Download - EMBA 5412 Pricing Decisions
Pricing Decisions
EMBA 5412Fall 2009
Pricing in today’s theory and practice* Not too much research on pricing- company and academic
Managers have a general tendency to believe that price is an important issue for customers. Research, however,has shown that customers are frequently unaware of prices paid and that price is one of the least important purchase criteria for them.
the impact of even small increases in price on profitability by far exceeds the impact of other levers of operational management, as shown in Fig. 1 (based on a sample of Fortune 500 companies).
A 5% increase in average selling price increases earnings before interest and taxes (EBIT) by 22% on average, compared with the increase of 12% and 10% for a corresponding increase in turnover and reduction in costs of goods sold, respectively.
2Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778
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Fig. 1. Pricing and its impact on profitability
Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778
4Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778
Fig. 2. High price and large market share—not as incompatible as commonly believed
In conclusion, it seems that managers, as price setters,have a general tendency to overestimate the importance ofprice for actual and potential customers
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Pricing and Business
How companies price a product or service ultimately depends on the demand and supply for it
Three influences on demand and supply:
1. Customers2. Competitors3. Costs
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Influences on Demand and Supply
Customers – influence price through their effect on the demand for a product or service, based on factors such as quality and product features
Competitors – influence price through their pricing schemes, product features, and production volume
Costs – influence prices because they affect supply (the lower the cost, the greater the quantity a firm is willing to supply)
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Time Horizons and Pricing Short-run pricing decisions have a time
horizon of less than one year and include decisions such as: Pricing a one-time-only special order with no
long-run implications Adjusting product mix and output volume in a
competitive market Long-run pricing decisions have a time
horizon of one 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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Pricing External sales- outside
Target pricing-Competition-based pricing Cost plus pricing Variable cost pricing Customer based pricing-value-based pricing Time and material pricing
Internal-within the company among divisions Negotiated transfer prices Cost based transfer prices Market based transfer prices Effect of outsourcing on transfer prices Transfers between divisions in different countries
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Profit MaximizationEconomic Theory
The quantity demanded is a function of the price that is charged
Generally, the higher the price, the lower the quantity demanded
Pricing Management should set the price that
provides the greatest amount of profit
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Quantity made and sold
per month
Determining the Profit-Maximizing Price and Quantity
Dollarsper unit
Demand
Marginalrevenue
q*
p*
Marginalcost
Profit is maximized where marginal cost equals
marginal revenue, resultingin price p* and quantity q*.
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Example 1Example 1 The editor of EMBA Magazine is considering three
alternative prices for her new monthly periodical. Her estimate of price and quantity demanded are:
Price QuantityTL 6 22,000TL 5 28,000TL 4 32,000
Monthly costs of producing and delivering the magazine include TL90,000 of fixed costs and variable costs of TL1.50 per issue.
Which price will yield the largest monthly profit?
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Solution Example 1
Price(TL) Demand
Variable Cost per unit(TL)
Contribution Margin per
unit(TL)Total CM
(TL)Fixed
Costs (TL)
Income Before
Tax (TL)6 22.000 1,5 4,5 99.000 90.000 9.0005 28.000 1,5 3,5 98.000 90.000 8.0004 38.000 1,5 2,5 95.000 90.000 5.000
Choose TL 6 TL based on quantitative factors given.
Need to consider qualitative factors as well.
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Determining the Profit-Maximizing Price and Quantity
Total revenueDollars Total cost
Total profit at the profit-maximizingquantity and price,
q* and p*.
Quantity made
and soldper month
q*
p*
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Price Elasticity
The impact ofprice changes on
sales volume
Demand is elastic ifa price increase has alarge negative impact
on sales volume.
Demand is inelastic ifa price increase has
little or no impact on sales volume.
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Who determines the price? Price takers- when there is a competitive market and
the company has no influence on price Once competition enters the market, the price of a
product becomes squeezed between the cost of the product and the lowest price of a competitor.
