1. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 1 Thème 6 Pricing Decisions and Cost Management

2. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 2 Pricing and Business How companies price a product or service ultimately depends on the demand and supply for it, Three influences on demand and supply: 1.Customers, 2.Competitors, 3.Costs.

3. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 3 Influences on Demand and Supply 1.Customers – influence price through their effect on the demand for a product or service, based on factors such as quality and product features, 2.Competitors – influence price through their pricing schemes, product features, and production volume, 3.Costs – influence prices because they affect supply (the lower the cost, the greater the quantity a firm is willing to supply).

4. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 4 Time Horizons and Pricing Short-run pricing decisions have a time horizon of less than one year and include decisions such as:  Pricing a one-time-only special order with no long-run implications,  Adjusting product mix and output volume in a competitive market. Long-run pricing decisions have a time horizon of one year or longer and include decisions such as:  Pricing a product in a major market where there is some leeway in setting price.

5. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 5 Differences Affecting Pricing: Long Run vs. Short Run 1.Costs that are often irrelevant for short-run policy decisions, such as fixed costs that cannot be changed, are generally relevant in the long run because costs can be altered in the long run. 2.Profit margins in long-run pricing decisions are often set to earn a reasonable return on investment – prices are decreased when demand is weak and increased when demand is strong.

6. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 6 Alternative Long-Run Pricing Approaches Market-Based: price charged is based on what customers want and how competitors react, Cost-Based: price charged is based on what it costs to produce, coupled with the ability to recoup the costs and still achieve a required rate of return.

7. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 7 Markets and Pricing Competitive Markets – use the market- based approach, Less-Competitive Markets – can use either the market-based or cost-based approach, Noncompetitive Markets – use cost-based approaches.

8. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 8 Market-Based Approach Starts with a target price, Target Price – estimated price for a product or service that potential customers will pay, Estimated on customers’ perceived value for a product or service and how competitors will price competing products or services.

9. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 9 Focused on design. Consideration given to the entire value chain. Focused simultaneously on profit and cost planning. Driven by the customer. Target costing is aimed at the earliest stages of new product and service development. The Target Costing Process

10. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 10 Concept development Planning and market analysis Production design and value engineering Production and continuous improvement Target price Profit margin Target cost Establishing the Target Price Attaining the Target Cost Components of the Target Costing Process

11. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 11  Develop products that satisfy customer needs.  Set target price using competitors’ prices and customers’ perceived value for product.  Target price – Profit margin = Target cost  Use value engineering to find least costly combination of resources to meet customer needs. Developing target prices and target costs requires four steps: Components of the Target Costing Process

12. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 12  Involve entire value chain in reducing costs while satisfying customer needs.  An understanding of relationships between process components and costs is critical.  A product’s functional characteristics to the customer are emphasized.  A primary objective is reducing development time.  ABC is used to determine changes that will reduce costs. Characteristics of the Target Costing Process

13. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 13 Understanding the Market Environment Understanding customers and competitors is important because: 1.Competition from lower cost producers has meant that prices cannot be increased, 2.Products are on the market for shorter periods of time, leaving less time and opportunity to recover from pricing mistakes, 3.Customers have become more knowledgeable and demand quality products at reasonable prices.

14. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 14 Five Steps in Developing Target Prices and Target Costs 1.Develop a product that satisfies the needs of potential customers, 2.Choose a target price, 3.Derive a target cost per unit:  Target Price per unit minus Target Operating Income per unit. 4.Perform cost analysis, 5.Perform value engineering to achieve target cost.

15. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 15 Value Engineering Value Engineering is a systematic evaluation of all aspects of the value chain, with the objective of reducing costs while improving quality and satisfying customer needs, Managers must distinguish value-added activities from non-value-added activities.

16. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 16 Value Engineering Terminology Value-Added Activities – an activity that, if eliminated, would reduce the actual or perceived value or utility (usefulness) customers obtain from using the product or service, Non-Value-Added Activities – an activity that, if eliminated, would not reduce the actual or perceived value or utility customers obtain from using the product or service. It is an activity the customer is unwilling to pay for.

17. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 17 Analysis and Classification Activities Value- and Non-value-Added Activities Non-value- Added Activities Reduce or Eliminate Value- Added Activities Continually Evaluate and Improve

18. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 18 Value-added activities enhance the value of products and services in the eyes of the customer while meeting goals of the business. Designing to customer specification. Processing for just-in-time delivery to customers. Competent customer service. Value-added activities enhance the value of products and services in the eyes of the customer while meeting goals of the business. Designing to customer specification. Processing for just-in-time delivery to customers. Competent customer service. I love them! Value-Added Activities

19. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 19 Non-value-added activities use resources without providing value to customers. Material and other inventory storage. Moving parts and materials in the factory. Waiting for work. Inspection. Creating scrap and rework. Product design without customer input. Non-value-added activities use resources without providing value to customers. Material and other inventory storage. Moving parts and materials in the factory. Waiting for work. Inspection. Creating scrap and rework. Product design without customer input. Get rid of them! Non-value-Added Activities

20. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 20 Example In a recent survey of the soap box market by Boards and More’s Marketing and Planning Department, customers expressed dissatisfaction with currently available packaging. Further analysis revealed soap manufacturers believe the packaging is too heavy, increasing their shipping costs. Soap consumers are also unhappy with the ink used because, when the boxes get wet, the printing bleeds or rubs off. A cross-functional, cross-organizational team is assembled to create a product to satisfy customer needs. Notice that two sets of customers, both in the value chain, are important: the soap manufacturer and the soap consumer. The product creation team consists of marketing, design engineering, accounting, and production engineering personnel from Boards and More and similar personnel from the printing firm and the soap company. The charge to the team is to create new paperboard for the cardboard soap boxes that satisfies customers’ needs.

21. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 21 Example All members of the value chain should participate in new product creation: if the new cardboard created by Boards and More is of a lighter weight but cannot properly absorb ink, then the solution is not viable. Similarly, if the cardboard is lightweight but its strength does not allow proper filling by the machinery at the soap manufacturer, then the solution is not feasible. Finally, in addition to the design changes that Boards and More considers undertaking, other team members from the printing or soap companies may want to modify or change their processes to satisfy the ultimate customer, the soap consumer.

22. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 22 Product function analysis The requirements/functions table helps the design engineers to focus on product functions that can best meet the needs of the customers.

23. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 23 Example The ability to bend and cut the cardboard is very important for how easy the box is to pour, its weight, and its strength. Unfortunately, the current technology in paperboard implies that, although lightweight cardboard is easier to bend and cut and is easier for the consumer to pour, it is not strong enough to meet the soap manufacturer’s requirements. If the box could be made stronger while simultaneously maintaining light weight and high absorption, several consumer requirements could be met. Of course, the problem of the additional cost associated with the lighter weight paperboard must be considered.

24. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 24 Example The marketing members of the team must determine the target price consumers are willing to pay to gain the desired requirements. After market surveys, it becomes clear that soap consumers are unwilling to pay more than the current price for the desired requirements. The soap manufacturer is thus unwilling to increase the amount it pays to Boards and More for the printed soap boxes.

25. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 25 Example Additional investigation reveals competitors are about to release new packaging designed to solve some of these problems—plastic bottles. The plastic bottles are lightweight and strong and have labels that eliminate the printing problems. Although this new packaging approach does not require a price increase, the head marketing and engineering managers at Boards and More are skeptical of its acceptance by soap consumers because of pouring problems. The narrow neck of the plastic jug causes the powdered soap to clump together as it pours, creating problems for the consumer. It is clear, however, that competitors are working to solve these problems.

26. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 26 The design engineers, working with the accountants who have gathered ABC information, have come up with a potential solution to meet customer requirements Example

27. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 27 Example The design engineers propose an initial target cost of $1.77. Lowering the wood fiber content of the paperboard and using microscopic plastic fibers that reduce weight and increase strength generates this initial target cost. The new mixture would require fewer pounds of pressure when being rolled but would require longer drying time and higher heat during drying. The paperboard would then be ready for printing. However, the printing company determines the new paperboard would require new printing technology because of absorption problems created by the plastic fibers. The new paperboard would increase printing costs by $0.03 and the total cost by $0.05 per box ($1.72 to $1.77).

28. Contrôle Interne Avancé-HEC Lausanne- 2007/2008 28 Example Because the initial target cost of $1.77 is too high to maintain previous margins, value engineering becomes critical. Cost must be driven out of the value chain or the proposed solution will not be acceptable. One piece of the value chain not yet considered is the bending and cutting used to create the box. Boards and More approaches the supplier that bends and cuts the boxes before they are shipped to the soap manufacturer. Boards and More asks for a price cut of $0.03 from the current price because the bending and cutting process should be easier and less costly, and the supplier agrees. Then Boards and More suggests splitting the remaining $0.02 of the total cost increase with the printer to achieve the target of $1.72, the price the soap producer is willing to pay. The printer agrees to the $0.01 reduction and Boards and More finds a way to cut $0.01 out of its heating and drying costs. Through value engineering across the value chain, suppliers and producers are able to arrive at the desired target cost.