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Pricing Decisions
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Cost Management
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PRICING AND BUSINESS
Chapter 13 Pricing Decisions and
Cost Management
Learning Objectives: How companies price a product or service
ultimately depends on the demand and supply for
After studying this chapter, you should be able to: it.
1. Discuss the three major factors that affect pricing decisions Three influences on demand and supply:
1. Customers
2. Understand how companies make long-run pricing decisions
2. Competitors
3. Price products using the target costing approach
3. Costs
4. Price products using the cost-plus approach
5. Use life-cycle budgeting and costing when making pricing
decisions
INFLUENCES ON DEMAND AND SUPPLY TIME HORIZONS AND PRICING
1. Customers—influence price through their effect on Shor t-run pricing decisions have a time horizon of
the demand for a product or service, based on less than one year and include decisions such as:
factors such as quality and product features Pricing a one-time-only special order with no long-run
2. Competitors—influence price through their pricing implications
schemes, product features, and production volume Adjusting product mix and output volume in a
3. Costs—influence prices because they affect supply competitive market
(the lower the cost, the greater the quantity a firm Long-run pricing decisions have a time horizon of one
is willing to supply) year or longer and include decisions such as:
Pricing a product in a major market where there is
some leeway in setting price
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DIFFERENCES AFFECTING PRICING: ALTERNATIVE LONG-RUN PRICING
LONG RUN VS. SHORT RUN APPROACHES
1. Costs that are often irrelevant for shor t-run policy
decisions, such as fixed costs that cannot be Market-based: price charged is based on what
changed, are generally relevant in the long run customers want and how competitors react.
because costs can be altered in the long run.
2. Profit margins in long-run pricing decisions are Cost-based: price charged is based on what it costs
often set to earn a reasonable return on to produce, coupled with the ability to recoup the
investment—prices are decreased when demand is costs and still achieve a required rate of return.
weak and increased when demand is strong.
MARKETS AND PRICING MARKET-BASED APPROACH
Competitive markets—use the market-based Star ts with a target price
approach Target price—estimated price for a product or service
Less-competitive markets—can use either the that potential customers will pay
market-based or cost-based approach Estimated on customers perceived value for a
Noncompetitive markets—use cost-based product or service and how competitors will price
approaches competing products or services
UNDERSTANDING THE FIVE STEPS IN DEVELOPING
MARKET ENVIRONMENT TARGET PRICES AND TARGET COSTS
Understanding customers and competitors is
impor tant because: 1. Develop a product that satisfies the needs of
potential customers.
1. Competition from lower cost producers has meant
that prices cannot be increased. 2. Choose a target price.
2. Products are on the market for shorter periods of 3. Derive a target cost per unit:
time, leaving less time and opportunity to recover Target price per unit minus target operating
from pricing mistakes. income per unit
3. Customers have become more knowledgeable and
4. Per form cost analysis.
demand quality products at reasonable prices.
5. Per form value engineering to achieve target cost.
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VALUE ENGINEERING VALUE ENGINEERING TERMINOLOGY
Value engineering is a systematic evaluation of all Value-added costs—a cost that, if eliminated, would
aspects of the value chain, with the objective of reduce the actual or perceived value or utility
reducing costs while improving quality and satisfying (usefulness) customers obtain from using the
customer needs. product or service.
Managers must distinguish value-added activities Non-value-added costs—a cost that, if eliminated,
and costs from non-value-added activities and costs. would not reduce the actual or perceived value or
utility customers obtain from using the product or
service. It is a cost the customer is unwilling to pay
for.
VALUE ENGINEERING TERMINOLOGY PROBLEMS WITH VALUE ENGINEERING
AND TARGET COSTING
Cost incurrence—describes when a resource is 1. Employees may feel frustrated if they fail to attain
consumed (or benefit foregone) to meet a specific targets.
objective 2. A cross-functional team may add too many
features just to accommodate the wishes of team
Locked-in costs (designed-in costs)—are costs that members.
have not yet been incurred but, based on decisions 3. A product may be in development for a long time
that have already been made, will be incurred in the as alternative designs are repeatedly evaluated.
future 4. Organizational conflicts may develop as the
Are a key to managing costs well burden of cutting costs falls unequally on different
business functions in the firm’s value chain.
COST-BASED (COST-PLUS) PRICING FORMS OF COST-PLUS PRICING
The general formula adds a markup component to Setting a target rate of return on investment: the
the cost base to determine a prospective selling target annual operating return that an organization
aims to achieve, divided by invested capital
price.
Selecting different cost bases for the “cost-plus”
Usually, it is only a star ting point in the price-setting calculation:
process. Variable manufacturing cost
Markup is somewhat flexible, based par tially on Variable cost
customers and competitors. Manufacturing cost
Full cost
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LIFE-CYCLE PRODUCT
COMMON BUSINESS PRACTICE
BUDGETING AND COSTING
Most firms use full cost for their cost-based pricing Product life-cycle spans the time from initial R&D on
decisions, because: a product to when customer service and suppor t are
It allows for full recovery of all costs of the product no long offered on that product (orphaned).
It allows for price stability Life-cycle budgeting involves estimating the
It is a simple approach revenues and individual value-chain costs
attributable to each product from its initial R&D to
its final customer service and suppor t.
Life-cycle costing tracks and accumulates individual
value-chain costs attributable to each product from
its initial R&D to its final customer service and
suppor t.