Ted Mitchell. Goal. Set a Selling Price that covers our Costs and Target Profit. Cost Based Pricing. Competitive Based Pricing Customer Based Pricing

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1 Cost Based Pricing Ted Mitchell Goal Set a Selling Price that covers our Costs and Target Profit 2 Cost Based Pricing Competitive Based Pricing Customer Based Pricing 3

2 Cost Based Pricing Is Most Important Why Cost Based Pricing Four Reasons 1 Fair 2 Easy to Calculate 3 Industry Stability 4 guarantee a profit Some Costing Is Crude Direct Materials plus Direct Labor plus 300% of Direct Labor (to cover Fixed Costs) plus A 50% Markup plus Competitive adjustment plus What the customer will bear

3 Price Formula Comes From The Basic Profit Formula Z = (P - V)Q - F The Basic Cost Based Pricing Formula is P = V + F Q + Z Q Basic Cost Based Pricing Formula is P = V + F Q + Z Q Most of the time we just plug in the values for V, F, Q, and Z and solve for the Price Some Basic Substitutions 9

4 Basic Cost Based Pricing Formula is P = V + F Q + Z Q Substitute Unit or Average Cost P = UnitCost + Z Q Remember Average Cost per Unit = Breakeven Price (BEP) BEP = V + F/Q Average Cost per Unit = Total Cost Number of Units Average Cost per Unit = (Total Cost of Goods Sold + Total Fixed) Quantity 11 Basic Cost Based Pricing Formula is P = V + F Q + Z Q Substitute Breakeven Price for the average cost per unit P = BEP + Z/Q

5 Comparing Retailer s and Manufacturer s Cost Based Pricing Formula Ted Mitchell 13 Example A boy buys a wagon for $20 and wants sell it and to earn a profit that will be a 60% markup on Price. What price must be charge? P-V = Mp(P) P = V/(1-Mp) P = $20/(1-0.6) = $20/.4 = $50 14 Retailer s Use Target Markup 15

6 Example A retailer buys a wagon for $20 and wants sell it and to earn a profit that will be a 60% markup on price. What price must he charge? P-V = Mp(P) P = V/(1-Mp) P = $20/(1-0.6) = $20/.4 = $50 16 Example A boy buys Where a wagon does for his $20 and wants sell desired it and markup to earn a profit that will come be a 60% from? markup on price. What price must he charge? P-V = Mp(P) P = V/(1-Mp) P = $20/(1-0.6) = $20/.4 = $50 17 Target Markup comes from his pattern of operations and expectations His history of fixed costs and normal profits 18

7 The Desired Markup or Target Profit Markup The boy has fixed costs of $2,200 and expects to make a net profit of $800 per month. He normally has a sales revenue of $5,000 a month. Target Profit Markup = (F+Z)/R TPMp = ($ $800)/$5000 TPMp = $3000/$5000 = 60% 19 The Desired Markup or Target Profit Markup The boy has fixed costs of $2,200 and expects to make a net profit of $800 per month. He normally has a sales revenue of $5,000 a month. Target Profit Markup = (F+Z)/R TZMp = ($ $800)/$5000 TZMp = $3000/$5000 = 60% 20 Retailers Often Use 21 Their variable cost (i.e., invoice of cost of the goods sold, V) and a Desired Markup or a Target Profit Markup (TZM p ) to determine their selling prices per unit P = V / (1 TZM p ) where TZMp = Target Profit Markup TZMp = (F + Z) / (Target Revenue) V = Variable Cost per Unit

8 Manufacturer s Use ROS 22 Manufacturers Often Use Average Costs of Production and a Desired Return on Sales (ROS) as a target profit to determine their prices Price = Average Cost per Unit (1- ROS) P = (V + F/Q) / (1 - ROS) where Average Cost per Unit = V + F/Q remembering Desired Profit = Z = ROS (Sales Revenue) 23 Exam Questions 24

9 Question #1 A boy buys a wagon for $4 and wants to sell it for a price that will earn him a 60% markup on price. What is the selling price he should choose for the wagon? 25 Question #1 A boy buys a wagon for $4 and wants to sell it for a price that will earn him a 60% markup on price. What is the selling price he should choose for the wagon to get a desired 60% markup? P = V (1 TZM p ) P = $4 (1 0.6) = $ Question #2 A boy buys a wagon for $4 and spends several hours cleaning and polishing it. His dad gives him the materials to make a For Sale Sign and he buys a can of paint for $1.25. He wants to sell the wagon for a price that cover his costs and earns him a fair profit. He believes that a 60% markup on price is fair and would cover all his costs. What is the selling price he should choose for the wagon to get a 60% markup? P = V (1 M p ) The new information P = $4 (1 0.6) = $10from Question #1 is

