COSTING FOR PRICING DECISIONS

1. COSTING FOR PRICING DECISIONS Gerald E. Smith, D.B.A. Carroll School of Management Boston College

2. PROFITABLE PRICING REQUIRES UNDERSTANDING THE TRUE COST The true cost is the cost incurred if a sale is made, or the cost not incurred if a sale is not made. IDENTIFYING TRUE COSTS Incremental (not the “full cost”) Avoidable (not the “sunk cost”)

3. THE FOCUS OF PROFITABLE PRICING Price $10 Unit Sales Volume 100,000 Total Revenue $1,000,000 Unit Variable Costs $3 Total Variable Costs $300,000 Unit Contribution $7 Total Contribution $700,000 Fixed Costs $500,000 Net Income Before Taxes $200,000

4. 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.

5. IDENTIFY INCREMENTAL FIXED COSTS SOME FIXED COSTS ARE ALSO INCREMENTAL FOR PRICING. They are the fixed costs incurred to implement a change in pricing. 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

6. IDENTIFY INCREMENTAL OPPORTUNITY COSTS 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. Beware of overlooking or ignoring opportunity costs. They are often incremental, even when associated with otherwise “fixed” assets. Examples: Alternative uses of capacity, funds, or management time.

7. SUNK COST FALLACY: WHICH COST IS RELEVANT INITIAL SITUATION Price Per Unit $22.50 Historical & Replacement Cost 13.50 Profit Contribution Per Unit 9.00 Cash Flow Per Unit 9.00 AFTER COST INCREASE Price Per Unit $22.50 Historical Cost 13.50 Replacement Cost 15.00 Profit Contribution Per Unit 9.00 Cash Flow Per Unit 7.50

8. COST ANALYSIS FOR PRICING DECISIONSBoscot Corporation TOTAL $/UNIT TRUE COST Direct Labor $144,000 $24 __________ Materials 42,000 7 __________ Plant & Equipment 216,000 36 __________ Sales & Marketing 12,000 2 __________ Order Process & Ship 24,000 4 __________ Warehousing 18,000 3 __________ General & Admin 66,000 11 __________ TOTAL $522,000 $87 What is the relevant unit cost?

9. USEFUL INFORMATION ABOUT BOSCOT Direct Labor Overtime pay is 1.5 times normal pay. Plant & Equipment Depreciated according to IRS rules. Marketing & Sales New salespeople must be hired, and a new promo program produced to target new buyers. Expected cost $6,000, regardless of sales actually generated. Order Process & Ship Buyers in new market segment order in quantities half the size of orders of current customers. Warehousing Owns and rents warehouse space. Warehousing for 1,500 units is charged at $4,500 of original building & maintenance. To warehouse 1,500 more units Build addition towarehouse at charge of $6,500; Stop leasing space to other companies, which earns rents of $6,000 per week. General & Admin Corporate overhead, R&D, etc

10. Reorganize Costs for Effective Management! PER UNITINCREMENTALTOTAL (for simple pricing decisions) (for pricing with (for determining overall incremental investment) business profitability) Price Incremental Revenue Sales Revenue - Unit Variable Cost - Incre. Variable Cost - Total Variable Costs Contribution Margin Incremental Contribution Total Contribution - Incremental Fixed Costs - Incremental Fixed Costs Net Incre. Contribution Net Contribution - Nonincremental Fixed and Sunk Costs Net Profit

11. 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!

12. WHY FOCUS ON CM • Tool of Competitive Advantage • Relative Advantage • Relative Cost • Tool for Segmentation Pricing • Set different prices for different segments • Can reach more segments • Indicator of how to drive profitability • High Margin: Volume-based Strategies • Low Margin: Gross Profit Bundling Strategies

13. Strategic Models to Manage the Business Unit Gross Profit Strategy Corporate Strategy Operating Strategy

14. Figure 1Incremental Gross Profit Strategies Volume-Based Gross Profit Strategies -- drive volume across the market Price/Bundling Gross Profit Strategies -- drive gross profit bundles through target segments Segment A Margin Margin Segment A Incr Cost Service Y Product A Margin Segment B Incr Cost Segment B Segment C Segment C Margin Margin Incremental Cost Segment D Service Z Segment D Product B High Margin Product Incr Cost Segment E Segment E Margin Margin Service X Product C TOTAL GROSS PROFIT TOTAL GROSS PROFIT Incr Cost Incr Cost

15. Figure 2Customer Opportunity Portfolio andGross Profit Strategies for Low Margin Managers Customized Bundling Strategies High-Differentiation Volume Strategies Low Price Sensitivity Custom Solution or Specialty Buyers Loyal Volume Buyers Higher relative prices, greater brand loyalty Convenience Bundling Strategies Platform Bundling Strategies Emerging Value Buyers Value- Added Buyers High Price Sensitivity Cost to Serve High Cost To Serve Low Cost To Serve Lower relative costs, greater volume and scale, lower transaction, relationship, and opportunity costs

16. Figure 3Perceived Competitive Advantage Competitor A Perceived Advantage Competitor B Perceived Disadvantage 80% Perceived Gross Margin 20% Perceived Gross Margin 80% Perceived Cost 20% Perceived Cost • Strategic Options: • Compete with Advertising • Compete with Promotions • Compete with Price • Managerial Motivation: • Offensive, Aggressive • Drive Volume • Strategic Options: • Compete with Limited • Non-Price Promotions • Managerial Motivation: • Defensive, Cautious • Protect Margin

17. Sidebar Figure 1AArrow Electronics Customer Portfolio(Bubble size = Segment Gross Profit relative to Total Gross Profit) Customized Bundling Strategies High-Differentiation Volume Strategies Low Price Sensitivity ICP- VA ICP- BAS Higher relative prices, greater brand loyalty Convenience Bundling Strategies Platform Bundling Strategies OEM- BAS OEM VA CM- VA X86- VA X86- BAS High Price Sensitivity CM- BAS CM- M&P Cost to Serve High Cost To Serve Low Cost To Serve Lower relative costs, greater volume and scale, lower transaction, relationship, and opportunity costs