Two Important Cost Based Methods

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1 Cost Based Default Prices In New Shoes Ted Mitchell How Did You Get The Price You Got? A Pricing Policy is a Statement That Explains How You Pick Your Price For Your Policy You Need to start with a Default Price or a Base Price The Default Price or Base Price is adjusted to reflect changes in demand, competition and costs Three Legs Of Pricing Policy 1) Demand Based or Customer Response Pricing 2) Competitor Based Pricing 3) Cost Based Pricing (The Most Common Base Price or Default Price) Two Important Cost Based Methods 1) Breakeven Price: A price that covers costs with zero profit Popular for Setting Bids 2) ROS Price: A price that covers costs and a target profit Popular with Manufacturers and Service Industries Breakeven Price Start with basic profit equation where Z = profit, P = Price, Q = Quantity of Units Sold V =variable cost per unit (Cost per Unit) F = all fixed or period costs (Promotion, Research and Development Costs) 1

2 Breakeven Price (BEP) Reorganize the basic profit equation to solve for the desired price PQ = VQ + F + Z Set the Profit or Z = 0 for Breakeven P = V + F/Q + 0/Q or Breakeven Price or BEP In The New Shoes Games BEP is a basic benchmark for setting the bid price V = variable cost of manufacturing F = all your promotion costs + all market research costs + share of the total product development cost Q = Forecasted Sales Volume Breakeven price (BEP) is better known as the average cost per unit or the unit cost. = average cost per unit The Crucial Questions in Using BEP 1) What Q to use? The one without extra winning or with the winning volume? 2) What V to use? The variable cost at the end of the last period or the variable cost that will occur by the end of this period? 3) The learning curve generates a lower future variable cost if we win the extra volume? We can calculate the variable cost per unit if we can predict the production volume with the regular sales and the additional bidding volume Game has 25% learning curve Every time Cumulative Production, CQ, doubles the cost per unit drops 25% V = 7500CQ When CQ was 300,000 units then 7500(300,000) = V = $40 When CQ was 600,000 units then 7500(600,000) = V = $30 (a drop of 25%) When CQ was 1,200,000 units then 7500(1,200,000) = V = $22.50 (a drop of 25%) The Crucial Point Do you want to lose money by bidding less than your Breakeven price? Yes (Five Teams Bid less than their V cost!) If it gets a cost advantage early in the PLC If it prevents a competitor from getting the advantage It provides a market share advantage (balanced score card) No It does not give us a variable cost advantage late in the PLC (too long to double the cumulative volume) It causes a drop in Gross profit! 2

3 Example in Manual p38 V = $21 per unit F = $3,711, Q = Forecasted Sales Volume = 170,000 BEP = ,711,428.57/170,000 = $42.83 ROS Pricing Uses Costs and a Target Profit Ted Mitchell Two Big Uses for ROS 1) A measure of the firm s efficiency in converting Sales Revenue into Profit Z = ROS(R) If ROS is 38% then 38 cents of every dollar of sales is profit. 2) Provides the target profit to be achieved when setting a selling price per unit Breakeven Price (BEP) Price with Target Profit Price with Target Profit Reorganized the basic profit equation to solve for the Breakeven price PQ = VQ + F + Z The equation for finding the price is Set the Profit or Z = 0 for Breakeven P = V + F/Q + 0/Q Reorganize the basic profit equation to solve for the desired price PQ = VQ + F + Z The equation for finding the price is Set the Profit or Z = A Target Return on Sales P = V + F/Q + Target Profit /Q Set the Target Profit or Z = Target Return on Sales Substitute Target Profit = ROS(R) P = V + F/Q + ROS(R)/Q Remember R = PQ P = V + F/Q + ROS(PQ)/Q P = V + F/Q + P(ROS) Reorganize P = (V + F/Q) / (1-ROS) Remember BEP = V+F/Q 3

4 Price with Target Profit With Target Profit = ROS(R) the ROS based Price, P, is Breakeven Price with a Target ROS Assume You Want to make at least your current ROS of 38% Your Current BEP = $42.83 P = / (1-0.38) = $69.08 Price that gives you the current ROS given your forecasted sales is $69.08 Why are Cost Based Default Prices Popular in Policy Statements? Simple to calculate only need internal records for variable costs, learning curve, forecast of future sales, promotion, etc. No outside customer response or demand formula No outside competitive data needed No experience needed Two Basic Models 1) Retailers using Markup Pricing 2) Manufacturer s using Breakeven Prices and Target Profits Retailer s Markup Pricing Manufacturer s Breakeven with Target Return (i.e. profit) desired markup (i.e. target the Return on Sales) 4

5 Target Markup (i.e. target Popular in Retailing the Return because on Sales) P Retailers = V + F/Q have + Target Z/Q Markups or Discounts Off List Popular that provides in Manufacturing the desired because markup (i.e. gross Manufacturers profit margin) use Breakeven Prices for Bidding and Return on Sales (ROS) for Efficiency and Profitability Targets Target Profit. Z (i.e., based on the Return on Sales) Target Markup (i.e. P - M p (P) = V P(1-M p ) = V target the Return on Sales) P = BEP + ROS(R)/Q P = BEP +ROS(P) These Two Pricing Problems will be on the exam! Target Markup (i.e. P - M p (P) = V P(1-M p ) = V target the Return on Sales) P = BEP + ROS(R)/Q P = BEP +ROS(P) You are a Retailer You are a retailer and you have purchased a pair of shoes for $25. You have a Target Markup or Discount Off List in your store of 70%. What is the price you need to sell the shoes for to achieve your target markup on price? You are a Retailer You are a retailer and you have purchased a pair of shoes for $25. (V = $25) You have a Target Markup or Discount Off List in your store of 70%. (Mp = 0.7) What is the price you need to sell the shoes for to achieve your target markup on price? P = V / (1-M p ) P = $25 / (1-0.7) = $

6 You are a Manufacturer of Shoes You are a manufacturer and you have a Breakeven price of $55 per pair of shoes. (BEP = $55) You have a Target Profit based on a 40% Return on Sales (ROS = 0.4) You have a Breakeven Price (BEP) What is the price you need to sell the shoes for to achieve your target markup on price? P = $55 / (1-0.4) = $91.67 These Assume That You Know Breakeven Markup, Price The Calculation for the Target Markup in Retailing Mp = (V+F+Z)/BER Drawn from Breakeven revenue with a target profit (Z) The Calculation for the Breakeven Price (BEP) in Manufacturing 6