Product costing/pricing strategy

• rivalry between existing competitors;
• the threat of new entrants;
• the threat of substitutes;
• the bargaining power of buyers and;
• the bargaining power of suppliers.

Each force will require indepth analysis of a checklist of factors. Examples of each of the factors may be viewed as follows:

• intensity of rivalry between existing competitors may be linked to determinants such as the number of competitors, marketing power, brand identity, product differences and cost structure. The rivalry will extend to the seeking of new markets and new products;
• the threat of new entrants will be affected by determinants such as the barriers to entry and the expected reaction from existing firms. New entrants will incur high capital costs of entry plus experience costs of developing expertise and the costs of brand identity development;
• the threat of substitutes may be determined by the level of innovation of existing producers, the ability of existing compet itors to finance responses to the threat (switching costs) and the propensity of buyers to substitute, possibly because of price considerations;
• the bargaining power of buyers may be linked to buyer concen tration. Where there are many buyers (e.g. of chocolate bars) they have little direct ability to negotiate the price of the product. Where there are few buyers (e.g. of aircraft fleets) they are likely to have a much greater level of bargaining power in relation to price;
• the bargaining power of suppliers may be viewed in a similar context to that of buyers. Supplier power and impact on costs will be greater where there are few of them. This principle may be viewed in the context of individual inputs for materials, labour and services.

The maintaining or improving of profit levels may also be viewed by considering the competitive strategy of the firm. Porter cited strategies with respect to competitive position, which may be used to provide competitive advantage:

• Cost leadership is characterised by a costconscious approach to operations, the pursuit of technical advantage and acknowledged lowest costs in the industry. Note that this low cost should not be equated with a `cheap' product philosophy. Also, low cost does not necessarily mean low price. It does mean the ability to lower price in time of severe price competition and provides a cushion to defend profit levels against competitors;
• Product differentiation is characterised by the use of multiple products, each branded and promoted. Competitors are forced to compete simultaneously on many fronts and must overcome brand loyalty through price cutting. Product differentiation should add attributes that are valued by the customer and that the customer is therefore, willing to pay for. This should aim to maximise the profit gap between price and cost;
• Niche marketing targets markets in which the company can focus on cost and quality in response to customer needs in a specific market. This should lead to higher profits in the short term;

Efforts to achieve retention and/or increase of market share and the maintenance or improvement of profit levels may also be viewed in the context of other `models' proposed in the 1990s.

Lynch and Cross (1991), viewed business as a performance pyramid

(see Figure 2). The levels in the pyramid link strategy and operations. Corporate vision is seen as looking forward through defining markets and the basis on which the company will compete. The bases of competing may include pricing policy, product innovation and quality, features such as quality of sales force, aftersales service, financial aid to customers and point of sale amenities. The pyramid views a range of objectives for both external effectiveness and internal efficiency. These objectives are to be achieved through measures at various levels as shown in the pyramid. These measures are seen to interact with each other both horizontally at each level and vertically across the levels in the pyramid.

Kaplan and Norton (1992) devised the `balanced scorecard' as a way in which to improve the range and linkage of performance measures.

Figure 3 illustrates four perspectives: financial, customer, internal business and innovation and learning. These perspectives seek to answer the questions as stated in

Figure 3. The scorecard adds to the traditional financial focus by seeking to monitor the internal business perspective in nonfinancial terms, to monitor change and improvement in products and methods and to provide an external focus aiming at ensuring customer satisfaction and continued or increased business from them.

Fitzgerald et al (1993) and Fitzgerald and Moon (1996), focus on performance in service businesses. Figure 4 shows their building blocks for dimensions, standard and rewards. The model focuses on results measured by financial performance and competitiveness. Improved competitiveness should lead to retention or increase in market share and improved financial performance. The determinants by which the results should be achieved are quality, flexibility, resource utilisation and innovation.

