Module 19 n 21

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Pricing and Other Product Management Decisions

Module 21

Peter D.

EASTON

Robert F.

HALSEY

Mary Lea

McANALLY

Al L.

HARTGRAVES

Wayne J.

MORSE

FINANCIAL & MANAGERIAL ACCOUNTING for MBAs 5e

Explain the importance of the value chain in managing products and describe the key components of an organization’s internal and external value chain.

Learning Objective

The Value Chain

The set of value-producing activities that stretches from basic raw materials to the final consumer

Each product or service has a separate value chain

All entities along the value chain depend on the final customer’s perception of the value and cost of a product or service

Goal of every organization is to maximize the value, while minimizing the cost of a product or service to final customers.

Three Levels of the Value Chain

Refining the value chain into processes helps management understand how entities within the chain add and incur costs

First Level: Business entities

Collections of related activities intended to achieve a common purpose

Second Level: Processes

The units of work

Third Level: Activities

Three Levels of the Value Chain

The value chain for the paperboard cartons used to package beverages shows three levels with each successive level showing more detail.

Internal Processes of the Internal Value Chain

Generic processes for an internal value chain:

Value Chain Perspective

Fosters supplier-buyer partnerships

Buyers deal with a reduced number of suppliers

Relationships involve sharing customer and other data (internal processes)

Common value chain is studied

Often process modifications are made to reduce overall costs and share increased profits

Virtual integration is the use of information technology and partnerships to allow entities along a value chain to act as if they are one economic entity.

Value Chain Perspective

Fosters focus on core competencies

Relationships with suppliers often begin to represent an extended family

Creates a competitive advantage

Suppliers can focus on efficient, low-cost manufacturing

Manufacturer can focus on marketing and product development

TAL Group is headquartered in Hong Kong and is a manufacturer of men's and women’s clothing. TAL has identified the value of partnering with customers and offers value chain solutions tailored to meet customers’ individual needs.

Customers are identified as partners on their website and include companies such as Burberry, Chico’s, Nordstrom, and JCPenney.

Supplier-Buyer Partnership Example

Source: http://www.talapparel.com/en/our-story/our-partners

Value-Added vs. Value Chain Perspectives

Value-Added Perspective

Value Chain Perspective

Goal is to maximize the value-added.

Goal is to maximize the value and minimize cost to final customers.

Focus is on the cost of resources to the organization and the selling price of products or services to the customer.

Often achieved by developing linkages or partnerships with suppliers and customers.

Distinguish between economic and cost-based approaches to pricing.

Learning Objective

The Pricing Decision

Important and complex decision for management

Directly affects the salability and profitability of individual products or services

Two pricing theories

Economic approaches

Cost-based approaches

Economic Approaches to Pricing

Provide a useful framework for thinking about pricing decisions

Economic models are seldom used for day to day pricing decisions.

Based on cost and revenue functions

Marginal revenue

The varying increment in total revenue derived from the sale of an additional unit

Marginal cost

The varying increment in total cost required to produce and sell an additional unit of product

Cost-Based Approaches to Pricing

Cost has traditionally been the most important consideration in pricing because

Cost data are available.

Feasible for setting prices in a short period of time

Cost-based prices are defensible.

Managers can argue they represent a fair profit

Revenues must exceeds costs if the firm is to remain in business.

Long run selling price must exceed the full cost of each unit

Cost-Based Pricing for a New Product

Begin with market research

*Proposed price should be evaluated based on competition and what customers are willing to pay.

Cost-Based Pricing in Single-Product Companies

Example

Lawn Chopper mows lawns and has an annual facilities cost totaling $110,000. Each lawn mowed costs $18. Management desires to achieve an annual profit of $25,000 at an annual volume of 4,000 lawns.

Profit = Total revenues – Total costs

Known data are entered into the profit formula.

$25,000 = (Price × 4,000) – ($110,000 + [$18 × 4,000])

Price = $51.75 per lawn

A price of $51.75 per lawn will allow Lawn Chopper to achieve its desired profit totaling $25,000.

Cost-Based Pricing in Multiple-Product Companies

Desired profits are obtained for entire company

Standard procedures are established for determining initial selling prices of each product

Typically include

Cost assigned to the product or services

Plus a markup to cover unassigned costs and to provide a profit

Cost-Based Pricing in Multiple-Product Companies

Possible cost bases for markups based on behavior and function

Direct materials costs

Variable manufacturing costs

Total variable costs (manufacturing, selling, and administrative costs)

Full manufacturing costs

Markup on Cost Base

General approach to developing a markup is to recognize that the markup must be large enough to provide for costs not included in the base, plus a profit.

Costs not included in the base + Desired profit

Costs included in the base

Markup on cost base =

Variable Cost Basis Example

Lawn Chopper has total assets of $320,000. Management desires an annual return of 9% on total assets. Fixed costs and expenses total $50,000, and variable costs and expenses total $180,000. Estimated variable costs per unit equals $15.

