Managing Finance and Budgets

1
Managing Finance and Budgets

• Lecture 6
• Costing and Pricing (2)

2
Session 6 - Costing Pricing (2)

• LEARNING OUTCOMES
• Understand different pricing techniques and
  critically evaluate the best one(s) in a
  particular situation relevant to SMEs and VCOs

3
Costing Pricing (2)

• KEY CONCEPTS
• Activity based costing
• Pricing strategies
• Cost plus pricing
• Marginal cost pricing
• Penetration pricing
• Price skimming

4
Activity Based Costing
5
Traditional Costing

• During the previous lecture we examined full
  costing, the traditional approach to costing
• This costs a job by
• Collecting all the cost for a job which can be
  directly attributed to it (Direct Costs)
• Allocating a proportion of the overheads to the
  job according to some formula (e.g. labour hours
  spent)

6
The Changing Business Environment (1)

• The traditional approach was devised to satisfy
  the needs of a largely production-based economy
• The UK economy of the 19th early 20th Century
  had the following features
• It was largely production-based.
• Production was direct-labour intensive and
  direct-labour paced
• There was a low level of overheads compared to
  direct costs
• There were relatively uncompetitive markets.

7
The Changing Business Environment (2)

• During the latter part of the 20th Century, this
  situation altered radically
• The current UK economy has the following
  features
• It is largely service-based.
• Production is capital-intensive and machine paced
• Even in manufacturing industries there are high
  levels of overheads as compared to direct costs
• There is a highly competitive international
  market.

8
The Changing Business Environment (3)

• In the highly competitive environment of the 21st
  , Century, there is a need to use costing
  procedures which recognise the higher
  contributions of overheads as compared to direct
  costs.
• For service-based industries, this is especially
  true in these organisations, overheads
  contribute overwhelmingly to costs.

9
Activity Based Costing

• Activity Based Costing (ABC) emerged precisely in
  order to take account of these increasing levels
  of overheads as a total of all costs .
• ABC focuses on Cost Drivers - all overheads are
  analysed, and attributed precisely to the
  activity (or activities) which generated them or
  require them.

10
Cost Drivers

• A Cost Driver is an activity which causes costs
  to be incurred.
• ABC should be contrasted with the Traditional
  approach
• In the Traditional approach, overheads render a
  service to the cost units (this is typified in
  the departmental approach, where for example
  service cost centres are departments like
  catering, personnel, and accounts.)
• In the ABC approach, all overheads are caused by
  cost units.

11
ABC in Practice

• Cost Pools are created for each type of cost (for
  example production, finishing, warehousing,
  transport)
• All costs associated with the activity are
  allocated to this pool.
• Costs in the pool are then allocated back to the
  activity according to the extent to which each
  unit of output drove the costs, using the cost
  driver identified.

Cost Pool 1 Transport
Activity A
Activity A
Activity B
Activity B
Cost Pool 2 Warehousing
Activity C
Activity C
12
ABC in Practice an Example

• ABC Suppliers are a warehousing and delivery
  company, supplying three different items of
  stationery (Items A, B, C what else?) to
  retailers.
• The company estimates that their running costs
  for next year will be 30,000 for the warehouse
  and 16,000 for transport.
• During next year, the company estimates
• Item Warehouse Max No. of items Estimated
• days per item per journey Sales
• A 10 days 50 2500 items
• B 2 days 75 7500 items
• C 12 days 100 5000 items

13
ABC in Practice Cost Pools

• ABC Suppliers estimates that their running costs
  for next year will be 16,000 for Transport and
  30,000 for Warehousing.
• These will be treated as two separate cost pools.

Transport 16,000
Item A
Item A
Item B
Item B
Warehousing 30,000
Item C
Item C
14
ABC in Practice Cost Driver (Transport)

• ABC suppliers use a method for allocating
  transport costs based on the following Cost
  Driver
• The cost driver uses the space taken up and the
  number of items
• Transport Cost Driver Method
• Determine the number of items required to fill a
  van.
• Determine the total number of items to be sold
• Calculate the number of journeys required.

