1. Strategy and Tactics of Pricing, The, 5/E
Chapter 9: Costs
Strategy and Tactics of Pricing, The, 5/E

2. Profitable Pricing Requires*
UNDERSTANDING THE TRUE COST (Page 181 & 182)
Profitable pricing involves an integration of costs and customer value
Profitable pricing often involves sacrificing gross profit in order to reduce future expenses* (Page 190)
Firms that price effectively decide what to produce and to whom to sell it by comparing the prices they can charge with the costs they must incur.*
Low cost producers can charge lower prices and sell more because it can profitability use low prices to attract more price sensitive buyers.*
The mistake that cost-plus pricers make is that they select the quantities they will sell and the buyers they will serve before identifying the prices they can charge. Then they try to impose cost-based prices that may be either more or less then what buyers will pay.*
Costs should never determine price, but costs do play a critical role in formulating a pricing strategy.
Not all costs are relevant for every pricing decision. A first step in pricing is to identify the relevant costs: those that actually determine the profit impact of the pricing decision. Relevant costs for pricing are incremental (not average), and avoidable (not sunk).
Incremental costs are the changes in costs that result from a pricing decision. Most fixed costs are not incremental and are therefore not relevant in the pricing decision. Some fixed costs are incremental when they change with the decision to change price. Beware of using average costs – they include costs that are not incremental and therefore irrelevant to proposed opportunity.
Avoidable costs are those that either have not yet been incurred or that can be reversed. Avoidable costs are those that the firm can control, as opposed to sunk costs, which are irreversible and committed. To be relevant for the pricing decision, a cost must be both incremental and avoidable. From a practical standpoint, the easiest way to identify the avoidable cost is to recognize that it is the future cost, not the historical cost, associated with making a sale.
Avoid misleading accounting. The traditional income statement reports quarterly or annual totals. For pricing, we are not concerned with the cost of all units produced in a period; we are concerned only with the cost of the units that will be affected by the decisions to be made. The value of reorganization is that it first focuses attention on costs that are incremental and avoidable and only later looks at costs that are non- incremental and sunk.

3. Profitable Pricing Requires cont: Page 182
Seller’s decisions about which products to produce and in what quantities depend critically on their cost of production
First evaluate what buyers can be convinced to pay and only then choose quantities to produce and markets to serve
Changes in costs should cause producers to change their prices, not because that changes what buyers will pay, but because it changes the quantities that the firm can profitably supply and the buyers it can profitably serve. (Page 182, Jet Fuel Costs)
Pricing decisions affect whether a company will sell less of the product at a higher price or more of the product at a lower price. In either scenario, some costs remain the same (in total).

4. Determining Relevant Costs* Page 182 & 183
IDENTIFYING TRUE COSTS* – Why Incremental Costs
* One cannot price effectively without understanding costs*. To be effective you must understand costs and apply cost plus formulas to labor costs, raw materials cost and overhead cost.*
- First step in pricing is to identify the relevant costs: those that actually determine the profit impact of the pricing decision*
Incremental – “Incremental costs are the costs associated with changes in pricing and sales”. *
Costs that rise or fall when prices change affect the relative profitability of different pricing strategies. We call these costs incremental because they represent the increment to costs (positive or negative) that results from the pricing decision
Incremental costs is the increase or decrease in costs as a result of one more or one less unit of output
Incremental costs are costs, over and above that a company would normally incur that are required to implement an activity such as hiring a consultant.
The distinction between incremental and non-incremental costs parallels closely, but not exactly, the more familiar distinction between variable and fixed costs.

5. Determining Relevant Costs cont: Page 183
Variable costs – such as the costs of raw materials in a manufacturing process, are costs of doing business. Because pricing decisions affect the amount of business that a company does, variable costs are always incremental for pricing.
Fixed costs – such as those for product design, advertising and overhead are costs of being in business. These are incremental when deciding whether a price will generate enough revenue to justify being in business of selling a product or serving a particular type of customer.
Incremental costs are those that directly result from implementing a price change or from offering a version of the product at a different price level. Example: Fixed cost for a restaurant to print menus with new prices. The fixed cost for an airline to advertise a new discount service would be incremental when deciding whether to offer products at those price levels.