Price makers- companies that influence the price• Organizations that choose to compete by offering
innovative products and services have a more difficult pricing decision because there is no existing price for the new product or service.
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Markets and Pricing
Competitive Markets – use the market-based approach
Less-Competitive Markets – can use either the market-based or cost-based approach
Noncompetitive Markets – use cost-based approaches
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Influences on Price
Customer demand Competitors’ behavior/prices/actions Costs Regulatory environment – legal,
political and image related
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Differences Affecting Pricing:Long Run vs. Short Run
Costs that are often irrelevant for short-run policy decisions, such as fixed costs that cannot be changed, are generally relevant in the long run because costs can be altered in the long run
Profit margins in long-run pricing decisions are often set to earn a reasonable return on investment – prices are decreased when demand is weak and increased when demand is strong
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Alternative Long-Run Pricing Approaches
Market-Based: price charged is based on what customers want and how competitors react
Cost-Based: price charged is based on what it cost to produce, coupled with the ability to recoup the costs and still achieve a required rate of return
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Market-Based Approach
Starts with a target price Target Price – estimated price for a
product or service that potential customers will pay
Estimated on customers’ perceived value for a product or service and how competitors will price competing products or services
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Understanding the Market Environment
Understanding customers and competitors is important because:
Competition from lower cost producers has meant that prices cannot be increased
Products are on the market for shorter periods of time, leaving less time and opportunity to recover from pricing mistakes
Customers have become more knowledgeable and demand quality products at reasonable prices
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Pricing approaches Cost plus mark-up
Variable – contribution margin approach, contribution margin( reflecting mark-up) should cover desired return on investment, all fixed costs
Absorption – common- mark-up covers all expenses except cost of goods sold plus the desired return on investment
Target costing– price is known (competitor’s), desired return on investment is known, price is known = determine the maximum cost per unit
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Cost-Plus PricingCompany estimates cost of production
Adds a markup to cost to arrive at price which allows for a reasonable profit
Benefits Simple approach
Limitations What % markup to use? Inherently circular for manufacturing firms Requires considerable judgment and
experimentation
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Product Life Cycle
http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf
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Life Cycle Costing Life cycle costs are the total costs estimated to be
incurred in the design, development, production, operation, maintenance, support, and final disposition of a product/system over its anticipated useful life span (Barringer and Weber, 1996).
Product Life-Cycle spans the time from initial R&D on a product to when customer service and support are no longer offered on that product (orphaned)
The best balance among cost elements is achieved when the total LCC is minimized (Barringer and Weber, 1996).
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Life-Cycle Product Budgeting and Costing
Life-Cycle Budgeting involves estimating the revenues and individual value-chain costs attributable to each product from its initial R&D to its final customer service and support
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 support
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Important Considerations for Life-Cycle Budgeting
Nonproduction costs are large Development period for R&D and
design is long and costly Many costs are locked in at the R&D
and design stages, even if R&D and design costs are themselves small
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Example Murmur company produces electronic components that typically
have about 27-month life cycle. In October 2008, a new component was proposed. Below are the budgeted costs and profits over the life cycle of the product.
