Chapter 13: joint management of revenues and costs Cost Management, Canadian Edition © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Learning Objectives Q1: How is value chain analysis used to improve operations? Q2: What is target costing and how is it performed? Q3: What is kaizen costing and how does it compare to target costing? Q4: What is life cycle costing? This slide is entirely automated – no clicks required. Q5: How are cost-based prices established? Q6: How are market-based prices established? Q7: What are the uses and limitations of cost-based and market-based pricing? Q8: What additional factors affect prices? © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Q1: How is value chain analysis used to improve operations? © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Value Chain Analysis The value chain is the series of sequential business processes an organization completes in order to deliver goods and services to customers. To manage costs, companies analyze the activities in the value chain. The first bullet is automated. One click is required for each bullet and sub-bullet. Non-value-added activities are those that can be reduced or eliminated without affecting the value of the goods to the customer. Value-added activities are necessary activities and support the value of the goods to the customer. © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Q2: What is target costing and how is it performed? © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Target Costing In competitive markets, companies may have no control over selling prices. The company’s only method to manage profits, then, is to manage costs. The first bullet is automated. The first click brings in the second bullet. The second click brings in the third bullet and the target cost formula. The selling price is used to back into the target cost of the product. – Target cost Selling price = Required profit margin © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Target Costing Target costing takes place before the decision to produce the product is final. It is most likely to be successful when: production and design processes are complex, relationships with suppliers are flexible, and potential customers may be willing to pay for product attributes that will differentiate the product from the competition. The first bullet is automated. One click is required for each remaining bullet and sub-bullet. © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Target Costing Example Ted’s Trailers is considering the design, production, and distribution of a new motorcycle trailer. The selling price of similar trailers is $1,200. Ted believes he can sell 10,000 trailers at this price, and he demands a margin of 25% of selling price on all products. Compute the target cost of the trailers. The given information is automated. The first click brings in the solutions. Target cost = $1,200 – ($1,200 x 25%) = $900 © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Target Costing Example The estimated production costs for the new trailer are shown below. Discuss the types of issues that Ted should investigate as he seeks to reduce these estimated costs to meet the target cost. Can the product be redesigned so that the quantity of materials and/or labour can be reduced? Can the purchase price of any of the materi-als be re-negotiated with the supplier(s)? Can the production process be redesigned so that the quantity of materials and/or labour can be reduced? The given information is automated. The first click brings in the 3 bullet points on the right of the slide. The second click brings in the 3 bullet points on the bottom of the slide. Can the design of the product be changed to incorporate features that the customer would be willing to pay for? Can variable selling expenses, for example, commissions, be reduced on this new product? Can more than 10,000 units be produced and sold so that the allocation of fixed costs per unit decreases? © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Q3: What is kaizen costing and how does it compare to target costing? © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Kaizen Costing In kaizen costing, explicit cost reductions are planned over time. Kaizen costing takes place after the production process has begun. The first bullet is automated. One click is required for each remaining bullet. Kaizen costing is a continuous improvement process that takes place over a longer planning horizon than target costing. © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Q4: What is life cycle costing? © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Life Cycle Costing Life cycle costing takes the product’s selling prices and costs over its entire life cycle into consideration. It is useful in industries with products that are expected to produce losses when first introduced, but rapid technological changes and increased volume are expected in future years. The first bullet is automated. One click is required for each remaining bullet. Initial production and process design costs will be viewed as costs to be matched against the revenues generated over the product’s entire life. © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Q5: How are cost-based prices established? © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Cost-Based Pricing A selling price that is computed as the product’s cost plus a markup is known as a cost-based price. The costs included in the base cost can be variable costs only or variable plus fixed costs. The first bullet is automated. One click is required for each remaining bullet. Some companies include only production costs in the cost base and others include production, selling, and administrative costs. © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Q6: How are market-based prices established? © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Market-Based Pricing A product’s selling price depends on the degree of competition and the degree to which the company’s product is differentiated from competitors’ products. Market-based prices are based on customer demand for the product. The first bullet is automated. One click is required for each remaining bullet. The