Transcript Cost Information for Pricing and Product Planning

Cost Information
for
Pricing
and
Product Planning
Chapter 6
Role Of Product Costs In Pricing
And Product Mix Decisions
• Understanding how to analyze product costs is
important for making pricing decisions:
– Managers make decisions about establishing or
accepting a price for their products
– Even when prices are set by the market and the firm
has little or no influence on product prices,
management still has to decide the best mix of
products to manufacture and sell
Role of Product Costs
• Product cost analysis is also significant when a
firm is deciding how best to deploy marketing
and promotion resources
– How much commission (or how many other
incentives) to provide the sales force for different
products
– How large a discount to offer off list prices
Short-term and Long-term
Pricing Considerations
• The costs of many resources are likely to be
committed costs in the short-term because firms
cannot easily alter the capacities made available
for many production and support activities
– For short-term decisions, it is important to note
whether surplus capacity is available for additional
production, or whether shortages of available capacity
limit additional production alternatives
Short-term and Long-term
Pricing Considerations
• The length of time a firm must commit its
production capacity to fill that order is important
because a long-term capacity commitment to a
marginally profitable order may:
– Prevent the firm from deploying its capacity for more
profitable products or orders, should demand for them
arise in the future
– Force the firm to add expensive new capacity to
handle future sales increases
Short-term and Long-term
Pricing Considerations
• If production is constrained by inadequate
capacity, managers need to consider whether
overtime production or the use of subcontractors
can help augment capacity in the short term
• In the long term, managers have considerably
more flexibility to adjust the capacities of activity
resources to match the demand for them in
producing various products
• Decisions about whether to introduce new
products or eliminate existing products have
long-term consequences
Ability To Influence Prices
– If the firm is one of a large number of firms in
an industry, and if there is little to distinguish
the products of different firms from each other:
– Such a firm is a price taker, and it chooses its
product mix given the prices set in the
marketplace for its products
Ability To Influence Prices
– Firms in an industry with relatively little
competition, who enjoy large market shares
and exercise industry leadership, must decide
what prices to set for their products
– Firms in industries in which products are highly
customized or otherwise differentiated from
each other also need to set the prices for their
differentiated products
– Such firms are price setters
Price Takers
• A small firm, or a firm with a negligible market
share in this industry, behaves as a price taker
– It takes the industry prices for its products as
given and then decides how many units of each
product it should produce and sell
Short-Term Decisions for Price Takers
• A price taker should produce and sell as much
as it can of all products whose costs are less
than industry prices
– Managers must decide which costs are
relevant to the short-term product mix
decision
– Managers may have little flexibility to alter the
capacities of some of the firm’s resources in
the short-run
Example - Garment Manufacturer
• Chunling Company that sells five types of readymade garments to discount stores such as Kmart
and Wal-Mart
• The company is operating at full capacity and is
contemplating short-term adjustments to its
product mix
• It is necessary for the company to determine:
– What costs will vary with production levels in this period
– What costs will remain fixed when a change occurs in
the production mix
Example - Garment Manufacturer
• The costs of utilities, plant administration,
maintenance, and depreciation for the machinery
and plant facility will not alter with a change in the
product mix, because the plant is operating at full
capacity
• Varying with the quantity of each garment
produced are:
– The costs of direct materials
– The direct labor that is paid on a piece-rate basis
• Inspectors are paid a monthly fixed salary, but
they are employed as required to support the
production of different garments
Example - Garment Manufacturer
• If its capacity were unlimited, the company could
produce garments to fill the maximum demand for
them
• Capacity is constrained, however, and therefore
the company must decide how best to deploy this
limited resource
• The capacity is fixed in the short-term, so the
company must plan production to maximize the
contribution to profit earned for every available
machine hour used
The Impact Of Opportunity Costs
• If the garment manufacturer receives a special
order request, it would have to decide the
minimum price it would accept
• Because its production capacity is limited, the
company must cut back the production of some
other garment to enable it to produce the goods
for the special order
• Giving up the production of some profitable
product results in an opportunity cost, which
equals the lost profit on the garments that the
company can no longer make
The Impact Of Opportunity Costs
• The lost profit in this case would be the
contribution on the goods it will not make
• The product with the lowest contribution per
hour should be sacrificed
• The profit (contribution) lost on those products
would need to be covered by the price of the
special order
Short-Term Pricing Decisions
for Price Setters
• In many businesses, potential customers
request that suppliers bid a price for an order
before they decide on the supplier with whom
they will place the order
Determining a Bid Price
• Assume that the full costs for the job are
estimated to be $28,500
• Setting the price of a product also means
determining a markup percentage above cost,
an approach known as cost-plus pricing
– Cost-plus pricing - the markup percentage is
determined by a company’s desired profit margin and
overall rate of return
– The company has decided the markup percentage is
normally to be 40% of full costs
Determining a Bid Price
• If the bid request came from a regular customer,
the bid price would have been $39,900
= 1.40 x $28,500
• But for this special order from a new customer,
what is the minimum acceptable price?
