Unit 11

Question 1

• Accounting Costs (Explicit) vs Economic Costs (Accounting plus Implicit or Opportunity)

Answer 1

• Accounting Costs vs Economic Costs
  
  • The accounting concept of costs includes only explicit costs, i.e., those that represent actual outlays of cash, the allocation of outlays of cash, or commitments to pay cash. Eg. Incurrence of payables, satisfaction of payables, and recognition of D&A.
  • The economic concept of costs ALSO include both explicit and implicit costs.
    
    • Implicit is linked to OPPORTUNITY COST. Manufacturer who wants to install a new line has to think about the foregone interest of the money that is not being applied due to capital expenditure.

Question 2

Marginal, differential or incremental analysis

Answer 2

• Throughout the relevant range, the incremental cost of an additional unit of output is the same.
• • Quantitative analysis:
    
    • When there is a constraint ( labor hours, machine hours, beds occupied, computer time used) the manager should direct limited resources towards those products or services that produces the MOST CONTRIBUTION MARGIN PER UNIT OF CONSTRAINT.
    • The remaining units of constraint (if any) is used for the next product with the highest contribution margin per unit of constraint.
• Qualitative factors:
  
  • Special price concessions place the firm in violation of the price discrimination provisions of Robinson – Patman Act of 1936.
  • Government contract pricing regulations apply.
  • Sales to a special customer affect sales in the firm’s regular market
  • Regular customers learn of a special price and demand equal terms.
  • Disinvestment, such as dropping of a product line, will hurt sales in the other product lines.
  • An outsourced product’s quality is acceptable and the supplier is reliable.
  • Employee morale may be affected. If employees are laid off or asked to few or too many hours, morale may be affected favorable or unfavorably.

Question 3

Decision Making - Special Orders

(Special orders with and without available capacity)

(Manufacturing overhed trick: only consider variable)

(labor hours per unit)

Answer 3

• Special orders when available capacity exists
  
  • When a manufacturer has available production capacity, no opportunity cost is involved when accepting a special order. This occurs because fixed costs are already committed and capacity is available.
    
    • When capacity is available, fixed costs are irrelevant. This means that the lower threshold for price is solely the CM.
    • The company should accept the order if the minimum price for the product is equal to variable costs.
    • The only fixed costs that should be considered are fixed costs that are incurred because of the special order.
• Special orders in the absence of available capacity
  
  • When a manufacturer lacks available production capacity, the differential costs of accepting the order must be considered.
  • Now not only variable costs, but also the opportunity costs of redirecting resources must be considered.
    
    • The manufacturer will have to reduce production of existing product lines to fill the special order.
    • This means that the revenue, variable and fixed costs related to reduced production of existing product lines are relevant. HOWEVER, ONLY INCREMENTALLY.
• Units per labor: eur per direct labor / eur per unit

Question 4

>> DECISION MAKING – MAKE OR BUY

Answer 4

• Make or buy decision
  
  • If the total relevant costs of production are less than the cost to buy the item, it should be made in-house (AND VICE VERSA)
  • AVOIDABLE COSTS AND VARIABLE MANUFATURING COSTS ARE NOT INCURRED IF THE BUY DECISION IS SELECTED.
  • WHAT COST WILL THE COMPANY AVOID IF IT BUYS FROM THE OUTSIDE SUPPLIER?
• As with special order:
  
  • Sunk costs are irrelevant
  • Costs that do not differ between two alternatives should be ignored because they are not relevant.
  • Opportunity cost must be considered when idle capacity is not available.
• Make or Buy When available capacity exists
  
  • Fixed costs are irrelevant.
• Make or Buy in the absence of available capacity
  
  • Differential costs must be considered. Allocable fixed costs are relevant since now they are on top of planned capacity.
  • If capacity is limited, the products made least efficiently should be outsourced so that resources can be concentrated on the products made most efficiently. YOU FIRST PRIORITIZE THE PRODUCT THAT IS CHEAPER VS OUTSOURCE OPPORTUNITY, USE THE REST OF CAPACITY TO PRODUCE THE SECOND BEST, AND IF REQUIREMENT IS STILL NEEDED BUY THE SECOND OUTSIDE.

Question 5

ADD OR DROP A SEGMENT DECISION

Answer 5

• Disinvestment decisions are the opposite of capital budgeting decisions. They are decisions to terminate rather than start an operation or product line, business segment or branch.
  
  • In general, if the marginal cost of a project exceeds the marginal revenue the firm should disinvest.
• 4 steps in making disinvestment decision
  
  • 1. Identify fixed costs that will be eliminated.
  • 2. Determine the revenue needed to justify continuing operations. In the short run, this amount should at least equal the variable cost of production or continued service.
  • 3. Establish the opportunity cost of funds that will be received upon disinvestment.
  • 4. Determine whether the carrying amount of the assets is equal to their economic value or not. If not reevaluate the decision suing current fair value rather than carrying amount.
• When a firm disinvests, excess capacity exists unless another project uses this capacity immediately. COST OF IDLE CAPACITY SHOULD BE TREATED AS A RELEVANT COST.

