Procurement in Industrial Management – BPT 3133

Price and Cost Analysis

CHAPTER OUTLINEIntroductionPrice Determination

Objective, Process and Factors

Price AnalysisVariables that influence an item’s price

Cost AnalysisTechniques : cost-based, break-even

Obtain Prices

INTRODUCTIONPrice = Monetary termsPrice often depends on circumstances: “ you pay more to fly when you want to

fly ”Some consumers are very interested in getting a low price and pay close attention to priceThere is a tendency to link quality with priceConsumers are often prepared to pay more if they expect to get excellent serviceAdding value doesn’t mean dropping price

PRICE DETERMINATIONIn pricing, an organization first must decide on its pricing objective / goal.The next step is to set the base price for a product.The final step involves designing pricing strategies that are compatible with the rest of the marketing mix.Many strategic questions must be answered:

Will our company compete on the basis of price or other factors?What kind of discount schedule (if any) should be adopted?

Pricing ObjectivesManagement should decide on its pricing objective before determining the price itself.

Profit-orientedAchieve a target return — pricing product to achieve a specified percentage return on sales or investment.Maximize profits — followed by the most companies.

Sales orientedIncrease sales volume.Maintain or increase market share.

Status quoStabilize prices.Meet competition.

SELECT PRICING OBJECTIVE

SELECT METHOD OF DETERMINING THE BASE PRICE

Cost-pluspricing

Price based onboth demand

and costs

Price set inrelation to

market alone

DESIGN APPROPRIATE STRATEGIES• Price vs. nonprice

competition• Skimming vs.

penetration• Discounts and

allowances

• Freight payments• One price vs.

flexible price• Psychological

pricing

• Leader pricing• Everyday low vs.

high-low pricing• Resale price

maintenance

The Process: An Illustration

Factors Affecting Price Decisions

Internal Factors1. Marketing

Objectives2. Marketing Mix

Strategy3. Product Cost4. Organizational

considerations

Internal Factors1. Marketing

Objectives2. Marketing Mix

Strategy3. Product Cost4. Organizational

considerations

External Factors1. Nature of the

market & demand2. Competition3. Environmental

factors (economy, resellers, government)

External Factors1. Nature of the

market & demand2. Competition3. Environmental

factors (economy, resellers, government)

PricingDecisions

PricingDecisions

Marketing

Objectives

SurvivalLow Prices to Cover Variable Costs

andSome Fixed Costs to Stay in

Business.Current Profit Maximization Choose the Price that Produces the

Maximum Current Profit, Etc.

Market Share LeadershipLow as Possible Prices to Become

the Market Share Leader.

Product Quality LeadershipHigh Prices to Cover Higher

Performance Quality and R & D.

Marketing Objectives

Price

Product Design

Distribution

Promotion

NonpricePositions

Marketing Mix Customers seek products that give them the best value in terms of benefits received for the price paid

Pricing Strategies : Product Mix

Optional-ProductPricing optional or accessory products sold with the main product. i.e camera bag.

Captive-ProductPricing products that must be used with the main product. i.e. film.

By-ProductPricing low-value by-products to get rid of them and make the main product’s price more competitive.Eg.: sawdust

Product-BundlingCombining several products and offering the bundle at a reduced price.Eg. : theater season tickets

Pricing Strategies : Product Mix

Pricing StrategiesF.O.B. Point-of-Production pricing: Price quoted at factory- buyer pays transportation.Uniform delivered pricing: Same delivered price quoted to all; works if transportation costs small. Zone-delivered pricing: Set same price within several zonesFreight-absorption pricing: Seller absorbs transport cost to penetrate market.Firms may adopt a one-price strategy or charge different prices to different customersFlexible pricing strategies: shoppers may pay different prices if they buy the same quantity

Pricing Strategies :Psychological

Considers the psychology of prices and not simply the economics.Customers use price less when they can judge quality of a product.Price becomes an important quality signal when customers can’t judge quality; price is used to say something about a product.

Value $22.00Sale $14.99

PRICE ANALYSIS Determine if the price offered is appropriate without examining the specific cost and profit calculations (cost details) Price been compared with:1. Other price offers2. Prices previously paid3. Going rate if applicable4. Prices charged for alternatives which could

substitute for what is offeredAny prices well below the norm should be examined with care

Major Considerations in Setting Price

PRICE ANALYSISVariety of variables that directly and indirectly influence an item’s price

Market structurePrice mechanism & competition conditions

Economic conditionsPricing strategy of the seller

Detail analysis of internal cost structuresMarket-Driven Pricing Models

Using the producer price index to manage price

Market Structure

Price mechanism

Competition Conditions

Monopoly One supplier

Duopoly Two supplier

Monopolistic Many suppliers, Differentiated product

Perfect Many suppliers, Same product

Monopsony One buyer, Many supplier

Competition conditions

Supply

Demand

Price

Volume or Quantity

Buyer’s Market

Supplier’s Market

Market Price

Market Driven Pricing Models1. Price volume models

Supplier analyzes the market to find the combination of price per unit and quantity of sales that maximizes its profit on the assumption that :

Lower price will result more units being soldGreater volume will spread the indirect cost over more units

2. Market Share ModelBased on assumption that long-run profitability depends on the market share obtained by the supplier (penetration pricing)

Market Share Model

Market Penetration

Setting a Low Price for a New Product in Order to “Penetrate” the Market Quickly and Deeply.

Attract a Large Number of Buyers and Win a Larger Market Share.

Market Penetration

Setting a Low Price for a New Product in Order to “Penetrate” the Market Quickly and Deeply.

Attract a Large Number of Buyers and Win a Larger Market Share.

