CHAPTER 12. PRICING DECISIONS, PRODUCT PROFITABILITY ...
CHAPTER 12. PRICING DECISIONS, PRODUCT PROFITABILITY DECISIONS, AND COST MANAGEMENT
Influences of costs vary among products, and pricing decisions differ greatly in both their time horizons and their contexts. The key to profitability is that companies sell units at the price a customer is willing to pay.
Major influence of pricing: 3 Pricing strategies: 1. Target pricing: price is based on what customers are willing to pay 2. Cost-plus pricing: flat rate target profit percentage is added to the full product cost 3. Life- cycle pricing/cradle to grave? Includes environmental costs of production, reclamation, recycling , and reuse of materials. 3 major influences on pricing decisions: 1. Customers: examine through their eyes-price, availability, customization and quality affect willingness to pay 2. Costs: whether company follows throughput, variable and full absorption costing models. Note: ABC systems provide superior information upon which to base pricing decisions. 3. Competitors: market characteristics: Monopoly, Oligopoly, Perfect competition etc. Product cost categories and the time horizon: -
Customer satisfaction, continuous improvement and dual internal/ external focus converge when it comes to pricing. Cost reduction includes all six value-chain business funcations from R&D to customer serviceupstream and downstream costs. Relevant cost is important: depends on capacity available, alternatives uses of capacity, and the time horizon. Short run ( less than 6 months), long run ( 1 year+)
The decision framework: relevant costs in short- run pricing One time special order from customers- depends on capacity use by special order relative to ordinary capacity use. 1. Identify the problem 2. Gather information: relevant cost. Note: in case of insufficient capacity, investment into fixed asset is relevant cost. Indirect MOH is relevant 3. Forecast future outcomes on the basis of available information: 4. Decide among alternatives 5. Evaluate performance
Target pricing using target costing The starting point for pricing decisions can be -
Market- based ( target pricing): starts with what price should u charge after looking into customer and competitors behaviour Cost based ( cost plus pricing):looks at cost and then reaction Life cycle ( cradle to grave costs, including reclamation, recycling, reusing)
Target pricing and target costing: Starts with Target pricing Target price per unit: estimated price for a product or service that potential customers will pay < based on customer and competitors behaviours> Target Margin percentage ( $ amount / revenue) -
Full absorption cost: target gross margin percentage Full product cost: operating margin/ operating profit percentage Full variable cost recovery: contribution or profit percentage Full cost recovery: net margin percentage
Long run: full cost recovery…. Short run: anything else than full cost recovery is good. -
Relies on sales and marketing organization Close contact and interaction with customers Identify customers needs and perceived value Conduct market research studies Target pricing is difficult for product differentiated goods and those with short consumer life cycle. Eg. Electronics
The decision framework and long-term pricing Target cost per unit: based on full product cost instead of full absorption cost and achieve target operating income per unit. Full product cost: includes all manufacturing and non manufacturing costs ( period costs) In the long run, a new design maybe implemented that requires different capacity and labour skills or changes in existing capacity management. It is Based on a thorough value analysis to help eliminate superfluous design features and non value added costs. If it’s unable to achieve target cost- alternative is to shut down Value analysis: focuses on product design stage where there is the greatest opportunity to change design, materials, and manufacturing processes to reduce costs.
VALUE ANALYSIS AND CROSS FUNCTIONAL TEAMS Value analysis team: top management experts in marketing, product design and engineering, process improvement, supply-chain management, distribution, customer service and management accounting. -
Evaluate the impact of the design innovations and modifications on all business functions of the value chain and choose the best that provides the greatest value to the customers relative to the costs.
