Chapter 18

Price Setting in the Business World

How are prices set by business people?

• Costs provide a price floor.• See what substitute products are priced at• Can you offer something of additional value

that people will pay a price premium for?• Use this information and market responses to

set your prices.• Remember, price increases & decreases have

a direct impact on unit profits

Markup Pricing

• Markup - a dollar amount added to the cost of products to get a selling price (638)

• Many retailers apply a standard markup to everything they sell.

• However, with modern data information price setting is changing to more of a market response method for many firms.

Markup Formulas

• Markup On Selling Price = – (Selling Price - Cost) / Selling Price

• Markup on Cost =– (Selling Price - Cost)/ Cost

Markup Conversions

• Percent Markup On Selling Price =– (Percent Markup on Cost)– (100% + % Markup on Cost)

• Percent Markup on Cost =– (Percent Markup on Selling Price)– (100% - % Markup on Selling Price)

Markup Example 1

• Your cost is $20 each and your selling price is $25. What is your markup on selling price and your markup on cost?

Answer 1

• Markup on selling price = – ($25 - $20) / $25 = 20%

• Markup on cost =– ($25 - $20) / $20 = 25%

Markup Example 2

• Your cost is $100 each and your selling price is $130. What is your markup on selling price and your markup on cost?

Answer for # 2

• Markup on selling price =– (130 - 100) / 130 = 23.08%

• Markup on cost =– (130 - 100) / 100 = 30%

Markup Example 3

• Your cost is $50 each and your selling price is $70. What is your markup on selling price and your markup on cost?

Answer to #3

• Markup on selling price =– (70 - 50) /70 = 28.57%

• Markup on cost =– (70 - 50) / 50 = 40%

Markup Example #4

• A] You have a 30% markup on selling price. What would this be if it was a markup on cost?

• B] You have a 20% markup on cost. What would this be if it was a markup on selling price?

Answer # 4

• A] 30 / (100 - 30) = 42.86%

• B] 20 / (100 + 20) = 16.67%

Stockturns

• Stockturn rate (498)

• Stockturn rate = – (sales in units) / (avg. inventory in units)

• Faster stockturn rates lower inventory holding costs. What is a “high” or “low” stockturn rate depends on the industry.

Average Cost Pricing

• Average Cost Pricing (490)

• Problems:– does not consider cost changes at different

output levels.– Does not consider the impact price has on

quantity demanded

Average Cost Pricing Is Common and Can Be Dangerous (E: 18-3)

Cost Relations (Exhibit 18-4)

Break Even Analysis

• Break - even analysis (505)

• Break - even point (505)

• BEP (in units) =– (Total Fixed Cost) / (Fixed Cost Contribution

per Unit)

Break-Even Analysis (Exhibit 18-8)

Break Even #1

• Your fixed costs are $100,000, your variable cost per unit = $15 and your unit price = $40. What is the break-even quantity?

• If you sell 3000 units, what is the profit?

• If you sell 6000 units, what is the profit?

Answer #1

• Break-even Quantity =– (100,000) / (40-15) = 4,000 units

• At 3000 units? – 3,000 ($40 - 15) - $100,000 = $25,000 loss

• At 6000 units?

• 6000 ( 40 - 15) - $100,000 = $50,000 profit

Break-even #2

• Your fixed costs are $25,000, your variable cost per unit = $5, and your unit price = $15. What is the break-even quantity?

• If you sell 1000 units what is the profit?

• If you sell 3000 units, what is the profit?

Answer #2

• Break-even– ($25,000) / ($15 - 5) = 2,500 units

• For 1000 units:– 1000 ($15 - 5) - $25,000 = -$15,000

• For 3000 units:– (3000 ($15 - 5) - $25,000 = $5,000

Break-Even #3

• Your fixed costs are $500,000, your variable cost per unit = $2.50, and your unit price is $10. What is the break-even quantity?

• If you sell 50,000 units what is the profit?

• If you sell 80,000 units, what is the profit?

Answer #3

• Break-Even– ($500,000) / ($10 - 2.5) = 66,667 units

• For 50,000 units– 50,000 ($10 - 2.5) - $500,000 = $125,000 loss

• For 80,000 units– 80,000 ($10 - 2.5) - $500,000 = $100,000

BE & ROI

• A target profit amount can be added to break even analysis to give the quantity needed to hit a certain profit goal. The target profit amount is added to the fixed costs in the equation.

BE & ROI Problem

• Take the last example. Our goal is now a 10% ROI. What is the quantity needed to hit this ROI target?

BE ROI Answer

• Our new “fixed costs” are

• $500,000 & the profit goal.– $500,000 + (500,000 x 0.1) = $550,000

• Break even for this ROI level is

• $550,000 / ($10 - 2.50) = 73,334 units

Break Even

• Calculating BEP at several possible prices and forecasting the probable demand at those price points can be helpful.

• BE Analysis is also a good illustration of why managers constantly look for ways to cut costs. Cost cuts means you can achieve profitability at much lower sales levels.

Problems with BE Analysis

• Break-even analysis has two big assumptions

• 1] There is a horizontal demand curve

• 2] Cost curves do not change over the production horizon

Competitive Bidding

• Six steps a firm should use:• 1] Decide if the bid is worth the bid preparation

costs• 2] Calculate the direct & indirect costs of the

contract• 3] Estimate the probabilities of acceptance at each of

several bid levels• 4] Calculate the expected profits at each bid level• 5] Evaluate the process after submission