Chapter Twelve

Pricing Decisions and Cost Management

Learning Objectives
Short-run and long-run pricing decisions

Target costing
Cost incurrence and locked-in costs Cost-plus costing Life-cycle budgeting and costing Non-costs factors in setting price

Anti-trust laws

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The Five Forces Affect Pricing

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Influences on Supply and Demand

1. Customers - by establishing demand level

Based on factors such as quality and product features

2. Competitors/Potential Entrants/Substitutes - by

establishing alternatives
Through pricing schemes, product features, and

production volume
3. Suppliers by affecting costs and supply The lower the cost, the greater the supply

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Strategic Positioning Affects Pricing

Cost Leadership:
Outperform competitors by producing at the lowest cost,
consistent with the quality demanded by the consumer

Differentiation:
Create value for the customer through product innovation, product features, customer service, etc. for which the customer is willing to pay

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Short-Term Pricing
Less than one year:
One time special order with no long-run implications Adjusting product mix and output volume in a competitive

market

Many costs are irrelevant in short-term pricing

Fixed costs - price above contribution margin R&D, design, etc. will not change in the short run

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Costing and Pricing for the Short Run Example

Lomas Corporation operates a plant with a monthly capacity of 500,000 cases of tomato sauce. Lomas is presently producing 300,000 cases per month. Del Valle has asked Lomas and two other companies to bid on supplying 150,000 cases each month for the next four months.
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Costing and Pricing for the Short Run Example

Cost Per Case Variable manufacturing Variable marketing and distribution Fixed manufacturing Fixed marketing and distribution Total $38 13 14 15 $80

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Costing and Pricing for the Short Run Example

If Lomas makes the extra 150,000 cases, the existing total fixed manufacturing overhead ($4,200,000 per month) would continue, plus an additional $165,000

of fixed overhead will be incurred per month.

Total fixed marketing and distribution costs will not change.

What price should Lomas bid?

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Costing and Pricing for the Short Run Example

Relevant Costs Variable manufacturing Fixed manufacturing $38.00 1.10

Total
$165,000 150,000 = $1.10

$39.10

Any bid above $39.10 will improve Lomass profitability in the short run.
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Costing and Pricing for the Short Run Example

Suppose that Lomas believes that Del Valle will sell the tomato sauce in Lomass current markets but at a lower price than Lomas. Relevant costs should include revenues lost on sales to existing customers.

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Long-Term Pricing
One year or longer Pricing a product in a major market where there is some

leeway in setting price

Fixed costs are relevant, since they can be managed in the

long run
Set Profit margins to earn a reasonable return on

investment
Lower prices when demand is weak and increase them

when demand is strong

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Long-Term Pricing Optimization

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Long-Term Pricing Approaches

Cost-based
Base price on production costs Plus a required rate of return

Market-based
Base price on customers demand and competitor reaction

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Markets and Pricing

Competitive markets market-based approach
Commodities such as oil, steel, etc.

Less-competitive markets either market-based or costbased approach

Professional services, high end automobiles, etc.
Usually look at costs first Often comes down to bidding or negotiation

Noncompetitive markets cost-based approach

Maximize margins constrained by customer limits
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Costing and Pricing for the Long Run Example

Latisha Computer Corporation manufactures
two brands of computers: Simple Computer (SC) and Complex Computer (CC). Latisha uses a long-run time horizon to price Complex Computer (CC).

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Costing and Pricing for the Long Run Example

Direct materials costs vary with the number of units produced. Direct manufacturing labor costs vary with direct manufacturing labor hours. Ordering and receiving, testing and

inspection, and rework costs vary

with their chosen cost drivers.
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Costing and Pricing for the Long Run Example

Ordering:
Testing: Rework:

$78 per order

$ 2 per inspection hour $38 per unit reworked $450.00

Cost per Unit

Direct materials Direct labor:

3.50 hours @ $19 per hour

Total

66.50
$516.50
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Costing and Pricing for the Long Run Example

Number of orders placed: Number of testing hours: Number of units reworked: 17,000 3,000,000 8,000

The direct fixed costs of machines used exclusively for the manufacture of Complex Computer total $7,000,000. What is the cost of producing 100,000 units of Complex Computer?
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Costing and Pricing for the Long Run Example

Direct material and labor Direct fixed costs Ordering (17,000 $78) Testing (3,000,000 $2) Rework (8,000 $38) Total $51,650,000 7,000,000 1,326,000 6,000,000 304,000 $66,280,000

$66,280,000 100,000 units = $662.80/unit

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Market-Based Pricing
Must understanding customers and competitors:

Competition from lower cost producers limits ability

to increase prices Commodity products must turn over quickly, leaving

little room to recover from pricing mistakes

Customers demand quality products at reasonable prices

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Market-Based Pricing
Start with a target price
Estimated price that potential customers will pay Based on customers perceived value Or how competitors will price competing products or

services

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Target Pricing/Target Costing

1.

