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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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Pricing Strategies- Cost plus pricing
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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Pricing Strategies- Cost plus pricing
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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Pricing Strategies- Cost plus pricing
Cost based pricing is popular because it issimple to use. However, there are variousdisadvantages
What are the
disadvantages?
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Pricing Strategies- Cost plus pricing
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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Pricing Strategies- Cost plus pricing
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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Pricing Strategies- Cost plus pricing
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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Pricing Strategies- Cost plus pricing
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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Pricing Strategies- Cost plus pricing
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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Pricing Strategies- Cost plus pricing
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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Pricing Strategies-Target Pricing
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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Pricing Strategies-Target Pricing
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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Pricing Strategies-Target Pricing
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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Pricing Strategies-Time and material pricing
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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Pricing Strategies-Time and material pricing
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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Pricing Strategies-Time and material pricing
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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Pricing Strategies-Time and material pricing
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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Pricing Strategies-Time and material pricing
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