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Pricing DecisionsPricing Decisions
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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
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Profit MaximizationProfit Maximization
Economic Theory
Pricing
Management should set the price thatprovides the greatest amount of profit
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Determining the ProfitDetermining the Profit--MaximizingMaximizing
Price and QuantityPrice and Quantity
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Total revenueDollars Total cost
Total profit at theprofit-maximizing
quantity and price,
q* and p*.
Quantity madeand sold
per monthq*
p*
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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 $1.50 per issue.
y Which price will yield the largest monthly profit?
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Solution Example 1Solution Example 1
Price($) Demand
Variable
Cost per
unit($)
Contribution
Margin per
unit($)
* Total
CM ($)
Fixed
Costs ($)
**Income
Before
Tax ($)
6 22,000 1.5 4.5 99,000 90,000 9,000
5 28,000 1.5 3.5 98,000 90,000 8,000
4 38,000 1.5 2.5 95,000 90,000 5,000
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Solution Example 1Solution Example 1
Price($) Demand
Variable
Cost per
unit($)
Contribution
Margin per
unit($)
* Total
CM ($)
Fixed
Costs ($)
**Income
Before
Tax ($)
6 22,000 1.5 4.5 99,000 90,000 9,000
5 28,000 1.5 3.5 98,000 90,000 8,000
4 38,000 1.5 2.5 95,000 90,000 5,000
Price (Demand)= Sales
* Sales-VC(Demand) = Total CMOR CM/u(Demand)
**Total CM-FC= Income before tax
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Solution Example 1Solution Example 1
Price($) 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)= 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.
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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
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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
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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
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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
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Which costs?Which costs?
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)
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Which costs?Which costs?
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% !
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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
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Cost Plus Pricing VersionsCost Plus Pricing Versions
variable total cost-plus-pricingTotal variable cost per unit $450
Fixed Costs $168,000Desired Profit $60,000
mark -up % 105.56%
markup $475
Price = cost + markup $925
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2. Variable Total Cost
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Cost Plus Pricing VersionsCost Plus Pricing Versions
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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
Price = cost + markup $925
3.Full Manufacturing Cost
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Cost Plus Pricing VersionsCost Plus Pricing Versions
total absor ption- cost-plus-pricingTotal cost per unit $800
Desired Pr ofit $60,000mark -up % 15.63%
markup $125
Price = cost + markup $925
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4.Full Cost
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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
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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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