Reverse engineering- disassembling and analyzing competitors’ products to determine product designs and materials and to become acquainted with the technologies competitors use. Key concepts: 1. Cost incurrence: arises when a resource is sacrificed or consumed. 2. Locked in costs (designed in costs) : cost that have not yet been incurred but that will be incurred in the future on the basis of decisions that have already been made. ( unavoidable) 3. Cost reduction can be achieved upto the time when costs are incurred. 4. Companies combine value engineering with kaizen/ continuous improvement methods that seek to improve productivity and eliminate waste during production and delivery of products. 5. Eliminating or reducing non value added cost may entail process improvements, but also reason to re-examine the production process is the anticipated volume of production. 6. Reducing variable cost requires reducing unit input cost –by negotiation/changing suppliers/ quantity of input consumed 7. Other factors: appropriate training, production scheduling and maintenance also reduce DL cost. VALUE ENGINEERING Systematic evaluation of all aspects of the value chain- to reduce cost while retaining both product attributes and quality the customer desires and will pay for. Some undesirable effects: -
Decreased morale if employees fail to attain performance targets A poorly designed product as the cross functional team compromises on various customer attributes A protracted development cycle causing a missed market opportunity Conflict among the business functions as the goal is to remove non-value added costs wherever they arise, but the burden of cost reduction will be unequal
Benefits: -
Strong employee participation will serve as motivation Focus on customer’s priorities will reduce the problem of compromises within pricing teams Disciplined progress cuts down on paralysis by analysis Nourishes co-operating corporate culture
Cost plus pricing Internal focus where starting point is cost If cost base is X , Markup is Y (usually a % of cost), prospective selling price = X+Y Markup : estimating target rate of return on investment which is what the organization must earn divided by invested capital. -
Often used when prices are regulated
Alternative cost-plus methods -
Company choose a reliable cost base and markup percentage on basis of experience in pricing products and to recover its cost and earn a desired return on investment Higher the operating leverage, higher the fixed cost
Use of full product costing which includes unitized fixed costs and period cost per unit as well as VC per unit from both COGS and period costs in cost base pricing decisions. Advantages: -
Full product cost recovery: informs managers of the minimum cost needed to recover to continue business rather than shut down Price stability: limits ability of managers to cut prices and facilitates planning Simplicity: no need for analysis of cost behaviour
Cost plus pricing contrasted against target pricing Target pricing approach: -
Eliminates the need for post implementation adjustment Based on customer preferences and competitor responses When target price is not achieved , need for redesign, price adjustment, and margin reduction Usually used for relatively unique or product differentiated products and services Refined cost driver identification and cost information- IMPORTANT in both
Life cycle pricing and relevant qualitative factors in pricing: PLC : time span from R&D to customer service, or from acquisition to disposal of an asset. Life cycle budgeting: estimate full products costs across the entire value chain of business functions: include recycling, reuse and reclamation costs of disposing of obsolete finished products. Customer life- cycle costing: focuses on external customer’s cost to acquire maintain and dispose of the product or services. Life cycle costing tracks and accumulates the actual costs attributable to each product from start to finish. ( cradle to grave costing and womb-to-tomb costing) and then continuously make improvements to keep cost at a minimum. ( important when customizing products as per customer’s need) -
Conduct sensitivity analysis that reports on three sets of assumptions about selling price and sales quanitity combinations. When P increases, Q falls. Skim the market: initially charge high price, then lower price for customers who wait.
Developing life cycle reports: -
Requires tracking costs and revenue on a product by product basis over several calendar periods. Important benefits: a. Clear set of revenue and costs across all business functions- high for upstream cost, low for downstream cost b. Total cost incurred in the early stages of a products are highlighted. Higher the cost, Higher is the need to quickly and accurately predict future revenue c. Interrelationships among business function cost categories are highlighted.: low R+D would result in high customer service cost.
Importance of locked in costs, target costing and value engineering in pricing and cost management is shown in LC cost. Conducting fair business and pricing decisions: Competition act “ protect the specific public interest in free competition” Price discrimination: act with intention of reducing or obstructing competition among customers. 4 key elements of price discrimination laws: -
Apply to manufacturers , not service providers Need for intent to obstruct competition Price difference due to different cost of production is not an offence Illegality hinges on the intent to obstruct or destroy competition when a manufacturer engages in price discrimination.
Illegal under section 5)(1)(c) of the act to engage in predatory pricing which occurs when manufacturers sell products at lower than cost with the intent to reduce competition. -
-
-
The predator must account for more than 35% of the market and be able to sustain a pricing increase for more than two years after the period of low pricing for its actions to be considered predatory pricing. Pricing below average variable cost is considered low: though it may not be so in some cases: where “ it is better for a manufacturer to produce and sell at a loss, than to cease production and suffer the loss of having to bear all fixed overhead” 4 general considerations when determining if price was unreasonably low: a. Magnitude of difference between average variable cost and the Sales price b. Higher the duration of sales at less than average variable cost c. Circumstances of the situation: eg. As defend to a competitors attack d. Any accrual of external or long term benefit to the seller arising from the selling at price below avg variable cost : higher the benefit, more unreasonable the price cut.
“ key is documenting the decision process as a defence to such accusation) Dumping: when non Canadian company: -
Sells goods in Canada, at a price below the market value in the home country, Receives a govt subsidy
-
The action materially injures or threatens to materially injure an industry in Canada
Collusive pricing: when companies in an industry conspire in their pricing and output decisions to achieve a price above the competitive price Peak-load pricing: practice of charging a higher price for the same product or service when demand approaches physical capacity limits. Environmental sustainability: Increasing social concern about what constitutes the end of a product’s life cycle. Cost of anti-pollution measures, responsible waste disposal during production and disposal of obsolete products now must be included in the life cycle costs Companies are developing a better understanding of how to design products, processes, and procedures to prevent and reduce pollution over the products’ life cycle and eliminate avoidable environmental costs Value added solution: design a recycling process
Influences of costs vary among products, and pricing decisions differ greatly in both their time horizons and their contexts. The key to profitability is that companies sell units at the price a customer is willing to pay.
