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Cost Based Pricing Rules

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Cost Based Pricing Rules

Ted Mitchell

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

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.

- Profit
- long run, short run

- Sales Revenue (Growth)
- Market Share (Penetration)
- Unit Sales Volume (Learning Curve)

- Image Maintenance
- Cash Flow (survival)
- Competitive Pricing (Stability, Price leader, price taker
- Avoid price competition

Costs of making the product, etc.

Customer Demand

Competitors

- Cost Based Methods
- Demand Based Methods
- Competitive Based (Going Rate, Bidding) Pricing

Cost Based Pricing Is Most Important

1 Fair

2 Easy to Calculate

3 Industry Stability

4 “guarantee a profit”

- Cost Plus (profit)
- Traditional Markup (Discount rate)
- Target Return on Investment
- Discounts & Allowances

- 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

- Pricing Formulas Tend To Be The Same Across An Industry
- Reduces Price Competition

Price Formula Comes From The Basic Profit Formula

Z = (P - V)Q - F

Price Formula Comes From The Basic Profit Formula

Z = (P - V)Q - F

Calculate the Price

Knowing Cost and Profit Targets

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

V

Production Experience

V

Production Experience

V

Cumulative

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

UNIT COST COMBINES

AVERAGE FIXED COSTS

AND VARIABLE COSTS

Substitute Unit Cost

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

“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

Profit is being measured as a percentage of sales revenue.

Substitute

Profit is being measured as a percentage of sales revenue.

Substitute

Simplify

Substitute

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

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)

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)

- Cost Plus (Profit)
- Traditional Markup Pricing
(Discount rate)

- Target Return on Investment
- Discounts & Allowances

- 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.

- 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

- 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)

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

- Cost Plus (Profit)
- Traditional Markup Pricing
(Discount rate)

- Target Return on Investment
- Discounts & Allowances

- 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

- Cost Plus (Profit)
- Traditional Markup Pricing
(Discount rate)

- Target Return on Investment
- Weakness Of Cost Based

- Discounts & Allowances

Where Does The Q Come From?

- Target Level Of Desired Production
Percent Of Normal Capacity

- Sales Forecasts

Cost Structure is Very Important

Total Cost

Dollars

Fixed Cost

Quantity Produced

#1 Percentage Of Normal Capacity

Often Becomes The Bases

For Expected Sales = Q!

Total Cost

Dollars

Fixed Cost

85% of Capacity

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

Time

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

or Production = Q

Using An Expected

Sales Forecast, Q,

To Select The Price

Because Price is Key Factor in Causing Sales

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

Price Causes Sales!

- The Expected Quantity Of Sales Should NOT Set The Price.
- The Price Determines The Quantity!

- 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)

- Cost Plus (Profit)
- Traditional Markup Pricing
(Discount rate)

- Target Return on Investment
- Weakness Of Cost Based

- Discounts & Allowances

- Cash Discounts
- Trade Discounts
- Quantity Discount
- Rebates (Cumulative)

Everything Is A Percentage Off Catalog List Prices

Importance Of Catalog And Pricing Sheet Updates

3% /10 net 30

- Encourage prompt payment
- Reduce cost of credit
- Industry standard

Straight Percentage Off List

- Pay For The Functions A Middleman Performs
- Class A or B Distributor
- OEM
- Educational
- Government

- Must Be Offered To All Customers
- Must Demonstrate Cost Saving Being Passed On

- Cumulative
- Competitive Rebates (software)
- Seasonal
- Advertising Allowances
- Case Allowances

- FOB origin
- FOB Destination
- Phantom Freight
- Postage Stamp Pricing

- 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