Pricing Decision Report

8/3/2019 Pricing Decision Report

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Pricing DecisionsPricing Decisions



Pricing and BusinessPricing and Business

y How companies price a product or

service ultimately depends on the

demand and supply for it

y 3 factors that influences pricing

decisions:

1. Customers

2. Competitors3. Costs



Profit MaximizationProfit Maximization

Economic Theory

Pricing

Management should set the price thatprovides the greatest amount of profit



Determining the ProfitDetermining the Profit--MaximizingMaximizing

Price and QuantityPrice and Quantity

4

Total revenueDollars Total cost

Total profit at theprofit-maximizing

quantity and price,

q* and p*.

Quantity madeand sold

per monthq*

p*



Example 1Example 1

y The editor of EMBA Magazine is consideringthree alternative prices for her new monthlyperiodical. Her estimate of price and quantitydemanded are:

Price Quantity$ 6 22,000$ 5 28,000$ 4 32,000

Monthly costs of producing and delivering themagazine include $90,000 of fixed costs andvariable costs of $1.50 per issue.

y Which price will yield the largest monthly profit?



Solution Example 1Solution Example 1

Price($) Demand

Variable

Cost per

unit($)

Contribution

Margin per

unit($)

* Total

CM ($)

Fixed

Costs ($)

**Income

Before

Tax ($)

6 22,000 1.5 4.5 99,000 90,000 9,000

5 28,000 1.5 3.5 98,000 90,000 8,000

4 38,000 1.5 2.5 95,000 90,000 5,000




Price($) Demand

Variable

Cost per

unit($)

Contribution

Margin per

unit($)

* Total

CM ($)

Fixed

Costs ($)

**Income

Before

Tax ($)

6 22,000 1.5 4.5 99,000 90,000 9,000

5 28,000 1.5 3.5 98,000 90,000 8,000

4 38,000 1.5 2.5 95,000 90,000 5,000

Price (Demand)= Sales

* Sales-VC(Demand) = Total CMOR CM/u(Demand)

**Total CM-FC= Income before tax




Price($) Demand

Variable

Cost per

unit($)

Contribution

Margin per

unit($)

* Total

CM ($)

Fixed

Costs ($)

**Income

Before

Tax ($)

6 22,000 1.5 4.5 99,000 90,000 9,000

5 28,000 1.5 3.5 98,000 90,000 8,000

4 38,000 1.5 2.5 95,000 90,000 5,000

Price (Demand)= Sales

* Sales-VC(Demand) = Total CMOR CM/u(Demand)

**Total CM-FC= Income before tax

Decision:

Choose $ 6 based on quantitative factors given.Need to

consider qualitative factors as well.



Who determines the price?Who determines the price?

y Price takers- when there is a competitivemarket and the company has no influence onprice

y Price makers- companies that influence theprice

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Pricing approachesPricing approaches

y Cost plus mark-up Variable ² contribution margin approach, contribution

margin( reflecting mark-up) should cover desired returnon investment, all fixed costs

Absorption ² common- mark-up covers all expensesexcept cost of goods sold plus the desired return oninvestment

y Target costing ² Competitor·s price is known,

desired return on investment is known, price is known.It determines the maximum cost per unit

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CostCost--Plus PricingPlus Pricing

Company estimates cost of productionx Adds a markup to cost to arrive at price which allows

for a reasonable profit

Benefitsx Simple approach

Limitations

x What % markup to use?x Inherently circular for manufacturing firmsx Requires considerable judgment and experimentation

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CostCost--Based (CostBased (Cost--Plus) PricingPlus) Pricing

y The general formula adds a markup

component to the cost base to determine

a prospective selling price

y Usually only a starting point in the price-

setting process

y Markup is somewhat flexible, based

partially on customers and competitors

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Forms of CostForms of Cost--Plus PricingPlus Pricing

y Setting a Target Rate of Return on Investment: theTarget Annual Operating Return that anorganization aims to achieve, divided by InvestedCapital

y Selecting different cost bases for the ́ cost-plusµcalculation: Variable Manufacturing Cost

Variable Cost

ManufacturingC

ost Full Cost

13



Common Business PracticeCommon Business Practice

y Most firms use full cost for their cost-

based pricing decisions, because:

Allows for full recovery of all costs of the

product

Allows for price stability

It is a simple approach

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CostCost--plus Pricingplus Pricing

y Selling Price=

Cost + mark-up% x Cost

y Mark-up % =

Desired profit per unit ÷ Unit cost

y Desired profit =

Desired ROI x Investment

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COSTCOST--BASED PRICINGBASED PRICING



Which cost?Which cost?

1. Variable manufacturing costPrice= variable manufacturing costs +

(markup% * variable manufacturing cost)

Mark-up should cover the remaining costs and provide for the desired profit,i.e. variable selling and all fixed costs

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nvmcu

fit desiredpro ADM FC VSC markup

*%

!

VSC: variable selling costs

FC: fixed costs ² manufacturing and selling

ADM:Administrative Expenses

n : number of units to be sold

vmcu:

variable manufacturing cost per unit



Which costs?Which costs?

