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Chapter 6 Cost Information for Pricing and Product Planning.

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1 Chapter 6 Cost Information for Pricing and Product Planning

2 2 Role Of Product Costs In Pricing And Product Mix Decisions Understanding how to analyze product costs is important for making pricing decisions: – At most firms whose managers make decisions about establishing or accepting a price for their products, managers need to make decisions about for example, whether they should offer discounts for large orders or to valued customers – Even when price are set by overall market supply and demand force and the firm has little or no influence on product prices, management still has to decide the best mix of products to manufacture and sell

3 3 Role of Product Costs Product cost analysis is also significant when a firm is deciding how best to deploy marketing and promotion resources – How much commission (or how many other incentives) to provide the sales force for different products – How large a discount to offer off list prices This chapter examines some of the more traditional methods of pricing and considers short- and long-run factors

4 4 Short-term and Long-term Pricing Considerations (1of3) Managers must consider both the short-term and long-term consequences of their decisions Many resources committed to activities are likely to be committed costs in the short-tem because firms cannot easily alter the capacities made available for many production and support activities for short-tem decisions, it is important to pay special attention to whether surplus capacity is available for additional production, or whether shortages of available capacity limit additional production alternatives

5 5 Short-term and Long-term Pricing Considerations (2of3) When evaluating a particular order, how long a firm must commit its production capacity to fill that order is of special concern. The length of time is relevant because a long- term capacity commitment to a marginally profitable order may: – Prevent the firm from deploying its capacity for more profitable products or orders, should demand for them arise in the future – Force the firm to add expensive new capacity to handle future sales increases

6 6 Short-term and Long-term Pricing Considerations (3of3) It production is constrained by inadequate capacity, managers need to consider whether overtime production or the use of subcontractors can herb augment capacity in the short term In the long term, managers have considerably more flexibility to adjust the capacities of activity resources to match the demand for them in producing various products Decisions about whether to introduce new products or eliminate existing products have long-term consequences – The emphasis is, therefore. on analyzing how such product decisions will affect the demand placed on the firms capacity resources

7 7 Ability To Influence Prices (1of2) Decision base the firm can influence the price of its products – If the firm is one of a large number of firms In an industry, and if there is little to distinguish the products of different firms from each other; prices will be set by the aggregate market forces of supply and demand No single firm can influence prices significantly by its own decisions Such smaller firm on the fringe must match the prices set by the industry leaders – Such a firm is a price taker, and it chooses its product mix given the prices set in the marketplace for its products

8 8 Ability To Influence Prices (2of2) – Firms in an industry with relatively little competition who enjoy large market shares and exercise leadership in an industry, must decide what prices to set for their products – Firms in industries in which products are highly customized or otherwise differentiated from each other (because of special features, characteristics, or customer service) also need to set the prices for their differentiated products – Such firms are price setters; they announce their prices, customers place orders, and production follows

9 9 Price Takers A small firm, or a firm with a negligible market share in this industry, behaves as a price taker – It takes the industry prices for its products – It risks losing its customers if demand higher price unless it can successfully differentiate its products by offering special features or services – it risks a price war if the small firm seeks to increase its market share by asking a price lower than the industry prices, This action is most painful to smaller firms that have fewer resources to rely on should an unprofitable price war occur

10 10 Short- Term Decisions for Price Takers A price taker should produce and sell as much as it can of all products whose costs are less than industry prices Although this may appear to be a simple decision rule, two important considerations complicate matters – First, managers must decide which costs are relevant to the short-term product mix decision – Second, in the short-term, managers may have little flexibility to alter the capacities of some of the firm's resources The available equipment capacity may limit the ability of a firm to produce and sell more products whose costs are lower than their prices

11 11 Garment Manufacturer Consider a company that sells five types of ready-made garments to discount stores such as Kmart and Wal-Mart The company is operating at full capacity and is contemplating short-term adjustments to its product mix It is necessary for the company to determine: – what costs will vary with production levels in this period – what costs will remain fixed when a change occurs in the production mix The costs of utilities, plant administration, maintenance, and depreciation for the machinery and plant facility will not alter with a change in the product mix, because the plant is operating at full capacity

12 12 Garment Manufacturer If capacity is constrained, the company must decide how best to deploy this limited resource If capacity is fixed in the short-term, so the company must clan production to maximize the contribution to profit earned for every available machine hour used – the company should rank-order the products by their contribution per machine hour, Not by their contribution per unit – Contribution per machine hour = contribution per unit + the number of machine hours per unit

13 13 The Impact Of Opportunity Costs If the garment manufacturer receives a special order request, it would have to decide the minimum price it would accept Its out-of-pocket costs will increase in the short-term by the amount of flexible costs required for the order, but a simple comparison of the price with flexible costs is not adequate for this decision Because its production capacity is limited, the company must cut back the production of some other garment to produce the goods for the special order Giving up the production of some profitable product results in an opportunity cost, which equals the lost profit on the garments that the company can no longer make.

