Module 20
Pricing and
Related Decisions
The Value Chain
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The set of value-producing activities that
stretches from basic raw materials to the final
consumer
 Each product or service has a separate value
chain
All entities along the value chain depend on the
final customer’s perception of the value and cost
of a product or service
Three Levels of the Value Chain
The value chain for the paperboard cartons used to
package beverages shows three levels with each successive
level showing more detail. Who does what activities best?
Value Chain Perspective
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Core competencies: Where do we fit in the chain
& what are we best at?
Relationships with suppliers & customers
becomes an integrated partnership (data &
vision)
Considers the full cost, including customer
use…
Meet together to improve product value,
processes and reduce costs
Fewer suppliers
 Some shared management

Supplier-Buyer Partnership
Example
Ford Motor Co. partners with selected suppliers
who meet quality tests. They share production
data, engineering design, and some training. Must
meet delivery of quality, time, and cost.
Industrial Molding Corp. (Lubbock) provides
plastic components for Ford (and 20 other
companies).
Source: Hirsch, Steve. E-Management - Suppliers Become Closer Partners
© International Trade Centre, International Trade Forum, Issue 3/2005.
The Pricing Decision
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Important and complex decision for
management
Directly affects the salability and profitability of
individual products or services
Two pricing theories
Economic approaches
 Cost-based approaches
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Economic Approaches to Pricing
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Based on cost and revenue functions
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Marginal revenue
 The varying increment in total revenue derived from the sale of an
additional unit
Marginal cost
 The varying increment in total cost required to produce and sell an
additional unit of product
Expand production until marginal revenue = marginal cost

For 1 company Expand to MC = Price
http://upload.wikimedia.org/wikipedia/commons/1/17/Profit_max_marginal_small.svg

Entire market clears when production expands and price decreases to MC
http://upload.wikimedia.org/wikipedia/commons/7/7a/Supply-and-demand.svg
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Marginal revenues often unknown—just a guess.
Cost-Based Approaches to Pricing

Cost has traditionally been the most important
consideration in pricing because

Cost data are available.
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Cost-based prices are defensible.
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Feasible for setting prices in a short period of time
Managers can argue prices represent a fair profit
Revenues must exceeds costs if the firm is to remain
in business.
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Long run selling prices must exceed the full costs
Cost-Based Pricing
in Single-Product Companies
Known data are entered into a profit formula
Example
Lawn Chopper mows lawns and has an annual facilities
cost totaling $30,000. Each lawn mowed costs $10.
Management desires to achieve an annual profit of $40,000
at an annual volume of 5,000 lawns.
Profit = Total revenues – Total costs
$40,000 = (Price × 5,000) – ($30,000 + [$10 × 5,000])
Price = $24 per lawn
Then, will the customers pay $24 per week to have their
lawns mowed?
Cost-Based Pricing in
Multiple-Product Companies
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Desired profits are obtained for entire company
Standard procedures are established for determining
initial selling prices of each product
 Typically include
 Cost assigned to the product or services
 Plus a markup to cover unassigned costs and to
provide a profit
Pricing Bases in
Multiple-Product Companies
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Possible cost bases for markups:
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Variable production costs
Variable production, selling, and administrative costs
Full manufacturing costs
Markup on Cost Base
General approach to developing a markup is to
recognize that the markup must be large enough to
provide for costs not included in the base, plus a
profit
Markup on cost base =
Costs not included in the base + Desired profit
Costs included in the base
Variable Cost Basis Example
Lawn Chopper has total assets of $320,000. Management
desires an annual return of 12.5% on total assets. Fixed
costs and expenses total $30,000, and variable costs and
expenses total $50,000. Estimated variable costs per unit
equals $10.
Desired annual profit = 12.5% × $320,000 = $40,000
Markup on Variable Costs
$30,000 + $40,000
$50,000
= 140% of VC
Selling price = $10 + ($10 × 1.40) = $24.00
Full Production Cost Basis
Example
Lawn Chopper’s fixed costs and expenses total $30,000, of which
$10,000 are selling and administrative costs. Total variable costs and
expenses total $50,000, with $5,000 of this amount selling and
administrative costs. Estimated variable costs per unit equal $10
(with $1 of this selling and administrative costs). Full production
cost = $20,000 + $45,000 = $65,000 or $13 for each of the 5,000
units. Desired profit is still $40,000.
Markup on Full Production Cost
$10,000 + $5,000 + $40,000
$20,000 + $45,000
= 84.6%
Selling price = $13 + ($13 × 84.6%) = $24.00
Critique of Cost-Based Pricing
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If cost-based pricing does not have accurate cost
assignments, some products could be priced too high and
others too low.
Cost-based pricing assumes goods or services are relatively
scarce and, generally, customers who want a product are
willing to pay the price.
Target Costing & Product
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Starts with determining what customers are
willing to pay for a product or service
Then subtracts a desired profit on sales to
determine the allowable cost of the product or
service
Team must design a product that meets
customer price, function, and quality
requirements while providing the desired profit
Save cost by designing the target product that will
eventually be in the market after competitors
have responded.
Target Costing Requirements

Requires cost information
Detailed information on the cost of alternatives
activities is needed
 Allows decision makers to select design and
production alternatives that are fast & cost effective
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Requires coordination with all involved
Need a basic understanding of the overall processes
required to bring a product to market
 Should appreciate cost consequences
 Must respect, cooperate, and communicate with
other team members
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Pros and Cons of Target Costing
Product Life Cycles
Products with a relatively long life go through
4 stages during their life cycle
Sales Revenue
Maturity
Sales are low. Often selling
prices are high. Customers
are affluent trendsetters.
Time
Sales level off. Price pressure
increases. Price reductions
could be needed.
Sales increase as product gains acceptance.
Selling prices often remain high. Customers
are loyal. Low competition.
Sales decline as product becomes
obsolete. Significant price cuts
needed to sell inventories.
Life Cycle Costs

Life cycle costs include all costs
associated with a product or service
ranging from
Cost incurred with initial conception
 Design
 Pre-production
 Production
 After production support
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Cost management aided by target
costing
Commitment and Expenditures
Commitments and expenditures of organizations for
high-technology products with relatively short product lives
Kaizen Costing
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A costing approach focused on continuous
improvement
Calls for establishing cost reduction targets for
products or services
Begins where target costing leaves off
Often found in companies that have adopted a
lean production philosophy
Successful companies
often use Kaizen to avoid
complacency.
Benchmarking
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A systematic approach to identifying best
practices to help an organization take action to
improve performance
Typically deals with
Target costs for a product, service or operation
 Customer satisfaction
 Quality
 Inventory levels
 Inventory turnover
 Cycle time
 Productivity
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