COMM 103 Chapter Notes - Chapter 12: Price Skimming, Psychological Pricing, Fixed Cost
Business Management Notes – Ch.12
Chapter 12: Cost-Base Analysis and Pricing
In order to understand an organization’s cost base, managers should focus on:
1. Make-up of cost base
2. % of cost base controllable in near term.
3. Market pressures that will impact cost base in future.
4. Volume and dollar requirements for breakeven.
5. “Good” costs vs. “bad” costs.
6. Evaluating cost base in comparison to competitors’.
Keys to composition of cost base:
•% of costs that are considered to be variable vs. fixed
•Cost areas that make up a significant % of overall base
Variable costs (direct costs) are those costs that are directly tied to the manufacturing of a
product or the delivery of a service depending on the type of business being assessed.
Fixed costs (indirect costs) are those costs that, although not directly tied to manufacturing, still
exist as a result of conducting business/operating the company. (E.g. insurance, interest
expense, utilities, etc.)
Committed costs are a type of indirect cost that the organization commits itself to within an
operating year (often spend in advance). (E.g. marketing cost, technology upgrade)
Fixed Costs + Committed Current Period Costs = Indirect Cost Base
Understanding an organization’s cost base helps determine pricing strategy that will be used to
market the product and its impact on profit.
More fixed/indirect costs = harder for management to cut costs
Retail businesses have more fixed costs, manufacturing have more variable (less demand, will
just produce less; reduce variable costs)
When cutting costs, managers need to think in terms of eliminating redundancies, low-value
activities, and management layers that does not erode productivity standards, accountability, or
eliminate vital processes within value cell zones (core value proposition).
Breakeven point (BEP) is the level of sales revenue or volume that is required for the
organization to cover all of its costs. (Total sales = total costs)
The BEP is considered to be the minimum acceptable position for a business in the short term.
BEP (units) = Total Fixed Costs/ Contribution Margin (in $)
BEP (units) = Total Fixed Costs/ (Selling Price/Unit – Variable Cost/ Unit)
BEP (units) x selling price = revenue/cost at BEP
BEP ($$$) = Total Fixed Costs/ Contribution Margin (in %)
BEP ($$$) = Total Fixed Costs/ (1 – Variable Cost %)
BEP is used to identify the level that sales revenue has to reach in order to cover the total
operating costs of an organization.
BEP + P (units) = (Total Fixed Costs + Profit Objective) / Contribution Margin (in $)
Mark-up refers to the addition to the manufacturer’s price that distributors add to the price of a
product to ensure that their own direct and indirect costs are covered and that their profit margin
Price discounting is a reduction in the price of the product with the intent to stimulate the sale
of the product over a defined period of time.
Price skimming refers to the utilization of a premium price strategy in order to maximize the
margin return on the sale of each individual unit.
Psychological pricing is the utilization of pricing tactics that are designed to respond to the
psychological tendencies of purchasers.
Rebates refers to a temporary price reduction offered on a product/service in order to stimulate
sales (POS or mail-in).
Price Impact Factors:
•Total cost base
•Value (actual or perceived)
•Effectiveness of marketing effort
•Price sensitivity within the product/service sector (elasticity)
Expense creep refers to the tendency for expenses associated with the organization’s various
cost lines to rise due to inflationary pressures, union negotiated contracts, and so on.
Total Cost-Base Analysis: Variable Costs + Fixed Costs + Required Contingencies (Debt
repayment, depreciation, equipment replacement, inflation) + Future Needs (R&D, market
studies, and cost-reduction initiatives)
Customer’s decision will be influenced by:
•Their ability/ willingness to pay
•Preferences in terms of functionality/ “psychographic” benefits
•Importance of quality and performance
•The number of direct alternatives available
More effective marketing = perceived product/service uniqueness = higher margins
•Determine profit objectives
•Assess current market pricing
•Analyze costs and volume potential. Develop demand and revenue possibilities
•Evaluate pricing options, price positioning, value proposition strengths and marketing
•Initiate recommended price
•Evaluate and adjust
Understanding the cost base is a critical step in determining which markets to pursue, ability
emphasize volume, and level of quality of products/services that should be produced.