# Cost Based Pricing - Welcome to Prospect Learning

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```					Detailed lecture on
Cost-Based Pricing
Ted Mitchell
Three Approaches to
Setting A Selling Pice

CostBased Pricing
Competitive Based Pricing
Customer Based Pricing

2
Goal
Seta Selling Price that covers
our Normal Costs and Profit
environment

3
A Basic Perspective
In Cost Based Pricing or
Budget Setting
You know Everything or
Everything is forecasted

4
Cost Based Pricing Is Most Important
Why Cost Based Pricing?
Four Reasons
1 Sounds Fair
2 Easy to Calculate
3 Industry Stability
4 “guarantee a profit”
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
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What   Costs Should I include?

8
Some Costing Is Crude
Direct Materials plus
Direct Labor plus
300% of Direct Labor (to
cover Fixed Costs) plus
A 50% Markup plus
What the customer will bear
Revenue, R = PQ                     PQ
Cost of Goods Sold, COGS = VQ       VQ
Gross profit, G = (P-V)Q            G
Gross Return on Sales, GROS = G/R
Markup Percentage, Mp = (P-V)/P
Direct Total Marketing Effort, TP   TP
Marketing Contribution, MC = G-TP   MC
Marketing Return on Sales
MROS = MC/R
Net Profit, Z = R – E - F           Z
Net Return on Sales, ROS = Z/R

10
To select the costs needed in
the calculation you need to
know the definition of the
profit that is being targeted

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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

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Revenue, R = PQ                     PQ
Cost of Goods Sold, COGS = VQ       VQ
Gross profit, G = (P-V)Q            G
Gross Return on Sales, GROS = G/R
Markup Percentage, Mp = (P-V)/P
Direct Total Marketing Effort, TP   TP
Marketing Contribution to Profit,   MC
MC = G-TP
Marketing Return on Sales
MROS = MC/R
Net Profit, Z = R – E - F           Z
Net Return on Sales, ROS = Z/R

13
Revenue, R = PQ                     PQ
Cost of Goods Sold, COGS = VQ       VQ
Gross profit, G = (P-V)Q            G
Gross Return on Sales, GROS = G/R
Markup Percentage, Mp = (P-V)/P
Direct Total Marketing Effort, TP   TP
Marketing Contribution to Profit,   MC
MC = G-TP
Marketing Return on Sales
MROS = MC/R
Net Profit, Z = R – E - F           Z
Net Return on Sales, ROS = Z/R

14
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

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Revenue, R = PQ                     PQ
Cost of Goods Sold, COGS = VQ       VQ
Gross profit, G = (P-V)Q            G
Gross Return on Sales, GROS = G/R
Markup Percentage, Mp = (P-V)/P
Direct Total Marketing Effort, TP   TP
Marketing Contribution to Profit,   MC
MC = G-TP
Marketing Return on Sales
MROS = MC/R
Net Profit, Z = R – E - F           Z
Net Return on Sales, ROS = Z/R

16
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
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Revenue, R = PQ                     PQ
Cost of Goods Sold, COGS = VQ       VQ
Gross profit, G = (P-V)Q            G
Gross Return on Sales, GROS = G/R
Markup Percentage, Mp = (P-V)/P
Direct Total Marketing Effort, TP   TP
Marketing Contribution to Profit,   MC
MC = G-TP
Marketing Return on Sales
MROS = MC/R
Net Profit, Z = R – E - F           Z
Net Return on Sales, ROS = Z/R

18
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

19
Target Returns (Profits)
Where Do They Come
From?
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
Price Formula Come From
The Basic Profit Formula
Z = (P - V)Q - F
The Basic Cost Based
Pricing Formula is
F Z
P=V + +
Q Q
Basic Cost Based
Pricing Formula is
F Z
P=V + +
Q Q
Plug in the values for V, F, Q,
and Z and solve for the Price
When    You are given the
dollar amounts of the profit
that you are to earn the
calculation is trivial
HOWEVER IT NEVER HAPPENS!

24
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
25
When given Profit as a
Rate of Return
Markup
P = V/(1-Mp)
Gross Return on Sales
P = V/(1-GROS)
Marketing Return on Sales
P = (V + TP/Q)/(1-MROS)
Return on Sales
P = (V+ TP/Q + F/Q)/(1-ROS)
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Know these four approaches to
price setting
Markup
P = V/(1-Mp)
Gross Return on Sales
P = V/(1-GROS)
Marketing Return on Sales
P = (V + TP/Q)/(1-MROS)
Return on Sales
P = (V+ TP/Q + F/Q)/(1-ROS)
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Where do they come from?
How   do we get the classic
return on sales method?

Price   =
(average    cost per unit)/(1-ROS)

28
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

29
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)
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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)

31
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
Substitute
R-COGS = GROS x Revenue
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R-COGS = GROS x Revenue
Revenue  =R=PxQ
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)

33
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)
34
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 percent
35    P = V/(1-GROS)
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
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)

37
Four Cost Based Pricing
Equations
Retailer’s Markup
P = V/(1-Mp)
Gross Return on Sales
P = V/(1-GROS)
Marketing Return on Sales
P = (V + TP/Q)/(1-MROS)
Classic Return on Sales
P = (V+ TP/Q + F/Q)/(1-ROS)
38    P = BEP/(1-ROS)
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

39
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
40
Cost Based Pricing Does

NOT  Guarantee Fairness
Not Guarantee Demand
Not Guarantee A Net Profit
Not Simplify if Managers
Unitcost versus variable cost
Sunk costs vs fixed cost
Discretionary, inescapable
41
Any  Questions on Cost Based
Pricing?

42

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