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
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?
Lecture Goals
Goals:
Explain target pricing and cost plus pricing, and make pricing decisions
Explain the intuition behind a customer profitability analysis
Explain the approaches to transfer pricing, its functions, and tax implications
Determine transfer prices in simple cases
Determinants of Prices: 3 C’s
Competition
* High impact on markets and prices
* Competitor prices can provide valuable info
about their cost structure
→ Reverse-engineer?
Customers
* Do products/services (quality) justify price?
* If not: they might switch to alternative
products and/or providers
* Transparency of prices (public/ private info)
→ Dynamic pricing?
Costs
* Role of the time horizon
* Short: focus on incremental, variable costs
* Long:
* Fixed costs become more important (full
costs relevant: prices ≥ 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 products
* Steps
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
Value-Engineering in Target Costing
- Evaluating all aspects of the target product to reduce costs while satisfying customer needs
- Focus on customer’s real wants and needs:
- Eliminate non-value-adding costs
- Reduce value-adding costs, but do not sacrifice necessary quality or product properties
- Timing of costs
*Cost incurrence: moment when the costs are incurred (standard in costing systems)
- Locked-in costs: moment when decision is made to incur certain costs
Cost plus pricing
Cost-driven approach: Given costs, what price/profit do we target (e.g. 10%
mark-up)
Steps
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)
Cost-Plus-Pricing
Cost-Plus-Pricing
Risks
- Strong internal focus might lead to neglecting the market’s “reality”
- Ignoring the market might have detrimental consequences
Cost-Plus-Pricing: Ignoring the Market
Case 1: Prices 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)
Case 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
(profits are lower than they could be)
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?
]
solating 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 pricing
* Dropping of a customer
What are thing to consider when assessing the value of a customer?
Customer Profitability Analysis (III)
- When assessing short- and long-run profitability, consider:
> Getting fixed and variable costs right
Likelihood of customer retention
Potential for customer growth
Externalities;
- Reputation (overall demand can increase from having well-known customers;
overall demand and likelihood of customer retention can decrease when customers have
the impression that a company does not care about customer needs) - Learning from customer, e.g., how to design good products and services
> Often, finding new customers is hard
decentralization in organizations
Decentralization is the process of moving decision-making away from a central authority to smaller groups within the organization.
Here are the key points:
- ## Responsibility centers: These are the groups that will be given the authority to make decisions. They could be individual departments, teams, or even subsidiaries.
-
Important features of decentralized decisions:
- Localized information and specialized skills: The people who make the decisions will have better knowledge of the local situation and the skills needed to make good decisions.
- ## Need to be aligned with headquarters’ interests: Even though decisions are made locally, they still need to be in line with the overall goals of the organization.
-
Tools to manage decentralized units:
- Targets and budgets: These give the responsibility centers a clear idea of what is expected of them.
- Analysis of variances: This is a process of comparing actual results to budgets and targets. It helps to identify areas where the responsibility centers are doing well or where they need improvement.
- Transfer prices: These are the prices that charged between different parts of the same organization. They can be used to ensure that responsibility centers are making decisions that are in the best interests of the organization as a whole.
Overall, decentralization can be a good way to improve efficiency and decision-making in an organization. However, it is important to carefully consider the potential drawbacks, such as the need to ensure that all decisions are aligned with the overall goals of the organization.
Transfer pricing
“The amount charged by one segment of an organization for a product or service that it supplies to
another segment of the same organization.”
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
————————————————
Justification of the prices of products
and services
————————————————
Performance evaluation of
departments and managers
- Based on department profit
- Contribution of different departments becomes
visible - Difficult to determine “correct” contribution in
case of high interdependencies and synergies
Foundation for (external) accounting and taxation
- While internal TP disappear when
consolidating accounts, they can influence
profits
Coordination Example Step 1: Centralized
A firm produces and sells products. The
firm is centralized, and top management
makes all decisions. The inverse demand
function (price) and the total cost function
are:
