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					     BUSI0027 E,F&G

           Session 10
       Pricing Decisions
     and Cost Management

Learning Objective 1

   Discuss the three major
    influences on pricing.

 Major Influences of Pricing Decisions
             -- Customers
 Higher price, lower demand

 Sensitivity to price change
      Elastic demand goods
           Having many substitutes, not necessities, taking a
            relatively large amount of consumer’s income

      Inelastic demand goods
           Having few substitutes, necessities, taking a
            relatively small amount of consumer’s income

 Major Influences of Pricing Decisions
        -- Competitors & Costs
 Competitors
   Higher price, higher supply
   Goods or services with many substitutes
    cannot charge too high prices
   Goods or services with no substitutes can set
    higher prices
 Costs
   Determine our own supply
   Price has to cover all costs

              Market Structure & Pricing
                  Perfect       Monopolistic   Oligopoly       Monopoly
                Competition     Competition
Number of          Many            Many          A few            No
Product         Homogeneous Differentiated        Little         Single
Barriers to          No            Low            High       Extremely high
Competition      Extremely       Very high     Moderate           No
Example         Farm products   Restaurants    Soft drinks   Pharmaceutics

      Market Structure & Pricing

Monopoly          Oligopoly           Monopolistic     Perfect
                                      Competition    Competition

           Increasing degree of market competition

Learning Objective 2

Distinguish between short-run
and long-run pricing decisions.

   Short-run vs. Long-run Pricing

 Irrelevant costs in the short-term often become
  relevant in the long-term

 Short-run pricing is often more opportunistic

 Profit margins in long-run pricing decisions are
  often set to earn a reasonable return on investment

     Example: Short-run Pricing
 Lomas has a monthly capacity of 500,000 cases of
  tomato sauce.
 Current production level: 300,000 cases per month.

                     Cost Per Case
       Variable manufacturing                $38
       Variable marketing and distribution    13
       Fixed manufacturing                    14
       Fixed marketing and distribution       15
       Total                                 $80

    Example: Short-run Pricing

 Dellas has asked Lomas and two other
  companies to bid on supplying tomato sauces
  for the next 2 months.

      What price should Lomas bid?

     Example: Short-run Pricing

 Case 1: to supply 150,000 cases per month, no
  additional capacity requirement, all fixed costs
  are not affected, and the current sales are not
  affected either

 Incremental Costs: $51 per case

>> To bid above $51 but below competitor’s bids

     Example: Short-run Pricing

 Case 2: to supply 250,000 cases per month,
  additional capacity which costs $500,000 is
  needed, fixed marketing and distribution costs
  are not affected, and the current sales are not
  affected either

 Incremental Costs: $53 per case

>> To bid above $53 but below competitor’s bids

     Example: Short-run Pricing

 Case 3: Similar to Case 2. BUT, Suppose Lomas
  believes that Dellas will sell the tomato sauce in
  Lomas’s current markets but at a lower price than

 Incremental Costs: $53 per case plus expected loss of
  current sales

 >> Relevant costs of the bidding decision should also
  include revenues lost on sales to existing customers.

           Long-run Pricing

 Relevant costs for long-run pricing decisions include
  all fixed and variable costs
 Prices should be set so that full costs of all business
  functions on the value chain can be recovered.


               Cost-based (Cost-Plus)

            Market Structure & Pricing
   The higher the degree of market competition, the
      more important the market force in pricing decisions

                              Hybrid of                  Market-based
Cost-Plus                       both                       Pricing

 Monopoly         Oligopoly               Monopolistic      Perfect
                                          Competition     Competition

         Market-based Pricing:
      Target Price and Target Cost

Target price is the estimated price for a
  product (or service) that potential
   customers will be willing to pay.
             Target Price
  – Target operating income per unit
        = Target cost per unit

Example: Target Pricing and Costing

Latisha’s management wants a 15% target
  operating income on sales revenues.
     Target price is $1,000 per unit.
    What is the target cost per unit?
         $1,000 × 0.15 = $150,
         $1,000 – $150 = $850
    Current full cost per unit is $950.
 Target Pricing & Target Costing

  Develop a product based on customer needs

            Determine target price

               Derive target cost

             Perform cost analysis

Perform value engineering to achieve target cost
           Value-Added Costs

A value-added cost is a cost that customers
    perceive as adding value, or utility,
          to a product or service:
 e.g., Adequate memory
  Pre-loaded software
 Easy-to-use keyboards

      Nonvalue-Added Costs

 A nonvalue-added cost is a cost that
 customers do not perceive as adding
value, or utility, to a product or service.
     e.g., Rework (product defect)
     Repair (machine breakdown)

       Cost-Plus Pricing

    The general formula for setting a
   cost-based price is to add a markup
       component to the cost base.
Cost base                        $    X
Markup component                      Y
Prospective selling price        $X + Y

                    Cost-Plus Pricing
Cost base (full unit cost)                           $720
Markup component of 12%                               86.4
Prospective selling price                           $806.40

Determine a target rate of return on investment, then based on
it derive the target operating income percentage.

