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Cost Based Pricing Rules

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### Cost Based Pricing Rules

### Calculate the Price

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

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

- Profit
- long run, short run

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

Pricing Goals Cont’d

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

Pricing Methods (Formulas)

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

Why Cost Based PricingFour Reasons

1 Fair

2 Easy to Calculate

3 Industry Stability

4 “guarantee a profit”

Types of Cost Based Methods

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

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

- 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

The Basic Cost BasedPricing Formula is

Price Formula Comes From The Basic Profit Formula

Z = (P - V)Q - F

Knowing Cost and Profit Targets

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

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

Variable Cost Is Of Modern Pricing Strategy!Not Unit Cost

UNIT COST COMBINES

AVERAGE FIXED COSTS

AND VARIABLE COSTS

Basic Cost Based Of Modern Pricing Strategy!Pricing Formula is

Substitute Unit Cost

Example Of Modern Pricing Strategy!

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

Example Of Modern Pricing Strategy!

“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. Of Modern Pricing Strategy!

Substitute

Profit is being measured as a percentage of sales revenue. Of Modern Pricing Strategy!

Substitute

Simplify Of Modern Pricing Strategy!

Substitute

Example Of Modern Pricing Strategy!

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

Classic Cost Plus Formula Is Of Modern Pricing Strategy!

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 Of Modern Pricing Strategy!

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 Of Modern Pricing Strategy!

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

- Target Return on Investment
- Discounts & Allowances

Markup Pricing Of Modern Pricing Strategy!

- 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 Of Modern Pricing Strategy!

- 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 Of Modern Pricing Strategy!

- 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 Of Modern Pricing Strategy!

Markup Pricing Of Modern Pricing Strategy!

- 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 Formulas Of Modern Pricing Strategy!

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

- Target Return on Investment
- Discounts & Allowances

Calculating A Price From A Cost Based Formula Is Easier Of Modern Pricing Strategy!If They Give You A Target Return or Profit Z in dollars

Then You Get to Substitute For The Profit, Z, and Solve Of Modern Pricing Strategy!

Example: Target Profit Of Modern Pricing Strategy!Pricing FormulaA Expected Profit of 15% ROI

Example: Target Profit Of Modern Pricing Strategy!Pricing FormulaA Expected Profit of 15% ROI

Example: Target Profit Of Modern Pricing Strategy!Pricing FormulaA Expected Profit of 15% ROI

Target Returns (Profits) Of Modern Pricing Strategy!Where Do They Come From?

Sources of Targets Of Modern Pricing Strategy!

- 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 Formulas Of Modern Pricing Strategy!

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

- Target Return on Investment
- Weakness Of Cost Based

- Discounts & Allowances

Basic Cost Based Of Modern Pricing Strategy!Pricing Formula is

Basic Cost Based Of Modern Pricing Strategy!Pricing Formula is

Where Does The Q Come From?

Q Can Come From Of Modern Pricing Strategy!

- Target Level Of Desired Production
Percent Of Normal Capacity

- Sales Forecasts

Cost Structure is Very Important Of Modern Pricing Strategy!

Total Cost

Dollars

Fixed Cost

Quantity Produced

#1 Percentage Of Normal Capacity Of Modern Pricing Strategy!

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

To Cost Based Pricing Projections Of Past Sales Is Popular You Need To Know

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

or Production = Q

The Fundamental Weakness Of Projections Of Past Sales Is Popular Cost Based Pricing Is

The Fundamental Weakness Of Projections Of Past Sales Is Popular Cost Based Pricing Is

Using An Expected

Sales Forecast, Q,

To Select The Price

Why? Projections Of Past Sales Is Popular

Because Price is Key Factor in Causing Sales

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

Price Causes Sales!

Remember Projections Of Past Sales Is Popular

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

Remember Projections Of Past Sales Is Popular

- 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 Formulas Projections Of Past Sales Is Popular

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

- Target Return on Investment
- Weakness Of Cost Based

- Discounts & Allowances

Discounts & Allowances Projections Of Past Sales Is Popular

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

Discounts & Allowances Projections Of Past Sales Is Popular

Everything Is A Percentage Off Catalog List Prices

Importance Of Catalog And Pricing Sheet Updates

Cash Discount Projections Of Past Sales Is Popular

3% /10 net 30

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

Trade Or Functional Discount Projections Of Past Sales Is Popular

Straight Percentage Off List

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

Quantity Discount Projections Of Past Sales Is Popular

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

Rebates & Allowances Projections Of Past Sales Is Popular

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

Shipping Costs Projections Of Past Sales Is Popular

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

Cost Based Pricing Does Projections Of Past Sales Is Popular

- 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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