Cost Based Pricing Rules Ted Mitchell

Pricing Two Views 1. We give you a good price Price Is Relative To Competition 2. We ask for this in exchange Price = Product + Place + Promotion Price Is A Reflection of Value

There are Price Setters and Price Takers A basic idea of marketing is to make your product sufficiently better than your competitors’ product from the customer’s point of view and not to be a price taker.

Pricing Goals  Profit  long run, short run  Sales Revenue (Growth)  Market Share (Penetration)  Unit Sales Volume (Learning Curve)

Pricing Goals Cont’d  Image Maintenance  Cash Flow (survival)  Competitive Pricing (Stability, Price leader, price taker  Avoid price competition

Basics C’s for Pricing Costs of making the product, etc. Customer Demand Competitors

Pricing Methods (Formulas)  Cost Based Methods  Demand Based Methods  Competitive Based (Going Rate, Bidding) Pricing

Cost Based Pricing Is Most Important

Why Cost Based Pricing Four Reasons 1 Fair 2 Easy to Calculate 3 Industry Stability 4 “guarantee a profit”

Types of Cost Based Methods  Cost Plus (profit)  Traditional Markup (Discount rate)  Target Return on Investment  Discounts & Allowances

Some Costing Is Crude  Direct Materials plus  Direct Labor plus  300% of Direct Labor (to cover Fixed Costs) plus  A 50% Markup plus  Competitive adjustment plus  What the customer will bear

 Pricing Formulas Tend To Be The Same Across An Industry  Reduces Price Competition

Z = (P - V)Q - F Price Formula Comes From The Basic Profit Formula

The Basic Cost Based Pricing Formula is Z = (P - V)Q - F Price Formula Comes From The Basic Profit Formula

15 Calculate the Price Knowing Cost and Profit Targets

The Variable Cost Is Crucial In The Idea Of Pricing Down The Learning Curve

Learning Curve Variable Cost Per Unit Is Reduced As Experience In Its Production Is Learned

Learning Curve V Production Experience

Learning Curve V Production Experience

Learning Curve V Cumulative

Forecasting Future Variable Cost Is A Very Important Part Of Modern Pricing Strategy!

Variable Cost Is Not Unit Cost UNIT COST COMBINES AVERAGE FIXED COSTS AND VARIABLE COSTS

Basic Cost Based Pricing Formula is Substitute Unit Cost

Example “We charge what it costs to make each unit plus a standard approved markup of 10% for our profit.”

Example “We charge what it costs to make each unit plus a standard approved markup of 10% for our profit.” Unit Cost is considered the cost to make each unit in a pricing formula

Profit is being measured as a percentage of sales revenue. Substitute

Profit is being measured as a percentage of sales revenue. Substitute

Simplify Substitute

Example “We charge what it costs to make each unit plus a standard approved markup of 10% for our profit.”

P = Unit Cost + x% of Final Price P = Unit Cost + x(P) P - xP = Unit Cost (1-x)P = Unit Cost P = Unit Cost Classic Cost Plus Formula Is (1- x)

P = Unit Cost + x% of Final Price P = Unit Cost + x(P) P - xP = Unit Cost (1-x)P = Unit Cost P = Unit Cost Classic Cost Plus Formula Is (1- x) Note: we use unit cost and a target profit margin

Types of Cost Based Formulas  Cost Plus (Profit)  Traditional Markup Pricing (Discount rate)  Target Return on Investment  Discounts & Allowances

33 Markup Pricing  Very Popular with Retailers  It uses the purchase cost of the merchandise which is the Variable cost.  The Target Markup which includes the fixed costs and the target profit.