Unit production cost 6unit life cycle cost 10unit whole life cost 12budgeted unit selling price 15
Budgeted costs 2008 2009 2010 item totaldevelopment (200.000) (200.000)production (240.000) (360.000) (600.000)logistics (80.000) (120.000) (200.000) annual (200.000) (320.000) (480.000) (1.000.000)post purchase costs-born by the customer (80.000) (120.000) (200.000)Annual total (200.000) (400.000) (600.000) (1.200.000)Units produced and sold 40.000 60.000
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Example Budgeted Product Income Statement
Year Revenues CostsAnnual Income
Cumulative Income
2008 (200.000) (200.000) (200.000)2009 600.000 (320.000) 280.000 80.0002010 900.000 (480.000) 420.000 500.000
Performance Report
Year Cost Item Actual CostsBudgeted Cost Variance
2008 Development 190.000 200.000 10.000 F2009 Production 300.000 240.000 (60.000) U
Logistics 75.000 80.000 5.000 F2010 Production 435.000 360.000 (75.000) U
Logistics 110.000 120.000 10.000 F
110.000 U
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Cost-Based (Cost-Plus) Pricing
The general formula adds a markup component to the cost base to determine a prospective selling price
Usually only a starting point in the price-setting process
Markup is somewhat flexible, based partially on customers and competitors
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Forms of Cost-Plus Pricing Setting a Target Rate of Return on
Investment: the Target Annual Operating Return that an organization aims to achieve, divided by Invested Capital
Selecting different cost bases for the “cost-plus” calculation: Variable Manufacturing Cost Variable Cost Manufacturing Cost Full Cost
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Common Business Practice
Most firms use full cost for their cost-based pricing decisions, because: Allows for full recovery of all costs of the
product Allows for price stability It is a simple approach
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Cost-plus Pricing
Selling Price=Cost + mark-up% x Cost
Mark-up % =Desired profit per unit ÷ Unit cost
Desired profit = Desired ROI x Investment
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Which cost?
Variable manufacturing costPrice= variable manufacturing costs + markup% * variable manufacturing costMark-up should cover the remaining costs and provide for the
desired profit, i.e. variable selling and all fixed costs
nvmcu
fitdesiredproADMFCVSCmarkup
*%
VSC: variable selling costsFC: fixed costs – manufacturing and sellingADM: Administrative Expenses n : number of units to be soldvmcu: variable manufacturing cost per unit
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Which costs?
Total variable costs Variable manufacturing and selling costs
Price= variable costs + markup %* variable costs
nvmcu
fitdesiredproADMFCmarkup
*%
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Which costs?
Absorption – manufacturing costs Unit manufacturing costs – both
variable and fixed Price= unit manuf. cost + markup %* unit manufacturing cost
ntunit
fitdesiredproADMSmarkup
*cos
&%
S&ADM: Selling and administrative costs
Unit cost : unit manufacturing cost (variable and fixed)
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Which costs?
Absorption – total costs Total costs – manufacturing and selling
and administrative –fixed (direct or allocated, variable costs)
Price= unit cost + markup %* unit cost
ntTotalunit
fitdesiredpromarkup
*cos%
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Example - PricingAnnual sales 480 unitsUnit costs:
Variable manufacturing cost $ 400Applied fixed manufacturing cost $ 250Absorption manufacturing cost $ 650Variable selling costs $ 50Allocated and direct fixed selling and administrative costs
$ 100Total cost (Manufacturing and S&ADM) $ 800
Investment $ 600,000Desired profit 10% of investment $ 60,000Annual Fixed Manufacturing Costs $ 120,000Annual Fixed (allocated and direct) Selling and Administrative Costs
$ 48,000
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Cost Plus Pricing Versions
variable manufacturing cost-plus-pricingVariable manufacturing cost $400Total Variable Selling Costs ($50 x 480 units) $24.000Desired profit $60.000Fixed Costs $168.000mark -up % 131,25%markup $525Price = cost + markup $925
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Cost Plus Pricing Versions
variable total cost-plus-pricingTotal variable cost per unit $450
Fixed Costs $168.000Desired Profit $60.000mark -up % 105,56%markup $475Price = cost + markup $925
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Cost Plus Pricing Versions
manufacturing cost per unit $650
Total variable selling costs $24.000
Fixed Selling and Administration $48.000
Desired Profit $60.000mark -up % 42,31%markup $275Price = cost + markup $925
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Cost Plus Pricing Versions
total absorption- cost-plus-pricingTotal cost per unit $800
Desired Profit $60.000mark -up % 15,63%markup $125Price = cost + markup $925
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Cost plus comparison
Cost plus type
Variable manufacturing cost plus mark up
Variable cost plus mark up
Manufacturing costs plus mark up
Full cost plus mark up
Mark up %
131.25 105.56 42.31 15.63
Price 925 925 925 925
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Retail cost plus mark-up
Mark up on cost of goods sold= (selling and administrative costs + operating income) / COGS
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Retail Example Yesim Textile’s income statement for 2007 is as follows:
Revenues TL1.427.010Cost of goods sold (713.500)Gross profit 713.510Selling and Administrative Exp (535.750)Operating profit TL177.760
Mark up % 100,00%
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Project Example EMBA Consultancy Co needs to bid for a project.
