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Strategy Strategy Management of Management of Price, Cost, and Price, Cost, and

QualityQuality

Strategy Strategy Management of Management of Price, Cost, and Price, Cost, and

QualityQuality

CChaptehapterr

99

Prepared by Douglas Cloud

Pepperdine University

Prepared by Douglas Cloud

Pepperdine University

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.

ObjectivesObjectivesObjectivesObjectives

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

ContinuedContinuedContinuedContinued

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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.

ObjectivesObjectivesObjectivesObjectives

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Traditional Cost-Based PricingTraditional Cost-Based Pricing

Determine customer wantsDetermine customer wants

Design product to meet Design product to meet customer wantscustomer wants

Determine Determine manufacturing or manufacturing or

service proceduresservice procedures

Determine Determine necessary necessary materialsmaterials

Next Slide

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Sell

Des

ign

prod

uct t

o m

eet c

usto

mer

wan

tsTraditional Cost-Based PricingTraditional Cost-Based Pricing

Determine price:Determine price:1.1. Predict selected costs.Predict selected costs.2.2. Add markup for other costs.Add markup for other costs.3.3. Add additional markup to Add additional markup to

achieve desired profit.achieve desired profit.

The resulting price is evaluated:The resulting price is evaluated:1.1. If acceptable, manufacture and sell.If acceptable, manufacture and sell.2.2. If unacceptable, redesign.If unacceptable, redesign.

Previous Slide

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Economic Approaches to PricingEconomic Approaches to PricingEconomic Approaches to PricingEconomic Approaches to Pricing

Economic models provide a useful framework for thinking

about pricing decisions.

Economic models provide a useful framework for thinking

about pricing decisions.

Despite their conceptual merit, economic models are seldom

used for pricing decisions.

Despite their conceptual merit, economic models are seldom

used for pricing decisions.

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Cost-Based Approaches to PricingCost-Based Approaches to PricingCost-Based Approaches to PricingCost-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.

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Cost-Based Pricing in Single-Cost-Based Pricing in Single-Product CompaniesProduct Companies

Cost-Based Pricing in Single-Cost-Based Pricing in Single-Product CompaniesProduct Companies

Assume Bright Rug Cleaners annual facilities

costs are $200,000

Assume Bright Rug Cleaners annual facilities

costs are $200,000The unit cost of cleaning a rug is $10.

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.

Management desires to achieve an annual profit of

$30,000 on an annual volume of

10,000 rugs.

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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-Cost-Based Pricing in Single-Product CompaniesProduct Companies

Cost-Based Pricing in Single-Cost-Based Pricing in Single-Product CompaniesProduct Companies

Solving for the price:

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For markups based on behavior and function, the possible cost bases include--

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-Cost-Based Pricing in Multiple-Product CompaniesProduct Companies

Cost-Based Pricing in Multiple-Cost-Based Pricing in Multiple-Product CompaniesProduct Companies

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For markups based on activity hierarchy, the possible cost bases include--

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-Cost-Based Pricing in Multiple-Product CompaniesProduct Companies

Cost-Based Pricing in Multiple-Cost-Based Pricing in Multiple-Product CompaniesProduct Companies

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Cost-Based Pricing in Multiple-Cost-Based Pricing in Multiple-Product CompaniesProduct Companies

Cost-Based Pricing in Multiple-Cost-Based Pricing in Multiple-Product CompaniesProduct Companies

Markup on cost base =

Costs not included in the base + Desired profit

Costs included in the base

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Variable Cost BasisVariable Cost BasisVariable Cost BasisVariable 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.

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 CostsMarkup on Variable Costs

Fixed costs

+ Desired profit

Variable costs and expenses

$400,000 + $200,000

$800,000= 0.75

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Variable Cost BasisVariable Cost BasisVariable Cost BasisVariable 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

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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.

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 CostsMarkup on Manufacturing Costs

Full Manufacturing Cost BasisFull Manufacturing Cost BasisFull Manufacturing Cost BasisFull Manufacturing Cost Basis

Desired profitFixed mfg. costs +

All costs and expenses besides fixed manufacturing costs

$300,000 + $200,000

$900,000= 0.556

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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 BasisFull Manufacturing Cost BasisFull Manufacturing Cost BasisFull Manufacturing Cost Basis

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Drawbacks to Cost-Based PricingDrawbacks to Cost-Based PricingDrawbacks to Cost-Based PricingDrawbacks 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.

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Robinson-Patman ActRobinson-Patman ActRobinson-Patman ActRobinson-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--

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next slide

Target CostingTarget Costing

Determine customer wants and price sensitivity.

Planned selling price is set.

Target cost is determined as: Selling price – Desired profit

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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 CostingTarget Costing

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Once target cost is achieved, manufacturing begins and

product is sold.

SellSell

Target CostingTarget Costing

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Understanding target costing requires market knowledge. Managers must

understand that target costing is not just about setting cost targets.

Understanding target costing requires market knowledge. Managers must

understand that target costing is not just about setting cost targets.

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Target costing first involves translating customer value expectations into an acceptable

product price. Next, the profit that shareholders expect to make is determined.

Target costing first involves translating customer value expectations into an acceptable

product price. Next, the profit that shareholders expect to make is determined.

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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.

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.

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Target costing Target costing reduces the time to reduces the time to

introduce new introduce new products.products.

Target costing Target costing reduces the time to reduces the time to

introduce new introduce new products.products.Target costing can be Target costing can be

applied to applied to components.components.

Target costing can be Target costing can be applied to applied to

components.components.Target costing Target costing requires detailed cost requires detailed cost

information.information.

Target costing Target costing requires detailed cost requires detailed cost

information.information.

Target costing Target costing requires requires

coordination.coordination.