15
ABC in Practice Cost Driver Calculation

• ABC Suppliers estimated that next year, the
  company will supply
• A 2500 items (_at_ 50 items per van) 50
  vanloads
• B 7500 items (_at_ 75 items per van) 100
  vanloads
• C 5000 items (_at_ 100 items per van) 50
  vanloads
• How much of the transport pool should we
  allocate to each item?

Transport 16 000
Item A ?
Activity A
Item B ?
Activity B
Warehousing 30,000
Activity C
Item C ?
16
ABC in Practice Cost Allocation

• ABC Suppliers next year will supply
• A 50 vanloads 25 of the total
• B 100 vanloads 50 of the total
• C 50 vanloads 25 of the total
• TOTAL 200 vanloads 100
• This means we should allocate the 16,000 in the
  proportions
• 25 for A, 50 for B and 25 for C

Transport 16 000
Item A 4000
Item A
Item B 8000
Item B
Warehousing 30,000
Item C 4000
Item C
17
ABC in Practice Cost Driver (Warehousing)

• ABC suppliers use a method for allocating
  warehousing costs based on the following Cost
  Driver
• The cost driver uses the number of days stored
  and the number of items
• Warehousing Cost Driver Method
• Determine the average number of days the item
  will be in the warehouse.
• Determine the total number of items to be sold
• Calculate the number of item-days which will be
  generated for each item over the period.

18
ABC in Practice Cost Driver Calculation

• ABC Suppliers estimated that next year, storage
  will be required
• A 2500 items (_at_ 10 days item) 25000
  item-days
• B 7500 items (_at_ 2 days per item) 15000
  item-days
• C 5000 items (_at_ 12 days per item) 60000
  item-days
• How much of the Warehousing pool should we
  allocate?

Transport 16 000
Item A ?
Activity A
Item B ?
Activity B
Warehousing 30,000
Activity C
Item C ?
19
ABC in Practice Cost Allocation

• ABC Suppliers estimate that next year, storage
  will be required
• A 25,000 item-days 25 of the total
• B 15,000 item-days 15 of the total
• C 60,000 item-days 60 of the total
• TOTAL 100,000 item-days 100
• This means we should allocate the 30,000 in the
  proportions
• 25 for A, 15 for B, 60 for C

Transport 16 000
Item A 7,500
Activity A
Item B 4,500
Activity B
Warehousing 30,000
Activity C
Item C 18,000
20
ABC in Practice Activity Costs

• ABC Suppliers now calculate that the allocated
  costs are
• Transport Warehousing Total
• A 4000 7500 11500
• B 8000 4500 12500
• C 4000 18000 22000
• TOTAL 16000 30000 46000

Transport 16,000
Item A 11500
Item A
Item B 12500
Item B
Warehousing 30,000
Item C 22000
Item C
21
ABC in Practice Costs per Item

• ABC Suppliers now calculate the cost of each
  item
• Total No. Supplied Cost per Item
• A 11500 2500 4.60
• B 12500 7500 1.67
• C 22000 5000 4.40

Transport 16,000
Each A 4.60
Item A
Each B 1.67
Item B
Warehousing 30,000
Each C 4.40
Item C
22
Activity One

• A company manufactures a range of 10 models of
  suitcases of various sizes and shapes. Each model
  is made in a small batch in order to keep stocks
  to a minimum.
• How would the company calculate costs per
  suitcase using a traditional Job Costing method?
• How might this change if an Activity-Based
  Costing system were used?