14 14 The Impact Of Opportunity Costs The lost profit in this case would be the contribution on the goods it will not make In deciding which products to take off of the production schedule; the company should once again look at the contribution per machine hour The product with the lowest contribution per hour should be sacrificed The profit (contribution) lost on those products would need to be covered by the price of the special order

15 15 Short- Term Pricing Decisions for Price Setters In many businesses, potential customers request that suppliers bid a price for an order before they decide on the supplier with whom they will place the order A new customer has asked for a bid on a set of customized tools

16 16 Available Surplus Capacity The company's incremental costs of filling the order will be $22,000 (material, direct labor, batch related expenses) The costs of supervision and business-sustaining support activities will not increase if excess capacity of these resources is available to meet the production needs of the order The price that the company should bid must cover the incremental costs for the job to be profitable – In other words, the minimum acceptable price Is $22,000 since surplus production capacity is available This is the price at which the company will break even on the order The company would likely add a profit margin above incremental costs and make the bid price something higher than $22,000, depending on competitive and demand conditions

17 17 No Available Surplus Capacity (1of3) If surplus machine capacity is not available, the company will have to incur additional costs to acquire the needed capacity Companies often meet such short-term capacity requirements by operating its plant overtime – Paying its supervisors overtime wages – Incurring additional expenditures for heating, lighting, cleaning, and security More machine maintenance and plant engineering activities will be necessary – Experience has shown that the incidence of machine breakdowns increases during the overtime shift

18 18 No Available Surplus Capacity (2of3) Under its machinery leasing contract, the company also incurs additional rental costs for the extra use of machines when it adds an overtime shift Assume management estimates the order would cause: – $5,100 of incremental supervision costs (including overtime premium) – -$5,400 of incremental business-sustaining costs Thus, the total cost of overtime required to manufacture customized tools for the order is $10,500 ($5100 + $5400)

19 19 No Available Surplus Capacity (3of3) Therefore, the minimum acceptable price in this case is $32,500 ($22,000 + $10,500) – The actual price will depend on the amount of markup charged over the incremental costs The principle illustrated here is the same as that described in the previous case: the minimum acceptable price must cover all incremental costs – When the firm must acquire additional capacity to satisfy the order, there are more Incremental costs involved in the decision to accept or reject the order

20 20 Long- Term Pricing Decisions for Price Setters You may have noticed that the relevant costs for the short-term special order pricing decision differ from the full costs of the job Most firms rely on full-cost information reports when setting prices – Typically, the accounting department provides cost reports to the marketing department, which then adds appropriate markups to the costs to determine benchmark or target prices for all products normally sold by the firm

21 21 Use of Full Costs in Pricing (1of3) There is economic justification for using full costs for pricing decisions in three types of circumstances: 1. Many contracts for the development and production of customized products and many contracts with governmental agencies specify that prices should equal full costs plus a markup, and prices set in regulated industries are based on full costs 2. When a firm enters into a long-term contractual relationship with a customer to supply a product, it has great flexibility in adjusting the level of commitment for all resources

22 22 Use of Full Costs in Pricing (2of3) Most activity costs will depend on the production decisions under the long-term contract, and full costs are relevant for the long-term pricing decision 3. In many industries, firms make short-term adjustments in prices, often by offering discounts from list prices instead of rigidly employing a fixed price based on full costs When demand for their products is low, the firms recognize the greater likelihood of surplus capacity in the short term

23 23 Use of Full Costs in Pricing (3of3) They adjust the prices of their products downward to acquire additional business based on the lower incremental costs they incur when surplus capacity is available When demand for their products is high, they recognize the greater likelihood that the existing capacity of activity resources is inadequate to satisfy all of the demand They adjust the prices upward based on the higher incremental costs they incur when capacity is fully utilize, thereby rationing the available capacity to the highest profit opportunity

24 24 Fluctuating Prices (1of2) Because demand conditions fluctuate over time, prices also fluctuate with demand conditions over time – Most hotels offer special weekend rates that are considerably lower than their weekday rates – Many amusement parks offer lower prices on weekdays when demand is expected to be low – Airfares between New York and London are higher in summer, when the demand is higher, than in winter, when the demand is lower – Long-distance telephone rates are lower in the evenings and on the weekends when the demand is lower

