Detailed lecture on Cost-Based Pricing

1. Detailed lecture on Cost-Based Pricing Ted Mitchell

2. Three Approaches to Setting A Selling Pice • Cost Based Pricing • Competitive Based Pricing • Customer Based Pricing

3. Goal • Set a Selling Price that covers our Normal Costs and Profit assuming a normal business environment

4. A Basic Perspective • In Cost Based Pricing or Budget Setting • You know Everything orEverything is forecasted

5. Cost Based Pricing Is Most Important

6. Why Cost Based Pricing? Four Reasons 1 Sounds Fair 2 Easy to Calculate 3 Industry Stability 4 “guarantee a profit”

7. In Cost Based Pricing or Budget Setting You know Everything • You are solving for the needed Price, P • You know the variable cost per unit, V • You know the Total Promotion Cost, TP • You know the other fixed costs, F • You know the profit needed or expected, Z • You know the sales quantity forecasted, Q • Solve for Price, P

8. What Costs Should I include?

9. 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

11. To select the costs needed in the calculation you need to know the definition of the profit that is being targeted

12. Remember the key is the definition of profit being used • Is it the gross profit? • Is it the marketing profit? • Is it the net profit

15. If you are given the dollar profit needed the calculation is trivial • If I tell you the dollars of gross profit normally needed, G • PQ– VQ = G • You know the invoice cost or variable cost per unit, V and Forecasted Quantity Solve for P • P = V + G/Q

17. If you are given the dollar profit needed the calculation is trivial • If I tell you the dollars of marketing profit needed, MC • PQ– VQ – TP = MC • You know normal V, Q, and the total marketing expense, TP • Solve for the Price P • P = V + TP/Q + MC/Q

19. If you are given the dollar profit needed the calculation is trivial • If I tell you the dollars of net profit normally needed, Z • PQ– VQ – TP – F = Z • You know the normal V, Q, TP, and other fixed costs, Solve for P • P = V + TP/Q + F/Q + Z/Q

20. Target Returns (Profits)Where Do They Come From?

21. 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

22. The Basic Cost BasedPricing Formula is Price Formula Come From The Basic Profit Formula Z = (P - V)Q - F

23. Basic Cost BasedPricing Formula is Plug in the values for V, F, Q, and Z and solve for the Price

24. When You are given the dollar amounts of the profit that you are to earn the calculation is trivial • HOWEVER IT NEVER HAPPENS!

25. You are told the the target profit in terms of • 1) normal markup, Mp • 2) normal gross return on sales, GROS • 3) normal marketing return on sales, MROS • 4) normal Net Return on Sales, ROS

26. When given Profit as a Rate of Return • MarkupP = V/(1-Mp) • Gross Return on SalesP = V/(1-GROS) • Marketing Return on SalesP = (V + TP/Q)/(1-MROS) • Return on SalesP = (V+ TP/Q + F/Q)/(1-ROS)

27. Know these four approaches to price setting • MarkupP = V/(1-Mp) • Gross Return on SalesP = V/(1-GROS) • Marketing Return on SalesP = (V + TP/Q)/(1-MROS) • Return on SalesP = (V+ TP/Q + F/Q)/(1-ROS)

28. Where do they come from? • How do we get the classic return on sales method? • Price = • (average cost per unit)/(1-ROS)

29. If you are told the target profit in terms of the normal return on sales then you are told To target a ROS of some % of Revenue • Z = ROS x R • Remember you know the forecasted revenue • Substitute ROS(R) = Z

30. How to get the ROS equation • P = V + TP/Q + F/Q + Z/Q • Substitute ROS(R) = Z • P = V + TP/Q + F/Q + ROS(R)/Q • Substitute P x Q = R • P = V +TP/Q +F/Q +ROS(PQ)/Q • Gather the P’s • P – ROS(P) = V +TP/Q +F/Q • P(1-ROS) = V +TP/Q +F/Q • P = (V +TP/Q +F/Q)/(1-ROS) P = Average Cost per Unit /(1-ROS)

31. Classic ROS Method • Price, P, is set knowing the average cost per unit or the breakeven price, BEP, and the normal return on sales. ROS • P = BEP/(1-ROS)

32. How to get the classic gross return on sales method for setting price? • R – COGS = Gross Profit • You are told you need a Gross Return on Sales of GROS equal to some % of sales • You know that • (GROS x Revenue) = Gross Profit • SubstituteR-COGS = GROS x Revenue

33. R-COGS = GROS x Revenue • Revenue = R = P x Q • Cost of Goods Sold = V x Q • PQ – VQ = GROS x P x Q • P-P(GROS) = V • P(1-GROS) = V • P = V/(1-GROS)

34. The classic Gross Return on Sales Method • Set the price based on the invoice cost or the variable cost per unit, V, and the normal percent of gross profit returned on sales, GROS • P = V/(1-GROS)

35. The classic retailer’s method of setting price is the markup method • P = V/(1-Mp) • In the game with a single product the gross return on sales percent is the same as the markup percentP = V/(1-GROS)

36. Retailer’s method of markup • You get the markup method simply by knowing the definition of markup on price • (P-V)/P = Mp • If you know the normal variable cost, V, and the normal profit margin or markup, Mp, needed to stay in business then

37. Retailer’s method of markup • (P-V)/P = Mp • P-V = Mp(P) • P – Mp(P) = V • P(1-Mp) = V • P = V/(1-Mp)

38. Four Cost Based Pricing Equations • Retailer’s MarkupP = V/(1-Mp) • Gross Return on SalesP = V/(1-GROS) • Marketing Return on SalesP = (V + TP/Q)/(1-MROS) • Classic Return on Sales • P = (V+ TP/Q + F/Q)/(1-ROS)P = BEP/(1-ROS)

39. Remember the key to cost-based pricing is the definition of the profit being used • 1) Is it the gross profit or profit after COGS? The gross profit returned on sales, GROS or the markup (the unit profit on price), Mp • 2) Is it the marketing profit or profit after total promotion?The marketing profit returned on sales, MROS • 3) Is it the net profit or profit after all expenses?the net profit returned on sales, ROS

40. Weakness of Cost Based Pricing • 1) it assumes that the demand or the quantity sold can be forecasted before you know the price you are charging • 2) it assumes that the costs are going to be the same as they normally are

41. Cost Based Pricing Does • NOT Guarantee Fairness • Not Guarantee Demand • Not Guarantee A Net Profit • Not Simplify if Managers Confused About Costs • Unit cost versus variable cost • Sunk costs vs fixed cost • Discretionary, inescapable

42. Any Questions on Cost Based Pricing?