Cost Information

for
Pricing
and
Product Planning
Chapter 6

Role Of Product Costs In Pricing

And Product Mix Decisions
Understanding how to analyze product costs is
important for making pricing decisions:
Managers make decisions about establishing or
accepting a price for their products
Even when prices are set by the market and the firm
has little or no influence on product prices,
management still has to decide the best mix of
products to manufacture and sell

Role of Product Costs

Product cost analysis is also significant when a
firm is deciding how best to deploy marketing
and promotion resources
How much commission (or how many other
incentives) to provide the sales force for different
products
How large a discount to offer off list prices

Short-term and Long-term

Pricing Considerations
The costs of many resources are likely to be
committed costs in the short-term because firms
cannot easily alter the capacities made available
for many production and support activities
For short-term decisions, it is important to note
whether surplus capacity is available for additional
production, or whether shortages of available capacity
limit additional production alternatives

Short-term and Long-term

Pricing Considerations
The length of time a firm must commit its
production capacity to fill that order is important
because a long-term capacity commitment to a
marginally profitable order may:
Prevent the firm from deploying its capacity for more
profitable products or orders, should demand for them
arise in the future
Force the firm to add expensive new capacity to handle
future sales increases

Short-term and Long-term

Pricing Considerations
If production is constrained by inadequate
capacity, managers need to consider whether
overtime production or the use of subcontractors
can help augment capacity in the short term
In the long term, managers have considerably
more flexibility to adjust the capacities of activity
resources to match the demand for them in
producing various products
Decisions about whether to introduce new
products or eliminate existing products have
long-term consequences

Ability To Influence Prices

If the firm is one of a large number of firms in
an industry, and if there is little to distinguish
the products of different firms from each other:
Such a firm is a price taker, and it chooses its
product mix given the prices set in the
marketplace for its products

Ability To Influence Prices

Firms in an industry with relatively little
competition, who enjoy large market shares
and exercise industry leadership, must decide
what prices to set for their products
Firms in industries in which products are highly
customized or otherwise differentiated from
each other also need to set the prices for their
differentiated products
Such firms are price setters

Price Takers
A small firm, or a firm with a negligible market
share in this industry, behaves as a price taker
It takes the industry prices for its products as
given and then decides how many units of each
product it should produce and sell

Short-Term Decisions for Price Takers

A price taker should produce and sell as much
as it can of all products whose costs are less
than industry prices
Managers must decide which costs are
relevant to the short-term product mix
decision
Managers may have little flexibility to alter the
capacities of some of the firms resources in
the short-run

Example - Garment Manufacturer

Chunling Company that sells five types of readymade garments to discount stores such as Kmart
and Wal-Mart
The company is operating at full capacity and is
contemplating short-term adjustments to its
product mix
It is necessary for the company to determine:
What costs will vary with production levels in this period
What costs will remain fixed when a change occurs in
the production mix

Example - Garment Manufacturer

The costs of utilities, plant administration,
maintenance, and depreciation for the machinery
and plant facility will not alter with a change in the
product mix, because the plant is operating at full
capacity
Varying with the quantity of each garment
produced are:
The costs of direct materials
The direct labor that is paid on a piece-rate basis

Inspectors are paid a monthly fixed salary, but they

are employed as required to support the
production of different garments

Example - Garment Manufacturer

If its capacity were unlimited, the company could
produce garments to fill the maximum demand for
them
Capacity is constrained, however, and therefore
the company must decide how best to deploy this
limited resource
The capacity is fixed in the short-term, so the
company must plan production to maximize the
contribution to profit earned for every available
machine hour used

The Impact Of Opportunity Costs

If the garment manufacturer receives a special
order request, it would have to decide the
minimum price it would accept
Because its production capacity is limited, the
company must cut back the production of some
other garment to enable it to produce the goods
for the special order
Giving up the production of some profitable
product results in an opportunity cost, which
equals the lost profit on the garments that the
company can no longer make

The Impact Of Opportunity Costs

The lost profit in this case would be the
contribution on the goods it will not make
The product with the lowest contribution per hour
should be sacrificed
The profit (contribution) lost on those products
would need to be covered by the price of the
special order

Short-Term Pricing Decisions

for Price Setters
In many businesses, potential customers
request that suppliers bid a price for an order
before they decide on the supplier with whom
they will place the order

Determining a Bid Price

Assume that the full costs for the job are
estimated to be $28,500
Setting the price of a product also means
determining a markup percentage above cost,
an approach known as cost-plus pricing
Cost-plus pricing - the markup percentage is
determined by a companys desired profit margin and
overall rate of return
The company has decided the markup percentage is
normally to be 40% of full costs

