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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Target Costing and Cost Analysis for Pricing Decisions Chapter 15

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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 1

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15-3 Major Influences on Pricing Decisions Pricing Decisions Political, legal, and image issues CompetitorsCosts Customer demand

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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 2

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15-5 How Are Prices Set? Costs Market Forces Prices are determined by the market, subject to costs that must be covered in the long run. Prices are based on costs, subject to reactions of customers and competitors.

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15-6 Economic Profit-Maximizing Pricing Firms usually have flexibility in setting prices. The quantity sold usually declines as the price is increased.

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15-7 Total Revenue Curve Total revenue Curve is increasing throughout its range, but at a declining rate. Dollars Quantity sold per month

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15-8 Demand Schedule and Marginal Revenue Curve Demand Sales price must decrease to sell higher quantity. Dollars per unit Quantity sold per month Marginal revenue Revenue per unit decreases as quantity increases.

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15-9 Total Cost Curve Dollars Quantity made per month Total cost increases at a declining rate. Total cost increases at an increasing rate.

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15-10 Quantity made per month Marginal Cost Curve Marginal cost Dollars per unit Quantity where marginal cost begins to increase.

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15-11 Quantity made and sold per month Determining the Profit-Maximizing Price and Quantity Dollars per unit Demand Marginal revenue Marginal cost q* p*

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15-12 Quantity made and sold per month Determining the Profit-Maximizing Price and Quantity Dollars per unit Demand Marginal revenue q* p* Marginal cost Profit is maximized where marginal cost equals marginal revenue, resulting in price p* and quantity q*.

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15-13 Determining the Profit-Maximizing Price and Quantity Total revenue Dollars Total cost Total profit at the profit-maximizing quantity and price, q* and p*. Quantity made and sold per month q*

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15-14 Price Elasticity The impact of price changes on sales volume Demand is elastic if a price increase has a large negative impact on sales volume. Demand is inelastic if a price increase has little or no impact on sales volume.

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15-15 Cross Elasticity The extent to which a change in a products price affects the demand for other substitute products.

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15-16 Limitations of the Profit-Maximizing Model Ê A firms demand and marginal revenue curves are difficult to discern with precision. Ë The marginal revenue, marginal cost paradigm is not valid for all forms of markets. Ì Marginal cost is difficult to measure.

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15-17 Role of Accounting Product Costs in Pricing Sophisticated decision model and information requirements Simplified decision model and information requirements Optimal DecisionsSuboptimal Decisions Economic pricing modelCost-based pricing Marginal-cost and marginal-revenue data Accounting product- cost data More costlyLess costly The best approach, in terms of costs and benefits, typically lies between the extremes. Exh. 15-4

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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 3

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15-19 Cost-Plus Pricing Price = cost + (markup percentage × cost) Variable manufacturing cost? Full-absorption manufacturing cost? Total cost, including selling and administrative? Total variable cost, including selling and administrative?

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15-20 Cost-Plus Pricing - Example Variable mfg. cost$ 400 Fixed mfg. cost 250 Full-absorption mfg. cost$ 650 Variable S & A cost 50 Fixed S & A cost 100 Total cost$ 800 We will use this unit cost information to illustrate the relationship between cost and markup necessary to achieve the desired unit sales price of $925.

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15-21 Cost-Plus Pricing - Example Variable mfg. cost$ 400 Fixed mfg. cost 250 Full-absorption mfg. cost$ 650 Variable S & A cost 50 Fixed S & A cost 100 Total cost$ 800 Price = cost + (markup percentage × cost) Price = $400 + (131.25% × $400) = $925 Markup on variable manufacturing cost

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15-22 Cost-Plus Pricing - Example Variable mfg. cost$ 400 Fixed mfg. cost 250 Full-absorption mfg. cost$ 650 Variable S & A cost 50 Fixed S & A cost 100 Total cost$ 800 Price = cost + (markup percentage × cost) Price = $450 + (105.56% × $450) = $925 Markup on total var. cost As cost base increases, the required markup percentage declines.

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15-23 Cost-Plus Pricing - Example Variable mfg. cost$ 400 Fixed mfg. cost 250 Full-absorption mfg. cost$ 650 Variable S & A cost 50 Fixed S & A cost 100 Total cost$ 800 Price = cost + (markup percentage × cost) Price = $650 + (42.31% × $650) = $925 Markup on full mfg. cost As cost base increases, the required markup percentage declines.

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15-24 Cost-Plus Pricing - Example Variable mfg. cost$ 400 Fixed mfg. cost 250 Full-absorption mfg. cost$ 650 Variable S & A cost 50 Fixed S & A cost 100 Total cost$ 800 Price = cost + (markup percentage × cost) Price = $800 + (15.63% × $800) = $925 Markup on total cost As cost base increases, the required markup percentage declines.

