Pricing and Product Strategy Costs (Ch 9) 1

Costs Ramifications of Costs How much buyers will pay is not a function of the seller’s costs. Typically, buyers do not care about the seller’s costs. What a manufacturer will produce and sell is a function of their costs. The manufacturer’s goal is to assess all relevant costs and use these costs to assist in developing a pricing strategy.

What are relevant costs? Incremental Costs – These are costs that vary with changes in sales volume (variable costs and, at times, some fixed costs). Avoidable Costs – These are costs that have yet to be incurred or that can be reversed by the company. Sunk costs, such as R&D, are not avoidable costs. Avoidable costs are future costs...usually related to replacing sold product. Examples: maintenance, delivery, marketing, inventory control So what’s the big deal about avoidable costs? If the costs of supply of materials to make product change often (price volatility), then the price of product replacing sold product can become volatile. The text uses the example of crude oil and gasoline prices…

Breaking down the profit equation . . . . Sales Revenue - Costs (Sales Volume x Price) – (Variable Costs + Fixed Costs) Variable Cost = Variable Unit Cost x Sales Volume The variable cost equation captures the effects of economies (or diseconomies) of scale. For example, a company may have to add additional capacity and employees when sales volume grows too large. This could also add to the company’s fixed cost structure.

Example PortaShelf – portable, lightweight, high-end shelving for residential use Current selling price = $100 Current sales volume at $100 price = 1 million units Total sales revenue = $100 x 1 million = $100 million Variable unit cost (marginal cost) = $60 per unit Unit contribution = $100 - $60 = $40 per unit Therefore, each unit sold currently contributes $40 to fixed cost recovery and profit. Say that fixed costs (plant, administration) are $30 million. Profit = [$100 x 1 million units] – [$60 x 1 million units + $30 million] = $10 million = 10% of gross sales revenue

Example PortaShelf is considering either raising or lowering their current price by 20%. The company would like to know how many units would have to be sold under these price changes to maintain the current profit margin of 10%. Current Price Option 1 Option 2 PortaShelf $100 $80 $120 20% decrease 20% increase

Example Option 1 – Decrease price by 20% to $80 Price = $80 Variable unit cost (marginal cost) = $60 Unit contribution = $80 - $60 = $20 per unit Therefore, each unit sold currently contributes $20 to fixed cost recovery and profit. Say that fixed costs (plant, administration) are $30 million. Thus, twice as many units must be produced to maintain the same profit level. Profit = [2 million units x $80] – [(2 million units x $60) + $30 million] (total revenue) (variable cost) (fixed cost) = $10 million

Example Option 1 A 20% reduction in price reduces the unit contribution by 50% and requires that unit sales double to achieve the current level of profitability. Question – Does PortaShelf have the operating capacity to double capacity? If the answer is no, then both variable unit costs and fixed costs will likely increase as PortaShelf: [1] adds capacity, [2] outsources production, [3] or a combination of both.

Example Option 2 – Increase price by 20% to $120 Price = $120 Variable unit cost (marginal cost) = $60 Unit contribution = $120 - $60 = $60 per unit Therefore, each unit sold currently contributes $60 to fixed cost recovery and profit. Say that fixed costs (plant, administration) are $30 million. Thus, production can be reduced by about 33% in order to maintain the current profit level. Profit = [667,000 units x $120] – [(667,000 units x $60) + $30 million] (total revenue) (variable cost) (fixed cost) = $10 million

Example Option 2 A 20% increase in price increases the unit contribution by 33% and requires that unit sales be only 2/3rds the current amount to maintain the current level of profitability. Depending on the organization of their operations, PortaShelf may not require various cost items that contribute to either their variable or fixed costs. For example, they may be able to: [1] sell a production facility, [2] use excess capacity to manufacture another product, [3] employ fewer workers or salespersons, and/or [4] spend less administrative time processing orders.

A Tabular Comparison of Profit Drivers Consider a 10% improvement in… Percentage Increase in Profit Profit Driver Profit Old Old New New Price Variable Unit Cost Sales Volume Fixed Costs $100 $60 $1 mil $30 mil $110 $54 $1.1 mil $27 mil $10 mil $20 mil $16 mil $14 mil $13 mil 100% 60% 40% 30% Note: A 10% improvement in price raises price from $100 to $110. If all other factors remain unchanged, then profit increases by 100% to $20 million. Source: Dolan, R.J. and H. Simon (1996), Power Pricing: How Managing Price Transforms the Bottom Line, New York: Free Press, 369 p.

Avoidable Costs Example Cost of Holding Inventory Sunk costs must be disregarded in the pricing decision Holding inventory can lead to added avoidable cost for two primary reasons: [1] interest cost of holding inventory…(putting the money to work elsewhere). This can also be viewed as an opportunity cost. [2] tax cost of holding inventory (property tax)

Avoidable Costs Example Cost of Holding Inventory Book Example Book currently priced at $20 and not selling. Book would likely sell very well at $10. Company’s cost of capital is 18% (interest on borrowed money). Years Inventory Held Interest Cost (avoidable) 1 $1.80 2 $3.90 3 $6.43 4 $9.39 5 $12.88 6 $16.99 7 $21.85 Interest cost to year n = $10 x (1.18n – 1) Interest costs offset the $20 book price just after 4 years of holding the inventory. Consider “Product Spoilage”

Contribution Margin CM = price less variable costs %CM = Total Contribution Margin Sales Revenue x 100 %CM is a measure of the leverage between a firm’s sales volume and its profit. It provides an indicator of the importance of sales volume as a marketing objective. Example from text (Exhibit 8.3) clearly shows the effect of selling two products with similar net profits but each having substantially different contribution margins due to their unique cost structures.

Contribution Margin Product A Product B Percentage of selling price accounted for by: Variable costs 80 20 Fixed and sunk costs 10 70 Net profit margin Contribution margin Break-even sales change (%) required to profit: 5% price reduction (advantage) +33.3 +6.7 10% price reduction (advantage) +100.0 +14.3 20% price reduction (advantage) (free) infinite 5% price increase (premium) -20.0 -5.9 10% price increase (premium) -33.3 -11.1 20% price increase (premium) -50.0 This partially explains why many U.S. companies have labor-intensive manufacturing located in countries with low-cost labor.