Chapter 12
Pricing and Cost Management
1
Players in Pricing

Customers
 Competitors (heterogeneous oligopoly)
Pricing Strategies
 passive





adapt price to competitors‘
will not induce competitive action
compete by quality, service, and differentiation
cost Management should ensure profitability
aggressive





based on cost leadership position
attempt to increase market share
induces retaliation by competitors
shakeout of weak competitors
target: quasi-monopoly position
2
Time Horizon of Pricing Decisions

short-run bottom price: incremental cost


But: beware of side effects:
 Is it really additional business???
 one-time customer could compete with „our“ other customers‘
business and undercut their prices (Cannibalization)
Relevant costs of the bidding decision should include revenues lost
on sales to existing customers (Opportunity costs)

long-run bottom price: cost of resources used for
the respective object



long-run prices should always be market-based


estimated by using ABC
but: Competition on the product market may require
reduction of the current cost level
exception: sometimes government contracts
neglecting market reaction foregoes profit potential
3
Target Price and Target Cost

Target price is part of the product concept



it is designed with the product using marketing research
methods (conjoint measurement)
Conjoint measurement uses experiments to figure out
customers‘ willingness to pay for the product depending on
its features
Target Cost


the allowable cost that leaves a target profit margin
based on predicted product life cycle sales volume at the
target price
 price and sales volume may change over the product life
cycle according to expected dynamics
 target profit then has to be determined as the net present
value of the Product all over the life cycle
 hard to estimate
4
Simultaneous Engineering

Specify product concept that satisfies the needs
of the target market segment


Choose a target price, estimate sales level at this price
Product design and design of productive system

processes
 equipment
 supply chain

are developed simultaneously.
Objective: find a solution that is viable under competition and
yields a positive net present value given the company‘s cost of
capital

i.e. its risk-adjusted rate of return
 sometimes if not usually, the required rate of return is set above
the market rate
 why?: the returns from the products must cover average
development costs of unsuccessful products.
5
Target rate of return
assuming constant price and sales volume or
considering an average over the product life cycle :
 rS = Target return on sales:
target cost = (1 - rS)  target price


markup = rS / (1 - rS)
rI = Target return on investment

rI can be derived from capital market data: „required rate of
return“ on the capital market
rS = rI / turnover rate
turnover rate = additional sales / additional investment
6
Example





A company has invested 100,000$ in assets to
produce a certain product.
The investors‘ required rate of return rI = 10%
Full costs of production per unit of the 1,000 units
produced is 150$.
What is the markup rate needed to earn the required
return on Investment?
What is the target return on sales?
7
Value-Added vs. Nonvalue-Added Costs

A value-added cost is a cost that customers perceive
as adding value, or utility, to a product or service

A nonvalue-added cost is a cost that customers do
not perceive as adding value, or utility, to a product or
service.




Cost of expediting
Rework
Repair
Value-added costs of processes, however, should be
defined from the company‘s point of view

it may be quite profitable to keep units in stock while this
does not add to customer value; however it saves other costs
8
How to determine the allowable costs of a
component



Target costing helps to determine what the allowable
costs of each component of a product are
Start from the allowable costs of the product
Proceed in three Steps:




Identify how different functions of the product (attributes)
affect the customers’ willingness to pay
Determine to what extent a component contributes to a
specified function or attitude
Taking step one and two into consideration to determine the
allowable cost of each component
Problem: Interaction effects between features
9
Cumulative Costs per Unit
Cost Incurrence and
Locked-in Costs
Value-Chain
Functions
R&D and
Design
Manufacturing
Mkt., Dist.,
& Cust. Svc.
10
Cost Incurrence and Locked-in Costs
At the end of the design stage, direct materials,
direct manufacturing labor, and many
manufacturing, marketing, distribution,
and customer-service costs are all locked in.
When a sizable fraction of the costs are locked in
at the design stage, the focus of value engineering
is on making innovations and modifying designs
at the product design stage.
11
Excursion: Interdependence of products

A company produces two different products, x1 and
x2
 The number of units that can be sold in the market
can be described using the following functions:
 x1 = 400 – 2p1 – (+) p2
 x2 = 200 – 4p2 –(+) p1
 Variable costs are k1 = 2 and k2 = 4
 Which kind of interdependence is expressed by –
(+)?
 How many units should be produced of each product
to maximize profit in either situation?
12
Life-Cycle Budgeting
The product life cycle spans the time from
original research and development, through
sales, to when customer support is no longer
offered for that product.
A life-cycle budget estimates revenues and
costs of a product over its entire life.
13
Costs beyond the market phase of the PLC

