Lecture 10 Flashcards
what is a good price for a product/service
Prices should not be
Too high: customers might stop buying your products
Too low: lost revenues/profits
what is a good price for a product/service
Economics
Inverse demand function: price as a function of quantity provided
(assumes perfect competition and price taking)
(how can a company know this (particularly, if products are heterogeneous))?
Firms deliver as long as price equals at least marginal costs
(what if companies can set prices)
(focus on short-term: what about recovering fixed costs)?
Determinants of price
Competition
Customers
Costs
Determinants of price
Competition
High impact on markets and prices
Competitor prices can provide valuable info about their cost structure
Determinants of prices: 3 Cs
Customers
Do products/services (quality) justify the price?
If not: they might switch to alternative products and/or providers
Transparency of prices (public or private knowledge)?
Dynamic pricing
Determinants of prices: 3 Cs
Costs
Role of the time horizon
Short: focus on incremental, variable costs
Long
Fixed costs become more important (full costs relevant: prices should cover unit costs)
Desire for price stability
Target costing: market driven approach
What can we deliver given what customers are willing to pay for our product?
Price taker markets; little room to differentiate producs
Steps of target costing:
1) Determine customers expectations, wants and needs regarding a product
2) Determine customers willingness to pay: target price
3) Target price - target profit = target cost
4) Perform value engineering to achieve target cost
V
Value engineering
Systematic revision of the value chain to reduce costs
Value engineering in target costing
Evaluating all aspects of the target product to reduce costs while satisfying customer needs: (eliminate non-value-adding costs
Reduce value-adding costs but do not sacrifice necessary quality or product properties
Timing of costs
locked in costs
Cost incurrence
Locked in costs
Moment when decision is made to incur certain costs
Cost incurrence:
Moment when the costs are incurred (standard in costing systems)
Cost plus pricing
Given costs, what price/profit do we target:
1) determine a cost base (full costs, absorption manufacturing costs, variable manufacturing costs, total variable costs)
2) Targeted mark-up in % (e.g. 10% on the full costs)
3) Selling price = costs + mark-up (e.g. price = 1.1 * full costs)
Risks: strong internal focus might lead to neglecting the markets reality
Ignoring the market might have detrimental consequences
Cost plus pricing: ignoring the market
1: costs are too high
Customers are not willing to pay the price as the market offers competitive alternatives
Less goods than planned are sold
Unit base decreases -> higher full costs (unit costs) –< higher price -> even less units sold
Company gets pushed out of the market (number of units sold too low)
Cost plus pricing: ignoring the market
2: prices too low
Price is lower than the market allows
More goods than planned are sold
unit base increases -> lower full costs (unit costs) -> Lower price -> even more units sold
Company gets sucked into the market
Customer profitability analysis (I)
Similar to the profitability of products, you can assess the profitability of customers
What are costs/cost-drivers of retaining/gaining a certain customer
What are the (potential) gains from a certain customer
Customer profitability analysis (I)
Isolating customer-specific costs/benefits
Feasibility depends on products/services and market
Examples for customer-specific costs:
Sales visits and meeting
Efficiency of the order process, contact time and (re)negotiations
Complaints and reclamations
Customer profitability analysis (II)
Reactions based on the analysis:
Different price setting
Dropping of a customer
To consider:
What does dropping/annoying certain customers do to a companys general reputations?
What are positive externalities of this customer that I might miss in ny analysis?
How influential is a customer?
Important features of decentralization decisions
Localized information, specialized skills
Need to be aligned with headquarters interests
Need to evaluate (performance of) decentralized units
Tools to manage decentralized units
-Targets and budgets
-Analysis of variances
-Transfer/internal prices
Transfer prices (TP)
The amount charged by one segment of an organization for a product or service that it supplies to another segment of the same organization
Profit (transfer pricing formula) dep 1
Profit = TP * Quantity - input costs
Profit (transfer pricing formula) dep2
PQuantity - (TPQuantity) - other input costs
Transfer prices: Functions
Coordinating (and transferring products and services between) departments
Performance evaluation of department and managers
Justification of the prices of products and services
Foundation for (external) accounting and taxation
Transfer prices: functions:
Coordinating (and transferring products and services between) departments
Headquarters can influence decentral decisions via the TP and the approach to calculate it
Changes in the TP lead to changes in internal demand and supply of products and services
Profit maximization of one department might have negative effects on others or the whole company
Transfer prices: functions:
Performance evaluation of department and managers
Based on department profit
Contribution of different departments become visible
Difficult to determine “correct” contribution in case of high interdependencies and synergies
Transfer prices: functions:
Foundation for (external) accounting and taxation
While internal TP disappear when consolidating accounts, they can influence profits
Transfer pricing: implecation of using MC (benefits)
Optimal coordination in the interest of the company
Transfer pricing: Implecations of using MC disadvantages
If the production department has fixed costs, they will not be recovered
To achieve optimal coordination, the production department will incur loss equal to its fixed costs
Any decrease in variable costs (good management behavior) will result in low TP
Coordination functions and performance evaluation functions may be in conflict
Fairness perceptions
Transfer pricing features
Useful when market prices of products/services are not available or too costly to obtain
MC: optimal coordination
Alternatives to MC (Full costs, costs-plus): suboptimal coordination, but other benefits
Dual-pricing as a potential solution:
Different TP for selling and buying departments (the difference is accounted for at the centralized level)
Market based approach: works best when
There are competitive markets for very similar products
Transaction costs at the market are negligible
Market prices are stable: large fluctuations in prices makes management decisions harder
high autonomy of departments
Manager behavior
If outside market exists and is easily usable:
If TP < market price, the production dept would not sell internally
IF TP> market price, the sales dept would not buy internally
TP needs to equal the market price
TP = market price leads to g ood manager decisions
For the production department: incentives to reduce costs, no incentives to misreport costs
Good coordination
Easier performance evaluation
High fairness perceptions
Negotiation based approach: TP determined by a negotiation process
Very decentralized approach:
Departments with high autonomy
Departments might arrive at very good/fair solutions
Potentially disadvantageous (negotiation based approach9
Time consuming
Negotiation can be lead very strategically
Perceptions of unfairness (e.g. from different bargaining powers, communication mode)
Potential negative effects for performance evaluation
Often, central intervention needed if parties fail to agree
Transfer prices can be a tool to optimize tax payments, but can sometimes be used illegally: arms length principle
TP between departments should be set as if departments would not be part of the same company
Tax considerations can be important for setting TP, but might clash with other TP functions (e.g. coordination)
(illegal) profit shifting with transfer prices
Very basic (iii) mechanism to move profits (away from a high-taxed country)
