Chapter Four

Cost Analysis and Pricing Decisions

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Outline:

1. Discuss the three major influences on pricing decisions

2. Understand how companies make short-run pricing

decisions

3. Understand how companies make long-run pricing

decisions

4. Describe two pricing practices in which non-cost factors

are important

5. Explain the effects of antitrust laws on pricing

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 1. Major influences on pricing decisions

• Three influences on demand and supply are

customers, competitors, and costs.

a. Customers

b. Competitors

c. Costs

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 …cont

a. Customers

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 …cont

b. Competitors

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 …Cont

c. Costs

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 2. Costing and Pricing Decisions for the Short Run

• <a year and one-time-only special order.

For example: Consider a short-run pricing decision

facing the management team at LL Computers. LL
produces two brands of computers - Deskpoint
(top-of-the-line product of the company), and
Provalue (a less-powerful chip-based machine).
MM Corporation has asked LL to bid on supplying
6,000 Provalue computers over the last three
months of 2010.

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 …cont

After this three-month period, MM is unlikely to

place any future sales orders with LL. MM will
sell Provalue computers under its own brand
name in regions and markets where LL does not
sell Provalue. Whether LL accepts or rejects this
order will not affect LL’s revenues - neither the
units sold nor the selling price - from the
existing sales channels.

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 …cont
The costs to produce 5,000 Provalue computers will
be $500 direct material per computer, $70
direct manufacture labor per computer, and
fixed costs of additional capacity to produce
Provalue is $300,000. Besides, even if no
additional costs will be required for R&D, design,
marketing, and distribution, their costs are
$5,400,000, $6,000,000, $15,000,000, and
$2,000,000 respectively. What price should LL
managers bid for the 6,000-computer order?

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 …Cont
What do companies consider when making
short-run pricing decisions?

Two key factors affect short-run pricing.

1. Many costs are irrelevant in short-run pricing

decisions.

2. Short-run pricing is opportunistic.

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3. Costing and Pricing Decisions for the Long Run

 A year or longer

 Pricing a product in a market where there

is some leeway (freedom to move) in
setting price.

 Long-run relationships with customers

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 …cont
For example:
Recall the example of LL company by
reviewing data for the year just ended,
2011. LL has no beginning or ending
inventory of Provalue and manufactures and
sells 150,000 units during the year. LL uses
activity-based costing (ABC) to calculate
the manufacturing cost of Provalue. LL has
three direct manufacturing costs (such as
direct materials,
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 …cont

direct manufacturing labor, and direct

machining costs), and three manufacturing
overhead cost pools (ordering and receiving
components, testing and inspection of final
products, and rework (correcting and fixing
errors and defects), in its accounting
system.

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 …cont
LL treats machining costs as a direct cost of
Provalue because Provalue is manufactured on
machines that only make Provalue. Furthermore,
direct machining costs are fixed costs of
leasing 300,000 machine-hours of capacity over
multiple years. These costs do not vary with the
number of machine-hours used each year. The
following Table shows product cost information
to produce 150,000 units of Provalue in 2011.

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 …cont

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 …cont
What price should LL managers price for
the 150,000 computer?

3.1 Alternative Long-Run Pricing Approaches

How do companies make long-run pricing decisions?

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 …cont
Three different approaches for pricing decisions:

1. Market-based

2. Cost-based (cost-plus)

3. Customer Life-Cycle Costing

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 …cont
1. Market-based
 It starts by considering customers and
competitors and then look at costs. The
market-based approach to pricing starts by
asking,
• Given what our customers want?
• How our competitors will react to what we do?
• What price should we charge?

 Recommended in competitive markets.

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 …cont
2. Cost-based (cost-plus pricing or cost-plus
mark-up)
 It starts by looking costs and then consider
customers or competitors. The cost-based
approach to pricing starts by asking,
• Given what it costs us to make this product?
• What price should we charge that will recoup
our costs ?”

 Recommended in not competitive (less

competitive) market.
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 …cont
How is the mark-up percentage determined?

a. Cost-Plus Target Rate of Return on Investment

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 …cont

Example: Call to LL company, LL’s (pre-tax) target

rate of return on investment is 18%, and capital
investment on Provalue computer is $96 million.

What is the mark-up operating income per unit

as a percentage of the full product cost per
unit?.

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 …cont
3. Customer Life-Cycle Costing

• Customer life-cycle costs focus on the total

costs incurred by a customer to acquire, use,
maintain, and dispose of a product or service.

For example, Company can charge a higher price

and/or gain market share if their products
require minimal maintenance, save electricity,
mechanics easier access.

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4. Additional Considerations for Pricing Decisions
In some cases, cost is not a major factor in setting
prices.

a. Price Discrimination
• Price discrimination is the practice of charging
different customers different prices for the
same product or service.

• Based on the paying capacity of the customers.

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 …Cont

For example: Consider the prices airlines

charge for a round-trip flight from Addis
Ababa to Dire Dawa. Ticket for a flight
with six-day advance purchase is Birr 4,000
if the passenger stays in Dire Dawa over a
night. It is Birr 4,240 if the passenger
returns without staying over a night.

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 …cont

Can this price difference be explained by the

difference in the cost to the airline of these
round-trip flights? No; it costs the same amount
to transport the passenger from Addis Ababa to
Dire Dawa and back, regardless of whether the
passenger stays in Dire Dawa over a night. This
difference in price is due to price discrimination.

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 …cont
b. Peak-Load Pricing
• Peak-load pricing is the practice of charging a
higher price for the same product or service
when the demand for the product or service
approaches the physical limit of the capacity.

For example, Airlines charged high fares during a

month around the time of the games.

• Based on the available (capacity) of the product

or service.
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5. The effects of antitrust laws on pricing
How do antitrust laws affect pricing?

 Companies are not always free to charge

whatever price they like.

a. Predatory Pricing

• Deliberately prices below its costs to drive

competitors out of the market and restrict
supply, and then raises prices rather than
enlarge demand.
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 …cont
b. Dumping

• Dumping occurs when a non-home company sells a

product in the home country at a price below the
market value in the country where it is produced.

For example, if dumping is proven, an antidumping

duty can be imposed under U.S. tariff laws equal
to the amount by which the foreign price exceeds
the U.S. price.

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 End of chapter Four

Thank you too!!!

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