Nonproduction Costs



Development Costs


less visible on a product-by-product basis.
When nonproduction costs are significant, identifying
these costs by product is essential for target pricing, target
costing, value engineering, and cost management.
When a high percentage of total life-cycle costs are
incurred before any production begins and before any
revenues are received, it is crucial for the company to have
as accurate a set of revenue and cost predictions for the
product as possible.
Costs after the end of the PLC


disposal costs
design for remanufacturing
14
Price Discrimination Laws


They apply to manufacturers, not service providers.
Price discrimination

under the U.S. Robinson-Patman Act, a manufacturer cannot
price-discriminate between two customers if the intent is to lessen
or prevent competition for customers.
 Price discrimination is permissible if differences in prices can be
justified by differences in costs.

Predatory pricing occurs when




the predator company charges a price that is below an
appropriate measure of its costs, and
the predator company has a reasonable prospect of recovering in
the future the money it lost by pricing below cost.
Most courts in the United States have defined the “appropriate
measure of costs” as the short-run marginal and average variable
costs.
Dumping occurs when

a non-U.S. company sells a product in the United States at a price
below the market value in the country of its creation, and its
action injures an industry in the United States.
15
Price Discrimination Laws

Collusive pricing occurs when
companies in an industry conspire in their pricing and
output decisions to achieve a price above the competitive
price.
Assignments for Chapter 12:

12-17 (5%)
 12-27 (8%)
 12-19 (5%)
 12-29 (=11.12-30) (8%)
 12-23 (8%), 12-31 (new in 11th ed.)(5%),
 12-33 (=11.12-28) (8%)
12-25 (5%), 12-35 (new in 11th ed.)(10%)
16
Quiz
1.
Short-run pricing decisions include
a.
pricing a main product in a major market
b.
considering all costs in the value-chain
of business functions.
c.
adjusting product mix and volume in a
competitive market while maintaining a stable price
if demand fluctuates from strong to weak.
d.
pricing for a special order with no longterm implications.
17
Quiz
2. Pritchard Company manufactures a product that
has a variable cost of $30 per unit. Fixed costs
total $1,500,000, allocated on the basis of the
number of units produced. Selling price is
computed by adding a 20% markup to full cost.
How much should the selling price be per unit
for 300,000 units?
a. $49
b. $43.75
c. $42
d. $35
18
Quiz
3.
The first step in implementing target pricing
and target costing is
a.
b.
c.
d.
choosing a target price.
determining a target cost.
developing a product that satisfies needs
of potential customers.
performing value engineering.
19
Quiz
4.
The best opportunity for cost reduction is
a.
phase of
design
the
of the
during the manufacturing
the value chain.
b.
during the product/process
phase of the value chain.
c.
during the marketing phase of
value chain.
d.
during the distribution phase
value chain.
20
Quiz
The following data apply to questions 5 and 6.
Each month, Haddon Company has $275,000 total
manufacturing costs (20% fixed) and $125,000
distribution and marketing costs (36% fixed).
Haddon’s monthly sales are $500,000.
5.
The markup percentage on full cost to arrive at the
target (existing) selling price is
a. 25%.
b. 75%.
c. 80%.
d. 20%.
6.
The markup percentage on variable costs to arrive
at the existing (target) selling price is
a. 20%.
b. 40%.
c. 80%.
d. 66 %.
21
Quiz
7.
The price of movie tickets for opening day
and the few days following compared to the price
six months later is an example of
a.
b.
c.
d.
price gouging.
peak-load pricing.
dumping.
demand elasticity.
22
Quiz
8.
Which of these do antitrust laws on pricing
not cover?
a.
b.
c.
d.
Collusive pricing
Dumping
Peak-load pricing
Predatory pricing
23
12-17 (data in million $)
Revenues (200,000 units @ $100 (average))
variable costs
direct materials ($35 per unit)
direct manufacturing labor ($10 per unit)
variable manufacturing overhead ($5 per unit)
sales commissions (15% of revenues)
other variable costs ($5 per unit)
total variable costs
Contribution margin
Fixed costs
Operating Income


