Target Costing and Cost Analysis for Pricing Decisions Chapter 15 Target Costing and Cost Analysis for Pricing Decisions

Learning Objective 1

Major Influences on Pricing Decisions Political, legal, and image issues Competitors Costs Customer demand Pricing Decisions

Learning Objective 2

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

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

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

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

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

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

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

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

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

The impact of price changes on sales volume 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.

Cross Elasticity The extent to which a change in a product’s price affects the demand for other substitute products.

Limitations of the Profit-Maximizing Model A firm’s demand and marginal revenue curves are difficult to discern with precision. The marginal revenue, marginal cost paradigm is not valid for all forms of markets. Marginal cost is difficult to measure.

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

Learning Objective 3

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

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.

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 Markup on variable manufacturing cost Price = cost + (markup percentage × cost) Price = $400 + (131.25% × $400) = $925

Cost-Plus Pricing - Example Markup on total var. cost As cost base increases, the required markup percentage declines. 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

Cost-Plus Pricing - Example Markup on full mfg. cost As cost base increases, the required markup percentage declines. 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

Cost-Plus Pricing - Example Markup on total cost As cost base increases, the required markup percentage declines. 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

Absorption-Cost Pricing Formulas Advantages Price covers all costs. Perceived as equitable. Comparison with competitors. Absorption cost used for external reporting. Disadvantages Full-absorption unit price obscures the distinction between variable and fixed costs.

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

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

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

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

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

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

Determining the Markup: Return-on-Investment Pricing Step 3: Compute the markup percentage on the $400 variable manufacturing cost. Markup percentage Unit sales price - Unit variable cost Unit variable cost = Markup percentage $925 per unit - $400 per unit $400 per unit = Markup percentage = 131.25 percent

Learning Objective 4

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.

Learning Objective 5

Market research determines the price at which a new product will sell. 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.

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 Key principles of target costing

Learning Objective 6

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

Learning Objective 7

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

Learning Objective 8

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

Learning Objective 9

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

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

Learning Objective 10

Competitive Bidding High bid price Low 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

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

Learning Objective 11

Legal Restrictions On Setting Prices Price discrimination Predatory pricing

End of Chapter 15 What is the right price?