Prepared by Debby Bloom-Hill CMA, CFM

CHAPTER 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing

Pricing Decisions Pricing decisions are often the most difficult decisions that managers face. Topics examined in this chapter include: Pricing from the standpoint of economic theory. Pricing of special orders. Cost-plus pricing and target costing. Measuring customer profitability and activity based pricing.

The Profit Maximizing Price Economic theory suggests that the quantity demanded is a function of the price that is charged. Generally, the higher the price, the lower the quantity demanded. If managers can estimate the quantity demanded at various prices, determining the optimal price is straightforward.

Estimating Demand The most difficult part of determining the profit maximizing price is determining the demand function. A number of approaches can be used: Sales managers in various regions could estimate the total quantity demanded at various prices. The product could be test marketed with a number of potential customers at various prices.

Estimating the Profit Maximizing Price

Pricing Special Orders Special orders are for goods and services not considered part of a company’s normal business. Prices charged and sales to existing customers are not affected.

Special Orders – Premier Lens Example Should Premier Lens accept special order of 20,000 lenses to be sold to Blix Camera for $73 per lens? Below is the full cost of $75 per lens

Special Orders – Premier Lens Example Fixed costs are not incremental, they will not change if the order is accepted.

Cost-Plus Pricing With a cost plus approach, the company starts with an estimate of product cost, typically excluding any selling or administrative costs. Adds a markup to arrive at a price that allows for a reasonable level of profit.

Cost-Plus Pricing Advantages: The cost plus approach is simple to apply. The company will earn a reasonable profit if a sufficient quantity can be sold at the specified price.

Cost-Plus Pricing Limitations: Determination of an appropriate markup requires considerable judgment. Experimentation with different markups may be necessary. Inherently circular for manufacturing firms. Need to estimate demand to determine the level of manufacturing capacity (a fixed cost) required which affects the price, yet the price affects the quantity demanded.

Target Costing Studies have shown that once a product is designed, it is difficult to make changes that reduce costs. 80% of a product’s costs cannot be reduced once it is designed. Product features drive costs. Target costing is an integrated approach to determine price, costs and design features to achieve a desired profit.

Target Costing The process begins with an analysis of competing products. This leads to a specification of features and price attractive to customers. The second step is to specify a desired level of profit. Then the engineering department with input from the cost accounting department develops a design that can be produced at a cost which will earn the desired profit.

Analyzing Customer Profitability Customer Profitability Measurement System (CPM): Indirect costs of servicing customers are assigned to cost pools. Examples include cost of processing orders, handling returns, shipments etc. Costs are allocated to specific customers using cost drivers to determine customer profitability. Subtracting these costs and product costs from customer revenue yields a measure of customer profitability.

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. May lead them to impose less cost on the supplier. Also called menu-based pricing.

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