Pricing Decisions EMBA 5412 Fall 2010 Pricing in

Pricing Decisions EMBA 5412 Fall 2010

Pricing in today’s theory and practice* o Not too much research on pricing- company and academic o Managers 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. o o Hinterhuber, A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778 2

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 3

Fig. 2. High price and large market share—not as incompatible as commonly believed In conclusion, it seems that managers, as price setters, have a general tendency to overestimate the importance of price for actual and potential customers Hinterhuber, A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778 4

Pricing and Business o How companies price a product or service ultimately depends on the demand supply for it o Three influences on demand supply: 1. Customers 2. Competitors 3. Costs 5

Influences on Demand Supply n n n Customers – influence price through their effect on the demand for a product or service, based on factors such as quality and product features Competitors – influence price through their pricing schemes, product features, and production volume Costs – influence prices because they affect supply (the lower the cost, the greater the quantity a firm is willing to supply) 6

Time Horizons and Pricing o Short-run pricing decisions have a time horizon of less than one year and include decisions such as: n Pricing a one-time-only special order with no long-run implications n Adjusting product mix and output volume in a competitive market o Long-run pricing decisions have a time horizon of one year or longer and include decisions such as: n Pricing a product in a major market where there is some leeway in setting price 7

Pricing o External sales- outside n Target pricing-Competition-based pricing n Cost plus pricing n Variable cost pricing n Customer based pricing-value-based pricing n Time and material pricing o Internal-within the company among divisions n Negotiated transfer prices n Cost based transfer prices n Market based transfer prices n Effect of outsourcing on transfer prices n Transfers between divisions in different countries 8

Profit Maximization Economic Theory n The quantity demanded is a function of the price that is charged n Generally, the higher the price, the lower the quantity demanded Pricing n Management should set the price that provides the greatest amount of profit 9

Determining the Profit. Maximizing Price and Quantity Profit is maximized where marginal cost equals marginal revenue, resulting in price p* and quantity q*. Dollars per unit p* Demand Marginal cost Marginal revenue q* Quantity made and sold per month 10

Example 1 o The editor of EMBA Magazine is considering three alternative prices for her new monthly periodical. Her estimate of price and quantity demanded are: Price TL 6 TL 5 TL 4 Quantity 22, 000 28, 000 32, 000 Monthly costs of producing and delivering the magazine include TL 90, 000 of fixed costs and variable costs of TL 1. 50 per issue. o Which price will yield the largest monthly profit? 11

Solution Example 1 Choose TL 6 TL based on quantitative factors given. Need to consider qualitative factors as well. 12

Determining the Profit. Maximizing Price and Quantity Total cost Total revenue Dollars p* Total profit at the profit-maximizing quantity and price, q* and p*. q* Quantity made and sold per month 13

Price Elasticity The impact of price changes on sales volume Demand 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. 14

Who determines the price? o Price takers- when there is a competitive market and the company has no influence on price n Once competition enters the market, the price of a product becomes squeezed between the cost of the product and the lowest price of a competitor. o Price makers- companies that influence the price • Organizations 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. 15

Markets and Pricing o Competitive Markets – use the market -based approach o Less-Competitive Markets – can use either the market-based or costbased approach o Noncompetitive Markets – use costbased approaches 16

Influences on Price o o Customer demand Competitors’ behavior/prices/actions Costs Regulatory environment – legal, political and image related 17

Differences Affecting Pricing: Long Run vs. Short Run n n 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 run Profit 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 18

Alternative Long-Run Pricing Approaches o Market-Based: price charged is based on what customers want and how competitors react o Cost-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 19

Market-Based Approach o Starts with a target price o Target Price – estimated price for a product or service that potential customers will pay o Estimated on customers’ perceived value for a product or service and how competitors will price competing products or services 20

Understanding the Market Environment o Understanding customers and competitors is important because: n Competition from lower cost producers has meant that prices cannot be increased n Products are on the market for shorter periods of time, leaving less time and opportunity to recover from pricing mistakes n Customers have become more knowledgeable and demand quality products at reasonable prices 21

22

Pricing approaches o Cost plus mark-up n Variable – contribution margin approach, contribution margin( reflecting mark-up) should cover desired return on investment, all fixed costs n Absorption – common- mark-up covers all expenses except cost of goods sold plus the desired return on investment o Target costing– price is known (competitor’s), desired return on investment is known, price is known = determine the maximum cost per unit 23

