pricing decisions
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Pricing DecisionsPricing DecisionsEMBA 5411
Budgeting and Pricing
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Pricing External sales- outside
Target costing Cost plus pricing Variable cost pricing Time and material pricing
Internal-within the company among divisions Negotiated transfer prices Cost based transfer prices Market based transfer prices Effect of outsourcing on transfer prices Transfers between divisions in different countries
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Profit MaximizationEconomic Theory
The quantity demanded is a function of the price that is charged
Generally, the higher the price, the lower the quantity demanded
Pricing Management should set the price that provides
the greatest amount of profit
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Quantity made
and soldper month
Determining the Profit-Maximizing Price and QuantityDollars
per unit
Demand
Marginalrevenue
q*
p*
Marginalcost
Profit is maximized where marginal cost equals
marginal revenue, resultingin price p* and quantity q*.
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Determining the Profit-Maximizing Price and Quantity
Total revenueDollars Total cost
Total profit at the profit-maximizingquantity and price,
q* and p*.
Quantity made
and soldper month
q*
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Price Elasticity
The impact ofprice changes on
sales volume
Demand is elastic ifa price increase has alarge negative impact
on sales volume.
Demand is inelastic ifa price increase has
little or no impact on sales volume.
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Who determines the price?
Price takers- when there is a competitive market and the company has no influence on price Once competition enters the market, the price of a
product becomes squeezed between the cost of the product and the lowest price of a competitor.
Price makers- companies that influence the price
• Organizations that choose to compete by offering innovative products and services have a more difficult pricing decision because there is no existing price for the new product or service.
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Influences on Price Customer demand Competitors’ behavior/prices/actions Costs Regulatory environment – legal, political
and image related
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Pricing approaches Cost plus mark-up
Variable – contribution margin approach, contribution margin( reflecting mark-up) should cover desired return on investment, all fixed costs
Absorption – common- mark-up covers all expenses except cost of goods sold plus the desired return on investment
Target costing – price is known, desired return on investment is known, price is known = determine the maximum cost per unit
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Product Life Cycle
http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf
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Life Cycle Costing Life cycle costs are the total costs
estimated to be incurred in the design, development, production, operation, maintenance, support, and final disposition of a product/system over its anticipated useful life span (Barringer and Weber, 1996).
The best balance among cost elements is achieved when the total LCC is minimized (Barringer and Weber, 1996).
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Cost-plus Pricing Cost + mark-up = price Mark-up = cost x desired % return
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Which cost? Variable manufacturing costPrice= vari.man. costs + markup% * var.man.costMark-up should cover the remaining costs and
provide for the desired profit, i.e. variable selling and all fixed costs
Desired profit = desired % return * investment
itproducednumberofuntperunitman
fitdesiredprotsfixedsellingmarkup
*cos..var
cos.var%
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Which costs? Total variable costs
Variable manufacturing and selling costs
Price= variable costs + markup %* variable costs
itproducednumberofuntperunitiable
fitdesiredprotsfixedmarkup
*cosvar
cos%
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Which costs? Absorption – manufacturing costs Unit manufacturing costs – both variable
and fixed
Price= unit manuf. cost + markup %* unit manufacturing cost
itproducednumberofuntunitmanuf
fitdesiredproensesadmsellingandmarkup
*cos.
