Cost Information

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Chapter 7 Cost Information for Pricing and
Products Planning
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Chapter Objectives To be able to 1. Show how
a firm chooses its roduct mix in the short
term 2. Explain how a firm adjusts its prices in
the short term depending on whether capacity is
limited 3. Discuss how a firm determines a
long-term benchmark price to guide its pricing
strategy 4. Evaluate the long-term
profitability of products and market segments
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• Short-term versus Long-term Pricing
  considerations
• Capacity
• Available not available.
• Price and timeframe to establish further
  capacity. Overtime, outsourcing, investments.
• Length of commitment of order.
• Profitability.
• Pricing
• Can prices be influenced - or are prices set?
• When producing a commodity prices are normally
  set by aggregate market forces of supply and
  demand. As such a single company can typically
  not influcence the prices. Similarly if the
  industri is domi- nated by a major player, then
  the smaller company has to adjust prices to the
  market leader.
• Contrary in a business area with relatively
  little competition or where the company is a
  major player, prices can be influenced.

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Classification of Pricing and Product Mix
Decisions Short-term decisions Price-taker
firm Price-setter firm Long-term
decisions Price-taker firm Price-setter
firm Definitions Price-taker A firm that
accepts the prices set in the marketplace for its
products. Price-setter A firm that can
determine the prices its customers will pay for
its products.
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• Short-term Product Mix Decisions - Price Takers
• Who
• Companies acting within a commodity based market
  area prices are
• determined by the aggregate production
  decisions of all companies within
• such a an industry.
• A small firm, or a firm with a negligible market
  share in this industry, behaves
• as a price-taker.
• What
• Relevant costs (short-run variable cost plus any
  opportunity cost)
• Production capacity
• Exhibit 7-2, 7-3, 7-4, 7-5, 7-6 and 7-7
• Maximization of profits
• Opportunity costs

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• Short-term Product Mix Decisions - Price Takers
• Definitions
• Incremental costs per unit The amount by which
  the total costs of production and sales
  increase when one additional unit of that
  product is produced and sold.
• Contribution per unit The price per unit lesss
  variable costs per unit.
• Contribution margin per
• machine hour A factor obtained by dividing the
  contribu- tion per unit by the number of
  machine hours per unit.
• Constrained resource A bottleneck that limits
  sales or production in the short-term.

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• Short-term Product Mix Decisions - Price Setters
• Who
• Market leader/major player selling specialized
  products
• What
• Relevant costs
• Production capacity
• Exhibit 7-8
• Scenario Available capacity
• Identify relevant cost
• Calculate breakeven
• Scenario No available capacity
• Identify options of establishing short-term
  capacity
• Identify relevant cost of additional capacity

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• Long-term Product Mix Decisions - Price Setters
• Who
• Market leader/major player selling specialized
  products
• Full costs instead of incremental costs, when
• 1) Many contracts for the development and
  production of customized products and man
  contracts with governmental agencies specify
  that prices should wqual full costs plus a
  markup. Prices set in regulated industries also
  are based on full costs.
• 2) When a firm enters into a long-term
  contractual relationship with a customer to
  supply a product, it has great flexibility in
  adjusting the level of commitment for all
  resources. Therefore, most activity costs will
  depend on the production decisions under the
  long-term contract, and full costs are relevant
  for the long-term pricing decision.
• 3) Most firms make short-term adjustments in
  prices, often by offering discounts from list
  prices instead of rigidly employing a fixed
  price based on full costs. When demand for their
  products is low, the firms recognize the greater
  likelihood of surplus capacity in the sort term.
  Accordingly, they adjust the prices of their
  products downward to acquire aditional business
  based on the lower incremental costs they incur
  when suprlus capacity is available. Converseley,
  when demand for their products is high, they
  recognize the greater likelihood that the
  existing capacity of activity resources is
  inadequate to satisfy all of the demand. Thus,
  they adjust the prices upward based on the
  higher incremental costs they incur when capacity
  is fully utilized. The higher prices serve to
  ration the available capacity to the highest
  profit opportunity.
• Exhibit 7-9 Short-term prices relative to
  long-term benchmark price.

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• Long-term Product Mix Decisions - Price Setters
• Markups
• Price elasticity When demand is relatively
  inelastic, profits will usually increase when
  prices increase. When demand is elastic, the
  quantities sold will decrease sharply when prices
  increase and profits decrease.
• Strength of demand Demand curve deviates from
  equilibrium
• Intensity of competition Supply curve deviates
  from equilibrium
• Strategy Penetration pricing strategy versus
  skimming price strategy
• Penetration pricing strategy The act of choosing
  a low markup for a new product to penetrate the
  market and win over market share from an
  established product of a competing firm.
• Skimming price strategy An act of initially
  charging customers a higher price, who are
  willing to pay more for the privilege of
  possessing a product.

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• Long-term Product Mix Decisions - Price Takers
• Decisions to add products to or to drop
  products from the product portfolio, influencing
  the whole cost structure of the company. Impacts
  both variable costs, batch-related costs,
  product- sustaining costs and maybe even general
  overhead.
• Full product line necessary? One-stop shopping?
• Customer incentives/customer behavior.
• If dropping products, profitability only
  improves if activity resources no longer required
  to support the discontinued product is
  eliminated and/or redeploy the resources from the
  eliminated products to produce more of the
  profitable products that is still offered.