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CH 05

Chapter 5 discusses the major influences on pricing decisions, including customer demand, competitor actions, and costs. It differentiates between short-run and long-run pricing decisions, providing examples of how to calculate relevant costs for bidding and pricing strategies. Additionally, it covers target pricing and cost-plus pricing methods, emphasizing the importance of understanding costs and desired profit margins.

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Tariku Kolcha
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11 views27 pages

CH 05

Chapter 5 discusses the major influences on pricing decisions, including customer demand, competitor actions, and costs. It differentiates between short-run and long-run pricing decisions, providing examples of how to calculate relevant costs for bidding and pricing strategies. Additionally, it covers target pricing and cost-plus pricing methods, emphasizing the importance of understanding costs and desired profit margins.

Uploaded by

Tariku Kolcha
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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The pricing of

goods and
services
Chapter 5
Major Influences on
Pricing Decisions

Customers influence prices through


their effect on demand.
Competitors influence prices through
their actions.
Costs influence prices because they
affect supply.
Time Horizon of
Pricing Decisions

Short-run decisions Long-run decisions


have a time horizon involve a time horizon
of less than a year: of a year or longer:
 pricing a one-time-  pricing a product in
only special order a major market where
 adjusting product price setting has
mix and output volume some leeway
Time Horizon of
Pricing Decisions

1. Costs that are often 2. Profit margins in


irrelevant for short-run long-run pricing
pricing decisions decisions are often set
(fixed costs) are often to earn a reasonable
relevant in the long run. return on investment.
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 $38.00
Fixed manufacturing 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 of the bidding decision
should include revenues lost on sales
to existing customers.
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 66.50
Total $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 $51,650,000


Direct fixed costs 7,000,000
Ordering (17,000 × $78) 1,326,000
Testing (3,000,000 × $2) 6,000,000
Rework (8,000 × $38) 304,000
Total $66,280,000
$66,280,000 ÷ 100,000 units = $662.80/unit
Alternative Long-Run
Pricing Approaches

Market-based

Cost-based
(also called cost-plus)
Target Price and Target Cost

Target price is the estimated price for


a product (or service) that potential
customers will be willing to pay.
Target Price
– Target operating income per unit
= Target cost per unit
Target Price and Target Cost

Steps in developing target prices and target costs:


1. Develop a product that satisfies the needs
of potential customers.
2. Choose a target price.
3. Derive a target cost per unit.
4. Perform value engineering to achieve target costs.
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
Implementing Target Pricing
and Target Costing

Value engineering is a systematic


evaluation of all aspects of the
value-chain business function with
the objective of reducing costs.
Cost-Plus Pricing

The general formula for setting a


cost-based price is to add a markup
component to the cost base.
Cost base $ X
Markup component Y
Prospective selling price $X + Y
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: $637.50


Markup component: (637.50 × .20) 127.50
Prospective selling price: $765.00
Cost-Plus Pricing

Assume that the capital investment needed for


CCI is $75 million, and the company (pretax)
target rate of return on investment is 17%.
What is the target annual operating income
that Latisha needs to earn from CCI?
$75,000,000 × .17 = $12,750,000
Cost-Plus Pricing

What is the target operating income per unit?


$12,750,000 ÷ 100,000 units = $127.50/unit
Cost-Plus Pricing

The 17% target rate of return on investment


expresses the company’s expected annual
operating income as a percentage of investment.
The 20% markup expresses operating
income per unit as a percentage of the
full product cost per unit.
Advantages of Using Full Costs

Full recovery of all costs of the product

Price stability

Simplicity
End of Chapter 5

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