EMBA’s recent income statement appears below:Revenues TL1.627.010Cost of Services
Material (TL45.000)Personnel (650.000)Overhead (555.000)
Total Cost of services (1.250.000)Gross profit 377.010Selling and Administrative Exp (235.750)Operating profit TL141.260
Mark up % 30,16%
Man-hour rate TL 65; overhead application 0.85 of personnel costs
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Project Example EMBA Consultancy needs to bid for a new project.
Material costs will be TL 5.000; 150 man hours will be used. What would be a guiding bidding price?
Material TL5.000,00Man-hour (150 man hourx65) 9.750,00Overhead (0.85*man-hour cost) 8.287,50Total Cost 23.037,50
mark up percentage 30,16%bid price TL29.985,79
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Pros and Cons of Cost plus pricing
Easy to compute No consideration to the demand side Sales volume plays an important role-
allocation of fixed costs over the products sold
If variable cost plus used then fixed costs might not be covered if not calculated correctly
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Pricing Special Orders
In some cases, it may be beneficial for a company to charge a price lower than its full cost Only if the order will not affect demand
for its other products
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Special Orders – Premier Lens Example
Given the following information, should Premier Lens produce 20,000 lenses to be sold to Blix Camera for $73 per lens?
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Special Orders – Premier Lens Example
The incremental analysis shows that it should. Note that the fixed costs are not incremental and need not be included in the decision making.
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Target Costing
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Five Steps in Developing Target Prices and Target Costs
1. Develop a product that satisfies the needs of potential customers
2. Choose a target price price is the same as the competition set price to increase customer base seek larger market share through price
3. Derive a target cost per unit: Target Price per unit minus Target Operating Income
per unit
4. Perform cost analysis5. Perform value engineering to achieve target
cost
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Value Engineering
Value Engineering is a systematic evaluation of all aspects of the value chain, with the objective of reducing costs while improving quality and satisfying customer needs
Managers must distinguish value-added activities and costs from non-value-added activities and costs
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Value Engineering Terminology Value-Added Costs – a cost that, if
eliminated, would reduce the actual or perceived value or utility (usefulness) customers obtain from using the product or service
Non-Value-Added Costs – a cost that, if eliminated, 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
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Value Engineering Terminology
Cost Incurrence – describes when a resource is consumed (or benefit forgone) to meet a specific objective
Locked-in Costs (Designed-in Costs) – are costs that have not yet been incurred but, based on decisions that have already been made, will be incurred in the future Are a key to managing costs well
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Problems with Value Engineering and Target Costing
1. Employees may feel frustrated if they fail to attain targets
2. A cross-functional team may add too many features just to accommodate the wishes of team members
3. A product may be in development for a long time as alternative designs are repeatedly evaluated
4. Organizational conflicts may develop as the burden of cutting costs falls unequally on different business functions in the firm’s value chain
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Example Target costingNownew company feels that there is a market niche for a
mouse with special new features. After surveying the features and prices of available mouses on the market, Marketing department believes that a price of TL 30 would be about right for the new mouse. Marketing department estimates to sell about 40.000 mouses. To design, develop and produce these new mouses and investment of TL 2.000.000 would be required. The company desires 15% ROI on all new projects. What is the highest target cost to manufacture, sell and service the new product?
