1. 9-1 Strategy Management of Price, Cost, and Quality C hapter 9 Prepared by Douglas Cloud Pepperdine University

2. 9-2 1.Distinguish between economic and cost-based approaches to pricing. 2.Describe target costing and explain why it is gaining widespread acceptance in highly competitive industries. 3.Explain the relationship between target costing and continuous improvement costing. ObjectivesObjectives After studying this chapter, you should be able to: ContinuedContinued

3. 9-3 4.Distinguish among the four basic types of quality costs and describe how quality cost information can assist in a program of quality management. 5.Explain how benchmarking can assist in quickly management, continuous improvement, and process reengineering. ObjectivesObjectives

4. 9-4 Traditional Cost-Based Pricing Determine customer wants Design product to meet customer wants Determine manufacturing or service procedures Determine necessary materials Next Slide

5. 9-5 Sell Design product to meet customer wants Traditional Cost-Based Pricing Determine price: 1.Predict selected costs. 2.Add markup for other costs. 3.Add additional markup to achieve desired profit. The resulting price is evaluated: 1.If acceptable, manufacture and sell. 2.If unacceptable, redesign. Previous Slide

6. 9-6 Economic Approaches to Pricing Economic models provide a useful framework for thinking about pricing decisions. Despite their conceptual merit, economic models are seldom used for pricing decisions.

7. 9-7 Cost-Based Approaches to Pricing  Cost data are available.  Cost-based prices are defensible.  Revenues must exceeds costs if the firm is to remain in business.

8. 9-8 Cost-Based Pricing in Single- Product Companies Assume Bright Rug Cleaners annual facilities costs are $200,000 The unit cost of cleaning a rug is $10. Management desires to achieve an annual profit of $30,000 on an annual volume of 10,000 rugs.

9. 9-9 Profit = Total revenues – Total costs $30,000 = (Price x 10,000 rugs) – ($200,000 + [$10 x 10,000 rugs]) (Price x 10,000) = $300,000 + $30,000 Price = $330,000  10,000 Price = $33 Cost-Based Pricing in Single- Product Companies Solving for the price:

10. 9-10 For markups based on behavior and function, the possible cost bases include-- Direct materials costs Variable manufacturing costs Variable costs (manufacturing, selling, and administrative) Full manufacturing costs Cost-Based Pricing in Multiple- Product Companies

11. 9-11 For markups based on activity hierarchy, the possible cost bases include-- Unit level costs Unit + batch level costs Unit + batch + product level costs Cost-Based Pricing in Multiple- Product Companies

12. 9-12 Cost-Based Pricing in Multiple- Product Companies Markup on cost base = Costs not included in the base + Desired profit Costs included in the base

13. 9-13 Variable Cost Basis Magnum Enterprises has total assets of $1,250,000 and management believes an annual return of 16 percent on total assets is appropriate. Fixed costs and expenses total $400,000, while variable costs and expenses total $800,000. Markup on Variable Costs Fixed costs+Desired profit Variable costs and expenses $400,000 + $200,000 $800,000 = 0.75

14. 9-14 Variable Cost Basis If the predicted variable costs for Product A1 are $12 per unit, the initial selling price for Product A1 is $21. Initial selling price = $12 + ($12 x 0.75) Initial selling price = $21

15. 9-15 Magnum Enterprises has total assets of $1,250,000 and management believes an annual return of 16 percent on total assets is appropriate. Fixed costs and expenses total $400,000, while variable costs and expenses total $800,000. Markup on Manufacturing Costs Full Manufacturing Cost Basis Desired profitFixed mfg. costs+ All costs and expenses besides fixed manufacturing costs $300,000 + $200,000 $900,000 = 0.556

16. 9-16 If the predicted manufacturing costs for Product B1 were $10, the initial selling price for Product B1 is $15.56: Initial selling price = $10 + ($10 x 0.556) Initial selling price = $15.56 Full Manufacturing Cost Basis

17. 9-17 Drawbacks to Cost-Based Pricing  Cost-based pricing requires accurate cost assignments.  The greater the portion of unassigned costs, the greater the likelihood of over or underpricing individual products.  Cost-based pricing assumes goods or services are relatively scarce and customers who want a product are, generally, willing to pay the price.  In a competitive environment, cost-based approaches increase the time and cost of bringing new products to market.

