%, the price using total cost

plus will be $1437.50 computed as follows:

Manufacturing costs

Variable cost $ 400Fixed cost 500

Full absorption manufacturing cost $ 900

Selling and administration costs

Variable cost 50Fixed cost 200

Total cost $1,150


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Example 2

Price = 1150 + 25% of 1150 = $1437.50

Cost based pricing may lead to the wrong decisionsbeing made, particularly in the short run


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Pricing Strategies-Target Pricing

Market research

determines the priceat which a newproduct will sell

Engineers and cost analystswork together to design a

product that can be manufacturedfor the allowable cost

Management subtractsan estimated profitmargin to yield the

target cost


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Target Costing

Design a product, and the manufacturingprocess, so that the product can be

manufactured at a cost that will enable the

firm to make a profit when the product is soldat an estimated market-driven price.

TargetPrice

TargetCost

TargetProfit


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Target costing is based on threepremises:

orienting products to customer affordability

(market-driven pricing) treating product cost as an independent variable

during the definition of a product's requirements

proactively working to achieve target cost during

product and process development


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Example Kiromoto Bhd is planning to launch a new CD-ROM

player with advanced features.

The marketing department believes that such a product

should sell for about $295 and would have total annualsales of about 200,000 units. In order to design,develop, and produce this CD-ROM player, aninvestment of $50 million would be required. Due to the

very short product lives of such products, the companyrequires a return on investment (ROI) of 40%.


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ExampleProjected sales (200,000 players X $295) $59,000,000

Less desired profit (40% X $50,000,000) 20,000,000

Target cost for 200,000 players $39,000,000

Average target cost per player

($39,000,000 200,000 players) $195


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Pricing Strategies-Time and material pricing

Price is the sum oflabor and materialcharges.

Used byconstructioncompanies,

printers, andprofessional servicefirms.


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Time charges:

Totallabor hours

required

Hourlylaborcost +

Overheadcost per

labor hour+

Hourly chargeto provide

profit margin

Material Charges:

Totalmaterial

costincurred

+Overheadper dollarof material

cost

Total

materialcost

incurred


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Example Motor Kong Repair Services incurs the following costs in a typical year:

Service PartsService employee wages $260,000Parts employee wages $ 40,000Shop supervision 36,000

Parts supervision 38,000Fringe benefits 59,000 15,000Supplies 6,000 2,000Utilities 12,000 5,000Rent 30,000 15,000Depreciation 40,000 5,000Other 7,000 2,000

Total $450,000 $122,000

The costs of parts used in repairs are billed directly to customers and are notincluded in the above table.

Determine the price to be charged to a customer on a repair job that requires3 hours of labor time and $40 in parts.


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Example Time Component

The service personnel work a total of 15,000 billable hoursin a typical year. Based on these data and a desired

margin of $5 per billable hour, the labor time rate would becomputed as follows:

Service costs per billable hour ($450,000 15,000) $30

Desired margin per billable hour 5

Time component charge $35

Thus, customers will be charged $35 per hour for servicepersonnel time.


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Example Material Component

The $122,000 cost of the parts department is recovered bymarking up the invoice cost of parts. Assume that the

invoice cost of parts is $305,000 per year. In addition, thecompany adds a 20% profit margin to the invoice cost.

Charge for ordering, handling, and

carrying parts ($122,000 $305,000) 40% of invoice cost

Desired profit margin on parts 20% of invoice cost

Material loading charge 60% of invoice cost

Thus, the amount charged for parts on a job willconsist of the invoice cost of the parts plus a materialloading charge equal to 60% of this cost.


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Example The Bill

In billing a job, the time and material components

are added together. For a repair job that requires 3 hours of labor timeand $40 in parts, the bill is as follows:

Time charge (3 hours $35) $105

Materials charge: Invoice cost of parts $40

Material loading charge ($40 60%) 24 64

Total price of the job $169


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Other Pricing Strategies

a. Special orderb. Competitive bidding

c. Penetration pricing

d. Price skimming

e. Value pricing

f. Loss leaders

g. Predatory pricing


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Price Elasticity

The degree of price elasticity impacts on thelevel of sales

The price elasticity of demand (PED) focuses

on the proportionate (percentage) changes inthe quantity demanded, given a percentage inthe change in price

PED =% Change in Quantity demanded

% Change in Price


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Price Elasticity

The impact ofprice changes on

sales volume

Demand iselastic if

a price increase has alarge negative impact

on sales volume

Demand is inelastic if

a price increase haslittle or no impacton sales volume


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Cost Analysis and Pricing Decisions

Price elasticityof demand

time and

material pricingPrice elasticity

Pricingstrategies

target pricing

cost-plus pricing Topic 6

Pricing decisions


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End ofTopic 6

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Lecture 6 Pricing