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15-25 Absorption-Cost Pricing Formulas Advantages ÊPrice covers all costs. ËPerceived as equitable. ÌComparison with competitors. ÍAbsorption cost used for external reporting. Disadvantages Full-absorption unit price obscures the distinction between variable and fixed costs.

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15-26 Variable-Cost Pricing Formulas Advantages ÊDo not obscure cost behavior patterns. ËDo not require fixed cost allocations. ÌMore useful for managers. Disadvantage Fixed costs may be overlooked in pricing decisions, resulting in prices that are too low to cover total costs.

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15-27 Determining the Markup: Return-on-Investment Pricing Solve for the markup percentage that will yield the desired return on investment.

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15-28 Price = cost + (markup percentage × cost) Price = $400 + (131.25% × $400) = $925 Recall the example using a percent markup on variable manufacturing cost. Determining the Markup: Return-on-Investment Pricing Lets solve for the percent markup. Invested capital is $300,000, the desired ROI is 20 percent, and annual sales volume is 480 units.

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15-29 Determining the Markup: Return-on-Investment Pricing ROI = Income Invested Capital 20% = Income $300,000 Income = 20% × $300,000 Income = $60,000 Step 1: Solve for the income that will result in an ROI of 20 percent.

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15-30 Determining the Markup: Return-on-Investment Pricing Step 2: Recall the unit cost information below. Solve for the unit sales price necessary to result in an income of $60,000. Variable mfg. cost$ 400 Fixed mfg. cost 250 Full-absorption mfg. cost$ 650 Variable S & A cost 50 Fixed S & A cost 100 Total cost$ 800

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15-31 Determining the Markup: Return-on-Investment Pricing 480 units × (Unit sales price - $800 unit cost) = $60,000 Unit sales price - $800 unit cost = $60, units Unit sales price - $800 unit cost = $125 per unit 480 units × (Unit profit margin) = $60,000 Unit sales price = $925 Step 2: Solve for the unit sales price necessary to result in an income of $60,000.

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15-32 Determining the Markup: Return-on-Investment Pricing Markup percentage Unit sales price - Unit variable cost Unit variable cost Step 3: Compute the markup percentage on the $400 variable manufacturing cost. = Markup percentage $925 per unit - $400 per unit $400 per unit = Markup percentage = percent

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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 4

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15-34 Strategic Pricing of New Products Uncertainties make pricing difficult. –Production costs. –Market acceptance. Pricing Strategies: –Skimming – initial price is high with intent to gradually lower the price to appeal to a broader market. –Market Penetration – initial price is low with intent to quickly gain market share.

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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 5

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15-36 Target Costing Market research determines the price at which a new product will sell. Management computes a manufacturing cost that will provide an acceptable profit margin. Engineers and cost analysts design a product that can be made for the allowable cost.

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15-37 Target Costing Key principles of target costing Price led costing Focus on the customer Focus on product design Focus on process design Cross-functional teams Life-cycle costs Value-chain orientation

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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 6

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15-39 The Role Of Activity-Based Costing In Setting A Target Cost. Production Process Component Activities

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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 7

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15-41 Product Cost Distortion High-volume products May be overcosted Low-volume products May be undercosted

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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 8

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15-43 Value Engineering and Target Costing Target cost information Product design Product costs Production processes Target cost information Product design Product costs Production processes Value Engineering (VE) Cost reduction Design improvement Process improvement Value Engineering (VE) Cost reduction Design improvement Process improvement

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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 9

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15-45 Time and Material Pricing Price is the sum of labor and material charges. Used by construction companies, printers, and professional service firms.

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15-46 Time and Material Pricing Time charges: Total labor hours required Hourly labor cost + Overhead cost per labor hour + Hourly charge to provide profit margin × Material Charges: Total material cost incurred + Overhead per dollar of material cost × Total material cost incurred

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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 10

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15-48 Competitive Bidding High bid price Low probability of winning bid High profit if winning bid Low bid price High probability of winning bid Low profit if winning bid

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15-49 Competitive Bidding Guidelines for Bidding Bidder has excess capacity l Low bid price l Any bid price in excess of incremental costs of job will contribute to fixed costs and profit. Bidder has no excess capacity l High bid price l Bid price should be full cost plus normal profit margin as winning bid will displace existing work.

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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 11

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15-51 Legal Restrictions On Setting Prices Price discrimination Predatory pricing

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15-52 End of Chapter 15 What is the right price?

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