18. 9-18 Robinson-Patman Act 1.The discriminatory lower price is in response to changing conditions in the market for the commodities involved. 2.The discriminatory lower price is made to meet an equally low price of a competitor. 3.The discriminatory lower price makes only due allowance for specific cost differences such as those resulting from long production runs and bulk shipments. 1.The discriminatory lower price is in response to changing conditions in the market for the commodities involved. 2.The discriminatory lower price is made to meet an equally low price of a competitor. 3.The discriminatory lower price makes only due allowance for specific cost differences such as those resulting from long production runs and bulk shipments. This act prohibits price discrimination unless--

19. 9-19 next slide Target Costing Determine customer wants and price sensitivity. Planned selling price is set.Target cost is determined as: Selling price – Desired profit

20. 9-20 Teams of employees from various areas and trusted vendors simultaneously: Design product Determine manufacturing procedure Determine necessary raw materials Costs are considered throughout this process. The process requires trade-offs to meet target cost. next slide Target Costing

21. 9-21 Once target cost is achieved, manufacturing begins and product is sold. Sell Target Costing

22. 9-22 Understanding target costing requires market knowledge. Managers must understand that target costing is not just about setting cost targets.

23. 9-23 Target costing first involves translating customer value expectations into an acceptable product price. Next, the profit that shareholders expect to make is determined.

24. 9-24 Netting these two items result in the target cost. Then, management must determine the proper mix of costs that will result in a quality product desired by the customer.

25. 9-25 Target costing reduces the time to introduce new products. Target costing can be applied to components. Target costing requires detailed cost information. Target costing requires coordination. Short product life cycles increase the importance of target costing.

26. 9-26 Advantages of Target Costing Proactive approach to cost management Orients organization toward customer Breaks down barriers between departments Enhances employee awareness and empowerment ContinuedContinued

27. 9-27 Advantages of Target Costing Fosters partnerships with suppliers Minimize nonvalue-added activities Encourages selection of lowest cost value-added activities Reduced time to market

28. 9-28 Disadvantages of Target Costing  Effective use requires the development of detailed cost data  Requires willingness to cooperate  Requires many meetings for coordination

29. 9-29 Product Life Cycle Startup Sales are low Selling price usually is high Customers tend to be affluent

30. 9-30 Product Life Cycle Startup Growth Sales increase at the product gains acceptance.

31. 9-31 Product Life Cycle Startup Growth Sales level off as the product matures. Maturity Some reduction in selling price may be necessary.

32. 9-32 Product Life Cycle Startup Growth Maturity Decline Sales decline as the product become obsolete.

33. 9-33 Product Marketing Life Cycle (Relatively long-lived products) Periodic Sales Time Startup Growth Maturity Decline

34. 9-34 Product Marketing Life Cycle (Relatively short-lived products) Periodic Sales Startup Growth Maturity Decline Time

35. 9-35 The Commitment and Expenditure of Money for High-Technology Products and Relatively Short Product Life 100 Percent of total costs Time Conception Design Pre- Production Support Production Cumulative commitment of money Cumulative expenditure of money

36. 9-36 Continuous Improvement Costing It is continuous improvement costing. It calls for establishing cost reduction targets for products or services. What is Kaizen costing? Successful world- class companies use Kaizen to avoid complacency.

37. 9-37 Quality Costs Quality is conformance to customer expectations. Successful companies know they must meet customers’ quality and price expectations. Quality is an essential element of the JIT approach to inventory management. Productivity is the relationship between output and inputs: Productivity = Output/Inputs Productivity is the relationship between output and inputs: Productivity = Output/Inputs

38. 9-38 Quality of Design and Quality of Conformance Step 1: Determine customer expectations Step 2: Develop functional specifications for the product or service Step 3: Turn functional specifications into design specifications Step 4: Develop detailed specifications Step 5: Deliver a product in conformance with the design specifications

39. 9-39 Success Requires Quality of Design and Conformance Quality of Design High Low Quality of Conformance LowHigh Do Right Things Wrong (Failure) Do Wrong Things Wrong (Failure) Do Wrong Things Right (Failure) Do Right Things Right (Winner!)

40. 9-40 Types of Quality Costs Preventive costs are incurred to prevent nonconforming products from being produced or nonconforming services from being performed. Appraisal costs are incurred to identify nonconforming products or services before they are delivered to customers. Internal failure costs occur when materials, components, products, or services are identified as defective before delivery to customers. External failure costs occur when nonconforming products are services are delivered to customers.

41. 9-41 Appraisal and internal failure costs are better than external failure costs. But, the way to reduce total quality costs is to spend money on prevention. Types of Quality Costs

42. 9-42 Quality Trend Analysis 20 - 18 - 16 - 14 - 12 - 10 - 8 - 6 - 4 - 2 - 0 - 1 2 3 4 5 6 External failure Internal failure Appraisal Prevention Period Percent of Sales

43. 9-43 Short-Run Analysis of the Economics of Quantity 0 Percent conforming to design specifications 100 Total Costs Total quality control Internal and external failure Prevention and appraisal

44. 9-44 Benchmarking Benchmarking is a systematic approach to identifying the best practices to help an organization take action to improve performance. Benchmarking is no longer regarded as spying.

45. 9-45 Alcoa’s Approach to Benchmarking 1.Decide what to benchmark 2.Plan the benchmark project 3.Understand your own performance 4.Study others 5.Learn from the data 6.Take action

46. 9-46C hapter 9 The End

47. 9-47