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Chapter 12

Pricing Decisions and Cost


Pricing and Business

How companies price a product or service

ultimately depends on the demand and supply
for it
If the price is too high, the sale will be lost. If
the price too low, earnings targets wont be hit.
Three influences on demand and supply:
1. Customers
2. Competitors
3. Costs

Major Influences on Pricing Decisions

1. Customers influence price through their effect

on the demand for a product or service, based
on factors such as quality and product features.
2. Competitors influence price through their
pricing schemes, product features, and
production volume
3. Costs influence prices because they affect
supply (the lower the cost, the greater the
quantity a firm is willing to supply).
The manager must consider all relevant cost in all
business functions from R&D to customer service
Time Horizons and Pricing

Short-run pricing decisions have a time horizon

of less than one year and include decisions such
Pricing a one-time-only special order with no long-run
Adjusting product mix and output volume in a
competitive market
Long-run pricing decisions have a time horizon
of one year or longer and include decisions such
as pricing a product in a major market

Differences Affecting Pricing:
Long Run vs. Short Run
1. Costs that are often irrelevant for short-run
policy decisions, such as fixed costs that
cannot be changed, are generally relevant in
the long run because costs can be altered in
the long run
2. Profit margins in long-run pricing decisions are
often set to earn a reasonable return on
In short run: prices are decreased when
demand is weak and increased when demand
is strong
Costing and Pricing for the Short Run
Astels Computers manufactures two brands of PCs
Deskpoint (Astels top-of-the-line product), and Provalue (a
less-powerful machine)
Datatech Corporation has asked Astel to bid on supplying
5,000 Provalue computers over the next three months.
Datatech will sell Provalue computers under its own brand
name and in regions and markets where Astel does not sell
Existing sales for Astel will not be affected.
Astel needs additional capacity for this 5,000 PCs.

Costing and Pricing for the Short Run
Example (contd.):
Before Astel can bid on Datatechs offer. Astels
managers must first estimate how much it will cost to
supply the 5,000 computers.

Direct Materials ($460/computer) $2,300,000

Direct Manufacturing labor ($64/computer) 320,000
Fixed costs of additional capacity 250,000
Total cost $2,870,000
Relevant cost/unit $574

Costing and Pricing for the Short Run (contd.)
Example (contd.):
The relevant cost per unit is $574. therefore, any selling
price above $574 will improve Astels profitability in the short
Astels managers also know that one of its competitors with
idle capacity will bid between ($596 and $610)
Management's strategy is to bid as high above $574 as
possible while remaining lower than competitors bid.
Astels managers must also consider other effects of its
pricing decision, such as wether Datatech will undercut
Astels selling price in Astels current markets. If Astels
managers believe this is a significant risk, the cost should
include the contribution margin lost on sales to existing
Astels managers decide to make a bid at a price of $595.
Costing and Pricing for the Short Run
Companies may experience strong demand for
their products in the short run, but they may have
limited capacity.
In these cases, companies strategically increase
prices in the short run to as much as the market
will bear.
We observe high short-run prices in the case of
new products or new models of older products,
such as microprocessors, computer chips, cellular
phones, and software.
Costing and Pricing for long Run

Long-run pricing is a strategic decision designed

to build long-run relationships with customers
based on stable and predictable prices.

A stable price:
Reduce the need for continuous monitoring of suppliers
Improves planning
Build long-run buyer-seller relationships.

Alternative Long-Run Pricing Approaches

Market-Based (target pricing): price charged is

based on what customers want and how
competitors react
Cost-Based: price charged is based on what it
cost to produce, coupled with the ability to
recoup the costs and still achieve a required rate
of return

Markets and Pricing
Competitive Markets (steel, oil, natural gas) use the
market-based approach
Less-Competitive Markets (automobiles, computers,
consulting services) can use either the market-based or
cost-based approach
Noncompetitive Markets use cost-based approaches

All approaches consider customers, competitors, and

costs. Only their starting points differ
Management must always keep in mind market forces,
regardless of which pricing approach is used. For
example, a price set via cost-plus thinking may simply be
unacceptable to customers so the price should be
reduced. 12
Market-Based Approach

Starts with a target price

Target Price estimated price for a product or
service that potential customers will pay
Estimated on:
Customers perceived value for a product or service.
(Close contact with customers by sales and marketing
departments, market research studies)