23
Activity One - Solution

• A range of 10 models of suitcases made in a
  small batch order .
• Costs per suitcase via Traditional Job Costing
• Amount of time spent (direct labour) would be
  calculated for each suitcase. This is then
  expressed as a fraction of the total labour time
  for all 10 suitcases.
• We then arrive at
• Direct Costs
• Materials Cost cost of materials for one
  suitcase
• Direct Labour Cost cost of labour to make one
  suitcase
• Indirect Costs
• Overheads Cost the fraction of the total
  overheads bill

24
Activity One - Solution

• A range of 10 models of suitcases made in a
  small batch order .
• Costs per suitcase via Activity Based Costing
• For Direct costs, we would do exactly as before
• For Indirect costs, we would create an Activity
  Pool for each type of overheads activity, e.g.
  transport, admin, warehouse, sales team.
• Each pool would require a cost-driver to
  apportion the cost to the different suitcases
  (e.g. if one suitcase is more popular, we might
  apportion less of the sales teams cost to it,
  but more admin cost since there would be more
  paperwork.)
• Each suitcase would receive a fraction of the
  total cost from each cost pool, which would be
  totalled to give the actual cost.

25
Benefits and Drawbacks of ABC

• ABC in theory should contribute towards fairer
  costing, and better controlled costs
• ABC in practice is time-consuming and can itself
  be a costly process.

26
Pricing Strategies
27
Pricing Strategies Issues and Principles

• In most markets the price of products or services
  will determine how many products or services
  will be sold.
• Usually,
• Lower Price Higher Sales
• Higher Price Lower Sales
• However, this is not always true. It may be the
  case, for example that a hotel which reduces its
  prices below a particular level, will be sending
  unwitting messages about the type of clientele
  which it caters for.

28
Pricing Strategies Issues and Principles

• Where products can be differentiated in other
  ways, price becomes less important.
• One prime example of this is through branding.
• For example, two types of trainer may, to all
  intents and purposes, be identical - except that
  one has a designer label, and so will attract a
  higher price.

29
Pricing Strategies Issues and Principles

• Prices need to be set therefore in the light of
  potential market factors, but also bearing in
  mind costs
• It is normally important to recoup costs, but as
  we shall see, it is sometimes a justifiable
  pricing strategy to sell below cost price. This
  normally occurs at the introduction of a product,
  or at the end of the sales run.
• In addition, an important strategy used by
  supermarkets, for example is the notion of a
  loss-leader, an item sold well below market
  value in order to attract custom into the store.

30
Pricing Strategies Issues and Principles

• Some products or services have a higher
  elasticity of demand - demand changes far more
  dramatically in relation to changes in price
• Items with a high elasticity of demand tend to be
  luxury items chocolate bars, alcohol etc.
  Higher prices for a product will tend to make
  people either switch brands or, if this is not
  possible, use less of the item.
• In contrast, necessary items such as electricity
  tend to have a low elasticity of demand.
  Increasing prices may cause some people to switch
  suppliers, but will not usually cause people to
  use less electricity.

31
Pricing Strategies Issues and Principles

• Break-even analysis assumes that pricing will
  remain constant over different volumes
• This may be a fair assumption over a small range
  of output. However there are economies of scale
  to consider.
• If you are a large-scale producer, you have more
  economic muscle to obtain discounts from your
  suppliers. On example of this is the prices paid
  by large supermarkets to the farming community.
• Additionally, while to some extent some
  overheads increase with sales, the relationship
  is not linear. A 100 increase in sales will not
  require us to have two managing directors instead
  of one!

32
Pricing Strategies Issues and Principles

• There are Price-makers and Price-Takers.
• A price-maker is someone who establishes the
  going market rate for a product. They are strong
  in the market and set the scene for everyone else
  .
• A price-taker is one who merely accepts the
  going market rate for their product.
• For example, when Dyson introduced a new type of
  cleaner, they became price-makers. The machine
  was revolutionary and demanded two or three times
  the (then) going rate for vacuum cleaners.
  Currently other manufacturers offer versions of
  the cleaner, priced to undercut Dyson.