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Example target costing
Projected Sales 40000 mouse 30 1.200.000Less Desired profit 15% 2.000.000 300.000Target Cost for 40000 mouse 900.000
Target Cost per mouse TL22,50
Customer-based pricing Value based pricing-the price is based on the
customer ‘demand’ or need for the product Unique product – value based pricing might be
helpful to create demand use price to support product image set price to increase product sales design a price range to attract many consumer
groups set price to increase volume sales price a bundle of products to reduce inventory
or to excite customers62
concept of economic (or customer) value Two interpretations:
the difference between the consumer’s willingness to pay and the actual price paid, which is equal to the ‘‘consumer surplus,’’ the excess value retained by the consumer.
the maximum amount a customer would pay to obtain a given product, that is, the price that would leave the customer indifferent between the purchase and foregoing the purchase. Customer value in this sense is equal to the microeconomic concept of a customer’s ‘‘reservation price’’ and the use value of goods.
product’s economic value is the price of the customer’s best alternative—reference value—plus the value of whatever differentiates the offering from the alternative— differentiation value (Nagle & Holden, 1999).
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To quantify economic value Step 1: Identify the cost of the competitive
product and process that consumer views as best alternative put oneself in the eyes and in the shoes of
customers and ask what they view as best alternative to the purchase of the product being analyzed
Step 2: Segment the market e.g. Microsoft, for example, is known for handing
out beta-versions of its latest enterprise software products to particularly knowledgeable companies and customer segments
64Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778
To quantify economic value Step 3: Identify all factors that differentiate the
product from the competitive product and process.
Step 4: Determine the value to the customer of these differentiating factors. Conjoint analysis is a simple tool which aims to
capture trade-offs in product features in a systematic way and to assign monetary values to specific attributes (Auty, 1995). Customers are presented with a set of two similar products differing in price and other qualitative features and are forced to indicate which set of attributes they prefer
65Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778
To quantify economic value Step 5: Sum the reference value and the
differentiation value to determine the total economic value. The product’s economic value is simply the sum of
the price of the reference product plus its differentiation value.
Step 6: Use the value pool to estimate future sales at specific price points. For each price point, sales can be expected to
comprise a significant share of all market segments, which value the product higher than the specific price examined
66Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778
Example of value based pricing Japanese industrial equipment manufacturer. In its home market, its standard model was priced at the
equivalent of US$80,000 compared with US$50,000 for a similar model by its main competitor from the United States.
In Japan, the company sold about 80% more units than its U.S. competitor, while in the United States, where the company had a weaker distribution system, both companies had roughly the same unit sales, although historical growth rates of the Japanese company had by far exceeded the growth rates of its U.S. rival.
What is the reason that the Japanese company was able to achieve both a high relative market share and a significant price premium?
67Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778
WHY?
For each industry segment,the Japanese company had developed detailed financial models of different cost and benefit components of its own equipment versus its main competitor
For a customer in the printing ink industry, the positive and negative differentiation value was quantified in the following way:
68Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778
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Analysis
Under this angle, the price premium of the Japanese company is modest. If an interest rate of 8% is applied to the net benefits gained over the average life cycle of this equipment of 4 years, the positive differentiation value amounts to well over US$300,000. Customers are expected to pay only a small fraction—less than 10% and US $30,000—of the product’s economic value.
70Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778
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Analyzing Customer Profitability
Customer Profitability Measurement System (CPM) Indirect costs of servicing customers are
assigned to cost pools For example the cost of processing orders and
handling returns
Costs are allocated to specific customers using cost drivers to determine customer profitability
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Customer Profitability Measurement System
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Example – Customer profitabilityExample – Customer profitability Delta Products has determined the following costs:
Order processing/order $5.00Additional handling cost per rush order $8.50Customer service calls/call $10.00Relationship management costs/customer $2,000.00
In addition to these costs, product costs amount to 90% of sales. In the prior year, Delta had the following experience with Johnson Brands:
Sales $53,800Number of orders 200Percent of orders marked rush 60Calls to customer service 140
Calculate the profitability of the Johnson Brands account.
