Chapter 12 -Pricing Decisions and Cost Management

Chapter Twelve Pricing Decisions and Cost Management

Learning Objectives 

Short-run and long-run pricing decisions

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Target costing

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Cost incurrence and locked-in costs

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Cost-plus costing

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Life-cycle budgeting and costing

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Non-costs factors in setting price

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Anti-trust laws

The Five Forces Affect Pricing

Influences on Supply and Demand 1. Customers - by establishing demand level 

Based on factors such as quality and product features

2. Competitors/Potential Entrants/Substitutes - by

establishing alternatives 

Through pricing schemes, product features, and production volume

a nd supply 3. Suppliers – by affecting costs and 

The lower the cost, the greater the supply

Strategic Positioning Affects Pricing 

Cost Leadership: Outperform competitors by producing at the lowest cost, consistent with the quality demanded by the consumer

 Differentiation:

Create value for the customer through product innovation, product features, customer service, etc. for which the customer is willing to pay

Short-Term Pricing Less than one year: 

One time special order with no long-run implications



Adjusting product mix and output volume in a competitive market

Many costs are irrelevant in short-term pricing 

Fixed costs - price above contribution margin

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R&D, design, etc. will not change in the short run

Costing and Pricing for the Short Run – Example Lomas Corporation operates a plant with a monthly capacity of 500,000 cases of tomato sauce. Lomas is presently producing 300,000 cases per month. Del Valle has asked Lomas and two other companies to bid on supplying 150,000 cases each month for the next four months.

Costing and Pricing for the Short Run – Example Cost Per Case Variable manufacturing

$38

Variable marketing and distribution

13

Fixed manufacturing

14

Fixed marketing and distribution

15

Total

$80

Costing and Pricing for the Short Run – Example If Lomas makes the extra 150,000 cases, the existing total fixed manufacturing overhead ($4,200,000 per month) would continue, plus an additional $165,000 of fixed overhead will be incurred per month. Total fixed marketing and distribution costs will not change. What price should Lomas bid?

Costing and Pricing for the Short Run – Example Relevant Costs Variable manufacturing Fixed manufacturing

$38.00 1.10

Total

$39.10 $165,000 ÷ 150,000 = $1.10 Any bid above $39.10 will improve

Lomas’s profitability in the short run.

Costing and Pricing for the Short Run – Example Suppose that Lomas believes that Del Valle will sell the tomato sauce in Lomas’s current

markets but at a lower price than Lomas. Relevant costs should include revenues lost on sales to existing customers.

Long-Term Pricing 

One year or longer 

Pricing a product in a major market where there is some leeway in setting price

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Fixed costs are relevant, since they can be managed in the long run

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Set Profit margins to earn a reasonable return on investment 

Lower prices when demand is weak and increase them when demand is strong

Long-Term Pricing Optimization

Long-Term Pricing Approaches Cost-based 

Base price on production costs 

Plus a required rate of return

Market-based 

Base price on customers demand and competitor reaction

Markets and Pricing Competitive markets — market-based approach 

Commodities such as oil, steel, etc.

Less-competitive markets — either market-based or costbased approach 

Professional services, high end automobiles, etc.

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Usually look at costs first 

Often comes down to bidding or negotiation

Noncompetitive markets — cost-based approach 

Maximize margins constrained by customer limits

Costing and Pricing for the Long Run – Example Latisha Computer Corporation manufactures two brands of computers: Simple Computer (SC) and Complex Computer (CC). Latisha uses a long-run time horizon to price Complex Computer (CC).

Costing and Pricing for the Long Run – Example Direct materials costs vary with the number of units produced. Direct manufacturing labor costs vary with direct manufacturing labor hours. Ordering and receiving, testing and inspection, and rework costs vary with their chosen cost drivers.

Costing and Pricing for the Long Run – Example Ordering:

$78 per order

Testing:

$ 2 per inspection hour

Rework:

$38 per unit reworked

Cost per Unit Direct materials

$450.00

Direct labor: 3.50 hours @ $19 per hour Total

66.50 $516.50

Costing and Pricing for the Long Run – Example Number of orders placed:

17,000

Number of testing hours:

3,000,000

Number of units reworked:

8,000

The direct fixed costs of machines used exclusively for the manufacture of Complex Computer total $7,000,000. What is the cost of producing 100,000 units of Complex Computer?

