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Hinterhuber,A, Towards value-based pricingAn integrative framework for decision making, Industrial Marketing Management 33 (2004) 765 778
Fig. 2. High price and large market sharenot as incompatible as commonly believed In conclusion, it seems that managers, as price setters, have a general tendency to overestimate the importance of price for actual and potential customers
Hinterhuber,A, Towards value-based pricingAn integrative framework for decision making, Industrial Marketing Management 33 (2004) 765 778
Customers influence price through their effect on the demand for a product or service, based on factors such as quality and product features Competitors influence price through their pricing schemes, product features, and production volume Costs influence prices because they affect supply (the lower the cost, the greater the quantity a firm is willing to supply)
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Long-run pricing decisions have a time horizon of one year or longer and include decisions such as:
Pricing a product in a major market where there is some leeway in setting price
Pricing
External sales- outside Target pricing-Competition-based pricing Cost plus pricing Variable cost pricing Customer based pricing-value-based pricing Time and material pricing Internal-within the company among divisions Negotiated transfer prices Cost based transfer prices Market based transfer prices Effect of outsourcing on transfer prices Transfers between divisions in different countries
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Profit Maximization
Economic Theory
The quantity demanded is a function of the price that is charged Generally, the higher the price, the lower the quantity demanded
Pricing
Management should set the price that provides the greatest amount of profit
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Example 1
The editor of EMBA Magazine is considering three alternative prices for her new monthly periodical. Her estimate of price and quantity demanded are: Price TL 6 TL 5 TL 4 Quantity 22,000 28,000 32,000
Monthly costs of producing and delivering the magazine include TL90,000 of fixed costs and variable costs of TL1.50 per issue. Which price will yield the largest monthly profit?
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Solution Example 1
Variable Contribution Income Cost per Margin per Total CM Fixed Before unit(TL) unit(TL) (TL) Costs (TL) Tax (TL) 1,5 4,5 99.000 90.000 9.000 1,5 3,5 98.000 90.000 8.000 1,5 2,5 95.000 90.000 5.000
Choose TL 6 TL based on quantitative factors given. Need to consider qualitative factors as well.
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q*
Price Elasticity
The impact of price changes on sales volume
Demand is elastic if a price increase has a large negative impact on sales volume. Demand is inelastic if a price increase has little or no impact on sales volume.
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Influences on Price
Customer demand Competitors behavior/prices/actions Costs Regulatory environment legal, political and image related
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Costs that are often irrelevant for shortrun policy decisions, such as fixed costs that cannot be changed, are generally relevant in the long run because costs can be altered in the long run Profit margins in long-run pricing decisions are often set to earn a reasonable return on investment prices are decreased when demand is weak and increased when demand is strong
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Market-Based Approach
Starts with a target price Target Price estimated price for a product or service that potential customers will pay Estimated on customers perceived value for a product or service and how competitors will price competing products or services
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Competition from lower cost producers has meant that prices cannot be increased Products are on the market for shorter periods of time, leaving less time and opportunity to recover from pricing mistakes Customers have become more knowledgeable and demand quality products at reasonable prices
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Pricing approaches
Cost plus mark-up
Variable contribution margin approach, contribution margin( reflecting mark-up) should cover desired return on investment, all fixed costs Absorption common- mark-up covers all expenses except cost of goods sold plus the desired return on investment
Target costing price is known (competitors), desired return on investment is known, price is known = determine the maximum cost per unit
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Cost-Plus Pricing
Company estimates cost of production
Adds a markup to cost to arrive at price which allows for a reasonable profit
Benefits
Simple approach
Limitations
What % markup to use? Inherently circular for manufacturing firms Requires considerable judgment and experimentation
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http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf
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Example
Murmur company produces electronic components that typically have about 27-month life cycle. In October 2008, a new component was proposed. Below are the budgeted costs and profits over the life cycle of the product.