33
Pricing Strategies

• We will look at four distinct pricing strategies
• Full-Cost Pricing
• Marginal Cost Pricing
• Penetration pricing
• Price-Skimming

34
Pricing Strategies 1 Full Cost Pricing

• Full Cost Pricing is sometimes called Cost-Plus
  Pricing)
• Summary of the Strategy
• Calculate the total cost of the product or
  service and add a given percentage for profit
• For example, if an item is costed at 2.28 (full
  cost of manufacture and distribution, inc.
  overheads), we might add 25 on to this for our
  profit margin
• 25 of 2.28 0.57
• Full Cost Price 2.85

35
Full Cost Pricing some issues

• Ignores market demand
• Used by price-makers not price-takers
• Sometimes used by SMEs where comparison between
  services is difficult
• Provides useful information even where not used
  to set price. Enables price-takers to identify
  the minimum they can accept

36
Pricing Strategies 2 Marginal Cost Pricing

• Marginal Cost Pricing is often called Relevant
  Cost Pricing
• Summary of the Strategy
• Calculate the minimum price for which the product
  or service can be sold profitably, using only
  variable and relevant costs.
• This is based on the following assumptions
• The market does not provide an opportunity to
  sell at full cost.
• The fixed costs will not be affected by the
  decision to produce or sell.

37
Marginal Cost Pricing Some Issues

• Can only really be used as a short-term approach,
  since it ignores the need to cover overheads
• Used, for example, when selling off airline
  seats, or stock which is about to be out of date
• It may affect the organisations ability to sell
  at full price
• It may lead to loss of customer goodwill
• It is often difficult to judge when to reduce
  prices to marginal level
• Used by price-takers very often selling for
  what they can get.

38
Pricing Strategies Penetration Pricing

• Summary of the Strategy
• Sell cheaply to achieve high volume and gain
  market share, then raise prices as soon as market
  share is established.
• This strategy can be seen in any number of
  introductory offers that are displayed in the
  high street. Very often new-release videos, for
  example are sold by outlets such as W H Smith in
  the first week of release at well below their
  subsequent price.

39
Penetration Pricing Some Issues

• It can dissuade competitors from entering the
  market
• Usually applies to new products
• Often seen in high-tech industries

40
Pricing Strategies Price-Skimming

• Summary of the Strategy
• Segment the market according to resistance to
  price
• Set initial price at high rate and sell to
  customers who are not worried about high prices
• Reduce price to expand to new level of customers
• Reduce price even further for high volume/mass
  market sales

41
Price-Skimming Some Issues

• This tends to be used where significant barriers
  to entry exist, where a company has an exclusive
  product, or when introducing new products ahead
  of competitors.
• One recent example of this is DVD Player
  technology.
• A few years ago, the home cinema market was
  dominated by VHS, and there was resistance to new
  and potentially more expensive technology.
• Initially DVD players were introduced costing
  thousands of pounds, and were only bought by
  wealthy enthusiasts.
• Having established the market, prices were
  lowered to hundreds of pounds, and begun to be
  seen as a must-have item.
• Today, cut-price DVDs can be bought for less than
  100, and are commonplace, with DVD disks
  overtaking the sales of VHS cassettes.

42
Activity Two

• Identify which pricing strategy you would use in
  each of the following situations.Give reasons for
  your answers.
• A company introducing a new electronic device
  into the consumer market
• A company providing management consultancy
  services for other businesses
• A company providing mains electricity supplies
• A company selling plastic water tanks to the
  plumbing industry
• A company offering an internet-based
  concert-booking service

43
Activity Two - Solution

• New electronic device into the consumer market
• Price Skimming (may be initial resistance)
• A company providing management consultancy
  services for other businesses
• Penetration Pricing (Competitive field hard to
  establish foothold)
• A company providing mains electricity supplies
• Penetration, then Full-Cost Pricing (If new
  company)
• A company selling plastic water tanks to the
  plumbing industry
• Full-Cost Pricing (recoup all manufacturing
  costs, standard item)
• A company offering an internet-based
  concert-booking service
• Marginal Pricing (high-volume, and as fixed
  costs are minimal)

44
Seminar Six - Activities

• Preparation read Chapter 11
• Describe key concepts
• Activity based costing
• Pricing strategies
• Cost plus pricing
• Marginal cost pricing
• Penetration pricing
• Price skimming
• Exercises 11.4 (page 365) and 11.8 - pages 367-8