6. Why Avoidable Costs* Page 186
Avoidable (not the “sunk cost”)
Avoidable costs are those that either have not yet been incurred or can be reversed.* The costs of selling a product, delivering it to the customer, and replacing the sold item in inventory are avoidable
The easiest way to identify the avoidable cost is to recognize that the cost of making a sale is always the current cost, resulting from the sale, not costs that occurred in the past*
“sunk cost”
The opposite of avoidable costs are sunk costs – those costs that a company is irreversible committed to bear. (Example – company’s expenditures on research and development are sunk costs, which cannot be changed regardless of any decisions made in the present)
Commercial airplanes, new truck, oil companies are examples (Page 187, review each and gallon of gasoline)
* The intelligent company bases its prices on the replacement cost, not the historical cost, of its inventory (Page 188)

7. 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.
The essence of incremental costing is to measure the cost incurred because a product is sold, or not incurred because it is not sold. There are four common errors that managers frequently make when attempting to develop useful estimates of true costs:
1. Beware of averaging total variable costs to estimate the cost of a single unit. The average is correct only when unit variable costs are constant.
2. Beware of accounting depreciation formulas. The relevant expense is the true decline in an asset's resale value.
3. Beware of treating a single cost as either all relevant or all irrelevant for pricing. The same cost may have both a fixed and a variable component, or may be only partially sunk.
Beware of overlooking opportunity costs. An opportunity cost is the profit that must be forgone when an asset is used to produce the product being priced rather than some other product

8. Estimating Relevant Costs* Pages 191 - 192
Four Common Errors mangers frequently make when attempting to develop estimates of true costs: (Page 191 &192)
Beware of averaging total variable costs to estimate the cost of a single unit, incremental cost per unit is not constant
Beware of accounting depreciation formulas. The relevant depreciation expense that should be used for all managerial decision making is the change in the current value of assets. For pricing and any other managerial decision making, however, depreciation expenses should be based on forecasts of the actual decline in the current market value of assets as a result of their use.
Beware of treating a single cost as either all relevant or all irrelevant for pricing. Costs should be divided into the portion that is relevant for pricing and the portion that is not.
Beware of overlooking opportunity costs. Opportunity cost is the contribution that a firm forgoes when it uses assets for one purpose rather then another.* Airlines use yield management systems to control and exploit the most important cost for ticket pricing: the opportunity cost of its capacity.* (Page 195 – Airlines seats – Discount vs. Full price)

9. Identify Incremental Fixed Costs – Page 193
Some fixed costs are also incremental for pricing
They are the fixed costs incurred to implement a change in pricing. (The fixed cost for a restaurant to print menus with NEW prices)
- If fixed costs change because of a change in price, then those incremental fixed costs are relevant to pricing. For example, if you must advertise a price change, it is relevant.
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
A helpful rule of thumb is: If fixed costs change because of a change in price, then those incremental fixed costs are relevant to pricing. For example, if you must advertise a price change, it is relevant.
However, fixed costs are always treated as “lumps” of costs, and not converting them to fixed costs per unit terms.
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

10. Identify Incremental Opportunity Costs – Page 195
Beware of overlooking or ignoring opportunity costs.
They are often incremental, even when associated with otherwise “fixed” assets.
Box 8-2 – Opportunity Costs: A Practical Illustration
Examples:
Alternative uses of capacity, funds, or management time.
Ask students to suggest examples of opportunity costs in the marketplace. It will be difficult because they are not accustomed to thinking this way. A couple of examples they may be familiar with:
Cell phone companies charge much higher prices for calls placed during business hours. This is because demand usually bumps up against capacity during these hours. Either they must add capacity to handle peak demand like this, or they can raise prices to those customers that must have access during the business day. These higher prices reflect the higher cost to serve peak customers; because demand is so high the company must turn away some customers who want access, or delay access risking that they will lose the call and perhaps the customer. These are opportunity costs -- the profit contribution foregone because the company chooses to serve some peak customers while turning others away.
Ask students if they know which airports Southwest Airlines chooses to fly into. If you want to fly to Boston you cannot -- you must fly to either Providence, RI or Manchester, NH. To fly to New York City, you must fly to Islip, Long Island -- some distance from the City. Why fly into these smaller airports? Because they are much less congested than the major airports like Boston’s Logan Airport, or New York’s LaGuardia or Kennedy Airports. Southwest’s business model is based on low cost and low price -- which means they must fill their planes to capacity. They must arrive and depart on time; if they did not passengers would miss the flight, leaving the plane partially empty when it took off. Furthermore, they would have turned away customers because of missed schedules that otherwise could have flown with them -- an opportunity cost of flying out of Boston or New York City where airport congestion usually results in some scheduling delays.

11. Costing Discussion Questions
In the mid 1960s, McDonald's offered their franchisees breakfast items (e.g., Egg McMuffin) that they could offer in the mornings when demand for hamburgers and fries was not very large.
What costs should a franchisee have properly considered in deciding whether to offer a breakfast menu and in determining the most profitable prices to charge for breakfast items?
Answer: Relevant costs should be incremental. That is, the additional costs incurred as a result of offering the items. Those are the costs of the food and the additional costs of labor and utilities incurred as a result of offering the breakfast menu. You should not include a prorated share of the cost of the building, real estate taxes, and other overhead as a cost of offering the breakfast menu since those costs are incurred regardless of whether the menu is offered. Breakfast items could be highly profitable even if the contribution earned on them could not cover a proportionate share (per dollar of revenue or hour of operation) of the fixed costs.

