Cost Based Pricing Rules

Ted Mitchell

Pricing Two Views

1. We give you a good price

Price Is Relative To Competition

2. We ask for this in exchange

Price = Product + Place + Promotion

Price Is A Reflection of Value

There are Price Setters

and Price Takers

A basic idea of marketing is to make your product sufficiently better than your competitors’ product from the customer’s point of view and not to be a price taker.

Pricing GoalsProfit

long run, short run

Sales Revenue (Growth)

Market Share (Penetration)

Unit Sales Volume (Learning Curve)

Pricing Goals Cont’d

Image MaintenanceCash Flow (survival)Competitive Pricing (Stability, Price leader, price taker

Avoid price competition

Basics C’s for Pricing

Costs of making the product, etc.

Customer Demand

Competitors

Pricing Methods (Formulas)

Cost Based MethodsDemand Based MethodsCompetitive Based (Going Rate, Bidding) Pricing

Cost Based Pricing Is Most Important

Why Cost Based Pricing

Four Reasons1 Fair

2 Easy to Calculate

3 Industry Stability

4 “guarantee a profit”

Types of Cost Based Methods

Cost Plus (profit)Traditional Markup (Discount rate)

Target Return on Investment

Discounts & Allowances

Some Costing Is Crude

Direct Materials plusDirect Labor plus300% of Direct Labor (to cover Fixed Costs) plus

A 50% Markup plusCompetitive adjustment plus

What the customer will bear

Pricing Formulas Tend To Be The Same Across An Industry

Reduces Price Competition

Z = (P - V)Q - F

Price Formula Comes From The Basic Profit Formula

The Basic Cost Based

Pricing Formula is

Z = (P - V)Q - F

P=V +FQ

+ZQ

Price Formula Comes From The Basic Profit Formula

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Calculate the Price

Knowing Cost and Profit Targets

The Variable Cost Is Crucial In The Idea

Of Pricing Down The Learning Curve

P=V +FQ

+ZQ

Learning Curve

Variable Cost Per Unit Is Reduced As Experience In Its Production Is Learned

Learning Curve

V

Production Experience

Learning Curve

V

Production Experience

Learning Curve

V

Cumulative

Forecasting Future Variable Cost Is A Very Important Part Of Modern Pricing Strategy!

P=V +FQ

+ZQ

Variable Cost Is Not Unit Cost

UNIT cos t =VariableCOST+FixedCOST

QuantitySOLD

UNIT cos t =V +FQ

UNIT COST COMBINES

AVERAGE FIXED COSTS

AND VARIABLE COSTS

Basic Cost BasedPricing Formula is

P=V +FQ

+ZQ

P=UnitCost+ZQ

Substitute Unit Cost

Example“We charge what it costs to make each unit plus a standard approved markup of 10% for our profit.”

Example

P=UnitCost+ZQ

“We charge what it costs to make each unit plus a standard approved markup of 10% for our profit.”Unit Cost is considered the cost to make each unit in a pricing formula

P=UnitCost+ZQ

Profit is being measured as a percentage of sales revenue.

Z =10%PQ Substitute

P=UnitCost+ZQ

Profit is being measured as a percentage of sales revenue.

Z =10%PQ Substitute

P=UnitCost+10%PQ

Q

P=UnitCost+ZQ

Simplify

Z =10%PQ Substitute

P=UnitCost+10%PQ

Q

Example“We charge what it costs to make each unit plus a standard approved markup of 10% for our profit.”

P=UnitCost+10%P

P = Unit Cost + x% of Final Price

P = Unit Cost + x(P)P - xP = Unit Cost(1-x)P = Unit Cost

P = Unit Cost

Classic Cost Plus Formula Is

(1- x)

P = Unit Cost + x% of Final Price

P = Unit Cost + x(P)P - xP = Unit Cost(1-x)P = Unit Cost

P = Unit Cost

Classic Cost Plus Formula Is

(1- x)

Note: we use unit cost and a target profit margin

Types of Cost Based Formulas

Cost Plus (Profit)Traditional Markup Pricing

(Discount rate)Target Return on Investment

Discounts & Allowances

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Markup Pricing

Very Popular with Retailers

It uses the purchase cost of the merchandise which is the Variable cost.

The Target Markup which includes the fixed costs and the target profit.