Product Life Cycles

Product life cycle is a relevant factor in the determining of product market strategies and the price/cost relationships which are factors in the pricing and profitability of a product. Smith (1997), illustrates theproduct life cycle as in

Figure 5. The

introductory phase of product uptake and volume will be affected by the level of advantage on price or quality over rival products. Also, investment in the improvement of product promotion, distribution and aftersales warranties will help to overcome customer resistance and any perception of relative lack of reliability andlongevity of the product. This view fits with aspects of the discussion of the Lynch and Cross performance pyramid and Kaplan and Norton's balanced scorecard in focusing on customer satisfaction and confidence. The

growth phase will be characterised by reduced uncertainty about the product, repeat buyers and brand loyalty and a perception of price and/or quality advantages by consumers. The maturity phase requires focus on retention of existing customers and attracting new ones. Also, a recognition of the need for competitive pricing over advertising. The

decline phase and the rate of such decline may depend on the degree of changes in fashion or technological change. The rate of decline may also be linked to the comparative price/quality advantages of emerging products.

Producers may attempt to rejuvenate products through product and user innovation, corresponding to positions A and B in Smith's life cycle illustration (Figure 5). Position A may focus on major product improvements and a repositioning of the product from a customer viewpoint. Position B may seek additional distribution outlets, perhaps through exports or through identifying new markets for the existing product.

Boston Consulting Group (BCG) Portfolio Matrix

The BCG portfolio matrix provides a useful framework for the analysis of a whole into the sum of its component parts. One area of use of such analysis is in the relative positioning of products through their life cycles.

Figure 6 shows an illustration of the components of the matrix. The vertical axis shows market growth rate as a measure of market attributes. The horizontal axis shows relative market share as a measure of competitive strength.

Products and their phase in their life cycles may be linked to the Cash Cows, Stars, Dogs and Question marks (?) of the matrix. The products may be viewed as:

• Cash Cows are in a mature market and enjoy the economies of scale and high profits with low growth rate. Few investment resources are required;
• Stars are market leaders and enjoy higher growth, but still require injection of investment and promotional expenditure to maintain their position and reputation. They will eventually turn into cash cows;
• Dogs are products which are now uncompetitive in static markets. No further investment or promotional expenditure is justified. They are unlikely to do more than break even;
• Question marks (?) are competitive products which have yet to make a significant market impact. They have the potential to become stars, but a question mark hangs over their ability to achieve sufficient market penetration to justify further invest- ment. Price, cost and other factors such as quality and brand loyalty are all factors in the overall strategy. It is important that a balance is achieved in the management of the matrix. Basic strategies listed by Smith (1997) are:
• build by increasing market share, even at the expense of short term profits. For example turning question marks (?) into stars. This may require a penetration pricing policy and investment in establishing quality and brand loyalty;
• hold by preserving market share and ensuring that cash cows remain cash cows. This may require additional investment in customer retention through competitive pricing and marketing;
• harvest through the use of funds to promote products with the potential to become future stars or to support existing stars;
• divest through the elimination of underperforming dogs and question marks (?) whose use of resources is inefficient.

The implementation of strategies which will achieve retention/increase of market share and which will maintain/improve profit levels may take place in conjunction with the application of one of a number of costing and pricing techniques. Accounting systems may use one or more of the following in their attempts to provide relevant information:

• traditional cost plus profit markup approach to product costing and price setting;
• an activity based approach to cost management and pricing;
• the use of target costing and pricing;
• price/demand relationships and pricing;
• relevant costs and pricing decisions.

This approach uses a functional/process analysis. An example of the total cost built up may be illustrated as shown in Figure 7. The information required for the cost build up may differ considerably depending on the type of product. Consider the different analysis required in each of the following situations:

1. a batch of light fittings made to customer specification.
2. a chemical produced in a multistage process cycle.
3. the construction of a bridge.

The mix of direct and indirect costs and the bases for the absorption of overhead costs will vary considerably for each situation.

(Paper 9 — June 1998, Q5 solution provides background discussion to

these three situations).

In the case of the batch of light fittings and the bridge construction, the company will be in a position of having to determine a selling price at which it wishes to offer to complete the work. This may require submitting a price in competition with other companies seeking the work. The profit markup percentage added will be subject to taxation and must then provide for dividends to shareholders, reinvestment in the business to replace existing assets or to finance new ventures and to protect the business against erosion of its capital base in periods of inflation.

