Chapter 12

1. Chapter 12 Pricing and Cost Management

2. Players in Pricing • Customers • Competitors (heterogeneous oligopoly) Pricing Strategies • passive • adapt price to competitors‘ • will not induce competitive action • compete by quality, service, and differentiation • cost Management should ensure profitability • aggressive • based on cost leadership position • attempt to increase market share • induces retaliation by competitors • shakeout of weak competitors • target: quasi-monopoly position

3. Time Horizon of Pricing Decisions • short-run bottom price: incremental cost • But: beware of side effects: • Is it really additional business??? • one-time customer could compete with „our“ other customers‘ business and undercut their prices (Cannibalization) • Relevant costs of the bidding decisionshould include revenues lost on salesto existing customers (Opportunity costs) • long-run bottom price: cost of resources used for the respective object • estimated by using ABC • but: Competition on the product market may require reduction of the current cost level • long-run prices should always be market-based • exception: sometimes government contracts • neglecting market reaction foregoes profit potential

4. Target Price and Target Cost • Target price is part of the product concept • it is designed with the product using marketing research methods (conjoint measurement) • Conjoint measurement uses experiments to figure out customers‘ willingness to pay for the product depending on its features • Target Cost • the allowable cost that leaves a target profit margin • based on predicted product life cycle sales volume at the target price • price and sales volume may change over the product life cycle according to expected dynamics • target profit then has to be determined as the net present value of the Product all over the life cycle • hard to estimate

5. Simultaneous Engineering • Specify product concept that satisfies the needs of the target market segment • Choose a target price, estimate sales level at this price • Product design and design of productive system • processes • equipment • supply chain are developed simultaneously. • Objective: find a solution that is viable under competition and yields a positive net present value given the company‘s cost of capital • i.e. its risk-adjusted rate of return • sometimes if not usually, the required rate of return is set above the market rate • why?: the returns from the products must cover average development costs of unsuccessful products.

6. Target rate of return assuming constant price and sales volume or considering an average over the product life cycle : • rS = Target return on sales: target cost = (1 - rS)  target price • markup = rS / (1 - rS) • rI = Target return on investment • rI can be derived from capital market data: „required rate of return“ on the capital market rS = rI / turnover rate turnover rate = additional sales / additional investment

7. Example • A company has invested 100,000$ in assets to produce a certain product. • The investors‘ required rate of return rI = 10% • Full costs of production per unit of the 1,000 units produced is 150$. • What is the markup rate needed to earn the required return on Investment? • What is the target return on sales?

8. Value-Added vs. Nonvalue-Added Costs • A value-added cost is a cost that customers perceive as adding value, or utility, to a product or service • A nonvalue-added cost is a cost that customers do not perceive as adding value, or utility, to a product or service. • Cost of expediting • Rework • Repair • Value-added costs of processes, however, should be defined from the company‘s point of view • it may be quite profitable to keep units in stock while this does not add to customer value; however it saves other costs

9. How to determine the allowable costs of a component • Target costing helps to determine what the allowable costs of each component of a product are • Start from the allowable costs of the product • Proceed in three Steps: • Identify how different functions of the product (attributes) affect the customers’ willingness to pay • Determine to what extent a component contributes to a specified function or attitude • Taking step one and two into consideration to determine the allowable cost of each component • Problem: Interaction effects between features

10. Cumulative Costs per Unit Value-Chain Functions R&D and Design Manufacturing Mkt., Dist., & Cust. Svc. Cost Incurrence andLocked-in Costs Locked-in Cost Curve Cost-Incurrence Curve

11. Cost Incurrence and Locked-in Costs At the end of the design stage, direct materials, direct manufacturing labor, and many manufacturing, marketing, distribution, and customer-service costs are all locked in. When a sizable fraction of the costs are locked in at the design stage, the focus of value engineering is on making innovations and modifying designs at the product design stage.

12. Excursion: Interdependence of products • A company produces two different products, x1 and x2 • The number of units that can be sold in the market can be described using the following functions: • x1 = 400 – 2p1 – (+) p2 • x2 = 200 – 4p2 –(+) p1 • Variable costs are k1 = 2 and k2 = 4 • Which kind of interdependence is expressed by – (+)? • How many units should be produced of each product to maximize profit in either situation?

13. Life-Cycle Budgeting The product life cycle spans the time from original research and development, through sales, to when customer support is no longer offered for that product. A life-cycle budget estimates revenues and costs of a product over its entire life.

