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Chapter 12

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Queen's University
COMM 103
Gregory Libitz

Chapter 12: Cost-Base Analysis and Pricing Understanding the Organization’s Cost Base  Managers must understand the configuration of the cost base of the org for which they are developing strategies, making decisions, and determining how the firm will compete  Key element of process is to identify the costs which will be faced, the percentage impact which key costs areas have on total cost base & degree of control managers have on costs  With a good understanding of the cost base, managers will better assess their financial options in the event of unexpected changes in market dynamics, unanticipated reductions in revenue, and strategic positioning shifts which the organization is planning  To develop a good understanding of an org’s cost base, managers need to focus on… o The make-up of their cost base o The percentage of the cost base which lies within their control in the near term o The market pressures which will impact the cost base going forward o Understanding the volume and dollar requirements necessary for breakeven o Evaluating their cost structure with respect to “good” vs. “bad” costs o Evaluating their costs in comparison to the cost base of competitors The Composition of an Organization’s Cost Base  An org’s cost base is made up of the total costs associated with delivering the org’s products and/or services to the marketplace  Think in terms of all the costs (across the value chain components) which an org incurs as it manufactures, distributes, markets, and sells to other businesses or consumers o Managers must understand the cost structure within each area – fully understand costs incurred producing & supporting p/s which is imp. to determine sale price  Also have to determine whether these costs are directly involved with the manufacturing process (direct/variable) or whether the costs are operational support costs (indirect/fixed) o Direct/Variable Costs + Indirect/Fixed Costs = An Org’s Total Cost Base  In analysing composition of org’s cost base, there are 2 things managers hope to identify o What percentage of our costs are considered to be fixed versus variable? o What cost areas (if any) make up a significant percentage of the overall cost base? Variable versus Fixed Costs  Variable costs are those which are directly tied to the manufacturing of a p/delivery of s o Ex. Material costs, labour costs, distribution costs o In the event that you stopped making the prod, these costs would disappear  Fixed Costs are those which exist as a result of conducting business and operating the org o Ex. Insurance, utilities, interest expense on debt, administration costs o These expenses, for the most part, are uncontrollable for the near term o Committed Costs: Costs which org commits itself to within an operating year, and which are often spent in advance or at the front end of a manufacturing/sales cycle  Ex. Marketing costs to promote new p/s, software upgrades, R&D costs  Understanding an org’s cost base is essential to determining the required pricing strategy which will be utilized in the marketing of the product and its corresponding impact on profit Degree of Managerial Control – Refer to pgs 406-409 for examples  Managers must also understand how the composition of this cost base will influence their ability to manage the company o In general, the more the cost base is composed of variable costs, the more control managers have over the actual mgnt of this cost base on a day-to-day basis o The more composed of fixed costs, the more difficult it is to use cost reduction strategies to protect the org’s profitability in response to a decrease in demand  It is also important to note that market dynamics will influence the composition and overall competitiveness of an org’s cost base o The ability to manage the cost base better than competitors can lead to a competitive advantage, resulting in a greater market share and profitability  Dependency on suppliers can also restrict an org’s ability to control total costs The Concept of Breakeven Point Analysis (BEP)  A critical outcome of analysing an org’s cost base is taking this info and utilizing it to determine the level of revenue required in order for the org to break even o The Breakeven Point is the level of sales revenue or volume which is required in order for the org to cover all of its costs – Total Revenue = Total Costs  For managers, this is considered to be the minimum acceptable position in the short term  Operating below the BEP means that the org is operating at a loss and would need to draw from internal cash to cover its expenses – if they have little cash = out of business  Volumes sold beyond the BEP would result in profit for the company Calculating the BEP in Units  Computing the BEP is easy once the org’s costs are categorized as variable or fixed  If costs are viewed at on a per unit basis, calculating the BEP in units would be the best  If costs are best understood as a percentage of sales revenue, then calculating the BEP in dollars makes the most sense  ( ) ( )  You can then easily multiply this by the selling price to determine the sales volume necessary to break even  Selling prices and costs do not remain static, but change over time o Managers must continually reassess their breakeven position in order to determine how changes to their cost structure or selling price will affect their BEP Calculating BEP Based on Total Sales Revenue  In some situations, companies provide such a wide variety of p/s that it makes it unrealistic to compute BEP on a per unit basis  In this situation, these org’s may be in a better position to compute BEP, initially, on the bases of total sales revenue ($$$)  ( )  VC% are the total variable costs as a percentage of revenue  With additional info, you can determine the number of customers you need to serve (annually, weekly, daily, hourly) in order to reach this breakeven point Using BEP to Understand Profit Objectives  As indicated earlier
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