1. Target Costing and Cost Analysis for Pricing Decisions CHAPTER 15 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

2. Major Influences on Pricing Decisions Pricing Decisions Political, legal, and image issues CompetitorsCosts Customer demand 15-2

3. 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. 15-3

4. Economic Profit-Maximizing Pricing Firms usually have flexibility in setting prices. The quantity sold usually declines as the price is increased. 15-4

5. Total Revenue Curve Total revenue Curve is increasing throughout its range, but at a declining rate Dollars Quantity sold per month 15-5

6. Total Cost Curve Dollars Quantity made per month Total cost increases at a declining rate Total cost increases at an increasing rate 15-6

7. Quantity made per month Marginal Cost Curve Marginal cost Dollars per unit Quantity where marginal cost begins to increase c 15-7

8. 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* 15-8

9. 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 15-9

10. 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? 15-10

11. 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. 15-11

12. 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. 15-12

13. 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. 15-13

14. 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. 15-14

15. 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. 15-15

16. 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. 15-16

17. Variable-Cost Pricing Formulas Advantages Does not obscure cost behavior patterns. Does 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. 15-17

18. Determining the Markup: Return-on-Investment Pricing Solve for the markup percentage that will yield the desired return on investment. 15-18

19. Price = cost + (markup percentage × cost) Price = $400 + (131.25% × $400) = $925 Recall the example using a 131.25 percent markup on variable manufacturing cost. Determining the Markup: Return-on-Investment Pricing 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. 15-19

20. 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. 15-20

21. 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 15-21

22. Determining the Markup: Return-on-Investment Pricing 480 units × (Unit sales price - $800 unit cost) = $60,000 Unit sales price - $800 unit cost = $60,000 480 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. 15-22

23. 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 = 131.25 percent 15-23

24. 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. 15-24

25. 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. 15-25

26. 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 15-26

27. Time and Material Pricing Price is the sum of labor and material charges. Used by construction companies, printers, and professional service firms. 15-27

28. 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 15-28

29. 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 15-29

30. 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. 15-30

31. Legal Restrictions On Setting Prices Price discrimination Predatory pricing 15-31

32. End of Chapter 15 What is the right price? 15-32