12. Reorganize Costs for Effective Management
Incremental Costing
For simple pricing decision
For pricing with incremental investment
Total Costing
For measuring overall business profitability
unit Price
incremental VC per unit
= contribution margin / unit
incremental revenue
incremental variable cost
= incremental contribution
incremental fixed costs
= Net incremental
contribution
sales revenue
total variable costs
= total contribution
net contribution
non-incremental fixed
and sunk costs
= net profit
Discuss problems with financial accounting data that require adjustments to make it managerially useful. You might do this through class discussion by asking the following questions:
Why is the relevant unit variable cost for pricing not necessarily equal to the firm's total expenditure on variable costs divided by its total sales?
Why is the number reported for "depreciation" on a company's income statement not necessarily the relevant depreciation for pricing?
Why might part of a cost (e.g., variable labor, the cost of a machine) be relevant for pricing but the remainder be irrelevant?
* What are opportunity costs and how do they relate to pricing? How is it that one can have an opportunity cost to use a piece of equipment for which the original purchase cost is entirely sunk?

13. Determine The Contribution Margin
PER UNIT Price
- Incremental Variable Costs
= Contribution Margin ($, %)
TOTAL Sales Revenue
- Total Variable Costs
= Total Contribution ($, %)
Accurate costs are especially relevant to the calculation of the Contribution Margin. If variable costs are inflated then CM will be smaller, leading managers to believe they have less margin available to compete with -- to retaliate against price-cutting competitors, or to reach price sensitive segments. This happens frequently with overhead burdens -- fixed overhead allocations per unit produced.
Ask students: When a firm allocates overhead burdens to each unit produced or sold how do these burdens affect variable costs and CM?
Answer: These overhead burdens are actually fixed costs, but when allocated they behave like variable costs -- that is, the more units you sell the greater your total variable costs appear to be, because many of your fixed costs have been converted into variable costs -- which of course is simply wrong.

14. Why Focus on CM?* Page
The percent contribution margins the share of price that adds to profit or reduces losses*
Contribution margin - The amount remaining from sales revenues after all variable expenses have been deducted (Contribution Margin = sales - variable costs)
Contribution margin- is the amount generated by sales to cover fixed costs, and it is important to identify these costs correctly.
Tool of Competitive Advantage – Page 198
Relative advantage
The percent contribution margin is a measure of the leverage between a firm’s sales volume and its profit. It indicates the importance of sales volume as a marketing objective.
Tool for Segmentation Pricing – Page 199
Set different prices for different segments
Can reach more segments
The percent contribution margin is an indicator of the firm’s ability to compete against competitors.
Why is the integrity of the CM so important?
Products with greater contribution margins have a competitive advantage over competitors with lower margins, because they have more margin available to use to retaliate and protect customers and customer segments.
A larger margin enables the firm to reach more segments in the marketplace -- those willing to pay higher prices, and those more price sensitive segments willing to pay only lower prices.
Margins define how to best leverage profitability. For high margin market segments, the best way to leverage greater profits is by driving sales volume -- volume-based strategies. For low margin segments, the best way to leverage greater profits is by either raising prices or bundling other products or services to augment low margins with higher margins add-ons.

15. Why Focus on CM?* Page
Indicator of how to drive profitability – Page 199
High margin: volume-based strategies
Low margin: price and bundling strategies
The percent contribution margin is a measure of the extent to which you can use segmentation pricing to serve and penetrate multiple market segments.
Segmentation pricing – means setting different prices for different market segments, each of which has a different cost to serve and different level of price sensitivity.*
For a given product the greater your percent contribution margin, the more flexibility you have to set higher prices for some customer segments and lower prices for other segments. (Page 199)
* The most important reason to identify costs correctly is to be able to calculate an accurate contribution margin* Page 204

16. Transfer Pricing Issues – Page 199
Question
Answer
Which costs are relevant to a pricing decision?
Incremental costs
How does external sourcing affect relevant costs?
Incrementalize non-incremental costs
Cost disadvantage
Reliance on price instead of volume
Who is affected?
Independent suppliers
How should fixed costs be dealt with?
Operating decisions vs. investment decisions

17. 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!

18. Chapter 8 Costs How Should they Affect Pricing Decisions?
The Strategy and Tactics of Pricing, 4E Thomas Nagle and John Hogan