2 Pricing in today’s theory and practice* Not too much research on pricing- company and academicManagers have a general tendency to believe that price is an important issue for customers. Research, however,has shown that customers are frequently unaware of prices paid and that price is one of the least important purchase criteria for them.the impact of even small increases in price on profitability by far exceeds the impact of other levers of operational management, as shown in Fig. 1 (based on a sample of Fortune 500 companies).A 5% increase in average selling price increases earnings before interest and taxes (EBIT) by 22% on average, compared with the increase of 12% and 10% for a corresponding increase in turnover and reduction in costs of goods sold, respectively.Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778
3 Fig. 1. Pricing and its impact on profitability Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778
4 In conclusion, it seems that managers, as price setters, Fig. 2. High price and large market share—not as incompatible as commonly believedIn conclusion, it seems that managers, as price setters,have a general tendency to overestimate the importance ofprice for actual and potential customersHinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778
5 Pricing and BusinessHow companies price a product or service ultimately depends on the demand and supply for itThree influences on demand and supply:CustomersCompetitorsCosts
6 Influences on Demand and Supply Customers – influence price through their effect on the demand for a product or service, based on factors such as quality and product featuresCompetitors – influence price through their pricing schemes, product features, and production volumeCosts – influence prices because they affect supply (the lower the cost, the greater the quantity a firm is willing to supply)
7 Time Horizons and Pricing Short-run pricing decisions have a time horizon of less than one year and include decisions such as:Pricing a one-time-only special order with no long-run implicationsAdjusting product mix and output volume in a competitive marketLong-run pricing decisions have a time horizon of one year or longer and include decisions such as:Pricing a product in a major market where there is some leeway in setting price
8 Pricing External sales- outside Target pricing-Competition-based pricing Cost plus pricingVariable cost pricingCustomer based pricing-value-based pricingTime and material pricingInternal-within the company among divisionsNegotiated transfer pricesCost based transfer pricesMarket based transfer pricesEffect of outsourcing on transfer pricesTransfers between divisions in different countries
9 Profit Maximization Economic Theory Pricing The quantity demanded is a function of the price that is chargedGenerally, the higher the price, the lower the quantity demandedPricingManagement should set the price that provides the greatest amount of profit
10 Quantity made and sold per month Determining the Profit-Maximizing Price and QuantityProfit is maximized where marginal cost equals marginal revenue, resulting in price p* and quantity q*.Dollars per unitp*DemandMarginal costQuantity made and sold per monthMarginal revenueq*
11 Example 1The editor of EMBA Magazine is considering three alternative prices for her new monthly periodical. Her estimate of price and quantity demanded are:Price QuantityTL ,000TL ,000TL ,000Monthly costs of producing and delivering the magazine include TL90,000 of fixed costs and variable costs of TL1.50 per issue.Which price will yield the largest monthly profit?
12 Solution Example 1 Choose TL 6 TL based on quantitative factors given. Need to consider qualitative factors as well.
13 Determining the Profit-Maximizing Price and Quantity Total costDollarsTotal revenuep*Total profit at the profit-maximizing quantity and price, q* and p*.Quantity made and sold per monthq*
14 The impact of price changes on sales volume Price ElasticityThe impact of price changes on sales volumeDemand is elastic if a price increase has a large negative impact on sales volume.Demand is inelastic if a price increase has little or no impact on sales volume.
15 Who determines the price? Price takers- when there is a competitive market and the company has no influence on priceOnce 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 priceOrganizations 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.