2.Total variable costs

Variable manufacturing and selling costs

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Price= VC + (MU% * VC)

nvmcu

fit desiredpro ADM FC markup

*%

!

FC: fixed costs ² manufacturing and selling

ADM:Administrative Expenses

n : number of units to be sold

vmcu:variable manufacturing cost per unit




3. Absorption ² Full manufacturing

costs

y Unit manufacturing costs ² both variable and fixed

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

nt unit

fit desiredpro ADM S markup

*cos

&%

!

S&ADM: Selling and administrative costs

Unit cost : unit manufacturing cost (variable and fixed)




4.Absorption ²Full/total costs

Total costs ² manufacturing and selling andadministrative ²fixed (direct or allocated,

variable costs)

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Price= TC + (markup % * TC)

nt Totalunit

fit desiredpromarkup

*cos% !



ExampleExample -- PricingPricing

Annual sales 480 units

Unit costs:Variable manufacturing cost $ 400

Applied fixed manufacturing cost $ 250

Absorption manufacturing cost $ 650Variable selling costs $ 50

Allocated and direct fixed selling and administrative costs$ 100

Total cost (Manufacturing and S&ADM) $ 800

Investment $ 600,000

Desired profit 10% of investment $ 60,000Annual Fixed Manufacturing Costs $ 120,000

Annual Fixed (allocated and direct) Selling and Administrative Costs$ 48,000

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Cost Plus Pricing VersionsCost Plus Pricing Versions

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variable manufacturing cost-plus-pricingVariable manufacturing cost $400

Total Variable Selling Costs ($50 x 480 units) $24,000

Desired profit $60,000

Fixed Costs $168,000

mark -up % 131.25%

markup $525

Price = cost + markup $925

1. Variable Manufacturing Cost




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

Fixed Costs $168,000Desired Profit $60,000

mark -up % 105.56%

markup $475


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2. Variable Total Cost




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manufacturing cost per unit $650

Total variable selling costs $24,000

Fixed Selling and Administration $48,000

Desired Pr ofit $60,000

mark -up % 42.31%

markup $275


3.Full Manufacturing Cost




total absor ption- cost-plus-pricingTotal cost per unit $800

Desired Pr ofit $60,000mark -up % 15.63%

markup $125


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4.Full Cost



Cost plus comparisonCost plus comparison

Costplustype

Variablemanufacturing

costplusmark up

Variablecostplus

mark up

Manufacturingcosts

plusmark up

Full costplusmark up

Mark

up %

131.25 105.56 42.31 15.63

Price 925 925 925 925

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Pricing Special OrdersPricing Special Orders

In some cases, it may be beneficial for a

company to charge a price lower than its full

cost Only if the order will not affect demand for its

other products

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Special OrdersSpecial Orders ² ² Premier Lens ExamplePremier Lens Example

Given the following information, should Premier Lens produce20,000 lenses to be sold to Blix Camera for $73 per lens?

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Special OrdersSpecial Orders ² ² Premier Lens ExamplePremier Lens Example

The incremental analysis shows that it should. Note that thefixed costs are not incremental and need not be included in thedecision making.

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Retail cost plus mark Retail cost plus mark--upup

y Mark up on cost of goods sold

= (selling and administrative costs +operating income) / COGS

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Retail ExampleRetail Example

y Yesim Textile·s income statement for 2007 is as follows:

Revenues $1,427,010

Cost of goods sold (713,500)Gross profit 713,510

Selling and Administrative Exp (535,750)

Operating profit $177,760

Mark up % 100.00%

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Project ExampleProject Example

y EMBA Consultancy Co needs to bid for a project. EMBA·srecent income statement appears below:

Revenues $1,627,010

Cost of Services

Material ($45,000)Personnel (650,000)

Overhead (555,000)

Total Cost of services (1,250,000)

Gross profit 377,010

Selling and Administrative Exp (235,750)

Operating profit $141,260

Mark up % 30.16%

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Man-hour rate $ 65; overhead application 0.85 of personnel costs



Project ExampleProject Example

y EMBA Consultancy needs to bid for a new project.Material costswill be $5,000; 150 man hours will be used. What would be a

guiding bidding price?

Material $5,000.00

Man-hour (150 man hourx65) 9,750.00

Overhead (0.85*man-hour cost) 8,287.50

Total Cost 23,037.50

mark up percentage 30.16%

bid price $29,985.79

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Target CostingTarget Costing

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Five Steps in DevelopingFive Steps in Developing

Target Prices and Target CostsTarget Prices and Target Costs

1. Develop a product that satisfies the needs of

potential customers

2. Choose a target pricex price is the same as the competition

x set price to increase customer base

x seek larger market share through price

3. Derive a target cost per unit:

Target Price per unit minus Target Operating Income

per unit4. Perform cost analysis

5. Perform value engineering to achieve target cost

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Pros and Cons of Cost plus pricingPros and Cons of Cost plus pricing

y Easy to compute

y No consideration to the demand side

y Sales volume plays an important role-

allocation of fixed costs over the

products sold

y If variable cost plus used then fixed costs

might not be covered if not calculatedcorrectly

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Pricing Decision Report