Cost-Plus Pricing Company estimates cost of production o Adds a markup to cost to arrive at price which allows for a reasonable profit Benefits o Simple approach Limitations o What % markup to use? o Inherently circular for manufacturing firms o Requires considerable judgment and experimentation 24

Product Life Cycle http: //www. hss. caltech. edu/~mcafee/Classes/BEM 106/PDF/Product. Life. Cycle. pdf 25

Life Cycle Costing o Life 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). o 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) o The best balance among cost elements is achieved when the total LCC is minimized (Barringer and Weber, 1996). 26

27

Life-Cycle Product Budgeting and Costing o 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 support o Life-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 28

Important Considerations for Life-Cycle Budgeting o Nonproduction costs are large o Development period for R&D and design is long and costly o Many costs are locked in at the R&D and design stages, even if R&D and design costs are themselves small 29

Example o Murmur 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. 30

Example 110. 000 U 31

Cost-Based (Cost-Plus) Pricing o The general formula adds a markup component to the cost base to determine a prospective selling price o Usually only a starting point in the price-setting process o Markup is somewhat flexible, based partially on customers and competitors 32

Forms of Cost-Plus Pricing o Setting a Target Rate of Return on Investment: the Target Annual Operating Return that an organization aims to achieve, divided by Invested Capital o Selecting different cost bases for the “costplus” calculation: n n Variable Manufacturing Cost Variable Cost Manufacturing Cost Full Cost 33

Common Business Practice o Most firms use full cost for their costbased pricing decisions, because: n Allows for full recovery of all costs of the product n Allows for price stability n It is a simple approach 34

Cost-plus Pricing o Selling Price= Cost + mark-up% x Cost o Mark-up % = Desired profit per unit ÷ Unit cost o Desired profit = Desired ROI x Investment 35

Which cost? o Variable manufacturing cost Price= variable manufacturing costs + markup% * variable manufacturing cost Mark-up should cover the remaining costs and provide for the desired profit, i. e. variable selling and all fixed costs VSC: variable selling costs FC: fixed costs – manufacturing and selling ADM: Administrative Expenses n : number of units to be sold vmcu: variable manufacturing cost per unit 36

Which costs? o Total variable costs n Variable manufacturing and selling costs Price= variable costs + markup %* variable costs 37

Which costs? o Absorption – manufacturing costs o Unit manufacturing costs – both variable and fixed Price= unit manuf. cost + markup %* unit manufacturing cost S&ADM: Selling and administrative costs Unit cost : unit manufacturing cost (variable and fixed) 38

Which costs? o Absorption – total costs n Total costs – manufacturing and selling and administrative –fixed (direct or allocated, variable costs) Price= unit cost + markup %* unit cost 39

Example - Pricing Annual sales 480 units Unit costs: Variable manufacturing cost Applied fixed manufacturing cost Absorption manufacturing cost Variable selling costs Allocated and direct fixed selling and administrative costs $ 400 $ 250 $ 650 $ 100 $ 800 Total cost (Manufacturing and S&ADM) Investment $ 600, 000 Desired profit 10% of investment $ 60, 000 Annual Fixed Manufacturing Costs $ 120, 000 Annual Fixed (allocated and direct) Selling and Administrative Costs $ 48, 000 40

Cost Plus Pricing Versions 41

Cost Plus Pricing Versions 42

Cost Plus Pricing Versions 43

Cost Plus Pricing Versions 44

Cost plus comparison Cost plus type Variable Manufac Full cost manufac cost plus turing mark up costs mark up cost plus mark up Mark up 131. 25 % 105. 56 42. 31 15. 63 Price 925 925 45

Retail cost plus mark-up o Mark up on cost of goods sold = (selling and administrative costs + operating income) / COGS 46

Retail Example o Yesim Textile’s income statement for 2007 is as follows: 47

Project Example o EMBA 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 48

Project Example o EMBA 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? 49

Pros and Cons of Cost plus pricing o Easy to compute o No consideration to the demand side o Sales volume plays an important role- allocation of fixed costs over the products sold o If variable cost plus used then fixed costs might not be covered if not calculated correctly 50

Pricing Special Orders In some cases, it may be beneficial for a company to charge a price lower than its full cost n Only if the order will not affect demand for its other products 51

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? 52

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. 53

Target Costing 54

Five Steps in Developing Target Prices and Target Costs 1. Develop a product that satisfies the needs of potential customers 2. Choose a target price § § § price is the same as the competition set price to increase customer base seek larger market share through price 3. Derive a target cost per unit: n Target Price per unit minus Target Operating Income per unit 4. Perform cost analysis 5. Perform value engineering to achieve target cost 55

