Cost Informationfor

Pricingand

Product Planning

Chapter 6

Role Of Product Costs In Pricing And Product Mix Decisions

• Understanding how to analyze product costs is important for making pricing decisions:– Managers make decisions about establishing or

accepting a price for their products– Even when prices are set by the market 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

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

Short-term and Long-termPricing Considerations

• The costs of many resources are likely to be committed costs in the short-term because firms cannot easily alter the capacities made available for many production and support activities– For short-term decisions, it is important to note

whether surplus capacity is available for additional production, or whether shortages of available capacity limit additional production alternatives

Short-term and Long-termPricing Considerations

• The length of time a firm must commit its production capacity to fill that order is important 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

Short-term and Long-termPricing Considerations

• If production is constrained by inadequate capacity, managers need to consider whether overtime production or the use of subcontractors can help 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

Ability To Influence Prices

– 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:

– Such a firm is a price taker, and it chooses its product mix given the prices set in the marketplace for its products

Ability To Influence Prices– Firms in an industry with relatively little

competition, who enjoy large market shares and exercise industry leadership, must decide what prices to set for their products

– Firms in industries in which products are highly customized or otherwise differentiated from each other also need to set the prices for their differentiated products

– Such firms are price setters

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 as

given and then decides how many units of each product it should produce and sell

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– Managers must decide which costs are

relevant to the short-term product mix decision

– Managers may have little flexibility to alter the capacities of some of the firm’s resources in the short-run

Example - Garment Manufacturer• Chunling 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

Example - Garment Manufacturer• 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

• Varying with the quantity of each garment produced are:– The costs of direct materials– The direct labor that is paid on a piece-rate basis

• Inspectors are paid a monthly fixed salary, but they are employed as required to support the production of different garments

Example - Garment Manufacturer

• If its capacity were unlimited, the company could produce garments to fill the maximum demand for them

• Capacity is constrained, however, and therefore the company must decide how best to deploy this limited resource

• The capacity is fixed in the short-term, so the company must plan production to maximize the contribution to profit earned for every available machine hour used

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

• Because its production capacity is limited, the company must cut back the production of some other garment to enable it 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

The Impact Of Opportunity Costs

• The lost profit in this case would be the contribution on the goods it will not make

• 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

Short-Term Pricing Decisionsfor 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

Determining a Bid Price

• Assume that the full costs for the job are estimated to be $28,500

• Setting the price of a product also means determining a markup percentage above cost, an approach known as cost-plus pricing– Cost-plus pricing - the markup percentage is

determined by a company’s desired profit margin and overall rate of return

– The company has decided the markup percentage is normally to be 40% of full costs

Determining a Bid Price• If the bid request came from a regular customer,

the bid price would have been $39,900= 1.40 x $28,500

• But for this special order from a new customer, what is the minimum acceptable price?

• One of the critical factors to consider is the level of available surplus capacity

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

• 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

No Available Surplus Capacity• 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

• More machine maintenance and plant engineering activities will be necessary

No Available Surplus Capacity• the company 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)

No Available Surplus Capacity

• The minimum acceptable price in this case is $32,500 ($22,000 + $10,500)

• The minimum acceptable price must cover all incremental costs

Long-Term Pricing Decisionsfor Price Setters

• 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

Use of Full Costs in Pricing

• 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

Use of Full Costs in Pricing

• 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

Use of Full Costs in Pricing

• 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

Fluctuating Prices

• 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

Fluctuating Prices

• 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

• 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

The Markup Rate

• Just as prices depend on demand conditions, markups increase with the strength of demand

• Markups also depend on the elasticity of demand

• Markups also fluctuate with the intensity of competition

The Markup Rate• 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 garner market share

– Firms sometimes employ a skimming price strategy where initially a higher price is charged to customers who are willing to pay more for the privilege of possessing the latest technological innovations

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

• 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

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, or2. 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

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

• The role of cost information also depends on the time frame involved in the decision

Economic Analysis of the Pricing Decision

Appendix 6-1

Quantity Decision

• Introductory textbooks in economics usually analyze the profit maximization decision by a firm in terms of the choice of a quantity to produce. In turn, the quantity choice determines the price of the product in the marketplace