Uni i n cost unit li cycl cost unit whol li cost budgeted unit selling price Budgeted costs development production logistics annual post purchase costs-born by the customer Annual total Units produced and sold 6 10 12 15 2008 (200.000) 2009 (240.000) (80.000) (320.000) (80.000) (400.000) 40.000 2010 (360.000) (120.000) (480.000) (120.000) (600.000) 60.000 item total (200.000) (600.000) (200.000) (1.000.000) (200.000) (1.200.000)
(200.000) (200.000)
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Example
Budgeted Pr duct Income Statement Annual Cumulative Income Income Year Revenues Costs 2008 (200.000) (200.000) (200.000) 2009 600.000 ( 20.000) 280.000 80.000 20.000 500.000 2010 900.000 ( 80.000)
Pe o mance Yea
epo t Budgeted Va iance Cost 200.000 10.000 240.000 (60.000) 80.000 5.000 360.000 (75.000) 120.000 10.000
Cost Item Actual Costs Development 190.000 Production 300.000 Logistics 75.000 Production 435.000 Logistics 110.000
F U F U F
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110.000 U
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Cost-plus Pricing
Selling Price= Cost + mark-up% x Cost Mark-up % = Desired profit per unit Unit cost Desired profit = Desired ROI x Investment
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Which cost?
Variable manufacturing cost
Price= variable manufacturing costs + markup% * variable manufacturing cost
Mark-up should cover the remaining costs and provide for the desired profit, i.e. variable selling and all fixed costs
Which costs?
Total variable costs
Variable manufacturing and selling costs
Price= variable costs + markup %* variable costs
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Which costs?
Absorption manufacturing costs Unit manufacturing costs both variable and fixed
Price= unit manuf. cost + markup %* unit manufacturing cost
Which costs?
Absorption total costs
Total costs manufacturing and selling and administrative fixed (direct or allocated, variable costs)
Price= unit cost + markup %* unit cost
arkup
Example - Pricing
Annual sales 480 units Unit costs:
Variable manufacturing cost Applied fixed manufacturing cost Absorption manufacturing cost Variable selling costs Allocated and direct fixed selling and administrative costs Total cost (Manufacturing and S&ADM) Investment Desired profit 10% of investment Annual Fixed Manufacturing Costs Annual Fixed (allocated and direct) Selling and $ 400 $ 250 $ 650 $ 50 $ 100 $ 800
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Fixed Costs
Desired Profit ark -up % markup Pri e = cost + markup
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Total variable selling costs ixed Selling and Administration Desired Profit
mark up % markup ric = c st + markup
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Desired Profit
mark -up % markup Pri e = cost + markup
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Mark up % Price
105.56
925
925
925
925
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Retail Example
Yesim Textiles income statement for 2007 is as follows:
Revenues Cost of goods so d Gross prof t Se ng and Adm n strat ve Operat ng prof t Mark up
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Project Example
EMBA Consultancy Co needs to bid for a project. EMBAs recent income statement appears below:
Revenues Cost of Services Material Personnel Overhead Total Cost of services Gross profit Selling and Administrative E p Operating profit Mark up % T 1.627.010 (T 45.000) (650.000) (555.000) (1.250.000) 377.010 (235.750) T 141.260 3 16%
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Project Example
EMBA Consultancy needs to bid for a new project. Material costs will be TL 5.000; 150 man hours will be used. What would be a guiding bidding price?
Material Man-hour (150 man hourx65) verhead (0.85*man-hour cost) Total Cost mark up percentage bid pri e
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Target Costing
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Value Engineering
Value Engineering is a systematic evaluation of all aspects of the value chain, with the objective of reducing costs while improving quality and satisfying customer needs Managers must distinguish valueadded activities and costs from nonvalue-added activities and costs
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Projected Sales Less esired profit Target ost for Target ost per mouse
30 . .
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Customer-based pricing
Value based pricing-the price is based on the customer demand or need for the product
Unique product value based pricing might be helpful to create demand
use price to support product image set price to increase product sales design a price range to attract many consumer groups set price to increase volume sales price a bundle of products to reduce inventory or to excite customers
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handing out beta-versions of its latest enterprise software products to particularly knowledgeable companies and customer segments
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Hinterhuber,A, Towards value-based pricingAn integrative framework for decision making, Industrial Marketing Management 33 (2004) 765 778
The products economic value is simply the sum of the price of the reference product plus its differentiation value.
