Pricing Decisions & Profitability Analysis Economic theory The optimum selling price is the price at which marginal revenue equals marginal cost. 1
Problems with applying economic theory 1. Difficult and costly to derive reasonably accurate estimates of demand. 2. Difficult to estimate cost functions to determine marginal cost at different output levels for many different products. 3. Demand is influenced by other factors besides price. 4. Profit maximization assumed firms may pursue other goals. Role of cost information in pricing decisions Price takers are those firms that have little control over the prices of their products or services. For price takers cost information is of vital importance in deciding on the output and mix of products and services. Price setters are those firms that have some discretion over the setting of selling prices for their products or services. Cost information is of vital importance to price setters in making pricing decisions. Firms may be price setters for some of their products /services and price takes for others. Four situations will be considered: 1. A price setting firm facing a short-run pricing decision 2. A price setting firm facing a long-run pricing decision 3. A price taker firm facing a short-run product-mix decision 4. A price taker firm facing a long-run product-mix decision 2
A price setting firm facing short-run pricing decisions Applies where companies are faced with the opportunity of bidding for one time special orders in competition with other suppliers. In this situation only the incremental cost of undertaking the order should be taken into account. Given the short-term one-off nature of the opportunity many costs will be nonincremental. Bids should be made at prices that exceed the incremental cost and must meet the following conditions: 1. Sufficient capacity must be available to meet the order. 2 The bid price should not effect future selling prices and the customer should not expect repeat business at short-term incremental cost. 3. The order will utilize unused capacity for only a short period and capacity will be released for use on more profitable opportunities. Class Exercise 01 Lomas Corporation operates a plant with a monthly capacity of 500,000 cases of tomato sauce. Lomas is presently producing 300,000 cases per month. De Vos has asked Lomas and two other companies to bid on supplying 150,000 cases each month for the next four months. Cost Per Case Variable manufacturing 38.00 Variable marketing and distribution 13.00 Fixed manufacturing 14.00 Fixed marketing and distribution 15.00 Total 80.00 If Lomas makes the extra 150,000 cases, the existing total fixed manufacturing overhead ($4,200,000 per month) would continue, plus an additional $165,000 of fixed overhead will be incurred per month. Total fixed marketing and distribution costs will not change. What PRICE should Lomas bid? 3
Class Exercise 02 Z Ltd manufacture and market a slimming drink which they sell for Rs 20.00 per bottle. The current output is 4,000 bottles per month which represents 80% of the capacity. They have the opportunity to utilize their surplus capacity by selling their product at Rs. 13.00 per bottle to Cargills who will sell it as a own label product. The total cost for the last month were Rs. 56,000 of which Rs. 16,000 were fixed costs, representing a total cost of Rs. 14.00 per bottle. Based on the above data should Z Ltd accept the order by Cargills? What other factors should be considered? Class Exercise 03 X Ltd imports and distributes kiddies toys. It most popular item is the Barbie Doll. This costs Rs. 120 with the manufacturer and a further Rs. 30.00 is incurred for customs duty and clearing charges per unit. The toys are sold to retailers at Rs. 200.00 per unit. Currently, they order 35,000 units per month which is sufficient to cater to the local demand. The supplier in China has offered a discount of 10% on his price, if X Ltd buys 50,000 or more units. X Ltd believes that if an attractive discount can be given to retailers, they will increase the quantity purchased. What is the minimum price X Ltd needs to sell to retailers to increase sales volume while NOT reducing the profit margin. 4
