COSTING FOR PRICING DECISIONS Gerald E. Smith, D.B.A. Carroll School of Management Boston College

PROFITABLE PRICING REQUIRES UNDERSTANDING THE TRUE COST The true cost is the cost incurred if a sale is made, or the cost not incurred if a sale is not made. IDENTIFYING TRUE COSTS Incremental (not the “full cost”) Avoidable (not the “sunk cost”)

THE FOCUS OF PROFITABLE PRICING Price $10 Unit Sales Volume 100,000 Total Revenue $1,000,000 Unit Variable Costs $3 Total Variable Costs $300,000 Unit Contribution $7 Total Contribution $700,000 Fixed Costs $500,000 Net Income Before Taxes $200,000

IDENTIFY INCREMENTAL VARIABLE COSTS VARIABLE COSTS ARE ALWAYS INCREMENTAL But be careful of averages! The incremental variable cost for a change in sales is often not equal to the average variable cost. Examples: – Overtime vs. average cost production; – Costs from multiple sources using different technologies (joint product vs. prime sourcing); – Average over different types of customers.

IDENTIFY INCREMENTAL FIXED COSTS SOME FIXED COSTS ARE ALSO INCREMENTAL FOR PRICING. They are the fixed costs incurred to implement a change in pricing. MOST FIXED COSTS ARE NOT INCREMENTAL Since they do not change with a change in price or sales, they are not incremental. They have no impact on the relative profitability of alternative pricing strategies. Examples: Product Development Costs; Advertising

IDENTIFY INCREMENTAL OPPORTUNITY COSTS Full costs--which include non-incremental fixed costs—are neither the actual costs incurred when making additional sales at lower prices, nor the actual costs saved when making fewer sales at higher prices. They are, therefore, misleading as a guide to pricing. Beware of overlooking or ignoring opportunity costs. They are often incremental, even when associated with otherwise “fixed” assets. Examples: Alternative uses of capacity, funds, or management time.

SUNK COST FALLACY: WHICH COST IS RELEVANT INITIAL SITUATION Price Per Unit $22.50 Historical & Replacement Cost Profit Contribution Per Unit 9.00 Cash Flow Per Unit 9.00 AFTER COST INCREASE Price Per Unit $22.50 Historical Cost Replacement Cost Profit Contribution Per Unit 9.00 Cash Flow Per Unit 7.50

COST ANALYSIS FOR PRICING DECISIONS Boscot Corporation TOTAL $/UNIT TRUE COST Direct Labor $144,000 $24__________ Materials 42,000 7__________ Plant & Equipment 216,000 36__________ Sales & Marketing 12,000 2__________ Order Process & Ship 24,000 4__________ Warehousing 18,000 3__________ General & Admin 66,000 11__________ TOTAL $522,000 $87 What is the relevant unit cost?

USEFUL INFORMATION ABOUT BOSCOT Direct LaborOvertime pay is 1.5 times normal pay. Plant & EquipmentDepreciated according to IRS rules. Marketing & SalesNew salespeople must be hired, and a new promo program produced to target new buyers. Expected cost $6,000, regardless of sales actually generated. Order Process & ShipBuyers in new market segment order in quantities half the size of orders of current customers. WarehousingOwns and rents warehouse space. Warehousing for 1,500 units is charged at $4,500 of original building & maintenance. To warehouse 1,500 more units Build addition towarehouse at charge of $6,500; Stop leasing space to other companies, which earns rents of $6,000 per week. General & AdminCorporate overhead, R&D, etc

Reorganize Costs for Effective Management! PER UNIT INCREMENTAL TOTAL (for simple pricing decisions) (for pricing with (for determining overall incremental investment) business profitability) Price Incremental Revenue Sales Revenue - Unit Variable Cost - Incre. Variable Cost - Total Variable Costs Contribution Margin Incremental Contribution Total Contribution - Incremental Fixed Costs - Incremental Fixed Costs Net Incre. Contribution Net Contribution - Nonincremental Fixed and Sunk Costs Net Profit

APPROXIMATELY RIGHT, OR PRECISELY WRONG Determining the true cost of a product or service--the incremental, avoidable cost--requires making adjustments to the full, average costs as calculated for financial purposes. These adjustments often require that you make judgments about which you are uncertain, and that are debatable. This is not, however, a reason to avoid making such judgments. It is better to make pricing decisions based on a rough idea of the true unit cost of your product or service than on a precise accounting of costs that are irrelevant to its profitability!