10 28 Question #2 A boy buys a wagon for $4 and spends several hours cleaning and polishing it. His dad gives him the materials to make a For Sale Sign and he buys a can of paint for $1.25. He wants to sell the wagon for a price that cover his costs and earns him a fair profit. He believes that a 60% markup on price is fair and would cover all his costs. What is the selling price he should choose for the wagon to get a 60% markup? P = V (1 TZM p ) P = $4 (1 0.6) = $10 29 Question #2 A boy buys a wagon for $4 and spends several hours cleaning and polishing it. His dad gives him the materials to make a For Sale Sign and he buys a can of paint for $1.25. He wants to sell the wagon for a price that cover his costs and earns him a fair profit. He believes that a 60% markup on price is fair and would cover all his costs. What is the selling price he should choose for the wagon to get a 60% markup? P = V (1 TZM p ) P = $4 (1 0.6) = $10 Same Answer! When You really understand the question You can ignore irrelevant information Question #2 is more realistic than Question #1 because it contains more information. 30 However, the extra information is irrelevant to solving the pricing problem.

11 In the real world we learn to disregard irrelevant information! 31 We learn to identify the relevant information by understanding the problem. If we just memorize the formula, then we will NOT understand the problem. 32 Question #3 A retailer buys wagons for $4 each. He plans on selling 20,000 wagons and has total fixed costs of $50,000. His target markup is a 60%. What is the selling price he should choose for the wagon? 33

12 Question #3 A retailer buys wagons for $4 each. He plans on selling 20,000 wagons and has total fixed costs of $50,000. His target markup is a 60%. What is the selling price he should choose for the wagon? P = V (1 TZM p ) P = $4 (1 0.6) = $10 34 A retailer with a target markup does NOT need to calculate the average cost per unit or the target profit. 35 The target markup (M p ) includes the fixed costs (F), the target revenue (R), and the desired profit (Z). M p = (F+Z)/R 36 Manufacturer s think in terms of the average cost of producing each wagon and the target return on sales. Manufacturer s need to calculate the average cost per unit or the breakeven price (BEP) Average Cost per Unit = V + F/Q BEP = V + F/Q

13 Question #4 A manufacturer makes wagons with a variable cost of $4 each and wants to sell them at a price that will provide a 35% return on sales. He plans on selling 20,000 wagons and has total fixed costs of $50,000. What is the selling price he should choose for the wagons? Question #4 A manufacturer makes wagons with a variable cost of $4 each and wants to sell them at a price that will provide a 35% return on sales. He plans on selling 20,000 wagons and has total fixed costs of $50,000. What is the selling price he should choose for the wagons? P = (V+F/Q) / (1 ROS) P = ($4 + $50,000/20,000) / (1 0.35) P = ($4 + $2.5)/ 0.65 = $10 Both have the same $10 price per wagon Because Both desire the same target profit of $3.50 per wagon 39 Same Costs per Wagon Same Target Profit per Wagon Same Selling Price Wagon

14 Operating Statement Revenue $10 per unit x 20,000 CoGS (total variable cost) $4 per unit x 20,000 Gross Profit $200,000 $80,000 $120,000 Markup = 60% Fixed Costs $50,000/20,000 = $2.5 per unit Profit $70,000/20,000 = $3.5 per unit $50,000 $70,000 ROS = 35% 40 Basic Pricing Formula P = V + F/Q + Z/Q P = $4 + $50,000/20,000 + $70,000/20,000 P = $4 per unit + $2.50 per unit + $3.50 per unit P = $10 per unit 41 You are the BOSS! The Operating Statement and the Basic Profit Equation 1) gives your employees TOO MUCH information 2) is TOO Complicated for employees to use 42

15 You Tell Them to Follow The Markup Pricing Rule Tell them 1) What the invoice cost is and what the target markup is 2) To take the Invoice Cost per Unit and Divide it by One minus the Target Markup 43 P = V / (1 Markup) Basic Cost Based Pricing Formula is P = V + F Q + Z Q You Substitute The Desired Return on Sales (ROS) for the Target Profit P = BEP / (1-ROS) Target Returns (Profits) Where Do They Come From?

16 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 Discounts & Allowances Cash Discounts Trade Discounts Quantity Discount Rebates (Cumulative) Discounts & Allowances Everything Is A Percentage Off Catalog List Prices Importance Of Catalog And Pricing Sheet Updates

17 Cash Discount 3% /10 net 30 Encourage prompt payment Reduce cost of credit Industry standard Trade Or Functional Discount Straight Percentage Off List Pay For The Functions A Middleman Performs Class A or B Distributor OEM Educational Government Quantity Discount Must Be Offered To All Customers Must Demonstrate Cost Saving Being Passed On

18 Rebates & Allowances Cumulative Competitive Rebates (software) Seasonal Advertising Allowances Case Allowances Shipping Costs FOB origin FOB Destination Phantom Freight Postage Stamp Pricing Cost Based Pricing Does Not Guarantee Demand Not Guarantee A Net Profit Not Simplify e.g. Managers Confused About Costs Unit cost versus variable cost Sunk costs vs fixed cost Discretionary

Two Important Cost Based Methods

Two Important Cost Based Methods 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