• One of the critical factors to consider is the level
of available surplus capacity
Available Surplus Capacity
• The company’s incremental costs of filling the order will be
$ 22,000 (material, direct labor, batch related expenses)
• The costs of supervision and business-sustaining support
activities will not increase if excess capacity of these
resources is available to meet the production needs of the
order
• The price that the company should bid must cover the
incremental costs for the job to be profitable
• The company would likely add a profit margin above
incremental costs and make the bid price something higher
than $22,000, depending on competitive and demand
conditions
No Available Surplus Capacity
• If surplus machine capacity is not available, the
company will have to incur additional costs to
acquire the needed capacity
• Companies often meet such short-term capacity
requirements by operating its plant overtime
• More machine maintenance and plant engineering
activities will be necessary
No Available Surplus Capacity
• the company incurs additional rental costs for the
extra use of machines when it adds an overtime
shift
• Assume management estimates the order would
cause:
– $5,100 of incremental supervision costs (including
overtime premium)
– $5,400 of incremental business-sustaining costs
• Thus, the total cost of overtime required to
manufacture customized tools for the order is
$10,500 ($5100 + $5400)
No Available Surplus Capacity
• The minimum acceptable price in this case is
$32,500 ($22,000 + $10,500)
• The minimum acceptable price must cover all
incremental costs
Long-Term Pricing Decisions
for Price Setters
• The relevant costs for the short-term special
order pricing decision differ from the full costs of
the job
• Most firms rely on full-cost information reports
when setting prices
Use of Full Costs in Pricing
• Economic justification for using full costs for
pricing decisions in three types of
circumstances:
1. Many contracts for the development and production
of customized products and many contracts with
governmental agencies specify that prices should
equal full costs plus a markup, and prices set in
regulated industries are based on full costs
2. When a firm enters into a long-term contractual
relationship with a customer to supply a product, it
has great flexibility in adjusting the level of
commitment for all resources
Use of Full Costs in Pricing
• Most activity costs will depend on the production
decisions under the long-term contract, and full
costs are relevant for the long-term pricing
decision
3. In many industries, firms make short-term
adjustments in prices, often by offering discounts
from list prices instead of rigidly employing a fixed
price based on full costs
• When demand for their products is low, the firms
recognize the greater likelihood of surplus
capacity in the short term
Use of Full Costs in Pricing
• They adjust the prices of their products downward
to acquire additional business based on the lower
incremental costs they incur when surplus capacity
is available
• When demand for their products is high, they
recognize the greater likelihood that the existing
capacity of activity resources is inadequate to
satisfy all of the demand
• They adjust the prices upward based on the higher
incremental costs they incur when capacity is fully
utilize, thereby rationing the available capacity to
the highest profit opportunity
Fluctuating Prices
• Because demand conditions fluctuate over time,
prices also fluctuate with demand conditions over
time
– Most hotels offer special weekend rates that are
considerably lower than their weekday rates
– Many amusement parks offer lower prices on
weekdays when demand is expected to be low
– Airfares between New York and London are higher in
summer, when the demand is higher, than in winter,
when the demand is lower
– Long-distance telephone rates are lower in the
evenings and on the weekends when the demand is
lower
Fluctuating Prices
• Although fluctuating short-term prices are based
on the appropriate incremental costs, over the
long term their average tends to equal the price
based on the full costs that will be recovered in a
long-term contract
• Most firms use full cost-based prices as target
prices, giving sales managers limited authority to
modify prices as required by the prevailing
competitive conditions
The Markup Rate
• Just as prices depend on demand
conditions, markups increase with the
strength of demand
• Markups also depend on the elasticity of
demand
• Markups also fluctuate with the intensity of
competition
The Markup Rate
• Firms decide on markups for strategic reasons:
– A firm may choose a low markup for a new product to
penetrate the market and win over market share from
an established product of a competing firm
– Many internet businesses have adopted the strategy
of setting low prices to build the business, acquire a
brand name, build a loyal customer base, and garner
market share
– Firms sometimes employ a skimming price strategy
where initially a higher price is charged to customers
who are willing to pay more for the privilege of
possessing the latest technological innovations
Long-Term Decisions for Price Takers
• Decisions to add a new product or to drop an
existing product from the portfolio of products
usually have significant long-term implications
for a firm’s cost structure
• Product-sustaining costs are relevant costs for
such decisions
• Batch-related costs are also likely to alter if a
change occurs in the product mix either in favor
of or against products manufactured in large
batches
Profit Increase is Not Automatic
