ACCOUNTING INFORMATION FOR PRICING DECISION

1. ACCOUNTING INFORMATION FOR PRICING DECISION Major Influence on Pricing Decision Economist ‘s Pricing Model Limitations of the Economist Pricing Model Pricing Policies Cost –based Pricing Target Costing Other Pricing approaches Penetration pricing Price skimming Competitive Bidding Second Semester 2012/2013

2. Major Influences on Pricing Decision (the three C’s) • Customers • customer influence price through their effect on demand • Competitor • Competitor offer alternative or substitute products that may affect demand and price • Costs • Costs influence price through their effect on supply Second Semester 2012/2013

3. Factors that influence Price Market Positioning Highest limit Customer value Competitor’s behaviour Price Legal, political and ethical values Product cost Lowest limit Second Semester 2012/2013

4. Market positioning • Firms choose to position themselves in certain market and thus influence the product price. • Eg. McDonald (price affordable for families and teenagers) Second Semester 2012/2013

5. Product costs • Cost of a product sets the lower limit of the price • To make profit need to produce at a cost below selling price • Importance of costs in price setting varies across industries • For agricultural products, pricing decisions usually based on a consideration of production costs and customer demand. Second Semester 2012/2013

6. Customer value • Need to understand customer value • Customer value as the value that a customer places on particular features of a product or service • Each area within the value chain needs to contribute to enhancing customer value Second Semester 2012/2013

7. Competitor behaviour • Competitor’s behaviour can affect a company’s pricing decision • New entrants gain market share by offering lower prices than market leader • E.g in the airline industry, telecommunication industry Second Semester 2012/2013

8. Legal, political ,ethical and image related issues • Legal issues : need to adhere to certain laws such as prohibiting companies from discriminating between customers, collusion in price setting • Political considerations/political pressure • Ethical considerations Second Semester 2012/2013

9. Competition Act 2010 the prohibition of anti-competitive practices such as price fixing or discrimination, excessive or predatory pricing, limiting or controlling of production and market access to maximise profit, imposing unfair trading terms and bid rigging.” Second Semester 2012/2013

12. Economic Profit Maximising model • Assume that as price increase the quantity demanded declines • Profit maximising price and quantity • Profit maximising quantity determined by the intersection of marginal costcurve and marginal revenue • Marginal cost: a graph of change in total cost that accompanies the change in the quantity of product produced and sold Second Semester 2012/2013

13. Economic Profit Maximising Model • Marginal revenue: a graph of the change in total revenue that accompanies a change in the quantity of product sold Second Semester 2012/2013

14. Limitations of Economic Model • Difficult to determine with precision the firm’s demand curve and marginal revenue • Many factors in addition to price affect product demand (advertising and promotion, product design and quality, company reputation) • MR and MC paradigm is not valid for all forms of markets (such as oligopolistic market) • Difficult to measure MC Second Semester 2012/2013

15. Pricing Strategies • Cost plus pricing • Value based pricing • Target costing and pricing Second Semester 2012/2013

16. Cost Plus Pricing • Why cost plus pricing? • Not enough time to do a thorough market analysis ( or a through demand and marginal cost analysis) for every products since most companies sell many products / services . Need a quick and straight forward method for setting prices • A fairly simple base for setting price Second Semester 2012/2013

17. Why cost plus pricing? (cont..) • Gives the manager a place to start, even though market consideration may ultimately determine the selling price • The cost of the product provides the floor . Price cannot be set below the floor in the long run. Second Semester 2012/2013

18. Cost plus pricing (cont…) • General formula: • Price = cost + (markup percentage x cost) • Absorption cost pricing formulas • Variable cost pricing formulas Second Semester 2012/2013

19. Absorption Cost Pricing • Reasons for its use: • Absorption cost provides a justifiable price that tends to be perceived as equitable by all parties • Absorption cost information is usually provided by a firm’s costing system because it is required under external reporting • In the long run price must cover all costs and a normal profit margin • Cost plus pricing on full costs give mgt an idea of how competitors set prices Second Semester 2012/2013

20. Absorption cost pricing (cont..) • Disadvantage: • They obscure the cost behaviour pattern of the firm since allocated fixed costs are included • Not consistent with CVP analysis Second Semester 2012/2013

21. Variable cost pricing • Advantages: • Consistent with CVP analysis. Do not obscure the cost behaviour pattern • Do not require allocation of fixed costs to individual product lines • Variable cost data are exactly the type of information that managers need when facing certain tactical short term pricing decisions. Second Semester 2012/2013

22. Variable cost pricing (cont…) • Disadvantage: • Tend to set the price too low for firm to cover fixed costs. In the long run, price must cover all costs and a normal profit margin. • Need for higher markups to ensure that all costs are covered Second Semester 2012/2013

23. Illustration: Total costs for the production of 480 sailing supplies Second Semester 2012/2013

24. Illustration • Variable manufacturing cost per unit = RM192,000/480 = RM400 • Absorption cost per unit = (192,000 + 120,000)/480 = RM650 • If management require a markup of 30% on absorption cost, the price will be determine as follows: • Price = RM650 + (0.3 + 650) = RM845 Second Semester 2012/2013

25. Return on Investment Pricing • Common approach to determine the profit margin in cost plus pricing • Profit margin is based on ROI • Average annual investment = RM300,000 • Target ROI = 20% • Target profit = Average invested capital x target ROI = RM300,000 x 20% = RM60,000 Second Semester 2012/2013

26. Illustration • Markup percentage to earn target profit • Cost plus based on absorption cost: • (60,000+72,000)/480 x 650 = 42.3% Profit required + total annual cost not include To achieve target ROI in cost base ________________________________________________ Annual volume x cost base per unit used Cost plus pricing formula Second Semester 2012/2013