In the case of the chemical product, the profit element may be the difference between market price and total cost. The product may be sold in a competitive market where a market price prevails which may be affected by a number of variables including level of customer demand and degree of competition. In this situation, the profit element may not provide the return which a cost plus profit markup approach would suggest.

A number of arguments can readily be raised against the use of a traditional cost plus profit markup approach to pricing. These include:

• lack of accuracy of the various cost allocations and apportionments;
• problems in determining the profit markup percentage;
• lack of flexibility in pricing since it assumes a single activity level when determining the absorption rate for fixed costs;
• does not take into account price: demand relationship considera- tions;
• does not allow for special pricing situations which consider factors such as the existence of spare capacity, the relevance of product specific or customer specific costs and the use of oppor- tunity cost in `oneoff' situations.

Consider some alternatives which are available in deciding on an acceptable price starting with the model in

Figure 7:

1. A smaller profit may be deemed acceptable if considerable com- petition exists. For example the price could be set at £8,500 which gives a profit of £1,220 (approximately 17% mark up on total cost).
2. If competition is very tough, the price could be set equal to total cost i.e., £7,280. This will at least be contributing to the fixed costs of the company which have to be paid whatever level of sales is achieved.
3. The company may have spare capacity which will be idle if no orders are obtained. In this situation only the variable costs are avoidable if the order is not obtained. The minimum price accept- able in such circumstances is therefore, the total variable (marginal) cost. It is unlikely that such a price would be accepted, but it could be used as a starting point in deciding on the acceptability of a price below total cost where spare capacity exists. Assume that addi- tional information relating to the situation in

Figure 7 shows that:

• prime cost is a variable cost;
• production overhead cost is 40% variable and 60% fixed;
• administration/selling cost is total fixed;
• distribution cost is a variable cost (e.g. outside carrier is used).

The total variable (marginal ) cost of the order is now:

If a selling price of £4,250 could be negotiated, should it be accepted? Where spare capacity exists this would give a net cash inflow of £461. In the absence of any more profitable orders it would be worthwhile having this order.

4. There may be some product (order) specific fixed costs which are avoidable if the

   order did not go ahead. For example there may be special supervision costs or sales and marketing costs which relate specifically to the order. In the

   Figure 7 example, assume that £800 of administration and selling cost is specifically incurred by the order. In this situation, the marginal cost of the order must include this amount in addition to the £3,789 calculated above. The price of £4,250 is no longer acceptable on financial grounds, since it will result in a net cash outflow of £339 (£4,250 - £3,789 - £800).

The traditional cost analysis model illustrates the functional analysis of indirect/overhead costs, with allocation and apportionment to departments/cost centres. The absorption of a share of overhead costs by product units tends to be implemented using a single volume related absorption basis such as direct labour hours or machine hours. An activity based approach will operate in conjunction with an activity based budgeting system which requires a move from a mainly functional focus to a focus on activities. A number of questions may be asked to help in the development of an activity model:

• what activities are being carried out and do they need to be carried out? Activities may be classified as primary or support activities. The cutting of steel sheet will be a primary activity. The mainte nance of cutting machinery will be a necessary support activity. Activities may also be classified as value-added or non-value added. The cutting of steel sheet is value-added, unnecessary aspects of a support activity such as maintenance are non-value-added, unnecessary movement of steel sheet is a non-value-added activity;
• how effectively are activities being carried out and to what quality and standard? This would require a study of the steel sheet cutting activity in terms of type of machinery used, the skills level of machine operators and the efficiency of the machinery;
• what is the principal cost driver which determines the level of resource required for an activity? In the cutting example this may be the number of cuts required. Could the number of cuts be reduced from (say) six cuts per sheet to four cuts per sheet?
• what is the relationship between an activity cost driver and its root cause? In the cutting example the number of cuts may be linked to the steel sheet purchasing policy. If the root cause of requiring six cuts per sheet is the size of

  sheet purchased, should this be overcome by reducing the size of sheet purchased?

Figure 8 shows the unit costs for each of three products where overhead costs are absorbed using

(a) a traditional rate per labour hour and

(b) an activity-based approach.