sensitivity of customer demand to changes in the selling price is called the price elasticity of demand. © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Market-Based Pricing An increase in selling price should decrease customer demand for the product so that fewer units are sold. When the decrease in units sales offsets the increased selling price, the price increase causes total revenue to decrease. This is known as elastic demand. The first bullet is automated. One click is required for each remaining bullet. When the decrease in units sales does not offset the increased selling price, the price increase causes total revenue to increase. This is known as inelastic demand. © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Market-Based Pricing Elastic demand: Inelastic demand: Total Revenue = Selling price x Quantity of units sold The sequence of text and arrows for elastic demand is automated. The first click starts the sequence for inelastic demand. Inelastic demand: Total Revenue = Selling price x Quantity of units sold © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Price Elasticity of Demand The price elasticity of demand is calculated as follows: Price elasticity of demand = ln(1 + % change in quantity sold) ln(1 + % change in price) The first bullet and first formula are automated. The first click brings in the second bullet and formula. This elasticity can be used to compute the profit-maximizing price: = Profit-maximizing price Elasticity Elasticity +1 x Variable cost © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Market-Based Pricing Example Ted’s Trailers sells horse trailers in a competitive market. The variable costs of producing the one-horse trailer are $850 per unit. Information from prior years indicates that a 10% increase in the trailer’s selling price results in a 15% decrease in customer demand. Calculate the price elasticity of demand and the profit-maximizing price for the one-horse trailer. The given information is automated. The first click brings in the elasticity computation. The second click brings in the profit maximizing price computation. Price elasticity of demand = ln(1 - 0.15) ln(1 + 0.10) -0.16252 0.09531 -1.70516 = Profit-maximizing price -1.70516 -0.70516 x $850 = $2,055 © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Q7: What are the uses and limitations of cost-based and market-based pricing? © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Uses & Limitations of Cost-Based Pricing Cost-based pricing is inappropriate in highly competitive markets. If products are priced based on allocated fixed costs, and the price is too high for the market, the quantity sold will decrease. This decrease in sales will cause an increase in the fixed costs allocated to each unit. The increase in allocated fixed costs will cause even higher prices and unit sales will decline even further. This is known as the death spiral. One click is required for each bullet and sub-bullet, including the first primary bullet. © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Uses & Limitations of Cost-Based Pricing Cost-based pricing is best used when a company produces highly customized products. However, there can still be problems in these instances. If the determined price is too high the customer will not buy the customized product. The determined price may be lower than the customer would have paid The first bullet is automated. One click is required for each remaining bullet and sub-bullet. © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Q8: What additional factors affect prices? © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Other Factors that Affect Pricing In peak-load pricing, companies charge higher prices when they are at higher capacities. When companies set high prices for newly-introduced products, and gradually lower prices to entice customers who would not have purchased at the higher price, this is known as price skimming. The first bullet is automated. One click is required for each remaining bullet. When prices are set unusually high to take advantage of specific situations, this is known as price gouging. © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Other Factors that Affect Pricing Under penetration pricing, companies charge lower prices for newly introduced products. Companies set prices for the interdepartmental transfer of goods and services known as transfer prices (chapter 15). The first bullet is automated. The first click brings in the second bullet. The second click brings in the 2 secondary bullets. When this is done to decrease consumer uncertainty about the new product it is legal. When this is done with the intent to eliminate all competition, it is illegal and is known as predatory pricing. © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Other Factors that Affect Pricing When for-profit companies charge different prices to different customers and it is not based on differential costs, this is illegal and is known as price discrimination. Not-for-profit companies can legally charge different prices to customers based on their ability to pay. The first bullet is automated. One click is required for each remaining bullet and sub-bullet. Collusive pricing, where competitors get together to determine prices, is not legal. Foreign-based companies selling products at prices lower than in the home country is known as dumping. © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Pricing in Not-For-Profit Organizations NPOs have objectives other than maximization on profits which results in more complex pricing decisions NPOs do not necessarily expect to recover all costs of their products NPOs receive funding from government funding, grants, donations, etc Prices may reflect organizational goals. Prices that are based on income with the objective of making services accessible to the wider population Tuition fees reduced for high-performing students to attract quality students to a learning institution © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al

Copyright Copyright © 2009 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. © John Wiley & Sons, 2009 Chapter 13: Joint Management of Revenues and Costs Cost Management, Cdn Ed, by Eldenburg et al