2. CHAPTER 8
Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing

3. Pricing Decisions
Pricing decisions often the most difficult decisions that managers face
Pricing Methods:
- profit maximizing price using economic theory
- Pricing of special orders
- Cost Plus pricing
- Target costing
- Activity based pricing

4. The Profit Maximizing Price
Economic theory
The quantity demanded is a function of the price that is charged
Generally, the higher the price, the lower the quantity demanded
To calculate profit maximizing price:
- Subtract variable costs from price to obtain the contribution margin
- Multiply by the quantity demanded
- Subtract fixed costs and estimate profits
- Select the price with the highest profit
Learning objective 1: Compute the profit maximizing price for a product or service

5. The Profit Maximizing Price
Learning objective 1: Compute the profit maximizing price for a product or service

6. Exercise 1 Estimates of price and quantity demanded
Price = $6.95, quantity demanded = 20,000
Price = $5.95, quantity demanded = 25,000
Price = $4.95, quantity demanded = 32,000
Variable cost = $1.50 per unit
Fixed cost = $80,000
Find the profit maximizing price
Learning objective 1: Compute the profit maximizing price for a product or service

7. Pricing Special Orders
Special orders are for goods and services not considered part of a company’s normal business
Price charged will not affect prices charged in normal course of business
Price may deviate from what is common
May charge a price less than full cost
Learning objective 2: Perform incremental analysis related to pricing a special order

8. Pricing Special Orders
Two alternatives: accept or reject
Consider incremental revenues and expenses
- Income before special order is the same for both alternatives, not incremental
- Calculate incremental revenue
- Calculate incremental expenses i.e., materials, labor and variable overhead
Learning objective 2: Perform incremental analysis related to pricing a special order

9. Special Orders – Premier Lens Example
Should Premier Lens accept special order of 20,000 lenses to be sold to Blix Camera for $73 per lens?
Below is the full cost of $75 per lens
Learning objective 2: Perform incremental analysis related to pricing a special order

10. Special Orders – Premier Lens Example
Perform incremental analysis
Fixed costs are not incremental, they will not change if the order is accepted
Learning objective 2: Perform incremental analysis related to pricing a special order

11. Commonwealth Edison
Learning objective 2: Perform incremental analysis related to pricing a special order

12. Review 1 Which of the following are relevant for a special order?
Total company income before the order
Fixed costs
Incremental revenues and expenses
Fixed manufacturing overhead
Answer: c
Learning objective 2: Perform incremental analysis related to pricing a special order

13. Cost-Plus Pricing Benefits
Company estimates product cost and adds a markup to arrive at price which allows for a reasonable profit
Benefits
- Simple approach
- Guarantees profit if sufficient quantity can be sold at the specified price
Learning objective 3: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms

14. Cost-Plus Pricing Limitations What markup percentage to use?
Requires considerable judgment and experimentation
Inherently circular for manufacturing firms:
- Need to estimate demand to determine
fixed manufacturing costs
- Price affects the quantity demanded
Learning objective 3: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms

15. Cost-Plus Pricing
Learning objective 3: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms

16. Review 2 Cost-plus pricing: Leads to profit maximization
Is inherently circular for manufacturing firms
Is difficult to perform
None of the above are correct
Answer: b
Is inherently circular for mfg firms
Learning objective 3: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms

17. Target Costing
Once a product is designed it is difficult to make changes that reduce costs
- 80% of a product’s costs cannot be reduced once it is designed
- Product features drive costs
Target costing
- Integrated approach to determine features, price, costs and design to ensure a profit
Learning objective 4: Explain the target costing process for a new product

18. Target Costing
Learning objective 4: Explain the target costing process for a new product

19. Target Costing
Slide 8-19
Learning objective 4: Explain the target costing process for a new product 19

20. Review 3 Target costing:
Requires specification of desired level of profit
Adds desired profit to existing costs
Is used primarily with products that are already in production
Leads to profit maximization
Answer: a
Requires specification of desired profit
Learning objective 4: Explain the target costing process for a new product

21. Analyzing Customer Profitability
Customer Profitability Measurement System (CPM)
Indirect costs of servicing customers are assigned to cost pools:
- cost of processing orders
- cost of handling returns
Costs are allocated to specific customers using cost drivers to determine customer profitability
Learning objective 5: Analyze customer profitability

22. Review 4 Customer profitability is measured as:
Revenue minus cost of goods sold
Revenue minus indirect manufacturing costs
Revenue minus cost of goods sold minus indirect service costs
Revenue minus cost of goods sold minus indirect manufacturing costs
Answer: c
Learning objective 5: Analyze customer profitability

23. Customer Profitability Measurement System
Learning objective 5: Analyze customer profitability

24. Cost Pools and Cost Drivers to Service Customers
Slide 8-24
Learning objective 5: Analyze customer profitability 24

25. Customer Profitability Analysis
Slide 8-25
Learning objective 5: Analyze customer profitability 25

26. Customer Profitability Analysis
Slide 8-26
Learning objective 5: Analyze customer profitability 26

27. Exercise 2
Delta products has determined the following costs and drivers for the Johnson Brand customer:
Calculate the profitability of the Johnson Brands customer.
Learning objective 5: Analyze customer profitability

28. Exercise 2
Delta products has determined the profitability of the Johnson Brand customer:
Slide 8-28
Learning objective 5: Analyze customer profitability 28

29. Customers Can Hurt Profitability
Learning objective 5: Analyze customer profitability

30. Activity-Based Pricing
Customers are presented with separate prices for services they request in addition to the cost of goods purchased
- Customers will carefully consider the services they request
- May lead them to impose less cost on the supplier
Also called menu-based pricing
Learning objective 6: Explain the activity-based pricing approach

31. Activity-Based Pricing
Customers are presented with separate prices for services they request in addition to the cost of goods purchased
- Customers will carefully consider the services they request
- May lead them to impose less cost on the supplier
Also called menu-based pricing
Slide 8-31
Learning objective 6: Explain the activity-based pricing approach 31

32. Review 5 With activity-based pricing:
Customers face a menu of prices for various services
Customers are encouraged to consider the costs they impose on a supplier
Customers may be charged less if they request less product variety in their orders
All of the above are correct
Answer: d

33. Pricing Decisions
Learning objective 6: Explain the activity-based pricing approach

34. Copyright
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