Investment capital                                  $96,000,000
Target rate of return on investment                     18%
Target annual income                               $17,280,000.00
Target operating income per unit (200,000 units)       $86.40
       Life-Cycle Budgeting

   The product life cycle spans the time from
original R&D, through sales, to when customer
  support is no longer offered for that product.
  A life-cycle budget estimates revenues and
     costs of a product over its entire life.

       e.g, Pharmaceuticals, automobiles

       Nonproduction Costs
Life-Cycle budgeting is especially important
  when nonproduction costs are large and
  development period for R&D and design
             is long and costly
      These costs are less visible on a
         product-by-product basis.

 When nonproduction costs are significant,
    identifying these costs by product is
 essential for target pricing, target costing,
 value engineering, and cost management.
Cost-Plus Pricing vs. Target Pricing

 Both methods have to consider customer,
  competitor, and cost
 The difference lies in the starting point of estimation

 Target pricing reduces the need to go back and forth
  among prospective cost-plus prices, customer
  reactions, and design modifications
 It depends on market structure

Learning Objective 3

   Understand Other Pricing
   Methods and Considerations

 Pricing Objectives

 Maximize revenue/profit

 Maximize quantity

 Quality leadership

 Survival consideration

        Penetration Pricing
 Objective: Quantity maximization
   Pricing a new product at a low initial price to
    build up market share quickly

 Suitable when
    product or service is new and customers have
     great uncertainty as to its value
    demand is expected to be highly elastic

 Example: Auditing project

Legal Aspects of Penetration Pricing

 Predatory pricing
    Setting prices below costs for the purpose of injuring
     competitors and eliminating competition

 Dumping
   a practice of selling in another market at a price
    which is lower than the price in your home market
   Under the WTO Agreement, dumping is condemned
    but not prohibited

                 Predatory Pricing
 Microsoft (Jun 2006)
   SunbeltBLOG posted an analysis of Microsoft’s
    pricing for their new security products, OneCare and
    Antigen, calling Microsoft on predatory pricing
    aimed at putting the rest of the security vendors out of

      SunbeltBLOG compares the numbers, pricing for the
       Microsoft products to comparable products from
       Symantec and McAfee, showing how Microsoft is
       undercutting their prices by as much as 44% for
       OneCare and as much as 63% for Antigen.
 China-Made Furniture (Mar 2006)
   Furniture manufacturers in Italy and Germany are
    considering taking anti-dumping actions against
    their rivals from China
   They accuse China of selling upholstered sofa and
    other seats or chairs in EU at prices lower than
    domestic prices
   The furniture industrial union of EU declaims that
    China-made products have eaten the market shares
    from 6% in 1999 to 48% in 2004

                 Skim Pricing
 Objective: Revenue/Profit maximization
   A higher price is charged when a product or service
    is firstly introduced

 Appropriate when
   product is new, a small group of customers value it,
    and the company enjoys monopolistic advantage
   customers are not highly price sensitive

 Example: A new hand phone model,
Legal Aspects of Skim Pricing
 Price Gouging
      Firms with market power charge a too high

 Collusive Pricing
      Companies in an industry conspire in their
       pricing and production decisions to achieve
       a price above the competitive price

             Collusive Pricing
 Bayer AG (2004)
     Bayer was a German company producing
      rubber chemicals and selling them to customers
      in the States and elsewhere.

     The US Department of Justice fined it $66m for
      colluding with various companies to artificially
      regulate prices in the rubber chemicals market

          Price Discrimination
         and Peak-Load Pricing
 Price Discrimination
      Charging different customers different prices
       for the same product or service
      e.g., Quantitative discounts

 Peak-load Pricing
      Charging a high price when the demand
       exceeds the physical capacity of supply
      e.g., Busy vs. non-busy season of hotels

               Price Discrimination
 Microsoft (Jan 1999)
   The US Justice Department sued Microsoft of using its
    overwhelming market power in operating systems to
    practice price discrimination
      Compaq and Dell paid much less for Windows than IBM
       and Gateway
      Compaq and Dell have good relationship with Microsoft
      Microsoft countered by saying that the price differences
       simply reflect the fact that some companies are better
       bargainers than others

                       Price below costs    Predatory
Penetration Pricing


                          Monopoly            Price
   Skim Pricing


Price Discrimination     To impair          Illegal Price
&Peak-Load Pricing      competition        Discrimination
          Final Exam
 Time:   23-May (2:30pm-4:30pm)

 Venue: Flora Ho Sports Centre

 Format: 20 MC, 7 calculation problems

 Coverage: Chapter 1- Chapter 12