• Economists present the quantity choice in terms of equating marginal revenue and marginal cost

Quantity Decision

• The firm chooses the quantity level, and the market demand conditions determine the corresponding price

• The firm that must choose a price, not a quantity, to announce to its customers

• Customers react to the price announced and determine the quantity that they demand

• The price decision analysis uses differential calculus to analyze the firm’s pricing decision

Pricing Decision

• Total costs, C, expressed in terms of its fixed and flexible cost components are: C = f + vQ,– Where f is the committed cost, v is the flexible

cost per unit, and Q is the quantity produced in units

• Quantity produced is assumed to be the same as quantity demanded

• The demand, Q, is represented as a decreasing linear function of the price P: Q = a – bP

• A higher value of b represents a demand function that is more sensitive (elastic) to price

Pricing Decision

– An increase of a dollar in the price decreases demand by b units

• A higher value of a reflects a greater strength of demand for the firm’s product. For any given price, P, the demand is greater when the parameter, a, has a higher value

• The total revenue, R, is given by the price, P, multiplied by the quantity sold, Q. Algebraically, we write this:

R = PQ = P(a – bP)

= aP – bP2• The profit, Π, is measured as the difference between the

revenue, R, and the cost, C:

Pricing DecisionΠ = R - C

= PQ - (f + vQ)

= P(a - bP) - F - v(a - bP)

= aP - bP2 - F - va + vbP • To find the profit-maximizing price, P*, we set the first

derivative of profit P with respect to P equal to zero:

dΠ /dP = A – 2bP + vb = 0• This equation implies:

P* = (a + vb)/2b = a/2b + v/2

Long-Term Benchmark Prices

• This simple economic analysis suggests that the price depends only on v, the flexible cost per unit

• A more complex analysis that considers simultaneously the pricing decision and the long-term decisions of the firm to commit resources to facility-sustaining, product-sustaining, and other activity capacities indicates that the costs of these committed resources do play a role in the pricing decision

• The costs of these committed activity resources appear to be committed costs in the short-term, but they can be changed in the long-term

Long-Term Benchmark Prices (2 of 2)

• The prices that a firm sets and adjusts in the short term, based on changing demand conditions, fluctuate around a long-term benchmark price, pL, that reflects the unit costs of the activity resource capacities:

pL = a/2b + (v + m)/2• m = f ÷ X is the cost per unit of normal capacity, X, of

facility-sustaining activities• the degree of price fluctuations around the benchmark

price increases with the proportion of committed costs• prices appear more volatile in capital-intensive industries

where a large proportion of costs are for facility-sustaining activities

Competitive Analysis (1 of 3)

• In a situation when other firms compete in the same industry with products that are similar but not identical to each other, some customers may switch their demand to a competing supplier if the competitor reduces its price

• Consider two firms, A and B, and represent the demand, QA, for firm A’s product as a function of its own price, PA, and the price, PB, set by its competitor:

QA = a – b PA + e PB

• The demand for firm A’s product falls by b units for each dollar increase in its own price, but increases by e units for each dollar increase in the competitor’s price, because firm A gains some of the market demand that firm B loses

Competitive Analysis (2 of 3)

• The profit, PA, for firm A is represented by the following:

Π A = PA QA - (f + v QA)

Π PA(a - b PA + e PB) - f - v(a - b PA + e PB)

• Profit maximization requires this:d π A ÷ d PA = a - 2b PA + e PB + vb = 0

• Therefore, the profit-maximizing price PA0 given

the other firm’s price PB is:PA

0 = (a + vb + e PB) ÷ 2b

• The pricing decision thus depends on what the competitor’s price is expected to be

Competitive Analysis (3 of 3)

• If the firm expects its competitor to behave as it does and expects it to choose the same price as its own, then we set PA = PB = P* in the equation

a - 2b PA 1 + e PB + vb = 0 to obtain:

a - 2bP* + eP* + vb = 0

P* = a + vb/2b - e• This price is the equilibrium price, because no

firm can increase its profits by choosing a different price provided the other firm maintains the same price P*