Determining a Bid Price

If the bid request came from a regular customer,
the bid price would have been $39,900
= 1.40 x $28,500

But for this special order from a new customer,

what is the minimum acceptable price?
One of the critical factors to consider is the level
of available surplus capacity

Available Surplus Capacity

The companys incremental costs of filling the order will be
$ 22,000 (material, direct labor, batch related expenses)
The costs of supervision and business-sustaining support
activities will not increase if excess capacity of these
resources is available to meet the production needs of the
order
The price that the company should bid must cover the
incremental costs for the job to be profitable
The company would likely add a profit margin above
incremental costs and make the bid price something higher
than $22,000, depending on competitive and demand
conditions

No Available Surplus Capacity

If surplus machine capacity is not available, the
company will have to incur additional costs to
acquire the needed capacity
Companies often meet such short-term capacity
requirements by operating its plant overtime
More machine maintenance and plant engineering
activities will be necessary

No Available Surplus Capacity

the company incurs additional rental costs for the
extra use of machines when it adds an overtime
shift
Assume management estimates the order would
cause:
$5,100 of incremental supervision costs (including
overtime premium)
$5,400 of incremental business-sustaining costs

Thus, the total cost of overtime required to

manufacture customized tools for the order is
$10,500 ($5100 + $5400)

No Available Surplus Capacity

The minimum acceptable price in this case is
$32,500 ($22,000 + $10,500)
The minimum acceptable price must cover all
incremental costs

Long-Term Pricing Decisions

for Price Setters
The relevant costs for the short-term special
order pricing decision differ from the full costs of
the job
Most firms rely on full-cost information reports
when setting prices

Use of Full Costs in Pricing

Economic justification for using full costs for
pricing decisions in three types of
circumstances:
1. Many contracts for the development and production
of customized products and many contracts with
governmental agencies specify that prices should
equal full costs plus a markup, and prices set in
regulated industries are based on full costs
2. When a firm enters into a long-term contractual
relationship with a customer to supply a product, it
has great flexibility in adjusting the level of
commitment for all resources

Use of Full Costs in Pricing

Most activity costs will depend on the production
decisions under the long-term contract, and full
costs are relevant for the long-term pricing
decision
3. In many industries, firms make short-term
adjustments in prices, often by offering discounts
from list prices instead of rigidly employing a fixed
price based on full costs
When demand for their products is low, the firms
recognize the greater likelihood of surplus capacity
in the short term

Use of Full Costs in Pricing

They adjust the prices of their products downward
to acquire additional business based on the lower
incremental costs they incur when surplus capacity
is available

When demand for their products is high, they

recognize the greater likelihood that the existing
capacity of activity resources is inadequate to
satisfy all of the demand
They adjust the prices upward based on the higher
incremental costs they incur when capacity is fully
utilize, thereby rationing the available capacity to
the highest profit opportunity

Fluctuating Prices
Because demand conditions fluctuate over time,
prices also fluctuate with demand conditions over
time
Most hotels offer special weekend rates that are
considerably lower than their weekday rates
Many amusement parks offer lower prices on
weekdays when demand is expected to be low
Airfares between New York and London are higher in
summer, when the demand is higher, than in winter,
when the demand is lower
Long-distance telephone rates are lower in the
evenings and on the weekends when the demand is
lower

Fluctuating Prices
Although fluctuating short-term prices are based
on the appropriate incremental costs, over the
long term their average tends to equal the price
based on the full costs that will be recovered in a
long-term contract
Most firms use full cost-based prices as target
prices, giving sales managers limited authority to
modify prices as required by the prevailing
competitive conditions

The Markup Rate

Just as prices depend on demand
conditions, markups increase with the
strength of demand
Markups also depend on the elasticity of
demand
Markups also fluctuate with the intensity of
competition

The Markup Rate

Firms decide on markups for strategic reasons:
A firm may choose a low markup for a new product to
penetrate the market and win over market share from
an established product of a competing firm
Many internet businesses have adopted the strategy
of setting low prices to build the business, acquire a
brand name, build a loyal customer base, and garner
market share
Firms sometimes employ a skimming price strategy
where initially a higher price is charged to customers
who are willing to pay more for the privilege of
possessing the latest technological innovations

Long-Term Decisions for Price Takers

Decisions to add a new product or to drop an
existing product from the portfolio of products
usually have significant long-term implications
for a firms cost structure
Product-sustaining costs are relevant costs for
such decisions
Batch-related costs are also likely to alter if a
change occurs in the product mix either in favor
of or against products manufactured in large
batches

Profit Increase is Not Automatic

Dropping products will help improve profitability
only if the managers:
1. Eliminate the activity resources no longer required to
support the discontinued product, or
2. Redeploy the resources from the eliminated products
to produce more of the profitable products that the
firm continues to offer