Value Engineering o Value Engineering is a systematic evaluation of all aspects of the value chain, with the objective of reducing costs while improving quality and satisfying customer needs o Managers must distinguish valueadded activities and costs from nonvalue-added activities and costs 56

Value Engineering Terminology o 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 service o Non-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 57

Value Engineering Terminology o Cost Incurrence – describes when a resource is consumed (or benefit forgone) to meet a specific objective o Locked-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 future n Are a key to managing costs well 58

Problems with Value Engineering and Target Costing 1. Employees may feel frustrated if they fail to attain targets 2. A cross-functional team may add too many features just to accommodate the wishes of team members 3. A product may be in development for a long time as alternative designs are repeatedly evaluated 4. Organizational conflicts may develop as the burden of cutting costs falls unequally on different business functions in the firm’s value chain 59

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 40. 000 mouses. To design, develop and produce these new mouses and investment of TL 2. 000 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? 60

Example target costing 61

Customer-based pricing o Value based pricing-the price is based on the customer ‘demand’ or need for the product n Unique product – value based pricing might be helpful to create demand o use price to support product image o set price to increase product sales o design a price range to attract many consumer groups o set price to increase volume sales o price a bundle of products to reduce inventory or to excite customers 62

concept of economic (or customer) value o Two interpretations: o 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). o o 63

To quantify economic value o Step 1: Identify the cost of the competitive product and process that consumer views as best alternative n put 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 analyzed o Step 2: Segment the market n e. g. Microsoft, for example, is known for handing out beta-versions of its latest enterprise software products to particularly knowledgeable companies and customer segments Hinterhuber, A, Towards value-based pricing—An integrative framework for decision making, Industrial 64 Marketing Management 33 (2004) 765– 778

To quantify economic value o Step 3: Identify all factors that differentiate the product from the competitive product and process. o Step 4: Determine the value to the customer of these differentiating factors. n 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 prefer Hinterhuber, A, Towards value-based pricing—An integrative framework for decision making, Industrial 65 Marketing Management 33 (2004) 765– 778

To quantify economic value o Step 5: Sum the reference value and the differentiation value to determine the total economic value. n The product’s economic value is simply the sum of the price of the reference product plus its differentiation value. o Step 6: Use the value pool to estimate future sales at specific price points. n 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 examined Hinterhuber, A, Towards value-based pricing—An integrative framework for decision making, Industrial 66 Marketing Management 33 (2004) 765– 778

Example of value based pricing o Japanese industrial equipment manufacturer. o 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. o 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. o 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 67 Marketing Management 33 (2004) 765– 778

WHY? o 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 competitor o For 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 68 Marketing Management 33 (2004) 765– 778

69

Analysis o Under 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 70 Marketing Management 33 (2004) 765– 778

Analyzing Customer Profitability Measurement System (CPM) n Indirect costs of servicing customers are assigned to cost pools n For example the cost of processing orders and handling returns n Costs are allocated to specific customers using cost drivers to determine customer profitability 71

Customer Profitability Measurement System 72

Example – Customer profitability o Delta Products has determined the following costs: Order processing/order Additional handling cost per rush order Customer service calls/call Relationship management costs/customer o In addition to these costs, product costs amount to 90% of sales. In the prior year, Delta had the following experience with Johnson Brands: Sales Number of orders Percent of orders marked rush Calls to customer service o $5. 00 $8. 50 $10. 00 $2, 000. 00 $53, 800 200 60 140 Calculate the profitability of the Johnson Brands account. 73

Example Solution o Profitability of Johnson Brand account Sales Less: Cost of good sold (. 9 × $53, 800) Order processing (200 × $5. 00) Rush handling (. 6 × 200 × $8. 50) Customer service (140 × $10. 00) Relationship management costs Profitability of Johnson Brands account $53, 800 $48, 420 $1, 000 $1, 020 $1, 400 $2, 000 $53, 840 $(40) 74

Time and Material Pricing o Determine a charge for labor that includes overhead o Determine a charge for materials that includes handling and storage costs o Include a profit o Sum = price o Used in service companies mainly; appropriate for construction companies as well 75

Example 4% x 1. 000 76

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 77

Time and Material Charges Material Charge formula Material 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)] =1. 04 x material costs incurred on job 4% of material costs 78

Example con’t 79

Activity-Based Pricing o Customers are presented with separate prices for services they request in addition to the cost of goods purchased n Customers will carefully consider the services they request o Example 80

