COSTING FOR
PRICING DECISIONS
Gerald E. Smith, D.B.A.
Carroll School of Management
Boston College
PROFITABLE PRICING REQUIRES

UNDERSTANDING THE TRUE COST
The true cost is the cost incurred if a sale is
made, or the cost not incurred if a sale is not
made.

IDENTIFYING TRUE COSTS
Incremental (not the “full cost”)
Avoidable (not the “sunk cost”)
THE FOCUS OF
PROFITABLE PRICING
Price
Unit Sales Volume
Total Revenue
$10
100,000
$1,000,000
Unit Variable Costs
Total Variable Costs
$3
$300,000
Unit Contribution
Total Contribution
$7
$700,000
Fixed Costs
$500,000
Net Income Before Taxes
$200,000
IDENTIFY INCREMENTAL
VARIABLE COSTS
VARIABLE COSTS ARE ALWAYS INCREMENTAL
But be careful of averages! The incremental variable
cost for a change in sales is often not equal to the
average variable cost.
Examples:
–
–
–
Overtime vs. average cost production;
Costs from multiple sources using different technologies
(joint product vs. prime sourcing);
Average over different types of customers.
IDENTIFY INCREMENTAL
FIXED COSTS
SOME FIXED COSTS ARE ALSO INCREMENTAL FOR PRICING.
They are the fixed costs incurred to implement a change in pricing.
MOST FIXED COSTS ARE NOT INCREMENTAL
Since they do not change with a change in price or sales, they are not
incremental. They have no impact on the relative profitability of
alternative pricing strategies.
Examples:
 Product Development Costs;
 Advertising
IDENTIFY INCREMENTAL
OPPORTUNITY COSTS
Full costs--which include non-incremental fixed costs—are neither the
actual costs incurred when making additional sales at lower prices,
nor the actual costs saved when making fewer sales at higher
prices. They are, therefore, misleading as a guide to pricing.
Beware of overlooking or ignoring opportunity costs.
They are often incremental, even when associated with otherwise
“fixed” assets.
Examples:
 Alternative uses of capacity, funds, or
 management time.
SUNK COST FALLACY:
WHICH COST IS RELEVANT
INITIAL SITUATION
Price Per Unit
Historical & Replacement Cost
Profit Contribution Per Unit
Cash Flow Per Unit
AFTER COST INCREASE
Price Per Unit
Historical Cost
Replacement Cost
Profit Contribution Per Unit
Cash Flow Per Unit
$22.50
13.50
9.00
9.00
$22.50
13.50
15.00
9.00
7.50
COST ANALYSIS FOR PRICING DECISIONS
Boscot Corporation
TOTAL
Direct Labor
$144,000
Materials
42,000
Plant & Equipment
216,000
Sales & Marketing
12,000
Order Process & Ship 24,000
Warehousing
18,000
General & Admin
66,000
TOTAL
$522,000
What is the relevant unit cost?
$/UNIT
$24
7
36
2
4
3
11
$87
TRUE COST
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__________
__________
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USEFUL INFORMATION ABOUT BOSCOT
Direct Labor
Plant & Equipment
Marketing & Sales
Order Process & Ship
Warehousing
General & Admin
Overtime pay is 1.5 times normal pay.
Depreciated according to IRS rules.
New salespeople must be hired, and a
new promo program produced to target
new buyers. Expected cost $6,000,
regardless of sales actually generated.
Buyers in new market segment order in
quantities half the size of orders of
current customers.
Owns and rents warehouse space.
Warehousing for 1,500 units is charged at
$4,500 of original building & maintenance.
To warehouse 1,500 more units
Build addition towarehouse at charge of $6,500;
Stop leasing space to other companies,
which earns rents of $6,000 per week.
Corporate overhead, R&D, etc
Reorganize Costs for
Effective Management!
PER UNIT
(for simple pricing decisions)
Price
- Unit Variable Cost
Contribution Margin
INCREMENTAL
(for pricing with
incremental investment)
Incremental Revenue
- Incre. Variable Cost
Incremental Contribution
- Incremental Fixed Costs
Net Incre. Contribution
TOTAL
(for determining overall
business profitability)
Sales Revenue
- Total Variable Costs
Total Contribution
- Incremental Fixed Costs
Net Contribution
- Nonincremental Fixed
and Sunk Costs
Net Profit
APPROXIMATELY RIGHT, OR
PRECISELY WRONG
Determining the true cost of a product or service--the
incremental, avoidable cost--requires making adjustments to the
full, average costs as calculated for financial purposes. These
adjustments often require that you make judgments about which
you are uncertain, and that are debatable. This is not, however,
a reason to avoid making such judgments.
It is better to make pricing decisions
based on a rough idea of the true unit
cost of your product or service than on a
precise accounting of costs that are
irrelevant to its profitability!
WHY FOCUS ON CM