Develop a product that satisfies potential customer

needs
2. 3.

Choose a target price Derive a target cost per unit: Target price per unit minus target operating income per unit Perform cost analysis Perform value engineering to achieve target cost
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4. 5.

Implementing Target Pricing and Target Costing

Latishas management wants a 15% target operating income on sales revenues of CC.

Target sales revenue is $750 per unit.

What is the target cost per unit? $750 .15 = $112.50, $750 $112.50 = $637.50

Current full cost per unit of CC is $662.80

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Value Engineering

Product Design Production Research and Development Securing raw materials and other resources

Marketing

Distribution Customer Service

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Value Engineering
A systematic evaluation of the value chain
Reduce costs while improving quality and satisfying

customer needs Distinguish value-added activities and costs from non-

value-added activities and costs

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Value Engineering Terminology

Value-added costs
If eliminated, would reduce the value to customers

Non-value-added costs
If eliminated, would

not reduce value to customers

A cost the customer is unwilling to pay for

Gray area
Many costs fit between the two extremes
e.g., preventative maintenance
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Value Engineering Terminology

Cost incurrence
The point in time when a resource is consumed (or

benefit foregone) Locked-in costs (designed-in costs)

Have not yet been incurred but, based on decisions that

have already been made, will be incurred in the future

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Cost Incurrence and Locked-In Costs Graph

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Problems with Value Engineering and Target Costing

Employee frustration with failed targets A cross-functional team may over-engineer, to accommodate the wishes of team members A product development may require a long time as alternative designs are repeatedly evaluated Risk of organizational conflict

The burden of cost cutting falls unequally on different

business functions
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Value Engineering and Target Costing

http://www.forbes.com/sites/joannmuller/2013/01/13/ new-corvette-is-a-sign-of-the-times-at-gm/

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Cost-Based (Cost-Plus) Pricing

Add a markup to the cost base to determine a prospective selling price
Usually, it is only a starting point in the price-setting

process
The markup is somewhat flexible, based partially on

customers and competitors

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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 Selecting the cost bases for the cost-plus calculation:
Variable manufacturing cost
Variable cost Manufacturing cost Full cost

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Common Business Practice

Most firms use full cost for their cost-based pricing basis, because:
It allows for full recovery of all costs It allows for price stability It is simple

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Cost-Plus Pricing

Assume that Latishas engineers have redesigned CC into CCI at a new cost of $637.50. The company desires a 20% markup on the full unit cost.

What is the prospective selling price?

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Cost-Plus Pricing

Cost base: Markup component: (637.50 .20)

$637.50 127.50

Prospective selling price:

$765.00

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Life-Cycle Budgeting and Costing

Estimating the revenues and individual value-chain costs

attributable to each product

From initial R&D to final customer service and

support
Until services are no long offered on that product

(orphaned)

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Important Considerations for Life-Cycle Budgeting

Non-production costs are significant
Development period for R&D and design is long and

costly
Many costs are locked in at the R&D and design stages,

even if R&D and design costs are themselves small

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Life Cycle Budgeting

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Other Important Considerations in Pricing Decisions

Price discrimination
Charging different customers different prices for the

same product or service

Illegal if the implication is to limit competition

Peak-load pricing
Charging a higher price for the same product or service

when demand approaches the production capacity limit

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The Legal Dimension of Price Setting

Price discrimination
Predatory pricing is deliberately lowering prices

below costs in an effort to drive competitors out of the market and restrict supply, and then raising prices

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The Legal Dimension of Price Setting

Dumping
A non-U.S. firm sells a product in the United States at a

price below the market value in the country where it is

produced
This lower price materially injures or threatens to

materially injure an industry in the United States

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The Legal Dimension of Price Setting

Collusive pricing
Companies conspire in their pricing and production

decisions to achieve a price above the competitive price

and so restrain trade

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