Cost Information for Pricing and Product Planning

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Cost Information for Pricing and Product Planning

• Chapter 7

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Introduction

• Wendy Stone, the owner of High Performance
  Springs, was meeting with her marketing manager
  and her controller.
• They were evaluating an offer from Lawson
  Corporation to purchase a large quantity of
  springs at 2.48 per pound.

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Introduction

• The accounting records show that the full cost of
  the spring is 2.79 per pound.
• This cost includes 1.38 of direct materials,
  0.76 of direct labor, and 0.65 of manufacturing
  support costs.
• Should High Performance Springs accept this
  offer?
• After reading this chapter, you will be able to...

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Learning Objectives

• Discuss the way a firm chooses its product mix in
  the short term in response to prices set in the
  market for its products.
• Explain the way a firm adjusts its prices in the
  short term depending on whether capacity is
  limited.

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Learning Objectives

• Discuss the way a firm determines a long-term
  benchmark price to guide its pricing strategy.
• Explain the way a firm evaluates the long-term
  profitability of its products and market segments.

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Learning Objective 1

• Discuss the way a firm chooses its product mix
  in the short term in response to prices set
  in the market for its products.

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Role of Product Costs in Pricing and Product-Mix
Decisions

• An understanding of product costs enables
  managers to make informed decisions related to
• prices
• discounts
• utilization of capacity
• product mix
• deployment of marketing resources

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Short- and Long-Term Pricing Considerations

• Managers must consider both the short-term and
  long-term consequences of their decisions.
• In the short run, resources committed to
  activities are likely to be fixed costs.
• For short-term decisions, it is also important to
  consider the availability of capacity.

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Short- and Long-Term Pricing Considerations

• In the long term, managers have more flexibility
  to adjust capacity resources to meet demand.
• Decisions about whether to introduce new products
  or eliminate existing products have long-term
  consequences.

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Short- and Long-Term Pricing Considerations

• What is a price taker?
• It is a firm that has little or no influence on
  the industry supply and demand forces.
• It chooses its product mix given the prices set
  in the marketplace for its products.

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Short- and Long-Term Pricing Considerations

• What is a price setter?
• It is a firm that sets or bids the prices of
  its products.
• It enjoys a significant market share in its
  industry segment.

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Classification of Pricing and Product-Mix
Decisions
Decision Type
Price-Taker Firm
Price-Setter Firm
Short-term decisions
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2
Long-term decisions
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3
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Short-Term Product-Mix Decisions Price Takers
Decision Type
Price-Taker Firm
Short-term decisions
1
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Short-Term Product-Mix Decisions Price Takers

• A firm with a very small market share has little
  influence over industry supply, demand, and
  prices.
• If the firm charges higher prices, customers go
  elsewhere.
• If it charges lower prices, large firms could
  engage in a price war.

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Short-Term Product-Mix Decisions Price Takers

• A price taker should produce and sell as many
  products as possible as long as costs are less
  than prices.
• What are two important considerations?
• Managers must decide which costs are relevant.
• Managers may not have much flexibility to
  alter the capacities of some of the firms
  resources.

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Short-Term Product-Mix Decisions Price Takers

• Consider Texmax, a small company in Mexico.
• It sells ready-made garments to discount stores
  in the United States.

Garment type Budgeted production Shirts
12,000 Dresses 5,000 Skirts
10,000 Blouses 15,000
Total 42,000
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Short-Term Product-Mix Decisions Price Takers

• Production is limited by 19,800 machine hours.