Costing and Pricing for the Long Run – Example Direct material and labor Direct fixed costs Ordering (17,000

×

Testing (3,000,000 Rework (8,000 Total

×

$51,650,000 7,000,000

$78) ×

$2)

$38)

1,326,000 6,000,000 304,000 $66,280,000

$66,280,000 ÷ 100,000 units = $662.80/unit

Market-Based Pricing Must understanding customers and competitors: 

Competition from lower cost producers limits ability to increase prices

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Commodity products must turn over quickly, leaving little room to recover from pricing mistakes

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Customers demand quality products at reasonable prices

Market-Based Pricing Start with a target price 

Estimated price that potential customers will pay 

Based on customers perceived value

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Or how competitors will price competing products or services

Target Pricing/Target Costing 1.

Develop a product that satisfies potential customer needs

2.

Choose a target price

3.

Derive a target cost per unit: Target price per unit minus target operating income per unit

4.

Perform cost analysis

5.

Perform value engineering to achieve target cost

Implementing Target Pricing and Target Costing Latisha’s management wants a 15% target

operating income on sales revenues of CC. Target sales revenue is $750 per unit. What is the target cost per unit? $750  .15 = $112.50, $750 – $112.50 = $637.50 ×

Current full cost per unit of CC is $662.80

Value Engineering Product Design Production Research and Development Securing raw materials and other resources

Marketing

Distribution Customer Service

Value Engineering A systematic evaluation of the value chain 

Reduce costs while improving quality and satisfying customer needs

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

and costs

Value Engineering Terminology Value-added costs 

If eliminated, would reduce the value to customers

Non-value-added costs 

If eliminated, would not  reduce value to customers 

A cost the customer is unwilling to pay for

Gray area 

Many costs fit between the two extremes 

e.g., preventative maintenance

Value Engineering Terminology Cost incurrence 

The point in time when a resource is consumed (or benefit foregone)

Locked-in costs (designed-in costs) 

Have not yet been incurred but, based on decisions that have already been made, will be incurred in the future

Cost Incurrence and Locked-In Costs Graph

Problems with Value Engineering and Target Costing 

Employee frustration with failed targets

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A cross-functional team may over-engineer, to accommodate the wishes of team members A product development may require a long time as alternative designs are repeatedly evaluated

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Risk of organizational conflict The burden of cost cutting falls unequally on different business functions

Value Engineering and Target Costing

http://www.forbes.com/sites/joannmuller/2013/01/13/ new-corvette-is-a-sign-of-the-times-at-gm/

Cost-Based (Cost-Plus) Pricing Add a markup to the cost base to determine a prospective selling price 

Usually, it is only a starting point in the price-setting process



The markup is somewhat flexible, based partially on customers and competitors

Forms of Cost-Plus Pricing Setting a target rate of return on investment 

The target annual operating return that an organization aims to achieve, divided by invested capital

Selecting the cost bases for the ―cost -plus‖ calculation: 

Variable manufacturing cost

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Variable cost

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Manufacturing cost

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Full cost

Common Business Practice Most firms use full cost for their cost-based pricing basis, because: 

It allows for full recovery of all costs

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It allows for price stability

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It is simple

Cost-Plus Pricing

Assume that Latisha’s engineers

have redesigned CC into CCI at a new cost of $637.50. The company desires a 20% markup on the full unit cost. What is the prospective selling price?

Cost-Plus Pricing

Cost base: Markup component: (637.50 × .20) Prospective selling price:

$637.50 127.50 $765.00

Life-Cycle Budgeting and Costing Estimating the revenues and individual value-chain costs attributable to each product 

From initial R&D to final customer service and support

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Until services are no long offered on that product (orphaned)

Important Considerations for Life-Cycle Budgeting 

Non-production costs are significant

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Development period for R&D and design is long and costly

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Many costs are locked in at the R&D and design stages, even if R&D and design costs are themselves small

Life Cycle Budgeting

Other Important Considerations in Pricing Decisions Price discrimination 

Charging different customers different prices for the same product or service

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Illegal if the implication is to limit competition

Peak-load pricing 

Charging a higher price for the same product or service when demand approaches the production capacity limit

The Legal Dimension of Price Setting Price discrimination 

Predatory pricing is deliberately lowering prices below costs in an effort to drive competitors out of the market and restrict supply, and then raising prices

The Legal Dimension of Price Setting Dumping 

A non-U.S. firm sells a product in the United States at a price below the market value in the country where it is produced

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This lower price materially injures or threatens to materially injure an industry in the United States