Cost based pricing rules
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Cost Based Pricing Rules. Ted Mitchell. Pricing Two Views. 1. We give you a good price Price Is Relative To Competition 2. We ask for this in exchange Price = Product + Place + Promotion Price Is A Reflection of Value. There are Price Setters and Price Takers.

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Cost based pricing rules

Cost Based Pricing Rules

Ted Mitchell


Pricing two views

Pricing Two Views

1. We give you a good price

Price Is Relative To Competition

2. We ask for this in exchange

Price = Product + Place + Promotion

Price Is A Reflection of Value


There are price setters and price takers

There are Price Setters and Price Takers

A basic idea of marketing is to make your product sufficiently better than your competitors’ product from the customer’s point of view and not to be a price taker.


Pricing goals

Pricing Goals

  • Profit

    • long run, short run

  • Sales Revenue (Growth)

  • Market Share (Penetration)

  • Unit Sales Volume (Learning Curve)


Pricing goals cont d

Pricing Goals Cont’d

  • Image Maintenance

  • Cash Flow (survival)

  • Competitive Pricing (Stability, Price leader, price taker

    • Avoid price competition


Basics c s for pricing

Basics C’s for Pricing

Costs of making the product, etc.

Customer Demand

Competitors


Pricing methods formulas

Pricing Methods (Formulas)

  • Cost Based Methods

  • Demand Based Methods

  • Competitive Based (Going Rate, Bidding) Pricing


Cost based pricing rules

Cost Based Pricing Is Most Important


Why cost based pricing four reasons

Why Cost Based PricingFour Reasons

1 Fair

2 Easy to Calculate

3 Industry Stability

4 “guarantee a profit”


Types of cost based methods

Types of Cost Based Methods

  • Cost Plus (profit)

  • Traditional Markup (Discount rate)

  • Target Return on Investment

  • Discounts & Allowances


Some costing is crude

Some Costing Is Crude

  • Direct Materials plus

  • Direct Labor plus

  • 300% of Direct Labor (to cover Fixed Costs) plus

  • A 50% Markup plus

  • Competitive adjustment plus

  • What the customer will bear


Cost based pricing rules

  • Pricing Formulas Tend To Be The Same Across An Industry

  • Reduces Price Competition


Cost based pricing rules

Price Formula Comes From The Basic Profit Formula

Z = (P - V)Q - F


The basic cost based pricing formula is

The Basic Cost BasedPricing Formula is

Price Formula Comes From The Basic Profit Formula

Z = (P - V)Q - F


Calculate the price

Calculate the Price

Knowing Cost and Profit Targets


The variable cost is crucial in the idea of pricing down the learning curve

The Variable Cost Is Crucial In The Idea Of Pricing Down The Learning Curve


Learning curve

Learning Curve

Variable Cost Per Unit Is Reduced As Experience In Its Production Is Learned


Learning curve1

Learning Curve

V

Production Experience


Learning curve2

Learning Curve

V

Production Experience


Learning curve3

Learning Curve

V

Cumulative


Cost based pricing rules

Forecasting Future Variable Cost Is A Very Important Part Of Modern Pricing Strategy!


Variable cost is not unit cost

Variable Cost Is Not Unit Cost

UNIT COST COMBINES

AVERAGE FIXED COSTS

AND VARIABLE COSTS


Basic cost based pricing formula is

Basic Cost BasedPricing Formula is

Substitute Unit Cost


Example

Example

“We charge what it costs to make each unit plus a standard approved markup of 10% for our profit.”


Example1

Example

“We charge what it costs to make each unit plus a standard approved markup of 10% for our profit.”

Unit Cost is considered the cost to make each unit in a pricing formula


Cost based pricing rules

Profit is being measured as a percentage of sales revenue.

Substitute


Cost based pricing rules

Profit is being measured as a percentage of sales revenue.

Substitute


Cost based pricing rules

Simplify

Substitute


Example2

Example

“We charge what it costs to make each unit plus a standard approved markup of 10% for our profit.”


Cost based pricing rules

Classic Cost Plus Formula Is

P = Unit Cost + x% of Final Price

P = Unit Cost + x(P)

P - xP = Unit Cost

(1-x)P = Unit Cost

P = Unit Cost

(1- x)


Cost based pricing rules

Classic Cost Plus Formula Is

Note: we use unit cost and a target profit margin

P = Unit Cost + x% of Final Price

P = Unit Cost + x(P)

P - xP = Unit Cost

(1-x)P = Unit Cost

P = Unit Cost

(1- x)


Types of cost based formulas

Types of Cost Based Formulas

  • Cost Plus (Profit)

  • Traditional Markup Pricing

    (Discount rate)

  • Target Return on Investment

  • Discounts & Allowances


Markup pricing

Markup Pricing

  • Very Popular with Retailers

  • It uses the purchase cost of the merchandise which is the Variable cost.

  • The Target Markup which includes the fixed costs and the target profit.