The products pass through a single production process in which three activities and cost drivers have been identified. The activities are material receipt and inspection, machine processing and material handling with cost drivers of number of batches of material, number of drilling operations and square metres of material handled respectively. Competitive prices per unit for the products X, Y and Z are £360, £400 and £700 respectively. The company normally requires a profit mark-up of 25% on cost for a product to be considered viable.

The information in

Figure 8 shows that where a traditional absorption approach is used, product X (27.7%) easily meets the profit mark-up requirement. Product Z (21.7%) is barely above the requirement. Product Y (10. 1 %) is clearly below the requirement. This information may lead management to pursue a strategy of:

• a planned expansion of sales of product X;
• consideration of the elimination of product Y;
• attempt to increase the price of product Z.

The ABC information in

Figure 8 indicates that product X is being sold at a net loss (2. 1%), product Y is earning a healthy profit (35.2%) and product Z is earning a much higher profit than thought (43.9%). The original strategy based on the traditional cost figures would, therefore, be inappropriate.

The benefits of the activity-based cost system may not be as straightforward as the above example would imply. Problems which may be difficult to overcome include:

• the selection of the relevant activities and cost drivers;
• the collection of data to enable accurate cost driver rates to be calculated;
• the problem of cost driver denominator level � similar to that in a traditional volume related system;
• achieving the required level of management commitment to the change.

An additional problem is the application of cost driver rates to products. This may require a hierarchical approach (Drury 1996). Activity sub-sets may be chosen which determine that costs may be identified as being incurred at different levels. These may be

unit based such as direct labour or power costs;

batch based such as work-in-progress movement or machine set up costs;

product sustaining such as material scheduling or design and testing costs;

product line sustaining such as line development or line maintenance. Other costs may be

factory sustaining and not readily charged to products other than on an arbitrary basis.

(Paper 9 � December 1998, Q3 solution provides a quantitative illustration of this approach). Target costing and pricing

Target costing has been used for some years in many of Japan�s assembly oriented industries.

Figure 9 provides an illustration of the

target setting process. Sakurai (1989), indicated the move towards products being increasingly tailored to meet customer requirements with a shortened life cycle expectation. The stages in the implementation of the target costing process may be summarised as follows:

• a product specification is determined for which an anticipated sales volume is estimated;
• a target selling price is set at which the company will be able to achieve a desired market share;
• the required profit is estimated based on return on sales (%) or return on investment;
• the target cost is calculated as target selling price minus target profit
• an estimated cost for the product is compiled based on the anticipated design specification and current cost levels
• estimated cost minus target cost represents any �cost gap� which exists;
• efforts are made to close the cost gap. This is more likely to be successful if efforts are made to �design out� costs prior to production, rather than to �control out� costs during the produc tion phase. This process will involve the application of a number of techniques. Value engineering may be carried out in order to evaluate the necessary features of the product such as the quantity and quality of materials and components and the conversion processes required to achieve the desired quality of finished product. This will involve discussions by members of various disciplines, including design, production and purchasing. An activity-based approach will be useful in determining value-added activities and non-value-added activities. It will also allow focus on cost drivers and their root causes
• final negotiations may take place with the customer before a decision is made whether the project will go ahead. Sakurai (1989), in his article indicated that an increase in selling price may be negotiated with the customer where the company can demonstrate that it has made all reasonable efforts to close the cost gap.

  (Paper 9 � June 1996, QI provides a scenario which illus trates and requires comment on, aspects of the target costing process).

Demand for products may be viewed as a function of a number of variables. Such variables may be internally or externally influenced. The level of promotion of a product, its brand image, its quality status and customer care, may all be addressed by the firm. The degree of competition, changing tastes of customers, technological progress and level of purchasing power are all external influences.