• Dropping products will help improve profitability
only if the managers:
1. Eliminate the activity resources no longer required to
support the discontinued product, or
2. Redeploy the resources from the eliminated products
to produce more of the profitable products that the
firm continues to offer
• Costs result from commitments to supply
activity resources
– They do not disappear automatically with the
dropping of unprofitable products
– Only when companies eliminate or redeploy the
resources themselves will actual expenses decrease
Summary
• Managers use cost information to assist them in
pricing and in product mix decisions
• The manner in which they use cost information in
making these decisions depend on whether the
firm is a major or minor entity in its industry
• The role of cost information also depends on the
time frame involved in the decision
Economic Analysis of the
Pricing Decision
Appendix 6-1
Quantity Decision
• Introductory textbooks in economics usually
analyze the profit maximization decision by a firm
in terms of the choice of a quantity to produce. In
turn, the quantity choice determines the price of
the product in the marketplace
• Economists present the quantity choice in terms
of equating marginal revenue and marginal cost
Quantity Decision
• The firm chooses the quantity level, and the
market demand conditions determine the
corresponding price
• The firm that must choose a price, not a quantity,
to announce to its customers
• Customers react to the price announced and
determine the quantity that they demand
• The price decision analysis uses differential
calculus to analyze the firm’s pricing decision
Pricing Decision
• Total costs, C, expressed in terms of its fixed and
flexible cost components are: C = f + vQ,
– Where f is the committed cost, v is the flexible
cost per unit, and Q is the quantity produced in
units
• Quantity produced is assumed to be the same as
quantity demanded
• The demand, Q, is represented as a decreasing
linear function of the price P: Q = a – bP
• A higher value of b represents a demand function
that is more sensitive (elastic) to price
Pricing Decision
– An increase of a dollar in the price decreases demand
by b units
• A higher value of a reflects a greater strength of demand
for the firm’s product. For any given price, P, the demand
is greater when the parameter, a, has a higher value
• The total revenue, R, is given by the price, P, multiplied
by the quantity sold, Q. Algebraically, we write this:
R = PQ = P(a – bP)
= aP – bP2
• The profit, Π, is measured as the difference between the
revenue, R, and the cost, C:
Pricing Decision
Π=R-C
= PQ - (f + vQ)
= P(a - bP) - F - v(a - bP)
= aP - bP2 - F - va + vbP
• To find the profit-maximizing price, P*, we set the first
derivative of profit P with respect to P equal to zero:
dΠ /dP = A – 2bP + vb = 0
• This equation implies:
P* = (a + vb)/2b = a/2b + v/2
Long-Term Benchmark Prices
• This simple economic analysis suggests that the
price depends only on v, the flexible cost per unit
• A more complex analysis that considers
simultaneously the pricing decision and the longterm decisions of the firm to commit resources to
facility-sustaining, product-sustaining, and other
activity capacities indicates that the costs of
these committed resources do play a role in the
pricing decision
• The costs of these committed activity resources
appear to be committed costs in the short-term,
but they can be changed in the long-term
Long-Term Benchmark Prices (2 of 2)
• The prices that a firm sets and adjusts in the short term,
based on changing demand conditions, fluctuate around
a long-term benchmark price, pL, that reflects the unit
costs of the activity resource capacities:
pL = a/2b + (v + m)/2
• m = f ÷ X is the cost per unit of normal capacity, X, of
facility-sustaining activities
• the degree of price fluctuations around the benchmark
price increases with the proportion of committed costs
• prices appear more volatile in capital-intensive industries
where a large proportion of costs are for facilitysustaining activities
Competitive Analysis (1 of 3)
• In a situation when other firms compete in the same
industry with products that are similar but not identical to
each other, some customers may switch their demand to a
competing supplier if the competitor reduces its price
• Consider two firms, A and B, and represent the demand,
QA, for firm A’s product as a function of its own price, PA,
and the price, PB, set by its competitor:
QA = a – b PA + e PB
• The demand for firm A’s product falls by b units for each
dollar increase in its own price, but increases by e units for
each dollar increase in the competitor’s price, because
firm A gains some of the market demand that firm B loses
Competitive Analysis (2 of 3)
• The profit, PA, for firm A is represented by the
following:
Π A = PA QA - (f + v QA)
Π PA(a - b PA + e PB) - f - v(a - b PA + e PB)
• Profit maximization requires this:
d π A ÷ d PA = a - 2b PA + e PB + vb = 0
• Therefore, the profit-maximizing price PA0 given
the other firm’s price PB is:
PA0 = (a + vb + e PB) ÷ 2b
• The pricing decision thus depends on what the
competitor’s price is expected to be
Competitive Analysis (3 of 3)
• If the firm expects its competitor to behave as it
does and expects it to choose the same price as
its own, then we set PA = PB = P* in the equation
a - 2b PA 1 + e PB + vb = 0 to obtain:
a - 2bP* + eP* + vb = 0
P* = a + vb/2b - e
• This price is the equilibrium price, because no
firm can increase its profits by choosing a
different price provided the other firm maintains
the same price P*