Management Decisions and Control 22421/0

Management Decisions
and Control
Lecture 7

Pricing and Product Mix

Decisions

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 Lecture Objectives
1. Introduction

3. The Economic Model

5. The Major Influences on Pricing Decisions

7. Short-run and Long-run Pricing Decisions

9. Cost-Plus Pricing (Cost Based)

11. Target Costing and Target Pricing (Market Based)

13. Relationship Between Life-Cycle Product Budgeting and

Costing in Pricing Decisions

15. Example

17. Legal, Political and Ethical Issues

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 Introduction
Pricing decisions are decisions that managers make about what to
charge for the products and
services they deliver. These decisions impact the revenues a company
earns, which must exceed
total costs if profits are to be achieved.

There is no single way of computing a product cost that is universally

relevant for all pricing
decisions.

Why? Because pricing decisions differ greatly in both their time

horizon and their contexts.

Product mix decisions are decisions that managers make about what
type of product to produce (or
service to offer) and how much to produce of each product (or the
extent to which a service is
offered). These decisions impact the profitability of the company and
often involves a traded off 3
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 Economic Model of Pricing Decisions
The economic model focuses on the optimal price and sales quantity
that will maximise profits.
Companies acting optimally should produce and sell units until the
marginal revenue equals the
marginal costs, where optimal production is determined by the market
price.

Companies selling commodity type products in highly competitive

markets (price takers) must
accept the price determined by market forces. While, in less
competitive markets, managers have
some discretion in setting prices subject to (1) how much customer’s
value the product (2) the
pricing strategies of competitors and (3) the costs of the product.

The price of a product or service is the outcome of the interaction

between demand for the
product or service and its supply. Major influences on pricing decisions
in the economic model are:
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 Customers influence
Management Decisions and Control 22421/0 price through their effect on demand.
 Short Run and Long Run Pricing
Decisions
Short run pricing decisions include the pricing of a one-off special
order with no long-term
implications or adjusting the product mix and output volume in a
competitive market. When
calculating product costs for short run pricing decisions, the following
factors need to be considered:
 When there is excess capacity, the incremental costs of producing
the product (or supplying the service).
 When there is NO excess capacity, both the incremental cost AND
the opportunity cost must be assessed.

Long run pricing decisions include pricing a product in a major

market where price setting has
considerable leeway. A stable price reduces the need to for continuous
monitoring of suppliers’
prices. Greater price stability also improves planning and builds long-
run buyer-seller relationships.

When calculating product costs for long run pricing decisions, the
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following
Management Decisions and Controlfactors
22421/0 need to be
 Approaches to Long Run Pricing
Decisions
 Cost-based pricing is often used as a starting point for pricing a
product or service. The starting point is the company’s own cost of
manufacturing a product or supplying a service and a desired
mark-up percentage is then applied on costs.

 Market-based pricing is a strategic approach to pricing a product

or service. The starting point is always the firm’s own strategy:
 Skimming pricing strategy: charging higher prices at the beginning of
the product cycle, or
 Market penetration strategy: charging lower prices to gain market share

However, it also requires management to consider the behaviour of

competitor’s and the value
that customer place on a product or service – target pricing and
target costing

These will be examined one at a time.

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 Cost Based (Cost-plus) Pricing
System
With cost plus pricing, the general formula for setting a price is:

Cost base $X
Mark-up on cost $Y
Prospective selling price $(X+Y)

Steps:
8. Define the cost base and what type of costs are include in the cost
base (eg absorption cost, full production costs or variable cost –
useful for short term pricing decisions)
9. Estimate all other costs not included in the cost base
10. Determine the required profit level (eg based on return on
investment or return on sales)
11. Calculate mark-up percentage

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 Target Costing and Target Pricing
(Market Based)
A target price is the estimated price for a product (or service) that
potential customers will be
willing to pay. This estimate is based on an understanding of
customer’s perceived value for a
product and competitors’ behaviour.

 Target operating income per unit is the operating income that

a company wants to earn on each unit of product (or service) sold
 The difference between target price and target operating income
is target cost
 Target cost per unit is the estimated long run cost per unit of a
product (or service) that, when sold at the target price, enables
the company to achieve the target operating income per unit

Developing ‘target prices’ and ‘target costs’ requires the consideration

of the following 4 steps:
 Develop a product that satisfies the needs of potential customers
 Choose a target price based on customers’ perceived value for
the product and the prices competitor’s charge and a target
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operating income
Management Decisions and Control 22421/0 per unit
 Value Engineering
Value engineering is a systematic evaluation of all aspects of the
value chain business functions,
with the objective of reducing costs while satisfying customer needs.
 Reduce/eliminate non-value-added activities. Value added
activities - change functionality
 Change process design or product design, about 90% of costs are
locked in at the design stage.
Cost incurrence occurs when a resource is sacrificed or used up.
Costing systems emphasise
cost incurrence. They recognise and record costs only when costs are
incurred.

