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How companies price a product or service ultimately depends on the demand and supply for it 3 factors that influences pricing decisions:
1. Customers 2. Competitors 3. Costs
Profit Maximization
Economic Theory Pricing
Management should set the price that provides the greatest amount of profit
q*
Example 1
y
The editor of EMBA Magazine is considering three alternative prices for her new monthly periodical. Her estimate of price and quantity demanded are: Price $6 $5 $4 Quantity 22,000 28,000 32,000
Monthly costs of producing and delivering the magazine include $90,000 of fixed costs and variable costs of $1.50 per issue.
y
Solution Example 1
Price($) Demand 6 22,000 5 28,000 4 38,000 Variable Contribution Cost per Margin per unit($) unit($) 1.5 4.5 1.5 3.5 1.5 2.5
* Total
**Income
Before Tax ($) 9,000 8,000 5,000
Fixed CM ($) Costs ($) 99,000 90,000 98,000 90,000 95,000 90,000
Solution Example 1
Price($) Demand 6 22,000 5 28,000 4 38,000 Variable Contribution Cost per Margin per unit($) unit($) 1.5 4.5 1.5 3.5 1.5 2.5
* Total
**Income
Before Tax ($) 9,000 8,000 5,000
Fixed CM ($) Costs ($) 99,000 90,000 98,000 90,000 95,000 90,000
Solution Example 1
Price($) Demand 6 22,000 5 28,000 4 38,000 Variable Contribution Cost per Margin per unit($) unit($) 1.5 4.5 1.5 3.5 1.5 2.5
* Total
**Income
Before Tax ($) 9,000 8,000 5,000
Fixed CM ($) Costs ($) 99,000 90,000 98,000 90,000 95,000 90,000
**Total CM-FC= Income before tax Decision: Choose $ 6 based on quantitative factors given. Need to consider qualitative factors as well.
Price takers- when there is a competitive market and the company has no influence on price Price makers- companies that influence the price
Pricing approaches
y
y Target
desired return on investment is known, price is known .It determines the maximum cost per unit
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CostCost-Plus Pricing
Company estimates cost of production
x Adds a markup to cost to arrive at price which allows for a reasonable profit
Benefits
x Simple approach
Limitations
x What % markup to use? x Inherently circular for manufacturing firms x Requires considerable judgment and experimentation
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CostCost-Based (Cost-Plus) Pricing (CostThe general formula adds a markup component to the cost base to determine a prospective selling price y Usually only a starting point in the pricesetting process y Markup is somewhat flexible, based partially on customers and competitors
y
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Setting a Target Rate of Return on Investment: the Target Annual Operating Return that an organization aims to achieve, divided by Invested Capital Selecting different cost bases for the cost-plus calculation:
Variable Manufacturing Cost Variable Cost Manufacturing Cost Full Cost
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Most firms use full cost for their costbased 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 Pricing
Selling Price= Cost + mark-up% x Cost y Mark-up % = Desired profit per unit Unit cost y Desired profit = Desired ROI x Investment
y
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Which cost?
1. Variable manufacturing cost
Price= 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
Which costs?
2.Total variable costs
Variable manufacturing and selling costs
Price= VC + (MU% * VC)
Which costs?
3. Absorption Full manufacturing costs
y
Which costs?
4. Absorption Full/total costs
Total costs manufacturing and selling and administrative fixed (direct or allocated, variable costs)
Example - Pricing
Annual sales 480 units Unit costs:
Variable manufacturing cost Applied fixed manufacturing cost Absorption manufacturing cost Variable selling costs Allocated and direct fixed selling and administrative costs $ 400 $ 250 $ 650 $ 50
$ 100 Total cost (Manufacturing and S&ADM) $ 800 Investment $ 600,000 Desired profit 10% of investment $ 60,000 Annual Fixed Manufacturing Costs $ 120,000 Annual Fixed (allocated and direct) Selling and Administrative Costs $ 48,000
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Fixed Costs
Desired Profit mark -up % markup Price = cost + markup
Total variable selling costs Fixed Selling and Administration Desired Profit
mark -up % markup Price = cost + markup
Desired Profit
mark -up % markup Price = cost + markup
4. Full Cost
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Mark up % Price
105.56
925
925
925
925
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up on cost of goods sold = (selling and administrative costs + operating income) / COGS
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Retail Example
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Revenues Cost of goods sold Gross profit Selling and Administrative Exp Operating profit Mark up %
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Project Example
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EMBA Consultancy Co needs to bid for a project. EMBAs recent income statement appears below:
Revenues Cost of Services Material Personnel Overhead Total Cost of services Gross profit Selling and Administrative Exp Operating profit Mark up % $1,627,010 ($45,000) (650,000) (555,000) (1,250,000) 377,010 (235,750) $141,260 30.16%
Project Example
y
EMBA Consultancy needs to bid for a new project. Material costs will be $5,000; 150 man hours will be used. What would be a guiding bidding price?
Material Man-hour (150 man hourx65) Overhead (0.85*man-hour cost) Total Cost mark up percentage bid price
Target Costing
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2.
Develop a product that satisfies the needs of potential customers Choose a target price
x price is the same as the competition x set price to increase customer base x seek larger market share through price
3.
4. 5.