Pricing Decisions

Pricing and Business

y

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

Determining the Profit-Maximizing ProfitPrice and Quantity

Dollars p* Total profit at the profit-maximizing quantity and price, q* and p*. Quantity made and sold per month
4

Total cost Total revenue

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

Which price will yield the largest monthly profit?

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

Price (Demand)= Sales * Sales-VC(Demand) = Total CM

OR CM/u(Demand)

**Total CM-FC= Income before tax

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

Price (Demand)= Sales * Sales-VC(Demand) = Total CM

OR CM/u(Demand)

**Total CM-FC= Income before tax Decision: Choose $ 6 based on quantitative factors given. Need to consider qualitative factors as well.

Who determines the price?

y

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

Cost plus mark-up

Variable contribution margin approach, contribution margin( reflecting mark-up) should cover desired return on investment, all fixed costs Absorption common- mark-up covers all expenses except cost of goods sold plus the desired return on investment

y Target

costing Competitors price is known,

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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Forms of Cost-Plus Pricing Costy

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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Common Business Practice

y

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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COST-BASED PRICING COST-

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

VSC  FC  ADM  desiredprofit markup% ! vmcu * n

VSC: variable selling costs FC: fixed costs manufacturing and selling ADM: Administrative Expenses n : number of units to be sold vmcu: variable manufacturing cost per unit
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Which costs?
2.Total variable costs
Variable manufacturing and selling costs
Price= VC + (MU% * VC)

FC  ADM  desiredprofit markup % ! vmcu * n

FC: fixed costs manufacturing and selling ADM: Administrative Expenses n : number of units to be sold vmcu: variable manufacturing cost per unit
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Which costs?
3. Absorption Full manufacturing costs
y

Unit manufacturing costs both variable and fixed

Price= unit manuf. cost + markup %* unit manufacturing cost

S & ADM  desiredprofit markup % ! unit cos t * n

S&ADM: Selling and administrative costs Unit cost : unit manufacturing cost (variable and fixed)
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Which costs?
4. Absorption Full/total costs
Total costs manufacturing and selling and administrative fixed (direct or allocated, variable costs)

Price= TC + (markup % * TC)

desiredprofit markup% ! Totalunit cos t * n
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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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Cost Plus Pricing Versions

variable manufacturing cost-plus-pricing
Variable manufacturing cost Total Variable Selling Costs ($50 x 480 units) Desired profit Fixed Costs mark -up % markup Price = cost + markup $400 $24,000 $60,000 $168,000 131.25% $525 $925

1. Variable Manufacturing Cost

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Cost Plus Pricing Versions

variable total cost-plus-pricing
Total variable cost per unit $450 $168,000 $60,000 105.56% $475 $925

Fixed Costs
Desired Profit mark -up % markup Price = cost + markup

2. Variable Total Cost

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Cost Plus Pricing Versions

manufacturing cost per unit $650 $24,000 $48,000 $60,000 42.31% $275 $925

Total variable selling costs Fixed Selling and Administration Desired Profit
mark -up % markup Price = cost + markup

3. Full Manufacturing Cost

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Cost Plus Pricing Versions

total absorption- cost-plus-pricing
Total cost per unit $800 $60,000 15.63% $125 $925

Desired Profit
mark -up % markup Price = cost + markup

4. Full Cost

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Cost plus comparison

Cost plus type
Variable manufac turing cost plus mark up 131.25 Variable cost plus mark up Manufac Full cost turing plus costs mark up plus mark up 42.31 15.63

Mark up % Price

105.56

925

925

925

925

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Pricing Special Orders

In some cases, it may be beneficial for a company to charge a price lower than its full cost
Only if the order will not affect demand for its other products

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Special Orders Premier Lens Example

Given the following information, should Premier Lens produce 20,000 lenses to be sold to Blix Camera for $73 per lens?

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Special Orders Premier Lens Example

The incremental analysis shows that it should. Note that the fixed costs are not incremental and need not be included in the decision making.

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Retail cost plus mark-up marky Mark

up on cost of goods sold = (selling and administrative costs + operating income) / COGS

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Retail Example
y

Yesim Textiles income statement for 2007 is as follows:

Revenues Cost of goods sold Gross profit Selling and Administrative Exp Operating profit Mark up %

$1,427,010 (713,500) 713,510 (535,750) $177,760 100.00%

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Project Example
y

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%

Man-hour rate $ 65; overhead application 0.85 of personnel costs

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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

$5,000.00 9,750.00 8,287.50 23,037.50 30.16% $29,985.79

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Target Costing

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Five Steps in Developing Target Prices and Target Costs

1.

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.

Derive a target cost per unit:

Target Price per unit minus Target Operating Income per unit

4. 5.

Perform cost analysis Perform value engineering to achieve target cost

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Pros and Cons of Cost plus pricing

Easy to compute y No consideration to the demand side y Sales volume plays an important roleallocation of fixed costs over the products sold y If variable cost plus used then fixed costs might not be covered if not calculated correctly
y
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