Other Important Considerations in Pricing Decisions o Price Discrimination – the practice of charging different customers different prices for the same product or service n Legal implications o Peak-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 81

The Legal Dimension of Price Setting o Price Discrimination is illegal if the intent is to lessen or prevent competition for customers o Predatory Pricing – deliberately lowering prices below costs in an effort to drive competitors out of the market and restrict supply, and then raising prices 82

The Legal Dimension of Price Setting o 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 US o Collusive 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 83

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 firm Such as: o Internal charge paid by final assembly division for components produced by other divisions o Service fees to operating departments for telecommunications, maintenance, and services by support services departments 84

Transfer Pricing o The transfer price creates revenues for the selling subunit and purchase costs for the buying subunit, affecting each subunit’s operating income o Intermediate Product – the product or service transferred between subunits of an organization 85

Effects of Transfer Prices Performance measurement: o Reallocate total company profits among business segments o Influence decision making by purchasing, production, marketing, and investment managers Rewards and punishments: o Compensation for divisional managers Partitioning decision rights: o Disputes over determining transfer prices 86

Three Transfer Pricing Methods 1. Market-based Transfer Prices 2. Cost-based Transfer Prices 3. Negotiated Transfer Prices 87

Market-Based Transfer Prices o 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. 88

Market-Based Transfer Prices o Lead to optimal decision making when three conditions are satisfied: 1. The market for the intermediate product is perfectly competitive 2. Interdependencies of subunits are minimal 3. There are no additional costs or benefits to the company as a whole from buying or selling in the external market instead of transacting internally 89

Market-Based Transfer Prices o 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 actions o Allows a firm to achieve goal congruence, motivating management effort, subunit performance evaluations, and subunit autonomy o Perhaps should not be used if the market is currently in a state of “distress pricing” 90

Cost-Based Transfer Prices o Top management chooses a transfer price based on the costs of producing the intermediate product. Examples include: n n Variable Production Costs Variable and Fixed Production Costs Full Costs (including life-cycle costs) One of the above, plus some markup o Useful when market prices are unavailable, inappropriate, or too costly to obtain 91

Cost-Based Transfer Pricing Alternatives o Prorating the difference between the maximum and minimum cost-based transfer prices o Dual-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 92

Negotiated Transfer Prices o 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 parties o May or may not bear any resemblance to cost or market data o Often used when market prices are volatile o Represent the outcome of a bargaining process between the selling and buying subunits 93

Comparison of Transfer-Pricing Methods Criteria Market. Based Cost. Based Negotiated Achieves Goal Congruence Yes, when markets are competitive Often, but not always Yes Useful for Evaluating Subunit Performance Yes, when markets are competitive Difficult unless Yes, but transfer prices are affected exceeds full cost by bargaining and even then is strengths of the somewhat buying and selling arbitrary divisions 94

Comparison of Transfer-Pricing Methods Criteria Market. Based Cost. Based Negotiated Motivates Management Effort Yes, when based on budgeted costs; less incentive to control costs if transfers are based on actual costs Yes Preserves Subunit Autonomy Yes, when markets are competitive No, because it is rule-based Yes, because it is based on negotiations between subunits 95

Comparison of Transfer-Pricing Methods Criteria Other Factors Market. Based Cost. Based Negotiated No market may Useful for Bargaining and exist or determining negotiations markets may full cost of take time and be imperfect or products; easy may need to be in distress to implement reviewed repeatedly as conditions change 96

Ideal Transfer Pricing Ideal transfer price would be o Opportunity cost, or the value forgone by not using the transferred product in its next best alternative use o Opportunity cost is the greater of variable production cost or revenue available if the product is sold outside of the firm 97

Minimum Transfer Price o The minimum transfer price in many situations should be: n Incremental cost is the additional cost of producing and transferring the product or service n Opportunity cost is the maximum contribution margin forgone by the selling subunit if the product or service is transferred internally 98

Transfer Pricing Methods o External market price n If external markets are comparable o Variable cost of production n Exclude fixed costs which are unavoidable o Full-cost of production n Average fixed and variable cost o Negotiated prices n Depends on bargaining power of divisions 99

Transfer Pricing Implementation o Disputes over transfer pricing occur frequently because transfer prices influence performance evaluation of managers o Internal accounting data are often used to set transfer prices, even when external market prices are available o o Classifying costs as fixed or variable can influence transfer prices determined by internal accounting data To reduce transfer pricing disputes, firms may reorganize by combining interdependent segments or spinning off some segments as separate firms 100

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. 101