Prices may be viewed as being set by overall market supply and demand forces. The Economist�s model assumes that the firm will attempt to set the selling price at a level where profits are maximised. An algebraic representation of the model may be constructed as follows:

• for monopolistic/imperfect competition, the model assumes that the lower the price, the larger will be the volume of sales. This relationship is known as the demand curve which may be ex pressed as P _x = P_o � a X, where P_x = price at X units, P_o = price at zero units, a = rate of change of demand with price and X = number of units;
• the total revenue (TR) line may be constructed by multiplying the demand curve by the quantity (X) units. We have TR _x = Po_X � aX²;
• the total cost line may be viewed as constructed from the basic accounting model of a fixed element and a variable element which varies in proportion to volume. This may be expressed as TC _x = b + cX, where b = fixed cost, c = variable cost per unit and X = number of units;
• The Economist�s model submits that the volume of production and sale should be increased to the point where the additional (or marginal) revenue (MR) is equal to the additional (or marginal) cost (MC). The selling price at which this sales volume occurs can then be determined. This process may be implemented by visual inspection of a tabulation of the data, the use of a graphical approach or the application of simple differential calculus.

A simple example may be used to illustrate the above procedures.

Saffro Systems plc has estimated that the demand/price relationship for one of its products is linear and the following data are available for the coming period:

The price at which the product will be marketed will be somewhere between the above parameters and will be a multiple of £5.

A preliminary estimate is that variable cost per unit will be £40 with fixed costs of £5,000 for the period. All fixed costs are an apportionment of company unavoidable fixed cost.

Saffro Systems plc wishes to determine the profit maximising selling price and sales volume.

Solution: The demand curve is P_x = P_o � aX

The price: demand relationship (a) = (£90 � £60)/(1,000 � 400) = 0.05 Note that this represents a downward sloping demand curve as volume increases. Starting with any point on the curve, the price at zero demand (P_o) may be calculated.

A price of £90 (P_x) applies where demand is 400 units (X)

Hence 90 = P_o � 0.05 x 400. Solving gives P_o = 110

Alternatively this may be obtained from a graph by plotting the price: demand curve (P_x) as in

Figure 10.

Total revenue may now be calculated by applying the equation formulated above where P_o = £110 and a = 0.05.

TR_x = P_o X � aX²

Giving TR_x = 110X - 0. 05X²

For example where demand (X) is 500 units:

Total revenue (TR) = 110 x 500 � 0.05 x 500² = £42,500

Total cost (TC_x) = b + cX where b = £5000 and c = £40

For example where demand is 500 units:

Total cost (TC) = 5,000 + 40 x 500 = £25,000

A table may be constructed as follows:

The table shows that total profit is maximised at £19,500 where the price is set at £75 giving a demand of 700 units.

Figure 10 shows a graphical representation of the situation. The total revenue (TR_x) and total cost (TC_x) curves are shown with the optimum position where the difference between the two is maximised. Note that the total revenue curve (TR_x) shows a decreasing slope as demand increases, which is reflected in the downward sloping marginal revenue curve (MR_x). The total cost curve (TC_x) is a straight line in the Saffro Systems plc example, indicating the assumption of a basic fixed cost and a constant variable cost element per unit. This means that the marginal cost line (MC_x) is a horizontal straight line in this case. Most textbook illustrations of the model would assume an increasing slope of total cost and an upward sloping marginal cost line. Examples of the increasing nature of costs might be the need for premium rates of pay for overtime working or increased material costs in order to obtain additional quantities at higher output levels.

The graphs show that the marginal revenue and marginal cost curves intersect where demand is 700 units, where price is £75 per unit and where profit (difference between TR_x and TC_x curves) is £19,500.

The application of differential calculus provides a concise representation and solution of the problem.

TR = 110X � 0.05X²

MR = dTR/dX = 110 � 0.1X

TC = 5,000 + 40X

MC = dTC/dX = 40

MR = MC for optimum solution

110 � 0.1X = 40

X = 700 units

Substituting in the price: demand equation to get the selling price at this demand level:

P = 110 � 0.05X = 110 � 0.05 x 700 = £75

The Economist�s model may be criticised as being difficult to apply in practice.

