McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 10 The Role of Costs in Pricing Decisions

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Cost Concepts Common costs support a number of activities or profit segments and cannot be objectively traced to a product or segment based on a direct physical relationship to that product or segment Opportunity costs reflect the “cost” of not choosing the best alternative or opportunity

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Cost Concepts Cash costs can lead to cash (or out-of- pocket) outlays or bookkeeping (depreciation or amortization) entries Noncash costs do impact the cash flows but do not reflect actual monetary outlays in a particular accounting period

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Full-Cost Method of Pricing A percentage of variable costs is added to the average variable costs to determine selling price Why do sellers resort to this pricing method? –They do not know consumer preferences –They do not know how rival sellers will react to price changes –They do not know the degree to which demand is sensitive to price changes –There is a belief that prices ought to equal full cost

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. The Nature of Overhead Overhead is that portion of period costs that cannot be objectively traced to particular operations, products, or other profit segments Overhead distribution involves assigning overhead costs to individual units within a profit segment

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Profitability Analysis Elements of profitability: –Price per unit (P). –Volume (units) sold per period (Q). –Costs. Variable per unit (or activity) (VC). Fixed per period (FC). –Monetary sales mix - The relative mix of revenues received across multiple product or service offerings.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Breakeven Formulas Breakeven quantity: where BEQ = break-even sales quantity FC = fixed costs P = selling price VC = variable costs

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Breakeven Formulas Breakeven sales revenue where BES = break-even sales revenue FC = fixed costs PV = Profit-Volume Ratio:

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Limitations of Break-Even Analysis  The assumption that variable costs remain proportional to volume at all output levels  The assumption that price is constant over relevant volume levels  Costs used the in the analysis may be relevant over a limited range of volume

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 11 Using Leverage For Developing Pricing Strategies

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Leverage Leverage is the rate at which the effect of a change in sales volume amplifies into a relatively greater change in financial performance. The sources of leverage include: –cost structure. –capital structure. –and the combination of these effects.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Testing Pricing Alternatives Price reductions immediately result in a loss of revenues and in profits How many additional units need to be sold before the firm’s profits will be equal to the level of profits before the price reduction? Price increases immediately result in a gain of revenues and profits How many units can the firm afford not to sell before profits become equal the level of profits prior to the price increase?

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Conditions For Profitable Price Reductions 1. Market demand should be price sensitive so as to derive proportionately larger sales volume. 2. The product should be in a growth market. 3. Firm’s leverage position should be greater than its competitors’ so as to derive proportionately greater financial benefit from the increased sales volume.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Relative Effect Of Firm’s PV Case 1: Firm’s PV < other firm: Price Increase.Price Increase. –Firm can afford to lose greater percentage of sales volume than competitor or distributor before profits go below current level. Price Decrease.Price Decrease. –Firm will need to increase sales volume by greater percentage than competitor or distributor to offset losses due to price decrease.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Relative Effect Of Firm’s PV Case 2: Firm’s PV > other firm: Price Increase.Price Increase. –Firm can afford to lose smaller percentage of sales volume than competitor or distributor before profits go below current level. Price Decrease.Price Decrease. –Firm will need to increase sales volume by smaller percentage than competitor or distributor to offset losses due to price decrease.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Monetary Sales Mix  When there are differences in the PVs among products in a line, a revision in the product selling mix may be more effective than increasing prices  By shifting emphasis to those products with relatively higher PVs, a firm has the opportunity to recover its profit position

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Resource Allocation Criteria  Some firms allocate the scarce resources according to the unit contributions (gross margin of each product)  Other firms make their allocation on the basis of total contributions  A third alternative is to allocate the scare material proportionately on the basis of resource requirements

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Pricing Principle When a resource is in limited supply, the decision criterion is to allocate resources to the profit segment with the highest contribution per resource unit (CPRU).When a resource is in limited supply, the decision criterion is to allocate resources to the profit segment with the highest contribution per resource unit (CPRU).

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Pricing Principle When the volume of products that could be sold is greater than the resource capacity to produce them, the largest contribution (and profit) results from providing those products, services and orders that maximize CPRU.When the volume of products that could be sold is greater than the resource capacity to produce them, the largest contribution (and profit) results from providing those products, services and orders that maximize CPRU.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 12 Marketing Profitability Analysis

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Marketing Cost Classifications Common fixed marketing costs are costs incurred in common for different profit segments and do not vary with the volume of sales or activities in any profit segment Direct variable marketing costs vary with an activity and can be assigned to profit segments Separable fixed marketing costs are costs that can be assigned to specific profit/sales segments

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Contribution Approach Contribution method avoids arbitrary assignment of common, fixed marketing costs –Once the contribution for each product or profit segment is determined, a PV ratio can be computed and alternative prices for each product can be analyzed exactly

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Net Profit Approach Net Profit Approach attempts to assign all indirect costs among profit segments –Marketing expenditures of a business are reclassified from a natural-expense basis into activity-cost groups –Activity cost groups are assigned to profit segments on the basis of measurable factors that exhibit causal relationships to the activity costs

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Cost Groups And Bases Of Assignment

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Cost Groups And Bases Of Assignment

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Cost Groups And Bases Of Assignment

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Cost Groups and Bases Of Assignment

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Cost Groups And Bases Of Assignment

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Cost Groups And Bases Of Assignment

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Cost Groups And Bases Of Assignment

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. The Concept of Customer Profitability Customers can be viewed as the main source of profits for the business firm 1. Measuring customer profit includes –Identifying the customer –Measuring the net revenue received (transaction price x volume) and actual costs incurred while serving the customer –Combining these elements into an estimate of profitability for each customer

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. The Concept of Customer Profitability 2. Distinguish between customer acquisition and customer retention when estimating costs associated with each customer 3. Combine the revenues and costs associated with each customer into an estimated profitability for each customer

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Solutions For Unprofitable Customers 1. Reassign marketing and selling resources to profitable customers –Establish call frequencies for profitable vs. Unprofitable customers. –Encourage mail, telephone, or electronic orders for unprofitable customers. –Unbundle services and make available on a fee basis. –Change channel of distribution.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Solutions For Unprofitable Customers 2. On small orders: –Require customers to pick up orders or arrange for delivery –Charge for delivery –Establish a minimum order size Include a surcharge for orders below minimum size Require cash on orders below minimum size Eliminate small orders

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Solutions For Unprofitable Customers 3. Establish a price structure –Volume discounts –Surcharges for small oders –End-of-year patronage discounts (rewards) 4. Establish a credit policy –Establish credit lines –Include cash discounts in price structure (early payment rewards)

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. Starting a Profitability Analysis Program  Concentrate initially on products that contribute a substantial amount of sales and profits  Simplify the analysis and reduce the costs of developing and implementing the program