Costs result from commitments to supply

activity resources
They do not disappear automatically with the
dropping of unprofitable products
Only when companies eliminate or redeploy the
resources themselves will actual expenses decrease

Summary
Managers use cost information to assist them in
pricing and in product mix decisions
The manner in which they use cost information in
making these decisions depend on whether the
firm is a major or minor entity in its industry
The role of cost information also depends on the
time frame involved in the decision

Economic Analysis of the

Pricing Decision
Appendix 6-1

Quantity Decision
Introductory textbooks in economics usually
analyze the profit maximization decision by a firm
in terms of the choice of a quantity to produce. In
turn, the quantity choice determines the price of
the product in the marketplace
Economists present the quantity choice in terms
of equating marginal revenue and marginal cost

Quantity Decision
The firm chooses the quantity level, and the
market demand conditions determine the
corresponding price
The firm that must choose a price, not a quantity,
to announce to its customers
Customers react to the price announced and
determine the quantity that they demand
The price decision analysis uses differential
calculus to analyze the firms pricing decision

Pricing Decision
Total costs, C, expressed in terms of its fixed and
flexible cost components are: C = f + vQ,
Where f is the committed cost, v is the flexible
cost per unit, and Q is the quantity produced in
units
Quantity produced is assumed to be the same as
quantity demanded
The demand, Q, is represented as a decreasing
linear function of the price P: Q = a bP
A higher value of b represents a demand function
that is more sensitive (elastic) to price

Pricing Decision
An increase of a dollar in the price decreases demand
by b units
A higher value of a reflects a greater strength of demand
for the firms product. For any given price, P, the demand
is greater when the parameter, a, has a higher value
The total revenue, R, is given by the price, P, multiplied
by the quantity sold, Q. Algebraically, we write this:
R = PQ = P(a bP)
= aP bP2
The profit, , is measured as the difference between the
revenue, R, and the cost, C:

Pricing Decision
=R-C
= PQ - (f + vQ)
= P(a - bP) - F - v(a - bP)
= aP - bP2 - F - va + vbP
To find the profit-maximizing price, P*, we set the first
derivative of profit P with respect to P equal to zero:
d /dP = A 2bP + vb = 0
This equation implies:
P* = (a + vb)/2b = a/2b + v/2

Long-Term Benchmark Prices

This simple economic analysis suggests that the
price depends only on v, the flexible cost per unit
A more complex analysis that considers
simultaneously the pricing decision and the longterm decisions of the firm to commit resources to
facility-sustaining, product-sustaining, and other
activity capacities indicates that the costs of
these committed resources do play a role in the
pricing decision
The costs of these committed activity resources
appear to be committed costs in the short-term,
but they can be changed in the long-term

Long-Term Benchmark Prices (2 of 2)

The prices that a firm sets and adjusts in the short term,
based on changing demand conditions, fluctuate around
a long-term benchmark price, pL, that reflects the unit
costs of the activity resource capacities:
pL = a/2b + (v + m)/2
m = f X is the cost per unit of normal capacity, X, of
facility-sustaining activities
the degree of price fluctuations around the benchmark
price increases with the proportion of committed costs
prices appear more volatile in capital-intensive industries
where a large proportion of costs are for facilitysustaining activities

Competitive Analysis (1 of 3)
In a situation when other firms compete in the same
industry with products that are similar but not identical to
each other, some customers may switch their demand to a
competing supplier if the competitor reduces its price
Consider two firms, A and B, and represent the demand,
QA, for firm As product as a function of its own price, PA,
and the price, PB, set by its competitor:
QA = a b PA + e PB
The demand for firm As product falls by b units for each
dollar increase in its own price, but increases by e units for
each dollar increase in the competitors price, because
firm A gains some of the market demand that firm B loses

Competitive Analysis (2 of 3)
The profit, PA, for firm A is represented by the
following:
A = PA QA - (f + v QA)
PA(a - b PA + e PB) - f - v(a - b PA + e PB)

Profit maximization requires this:

d A d PA = a - 2b PA + e PB + vb = 0

Therefore, the profit-maximizing price PA0 given

the other firms price PB is:
PA0 = (a + vb + e PB) 2b

The pricing decision thus depends on what the

competitors price is expected to be

Competitive Analysis (3 of 3)
If the firm expects its competitor to behave as it
does and expects it to choose the same price as
its own, then we set PA = PB = P* in the equation
a - 2b PA 1 + e PB + vb = 0 to obtain:
a - 2bP* + eP* + vb = 0
P* = a + vb/2b - e
This price is the equilibrium price, because no
firm can increase its profits by choosing a
different price provided the other firm maintains
the same price P*