Mdc Lecture 7

Management Decisions and Control 22421/0

Management Decisions and Control Lecture 7 Pricing and Product Mix Decisions 1

Lecture Objectives 1.

Introduction

3.

The Economic Model

5.

The Major Influences on Pricing Decisions

7.

Short-run and Long-run Pricing Decisions

9.

Cost-Plus Pricing (Cost Based)

11.

Target Costing and Target Pricing (Market Based)

13.

Relationship Between Life-Cycle Product Budgeting and Costing in Pricing Decisions

15.

Example

17.

Legal, Political and Ethical Issues 2

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Introduction Pricing decisions are decisions that managers make about what to charge for the products and services they deliver. These decisions impact the revenues a company earns, which must exceed total costs if profits are to be achieved. There is no single way of computing a product cost that is universally relevant for all pricing decisions. Why? Because pricing decisions differ greatly in both their time horizon and their contexts. Product mix decisions are decisions that managers make about what type of product to produce (or service to offer) and how much to produce of each product (or the extent to which a service is offered). These decisions impact the profitability of the company and 3 often involves a traded off

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Economic Model of Pricing Decisions The economic model focuses on the optimal price and sales quantity that will maximise profits. Companies acting optimally should produce and sell units until the marginal revenue equals the marginal costs, where optimal production is determined by the market price. Companies selling commodity type products in highly competitive markets (price takers) must accept the price determined by market forces. While, in less competitive markets, managers have some discretion in setting prices subject to (1) how much customer’s value the product (2) the pricing strategies of competitors and (3) the costs of the product. The price of a product or service is the outcome of the interaction between demand for the product or service and its supply. Major influences on pricing decisions in the economic model are: 4  Customers influence price through their effect on demand. Management Decisions and Control 22421/0

Short Run and Long Run Pricing Decisions Short run pricing decisions include the pricing of a one-off special order with no long-term implications or adjusting the product mix and output volume in a competitive market. When calculating product costs for short run pricing decisions, the following factors need to be considered:  When there is excess capacity, the incremental costs of producing the product (or supplying the service).  When there is NO excess capacity, both the incremental cost AND the opportunity cost must be assessed. Long run pricing decisions include pricing a product in a major market where price setting has considerable leeway. A stable price reduces the need to for continuous monitoring of suppliers’ prices. Greater price stability also improves planning and builds longrun buyer-seller relationships. When calculating product costs for long run pricing decisions, the following need to be Management Decisions and Controlfactors 22421/0

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Approaches to Long Run Pricing Decisions 

Cost-based pricing is often used as a starting point for pricing a product or service. The starting point is the company’s own cost of manufacturing a product or supplying a service and a desired mark-up percentage is then applied on costs.



Market-based pricing is a strategic approach to pricing a product or service. The starting point is always the firm’s own strategy:  

Skimming pricing strategy: charging higher prices at the beginning of the product cycle, or Market penetration strategy: charging lower prices to gain market share

However, it also requires management to consider the behaviour of competitor’s and the value that customer place on a product or service – target pricing and target costing These will be examined one at a time. 6 Management Decisions and Control 22421/0

Cost Based (Cost-plus) Pricing System With cost plus pricing, the general formula for setting a price is: Cost base Mark-up on cost Prospective selling price

$X $Y $(X+Y)

Steps: 8. Define the cost base and what type of costs are include in the cost base (eg absorption cost, full production costs or variable cost – useful for short term pricing decisions) 9. Estimate all other costs not included in the cost base 10. Determine the required profit level (eg based on return on investment or return on sales) 11. Calculate mark-up percentage

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Target Costing and Target Pricing (Market Based) A target price is the estimated price for a product (or service) that potential customers will be willing to pay. This estimate is based on an understanding of customer’s perceived value for a product and competitors’ behaviour.   

Target operating income per unit is the operating income that a company wants to earn on each unit of product (or service) sold The difference between target price and target operating income is target cost Target cost per unit is the estimated long run cost per unit of a product (or service) that, when sold at the target price, enables the company to achieve the target operating income per unit

Developing ‘target prices’ and ‘target costs’ requires the consideration of the following 4 steps:  Develop a product that satisfies the needs of potential customers  Choose a target price based on customers’ perceived value for the product and the prices competitor’s charge and a target 8 operating income per unit Management Decisions and Control 22421/0

Value Engineering Value engineering is a systematic evaluation of all aspects of the value chain business functions, with the objective of reducing costs while satisfying customer needs.  Reduce/eliminate non-value-added activities. Value added activities - change functionality  Change process design or product design, about 90% of costs are locked in at the design stage. Cost incurrence occurs when a resource is sacrificed or used up. Costing systems emphasise cost incurrence. They recognise and record costs only when costs are incurred. Locked-in or designed-in (committed) costs are those costs that have not yet been incurred but that will be incurred in the future on the basis of design decisions that have already been made. Why is it important to distinguish between when costs are locked in and when costs are incurred? Because it is difficult to alter or reduce costs that have already been 9 locked in. Management Decisions and Control 22421/0

Pattern of Cost Incurrence

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Life-Cycle Product Budgeting The product life-cycle spans the time from initial R&D to the time at which support to customers is withdrawn. 

