Chapter 9: Costs Strategy and Tactics of Pricing, The, 5/E

Chapter 9: Costs

Strategy and Tactics of Pricing, The, 5/E

2The Strategy and Tactics of Pricing

Profitable Pricing Requires*

UNDERSTANDING THE TRUE COST (Page 181 & 182)– Profitable pricing involves an integration of costs and customer value– Profitable pricing often involves sacrificing gross profit in order to reduce future

expenses* (Page 190)– Firms that price effectively decide what to produce and to whom to sell it by

comparing the prices they can charge with the costs they must incur.*– Low cost producers can charge lower prices and sell more because it can

profitability use low prices to attract more price sensitive buyers.*– The mistake that cost-plus pricers make is that they select the quantities they will

sell and the buyers they will serve before identifying the prices they can charge. Then they try to impose cost-based prices that may be either more or less then what buyers will pay.*

– Costs should never determine price, but costs do play a critical role in formulating a pricing strategy.


Profitable Pricing Requires cont: Page 182

– Seller’s decisions about which products to produce and in what quantities depend critically on their cost of production

– First evaluate what buyers can be convinced to pay and only then choose quantities to produce and markets to serve

– Changes in costs should cause producers to change their prices, not because that changes what buyers will pay, but because it changes the quantities that the firm can profitably supply and the buyers it can profitably serve. (Page 182, Jet Fuel Costs)

– Pricing decisions affect whether a company will sell less of the product at a higher price or more of the product at a lower price. In either scenario, some costs remain the same (in total).


Determining Relevant Costs* Page 182 & 183

IDENTIFYING TRUE COSTS* – Why Incremental Costs

* One cannot price effectively without understanding costs*. To be effective you must understand costs and apply cost plus formulas to labor costs, raw materials cost and overhead cost.*

- First step in pricing is to identify the relevant costs: those that actually determine the profit impact of the pricing decision*

– Incremental – “Incremental costs are the costs associated with changes in pricing and sales”. *

– Costs that rise or fall when prices change affect the relative profitability of different pricing strategies. We call these costs incremental because they represent the increment to costs (positive or negative) that results from the pricing decision

– Incremental costs is the increase or decrease in costs as a result of one more or one less unit of output

– Incremental costs are costs, over and above that a company would normally incur that are required to implement an activity such as hiring a consultant.

– The distinction between incremental and non-incremental costs parallels closely, but not exactly, the more familiar distinction between variable and fixed costs.


Determining Relevant Costs cont: Page 183

– Variable costs – such as the costs of raw materials in a manufacturing process, are costs of doing business. Because pricing decisions affect the amount of business that a company does, variable costs are always incremental for pricing.

– Fixed costs – such as those for product design, advertising and overhead are costs of being in business. These are incremental when deciding whether a price will generate enough revenue to justify being in business of selling a product or serving a particular type of customer.

– Incremental costs are those that directly result from implementing a price change or from offering a version of the product at a different price level. Example: Fixed cost for a restaurant to print menus with new prices. The fixed cost for an airline to advertise a new discount service would be incremental when deciding whether to offer products at those price levels.


Why Avoidable Costs* Page 186

– Avoidable (not the “sunk cost”) – Avoidable costs are those that either have not yet been incurred or can be

reversed.* The costs of selling a product, delivering it to the customer, and replacing the sold item in inventory are avoidable

– The easiest way to identify the avoidable cost is to recognize that the cost of making a sale is always the current cost, resulting from the sale, not costs that occurred in the past*

– “sunk cost”– The opposite of avoidable costs are sunk costs – those costs that a company is

irreversible committed to bear. (Example – company’s expenditures on research and development are sunk costs, which cannot be changed regardless of any decisions made in the present)

– Commercial airplanes, new truck, oil companies are examples (Page 187, review each and gallon of gasoline)

– * The intelligent company bases its prices on the replacement cost, not the historical cost, of its inventory (Page 188)


Identify Incremental Variable Costs

VARIABLE COSTS ARE ALWAYS INCREMENTAL

But be careful of averages! The incremental variable cost for a change in sales is often not equal to the average variable cost

Examples:

– Overtime vs. average cost production;– Costs from multiple sources using different technologies (joint product vs. prime

sourcing);– Average over different types of customers.


Estimating Relevant Costs* Pages 191 - 192

Four Common Errors mangers frequently make when attempting to develop estimates of true costs: (Page 191 &192)

1. Beware of averaging total variable costs to estimate the cost of a single unit, incremental cost per unit is not constant

2. Beware of accounting depreciation formulas. The relevant depreciation expense that should be used for all managerial decision making is the change in the current value of assets. For pricing and any other managerial decision making, however, depreciation expenses should be based on forecasts of the actual decline in the current market value of assets as a result of their use.

3. Beware of treating a single cost as either all relevant or all irrelevant for pricing. Costs should be divided into the portion that is relevant for pricing and the portion that is not.