A price setting firm facing long-run pricing decisions Three scenarios considered: 1. Pricing customized products using cost-plus pricing. 2. Pricing non-customized products using cost-plus pricing or demand estimates. 3. Pricing non-customized products using target costing. In the long-term a firm can adjust the supply of resources that are committed to it - therefore a product or service should be priced to cover all of the resources that are committed to it. Price setters have stronger grounds for adopting ABC. Pricing customized products using cost-plus pricing: 1. An accurate costing system is required since under-costing will result in acceptance of unprofitable business and over-costing in the loss of profitable business. 2.To determine the selling price a full cost/long-run cost should be calculated and a mark-up added (i.e. a cost-plus selling price is determined) 3. Cost assignment for pricing should be based on direct cost tracing or cause-andeffect assignments Arbitrary allocations (e.g. some business/facility-sustaining costs) should be allocated using behavioural drivers or covered within the mark-up. 4. ABC provides a better understanding of cost behaviour for negotiating with customers the price and size of the orders. 5
Class Exercise 04 The Kalahari Company has received request for a price quotation from one of its regular customer for an order of 500 units with the following characteristics: Direct Labour Hours per Unit (@ 10/- per hr) 2 hours Direct Materials cost per unit Rs. 22.00 Machine hours per unit produced (@ 300/- ) 1 hour Number of times material need to be bought 6 times Number of production runs 4 runs Average set-up time per production run 3 hours s Number of deliveries 1 Number of customer visits 2 Engineering and Design Support 50 hours Customer Support 50 hours Details of activities required for the order are as follows: Activity Cost Driver Purchasing and receiving materials Rs. 100/ per order Scheduling Production Rs. 250/ per production run Setting up Machines Rs. 120/ per set up Packing and delivering Rs. 400/ per delivery Calculate the minimum selling price at a profit mark-up of 45% on total costs. An organisation employs 20 people who each work 40 hours per week and whose Average rate of pay is Rs 3.00 per Direct Labour Hour. The company has to make a choice of accepting ONE of two contracts: DW or HK. Each would last 13 weeks. DW HK Per batch of 12 Units Direct Materials 22.50 7.50 Direct Labour 7.50 15.00 Prime Cost 30.00 22.50 Selling Price 53.75 67.50 The organisation s standard overheads per week are Rs 1,500 of which Rs 1,000 is variable and Rs 500 is fixed. Overheads are absorbed by a standard rate per direct labour hour. Required: Class Exercise 05 a) Calculate the total cost per batch of 12 units b) Calculate the percentage profit to sale for each contract c) State which contract should be undertaken 6
Pricing non-customized products (Cost-plus pricing): 1. Pricing decision involves large volumes to many customers of a single product/service. 2. Cost-plus pricing requires an estimate of sales volume to determine unit cost in order to derive the cost-plus price. 3. Recommended that cost-plus prices are estimated for a range of potential sales volumes Class Exercise 06 The Auckland Company is launching a new product. The sales volume will depend on the selling price and customer acceptance. The company expects a minimum profit of Rs 2 Mn from the sale of this product. The estimated demand levels and costs are given below: Sales Vo. ('000) 100 120 140 160 180 200 Total Costs (Rs '000) 10,000 10,800 11,200 11,600 12,600 13,000 s Calculate the minimum selling price required at each level of demand to obtain the target profit. What is the mark-up% at each level of demand to meet the profit objective 7
Pricing non-customized products (Using demand estimates): If approximations of demand can be derived they may be preferable to using the cost-plus pricing approach. Class Exercise 07 The Auckland Company has now done market research and have obtained potential selling price points and demand levels as follows: Potential selling price Rs 100 Rs 90 Rs 80 Rs 70 Rs 60 Sales Vo. ('000) 120 140 180 190 200 Total Costs (Rs '000) 10,800 11,200 12,600 12,800 13,000 Calculate the estimated profit / loss arising from each level of demand. What is the mark-up% at each level of demand? Pricing non-customized products (Target costing): 1. Target costing is the reverse of cost-plus pricing The target selling price is the starting point. 2. Four stages are involved: Stage 1: Determine the target price which customers will be prepared to pay for the product. Stage 2: Deduct a target profit margin from the target price to determine the target cost. Stage 3: Estimate the actual cost of the product. Stage 4: If estimated actual cost exceeds the target cost investigate ways of driving down the actual cost to the target cost. 3. Marketing factors and customer research provide the basis for determining selling price (Not cost). 4. Emphasizes a team approach to achieving the target cost. 5. Most suited to high sales volume products. 8