Question 6

>> Price Elasticity of Demand

(FORMULA WITH ABS Q ON TOP - MINUS AND PLUS - AND PRICE BELOW -MINUS AND PLUS)

Answer 6

• Price elasticity of demand
  
  • Ed = % change in qty demanded / % change in Price
  • Ed with midpoint formula = ABS(Q1-Q2)/ABS(Q1+Q2) / ABS (P1-P2)/ABS(P1+P2)
    
    • Has to be positive.
    • REMEMBER QTY IS ON TOP (X-X)/(Y-Y)

Question 7

Price setting factors

(Internal vs External)

Answer 7

• Internal factors
  
  • Marketing objectives might include survival, current profit maximization, market share leadership, or product-quality leadership.
  • Marketing-mix strategy.
  • All relevant costs (variable, fixed and total costs) in the value chain from R&D to customer service affect the amount of a product that the company is willing to supply.
  • Organizational focus of pricing decisions
  • Capacity
• External factors
  
  • The type of market (pure competition, monopolistic competition, oligopolistic competition or monopoly) affects the price.
  • Customer perception of value and price is the value that the customer thinks he is deriving from consuming a product or a service and the price he is willing to pay. The higher the price, the higher the perceived value.
  • The price demand relationship
    
    • Sometimes prestige good ranges happen where shift of demand curve is upward slopping, but then it should return to normality.
    • Elasticity of demand
  • Competitors products, costs, prices and amounts supplied

Question 8

General pricing approaches

(Market based pricing

Competition pricing

New new product pricing - price skimming - R&D then high at beginning - vs penetration pricing)

Pricing by intermediaries (markup and mark down)

Answer 8

• Market-based (buyer-based) pricing
  
  • Not based in seller cost but rather in value perceived and competitor’s actios.
  • Typical when there are many competitors and product is undifferentiated, as in many commodity markets.
• Competition- based pricing
  
  • Based mostly on competitors pricing
• New product pricing (PRICE SKIMMING PREMIUM VS PENETRATION PRICING BUDGEt)
  
  • PRICE SKIMMING relates to high initial prices to attract buyers who are not concerned with price and to recover research and development costs (PS5).
  • PENETRATION PRICING is the practice of setting an introductory price relatively low to gain deep market penetration.
• Pricing by intermediaries (price based in proxy to get market share or differentiate)
  
  • Using markups tied closely to the price paid for a product
  • Using markdowns, a reduction in the original prices set on a product.

Question 9

Geographical Pricing

(FOB ORIGIN VS FOB DESTINATION)

Answer 9

• FOB origin / FOB destination – purchaser pays the freight/shipping cost and gains ownership as soon as product leaves point of origin / and vice versa
• Zone pricing sets differential freight charges for customer based on their location.
• Basing point pricing charges each customer freight costs incurred from given strategic points.
• Freight absorption pricing absorbs all or part of the actual freight charges (customers are not charged delivery).

Question 10

Discounts and allowance

(Value pricing

Cash and Qty descounts

Seasonal discounts)

Answer 10

• Cash discounts encourage prompt payment, improve cashflows, and avoid bad debts.
• Qty discounts encourage large volume purchases
• Trade (functional discounts) are offered to members of marketing channel that are selling for example.
• Seasonal discounts help to smooth production.
• Allowances reduce list prices.
• Value pricing entails redesigning product to improve quality without raising prices or offering the same quality at lower prices.

Question 11

Product Mix Pricing

(Optional product pricing, product line pricing, product bundle)

Answer 11

• Product-Mix Pricing
  
  • Product-line pricing sets price steps among the products based on costs, consumer perception and competitors pricing.
  • Optional product pricing requires the firm to choose which products to offer as accessories and which as standards features.
  • Captive product involves the sell of a main and a captive product (razor and blade).
  • By-product usually sets prices at any amount in excess of storing and delivering by-products.
  • Product-bundle pricing entails selling combinations of products at a price lower than of the individual items.

Question 12

Predatory Pricing (dumping is a form of predatory pricing but applied to transactions with other countries)

Price discrimination among customers ( Robinson Patman act of 1936)

Collusive Pricing

Se

Answer 12

• Pricing below product costs to destroy competitor is illegal (predatory pricing)
• Price discrimination among customers (Robinson-Patman Act of 1936 applies to manufacturers on both seller and buy side and makes this pricing illegal apart from some exceptions linked to competition and inherent serving costs).
• Collusive pricing violates antitrust laws.
• Selling below costs in other countries (dumping).