Garment Total Hours Type
Hours Production Required Shirts 0.4
12,000 4,800 Dresses 0.8 5,000
4,000 Skirts 0.5 10,000
5,000 Blouses 0.4 15,000
6,000 Totals 42,000 19,800
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Short-Term Product-Mix Decisions Price Takers

• Assume the following selling prices and variable
  costs
• Shirts selling price per unit is 5.00 and
  variable costs are 4.00.
• What is the contribution margin per unit?
• 1.00

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Short-Term Product-Mix Decisions Price Takers

• Dresses selling price per unit is 15.20 and
  variable costs are 10.40.
• What is the contribution margin per unit?
• 4.80
• Skirts selling price per unit is 9.00 and
  variable costs are 6.80.
• What is the contribution margin per unit?
• 2.20

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Short-Term Product-Mix Decisions Price Takers

• Blouses selling price per unit is 8.00 and
  variable costs are 4.40.
• What is the contribution margin per unit?
• 3.60
• Assume that, in addition to the originally
  budgeted amount, another 2,000 blouses could be
  produced and sold at the existing price.

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Short-Term Product-Mix Decisions Price Takers

• Should Texmax produce and sell these additional
  blouses?
• Yes, because blouses have the highest
  contribution margin per machine hour.
• Shirts 1.00 0.4 2.50
• Dresses 4.80 0.8 6.00
• Skirts 2.20 0.5 4.40
• Blouses 3.60 0.4 9.00

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Short-Term Product-Mix Decisions Price Takers

• The contribution margin per unit of the
  constrained resource is the criterion used to
  decide which products are most profitable to
  produce and sell at the prevailing prices.

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Short-Term Product-Mix Decisions Price Takers

• How should the 19,800 machine hours be used?
• Blouses 17,000 .04 6,800
• Dresses 5,000 0.8 4,000
• Skirts 10,000 0.5 5,000
• Shirts 10,000 0.4 4,000
• Notice that only 10,000 shirts can be produced.

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Short-Term Product-Mix Decisions Price Takers

• What is an opportunity cost?
• It is the amount of lost profit when the
  opportunity afforded by one alternative is
  sacrificed to pursue another alternative.
• In order to produce the additional 2,000 blouses,
  Texmax must decrease the production of shirts by
  2,000.

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Short-Term Product-Mix Decisions Price Takers

• Each shirt contributes 1.00, so cutting back
  the production of 2,000 shirts causes a
  sacrifice of 2,000 in profits.

Costs of Producing 2,000 Blouses Cost Type
Per Unit Total Variable
cost 4.40 8,800 Opportunity cost
1.00 2,000 Total 5.40 10,800
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Short-Term Product-Mix Decisions Price Setters
Decision Type
Price-Setter Firm
Short-term decisions
2
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Short-Term Product-Mix Decisions Price Setters

• Setting the price of a product means determining
  its full cost and a markup percentage above cost.
• This approach is known as cost-plus pricing.
• Full costs include the sum of all direct
  materials, direct labor, and support activity
  costs.

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Learning Objective 2

• Explain the way a firm adjusts its prices in the
  short term depending on whether capacity is
  limited.

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Capacity Issues

• Special orders that do not involve a
  long-term contract should be priced in
  relationship to available capacity.
• When capacity is available, incremental revenues
  have to be greater than incremental costs.

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Capacity Issues

• When capacity is not available, the minimum
  acceptable price must cover all incremental
  costs.
• This will result in additional costs.
• How can additional capacity be acquired?
• overtime operations
• subcontracting

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Capacity Issues

• What are incremental costs and revenues?
• They are the amount by which costs or revenues
  change if one particular decision is made
  instead of another.
• What is an incremental cost per unit?
• It is the amount by which total production costs
  increase when one additional unit of a product
  is produced.

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Capacity Issues

• What are relevant costs or revenues?
• They are the costs or revenues that differ across
  alternatives and therefore must be considered in
  deciding which alternative is the best.

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Learning Objective 3

• Discuss the way a firm determines a long-term
  benchmark price to guide its pricing strategy.

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Long-Term Pricing Decisions Price Setters
Decision Type
Price-Setter Firm
Long-term decisions
3
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Long-Term Pricing Decisions Price Setters

• Costs which are relevant for short-term pricing
  decisions are not the same as those which are
  relevant for long-term pricing decisions.
• Most firms rely on full-cost information reports
  when setting prices.