Life-cycle costing: tracks & accumulates the actual costs attributable to each product over its life-cycle



Life cycle budgeting: estimates the revenue and costs attributable to each product over its life cycle - provides important information for pricing decision, eg. mobile telephone contract.



Life-cycle report: spans more than 1 calendar year  The full set of revenues and costs associated with each product becomes visible.  Interrelationships between the various cost categories are highlighted, eg. companies that cut back on their R&D and product design costs may experience large increases in customer-service costs in subsequent years. 11

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Example Revenue COGS Direct material costs Direct labour costs Direct machining Manufacturing overhead OperatingCosts R&D costs Design costs Marketing costs * Distribution costs * Customer service costs Full productcosts Operatingincome

Total for 150,000units

Per Unit

150,000,000

1,000

69,000,000 9,600,000 11,400,000 12,000,000 102,000,000

460 64 76 80 680

5,400,000 6,000,000 15,000,000 3,600,000 3,000,000 33,000,000 135,000,000 15,000,000

36 40 100 24 20 220 900 100

*50%of marketing and distribution costs are variable costs Management Decisions and Control 22421/0

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Example Cost-Based Pricing Example Cost base = $680 - using total production costs as the cost base Other costs (operating costs) $220 + profit target $100 = $320 Percentage mark-up on cost = Selling price = Market-Based Pricing Example Target selling price = $800 Target income per unit = 10% of the selling price = $80 Target cost = $720 (=$800 - $80) Current cost = $900 How much does the cost have to be reduced by? How do we do that? Management Decisions and Control 22421/0

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Achieving Target Cost per Unit   

Design a new product that has fewer components (*1) Easier to manufacture and test (*2) Increase output from 150,000 to 200,000 units (*3) Costcategory Direct material Direct labour Direct machining No. of orders Testing hours Units reworked

Old 460 64 76 22,500 4,500,000 12,000

New 385 53 57 21,250 3,000,000 13,000

Simplied circuit board, fewer components (*1) Easier to assemble (*1 &*2) Increased production: fixed costs spread over more units (*3) Number of components reduced from450 to 425 (*1) Easier to test: reduce from30 to 15 hours (*2) Less rework (from8%to 6.5%) but more units (*2)

TargetCostCalculations New(estimatedcost) for 200,000units per unit Directmanufacturing Direct material Direct labour Direct machining costs Total directcosts Manufacturingoverheads Ordering and receiving Testing and inspection Rework costs Total O/H Total manufacturing Management Decisions and Control 22421/0

Old per unit

77,000,000 10,600,000 11,400,000 99,000,000

385.00 53.00 57.00 495.00

460.00 64.00 76.00 600.00

1,700,000 6,000,000 1,300,000 9,000,000 108,000,000

8.50 30.00 6.50 45.00 540.00

12.00 60.00 8.00 80.00 680.00

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Example Total for 200,000units

Per unit

160,000,000

800

77,000,000 10,600,000 11,400,000 9,000,000 108,000,000

385 53 57 45 540

Full productcosts

4,000,000 6,000,000 18,000,000 5,000,000 3,000,000 36,000,000 144,000,000

20 30 90 25 15 180 720

Operatingincome

15,000,000

80

Revenue COGS Direct material costs Direct labour costs Direct machining Manufacturing overhead Operatingcosts R&D costs Design costs Marketing costs Distribution costs Customer service costs

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Legal, Political and Ethical Issues Under anti-trust laws, the Australian Competition and Consumer Commission (ACCC) have the power to outlaw the following behaviors: 

Price discrimination is the practice of charging some customers a higher price than others. Three key features of the price discrimination laws are:   







they apply to manufacturers and not service providers price discrimination is permissible if differences in prices can be justified by differences in costs, and price discrimination is illegal only if the intent is to destroy competition – Predatory pricing.

Resale price maintenance occurs when a supplier dictates the minimum price at which a product or services is to be resold to a buyer. Peak-load pricing is the practice of charging a higher price for the same product or service when demand approaches physical capacity units. 16 Collusive pricing occurs when companies in an industry conspire

Management Decisions and Control 22421/0