Class 7 – Ch14 Pricing Decisions and Cost Management

Part I. Recap of Chapter 13

[Strategy]Definition, Classification, Formulation
Classification: Cost-leadership & Product differentiation
Formulation: Porter’s Five Forces Model

[Strategy Implementation] Balanced Scorecard

Strategy Map: Objectives → Measures → Initiatives → Target Performance → Actual Performance

[Strategy Evaluation] Strategic Profitability Analysis and Capacity Management

Strategic Profitability Analysis: Growth Component, Price-Recovery Component, and Productivity
Component.
Companies that have been successful at cost leadership will show favorable productivity and growth
components; Companies that have successfully differentiated their products will show favorable
price-recovery and growth components.

Capacity Management: Make use of unused capacity & downsizing (rightsizing)

Part II. Ch14 Pricing Decisions and Cost Management

LO1 Determinants of Prices

LO2 Costing and Pricing for the Long Run
[Pricing Decisions] LO1 Determinants of Prices, Time Horizons,

1. Determinants of Prices:
Customers, Competitors, and Costs

But,
How to price a product or service ultimately
depends on the demand and supply.

Customer: Customers influence price through their effect on the demand for a product or service.
The demand is affected by factors such as the features of a product and its quality. Managers always
examine pricing decisions through the eyes of their customers and then manage costs to earn a profit.

Competitors: influence price through their competing pricing schemes, product features, and
production volume [Demand]

Costs: Costs influence prices because they affect supply.

2. Time Horizons
Short-run pricing decisions have a time horizon of less than one year:
- Pricing a one-time-only special order with no long-run implications
- Costs are often irrelevant such as fixed costs that cannot be changed in the short run-
- Short-run pricing is more opportunistic (possible myopia)

Long-run pricing decisions have a time horizon of one year or longer:

- Relevant costs include all fixed and variable costs
- Long-run pricing is a strategic decision designed to build long-run relationships with
customers based on stable and predictable prices.

[Pricing Decisions] LO2 Costing and Pricing for the Long Run
1. Recap of the value chain
180

COA
 wmur
2. Long-Run Pricing Approaches
Demand
Cos
1) Market-Based: Target Pricing
Price is based on what customers want and how competitors will react;
→ Use in competitive markets because firms accept the price determined by customers and
competitors and use cost information to decide the output units to maximize operating
income.

o_O
2) Cost-Based: Cost-Plus Pricing
Supply
Price is based on what it costs to produce and the ability to achieve a required rate of return
(Cost + Markup);
→ Use in non-competitive markets (monopolist such as electric utilities) because firms do
not need to respond to competitors’ prices

Illustration 1
Astel Inc. produces 150,000 Provlaue computers (No beginning and ending inventory).
Manufacturing cost information is as follows:
Manufacturing Cost Information to Produce
150,000 Units of Provalue
Cost Category Cost Details of Cost Driver Quantities Total Quantity of Cost per
Driver Cost Driver Unit of

Direct Manufacturing Costs:

亖
Cost
Driver

co
Direct materials No.
kits
of 1 kit per unit 150,
000
Units
ieonz
Fill $460

0 不
e
Direct DML- 3.2 DML- 150, Units Fill $20
manufacturing hours hours per 000
labor (DML) unit 401000mn

00
Direct machining Machine 300,000 $38
(fixed) hours
Manufacturing Overhead Costs:
赢
0
Ordering and No. of 50 orders per 450 compone Fill $80
receiving orders componen nts 22 500

亝
 t
1501000x30
Testing
inspection
and Testing
hours 0
30 testing-
hours per
150,
000
units Fill

45001000
$2

unit
Rework 8% defect
rate

010oiE3 io000
Rework 2.5 rework- Fill defective Fill $40
hours hours per units
defective
unit

000 8 Rewrl

Manufacturing Costs of Provalue for 2019 Using Activity-Based Costing are as follows:
Total Manufacturing Costs for Manufacturing Cost per Unit
150,000 Units
Direct manufacturing costs:

器
Direct material costs $ 69,000,000 $460

__
115000
Direct
labor costs
manufacturing
1099
Fill Fill
64
Direct machining costs Fill Fill
Total Manufacturing Fill Fill
 Costs

Manufacturing overhead
costs:
Ordering and receiving Fill Fill
costs
Testing and inspection Fill Fill
costs
Rework costs Fill Fill
Total Manufacturing Fill Fill
overhead cost