16 Markets and PricingCompetitive Markets – use the market-based approachLess-Competitive Markets – can use either the market-based or cost-based approachNoncompetitive Markets – use cost-based approaches
17 Influences on Price Customer demand Competitors’ behavior/prices/actionsCostsRegulatory environment – legal, political and image related
18 Differences Affecting Pricing: Long Run vs. Short Run Costs that are often irrelevant for short-run policy decisions, such as fixed costs that cannot be changed, are generally relevant in the long run because costs can be altered in the long runProfit margins in long-run pricing decisions are often set to earn a reasonable return on investment – prices are decreased when demand is weak and increased when demand is strong
19 Alternative Long-Run Pricing Approaches Market-Based: price charged is based on what customers want and how competitors reactCost-Based: price charged is based on what it cost to produce, coupled with the ability to recoup the costs and still achieve a required rate of return
20 Market-Based Approach Starts with a target priceTarget Price – estimated price for a product or service that potential customers will payEstimated on customers’ perceived value for a product or service and how competitors will price competing products or services
21 Understanding the Market Environment Understanding customers and competitors is important because:Competition from lower cost producers has meant that prices cannot be increasedProducts are on the market for shorter periods of time, leaving less time and opportunity to recover from pricing mistakesCustomers have become more knowledgeable and demand quality products at reasonable prices
23 Pricing approaches Cost plus mark-up Variable – contribution margin approach, contribution margin( reflecting mark-up) should cover desired return on investment, all fixed costsAbsorption – common- mark-up covers all expenses except cost of goods sold plus the desired return on investmentTarget costing– price is known (competitor’s), desired return on investment is known, price is known = determine the maximum cost per unit
24 Cost-Plus Pricing Company estimates cost of production Benefits Adds a markup to cost to arrive at price which allows for a reasonable profitBenefitsSimple approachLimitationsWhat % markup to use?Inherently circular for manufacturing firmsRequires considerable judgment and experimentation
26 Life Cycle CostingLife 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).Product Life-Cycle spans the time from initial R&D on a product to when customer service and support are no longer offered on that product (orphaned)The best balance among cost elements is achieved when the total LCC is minimized (Barringer and Weber, 1996).
28 Life-Cycle Product Budgeting and Costing Life-Cycle Budgeting involves estimating the revenues and individual value-chain costs attributable to each product from its initial R&D to its final customer service and supportLife-Cycle Costing tracks and accumulates individual value-chain costs attributable to each product from its initial R&D to its final customer service and support
29 Important Considerations for Life-Cycle Budgeting Nonproduction costs are largeDevelopment period for R&D and design is long and costlyMany costs are locked in at the R&D and design stages, even if R&D and design costs are themselves small
30 ExampleMurmur company produces electronic components that typically have about 27-month life cycle. In October 2008, a new component was proposed. Below are the budgeted costs and profits over the life cycle of the product.
32 Cost-Based (Cost-Plus) Pricing The general formula adds a markup component to the cost base to determine a prospective selling priceUsually only a starting point in the price-setting processMarkup is somewhat flexible, based partially on customers and competitors
33 Forms of Cost-Plus Pricing Setting a Target Rate of Return on Investment: the Target Annual Operating Return that an organization aims to achieve, divided by Invested CapitalSelecting different cost bases for the “cost-plus” calculation:Variable Manufacturing CostVariable CostManufacturing CostFull Cost
34 Common Business Practice Most firms use full cost for their cost-based pricing decisions, because:Allows for full recovery of all costs of the productAllows for price stabilityIt is a simple approach
35 Cost-plus Pricing Selling Price= Cost + mark-up% x Cost Mark-up % = Desired profit per unit ÷ Unit costDesired profit = Desired ROI x Investment
36 Which cost? Variable manufacturing cost Price= variable manufacturing costs +markup% * variable manufacturing costMark-up should cover the remaining costs and provide for the desired profit, i.e. variable selling and all fixed costsVSC: variable selling costsFC: fixed costs – manufacturing and sellingADM: Administrative Expensesn : number of units to be soldvmcu: variable manufacturing cost per unit
37 Which costs? Total variable costs Variable manufacturing and selling costsPrice= variable costs + markup %* variable costs
38 Which costs? Absorption – manufacturing costs Unit manufacturing costs – both variable and fixedPrice= unit manuf. cost + markup %* unit manufacturing costS&ADM: Selling and administrative costsUnit cost : unit manufacturing cost (variable and fixed)
39 Which costs? Absorption – total costs Total costs – manufacturing and selling and administrative –fixed (direct or allocated, variable costs)Price= unit cost + markup %* unit cost
40 Example - Pricing Annual sales 480 units Unit costs: Variable manufacturing cost $ 400Applied fixed manufacturing cost $ 250Absorption manufacturing cost $ 650Variable selling costs $ 50Allocated and direct fixed selling and administrative costs $ 100Total cost (Manufacturing and S&ADM) $ 800Investment $ 600,000Desired profit 10% of investment $ 60,000Annual Fixed Manufacturing Costs $ 120,000Annual Fixed (allocated and direct) Selling and Administrative Costs $ 48,000
45 Cost plus comparison Cost plus type Mark up % Price 925 Variable manufacturing cost plus mark upVariable cost plus mark upManufacturing costs plus mark upFull cost plus mark upMark up %131.25105.5642.3115.63Price925
46 Retail cost plus mark-up Mark up on cost of goods sold = (selling and administrative costs operating income) / COGS
47 Retail ExampleYesim Textile’s income statement for 2007 is as follows:
48 Project ExampleEMBA Consultancy Co needs to bid for a project. EMBA’s recent income statement appears below:Man-hour rate TL 65; overhead application 0.85 of personnel costs
49 Project ExampleEMBA Consultancy needs to bid for a new project. Material costs will be TL 5.000; 150 man hours will be used. What would be a guiding bidding price?
