Pricing Decisions

1. Pricing Decisions EMBA 5412 Fall 2010

2. 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. Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778

3. 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

4. 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 of price for actual and potential customers Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778

5. 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: • Customers • Competitors • Costs

6. 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)

7. 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

8. 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

9. Profit Maximization Economic Theory • The quantity demanded is a function of the price that is charged • Generally, the higherthe price, the lower the quantity demanded Pricing • Management should set the price that provides the greatest amount of profit

10. Determining the Profit-Maximizing Price and Quantity Profit is maximized where marginal cost equalsmarginal revenue, resultingin price p* and quantity q*. Dollarsper unit p* Demand Marginalcost Quantity made and soldper month Marginalrevenue q*

11. Example 1 • The editor of EMBA Magazine is considering three alternative prices for her new monthly periodical. Her estimate of price and quantity demanded are: PriceQuantity TL 6 22,000 TL 5 28,000 TL 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?

12. Solution Example 1 Choose TL 6 TL based on quantitative factors given. Need to consider qualitative factors as well.

13. Determining the Profit-Maximizing Price and Quantity Totalcost Dollars Total revenue p* Total profit at the profit-maximizingquantity and price,q* and p*. Quantity made and soldper month q*

14. Price Elasticity The impact ofprice changes onsales volume Demand is elastic ifa price increase has alarge negative impacton sales volume. Demand is inelastic ifa price increase haslittle or no impact on sales volume.

15. 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.

16. 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

17. Influences on Price • Customer demand • Competitors’ behavior/prices/actions • Costs • Regulatory environment – legal, political and image related

18. 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

19. 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

20. 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

21. 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

23. 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

24. Cost-Plus Pricing Company 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

25. Product Life Cycle http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf

26. 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).

28. 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

29. 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

30. 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.

31. Example 110.000 U

32. 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

33. 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

34. 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

35. Cost-plus Pricing • Selling Price=Cost + mark-up% x Cost • Mark-up % =Desired profit per unit ÷ Unit cost • Desired profit = Desired ROI x Investment

36. Which cost? • Variable manufacturing cost Price= variable manufacturing costs + markup% * variable manufacturing cost Mark-up should cover the remaining costs and provide for the desired profit, i.e. variable selling and all fixed costs VSC: variable selling costs FC: fixed costs – manufacturing and selling ADM: Administrative Expenses n : number of units to be sold vmcu: variable manufacturing cost per unit

37. Which costs? • Total variable costs • Variable manufacturing and selling costs Price= variable costs + markup %* variable costs

38. Which costs? • Absorption – manufacturing costs • Unit manufacturing costs – both variable and fixed Price= unit manuf. cost + markup %* unit manufacturing cost S&ADM: Selling and administrative costs Unit cost : unit manufacturing cost (variable and fixed)

39. Which costs? • Absorption – total costs • Total costs – manufacturing and selling and administrative –fixed (direct or allocated, variable costs) Price= unit cost + markup %* unit cost

40. Example - Pricing Annual sales 480 units Unit costs: Variable manufacturing cost $ 400 Applied fixed manufacturing cost $ 250 Absorption manufacturing cost $ 650 Variable selling costs $ 50 Allocated and direct fixed selling and administrative costs $ 100 Total cost (Manufacturing and S&ADM) $ 800 Investment $ 600,000 Desired profit 10% of investment $ 60,000 Annual Fixed Manufacturing Costs $ 120,000 Annual Fixed (allocated and direct) Selling and Administrative Costs $ 48,000

41. Cost Plus Pricing Versions

42. Cost Plus Pricing Versions

43. Cost Plus Pricing Versions

44. Cost Plus Pricing Versions

45. Cost plus comparison

46. Retail cost plus mark-up • Mark up on cost of goods sold= (selling and administrative costs + operating income) / COGS

47. Retail Example • Yesim Textile’s income statement for 2007 is as follows:

48. Project Example • EMBA Consultancy Co needs to bid for a project. EMBA’s recent income statement appears below: Man-hour rate TL 65; overhead application 0.85 of personnel costs

49. 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?

50. 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