We remember that

We remember that

  • The target markup for a target profit was

  • Mp* = (F+Z)/ R

  • We consider Mp*(R) = F+Z and substitute into

  • PQ - vQ = F+Z

  • PQ - vQ = Mp*(R)

  • and substitute R = PQ

  • (P-V)Q = Mp*PQ

  • P-V = Mp*P

  • P-Mp*P = V

  • P = V / (1-Mp*) is markup pricing


Another way

Another Way

  • Consider the breakeven price with a target profit

  • P = V +(F+Z)/Q

  • Divide both sides by P

  • (1/P)P = V/P + (F+Z)/PQ

  • Where (F+Z)/PQ = Mp = Target markup

  • 1 = V/P +Mp

  • (1-Mp)P = V

  • P = V/(1-Mp)


When you have a target markup the markup pricing formula is

When you have a target markup, The Markup Pricing Formula Is


Markup pricing1

Markup Pricing

  • Remember the markup pricing is to cover the total contribution needed to cover the Fixed Costs and the Target Operating Profit!


Types of cost based formulas1

Types of Cost Based Formulas

  • Cost Plus (Profit)

  • Traditional Markup Pricing

    (Discount rate)

  • Target Return on Investment

  • Discounts & Allowances


Cost based pricing rules

Calculating A Price From A Cost Based Formula Is EasierIf They Give You A Target Return or Profit Z in dollars


Then you get to substitute for the profit z and solve

Then You Get to Substitute For The Profit, Z, and Solve


Example target profit pricing formula a expected profit of 15 roi

Example: Target Profit Pricing FormulaA Expected Profit of 15% ROI


Example target profit pricing formula a expected profit of 15 roi1

Example: Target Profit Pricing FormulaA Expected Profit of 15% ROI


Example target profit pricing formula a expected profit of 15 roi2

Example: Target Profit Pricing FormulaA Expected Profit of 15% ROI


Target returns profits where do they come from

Target Returns (Profits)Where Do They Come From?


Sources of targets

Sources of Targets

  • 1 Deciding What Seems Fair

  • 2 Wanting A Better Return Than Last Year

  • 3 Establishing What They Believe They Can Get

  • 4 Estimated Cost Of Capital

  • 5 Wanting To Stabilize Prices


Types of cost based formulas2

Types of Cost Based Formulas

  • Cost Plus (Profit)

  • Traditional Markup Pricing

    (Discount rate)

  • Target Return on Investment

    • Weakness Of Cost Based

  • Discounts & Allowances


Basic cost based pricing formula is1

Basic Cost Based Pricing Formula is


Basic cost based pricing formula is2

Basic Cost Based Pricing Formula is

Where Does The Q Come From?


Q can come from

Q Can Come From

  • Target Level Of Desired Production

    Percent Of Normal Capacity

  • Sales Forecasts


Cost based pricing rules

Cost Structure is Very Important

Total Cost

Dollars

Fixed Cost

Quantity Produced


Cost based pricing rules

#1 Percentage Of Normal Capacity

Often Becomes The Bases

For Expected Sales = Q!

Total Cost

Dollars

Fixed Cost

85% of Capacity


Cost based pricing rules

#2 Forecasting The Quantity That Will Be Sold From Simple Projections Of Past Sales Is Popular

Time


To cost based pricing you need to know

To Cost Based Pricing You Need To Know

Variable cost , Fixed cost, Target Profit, & Estimate of Future Sales

or Production = Q


The fundamental weakness of cost based pricing is

The Fundamental Weakness OfCost Based Pricing Is


The fundamental weakness of cost based pricing is1

The Fundamental Weakness OfCost Based Pricing Is

Using An Expected

Sales Forecast, Q,

To Select The Price


Cost based pricing rules

Why?

Because Price is Key Factor in Causing Sales

Revenue = f(Price, Promotion, Place, Product)

Price Causes Sales!


Remember

Remember

  • The Expected Quantity Of Sales Should NOT Set The Price.

  • The Price Determines The Quantity!


Remember1

Remember

  • The Expected Quantity Of Sales Should NOT Set The Price.

You Need Sales Estimates Based On The Demand At The Planned Price (i.e. Demand Based Pricing)


Types of cost based formulas3

Types of Cost Based Formulas

  • Cost Plus (Profit)

  • Traditional Markup Pricing

    (Discount rate)

  • Target Return on Investment

    • Weakness Of Cost Based

  • Discounts & Allowances


Discounts allowances

Discounts & Allowances

  • Cash Discounts

  • Trade Discounts

  • Quantity Discount

  • Rebates (Cumulative)


Discounts allowances1

Discounts & Allowances

Everything Is A Percentage Off Catalog List Prices

Importance Of Catalog And Pricing Sheet Updates


Cash discount

Cash Discount

3% /10 net 30

  • Encourage prompt payment

  • Reduce cost of credit

  • Industry standard


Trade or functional discount

Trade Or Functional Discount

Straight Percentage Off List

  • Pay For The Functions A Middleman Performs

    • Class A or B Distributor

    • OEM

    • Educational

    • Government


Quantity discount

Quantity Discount

  • Must Be Offered To All Customers

  • Must Demonstrate Cost Saving Being Passed On


Rebates allowances

Rebates & Allowances

  • Cumulative

  • Competitive Rebates (software)

  • Seasonal

  • Advertising Allowances

  • Case Allowances


Shipping costs

Shipping Costs

  • FOB origin

  • FOB Destination

    • Phantom Freight

    • Postage Stamp Pricing


Cost based pricing does

Cost Based Pricing Does

  • Not Guarantee Demand

  • Not Guarantee A Net Profit

  • Not Simplify e.g. Managers Confused About Costs

    • Unit cost versus variable cost

    • Sunk costs vs fixed cost

    • Discretionary


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