25 25 Fluctuating Prices (2of2) Although fluctuating short-term prices are based on the appropriate incremental costs, over the long term their average tends to equal the price based on the full costs that will be recovered in a long-term contract In other words. the price determined by adding on a markup to the full costs of a product serves as a benchmark or target price from which the firm can adjust prices up or down depending on demand conditions Most firms use full cost-based prices as target prices, giving sales managers limited authority to modify prices as required by the prevailing competitive conditions

26 26 The Markup Rate (1of2) Just as prices depend on demand conditions, markups increase with the strength of demand – If more customers demand more or a product, then the firm is able to command a higher markup Markups also depend on the elasticity of demand – Demand is said to be elastic if customers are very sensitive to the price, that is, if a small increase in the price results in a large decrease in the demand – Markups are smaller when demand is more elastic Markups also fluctuate with the intensity of competition – If competition is intense, it is more difficult for a firm to sustain a price much higher than its incremental costs

27 27 The Markup Rate (2of2) Firms decide on markups for strategic reasons: – A firm may choose a low markup for a new product to penetrate the market and win over market share from an established product of a competing firm – Many internet businesses have adopted the strategy of setting low prices to build the business, acquire a brand name, build a loyal customer base, and gamer market share – In contrast to this penetration pricing strategy, firms sometimes employ a skimming price strategy, as in the audio and video equipment industry, where initially a higher price is charged to customers who are willing to pay more for the privilege of possessing the latest technological innovations

28 28 Long- Term Decisions for Price Takers Decisions to add a new product or to drop an existing product from the portfolio of products usually have significant long-term implications for a firm's cost structure Product-sustaining costs are relevant costs for such decisions – Product design and engineering, vendor and purchasing costs, part maintenance, and dedicated sales force costs Batch-related costs are also likely to alter if a change occurs in the product mix either in favor of or against products manufactured in large batches – Setups, materials handling, and first-item inspections

29 29 Use of Full Costs (1of3) Bear in mind that managers cannot easily change the amount of resources committed for many product- sustaining and several batch-related activities in the short run The cost consequences of either introducing a new product or deleting an existing product evolve over time – Both decisions require careful implementation plans stretching over several periods

30 30 Use of Full Costs (2of3) As a result, managers use the full costs of products, including the cost of using various resources to produce and sustain the product – Such resources include the number of setup staff, the number of product and process engineers, and the number of quality inspectors Managers use the costs of all resources in their product- related decisions, because in the long-term, the firm is able to adjust the capacity of activity resources to match the resource levels demanded by the product quantities and mix

31 31 Use of Full Costs (3of3) Comparing product costs with their market prices reveals which products are not profitable in the long- term – Over the long-term, firms can adjust activity resource capacities to match production requirements If some products have full costs that exceed the market price, the firm must consider several options – Although dropping these products appears is to be an obvious option, customers may expect the company to maintain a full product line – But a comparison of the prices with costs still provides a valuable signal to managers because it indicates the net cost of the strategy to offer a full product line

32 32 Options if Full Cost > Price (1of2) Managers may consider options other than dropping the product – Reengineering or redesigning unprofitable products. to eliminate or reduce costly activities and bring their costs in line with market prices – For example, they could improve the production processes to reduce setup times and streamline material and product flows They may want to explore market conditions more carefully and differentiate their products further to raise prices and bring them in line with the costs

33 33 Options if Full Cost > Price (2of2) Firms may offer customers incentives, such as quantity discounts, to increase order sizes and thereby reduce total batch-related costs If these steps fail, and if the marketing strategy of offering such a full product line cannot justify the high net cost of such products, then managers must consider a plan to phase out the products from their line – Customers also need to be shifted to substitute products still retained in the company's product line

34 34 Profit Increase is Not Automatic Dropping products will help improve profitability only if the managers: 1. Eliminate the activity resources no longer required to support the discontinued product. or 2. Redeploy the resources from the eliminated products to produce more of the profitable products that the firm continues to offer Costs result from commitments to supply activity resources – They do not disappear automatically with the dropping of unprofitable products – Only when companies eliminate or redeploy the resources themselves will actual expenses decrease

35 35 Summary Managers use cost information to assist them in pricing and in product mix decisions The manner in which they use cost information in making these decisions depend on whether the firm is a major or minor entity in its industry – A major entity would be able to influence the setting of prices – A minor entity would take the industry prices as given and adjust its product mix in response to the prices it could charge The role of cost information also depends on the time frame involved in the decision – Business-sustaining costs are frequently relevant for long-term decisions, but less often for short-term decisions – Short-term prices are based on incremental costs that depend on the availability of activity resource capacity


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