14. Costs beyond the market phase of the PLC • Nonproduction Costs • less visible on a product-by-product basis. • When nonproduction costs are significant,identifying these costs by product isessential for target pricing, target costing,value engineering, and cost management. • Development Costs • When a high percentage of total life-cyclecosts are incurred before any productionbegins and before any revenues are received,it is crucial for the company to have asaccurate a set of revenue and costpredictions for the product as possible. • Costs after the end of the PLC • disposal costs • design for remanufacturing

15. Price Discrimination Laws • They apply to manufacturers, not service providers. • Price discrimination • under the U.S. Robinson-Patman Act, a manufacturer cannot price-discriminate between two customers if the intent is to lessen or prevent competition for customers. • Price discrimination is permissible if differences in prices can be justified by differences in costs. • Predatory pricing occurs when • the predator company charges a price that is below an appropriate measure of its costs, and • the predator company has a reasonable prospect of recovering in the future the money it lost by pricing below cost. • Most courts in the United States have definedthe “appropriate measure of costs” as theshort-run marginal and average variable costs. • Dumping occurs when • a non-U.S. company sells a product in the United States at a price below the market value in the country of its creation, and its action injures an industry in the United States.

16. Price Discrimination Laws • Collusive pricingoccurs when companiesin an industry conspire in their pricingand outputdecisions to achieve a priceabove the competitive price. Assignments for Chapter 12: • 12-17 (5%) • 12-27 (8%) • 12-19 (5%) • 12-29 (=11.12-30) (8%) • 12-23 (8%), 12-31 (new in 11th ed.)(5%), • 12-33 (=11.12-28) (8%) 12-25 (5%), 12-35 (new in 11th ed.)(10%)

17. Quiz 1.       Short-run pricing decisions include a.       pricing a main product in a major market b.       considering all costs in the value-chain of business functions. c.       adjusting product mix and volume in a competitive market while maintaining a stable price if demand fluctuates from strong to weak. d.       pricing for a special order with no long-term implications.

18. Quiz • Pritchard Company manufactures a product that has a variable cost of $30 per unit. Fixed costs total $1,500,000, allocated on the basis of the number of units produced. Selling price is computed by adding a 20% markup to full cost. How much should the selling price be per unit for 300,000 units? • a. $49 b. $43.75 c. $42 d. $35

19. Quiz  3.       The first step in implementing target pricing and target costing is a.       choosing a target price. b.       determining a target cost. c.       developing a product that satisfies needs of potential customers. d.       performing value engineering.

20. Quiz  4.       The best opportunity for cost reduction is a.       during the manufacturing phase of the value chain. b.       during the product/process design phase of the value chain. c.       during the marketing phase of the value chain. d.       during the distribution phase of the value chain.

21. Quiz • The following data apply to questions 5 and 6. • Each month, Haddon Company has $275,000 total manufacturing costs (20% fixed) and $125,000 distribution and marketing costs (36% fixed). Haddon’s monthly sales are $500,000. • 5.       The markup percentage on full cost to arrive at the target (existing) selling price is • 25%. b. 75%. c. 80%. d. 20%. • 6.       The markup percentage on variable costs to arrive at the existing (target) selling price is • a. 20%. b. 40%. c. 80%. d. 66 %.

22. Quiz 7.       The price of movie tickets for opening day and the few days following compared to the price six months later is an example of a.       price gouging. b.       peak-load pricing. c.       dumping. d.       demand elasticity.

23. Quiz 8.       Which of these do antitrust laws on pricing not cover? a.       Collusive pricing b.       Dumping c.       Peak-load pricing d.       Predatory pricing

24. 12-17 (data in million $) • Offer: 3000 units @ $85; capacity: 300 000 units < max demand • Sales manager would accept flat sales commission: $6,000 • effect on operating income if accepted? • Accept?

25. 12-27 (in $1 000) • capacity: 1 500 crates; relevant range of fixed costs: 500 to 1500 crates. • markup% of total variable costs • Offer: 200 crates @ $55 cash; $2000 cost of special packaging; customer disappears in six weeks. Accept? • If customer stays in business: Accept?

26. 12-19 (in 1 000$) • classify: value-added/non-value-added/ grey area • if 65% of cost in grey area is value-added: how much of total cost is value-added/non-value-added? • quality improvement and other cost Management measures: change %ages in right-hand column (b) (c)

27. 12-29

28. 12-23 • expected demand: 16 000 room nights • capital invested: $960 000 • target return: 25% • Price per room night? • a price decrease of 10% would increase demand by 10%; decrease price?

29. 12-31 • Order: 5 000 violins • @ full cost + maximum markup of 20% • minimum acceptable price • price @ full cost (without administrative cost) + incr. administrative cost + maximum markup of 20% • take offer @ $33 per unit?

30. 12-33 • bdgeted supply 80 000 hrs of labor • variable costs $12 per hr. • fixed costs: $240 000 • cost plus price @20%? • optimal price if: • Comment

31. 12-25

32. 12-35  • price $480, sales 4 000 units of either model. Which one should be chosen? • cost structures? • Yellin‘s favorite model, when she leaves after year 2 and gets a bonus according to division OI?