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We remember that The target markup for a target profit was Mp* = (F+Z)/ R We consider Mp*(R) = F+Z and substitute

into PQ - vQ = F+Z PQ - vQ = Mp*(R) and substitute R = PQ (P-V)Q = Mp*PQ P-V = Mp*P P-Mp*P = V P = V / (1-Mp*) is markup pricing

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Another Way Consider the breakeven price with a

target profit P = V +(F+Z)/Q Divide both sides by P (1/P)P = V/P + (F+Z)/PQ Where (F+Z)/PQ = Mp = Target

markup 1 = V/P +Mp (1-Mp)P = V P = V/(1-Mp)

When you have a target markup, The Markup Pricing

Formula Is

€

P =VariableCost(1−Markup)

€

P =VariableCost

(1−DiscountOffList)

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Markup PricingRemember the markup pricing is to cover the total contribution needed to cover the Fixed Costs and the Target Operating Profit!

Types of Cost Based Formulas

Cost Plus (Profit)Traditional Markup Pricing

(Discount rate)Target Return on Investment

Discounts & Allowances

Calculating A Price From A Cost Based Formula Is EasierIf They Give You

A Target Return or Profit Z in dollars

Then You Get to Substitute For The Profit, Z, and Solve

P=V +FQ

+ZQ

Example: Target Profit Pricing Formula

A Expected Profit of 15% ROI

P=V +FQ

+ZQ

Example: Target Profit Pricing Formula

A Expected Profit of 15% ROI

P=V +FQ

+.15 Investment( )

Q

Example: Target Profit Pricing Formula

A Expected Profit of 15% ROI

P=V +FQ

+.15 Investment( )

Q

P=UnitCost+.15 Investment( )

Q

Target Returns (Profits)

Where Do They Come From?

Sources of Targets

1 Deciding What Seems Fair2 Wanting A Better Return Than Last Year

3 Establishing What They Believe They Can Get

4 Estimated Cost Of Capital5 Wanting To Stabilize Prices

Types of Cost Based Formulas

Cost Plus (Profit)Traditional Markup Pricing

(Discount rate)Target Return on Investment

Weakness Of Cost Based

Discounts & Allowances

Basic Cost Based Pricing Formula is

P=V +FQ

+ZQ

Basic Cost Based Pricing Formula is

P=V +FQ

+ZQ

Where Does The Q Come From?

Q Can Come From

Target Level Of Desired Production

Percent Of Normal Capacity

Sales Forecasts

Dollars

Fixed Cost

Total Cost

Cost Structure is Very Important

Quantity Produced

Dollars

85% of Capacity

Fixed Cost

Total Cost

#1 Percentage Of Normal Capacity Often Becomes The Bases

For Expected Sales = Q!

#2 Forecasting The Quantity That Will Be Sold From Simple Projections Of Past Sales Is Popular

Time

To Cost Based Pricing You Need To Know

P=V +FQ

+ZQ

Variable cost , Fixed cost, Target Profit, & Estimate of Future Sales or Production = Q

The Fundamental Weakness Of

Cost Based Pricing Is

The Fundamental Weakness Of

Cost Based Pricing Is

Using An Expected

Sales Forecast, Q,

To Select The Price

Why?

Because Price is Key Factor in Causing Sales

Revenue = f(Price, Promotion, Place, Product)

Price Causes Sales!

Remember

The Expected Quantity Of Sales Should NOT Set The Price.

The Price Determines The Quantity!

Remember

The Expected Quantity Of Sales Should NOT Set The Price.

You Need Sales Estimates Based On The Demand At The Planned Price (i.e. Demand Based Pricing)

Types of Cost Based Formulas

Cost Plus (Profit)Traditional Markup Pricing

(Discount rate)Target Return on InvestmentWeakness Of Cost Based

Discounts & Allowances

Discounts & Allowances

Cash DiscountsTrade DiscountsQuantity DiscountRebates (Cumulative)

Discounts & Allowances

Everything Is A Percentage Off Catalog List Prices

Importance Of Catalog And Pricing Sheet Updates

Cash Discount

3% /10 net 30Encourage prompt payment

Reduce cost of creditIndustry standard

Trade Or Functional Discount

Straight Percentage Off ListPay For The Functions A Middleman Performs

Class A or B Distributor

OEM EducationalGovernment

Quantity Discount

Must Be Offered To All Customers

Must Demonstrate Cost Saving Being Passed On

Rebates & Allowances

CumulativeCompetitive Rebates

(software)

SeasonalAdvertising AllowancesCase Allowances

Shipping Costs

FOB originFOB Destination

Phantom FreightPostage Stamp Pricing

Cost Based Pricing Does

Not Guarantee DemandNot Guarantee A Net Profit

Not Simplify e.g. Managers Confused About CostsUnit cost versus variable costSunk costs vs fixed costDiscretionary