PRICE STRATEGY PRICING METHODS COST BASED PRICING In

PRICE STRATEGY: PRICING METHODS

COST BASED PRICING • In the case of cost base pricing, a company arrives at a list price for the product by calculating its total costs and then adding a desire profit margin • The calculation for such cost include the following: – Fixed Costs • Costs that do not vary with different quantities of output (equipment, light, heat, power, ect) – Variable Costs • Change according to the level of output (labor and raw materials) • Variable costs may rise or fall depending on production level • Generally, the more a firm is producing the cheaper the product is to make due to more efficiency in labor and cheaper mass purchases of supplies and materials • In long term, firm must establish pricing strategy to recover total costs (fixed plus variable) • Companies have three choices in pricing to do so: full-cost pricing, target pricing, break even pricing

COST BASED PRICING: FULL-COST • In order to gain profit, a desired profit margin is added to the full cost of the price • In such a system, profits are based on costs rather than on demand or revenue of a product • When a firm established a desired level of profit that must be adhered to, the profit goal can be interpreted as a fixed cost • This method can also be known as cost-plus pricing • Formula: Price = Total Fixed Costs + Total Variable Costs + Projected Profit Quantity Produced

COST BASED PRICING: FULL-COST • A manufacturer of colour television has a fixed cost of $100, 000 and a variable cost of $300 for every unit produced. The profit objective is to achieve $10, 000 based on 150 televisions. What is the selling price? • Formula: Price = Total Fixed Costs + Total Variable Costs + Projected Profit Quantity Produced =100, 000 + ($300 x 150) +$10, 000 150 = $155 000 150 = $1033. 33

COST BASED PRICING: TARGET PRICING • Target Pricing is designed to generate a desirable rate of return on investment (ROI) and is based on the full costs of producing a product • For this method to be effective, the firm must have the ability to sell as much as it produces • The major drawback of this method is that demand is not considered • If the quantity produced is not sold at the target price, the objective of the strategy, to achieve a desired level of ROI, is defeated • Formula: Price = Investment Costs x Target Return on Investment % Standard Volume + Average Total Costs (as Standard Volume/Unit)

COST BASED PRICING: TARGET PRICING • A manufacturer has just built a new plant at a cost of $75 000. The target return on the investment is 10%. The standard volume of production for the year is estimated at 15 000 units. The average total cost for each unit is $5000 based on the standard volume of 15 000 units. What is the selling price? • Formula: Price = Investment Costs x Target Return on Investment % Standard Volume + Average Total Costs (as Standard Volume/Unit) = $75 000 x. 10 + $5000 15 000 = $5500

COST BASED PRICING: BREAK-EVEN ANALYSIS • Break even analysis has a greater emphasis on sales than do the other methods, and it allows a firm to assess profit at alternative price level • Break even analysis determines the sales in units or dollars that are necessary for total revenue (price x quantity) to equal total costs (fixed plus variable costs) at a certain price. • The concept is simple, if sales are above the break-even point (BEP) the firm yields a profit, if the sales are below the BEP, a loss results • Formula: Break Even in Units = Total Fixed Costs Prices – Variable Costs Per Unit Break Even in Dollars = Total Fixed Costs 1 - Variable Cost (Per Unit) Price

COST BASED PRICING: BREAK-EVEN ANALYSIS • A manufacturer incurs total fixed costs of $180 000. Variable costs are $0. 20 per unit. The product sells for $0. 80. What is the break-even point in unit? In dollars? • Formula: Break Even in Units = $210 000 $0. 80 – $0. 20 = 350 000 Break Even in Dollars = $180, 000 $0. 20 $0. 80 = $240 000 1 -

DEMAND-BASED PRICING • As the name suggests, the price that customers will pay influences the demand based pricing the most • In determining price, then, a company can proceed in two directions. – Chain Mark Up/Forward Pricing • To establish all costs and profit expectations at the point of the manufacture, adding appropriate profit margins for various distributors, thus arriving at a retail selling price that hopefully is in line with customer expectations – Demand Minus Pricing/Backwards Pricing • To determine what a consumer will pay at retail and then aim to manufacture a product that is below that price and gives a significant or desired profit

DEMAND-BASED PRICING • Chain Mark Up/Forward Pricing – A CD distributor has determined people are willing to spend $30 for a three cd set of Lil Yacthy. The company estimates that marketing expenses and profits will be 40% of the selling price. How much can the firm spend on producing these CDs? Product Cost = Price x [(100 -Markup %)/100] = $30 x [(100 -40)/100] = $30 x (60/100) = $18

DEMAND-BASED PRICING • Demand Minus Pricing/Backwards Pricing – A manufacture of blue jeans has determined their total costs are $20 per pair of jeans. The company sells the jeans through the wholesalers who in turn sells jeans to retailers. The wholesaler requires a markup of 20% and the retailer requires a mark up of 40%. The manufacturer needs a mark up of 25%. What price will everyone pay? Manufacturer Cost and Selling Price = $20 + 25% Markup = $20 + $5 = $25 Wholesaler’s Cost and Selling Price = Manuf. Selling Price + 20% Markup = $25 + $5 = $30 Retailer’s Cost and Selling Price = Wholes. Selling Price + 40% = $30+$12 =$42

COMPETITIVE BIDDING • Involves two or more firms submitting a purchaser written price quotations based on specifications established by a purchaser • Due to dynamics of competitive bidding and the size, resources, and objectives of potential bidders, it is difficult to explain how costs and price quotations are arrived at • Example: Construction – Some companies may want big profit while others might want to use break even analysis – Goal is to cover all their total and variable costs and add a small profit (large enough to make it worth it, small enough to win bid)