Tool of Competitive Advantage
–
–

Tool for Segmentation Pricing
–
–

Relative Advantage
Relative Cost
Set different prices for different segments
Can reach more segments
Indicator of how to drive profitability
–
–
High Margin: Volume-based Strategies
Low Margin: Gross Profit Bundling Strategies
Strategic Models to Manage
the Business Unit
Gross Profit Strategy
Corporate Strategy
Operating Strategy
Decision Maker
Market Managers
Top Management
Operating Managers
Management Focus
Short-term gross profitability of
customer opportunities
Longer-term net profitability of
business investments and
resource allocations
Short-term efficiency and
effectiveness of
Management Decisions
Which opportunity to serve
Terms of the transaction
-- Pricing
-- Product definition
-- Service definition
-- Where to deliver (location)
-- When to deliver (timing)
-- How much (volumes)
Which business units to invest
resources in
How much to invest
What resource mix to invest
-- Financial
-- Human resources
-- Tangible assets
-- Intangible assets
How to deploy resources
How to manufacture
How to service
When to serve
What to deliver
How to deliver
Performance Measures
Business unit gross margins, gross
profit
Customer, market segment gross
margins, gross profit
Total net earnings
Financial Return Measures,
e.g., ROI, ROA, ROE
Customer satisfaction
Perceived quality
Process efficiency
Process productivity
Figure 1
Incremental Gross Profit Strategies
Volume-Based
Gross Profit Strategies -drive volume across the market
Incr
Cost
Service Y
Segment B
Margin
Product A
Segment A
Price/Bundling
Gross Profit Strategies -drive gross profit bundles through target segments
Margin
Segment A
Incr
Cost
Segment B
Margin
Segment D
Margin
Segment D
Incr
Cost
TOTAL
GROSS PROFIT
Segment E
Margin
Incr
Cost
Product C
Segment E
Service X
High Margin
Product
Margin
Service Z
Incremental Cost
Segment C
Product B
Segment C
Margin
Incr
Cost
TOTAL
GROSS PROFIT
Figure 2
Customer Opportunity Portfolio and
Gross Profit Strategies for Low Margin Managers
Low
Price
Sensitivity
Customized Bundling Strategies
Higher relative prices,
greater brand loyalty
Custom
Solution or
Specialty
Buyers
Convenience Bundling Strategies
Emerging
Value
Buyers
High-Differentiation Volume Strategies
Loyal
Volume
Buyers
Platform Bundling Strategies
ValueAdded
Buyers
High
Price
Sensitivity
High Cost
To Serve
Lower relative costs, greater volume and scale, lower
transaction, relationship, and opportunity costs
Low Cost
To Serve
Cost to
Serve
Figure 3
Perceived Competitive Advantage
Competitor A
Perceived Advantage
Competitor B
Perceived Disadvantage
20%
Perceived
Gross Margin
80%
Perceived
Gross Margin
80%
Perceived
Cost
20%
Perceived
Cost
Strategic Options:
1. Compete with Advertising
2. Compete with Promotions
3. Compete with Price
Managerial Motivation:
• Offensive, Aggressive
• Drive Volume
Strategic Options:
1. Compete with Limited
Non-Price Promotions
Managerial Motivation:
• Defensive, Cautious
• Protect Margin
Sidebar Figure 1A
Arrow Electronics Customer Portfolio
(Bubble size = Segment Gross Profit relative to Total Gross Profit)
Higher relative prices,
greater brand loyalty
Low
Price
Sensitivity
Customized Bundling Strategies
High-Differentiation Volume Strategies
ICPBAS
ICPVA
Convenience Bundling Strategies
Platform Bundling Strategies
OEMBAS
CMVA
High
Price
Sensitivity
CMM&P
High Cost
To Serve
X86VA
OEM
VA
CMBAS
Lower relative costs, greater volume and scale, lower
transaction, relationship, and opportunity costs
X86BAS
Low Cost
To Serve
Cost to
Serve