Major influence of pricing: 3 Pricing strategies: 1. Target pricing: price is based on what customers are willing to pay 2. Cost-plus pricing: flat rate target profit percentage is added to the full product cost 3. Life- cycle pricing/cradle to grave? Includes environmental costs of production, reclamation, recycling , and reuse of materials. 3 major influences on pricing decisions: 1. Customers: examine through their eyes-price, availability, customization and quality affect willingness to pay 2. Costs: whether company follows throughput, variable and full absorption costing models. Note: ABC systems provide superior information upon which to base pricing decisions. 3. Competitors: market characteristics: Monopoly, Oligopoly, Perfect competition etc. Product cost categories and the time horizon: -
Customer satisfaction, continuous improvement and dual internal/ external focus converge when it comes to pricing. Cost reduction includes all six value-chain business funcations from R&D to customer serviceupstream and downstream costs. Relevant cost is important: depends on capacity available, alternatives uses of capacity, and the time horizon. Short run ( less than 6 months), long run ( 1 year+)
The decision framework: relevant costs in short- run pricing One time special order from customers- depends on capacity use by special order relative to ordinary capacity use. 1. Identify the problem 2. Gather information: relevant cost. Note: in case of insufficient capacity, investment into fixed asset is relevant cost. Indirect MOH is relevant 3. Forecast future outcomes on the basis of available information: 4. Decide among alternatives 5. Evaluate performance
Target pricing using target costing The starting point for pricing decisions can be -
Market- based ( target pricing): starts with what price should u charge after looking into customer and competitors behaviour Cost based ( cost plus pricing):looks at cost and then reaction Life cycle ( cradle to grave costs, including reclamation, recycling, reusing)
Target pricing and target costing: Starts with Target pricing Target price per unit: estimated price for a product or service that potential customers will pay < based on customer and competitors behaviours> Target Margin percentage ( $ amount / revenue) -
Full absorption cost: target gross margin percentage Full product cost: operating margin/ operating profit percentage Full variable cost recovery: contribution or profit percentage Full cost recovery: net margin percentage
Long run: full cost recovery…. Short run: anything else than full cost recovery is good. -
Relies on sales and marketing organization Close contact and interaction with customers Identify customers needs and perceived value Conduct market research studies Target pricing is difficult for product differentiated goods and those with short consumer life cycle. Eg. Electronics
The decision framework and long-term pricing Target cost per unit: based on full product cost instead of full absorption cost and achieve target operating income per unit. Full product cost: includes all manufacturing and non manufacturing costs ( period costs) In the long run, a new design maybe implemented that requires different capacity and labour skills or changes in existing capacity management. It is Based on a thorough value analysis to help eliminate superfluous design features and non value added costs. If it’s unable to achieve target cost- alternative is to shut down Value analysis: focuses on product design stage where there is the greatest opportunity to change design, materials, and manufacturing processes to reduce costs.
VALUE ANALYSIS AND CROSS FUNCTIONAL TEAMS Value analysis team: top management experts in marketing, product design and engineering, process improvement, supply-chain management, distribution, customer service and management accounting. -
Evaluate the impact of the design innovations and modifications on all business functions of the value chain and choose the best that provides the greatest value to the customers relative to the costs.