Step 6: Use the value pool to estimate future sales at specific price points.
For each price point, sales can be expected to comprise a significant share of all market segments, which value the product higher than the specific price examined
Hinterhuber,A, Towards value-based pricingAn integrative framework for decision making, Industrial Marketing Management 33 (2004) 765 778 66
WHY?
For each industry segment,the Japanese company had developed detailed financial models of different cost and benefit components of its own equipment versus its main competitor For a customer in the printing ink industry, the positive and negative differentiation value was quantified in the following way:
Hinterhuber,A, Towards value-based pricingAn integrative framework for decision making, Industrial Marketing Management 33 (2004) 765 778 68
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Analysis
Under this angle, the price premium of the Japanese company is modest. If an interest rate of 8% is applied to the net benefits gained over the average life cycle of this equipment of 4 years, the positive differentiation value amounts to well over US$300,000. Customers are expected to pay only a small fraction less than 10% and US $30,000of the products economic value.
Hinterhuber,A, Towards value-based pricingAn integrative framework for decision making, Industrial Marketing Management 33 (2004) 765 778 70
Costs are allocated to specific customers using cost drivers to determine customer profitability
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In addition to these costs, product costs amount to 90% of sales. In the prior year, Delta had the following experience with Johnson Brands:
Sales Number of orders Percent of orders marked rush Calls to customer service $53,800 200 60 140
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Example Solution
Profitability of Johnson Brand account
Sales Less: Cost of good sold (.9 $53,800) Order processing (200 $5.00) Rush handling (.6 200 $8.50) Customer service (140 $10.00) Relationship management costs Profitability of Johnson Brands account $53,800 $48,420 $1,000 $1,020 $1,400 $2,000 $53,840 $(40)
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Example
Investment Desired pro it 10% o investment Annual labor hours Hourly charge to cover pro it margin Labor rate per hour Annual overhead costs: Material handling and storage Other overhead costs(supervision,utilities, insurance,and depreciation) Annual cost o materials used in repair department
4% x 1.000.000
$200,000.00 $1,000,000.00
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= material costs incurred on job +[material costs incurred on job * ($40,000/$1,000,000)] =1.04 x material costs incurred on job
4% of material costs
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Example cont
JOB NO r r t f t r t t t r t t t r r f t t r t . , , . . , ,
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Activity-Based Pricing
Customers are presented with separate prices for services they request in addition to the cost of goods purchased
Customers will carefully consider the services they request
Example
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Peak-Load Pricing the practice of charging a higher price for the same product or service when the demand for it approaches the physical limit of the capacity to produce that product or service
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Transfer pricing
Transfer Price is:
the internal price charged by one segment of a firm for a product or service supplied to another segment of the same firm
Such as:
Internal charge paid by final assembly division for components produced by other divisions Service fees to operating departments for telecommunications, maintenance, and services by support services departments
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Transfer Pricing
The transfer price creates revenues for the selling subunit and purchase costs for the buying subunit, affecting each subunits operating income Intermediate Product the product or service transferred between subunits of an organization
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Variable Production Costs Variable and Fixed Production Costs Full Costs (including life-cycle costs) One of the above, plus some markup
Useful when market prices are unavailable, inappropriate, or too costly to obtain
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MarketBased
Yes, when markets are competitive
CostBased
Often, but not always
Negotiated
Yes
Difficult unless transfer price exceeds full cost and even then is somewhat arbitrary
Yes, but transfer prices are affected by bargaining strengths of the buying and selling divisions
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MarketBased
Yes
CostBased
Yes, when based on budgeted costs; less incentive to control costs if transfers are based on actual costs
Negotiated
Yes
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MarketBased
CostBased
Negotiated
No market may Useful for Bargaining and exist or determining negotiations markets may full cost of take time and be imperfect or products; easy may need to be in distress to implement reviewed repeatedly as conditions change
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Incremental cost is the additional cost of producing and transferring the product or service Opportunity cost is the maximum contribution margin forgone by the selling subunit if the product or service is transferred internally
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