27. Illustration • What is the markup percentage for cost plus pricing based on total costs? Target Profit Annual volume x Total cost per unit (60,000)/ ( 480 x 800) = 15.63% Second Semester 2012/2013

28. Target Pricing and Target Costing • Target Pricing is a market –based approach • Target price is the estimated for a product or service that a potential customer will be willing to pay. • Target Cost per unit = Target price – Target operating income / unit Second Semester 2012/2013

29. Key Principles of Target Costing • Price led costing • To set target cost, need to first determine the target price • Focus on the customer • Need to listen to the customer • Aggressively seek customer feedback • TC is market driven Second Semester 2012/2013

30. Key Principles of Target Costing • Focus on product design • Design engineering is a key element in TC • Design the product from ground up so that it can be produced at target cost • Product must be designed for manufacturability • Focus on process design • Every aspect of production process must be examined to ensure that product is produced as efficiently as possible • Every aspect of production process must be designed with the target cost in mind Second Semester 2012/2013

31. Key Principles of Target Costing • Cross functional teams • Involve people from many different functions who are responsible for the entire product • Life cycle costs • Need to incorporate all of the product ‘s life cycle costs (cost of product planning and concept design, preliminary design, detailed design and testing,production distribution and customer service) Second Semester 2012/2013

32. Implementing Target Costing • Steps in developing target price and target costs • Develop a product that can satisfy the needs of potential customers • Choose a target price • Decide a target cost per unit (the cost business aim to achieve) • Perform cost analysis • Perform value engineering to achieve target costs • Requires cross functional teams Second Semester 2012/2013

33. Step 1: Develop a product that satisfies the needs of potential customer • Understand customer requirements • Analysis of competitors’ product Second Semester 2012/2013

34. Step 2: Choose a target price • Need to understand customer value • Understand how competitors will price competing products Second Semester 2012/2013

35. Step 3: Derive a target cost per unit • Target price minus target operating income per unit • Estimated long run cost per unit of a product/service that enables the firm to achieve target operating income per unit • Includes all future cost (both fixed and variable) Second Semester 2012/2013

36. Step 4: Perform Cost Analysis • Analyze which aspects of a product/service to target for reduction • E.g : consider the function perform by different component parts, current cost of different component parts, importance that customer place on different product features Second Semester 2012/2013

37. Step 5: Perform value engineering to achieve target cost • VE is a systematic evaluation of all aspects of a value chain business function with the objective of reducing costs • Used to reduce the non-value added activities/cost and achieve greater efficiency in value added activities Second Semester 2012/2013

38. Value engineering and TC • VE as a cost reduction and process improvement technique that utilizes information collected about a product’s design and production processes, then examines various attributes of the design and processes to identify candidates for improvement efforts • Leading companies that practiced TC include: Isuzu motors, Caterpillar, Kodak Second Semester 2012/2013

39. Value engineering and TC • Encompasses improvements in product design, changes in material specifications and modifications in process method • Need to distinguish value added activities and cost from non-value added activities and costs Second Semester 2012/2013

40. Value added cost/activities • A cost / an activity that if eliminated would reduce the actual or perceived value or its usefulness customers obtain from using the product/service. E.g. cost of specific product features and attributes desired by customer such as special designs on notebooks. Second Semester 2012/2013

41. Non- value added cost activities • A cost if eliminated would not reduce actual or perceived value or usefulness customer obtain from using the product/services. E.g : cost of expediting, rework, repair Second Semester 2012/2013

42. Reasons for using Target Costing • Many firms have less control over price . Market (supply and demand) determines price • Most of the cost of a product is determined in the design stage Second Semester 2012/2013

43. An example of Target Costing • Product: hand mixer with certain new feature • Target Price= RM30 • Est. annual sales = 40,000 • Investment requirement= RM2,000,000 • Desired ROI= 15% Second Semester 2012/2013

44. An example of Target Costing Second Semester 2012/2013

45. Kaizen Costing • Kaizen: making improvements to a process through small incremental amounts rather than through large innovation • Kaizen:Continual and gradual improvement through small betterment acitivities • Aim of KC is to reduce the cost of the components and products by a pre- specified amount. • Its implementation relies on employee empowerment i.e workers are given the responsibility to improve the processes and reduce costs. Workers are assumed to have superior knowledge about how to improve the processes Second Semester 2012/2013

46. Kaizen Costing • Potential cost reductions are smaller with kaizen costing because products are already in the manufacturing stage of their life cycles and a significant proportion of costs will have become locked- in • Locked in costs: cost that have not been incurred but will be incurred in the future on the basis of the decisions that have already been made Second Semester 2012/2013

47. Kaizen Costing Vs Target Costing • Applied during the manufacturing stage of the product life cycle • Focuses on production processes and cost reduction are achieved primarily through the increased efficiency of the production process • Applied during the design stage • Focus on the product and cost reduction is achieved through product design Second Semester 2012/2013

48. Life Cycle Costing • Estimates and accumulates costs over a product’s entire life cycle. In order to determine whether the profits earned during the manufacturing phase will cover the cost incurred during the pre and post manufacturing stages • Tracks and accumulates business function costs of the value chain attributable toe ch product from its initial R & D to its final customer service and support Second Semester 2012/2013

49. Life Cycle Budgeting and Pricing Decision • Life cycle costs provide information needed for strategically evaluating pricing decision • To be profitable, must generate enough revenue to recover costs in all the business functions of the value chain (R & D costs, Design costs, production costs, marketing costs, Distribution costs and customer service costs Second Semester 2012/2013

50. Life cycle costing • Helps management to understand the cost consequences of developing and making a product and to identify areas in which cost reduction efforts are likely to be effective. Second Semester 2012/2013