2.

Describe and explain cost-plus pricing in a service firm context, specifying cost
categories and their influence on Pricing.

Cost Plus pricing is a calculation method of a price of a Product or Service based on the costs
incurred during the production process of the Product or Service and adding the profit margin to
the total cost of the Items. These costs include Direct and Indirect costs of the Product or
Service. Direct costs include direct material and direct labor (salary & wages) cost of a
product/service and other variable costs which are directly attributable to the cost of the items.
Indirect costs include fixed costs which cannot be attributable as a cost of an Item. Indirect costs
include Administration Costs (GM salary/Accountant salary), Sales and marketing costs (Sales
Manager commission, Marketing campaign costs) and Finance costs (Bank charges, Bank loan
interest).

The Cost-plus pricing strategy is made on the basis that customers are willing to accept the price
set by the company. Even though the pricing strategy set by the company can be a sought after
one which customers cannot refuse easily, in a competitive and a more volatile market, even the
most sought after pricing strategy could go wrong as the competitors are always behind each
other and even slightest change in price can shift the wave towards the competitor. If a company
loses its demand due to pressure from its competitors, they must regain their lost ground. The
best way to do this is reducing the costs. However, if they did not approach the cost reducing
plan in a strategic way, they could lose more resources like experienced staff which cannot be
rehire when company starts to gain its momentum again.
For a Service industry-based company, a Cost-plus pricing strategy could prove unsuitable as the
large portion of their direct costs are labor costs and reducing labor costs short term could prove
costly in the long run. Further if the company operates in a competitive and volatile market,
Cost-plus pricing strategy could not be effective and in a competitive market, customers are less
likely to accept the price set by the company. Further, in a service industry-based company, fixed
costs like marketing costs comprise a significant portion and cannot be ignored. Therefore, if a
service industry-based company adopting a Cost-plus pricing strategy, it could prove ineffective
given the competitiveness and the volatility of the market. Therefore, a more comprehensive
method of costing should be a adopted such as Target Costing by a Service industry-based
company.
4. Assess the specific challenges of introducing TC in a service firm as opposed to a
manufacturing firm. How should TC be adapted in a service firm?

The main differences in products in between service and manufacturing firms could be that i)
The products are Intangible and perishable ii) Major portion of costs reflects direct labor iii)
Fixed costs represents a major portion of the total costs

The services offered and its key features needs to be clearly mentioned to decide most valuable
features to a customer prior to set the selling price. To do this, customer feedback can be
important. However, given the nature of the products, engaging with customers to do this could
be difficult for a service product.
In Target costing, Affordable service cost is determined by deducting the profit margin from the
target selling price. However, the large portion of service costs represents the labor costs in a
service firm and therefore reducing the labor costs could prove challenging.
The marketing costs of a service firm represent a large proportionate from the total cost. These
costs are prearranged and there could be a little room for improvement in the costs given their
nature.
5. How would you improve the profitability of Sunline? Evaluate the specific steps you
would consider. Focus on costs currently incurred and how they could be reprioritized and
cut to meet the target cost, in line with the current competitive positioning. Use the
information in the Tables 2-4 to illustrate and justify your answer.