Class Exercise 08 A sole-proprietor intends setting up a bakery to manufacture and market various cakes. The current market price for a standard butter cake is Rs. 300/- per Kilo. He estimates that he can produce and sell 1000 cakes per month and wishes to obtain a profit margin of 45% from the selling price. What is the total cost of a cake that he would need to produce at in order to meet his profit objective and to be able to compete in the marketplace? s Class Exercise 09 The digital electronics company plans to introduce a new camera to the market. The Company has a target profit margin of 30% of selling price. The following information Is available to the management for evaluation of the project: Projected Lifetime Sales Volume 300,000 units Target selling price Rs 800.00 Projected cost per unit Rs 700.00 a) Calculate the target cost that will meet the profit objective of the company? b) What management action is possible to bridge the gap between the expected cost and target cost? s 9
A price taker firm facing short-run product-mix decisions Applies where opportunities exist for taking on short-term business at a market determined selling price. Cost information required and the same conditions apply as those specified for a price setter facing short-term pricing decisions. If short-term capacity constraints apply the product mix should be based on maximizing contribution per limiting factor Class Exercise 10 The following detail are available regarding three products: X Y Z Selling Price 200.00 300.00 400.00 Direct Materials (Rs 4/Kg) 20.00 112.00 90.00 Direct Labour (Rs 8/Hour) 80.00 44.00 120.00 Variable Overheads 40.00 22.00 60.00 Variable overheads are recovered at the rate of Rs 4/hour. Total fixed overheads are Rs. 120,000. a) Calculate the profit margin per product b) Prioritize the production based on sales, labour and materials s 10
A price taker firm facing long-run product-mix decisions In the long-term a firm can adjust the supply of resources that are committed to it Therefore the sales revenue from a product or service should be sufficient to cover all of the resources that are committed to it. Periodic profitability analysis is required to ensure that only profitable products/services are marketed. Profitability analysis should be used as an attention-directing mechanism. Ideally ABC hierarchical profitability analysis should be used An illustration of hierarchical profitability analysis) 11
Cost-plus pricing Different cost bases and mark-ups can be used to determine the cost-plus selling price: Cost base Mark-up Cost-plus (Rs) % selling price (Rs) (1) Direct variable costs 200 250 500 (2) Direct nonvariable costs 100 (3) Total direct costs 300 70 510 (4) Indirect costs 80 (5) Total cost (excluding higher level sustaining costs) 380 40 532 (6) Higher level sustaining costs 60 (7) Total cost 440 20 528 Cost-plus pricing Target mark-ups seek to provide a contribution to non-assigned costs and profit. Target mark-ups are also adjusted to reflect demand, types of products, industry norms, competitive position, etc. Criticisms of cost-plus pricing: 1. Ignores demand 2. Does not necessarily ensure that total sales revenue will exceed total cost. 3. Can lead to wrong decisions if budgeted activity is used to unitize costs. 4. Circular reasoning Volume estimates are required to estimate unit fixed costs and ultimately price. 12
Reasons for using cost-plus pricing: 1. May encourage price stability 2. Demand can be taken into account by adjusting the target mark-ups. 3. Simplicity 4. Difficulty in applying sophisticated procedures where a firm markets hundreds of products/services. 5. Used as a guidance to setting the price but other factors are also taken into account. 6. Applied to only the relatively minor revenue items. Pricing policies Price-skimming Penetration pricing Pricing policies may vary depending on the different stages of a product s life cycle. Customer Profitability Analysis 13
Class Example The Darwin Company has recently adopted customer profitability analysis. It has undertaken a customer profitability review for the past 12 months. Details of the activities and the cost driver rates relating to those expenses that can be attributed to customers are as follows: Activity Sales Order Processing Sales Visits Normal Delivery Costs Special (Urgent) Deliveries Credit Collection Cost Cost Driver Rate Rs 300 per sales order Rs 200 per sales visit Rs 1 per delivery kilometer Rs 500 per special deliveries 10% per year on average payment time Customer A B Y Z Number of sales orders 200 100 50 30 Number of sales visits 20 10 5 5 Kilometers per delivery 300 200 100 50 Number of deliveries 100 50 25 25 Total Delivery KMs 30000 10000 2500 1250 Special (Urgent) Deliveries 20 5 0 0 Average Collection period (days) 90 30 10 10 Annual Sales $ 1.0Mn $ 1.0Mn $ 0.5Mn $ 2.0Mn Annual Operating Profit $90,000 $120,000 $70,000 $200,000 14