Question 13

Cost Based Pricing

(linked to job costing sustem as opposed to standard product)

(costs of unused capacity and black hole demand spiral)

Answer 13

• Cost-based pricing
  
  • Starts with cost determination followed by setting a price that will recover the value chain costs and provide a desired return on investment (cost plus target rate of return).
    
    • When there is significant product differentiation, like auto industry, both cost based and market based pricing approaches are combined
  • A SITUATION INVOLVING A JOB COSTING SYSTEM (MADE TO ORDER PRODUCT OPPOSES STANDARD PRODUCT) WOULD BE MOST CONDUCTIVE TO THE USE OF A COST BASED PRICING APPROACH.
  • Markup pricing (percentage on top of costs)
    
    • Variable cost may be used for the basis for cost, but then fixed costs must be covered by markup.
  • The costs of unused capacity in production facilities, dx channels, marketing organization are ordinarily not assigned to products or services, so their inclusion in overhead rates may distort pricing decisions.
    
    • Otherwise, generates downward (black hole) demand spiral where unused capacity increases even more due to high prices.

Question 14

Target Pricing

Answer 14

• Target pricing is the expected market price for a product or service, given the company’s knowledge of its consumer’s perceptions of value and competitor’s responses.
  
  • Reverse engineering from competition is involved.
  • The sale price is known before the product is developed and then you run backwards to find cost so it goes in opposition of full cost pricing.
• Target pricing takes a product’s entire life cycle into consideration. Product life cycle is the cycle through which every product goes from introduction to withdrawal or eventual demise.
• Value engineering is a means of reaching targeted cost levels. Minimizing costs without sacrificing customer satisfaction.
  
  • Identifies value add and non-value add costs. Value added costs cannot be eliminated without reducing quality. VALUE ADD INVOLVES PROVIDING NEW FUNCTIONALITIES TO THE CUSTOMER (IF YOU TAKE IT OUT YOU REDUCE QUALITY PERCEIVED). THE COST OF ADDITIONAL REPAIR COSTS IS NON VALUE ADD BECAUSE IT COMES FROM A DEFICIENCY IN THE PRODUCT.
  • Differentiates between locked-in (designed-in) costs and cost incurrence.

Question 15

Product Life Cycle

(strategy for each cycle

Intro: infiltrate market and build supplier relations

Growth: enters new market, and attempts to build brand loyalty and maximize mkt share

Maturity: defend market share and maximize profit

Decline: focus on most loyal customers and withdraw by reducing promotion

Answer 15

• The product life cycle has five phases:
  
  • Research and development (no sales and high costs)
  • Introduction (few competitors). Profits are usually low due to low sales growth, and also high CAC (encourage customer to adopt) and high unit costs of production. Strategy is to infiltrate the market, build supplier relations, and plan for competition.
  • Growth stage: number of competitors increase but does not peak, cost gains are big due to spread of fixed costs over higher quantities (price falls). Sales and profit accelerate, promotion spending decreases or stays stable.
    
    • The entity enters new market segments and dx channels and attempts to build brand loyalty and max market share.
  • Maturity phase: sales peak BUT growth declines>> Activity based costing and competitors are most numerous. Per customer cost is low.
    
    • Strategy is to defend market share and maximize profits through diversification of brands. Cost cutting and customer care.
  • Decline stage : number of competitors decline. Sales and profits drop as prices are cut, and some entities leave the market. Late adopter customer (laggards) come in, and per customer cost is low.
    
    • Weak products and unprofitable dx media are eliminated and advertising budgets are optimized to the max to retain the most loyal customers. Strategy is to withdraw by reducing production, promotion and inventory.

Question 16

Life Cycle Costing

(Upstream - R&D design material - and downstream - marketing and customer services)

CUSTOMERS PAY A PREMIUM FOR A PRODUCT WITH LOW AFTER PURCHASE COSTS.

Answer 16

• Lyfe cycle costing
  
  • Costs incurred before production are UPSTREAM costs (R&D,design, raw material), and after production are DOWNSTREAM COSTS (marketing and customer services INCLUDES WARRANTY). In the middle are the manufacturing costs. EMPHASIS IS ON THE NEED TO PRICE PRODUCTS TO COVER ALL COSTS, NOT JUST PRODUCTION COSTS.
    
    • WHOLE LIFE COST IS A MORE GENERAL CONCEPT THAT ADDS (OPERATING SUPPORT, REPAIR AND DISPOSAL) TO THE LIFE CYCLE COST. CUSTOMERS PAY A PREMIUM FOR A PRODUCT WITH LOW AFTER PURCHASE COSTS.
  • Advantage because it allows for better cost controlling on upstream phase. Better planning on upstream phase (where 90% of the cost is commited – property etc)) allows for lower costs on downstream process (better product design feature for example).