exp.%
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Which costs? Absorption – total costs
Total costs – manufacturing and selling and administrative –fixed (direct or allocated, variable costs)
Price= unit cost + markup %* unit cost
itproducednumberofuntunit
fitdesiredpromarkup
*cos%
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Example - PricingAnnual production 480 unitsUnit costs:
Variable manufacturing cost $ 400Applied fixed manufacturing cost $ 250Absorption manufacturing cost $ 650Variable selling costs $ 50Allocated and direct fixed selling and administrative costs
$ 100Total cost $ 800
Investment $ 600,000Desired profit 10% of investment $ 60,000Annual Fixed Manufacturing Costs $ 120,000Annual Fixed (allocated and direct) Selling and Administrative
Costs $ 48,000
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Cost Plus Pricing Versionsvariable manufacturing cost-plus-pricingVariable manufacturing cost $400
Total Variable Selling Costs ($50 x 480 units) $24,000mark -up % 131.25%markup $525Price = cost + markup $925
variable total cost-plus-pricingTotal variable cost per unit $450
mark -up % 105.56%markup $475Price = cost + markup $925
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Cost Plus Pricing Versionsabsorption manufacturing cost-plus-pricingmanufacturing cost per unit $650
Total variable selling costs $24,000mark -up % 42.31%markup $275Price = cost + markup $925
total absorption- cost-plus-pricingmanufacturing cost per unit $800
mark -up % 15.63%markup $125Price = cost + markup $925
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Time and Material Pricing Determine a charge for labor that includes
overhead Determine a charge for materials that
includes handling and storage costs Include a profit Sum = price Used in service companies mainly;
appropriate for construction companies as well
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ExampleInvestment $700,000.00Desired profit 10% of investment $70,000.00Annual labor hours 10,000Hourly charge to cover profit margin $7.00
Labor rate per hour $18.00Annual overhead costs:
Material handling and storage $40,000.00
Other overhead costs(supervision,utilities, insurance,and depreciation) $200,000.00
Annual cost of materials used in repair department $1,000,000.00
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Time and Material ChargesTime Charge per hour = hourly labor cost + annual overhead (excluding material overhead) / annual labor hours+ hourly charge to cover profit margin
= $18 + ($200,000 / 10,000 hours) + $7 = $ 45 per hour
Material Charge formulaMaterial cost incurred on job
+[material cost incurred on job *(material handling and storage costs /
annual cost of materials used in Repair department)] = material costs incurred on job +[material costs incurred on job
($40,000/$1,000,000)]=1.04 x material costs incurred on job
4% of material costs
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Example con’tJOB NO 101Labor hours 200cost of materials $8,000
total price of job 101material cost $8,000handling and storage $320 total material cost $8,320.00
Labor rate $45.00labor hours 200
$9,000.00TOTAL COST OF JOB 101 $17,320.00
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Internal Pricing – Transfer pricing issueTransfer Price is:
the internal price charged by one segment of a firm for a product or service supplied to another segment of the same firm
Such as: Internal charge paid by final assembly division for
components produced by other divisions Service fees to operating departments for
telecommunications, maintenance, and services by support services departments
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Effects of Transfer Prices Performance measurement: Reallocate total company profits among business segments Influence decision making by purchasing, production, marketing, and
investment managers
Rewards and punishments: Compensation for divisional managers
Partitioning decision rights: Disputes over determining transfer prices
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Ideal Transfer PricingIdeal transfer price would be Opportunity cost, or the value forgone by not using
the transferred product in its next best alternative use
Opportunity cost is the greater of variable production cost or revenue available if the product is sold outside of the firm
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Transfer Pricing Methods External market price
If external markets are comparable Variable cost of production
Exclude fixed costs which are unavoidable Full-cost of production
Average fixed and variable cost Negotiated prices
Depends on bargaining power of divisions
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Transfer Pricing Implementation
Disputes over transfer pricing occur frequently because transfer prices influence performance evaluation of managers
Internal accounting data are often used to set transfer prices, even when external market prices are available
Classifying costs as fixed or variable can influence transfer prices
determined by internal accounting data
To reduce transfer pricing disputes, firms may reorganize by combining interdependent segments or spinning off some segments as separate firms
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Transfer Pricing for International TaxationWhen products or services of a multinational firm are transferred between
segments located in countries with different tax rates, the firm attempts to set a transfer price that minimizes total income tax liability.
Segment in higher tax country:Reduce taxable income in that country by charging high prices on imports and low prices on exports.
Segment in lower tax country:Increase taxable income in that country by charging low prices on imports and high prices on exports.
Government tax regulators try to reduce transfer pricing manipulation.
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