50 Pros and Cons of Cost plus pricing Easy to computeNo consideration to the demand sideSales volume plays an important role- allocation of fixed costs over the products soldIf variable cost plus used then fixed costs might not be covered if not calculated correctly
51 Pricing Special Orders In some cases, it may be beneficial for a company to charge a price lower than its full costOnly if the order will not affect demand for its other products
52 Special Orders – Premier Lens Example Given the following information, should Premier Lens produce 20,000 lenses to be sold to Blix Camera for $73 per lens?
53 Special Orders – Premier Lens Example The incremental analysis shows that it should. Note that the fixed costs are not incremental and need not be included in the decision making.
55 Five Steps in Developing Target Prices and Target Costs Develop a product that satisfies the needs of potential customersChoose a target priceprice is the same as the competitionset price to increase customer baseseek larger market share through priceDerive a target cost per unit:Target Price per unit minus Target Operating Income per unitPerform cost analysisPerform value engineering to achieve target cost
56 Value EngineeringValue Engineering is a systematic evaluation of all aspects of the value chain, with the objective of reducing costs while improving quality and satisfying customer needsManagers must distinguish value-added activities and costs from non-value-added activities and costs
57 Value Engineering Terminology Value-Added Costs – a cost that, if eliminated, would reduce the actual or perceived value or utility (usefulness) customers obtain from using the product or serviceNon-Value-Added Costs – a cost that, if eliminated, would not reduce the actual or perceived value or utility customers obtain from using the product or service. It is a cost the customer is unwilling to pay for
58 Value Engineering Terminology Cost Incurrence – describes when a resource is consumed (or benefit forgone) to meet a specific objectiveLocked-in Costs (Designed-in Costs) – are costs that have not yet been incurred but, based on decisions that have already been made, will be incurred in the futureAre a key to managing costs well
59 Problems with Value Engineering and Target Costing Employees may feel frustrated if they fail to attain targetsA cross-functional team may add too many features just to accommodate the wishes of team membersA product may be in development for a long time as alternative designs are repeatedly evaluatedOrganizational conflicts may develop as the burden of cutting costs falls unequally on different business functions in the firm’s value chain
60 Example Target costing Nownew company feels that there is a market niche for a mouse with special new features. After surveying the features and prices of available mouses on the market, Marketing department believes that a price of TL 30 would be about right for the new mouse. Marketing department estimates to sell about mouses. To design, develop and produce these new mouses and investment of TL would be required. The company desires 15% ROI on all new projects. What is the highest target cost to manufacture, sell and service the new product?
62 Customer-based pricing Value based pricing-the price is based on the customer ‘demand’ or need for the productUnique product – value based pricing might be helpful to create demanduse price to support product imageset price to increase product salesdesign a price range to attract many consumer groupsset price to increase volume salesprice a bundle of products to reduce inventory or to excite customers
63 concept of economic (or customer) value Two interpretations:the difference between the consumer’s willingness to pay and the actual price paid, which is equal to the ‘‘consumer surplus,’’ the excess value retained by the consumer.the maximum amount a customer would pay to obtain a given product, that is, the price that would leave the customer indifferent between the purchase and foregoing the purchase. Customer value in this sense is equal to the microeconomic concept of a customer’s ‘‘reservation price’’ and the use value of goods.product’s economic value is the price of the customer’s best alternative—reference value—plus the value of whatever differentiates the offering from the alternative— differentiation value (Nagle & Holden, 1999).
