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Tuesday, July 26, 2011

Pricing Products and Services

Pricing is not a problem for some businesses. They make products or provide a service that is in competition with others, identical products or services for which a market price already exists. Customers will not pay more that this price, and there is no reason to charge less. Under these circumstances, the company simply charges the prevailing market price. Markets for basic raw materials such as farm products and minerals follow this pattern.

Here we are concerned with the more common situation in which a company is faced with the problem of setting its own prices. Clearly, the pricing decision can be critical. If the price is too high, customers will avoid purchasing the company's products. If the price is set too low, the company's costs may not be covered.

the usual approach in pricing is to mark up cost. A product's markup is the difference between its selling price and its cost. The markup is usually expressed as a percentage of cost. This approach is called cost plus pricing because the predetermined markup percentage is applied to the cost base to determine a target selling price.

Selling price = Cost + (Markup × Cost)

For example, if a company uses a markup of 50%, to the costs of its products to determine the selling price. If a product costs $10, then it would charge $15 for the products.

Two key issues must be addressed when the cost plus approach to pricing is used. First, What cost should be used? Second, how should the markup be determined? Several alternatives approaches are considered here, starting with the generally favored by economists.

Price Elasticity of Demand--Economists' Approach to Pricing:

If a company raises the price of a product, unit sales ordinarily falls. Because of this, pricing is a delicate balancing act in which the benefits of higher revenues per unit are traded off against the lower volume that results from charging higher prices. The sensitivity of unit sales to changes in prices is called the price elasticity of demand. Click here to read full article.

Absorption Costing Approach to Cost Plus Pricing:

The absorption costing approach to cost plus pricing differs from the economists' approach (price elasticity of demand) both in what costs are marked up and in how markup is determined. Under the absorption costing approach to cost plus pricing, the cost base is the absorption costing unit product cost rather than variable costing. Click here to read full article.

Target Costing:

Target costing is the process of determining the maximum allowable cost for a new product and then developing a prototype that can be profitably made for that maximum target cost figure. Click here to read full article.

Time and Material Pricing in Service Companies:

Some companies--particularly in service industries-- use a variation of cost plus pricing called time and material pricing. Under this method, two pricing rates are established--one based on direct labor time and other based on the cost of direct materials used

Definition and Explanation of Time and Materials Pricing:
Some companies--particularly in service industries-- use a variation of cost plus pricing called time and material pricing. Under this method, two pricing rates are established--one based on direct labor time and other based on the cost of direct materials used. This pricing method is used in repair shops, in printing shops, and by many professionals such as physicians and dentists. The time and material rates are usually market determined. In other words, the rates are determined by the interplay of supply and demand and by competitive conditions in the industry. However, some companies set the rates using a process similar to the process followed in the absorption costing approach to cost plus pricing. In this case, the rates include allowances for selling, general and administrative expenses; other direct and indirect costs; and a desired profit. This page will show how the rates might be set using the cost-plus approach.

Time Component:
The time component is typically expressed as a rate per hour of labor. The rate is computed by adding together three elements:

The direct costs of the employee, including salary and fringe benefits.
A pro rata allowance for selling, general, and administrative expenses of the organization.
An allowance for a desired profit per hour of employee time.
In some organizations (such as a repair shop), the same hourly rate will be charged regardless of which employee actually works on the job; in other organizations, the rate may vary by employee. For example, in a public accounting firm, the rate charged for a new assistant accountant's time will generally be less than the rate charged for an experienced senior accountant or for a partner.

Material Component:
The material component is determined by adding a material loading charge to the invoice price of any materials used on the job. The material loading charge is designed to cover the costs of ordering, handling, and carrying materials in stock, plus a profit margin on the materials themselves.

Example of Time and Material Pricing:
To provide a numerical example of time and material pricing, consider the following:

Quality Auto Shop uses time and material pricing for all of its repair work. The following costs have been budgeted for the coming year:

Repairs Parts
Mechanics' wages $300,000
Service manager--salary 40,000
Parts manager--salary $36,000
Clerical assistant--salary 18,000 15,000
Retirement and insurance--16% of salary and wages 57,280 8,160
Supplies 720 540
Utilities 36,000 20,800
Property taxes 8,400 1,900
Depreciation 91,600 37,600
Invoice cost of parts used 400,000

Total budgeted cost

The company expects to bill customers for 24,000 hours of repair time. A profit of $7 per hour of repair time is considered to be feasible, given the competitive conditions in the market. For parts, the competitive markup on the invoice cost of parts used is 15%.

The following schedule shows the calculation of the billing rate and the material loading charge to be used over the next year.


Time Component: Repairs Parts: Material Loading Charge
Total Per Hour* Total Percent**
Cost of mechanics' time:
Mechanics' wages $300,000
Retirement and insurance (16% of wages) 48,000
Total cost 348,000 $14.5
For repairs--other cost of repair service. For parts--cost of ordering handling, and storing parts:
Repairs service manager--salary 40,000
Parts manager salary $36,000
Clerical assistant salary 18,000 15,000
Retirement and insurance (16% of salaries) 9,280 8,160
Supplies 720 540
Utilities 36,000 20,800
Property taxes 8,400 1,900
Depreciation 91,600 37,600
-------- ---------
Total cost 204,000 8.50 120,000 30%
-------- --------
Desired profit:
24,000 hours × $7per hour 168,000 7.00
15% × $400,000 60,000 15%
------- ------- ------- -------
Total amount to be billed $720,000 $30.00 $180,000 45%
====== ===== ====== ====
*Based on 24,000 hours
**Based on $400,000 invoice cost of parts. The charge for ordering, handling, and storing parts, for example, is computed as follows: $120,000 cost / $400,000 invoice cost = 30%

Note that the billing rate, or time component, is $30 per hour of repair time and the material loading charge is 45% of the invoice cost of parts used. Using these rates, a repair job that requires 4.5 hours of mechanics time and $200 in parts would be billed as follows:

Labor time: 4.5 hours $30 per hour $135
Parts used:
Invoice cost $200
Material loading charge: 45% $200 90 290
-------- ------
Total price of the job $425

Rather than using labor hours as the basis for calculating the time rate, a machine shop, a printing shop, or a similar organization might use machine-hours.

This method of setting prices is a variation of the absorption costing approach. As such, it is not surprising that is suffers from the same problem. Customers may not be willing to pay the rates that have been computed. If actual business is less that the forecasted 24,000 hours and $400,000 worth of parts, the profit objectives will not be met and the company may not even break even.

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