Locked-in or designed-in (committed) costs are those costs that

have not yet been incurred but
that will be incurred in the future on the basis of design decisions that
have already been made.
Why is it important to distinguish between when costs are locked in and
when costs are incurred?
Because it is difficult to alter or reduce costs that have already been
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locked in.
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 Pattern of Cost Incurrence

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 Life-Cycle Product Budgeting
The product life-cycle spans the time from initial R&D to the time at
which support to
customers is withdrawn.

 Life-cycle costing: tracks & accumulates the actual costs

attributable to each product over its life-cycle

 Life cycle budgeting: estimates the revenue and costs

attributable to each product over its life cycle - provides important
information for pricing decision, eg. mobile telephone contract.

 Life-cycle report: spans more than 1 calendar year

 The full set of revenues and costs associated with each product
becomes visible.
 Interrelationships between the various cost categories are
highlighted, eg. companies that cut back on their R&D and
product design costs may experience large increases in
customer-service costs in subsequent years.
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 Example
Total for
Per Unit
150,000units
Revenue 150,000,000 1,000
COGS
Direct material costs 69,000,000 460
Direct labour costs 9,600,000 64
Direct machining 11,400,000 76
Manufacturing overhead 12,000,000 80
102,000,000 680
OperatingCosts
R&D costs 5,400,000 36
Design costs 6,000,000 40
Marketing costs * 15,000,000 100
Distribution costs * 3,600,000 24
Customer service costs 3,000,000 20
33,000,000 220
Full productcosts 135,000,000 900
Operatingincome 15,000,000 100

*50%of marketing and distribution costs are variable costs

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 Example
Cost-Based Pricing Example

Cost base = $680 - using total production costs as the cost base
Other costs (operating costs) $220 + profit target $100 = $320

Percentage mark-up on cost =

Selling price =

Market-Based Pricing Example

Target selling price = $800

Target income per unit = 10% of the selling price = $80
Target cost = $720 (=$800 - $80)
Current cost = $900

How much does the cost have to be reduced by?

How do we do that?
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 Achieving Target Cost per Unit
 Design a new product that has fewer components (*1)
 Easier to manufacture and test (*2)
 Increase output from 150,000 to 200,000 units (*3)
Costcategory Old New
Direct material 460 385 Simplied circuit board, fewer components (*1)
Direct labour 64 53 Easier to assemble (*1 &*2)
Direct machining 76 57 Increased production: fixed costs spread over more units (*3)
No. of orders 22,500 21,250 Number of components reduced from450 to 425 (*1)
Testing hours 4,500,000 3,000,000 Easier to test: reduce from30 to 15 hours (*2)
Units reworked 12,000 13,000 Less rework (from8%to 6.5%) but more units (*2)

TargetCostCalculations
New(estimatedcost) Old
for 200,000units per unit per unit
Directmanufacturing
Direct material 77,000,000 385.00 460.00
Direct labour 10,600,000 53.00 64.00
Direct machining costs 11,400,000 57.00 76.00
Total directcosts 99,000,000 495.00 600.00
Manufacturingoverheads
Ordering and receiving 1,700,000 8.50 12.00
Testing and inspection 6,000,000 30.00 60.00
Rework costs 1,300,000 6.50 8.00
Total O/H 9,000,000 45.00 80.00
Total manufacturing 108,000,000 540.00 680.00
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 Example
Total for
Per unit
200,000units

Revenue 160,000,000 800

COGS
Direct material costs 77,000,000 385
Direct labour costs 10,600,000 53
Direct machining 11,400,000 57
Manufacturing overhead 9,000,000 45
108,000,000 540
Operatingcosts
R&D costs 4,000,000 20
Design costs 6,000,000 30
Marketing costs 18,000,000 90
Distribution costs 5,000,000 25
Customer service costs 3,000,000 15
36,000,000 180
Full productcosts 144,000,000 720
Operatingincome 15,000,000 80

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 Legal, Political and Ethical Issues
Under anti-trust laws, the Australian Competition and Consumer
Commission (ACCC)
have the power to outlaw the following behaviors:

 Price discrimination is the practice of charging some customers a

higher price than others. Three key features of the price
discrimination laws are:
 they apply to manufacturers and not service providers
 price discrimination is permissible if differences in prices can be justified
by differences in costs, and
 price discrimination is illegal only if the intent is to destroy competition –
Predatory pricing.

 Resale price maintenance occurs when a supplier dictates the

minimum price at which a product or services is to be resold to a
buyer.
 Peak-load pricing is the practice of charging a higher price for the
same product or service when demand approaches physical
capacity units.
 Collusive pricing occurs when companies in an industry conspire 16
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