Reverse engineering- disassembling and analyzing competitors’ products to determine product designs and materials and to become acquainted with the technologies competitors use. Key concepts: 1. Cost incurrence: arises when a resource is sacrificed or consumed. 2. Locked in costs (designed in costs) : cost that have not yet been incurred but that will be incurred in the future on the basis of decisions that have already been made. ( unavoidable) 3. Cost reduction can be achieved upto the time when costs are incurred. 4. Companies combine value engineering with kaizen/ continuous improvement methods that seek to improve productivity and eliminate waste during production and delivery of products. 5. Eliminating or reducing non value added cost may entail process improvements, but also reason to re-examine the production process is the anticipated volume of production. 6. Reducing variable cost requires reducing unit input cost –by negotiation/changing suppliers/ quantity of input consumed 7. Other factors: appropriate training, production scheduling and maintenance also reduce DL cost. VALUE ENGINEERING Systematic evaluation of all aspects of the value chain- to reduce cost while retaining both product attributes and quality the customer desires and will pay for. Some undesirable effects: -
Decreased morale if employees fail to attain performance targets A poorly designed product as the cross functional team compromises on various customer attributes A protracted development cycle causing a missed market opportunity Conflict among the business functions as the goal is to remove non-value added costs wherever they arise, but the burden of cost reduction will be unequal
Benefits: -
Strong employee participation will serve as motivation Focus on customer’s priorities will reduce the problem of compromises within pricing teams Disciplined progress cuts down on paralysis by analysis Nourishes co-operating corporate culture
Cost plus pricing Internal focus where starting point is cost If cost base is X , Markup is Y (usually a % of cost), prospective selling price = X+Y Markup : estimating target rate of return on investment which is what the organization must earn divided by invested capital. -
Often used when prices are regulated
Alternative cost-plus methods -
Company choose a reliable cost base and markup percentage on basis of experience in pricing products and to recover its cost and earn a desired return on investment Higher the operating leverage, higher the fixed cost
Use of full product costing which includes unitized fixed costs and period cost per unit as well as VC per unit from both COGS and period costs in cost base pricing decisions. Advantages: -
Full product cost recovery: informs managers of the minimum cost needed to recover to continue business rather than shut down Price stability: limits ability of managers to cut prices and facilitates planning Simplicity: no need for analysis of cost behaviour
Cost plus pricing contrasted against target pricing Target pricing approach: -
Eliminates the need for post implementation adjustment Based on customer preferences and competitor responses When target price is not achieved , need for redesign, price adjustment, and margin reduction Usually used for relatively unique or product differentiated products and services Refined cost driver identification and cost information- IMPORTANT in both
Life cycle pricing and relevant qualitative factors in pricing: PLC : time span from R&D to customer service, or from acquisition to disposal of an asset. Life cycle budgeting: estimate full products costs across the entire value chain of business functions: include recycling, reuse and reclamation costs of disposing of obsolete finished products. Customer life- cycle costing: focuses on external customer’s cost to acquire maintain and dispose of the product or services. Life cycle costing tracks and accumulates the actual costs attributable to each product from start to finish. ( cradle to grave costing and womb-to-tomb costing) and then continuously make improvements to keep cost at a minimum. ( important when customizing products as per customer’s need) -
Conduct sensitivity analysis that reports on three sets of assumptions about selling price and sales quanitity combinations. When P increases, Q falls. Skim the market: initially charge high price, then lower price for customers who wait.
Developing life cycle reports: -
Requires tracking costs and revenue on a product by product basis over several calendar periods. Important benefits: a. Clear set of revenue and costs across all business functions- high for upstream cost, low for downstream cost b. Total cost incurred in the early stages of a products are highlighted. Higher the cost, Higher is the need to quickly and accurately predict future revenue c. Interrelationships among business function cost categories are highlighted.: low R+D would result in high customer service cost.
Importance of locked in costs, target costing and value engineering in pricing and cost management is shown in LC cost. Conducting fair business and pricing decisions: Competition act “ protect the specific public interest in free competition” Price discrimination: act with intention of reducing or obstructing competition among customers. 4 key elements of price discrimination laws: -
Apply to manufacturers , not service providers Need for intent to obstruct competition Price difference due to different cost of production is not an offence Illegality hinges on the intent to obstruct or destroy competition when a manufacturer engages in price discrimination.
Illegal under section 5)(1)(c) of the act to engage in predatory pricing which occurs when manufacturers sell products at lower than cost with the intent to reduce competition. -
-
-
The predator must account for more than 35% of the market and be able to sustain a pricing increase for more than two years after the period of low pricing for its actions to be considered predatory pricing. Pricing below average variable cost is considered low: though it may not be so in some cases: where “ it is better for a manufacturer to produce and sell at a loss, than to cease production and suffer the loss of having to bear all fixed overhead” 4 general considerations when determining if price was unreasonably low: a. Magnitude of difference between average variable cost and the Sales price b. Higher the duration of sales at less than average variable cost c. Circumstances of the situation: eg. As defend to a competitors attack d. Any accrual of external or long term benefit to the seller arising from the selling at price below avg variable cost : higher the benefit, more unreasonable the price cut.
“ key is documenting the decision process as a defence to such accusation) Dumping: when non Canadian company: -
Sells goods in Canada, at a price below the market value in the home country, Receives a govt subsidy
-
The action materially injures or threatens to materially injure an industry in Canada
Collusive pricing: when companies in an industry conspire in their pricing and output decisions to achieve a price above the competitive price Peak-load pricing: practice of charging a higher price for the same product or service when demand approaches physical capacity limits. Environmental sustainability: Increasing social concern about what constitutes the end of a product’s life cycle. Cost of anti-pollution measures, responsible waste disposal during production and disposal of obsolete products now must be included in the life cycle costs Companies are developing a better understanding of how to design products, processes, and procedures to prevent and reduce pollution over the products’ life cycle and eliminate avoidable environmental costs Value added solution: design a recycling process