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Example SolutionExample Solution
Profitability of Johnson Brand account
Sales $53,800
Less:Cost of good sold (.9 × $53,800) $48,420Order processing (200 × $5.00) $1,000Rush handling (.6 × 200 × $8.50) $1,020Customer service (140 × $10.00) $1,400Relationship management costs $2,000 $53,840
Profitability of Johnson Brands account $(40)
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Time and Material Pricing Determine a charge for labor that
includes overhead Determine a charge for materials that
includes handling and storage costs Include a profit Sum = price Used in service companies mainly;
appropriate for construction companies as well
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ExampleInvestment $700,000.00Desired profit 10% of investment $70,000.00Annual labor hours 10,000Hourly charge to cover profit margin $7.00
Labor rate per hour $18.00Annual overhead costs:
Material handling and storage $40,000.00
Other overhead costs(supervision,utilities, insurance,and depreciation) $200,000.00
Annual cost of materials used in repair department $1,000,000.00
4% x 1.000.000
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Time and Material Charges
Time Charge per hour = hourly labor cost +
(annual overhead [excluding material overhead] / annual labor hours) +hourly charge to cover profit margin
= $18 + ($200,000 / 10,000 hours) + $7 = $ 45 per labor hour
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Time and Material Charges
Material Charge formulaMaterial cost incurred on job+[material cost incurred on job * (material handling and storage costs / annual cost of
materials used in Repair Department)] = material costs incurred on job +[material
costs incurred on job * ($40,000/$1,000,000)]
=1.04 x material costs incurred on job
4% of material costs
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Example con’tJOB NO 101Labor hours 200cost of materials $8.000
total price of job 101material cost $8.000handling and storage $320 total material cost $8.320,00
Labor rate $45,00labor hours 200
$9.000,00TOTAL COST OF JOB 101 $17.320,00
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Activity-Based Pricing Customers are presented with separate
prices for services they request in addition to the cost of goods purchased Customers will carefully consider the services they request
Example
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Other Important Considerations in Pricing Decisions
Price Discrimination – the practice of charging different customers different prices for the same product or service Legal implications
Peak-Load Pricing – the practice of charging a higher price for the same product or service when the demand for it approaches the physical limit of the capacity to produce that product or service
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The Legal Dimension of Price Setting Price Discrimination is illegal if the
intent is to lessen or prevent competition for customers
Predatory Pricing – deliberately lowering prices below costs in an effort to drive competitors out of the market and restrict supply, and then raising prices
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The Legal Dimension of Price Setting
Dumping – a non-US firm sells a product in the US at a price below the market value in the country where it is produced, and this lower price materially injures or threatens to materially injure an industry in the US
Collusive Pricing – occurs when companies in an industry conspire in their pricing and production decisions to achieve a price above the competitive price and so restrain trade
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Transfer pricing
Transfer Price is:the internal price charged by one segment of a firm for a product or service supplied to another segment of the same firm
Such as: Internal charge paid by final assembly division
for components produced by other divisions Service fees to operating departments for
telecommunications, maintenance, and services by support services departments
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Transfer Pricing
The transfer price creates revenues for the selling subunit and purchase costs for the buying subunit, affecting each subunit’s operating income
Intermediate Product – the product or service transferred between subunits of an organization
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Effects of Transfer Prices
Performance measurement: Reallocate total company profits among
business segments Influence decision making by purchasing,
production, marketing, and investment managers
Rewards and punishments: Compensation for divisional managers
Partitioning decision rights: Disputes over determining transfer prices
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Three Transfer Pricing Methods
1. Market-based Transfer Prices2. Cost-based Transfer Prices3. Negotiated Transfer Prices
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Market-Based Transfer Prices
Top management chooses to use the price of a similar product or service that is publicly available. Sources of prices include trade associations, competitors, etc.