34 We remember that  The target markup for a target profit was  Mp* = (F+Z)/ R  We consider Mp*(R) = F+Z and substitute into  PQ - vQ = F+Z  PQ - vQ = Mp*(R)  and substitute R = PQ  (P-V)Q = Mp*PQ  P-V = Mp*P  P-Mp*P = V  P = V / (1-Mp*) is markup pricing

35 Another Way  Consider the breakeven price with a target profit  P = V +(F+Z)/Q  Divide both sides by P  (1/P)P = V/P + (F+Z)/PQ  Where (F+Z)/PQ = M p = Target markup  1 = V/P +Mp  (1-Mp)P = V  P = V/(1-Mp)

When you have a target markup, The Markup Pricing Formula Is

37 Markup Pricing  Remember the markup pricing is to cover the total contribution needed to cover the Fixed Costs and the Target Operating Profit!

Types of Cost Based Formulas  Cost Plus (Profit)  Traditional Markup Pricing (Discount rate)  Target Return on Investment  Discounts & Allowances

Calculating A Price From A Cost Based Formula Is Easier If They Give You A Target Return or Profit Z in dollars

Then You Get to Substitute For The Profit, Z, and Solve

Example: Target Profit Pricing Formula A Expected Profit of 15% ROI

Target Returns (Profits) Where Do They Come From?

Sources of Targets  1 Deciding What Seems Fair  2 Wanting A Better Return Than Last Year  3 Establishing What They Believe They Can Get  4 Estimated Cost Of Capital  5 Wanting To Stabilize Prices

Types of Cost Based Formulas  Cost Plus (Profit)  Traditional Markup Pricing (Discount rate)  Target Return on Investment  Weakness Of Cost Based  Discounts & Allowances

Basic Cost Based Pricing Formula is

Where Does The Q Come From?

Q Can Come From  Target Level Of Desired Production Percent Of Normal Capacity  Sales Forecasts

Dollars Fixed Cost Total Cost Cost Structure is Very Important Quantity Produced

Dollars 85% of Capacity Fixed Cost Total Cost #1 Percentage Of Normal Capacity Often Becomes The Bases For Expected Sales = Q!

#2 Forecasting The Quantity That Will Be Sold From Simple Projections Of Past Sales Is Popular Time

To Cost Based Pricing You Need To Know Variable cost, Fixed cost, Target Profit, & Estimate of Future Sales or Production = Q

The Fundamental Weakness Of Cost Based Pricing Is

Using An Expected Sales Forecast, Q, To Select The Price

Why? Because Price is Key Factor in Causing Sales Revenue = f(Price, Promotion, Place, Product) Price Causes Sales!

Remember  The Expected Quantity Of Sales Should NOT Set The Price.  The Price Determines The Quantity!

Remember  The Expected Quantity Of Sales Should NOT Set The Price. You Need Sales Estimates Based On The Demand At The Planned Price (i.e. Demand Based Pricing)

Types of Cost Based Formulas  Cost Plus (Profit)  Traditional Markup Pricing (Discount rate)  Target Return on Investment  Weakness Of Cost Based  Discounts & Allowances

Discounts & Allowances  Cash Discounts  Trade Discounts  Quantity Discount  Rebates (Cumulative)

Discounts & Allowances Everything Is A Percentage Off Catalog List Prices Importance Of Catalog And Pricing Sheet Updates

Cash Discount 3% /10 net 30  Encourage prompt payment  Reduce cost of credit  Industry standard

Trade Or Functional Discount Straight Percentage Off List  Pay For The Functions A Middleman Performs  Class A or B Distributor  OEM  Educational  Government

Quantity Discount  Must Be Offered To All Customers  Must Demonstrate Cost Saving Being Passed On

Rebates & Allowances  Cumulative  Competitive Rebates (software)  Seasonal  Advertising Allowances  Case Allowances

Shipping Costs  FOB origin  FOB Destination  Phantom Freight  Postage Stamp Pricing

Cost Based Pricing Does  Not Guarantee Demand  Not Guarantee A Net Profit  Not Simplify e.g. Managers Confused About Costs  Unit cost versus variable cost  Sunk costs vs fixed cost  Discretionary