ACT503 Chap.7 Pricing Decisions and Cost Management
Pricing Decisions and Cost Management
Three influences, and two routes through them
Price ultimately depends on demand and supply, and three things influence it. Customers influence price through demand, by way of the features and quality they want. Competitors influence it because what they can charge is set by their own technology, the capacity they hold and how they choose to run it. Costs influence it through supply.
Two long run approaches enter that triangle from opposite ends: a market based approach asks what price to charge given what customers want and how competitors will react, while a cost based approach asks what price recoups costs and earns a target return.
The course gives three reasons for understanding customers and competitors first: lower cost competitors restrain price, shorter product lives leave less time to recover from a pricing mistake, and customers now have online access to prices.
Target costing runs the calculation backwards
A target price is the price potential customers are estimated to be willing to pay, built from perceived value and competitor pricing.
Four steps follow: settle a product specification that meets what buyers want, fix the price the market will bear, take the required profit per unit off that price to leave the permitted cost, and then engineer the design down to it.
Target costing puts a ceiling on what a new product may cost and obliges the development team to design something that can be built under it, and two characteristics motivate it: the market determines price, and most of a product's cost is determined at the design stage.
Its stated limitations are that the required margin depends on a sales volume estimate and that dividing assets and required return between several products can be arbitrary.
Cost plus, life cycle and the practices that are unlawful
Cost plus pricing adds a markup to a cost base, and the narrower the base the more the markup has to carry, which is why the same firm can quote very different markups without contradiction.
Full cost is common practice for three reasons: full recovery, price stability and simplicity. The markup can be derived so that the firm earns a target rate of return on investment. Life cycle budgeting estimates revenues and costs across the whole value chain, and the chapter separates costs incurred from costs locked in, which explains why environmental costs are hardest to remove after a design is fixed.
Four non cost practices close the chapter: predatory and collusive pricing are unlawful, price discrimination is allowed where a cost difference explains it, and charging more at capacity constrained times is ordinary trade.
What this chapter covers
- 01
Customers, competitors and costs as the three influences
- 02
Short run against long run pricing horizons
- 03
Market based against cost based approaches
- 04
The four steps to a target price and a target cost
- 05
Value engineering as the only step with slack in it
- 06
Four cost bases and why full cost is common practice
- 07
The markup that delivers a target return on investment
- 08
Life cycle budgeting and customer life cycle costs
- 09
Cost incurrence against locked in cost
- 10
Predatory, collusive, discriminatory and peak load pricing
Derive a target cost, then test the same product under cost plus
- 2Required operating income in total and per unit.
- 3Target cost per unit, and the current cost per unit built from all three elements.
- 4The markup percentage on absorption cost and the cost plus price.
- 2Compare the two prices and say what the comparison means.
Key terms
- Target Price
- The estimated price that potential customers are willing to pay, built from their perceived value of the product and from what competitors charge. It is a market estimate rather than a calculation, and in target costing it is an input.
- Target Cost
- The ceiling on what a new product may cost, equal to the price it is expected to fetch less the profit required from it. It is a constraint imposed on a design team rather than a measurement reported to it.
- Value Engineering
- The examination of every business function across the value chain to reduce cost while still satisfying customer needs. It is the fourth step of target costing and the only one with any slack in it once price and required profit are fixed.
- Cost Plus Pricing
- A method that adds a markup component to a chosen cost base. The narrower the base, the more the markup must carry, and the resulting price is prospective rather than final.
- Locked In Cost
- A cost that an earlier decision has committed the firm to incurring, even though nothing has yet been spent. No accounting system records the moment it is locked in, which is why cost reduction programmes aimed at the factory disappoint.
- Customer Life Cycle Cost
- The total cost a customer incurs to acquire, use, maintain and dispose of a product. It influences the price a company can charge, because a buyer paying for the whole life will pay more for lower running costs.
- Price Discrimination
- Quoting one buyer a different figure from another for an identical item. It is permissible where justified by differences in cost and unlawful where the purpose is to weaken or shut out a rival.
Pricing Decisions and Cost Management FAQ
What is the difference between target costing and cost plus pricing?
The direction in which the calculation is solved. Target costing takes the price from the market and the profit from the capital employed and leaves cost as the constraint the design has to meet. Cost plus takes the cost as given and produces a price through a markup. The first sets characteristics and price before computing a cost; the second computes a price that the market may then refuse.
Why is full cost the common base in practice?
For three reasons the course names: it recovers all product costs, it gives price stability, and it is simple to administer. Price stability has a value of its own in a long run relationship, because a predictable price reduces the buyer's need to monitor the market and improves planning on both sides, which is part of what a long run price is selling.
Why do environmental costs need to be dealt with at the design stage?
Because they are largely locked in there. A cost is incurred when a resource is consumed and locked in when an earlier decision commits the firm to consuming it, and the accounting system records only the first. By the time a factory is spending, the design has already determined most of what it will spend, so a programme aimed at the spending arrives after the point of leverage.
When is charging two customers different prices a problem?
When the difference is not justified by a difference in cost and the purpose is to weaken or shut out a rival. Price discrimination itself is ordinary, and peak load pricing, charging more at the times when demand presses against available capacity, is ordinary too. Predatory pricing below cost to drive competitors out and collusive pricing to hold a price above the competitive level are unlawful.
Exam move
Pick a product you own and try to reconstruct its target cost: guess what the market would pay, guess the capital behind it, and see what that leaves for cost. Then list the decisions that must already have been taken at the design stage to make that cost reachable. That exercise makes the locked in cost idea concrete faster than any definition does.
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