20'2 0 co1150 000

0 0
Suppose the selling price is 1,000 and we sold out all of 150,000 units
Profitability of Provalue Division for 2019 Using Value-Chain Activity-Based Costing:
Total Per Unit
Revenues 150,000,000 1,000
Costs of goods sold Fill Fill
lozow 00 680
Operating costs:
R&D costs 2,400,000 16
Design costs of product 3,000,000 20
and process
Marketing and 15,000,000 100
administration costs
Distribution costs 9,000,000 60
Customer-service costs 3,600,000 24
 Total Operating costs 33,000,000 220
Full cost of the product 135,000,000 900
Operating income 15,000,000 100

o_O07900

3. Market-Based: Target Pricing

Four steps in developing target prices and target costs:
1) Develop a product that satisfies the needs of potential customers
2) Choose a target price based on:
What the potential customers will pay;
How competitors will price competing products
3) Derive a target cost per unit (all future costs):
Target Price per unit - Target Operating Income per unit
4) Perform value engineering to achieve target cost

Illustration 1 – Continued

1) Their market research indicates that customers do not value Provalue’s extra features, such as
special audio elements and designs that make the PC run faster. Instead, customers want Astel
to redesign Provalue into a basic, reliable, and low-priced PC.
o
o_o
2) Competitors are expected to lower the prices of PCs to $850. Astel’s managers want to respond

O__0_
aggressively by reducing the price of Provalue by 20%, from $1,000 to $800 per unit. At this
lower price, the marketing manager forecasts an increase in annual sales from 150,000 to

C T
O_O
200,000 units.
Target
Price0
3) To earn the target return on capital, Astel needs to earn 10% target operating income per unit on
the 200,000 units of Provalue it plans to sell.

get02
 三 0
wnn
no 00
0 0 O
si _t
4)
cCOQscu.eu
Provalue’s $720 target cost per unit is $180 below its current unit cost of $900. To achieve the target
cost, Astel must attempt to reduce costs in all parts of the value chain, from R&D to customer service.
an

day
Current
→ That is “VALUE ENGINEERING.”

Value Engineering
1800
Value Engineering is a systematic evaluation of all aspects of the value chain, with the objective of
reducing costs while improving quality and satisfying customer needs.

-
o
Distinguish costs from value-added activities and costs from non-value-added activities:

Value-Added Cost: a cost that, if eliminated, would reduce the actual or perceived value
or utility (usefulness) customers obtain from using the product or service (e.g., direct
manufacturing costs);

Non-Value-Added Cost: a cost that, if eliminated, would not reduce the actual or perceived
value or utility customers obtain from using the product or service. Customer is unwilling
to pay for the cost. (e.g. abnormal spoilage)
- Distinguish cost incurrence from locked-in costs:
Cost Incurrence: describes when a resource is consumed (or benefit forgone) to meet a
specific objective. (Costing systems measure cost incurrence)
Real
Locked-in Costs (Designed-in Costs): costs that have not yet been incurred but will be
incurred in the future based on decisions (e.g., design choices) that have already been made

hypothetical
Teen Company

seed A to seedB
imaginary hypothetical

1 Real historical
curve

0 CC CO2024
(Illustration 1-Continued) Achieving the Target Cost per Unit for Provalue:

O rnnr

Ǒ
 0 0
0
4. Cost-Based: Cost-Plus Pricing
是
Cost base + Markup fromother5
1) Cost-Plus target rate of return on investment (ROI)
stages of
nnnnnntt
ROI = Target operating income / Invested capital (which can be defined in many ways, e.g. total valueChain
assets)

Price = cost per unit + target income per unit

Example:
Firm A invested $96,000,000 with an expected rate of return of 18%. Budgeted production:
200,000 units. Full product cost: $720/unit.

Price = 720
961的
器
器

When the “investment” used to support a product is unknown……

2) Different cost bases & markup percentages:

 Most firms use full cost because it:
1. allows for full recovery of all costs of the product
2. allows for price stability: limit salespeople’s ability to cut prices
3. is simple

In(After)-Class Exercise 1
currentcore
cp It has costs of $2,800. A competitor is
WA Co. currently sells radios for $3,600.
bringing a new radio to market that un cnn.n believes
will sell for $3,200. Management st it must
lower the price to $3,200 to compete in the market for radios. Marketing believes that
ce.co
the new price will cause sales to increase by 10%, even with a new competitor in the
market. WA’s sales are currently 1,000 radios per year.

Required: 1000X111 11100n

a. What is the target cost if target operating income is 25% of sales?
b. What is the change in operating income if marketing is correct and peruntn
onlynnthe sales
price is changed?

ae ēgǎǎiyeiōkǐzǒgōt
c. What is the target cost if the company wants to maintain its same income level,
and marketing is correct?

3200 0175 2400mn

800 000
3600 28007三
b 1 000
2400 880 000
1 100 3200
2472.73
080 000