Use Under These Conditions:

Market Must be Highly Price-Sensitive so a Low Price Produces More Market Growth.Production/ Distribution Costs Must Fall as Sales Volume Increases.Must Keep Out Competition & Maintain Its Low Price Position or Benefits May Only be Temporary.

Market Driven Pricing Models3. Market-Skimming Model

Prices are set to achieve a high profit on each unit by selling to supply managers who are willing to pay for products or services of perceived higher value

4. Promotional Pricing ModelPricing for individual products that is set to enhance the sales of the overall product line

5. Revenue Pricing ModelObtaining sufficient current revenue to pay for operating cost – during market slowdowns

Market-Skimming Model

Market Skimming

Setting a High Price for a New Product to “Skim” Maximum Revenues from the Target Market.

Results in Fewer, But More Profitable Sales.

Market Skimming

Setting a High Price for a New Product to “Skim” Maximum Revenues from the Target Market.

Results in Fewer, But More Profitable Sales.

Use Under These Conditions:

Product’s Quality and Image Must Support Its Higher Price.Costs Can’t be so High that They Cancel the Advantage of Charging More.Competitors Shouldn’t be Able to Enter Market Easily and Undercut the High Price.

Promotional Pricing Model

Involves setting price steps between various products in a product line based on:

Cost differences between productsCustomer evaluations of different features Competitors’ prices.

6. Competition Pricing ModelPricing actions or reactions to pricing proposals offered or expected to be offered by the supplier’s competitorsDetermine the highest price that can be offered that will still be lower than the price offered by competitors

7. Cash DiscountsOffer incentives to pay invoices promptlyPayment with certain period of time

Market Driven Pricing Models

Setting Prices

Sealed-BidCompany Sets Prices Based on What They Think Competitors

Will Charge.

Going-Rate Company Sets Prices Based on What

Competitors Are Charging.

??

Competition Pricing Model

Cash Discount

Cash Discount Seasonal Discount

Q uantity Discount Trade-In Allow ance

Functional Discount Prom otional Allow ance

A d jus tin g B as ic Pr ice to Rew ard Cu s tom ersF o r C erta in R esp on ses

COST ANALYSIS

It looks at one aspect only : how quoted price relates to cost of productionUseful technique for keeping prices realistic in the absence of effective competitionConcentrates attention on what costs ought to be incurred before the work is done

Cost Analysis Techniques

Cost-based pricing modelsCost-markup pricing modelMargin pricing modelRate-of-Return pricing model

Product specificationEstimate supplier costs using reverse price analysisBreak-even analysis

Cost-Based Pricing Model

Certainty About Costs

Pricing is Simplified

Price Competition is

Minimized

UnexpectedSituational

Factors

Attitudes of

Others

Ignores Current

Demand & Competition

Cost-Plus Pricing is an

Approach That Adds a

Standard Markup to the Cost of the Product.

Simplest Pricing Method

Much Fairer to

Buyers & Sellers

Cost andprofit= 100%= RM72

MANUFACTURER

Mfgselling price= 100%= RM72

WHOLESALER

W/sselling price= 100%= RM90

Cost = 80% = RM72

Mark-up = 20% = RM18

RETAILER

Re-tailer’sselling price= 100%= RM150

Mark-up = 40% = RM60

Cost = 60% = RM90

Cost toConsumer = RM150

CONSUMER

Cost-Markup Pricing Model

Margin Pricing Model

Unit Selling Price = (Cost) + (Margin Rate)(Cost)

Example :Cost - RM 50Margin Rate – 25%

Unit Selling Price = RM 50 + (0.25)(50) = RM 50 + RM 12.50 = RM 62.50

Cost – 100%

MR -25%

Unit Selling Price

Rate-of-Return Pricing Model

Unit Selling Price = Unit Cost + Unit Profit

Example :Supplier wanted a 20% return on its investment of RM 300,000 (which might include R&D, equipment, etc.) to make 4000 parts with a total cost of RM50 each.

Unit Selling Price = RM 50 + (0.20)(RM 300,000)

4000 = RM 50 + RM 15 = RM 65.00

Reverse Price AnalysisAlso known as “Should Cost” analysisEvaluating whether a supplier’s price is justifiable and reasonable

Hypothetical Price

RM 20

Profit (15%) RM 3

Subtotal RM 17

Direct Material RM 4

Subtotal RM 13

Direct Labor RM 3

Mfg. Burden RM 10

Purchaser should attempt to initiate discussion in the following areas to discover opportunities for cost reductions :1. Plant Utilization2. Process Capability3. Learning-Curve Effect4. The Supplier

Workforce5. Management

Capability6. Purchasing Efficiency

Break-Even Analysis

To identify the point where revenue equals cost & the expected profit/loss at different production volumes.Strategic planning tool – to estimate expected profit or loss over a range of salesBreak-Even :

TR = TC

= VC + FC

Fixed costs: These are costs that are the same regardless of how many items you sell. All start-up costs, such as rent, insurance and computers are considered fixed costs since you have to make these outlays before you sell your first item.

Variable costs: These are recurring costs that you absorb with each unit you sell. For example, if you were operating a greeting card store where you had to buy greeting cards from a stationary company for $1 each, then that dollar represents a variable cost. As your business and sales grow, you can begin appropriating labor and other items as variable costs if it makes sense for your industry.

Break-Even Analysis

Break-Even AnalysisExample :Purchase or Sale Price - RM 10Variable Cost per Unit – RM 6Fixed Cost – RM 30,000

Break-Even Unit : TR = VC + FC RM10 (x) = RM6 (x) + RM 30,000 RM4 X = RM 30,000 X = 7,500 units

Net Income / Loss = TR – (VC + FC)

How Buyers Obtain Prices

A price list is made availablePrices are quoted on requestPotential suppliers submit sealed bids or tendersPurchase are made at auction or by reverse auctionBy negotiation