How competitors will price competing products or

services. (Understand competitors technologies,
products or services, costs, and financial conditions.
Information from customers, suppliers, employees of
competitors, and reverse engineering.)
Five Steps in Developing
Target Prices and Target Costs
1. Develop a product that satisfies the needs of
potential customers
Based on customer requirements and an analysis of
competitors products, Astel plans the product
features and modifications (reliable PC).
2. Choose a target price
Astel expects its competitors to lower the price by
15%. Astels manager wants to reduce the price by
20% (from $1,000 to $800 per unit). At this lower
price, annual sales are expected to increase from
150,000 to 200,000 units

Five Steps in Developing
Target Prices and Target Costs (contd.)
3. Derive a target cost per unit:
Target Price per unit minus Target Operating Income
per unit
Astels management needs 10% target operating
income on target revenues.
Total target OI = 10% ($800 /unit X 200,000 unit)=
Target OI per unit = $16,000,000 200,000 = $80/unit
Target cost per unit = target price target OI/unit
Target cost per unit = $800 - $80 =$720
Current cost per unit of Provalue = $900
Five Steps in Developing
Target Prices and Target Costs (contd.)

4. Perform cost analysis

This step analyzes which aspects of a product or service
to target for cost reduction
Examples: the current costs of different components, the
function performed by different components, the
importance that customers place on different product
5. Perform value engineering to achieve target cost
Value engineering is a systematic evaluation for all
aspects of the value chain, with the objective of reducing
costs while improving quality and satisfying customer
Value Engineering

Managers must distinguish value-added activities

and costs from non-value-added activities and costs.

Value-Added Costs a cost that, if eliminated, would reduce

the actual or perceived value or utility (usefulness) customers
obtain from using the product or service (example: Adequate
memory in PC)
Non-Value-Added Costs a cost that, if eliminated, would
not reduce the actual or perceived value or utility customers
obtain from using the product or service. It is a cost the
customer is unwilling to pay for (example: cost of producing
defective products).
Value Engineering Terminology

Cost Incurrence describes when a resource is

consumed (or benefit forgone) to meet a specific
Locked-in Costs (Designed-in Costs) are costs
that have not yet been incurred but, based on
decisions that have already been made, will be
incurred in the future
Are a key to managing costs well
To help reduce costs, Astels managers must focus
on the design stage.
Cross-functional teams to coordinate actions that
needed to be taken throughout the value chain.
Value Engineering Terminology

Cost-Based (Cost-Plus) Pricing

The general formula for setting a cost-based

price adds a markup component to the cost
base to determine a prospective selling price
Usually only a starting point in the price-setting
Markup is somewhat flexible, based partially on
customers and competitors
Example: Assume Astel uses 12% markup on the full unit
cost of the product in developing the selling price:
Cost base (full unit cost of Provalue II ) = $720
Markup component of 12% (0.12 X 720) = $86.40
Prospective selling price = $806.40
Forms of Cost-Plus Pricing
Setting a Target Rate of Return on Investment: the
Target Annual Operating Return that an
organization aims to achieve, divided by Invested
Capital. (Invested capital is defined here as total
Example: Assume Astels target rate of return on
investment is 18%, and Provalue capital investment is
$96 million.
Target annual operating income (0.18X$96 million)=
Target annual operating income/unit = $86.40
The markup of $86.40 = 86.40 720 = 12%
Selling price = 720 + 86.40 = $806.40
Alternative Cost-Plus Methods
Selecting different cost bases for the cost-plus
Variable Manufacturing Cost
Variable Cost
Manufacturing Cost
Full Cost

Cost base Estimated Markup Markup Selling

cost/unit percentage component price
Variable $483.00 65% $313.95 $796.95
manufacturing cost
Variable cost of the 547.00 45% 246.15 793.15
Manufacturing cost 540.00 50% 270.00 810.00
Full cost of the 720.00 12% 86.40 806.40
product 22
Common Business Practice
Most firms use full cost for their cost-based pricing
decisions, because:
Allows for full recovery of all costs of the
Allows for price stability (because it limits the
ability of salesperson to cut prices)
It is a simple approach (no need to detailed
analysis to cost behavior patterns to separate
costs into fixed and variable components for
each product)