64 To quantify economic value Step 1: Identify the cost of the competitive product and process that consumer views as best alternativeput oneself in the eyes and in the shoes of customers and ask what they view as best alternative to the purchase of the product being analyzedStep 2: Segment the markete.g. Microsoft, for example, is known for handing out beta-versions of its latest enterprise software products to particularly knowledgeable companies and customer segmentsHinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778
65 To quantify economic value Step 3: Identify all factors that differentiate the product from the competitive product and process.Step 4: Determine the value to the customer of these differentiating factors.Conjoint analysis is a simple tool which aims to capture trade-offs in product features in a systematic way and to assign monetary values to specific attributes (Auty, 1995). Customers are presented with a set of two similar products differing in price and other qualitative features and are forced to indicate which set of attributes they preferHinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778
66 To quantify economic value Step 5: Sum the reference value and the differentiation value to determine the total economic value.The product’s economic value is simply the sum of the price of the reference product plus its differentiation value.Step 6: Use the value pool to estimate future sales at specific price points.For each price point, sales can be expected to comprise a significant share of all market segments, which value the product higher than the specific price examinedHinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778
67 Example of value based pricing Japanese industrial equipment manufacturer.In its home market, its standard model was priced at the equivalent of US$80,000 compared with US$50,000 for a similar model by its main competitor from the United States.In Japan, the company sold about 80% more units than its U.S. competitor, while in the United States, where the company had a weaker distribution system, both companies had roughly the same unit sales, although historical growth rates of the Japanese company had by far exceeded the growth rates of its U.S. rival.What is the reason that the Japanese company was able to achieve both a high relative market share and a significant price premium?Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778
68 WHY?For each industry segment,the Japanese company had developed detailed financial models of different cost and benefit components of its own equipment versus its main competitorFor a customer in the printing ink industry, the positive and negative differentiation value was quantified in the following way:Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778
70 AnalysisUnder this angle, the price premium of the Japanese company is modest. If an interest rate of 8% is applied to the net benefits gained over the average life cycle of this equipment of 4 years, the positive differentiation value amounts to well over US$300,000. Customers are expected to pay only a small fraction—less than 10% and US $30,000—of the product’s economic value.Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778
71 Analyzing Customer Profitability Customer Profitability Measurement System (CPM)Indirect costs of servicing customers are assigned to cost poolsFor example the cost of processing orders and handling returnsCosts are allocated to specific customers using cost drivers to determine customer profitability
73 Example – Customer profitability Delta Products has determined the following costs:Order processing/order $5.00Additional handling cost per rush order $8.50Customer service calls/call $10.00Relationship management costs/customer $2,000.00In addition to these costs, product costs amount to 90% of sales. In the prior year, Delta had the following experience with Johnson Brands:Sales $53,800Number of ordersPercent of orders marked rushCalls to customer serviceCalculate the profitability of the Johnson Brands account.
74 Example Solution Profitability of Johnson Brand account Sales $53,800 Less:Cost of good sold (.9 × $53,800) $48,420Order processing (200 × $5.00) $1,000Rush handling (.6 × 200 × $8.50) $1,020Customer service (140 × $10.00) $1,400Relationship management costs $2,000 $53,840Profitability of Johnson Brands account $(40)
75 Time and Material Pricing Determine a charge for labor that includes overheadDetermine a charge for materials that includes handling and storage costsInclude a profitSum = priceUsed in service companies mainly; appropriate for construction companies as well
77 Time and Material Charges Time 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 labor hour
78 Time and Material Charges 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 job4% of material costs
80 Activity-Based Pricing Customers are presented with separate prices for services they request in addition to the cost of goods purchasedCustomers will carefully consider the services they requestExample
81 Other Important Considerations in Pricing Decisions Price Discrimination – the practice of charging different customers different prices for the same product or serviceLegal implicationsPeak-Load Pricing – the practice of charging a higher price for the same product or service when the demand for it approaches the physical limit of the capacity to produce that product or service
82 The Legal Dimension of Price Setting Price Discrimination is illegal if the intent is to lessen or prevent competition for customersPredatory Pricing – deliberately lowering prices below costs in an effort to drive competitors out of the market and restrict supply, and then raising prices
83 The Legal Dimension of Price Setting Dumping – a non-US firm sells a product in the US at a price below the market value in the country where it is produced, and this lower price materially injures or threatens to materially injure an industry in the USCollusive Pricing – occurs when companies in an industry conspire in their pricing and production decisions to achieve a price above the competitive price and so restrain trade
84 Transfer pricing Transfer Price is: the internal price charged by one segment of a firm for a product or service supplied to another segment of the same firmSuch as:Internal charge paid by final assembly division for components produced by other divisionsService fees to operating departments for telecommunications, maintenance, and services by support services departments
85 Transfer PricingThe transfer price creates revenues for the selling subunit and purchase costs for the buying subunit, affecting each subunit’s operating incomeIntermediate Product – the product or service transferred between subunits of an organization
86 Effects of Transfer Prices Performance measurement:Reallocate total company profits among business segmentsInfluence decision making by purchasing, production, marketing, and investment managersRewards and punishments:Compensation for divisional managersPartitioning decision rights:Disputes over determining transfer prices
87 Three Transfer Pricing Methods Market-based Transfer PricesCost-based Transfer PricesNegotiated Transfer Prices
88 Market-Based Transfer Prices Top management chooses to use the price of a similar product or service that is publicly available. Sources of prices include trade associations, competitors, etc.