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Market-Based Transfer Prices Lead to optimal decision making
when three conditions are satisfied:1. The market for the intermediate product
is perfectly competitive2. Interdependencies of subunits are
minimal3. There are no additional costs or benefits
to the company as a whole from buying or selling in the external market instead of transacting internally
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Market-Based Transfer Prices A perfectly competitive market exists when
there is a homogeneous product with buying prices equal to selling prices and no individual buyer or seller can affect those prices by their own actions
Allows a firm to achieve goal congruence, motivating management effort, subunit performance evaluations, and subunit autonomy
Perhaps should not be used if the market is currently in a state of “distress pricing”
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Cost-Based Transfer Prices Top management chooses a transfer price
based on the costs of producing the intermediate product. Examples include: Variable Production Costs Variable and Fixed Production Costs Full Costs (including life-cycle costs) One of the above, plus some markup
Useful when market prices are unavailable, inappropriate, or too costly to obtain
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Cost-Based Transfer Pricing Alternatives
Prorating the difference between the maximum and minimum cost-based transfer prices
Dual-Pricing – using two separate transfer-pricing methods to price each transfer from one subunit to another. Example: selling division receives full cost pricing, and the buying division pays market pricing
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Negotiated Transfer Prices Occasionally, subunits of a firm are free to
negotiate the transfer price between themselves and then to decide whether to buy and sell internally or deal with external parties
May or may not bear any resemblance to cost or market data
Often used when market prices are volatile Represent the outcome of a bargaining
process between the selling and buying subunits
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Comparison of Transfer-Pricing Methods
Criteria Market-Based
Cost- Based
Negotiated
Achieves Goal Congruence
Yes, when markets are competitive
Often, but not always
Yes
Useful for Evaluating Subunit
Performance
Yes, when markets are competitive
Difficult unless transfer price
exceeds full cost and even then is
somewhat arbitrary
Yes, but transfer prices are affected
by bargaining strengths of the
buying and selling divisions
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Comparison of Transfer-Pricing Methods
Criteria Market-Based
Cost- Based
Negotiated
Motivates Management
Effort
Yes Yes, when based on budgeted costs; less incentive to control costs if
transfers are based on actual costs
Yes
Preserves Subunit Autonomy
Yes, when markets are competitive
No, because it is rule-based
Yes, because it is based on
negotiations between subunits
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Comparison of Transfer-Pricing Methods
Criteria Market-Based
Cost- Based
Negotiated
Other Factors No market may exist or
markets may be imperfect or
in distress
Useful for determining full cost of
products; easy to implement
Bargaining and negotiations
take time and may need to be
reviewed repeatedly as
conditions change
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Ideal Transfer PricingIdeal transfer price would be Opportunity cost, or the value forgone by not using the
transferred product in its next best alternative use Opportunity cost is the greater of variable production
cost or revenue available if the product is sold outside of the firm
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Minimum Transfer Price The minimum transfer price in many
situations should be:
Incremental cost is the additional cost of producing and transferring the product or service
Opportunity cost is the maximum contribution margin forgone by the selling subunit if the product or service is transferred internally
Minimum Transfer Price =
Incremental cost per unit incurred up to the point of
transfer +Opportunity Cost per unit
to the selling subunit
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Transfer Pricing Methods External market price
If external markets are comparable Variable cost of production
Exclude fixed costs which are unavoidable Full-cost of production
Average fixed and variable cost Negotiated prices
Depends on bargaining power of divisions
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Transfer Pricing Implementation
Disputes over transfer pricing occur frequently because transfer prices influence performance evaluation of managers
Internal accounting data are often used to set transfer prices, even when external market prices are available
Classifying costs as fixed or variable can influence transfer prices
determined by internal accounting data
To reduce transfer pricing disputes, firms may reorganize by combining interdependent segments or spinning off some segments as separate firms
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Transfer Pricing for International Taxation
When products or services of a multinational firm are transferred between segments located in countries with different tax rates, the firm attempts to set a transfer price that minimizes total income tax liability.
Segment in higher tax country:Reduce taxable income in that country by charging high prices on imports and low prices on exports.
Segment in lower tax country:Increase taxable income in that country by charging low prices on imports and high prices on exports.
Government tax regulators try to reduce transfer pricing manipulation.