As per the Table 4 the required cost cutting of 28% required using a TC approach. This is a
significant 1/3rd from the current costs. In the Table 2, payroll costs accounted for $ 3.87Mn per
quarter, which is equivalent to 45% of total costs and this will be a more significant area which
can reduce the costs. given the service firms costs represents a significant portion of the direct
costs compared to production firms, this could be an area where Sunline can focus on.
As given in the case, the main 2 areas of Sunline’s business model are:
i) Underwriting new policies
ii) Managing claims.
Underwriting staff has given a target of 20 new policy sales per week, which is around 3 per day.
This seems underwriting staff are not performing for their full potential. Therefore, it is advisable
to focus to reduce cost in this aspect. Evaluating the performance of the underwriting staff and
reduce the number of staff and keeping only the well performing staff under the payroll. This
could not only reduce the salary expenses, but also reduce the commission amount as well.
Managing claims could be a specialty are where large amount of labor costs could involve in.
The major time-consuming activities relating to claims could be i) Receiving claim documents ii)
in house investigation iii) outside investigation iv) payment of claims iv) customer support
service. These activities could be labor consuming and need to look at alternative ways of getting
these works done like outsourcing claims department to BPO firm.
Sales and marketing costs comprises 16.7% of the total costs which is equivalent $ 1.4Mn per
quarter. Since Sunline Auto adopted new distribution channels and in the process of using social
media and other alternative platforms to promote the brand. Therefore, the effectiveness of these
channels could investigate as these involves huge amounts of costs.
Retail store leases represents a large cost equivalent to $1.5Mn per quarter. This is 18.1% of the
total costs. As the company moving towards online based sales, it is worth investigating the
effectiveness of spending this much of cost towards retail store leases moving forward.
Claim costs represents $ 0.9Mn per quarter which is 10.7% from the total costs. This could be
due to lack of accounting provisions made for the claim costs. As claim costs are uneven, based
on the incidents, it is wise to make a current provision based on the current affairs as to estimate
any higher number of claims in the future. Therefore, it is advisable to review the provisioning
policy of the sunline to reduce the higher cost of claims in a worst-case scenario.
The above suggestions will help improving target cost of the Sunline Auto and contribute
towards reducing the total costs given that the suggestions being implemented.

6. Evaluate and explain the key challenges (cultural, management systems, information
needs, etc.) involved in implementing a TC approach at Sunline.
Implementation of TC approach requires coordination and corporation of the whole firm. Not
only the whole firm, it requires corporation from the staff in partner firms as well. The TC
approach cannot implement in a sudden and it takes time to be succeeded in any environment.
The starting point of TC approach should be to devise a strategy plant to achieve TC approach.
The firm needs a clear plan to understand about their customers to gain the competitive
advantage.

A thorough understanding of the features of services expected by its customers will help the firm
determine the selling price of the service. This process requires an extensive analysis of customer
preferences and willingness to pay the price. Every key feature of the product or service must be
assessed with a sample group of customers and should be compared to similar features in
competitors, and a price range should be chosen from which a final target selling price can be
derived. An ongoing improvement process will follow to reach an acceptable selling price.

The firm should clearly set the target return it requires over a long term based on its capital
requirements and be able to track this margin down to a product and service level. While this
sounds like a simple task, in many firms this process will be a challenge. Many firms do not have
a clear expectation of financial returns and tend to operate opportunistically, taking whatever
level of return they can extract from their operations. Once the required return decided, the firm
can reach at an allowable cost by taking this margin away from the targeted selling price.

Delivering on the target cost will require the firm to establish effective and efficient management
and operational processes and transform its culture to support TC. Firms such as Toyota spend
years investing in process improvement initiatives, using techniques such as Lean and Six Sigma
to scientifically assess the efficiency and effectiveness of all activities to enhance the existing
processes and to operate at a cost that support the firm’s target costs for production. The firm’s
culture needs to encourage and embrace activities where each employee is committed to thinking
about and acting on cost improvements. Timely and accurate accounting information on costs
needs to be available to signal to all staff areas where costs need to be reduced.

Adopting a TC approach requires a firm to align its strategy with its business model, to initiate
improved management and operational processes that transform its culture, and to collect
information to allow employees to concentrate on managing costs that is strategic and long-term.
The firm needs to clearly define its business model, its value propositions, customer relationships
and segments, and tailor products and services to each segment. Customer intimacy—knowing
well each type of customer’s needs, expectations, and budget—becomes important to assess what
features of the product or service they require and how much they are willing to pay. Equally
important are the value chain partnerships and an intimate understanding of the business model
of key partners to ensure they are willing and able to strategically manage the component costs
that sunk into the service costs of the local firm.