WHY FOCUS ON CM Tool of Competitive Advantage – Relative Advantage – Relative Cost Tool for Segmentation Pricing – Set different prices for different segments – Can reach more segments Indicator of how to drive profitability – High Margin: Volume-based Strategies – Low Margin: Gross Profit Bundling Strategies

Strategic Models to Manage the Business Unit Decision MakerMarket ManagersTop ManagementOperating Managers Management FocusShort-term gross profitability of customer opportunities Longer-term net profitability of business investments and resource allocations Short-term efficiency and effectiveness of Management DecisionsWhich opportunity to serve Terms of the transaction -- Pricing -- Product definition -- Service definition -- Where to deliver (location) -- When to deliver (timing) -- How much (volumes) Which business units to invest resources in How much to invest What resource mix to invest -- Financial -- Human resources -- Tangible assets -- Intangible assets How to deploy resources How to manufacture How to service When to serve What to deliver How to deliver Performance MeasuresBusiness unit gross margins, gross profit Customer, market segment gross margins, gross profit Total net earnings Financial Return Measures, e.g., ROI, ROA, ROE Customer satisfaction Perceived quality Process efficiency Process productivity Gross Profit StrategyCorporate StrategyOperating Strategy

Figure 1 Incremental Gross Profit Strategies Segment A Segment B Segment C Segment D Segment E TOTAL GROSS PROFIT Margin Segment A Segment B Segment C Segment D Segment E TOTAL GROSS PROFIT Incremental Cost Margin Incr Cost Margin Incr Cost Incr Cost Margin Incr Cost Margin Incr Cost Volume-Based Gross Profit Strategies -- drive volume across the market Price/Bundling Gross Profit Strategies -- drive gross profit bundles through target segments High Margin Product Margin Product A Product B Service X Service Y Service Z Product C

Figure 2 Customer Opportunity Portfolio and Gross Profit Strategies for Low Margin Managers High Cost To Serve Low Cost To Serve Low Price Sensitivity High Price Sensitivity Cost to Serve Platform Bundling Strategies Higher relative prices, greater brand loyalty Lower relative costs, greater volume and scale, lower transaction, relationship, and opportunity costs Value- Added Buyers Loyal Volume Buyers High-Differentiation Volume StrategiesCustomized Bundling Strategies Custom Solution or Specialty Buyers Emerging Value Buyers Convenience Bundling Strategies

Figure 3 Perceived Competitive Advantage 80% Perceived Gross Margin 20% Perceived Cost 80% Perceived Cost 20% Perceived Gross Margin Strategic Options: 1.Compete with Advertising 2.Compete with Promotions 3.Compete with Price Managerial Motivation: Offensive, Aggressive Drive Volume Strategic Options: 1.Compete with Limited Non-Price Promotions Managerial Motivation: Defensive, Cautious Protect Margin Competitor A Perceived Advantage Competitor B Perceived Disadvantage

Sidebar Figure 1A Arrow Electronics Customer Portfolio (Bubble size = Segment Gross Profit relative to Total Gross Profit) High Cost To Serve Low Cost To Serve Low Price Sensitivity High Price Sensitivity Cost to Serve Platform Bundling Strategies Higher relative prices, greater brand loyalty Lower relative costs, greater volume and scale, lower transaction, relationship, and opportunity costs High-Differentiation Volume StrategiesCustomized Bundling Strategies Convenience Bundling Strategies ICP- BAS ICP- VA CM- VA CM- BAS OEM- BAS X86- VA CM- M&P OEM VA X86- BAS