The following points may be raised:

• it is likely to be very difficult to quantify price: demand relationships. At best an approximation can be ventured;
• the total cost and marginal cost functions prepared by the acc- counting system are likely to be only an approximation of the true cost function;
• many factors other than price affect quantity demanded. These include the amount and quality of sales effort, product design and quality and customer care;
• the model assumes the pursuit and application of a profit maximising strategy. However a variety of competitive forces are likely to influence the strategy implemented during the life cycle of any product.

(Paper 9 � December 1997, Q1 required the use of price/demand relationships in estimating the price at which to launch a product in order to gain market share which it is then hoped to hold in the face of future increased competition.)

Relevant costs and pricing decisions

Pricing decisions may require consideration of the specific circumstances in which the decision is being made and the relevant costs for that decision. Examples of such circumstances are:

• the use of spare capacity. This was discussed earlier where it was illustrated that a marginal cost approach might be applied where any contribution to company fixed costs earned by com- paring the best price available with marginal cost is worth having in the short term where no better alternative use of the resources is available. Another illustration of this might be the acceptance of a one-off contract after taking into account the opportunity cost of inputs. For example a contract may be able to make use of materials which have an inventory value of £100,000 but which are old stock which if not used on the proposed contract could only be sold at a scrap value of £10,000. The contract price appears to be £50,000 less than total cost on a conventional total cost basis. However, given that the opportunity cost of the materials is only £10,000 and not the £100,000 included in the current figures, the contract price may be viewed as £40,000 in excess of total relevant costs on an incremental opportunity cost basis;
• the identification of customer specific costs may be relevant in deciding on a profit maximising sales strategy. Consider a situation where product A is sold to two customers X and Y byAlpha plc. The existing system charges costs to the product without considering customer specific aspects of cost. Product profitper unit is estimated as £23.25 per unit based on production/ sales of 9,000 units sold in equal numbers to customers X and Y, giving a total profit of £209,250. Customers X and Y currently require 8,000 units and 5,000 units respectively. Only 9,000 units worth of production capacity is available. An investigation of costs by Alpha plc reveals that some costs are customer specific and a revised profit analysis per unit is as follows:

Alpha plc would now sell 8,000 units to customer X and 1,000 units to customer Y in order to maximise profit. Total profit would now be 8,000 x £31 + 1,000 x £15.50 = £263,500. It may be however, that Alpha plc will decide to adopt a different strategy. Customer Y may be a valued client who also buys other products and with whom business is expected to grow. It may be known that customer B has trading problems and future sales may fall off rapidly. Alpha plc may decide to accept a lower overall profit in the short term and/or may attempt to obtain a price increase from customer Y on the basis of the high distribution cost incurred on sales to it.

(Paper 9 � December 1997, Q3 � illustrates the use of customer specific costs) Conclusion

The above discussion has indicated that price may be affected by a number of factors. Price may be used when seeking to retain or increase market share (e.g., to deter new entrants to the market). It may be used in different ways at different stages in a product life cycle (e.g. the milking of cash cows). It may be affected by the basis on which costs are attached to products ( e.g., the impact of an ABC analysis to the perceived unit cost/price relationships). It may be determined at the outset in a short life product (with a focus on how to reduce costs to a target level necessary to give the required level of return). The Economist�s price/demand model may be conceptually appealing (but ignore a number of other factors which influence demand). Relevant cost may be important in pricing decisions (such as customer specific costs). References

1. Drury, Management and Cost Accounting, International Thomson Business Press, (1996).
2. Fitzgerald, et al, Performance Measurement in Service Busi- nesses, CIMA, (1993).
3. Fitzgerald and Moon, Performance Measurement in Service In dustries: Making it Work, CIMA, (1996).
4. Kaplan and Norton, Harvard Business Review,"The Balanced Scorecard � Measures that Drive Performance," January/Febru- ary, (1992).
5. Lynch and Cross, Measure Up! � Yardsticks for Continuous Improvement, Blackwell, (USA), (1991).
6. Sakurai, Journal of Cost Management for the Manufacturing Industries,"Target Costing and how to use it," iii No 2, (1989)
7. Smith, Strategic Management Accounting � text and cases, Butterworth/Heinemann, (1997).
8. Porter, Competitive Strategy: techniques for analysing industries and competitors, Free Press, (1980).