4. Beware of overlooking opportunity costs. Opportunity cost is the contribution that a firm forgoes when it uses assets for one purpose rather then another.* Airlines use yield management systems to control and exploit the most important cost for ticket pricing: the opportunity cost of its capacity.* (Page 195 – Airlines seats – Discount vs. Full price)


Identify Incremental Fixed Costs – Page 193

Some fixed costs are also incremental for pricing – They are the fixed costs incurred to implement a change in pricing. (The fixed cost

for a restaurant to print menus with NEW prices)

- If fixed costs change because of a change in price, then those incremental fixed costs are relevant to pricing. For example, if you must advertise a price change, it is relevant.

Most fixed costs are not incremental– Since they do not change with a change in price or sales, they are not

incremental. They have no impact on the relative profitability of alternative pricing strategies.

Examples:– Product Development Costs– Advertising

Full costs--which include non-incremental fixed costs—are neither the actual costs incurred when making additional sales at lower prices, nor the actual costs saved when making fewer sales at higher prices. They are, therefore, misleading as a guide to pricing

Full costs--which include non-incremental fixed costs—are neither the actual costs incurred when making additional sales at lower prices, nor the actual costs saved when making fewer sales at higher prices. They are, therefore, misleading as a guide to pricing


Identify Incremental Opportunity Costs – Page 195

Beware of overlooking or ignoring opportunity costs.– They are often incremental, even when associated with otherwise

“fixed” assets.– Box 8-2 – Opportunity Costs: A Practical Illustration

Examples:– Alternative uses of capacity, funds, or management time.


Costing Discussion Questions

In the mid 1960s, McDonald's offered their franchisees breakfast items (e.g., Egg McMuffin) that they could offer in the mornings when demand for hamburgers and fries was not very large.

What costs should a franchisee have properly considered in deciding whether to offer a breakfast menu and in determining the most profitable prices to charge for breakfast items?


Reorganize Costs for Effective Management

Incremental Costing For simple pricing decision

Incremental CostingFor pricing with incremental

investment

Total CostingFor measuring overall business profitability

unit Price

incremental VC per unit

= contribution margin / unit

incremental revenue

incremental variable cost

= incremental contribution

incremental fixed costs

= Net incremental

contribution

sales revenue

total variable costs

= total contribution

incremental fixed costs

net contribution

non-incremental fixed

and sunk costs

= net profit


Determine The Contribution Margin

PER UNIT Price

- Incremental Variable Costs

= Contribution Margin ($, %)

PER UNIT Price

- Incremental Variable Costs

= Contribution Margin ($, %)

TOTAL Sales Revenue

- Total Variable Costs

= Total Contribution ($, %)

TOTAL Sales Revenue

- Total Variable Costs

= Total Contribution ($, %)


Why Focus on CM?* Page 197 - 199

• The percent contribution margins the share of price that adds to profit or reduces losses*

• Contribution margin - The amount remaining from sales revenues after all variable expenses have been deducted (Contribution Margin = sales - variable costs)

• Contribution margin- is the amount generated by sales to cover fixed costs, and it is important to identify these costs correctly.

Tool of Competitive Advantage – Page 198– Relative advantage– The percent contribution margin is a measure of the leverage between a

firm’s sales volume and its profit. It indicates the importance of sales volume as a marketing objective.

Tool for Segmentation Pricing – Page 199– Set different prices for different segments– Can reach more segments– The percent contribution margin is an indicator of the firm’s ability to

compete against competitors.


Why Focus on CM?* Page 197 - 199

Indicator of how to drive profitability – Page 199

– High margin: volume-based strategies

– Low margin: price and bundling strategies

– The percent contribution margin is a measure of the extent to which you can use segmentation pricing to serve and penetrate multiple market segments.

– Segmentation pricing – means setting different prices for different market segments, each of which has a different cost to serve and different level of price sensitivity.*

– For a given product the greater your percent contribution margin, the more flexibility you have to set higher prices for some customer segments and lower prices for other segments. (Page 199)

* The most important reason to identify costs correctly is to be able to calculate an accurate contribution margin* Page 204


Transfer Pricing Issues – Page 199

Question Answer

Which costs are relevant to a pricing decision?

Incremental costs

How does external sourcing affect relevant costs?

Incrementalize non-incremental costs

Cost disadvantage

Reliance on price instead of volume

Who is affected? Independent suppliers

How should fixed costs be dealt with?

Operating decisions vs. investment decisions


Approximately Right, Or Precisely Wrong

Determining the true cost of a product or service--the incremental, avoidable cost--requires making adjustments to the full, average costs as calculated for financial purposes. These adjustments often require that you make judgments about which you are uncertain, and that are debatable. This is not, however, a reason to avoid making such judgments.

It is better to make pricing decisions based on a

rough idea of the true unit cost of your product or service

than on a precise accounting of costs that are irrelevant

to its profitability!

Chapter 8 CostsHow Should they Affect Pricing Decisions?

The Strategy and Tactics of Pricing, 4E

Thomas Nagle and John Hogan

Documents

Chapter 9: Costs Strategy and Tactics of Pricing, The, 5/E