1.
2.
20
7
2
1
3
1
14
6
5
1
Offer: 3000 units @ $85; capacity: 300 000 units < max demand
Sales manager would accept flat sales commission: $6,000
effect on operating income if accepted?
Accept?
24
12-27 (in $1 000)
Revenues (1 000 crates @ $100)
CoGS ($20 000 fixed)
Gross margin
Marketing costs ($16 000 fixed)
OI

1.
2.
3.
$100
60
40
30
10
capacity: 1 500 crates; relevant range of fixed costs:
500 to 1500 crates.
markup% of total variable costs
Offer: 200 crates @ $55 cash; $2000 cost of special
packaging; customer disappears in six weeks.
Accept?
If customer stays in business: Accept?
25
12-19 (in 1 000$)
Materials and labor for servicing machine tools
rework costs
expediting costs caused by work delays
materials handling costs
materials procurement and inspection costs
preventive maintenance of equipment
breakdown maintenance of equipment
1.
2.
3.
800
75
60
50
35
15
55
-5%
-75%
-75%
-25%
-20%
+50%
-40%
(a)
(b)
(c)
classify: value-added/non-value-added/ grey area
if 65% of cost in grey area is value-added: how much of total
cost is value-added/non-value-added?
quality improvement and other cost Management measures:
change %ages in right-hand column
26
12-29
Indirect Manufacturing
Cost per Unit of
Cost Pool
Cost Driver
Cost Driver
Materials handling
Number of parts
$ 0,80
Assembly management Hours of assembly time
$48,00
Machine insertion of partsNo. of machine inserted parts $ 0,75
Manual insertion of parts No. of manually inserted parts $ 1,90
Quality testing
Testing hours
$35,00
Direct material cost per unit
Indirect Manufacturing
Cost Pool
Materials handling
Assembly management
Machine insertion of parts
Manual insertion of parts
Quality testing
Quantity of Cost Driver Per Output Unit
P-81
P-63
P-81 REV P-63 REV
90
50
75
42 parts
2,8
1,8
2,0
1,5 assembly-hours
49
31
59
29 parts
41
19
16
13 parts
1,2
1,0
1,2
0,9 testing-hours
Direct material cost per unit $400,50
$286,50
$385,00
$260,00
27
12-23
variable operating costs
$3 per room-night
fixed costs
salaries and wages
$175 000
maintenance of building and pool
37 000
other operating and administration costs 140 000
total fixed costs
352 000



1.
2.
expected demand: 16 000 room nights
capital invested: $960 000
target return: 25%
Price per room night?
a price decrease of 10% would increase demand by 10%;
decrease price?
28
12-31


1.
2.
3.
Order: 5 000 violins
@ full cost + maximum markup of 20%
minimum acceptable price
price @ full cost (without administrative cost) + incr.
administrative cost + maximum markup of 20%
take offer @ $33 per unit?
Assembly rate
4
Variable direct manufacturing labor cost
$
60
Variable overhead cost
$
20
Fixed overhead cost
$
50
Incremental administrative costs $10.000
violins per direct manufacturing labor hour
per direct manufacturing labor hour
per direct manufacturing labor hour
per direct manufacturing labor hour
29
12-33



1.
2.
bdgeted supply 80 000 hrs of labor
variable costs $12 per hr.
fixed costs: $240 000
cost plus price @20%?
optimal price if:
Price per hr.
$16
17
18
19
20
3.
Demand (1000 hrs)
120
100
80
70
60
Comment
30
12-25
Production and sales
Life cycle costs
R&D and design
Manufacturing
variable cost per watch
variable cost per batch of 500 units
fixed costs
Marketing
variable cost per watch
fixed cost
Distribution
variable cost per batch of 160 units
fixed costs
Customer service cost per watch
400 000 units @ $40
$1 000 000
$15
$600
$1,800,000
$3.20
$1,000,000
$280
$720 000
$1.50
31
12-35
Years 1 & 2
R&D Costs
Design Costs
GL1
GL2
$240.000
160.000
$150.000
75.000
Variable Cost
Total
Variable Cost
Total
Fixed Costs Per Package Fixed Costs Per Package
$25
$100.000
$25
$100.000
Production costs
40
90.000
24
70.000
Marketing costs
25
80.000
16
50.000
Distribution costs
50
100.000
30
Customer service costs 80.000
Years 3 to 6
1.
2.
3.
price $480, sales 4 000 units of either model. Which
one should be chosen?
cost structures?
Yellin‘s favorite model, when she leaves after year 2
and gets a bonus according to division OI?
32