Target costing Target costing requires requires

coordination.coordination.Short product Short product

life cycles life cycles increase the increase the

importance of importance of target costing.target costing.

Short product Short product life cycles life cycles

increase the increase the importance of importance of target costing.target costing.

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Advantages of Target CostingAdvantages of Target CostingAdvantages of Target CostingAdvantages of Target Costing

• Proactive approach to cost management

• Orients organization toward customer

• Breaks down barriers between departments

• Enhances employee awareness and empowerment

ContinuedContinuedContinuedContinued

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Advantages of Target CostingAdvantages of Target CostingAdvantages of Target CostingAdvantages of Target Costing

• Fosters partnerships with suppliers

• Minimize nonvalue-added activities

• Encourages selection of lowest cost value-added activities

• Reduced time to market

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Disadvantages of Target CostingDisadvantages of Target CostingDisadvantages of Target CostingDisadvantages of Target Costing

Effective use requires the development of detailed cost data

Requires willingness to cooperate

Requires many meetings for coordination

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Product Life CycleProduct Life Cycle

StartupStartup Sales are low

Selling price usually is high

Customers tend to be affluent

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Product Life CycleProduct Life Cycle

StartupStartup

GrowthGrowthSales increase at the product gains acceptance.

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Product Life CycleProduct Life Cycle

StartupStartup

GrowthGrowth

Sales level off as the product

matures.

MaturityMaturity

Some reduction in selling price may

be necessary.

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Product Life CycleProduct Life Cycle

StartupStartup

GrowthGrowth

MaturityMaturity

DeclineDecline

Sales decline as the product become

obsolete.

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Product Marketing Life Cycle(Relatively long-lived products)

Product Marketing Life Cycle(Relatively long-lived products)

Periodic Sales

Time

Startup Growth Maturity DeclineStartup Growth Maturity Decline

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Product Marketing Life Cycle(Relatively short-lived products)

Product Marketing Life Cycle(Relatively short-lived products)

Periodic Sales Startup Growth Maturity DeclineStartup Growth Maturity Decline

Time

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The Commitment and Expenditure of The Commitment and Expenditure of Money for High-Technology Products Money for High-Technology Products

and Relatively Short Product Lifeand Relatively Short Product Life

The Commitment and Expenditure of The Commitment and Expenditure of Money for High-Technology Products Money for High-Technology Products

and Relatively Short Product Lifeand Relatively Short Product Life

100

Per

cent

of

tota

l cos

ts

Time

Conception Design Pre- Production Support Production

Cumulative commitment of

moneyCumulative expenditure of

money

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Continuous Improvement CostingContinuous Improvement CostingContinuous Improvement CostingContinuous Improvement Costing

It is continuous improvement costing. It calls for establishing cost

reduction targets for products or services.

It is continuous improvement costing. It calls for establishing cost

reduction targets for products or services.

What is Kaizen

costing?

What is Kaizen

costing?

Successful world-class companies use

Kaizen to avoid complacency.

Successful world-class companies use

Kaizen to avoid complacency.

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Quality CostsQuality CostsQuality CostsQuality Costs

Quality is conformance to customer

expectations.

Quality is conformance to customer

expectations.Successful companies know they must meet

customers’ quality and price expectations.

Successful companies know they must meet

customers’ quality and price expectations.

Quality is an essential element of the JIT

approach to inventory management.

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

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Quality of Design andQuality of Design and Quality of Conformance Quality of ConformanceQuality of Design andQuality of Design and

Quality of Conformance Quality of ConformanceStep 1: Determine customer expectationsStep 2: Develop functional specifications

for the product or serviceStep 3: Turn functional specifications into

design specificationsStep 4: Develop detailed specificationsStep 5: Deliver a product in conformance

with the design specifications

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Success Requires Quality of Success Requires Quality of Design and ConformanceDesign and Conformance

Success Requires Quality of Success Requires Quality of Design and ConformanceDesign and Conformance

Qua

lity

of

Des

ign

High

Low

Quality of ConformanceLow High

Do Right Things Wrong (Failure)

Do Wrong Things Wrong (Failure)

Do Wrong Things Right (Failure)

Do Right Things Right

(Winner!)

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Types of Quality CostsTypes of Quality CostsTypes of Quality CostsTypes of Quality Costs

Preventive costs are incurred to prevent

nonconforming products from being

produced or nonconforming

services from being performed.

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.

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.

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.

External failure costs occur when

nonconforming products are services

are delivered to customers.

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Appraisal and internal failure costs are better

than external failure costs.

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.

But, the way to reduce total quality costs is to

spend money on prevention.

Types of Quality CostsTypes of Quality CostsTypes of Quality CostsTypes of Quality Costs

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Quality Trend AnalysisQuality Trend Analysis

20 -

18 -

16 -

14 -

12 -

10 -

8 -

6 -

4 -

2 -

0 -1 2 3 4 5 6

External failure

Internal failure

AppraisalPrevention

Period

Per

cent

of

Sale

s

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Short-Run Analysis of the Short-Run Analysis of the Economics of QuantityEconomics of Quantity

Short-Run Analysis of the Short-Run Analysis of the Economics of QuantityEconomics of Quantity

0 Percent conforming to design specifications 100

Total Costs

Total quality control

Internal and external failure

Prevention and appraisal

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BenchmarkingBenchmarking

Benchmarking is a systematic approach to

identifying the best practices to help an organization take

action to improve performance.

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.

Benchmarking is no longer regarded

as spying.

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Alcoa’s Approach to Alcoa’s Approach to BenchmarkingBenchmarking

Alcoa’s Approach to Alcoa’s Approach to BenchmarkingBenchmarking

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

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CChapter

99

The The EndEndThe The EndEnd

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