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Long-Term Pricing Decisions Price Setters

• There is economic justification for reliance on
  full costs for pricing decisions in three types
  of circumstances.
• When contracts specify full cost of jobs plus
  markup
• When a firm enters into a long-term contractual
  relationship with a customer to supply a product

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Long-Term Pricing Decisions Price Setters

• When a firm adjusts its prices up and down to
  respond to changes in supply and demand, and the
  price tends to approximate the price on full
  costs
• Most firms use full cost-based prices as target
  prices.

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Short-Term Prices Relative to Long-Term Benchmark
Price
High Demand
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Price
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Benchmark Price
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Low Demand
1 2 3 4 5 6 7 8 9 10 11 12 13 14
15 16 Month
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Short-Term Prices Relative to Long-Term Benchmark
Price

• Prices depend on demand conditions.
• Markups increase with the strength of demand.
• Markups depend on the elasticity of demand.
• Markups also fluctuate with the intensity of
  competition.

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Short-Term Prices Relative to Long-Term Benchmark
Price

• What is elasticity of demand?
• Demand is said to be elastic if customers
  are very sensitive to the price.
• A small increase in price results
  in a large decrease in demand.

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Short-Term Prices Relative to Long-Term Benchmark
Price

• When demand is relatively inelastic, profits will
  usually increase when prices increase.
• Firms often lower markups for strategic reasons.
• What are these reasons?
• Penetration pricing strategy
• Skimming pricing strategy

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Pricing Strategies

• What is a penetration pricing strategy?
• It is charging a lower price initially to win
  over market share from an established product of
  a competing firm.
• What is a skimming pricing strategy?
• It is charging a higher price initially from
  customers willing to pay more for the privilege
  of possessing a new product.

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Long-Term Pricing Decisions Price Takers
Decision Type
Price-Taker Firm
Long-term decisions
4
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Long-Term Pricing Decisions Price
Takers

• Decisions to add a new product or to drop an
  existing product from the portfolio of products
  usually have significant long-term implications
  for the cost structure of a firm.
• Product-sustaining and batch-related costs are
  likely to change.

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Learning Objective 4

• Explain the way a firm evaluates the long-term
  profitability of its products and market segments.

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Long-Term Profitability

• When making long-term product mix decisions,
  managers use the full costs of products that
  incorporate the cost of using various activity
  resources.
• Comparing product costs with their market prices
  reveals which products are not profitable in the
  long term.

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Long-Term Profitability

• If some products have full costs that exceed the
  market price, the firm must consider several
  options.
• The impact of dropping products on the cost
  structure of the firm
• The need to maintain a full product line

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Long-Term Profitability

• The redeployment or elimination of resources no
  longer used
• The feasibility of changing resources committed
  to batch-related and product sustaining
  activities
• Managers also may want to explore market
  conditions more carefully and differentiate their
  products further to raise prices and bring them
  in line with the costs.

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Long-Term Profitability

• When will dropping products help improve
  profitability?
• When managers eliminate the activity resources no
  longer required to support the discontinued
  product
• When managers redeploy the resources from the
  eliminated products to produce more of the
  profitable products that the firm continues to
  offer

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Long-Term Profitability

• Capacity constraints are likely to be less of
  a concern for product-mix decisions that have
  long-term effects.
• Firms can adjust the level of resources committed
  to most activities.
• Comparison of the price of a product with its
  activity-based costs provides a valuable
  evaluation of its long-run profitability.

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Conclusion

• Should High Performance Springs slash the price
  of its spring to obtain business from a reputable
  customer, the Lawson Corporation?
• Fixed costs can be ignored, and variable costs
  alone are relevant only for analyzing a
  short-term pricing decision.

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Conclusion

• For long-term pricing decisions, the costs of
  many more resources are relevant because firms
  can adjust the supply of most resources over the
  long-term.

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Conclusion

• A case for a lower price for Lawson could be made
  as a part of a penetration pricing strategy.
• High Performance Springs must consider the
  reaction of its existing customers.
• It also must consider its competitors, who may
  cut prices to respond to Precisions discounting.

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End of Chapter 7