Prepared by Debby Bloom-Hill CMA, CFM

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

Pricing Decisions  Pricing decisions are often the most difficult decisions that managers face  Pricing decisions examined in this chapter include  Profit maximizing price from the standpoint of economic theory  Pricing of special orders  Marking up costs and target costing  Measuring customer profitability and activity based pricing Slide 8-3

The Profit Maximizing Price  Economic theory suggests that the quantity demanded is a function of the price that is charged  Generally, the higher the price, the lower the quantity demanded  If managers can estimate the quantity demanded at various prices, determining the optimal price is straightforward Slide 8-4Learning objective 1: Compute the profit maximizing price for a product or service

The Profit Maximizing Price  To calculate the profit maximizing price:  Subtract unit variable costs from price to obtain the contribution margin  Multiply the contribution margin by the quantity demanded  Subtract fixed costs and estimate profits  Select the price with the highest profit Slide 8-5Learning objective 1: Compute the profit maximizing price for a product or service

Estimating the Profit Maximizing Price Slide 8-6Learning objective 1: Compute the profit maximizing price for a product or service

Estimating Demand  The most difficult part of determining the profit maximizing price is determining the demand function  A number of approaches can be used  Sales managers in various regions could estimate the total quantity demanded at various prices  The product could be test marketed with a number of potential customers at various prices Slide 8-7Learning objective 1: Compute the profit maximizing price for a product or service

 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 Slide 8-8Learning objective 1: Compute the profit maximizing price for a product or service

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 the normal course of business  The company may be better off charging a price that is below full cost Slide 8-9Learning objective 2: Perform incremental analysis related to pricing a special order

Pricing Special Orders  The special order decision presents two alternatives  Accept  Reject  Income from the main business is the same under both alternatives  It is not incremental and need not be considered in the special order Slide 8-10Learning objective 2: Perform incremental analysis related to pricing a special order

Pricing Special Orders  Need to consider incremental revenues and incremental costs  The incremental revenue is the revenue associated with the special order  Incremental costs can include  Direct materials  Direct labor  Variable overhead  Incremental fixed costs Slide 8-11Learning objective 2: Perform incremental analysis related to pricing a special order

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 Slide 8-12Learning objective 2: Perform incremental analysis related to pricing a special order

Special Orders – Premier Lens Example  Perform incremental analysis  Fixed costs are not incremental, they will not change if the order is accepted Slide 8-13Learning objective 2: Perform incremental analysis related to pricing a special order

Commonwealth Edison Slide 8-14Learning objective 2: Perform incremental analysis related to pricing a special order

Which of the following is true? a.In pricing special orders, fixed costs typically are not relevant b.In pricing special orders, fixed costs typically are relevant Answer: a Fixed costs typically are not relevant Slide 8-15Learning objective 2: Perform incremental analysis related to pricing a special order

Cost-Plus Pricing  With a cost plus approach, the company starts with an estimate of product cost  Typically excluding any selling or administrative costs  Adds a markup to arrive at a price that allows for a reasonable level of profit Slide 8-16Learning objective 3: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms

Cost-Plus Pricing  Advantages  The cost plus approach is simple to apply  The company will earn a reasonable profit if a sufficient quantity can be sold at the specified price  The approach also has limitations Slide 8-17Learning objective 3: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms

Cost-Plus Pricing  Limitations  Determination of an appropriate markup requires considerable judgment  Experimentation with different markups may be necessary  Inherently circular for manufacturing firms  Need to estimate demand to determine fixed costs and the price, yet the price affects the quantity demanded Slide 8-18Learning objective 3: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms

Cost-Plus Pricing Slide 8-19Learning objective 3: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms

All of the following are limitations of cost plus pricing except a.Determination of the markup percentage requires judgment b.Is inherently circular for manufacturing firms c.Experimentation may be necessary d.Cost plus is simple to apply Answer: d Simplicity is an advantage of cost plus pricing Slide 8-20Learning objective 3: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms

Target Costing Slide 8-21Learning objective 4: Explain the target costing process for a new product  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

Target Costing Slide 8-22Learning objective 4: Explain the target costing process for a new product  The process begins with an analysis of competing products  This leads to a specification of features and price attractive to customers  The second step is to specify a desired level of profit  Then the engineering department with input from the cost accounting department develops a design that can be produced at a cost which will earn the desired level of profit

Target Costing Slide 8-23Learning objective 4: Explain the target costing process for a new product

Target costing: a.Requires specification of desired level of profit b.Adds desired profit to existing costs c.Is used primarily with products that are already in production d.Leads to profit maximization Answer: a Requires specification of desired profit Slide 8-24Learning objective 4: Explain the target costing process for a new product

Analyzing Customer Profitability  Customer Profitability Measurement System (CPM)  Indirect costs of servicing customers are assigned to cost pools  Indirect costs include processing orders, handling returns, and shipments  Costs are allocated to specific customers using cost drivers to determine customer profitability  Subtracting these costs and product costs from customer revenue yields a measure of customer profitability Slide 8-25Learning objective 5: Analyze customer profitability

Customer profitability is measured as: a.Revenue minus cost of goods sold b.Revenue minus indirect manufacturing costs c.Revenue minus cost of goods sold minus indirect service costs d.Revenue minus cost of goods sold minus indirect manufacturing costs Answer: c Revenue minus cost of goods sold minus indirect service costs Slide 8-26Learning objective 5: Analyze customer profitability

Customer Profitability Measurement System Slide 8-27Learning objective 5: Analyze customer profitability

Cost Pools and Cost Drivers to Service Customers Slide 8-28 Learning objective 5: Analyze customer profitability

Customer Profitability Analysis Slide 8-29 Learning objective 5: Analyze customer profitability

A customer profitability measurement (CPM) system: a.Allocates indirect costs to individual customers b.Traces revenue to individual customers c.Traces cost of goods sold to individual customers d.All of the above are true Answer: d All of the above are true Slide 8-30Learning objective 5: Analyze customer profitability

Customer Profitability Analysis Slide 8-31 Learning objective 5: Analyze customer profitability

Customer Profitability and Performance Measures  Some examples of performance measures that will drive managers to improve customer profitability  Percent of customers who are not profitable  Dollar loss for customers who are not profitable  Average profit per customer  Number of customer service requests per 100 customers  Percent of customers who return items  Dollar value of returned items Slide 8-32Learning objective 5: Analyze customer profitability

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 8-33Learning objective 6: Explain the activity- based pricing approach

Activity-Based Pricing  Customers might object as the price they pay should cover these costs  Ways to deal with this resistance  Lower prices slightly and then encourage customers to make fewer but larger purchases  Customers could be encouraged to limit the variety of goods they order  Activity-based pricing could be used only on the least profitable customers Slide 8-34Learning objective 6: Explain the activity- based pricing approach

Pricing Decisions Slide 8-35Learning objective 6: Explain the activity- based pricing approach

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