Cost Based Pricing Rules

1. Cost Based Pricing Rules Ted Mitchell

2. 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

3. 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.

4. Pricing Goals • Profit • long run, short run • Sales Revenue (Growth) • Market Share (Penetration) • Unit Sales Volume (Learning Curve)

5. Pricing Goals Cont’d • Image Maintenance • Cash Flow (survival) • Competitive Pricing (Stability, Price leader, price taker • Avoid price competition

6. Basics C’s for Pricing Costs of making the product, etc. Customer Demand Competitors

7. Pricing Methods (Formulas) • Cost Based Methods • Demand Based Methods • Competitive Based (Going Rate, Bidding) Pricing

8. Cost Based Pricing Is Most Important

9. Why Cost Based PricingFour Reasons 1 Fair 2 Easy to Calculate 3 Industry Stability 4 “guarantee a profit”

10. Types of Cost Based Methods • Cost Plus (profit) • Traditional Markup (Discount rate) • Target Return on Investment • Discounts & Allowances

11. 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

12. Pricing Formulas Tend To Be The Same Across An Industry • Reduces Price Competition

13. Price Formula Comes From The Basic Profit Formula Z = (P - V)Q - F

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

15. Calculate the Price Knowing Cost and Profit Targets

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

17. Learning Curve Variable Cost Per Unit Is Reduced As Experience In Its Production Is Learned

18. Learning Curve V Production Experience

19. Learning Curve V Production Experience

20. Learning Curve V Cumulative

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

22. Variable Cost Is Not Unit Cost UNIT COST COMBINES AVERAGE FIXED COSTS AND VARIABLE COSTS

23. Basic Cost BasedPricing Formula is Substitute Unit Cost

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

25. 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

26. Profit is being measured as a percentage of sales revenue. Substitute

27. Profit is being measured as a percentage of sales revenue. Substitute

28. Simplify Substitute

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

30. 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)

31. 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)

32. Types of Cost Based Formulas • Cost Plus (Profit) • Traditional Markup Pricing (Discount rate) • Target Return on Investment • Discounts & Allowances

33. 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.

34. 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

35. 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)

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

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

38. Types of Cost Based Formulas • Cost Plus (Profit) • Traditional Markup Pricing (Discount rate) • Target Return on Investment • Discounts & Allowances

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

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

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

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

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

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

45. 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

46. Types of Cost Based Formulas • Cost Plus (Profit) • Traditional Markup Pricing (Discount rate) • Target Return on Investment • Weakness Of Cost Based • Discounts & Allowances

47. Basic Cost Based Pricing Formula is

48. Basic Cost Based Pricing Formula is Where Does The Q Come From?

49. Q Can Come From • Target Level Of Desired Production Percent Of Normal Capacity • Sales Forecasts

50. Cost Structure is Very Important Total Cost Dollars Fixed Cost Quantity Produced