Desired annual profit = 9% x $320,000 = $28,800

Selling price = $15 + ($15 x 0.438) = $21.57

Markup on variable costs =

$50,000 + $28,800

$180,000

= 0.438

Full Manufacturing Cost Basis Example

Lawn Chopper’s fixed costs and expenses total $50,000, of which $10,000 are selling and administrative costs. Total variable costs and expenses total $180,000, with $30,000 of this amount selling and administrative costs. Estimated variable costs per unit equal $15 (with $1 of this selling and administrative costs).

Selling price = $14 + ($14 x 0.362) = $19.07 Selling and administrative costs must be covered.

Desired annual profit = 9% x $320,000 = $28,800

= 0.362

Markup on full manufacturing costs

$10,000 + $30,000 + $28,800

$190,000

Cost-Based Pricing for Special Orders

Used to bid on unique projects

If the project requires

Dedicated assets, or

Acquisition of new fixed assets, or

An investment in employee training

The desired profit on the special order or project should allow for an adequate return on the additional investment.

Critique of Cost-Based Pricing

If cost-based pricing does not have accurate cost assignments, some products could be priced too high and others too low.

The higher the portion of unassigned costs, the greater is the likelihood of over- or underpricing individual products.

Cost-based pricing assumes goods or services are relatively scarce and, generally, customers who want a product are willing to pay the price.

In a competitive environment, cost-based approaches increase the time and cost of bringing new products to market.

Explain target costing and discuss its acceptance in highly competitive industries.

Learning Objective

Target Costing

Starts with determining what customers are willing to pay for a product or service

Then subtracts a desired profit on sales to determine the allowable cost of the product or service

Cost is communicated to the target costing team

Team must design a product that meets customer price, function, and quality requirements while providing the desired profit

Allowable cost = Target cost of product or service

Target Costing and Cost Management

Reflects the belief that costs are best managed by decisions made during product development

Helps orient employees toward the final customer

Reinforces the notion that all departments within the organization and through the value chain must work together

Target Costing in a Competitive Environment

Encouraging Design for Production

Target costing keeps the customer's function, quality, and price requirements in the forefront at all times.

Design for manufacturers

Target costing forces product design engineers to explicitly consider the costs of manufacturing and servicing a product while it is being designed

Examples

Placing a side access panel in an appliance for easy access for repairs

Using standard-size parts to reduce inventory

Using molded parts to avoid assembling

Time Reduction to Introduce Products

Eliminates the evaluation of marketability of a product at a cost-plus price and having to recycle the design though several departments

Involving vendors makes the vendors aware of the necessity of meeting a target cost

Facilitates concurrent engineering of components to be produced outside the organization and reduces time to obtain components

Target Costing Requirements

Requires cost information

Detailed information on the cost of alternatives activities is needed

Allows decision makers to select design and manufacturing alternatives

Requires coordination with all involved

Need a basic understanding of the overall processes required to bring a product to market

Should appreciate cost consequences

Must respect, cooperate, and communicate with other team members

Pros and Cons of Target Costing

PROS

Takes proactive approach to cost management

Orients organization toward customer

Breaks down barriers between departments

Enhances employee awareness and empowerment

Fosters partnerships with suppliers

Minimizes non-value-added activities

Encourages selection of lowest-cost-value-added activities

Reduces time to market

CONS

To be effective, requires the development of detailed cost data

Requires willingness to cooperate

Requires many meetings for coordination

Product Life Cycles

Products with a relatively long life go through four stages during their life cycle.

Time

Sales Revenue

Start-up

Sales are low. Often selling prices are high. Customers are affluent trendsetters.

Growth

Sales increase as product gains acceptance. Selling prices often remain high. Customers are loyal. Low competition.

Maturity

Sales level off. Price pressure increases. Price reductions could be needed.

Decline

Sales decline as product becomes obsolete. Significant price cuts needed to sell inventories.

Life Cycle Costs

Lifecycle costs include all costs associated with a product or service including:

Cost incurred with initial conception

Design

Pre-production

Production

After production support

Cost management aided by target costing

Commitment and Expenditures

Commitments and expenditures of organizations for high-technology products with relatively short product lives:

Illustrate the relation between target costing and continuous improvement costing.

Learning Objective

Continuous Improvement (Kaizen) Costing

A costing approach focused on continuous improvement

Successful world-class companies use Kaizen to avoid complacency.

Calls for establishing cost reduction targets for products or services

Begins where target costing leaves off

Often found in companies that have adopted a lean production philosophy

Explain how benchmarking enhances quality management, continuous improvement, and process reengineering.

Learning Objective

Benchmarking

A systematic approach to identifying best practices to help an organization take action to improve performance

Typically deals with

Target costs for a product, service or operation

Customer satisfaction

Quality

Inventory levels

Inventory turnover

Cycle time

Productivity

Benchmarking is no longer regarded as spying.

Benchmarking

Provides measurements in setting goals

Can lead to dramatic innovations

Can help overcome resistance to change

Typical benchmarking steps

Decide what to benchmark

Plan the benchmark project

Understand your own performance

Study others

Learn from the data

Take action

The End