89 Market-Based Transfer Prices Lead to optimal decision making when three conditions are satisfied:The market for the intermediate product is perfectly competitiveInterdependencies of subunits are minimalThere are no additional costs or benefits to the company as a whole from buying or selling in the external market instead of transacting internally
90 Market-Based Transfer Prices A perfectly competitive market exists when there is a homogeneous product with buying prices equal to selling prices and no individual buyer or seller can affect those prices by their own actionsAllows a firm to achieve goal congruence, motivating management effort, subunit performance evaluations, and subunit autonomyPerhaps should not be used if the market is currently in a state of “distress pricing”
91 Cost-Based Transfer Prices Top management chooses a transfer price based on the costs of producing the intermediate product. Examples include:Variable Production CostsVariable and Fixed Production CostsFull Costs (including life-cycle costs)One of the above, plus some markupUseful when market prices are unavailable, inappropriate, or too costly to obtain
92 Cost-Based Transfer Pricing Alternatives Prorating the difference between the maximum and minimum cost-based transfer pricesDual-Pricing – using two separate transfer-pricing methods to price each transfer from one subunit to another. Example: selling division receives full cost pricing, and the buying division pays market pricing
93 Negotiated Transfer Prices Occasionally, subunits of a firm are free to negotiate the transfer price between themselves and then to decide whether to buy and sell internally or deal with external partiesMay or may not bear any resemblance to cost or market dataOften used when market prices are volatileRepresent the outcome of a bargaining process between the selling and buying subunits
94 Comparison of Transfer-Pricing Methods CriteriaMarket-BasedCost- BasedNegotiatedAchieves Goal CongruenceYes, when markets are competitiveOften, but not alwaysYesUseful for Evaluating Subunit PerformanceDifficult unless transfer price exceeds full cost and even then is somewhat arbitraryYes, but transfer prices are affected by bargaining strengths of the buying and selling divisions
95 Comparison of Transfer-Pricing Methods CriteriaMarket-BasedCost- BasedNegotiatedMotivates Management EffortYesYes, when based on budgeted costs; less incentive to control costs if transfers are based on actual costsPreserves Subunit AutonomyYes, when markets are competitiveNo, because it is rule-basedYes, because it is based on negotiations between subunits
96 Comparison of Transfer-Pricing Methods CriteriaMarket-BasedCost- BasedNegotiatedOther FactorsNo market may exist or markets may be imperfect or in distressUseful for determining full cost of products; easy to implementBargaining and negotiations take time and may need to be reviewed repeatedly as conditions change
97 Ideal Transfer Pricing Ideal transfer price would beOpportunity cost, or the value forgone by not using the transferred product in its next best alternative useOpportunity cost is the greater of variable production cost or revenue available if the product is sold outside of the firm
98 Minimum Transfer Price The minimum transfer price in many situations should be:Incremental cost is the additional cost of producing and transferring the product or serviceOpportunity cost is the maximum contribution margin forgone by the selling subunit if the product or service is transferred internally
99 Transfer Pricing Methods External market priceIf external markets are comparableVariable cost of productionExclude fixed costs which are unavoidableFull-cost of productionAverage fixed and variable costNegotiated pricesDepends on bargaining power of divisions
100 Transfer Pricing Implementation Disputes over transfer pricing occur frequently because transfer prices influence performance evaluation of managersInternal accounting data are often used to set transfer prices, even when external market prices are availableClassifying costs as fixed or variable can influence transfer prices determined by internal accounting dataTo reduce transfer pricing disputes, firms may reorganize by combining interdependent segments or spinning off some segments as separate firms
101 Transfer Pricing for International Taxation When 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.