Chapter Fifteen

Target Costing and Cost Analysis for Pricing Decisions

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objective 1

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Major Influences on Pricing Decisions

Customer demand Political, legal, and image issues

Pricing Decisions

Competitors

Costs

Learning Objective 2

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

How Are Prices Set?

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 ProfitPricing

Firms usually have flexibility in setting prices. The quantity sold usually declines as the price is increased.

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 Marginal unit decreases revenue as quantity increases.

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

Dollars per unit

Determining the Profit-Maximizing ProfitPrice and Quantity

p* Demand Marginal cost q* Marginal Quantity made revenue and sold per month

Dollars per unit

Determining the Profit-Maximizing ProfitPrice and Quantity

Profit is maximized where marginal cost equals marginal revenue, resulting in price p* and quantity q*. Demand Marginal cost q* Marginal Quantity made revenue and sold per month

p*

Determining the Profit-Maximizing ProfitPrice and Quantity

Dollars Total cost Total revenue

Total profit at the profit-maximizing quantity and price, q* and p*. Quantity made and sold per month

q*

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 products price affects the demand for other substitute products.

Limitations of the ProfitProfit-Maximizing Model

A firms 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

Optimal Decisions Economic pricing model
Sophisticated decision model and information requirements

Exh. 15-4

Suboptimal Decisions Cost-based pricing

Simplified decision model and information requirements

Marginal-cost and Accounting productmarginal-revenue data cost data More costly Less costly The best approach, in terms of costs and benefits, typically lies between the extremes.

Learning Objective 3

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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

CostCost-Plus Pricing - Example

Variable mfg. cost Fixed mfg. cost Full-absorption mfg. cost Variable S & A cost Fixed S & A cost Total cost $ 400 250 $ 650 50 100 $ 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.

CostCost-Plus Pricing - Example

Variable mfg. cost Fixed mfg. cost Full-absorption mfg. cost Variable S & A cost Fixed S & A cost Total cost $ 400 250 $ 650 50 100 $ 800 Markup on variable manufacturing cost

Price = cost + (markup percentage cost) Price = $400 + (131.25% $400) = $925

CostCost-Plus Pricing - Example

Variable mfg. cost Fixed mfg. cost Full-absorption mfg. cost Variable S & A cost Fixed S & A cost Total cost $ 400 250 $ 650 50 100 $ 800 Markup on total var. cost As cost base increases, the required markup percentage declines.

Price = cost + (markup percentage cost) Price = $450 + (105.56% $450) = $925

CostCost-Plus Pricing - Example

Variable mfg. cost Fixed mfg. cost Full-absorption mfg. cost Variable S & A cost Fixed S & A cost Total cost $ 400 250 $ 650 50 100 $ 800 Markup on full mfg. cost As cost base increases, the required markup percentage declines.

Price = cost + (markup percentage cost) Price = $650 + (42.31% $650) = $925

CostCost-Plus Pricing - Example

Variable mfg. cost Fixed mfg. cost Full-absorption mfg. cost Variable S & A cost Fixed S & A cost Total cost $ 400 250 $ 650 50 100 $ 800 Markup on total cost As cost base increases, the required markup percentage declines.

Price = cost + (markup percentage cost) Price = $800 + (15.63% $800) = $925

AbsorptionAbsorption-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.

VariableVariable-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-onReturn-on-Investment Pricing

Solve for the markup percentage that will yield the desired return on investment.

Determining the Markup: Return-onReturn-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 Lets 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-onReturn-on-Investment Pricing

Step 1: Solve for the income that will result in an ROI of 20 percent.

Income ROI = Invested Capital Income 20% = $300,000 Income = 20% $300,000 Income = $60,000

Determining the Markup: Return-onReturn-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 Fixed mfg. cost Full-absorption mfg. cost Variable S & A cost Fixed S & A cost Total cost $ 400 250 $ 650 50 100 $ 800

Determining the Markup: Return-onReturn-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 Unit sales price - $800 unit cost = 480 units Unit sales price - $800 unit cost = $125 per unit Unit sales price = $925

Determining the Markup: Return-onReturn-on-Investment Pricing

Step 3: Compute the markup percentage on the $400 variable manufacturing cost. Unit sales price - Unit variable cost Unit variable cost $925 per unit - $400 per unit $400 per unit

Markup percentage Markup percentage Markup percentage

= =

= 131.25 percent

Learning Objective 4

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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
Price led costing Life-cycle costs Cross-functional teams

Key principles of target costing

Value-chain orientation

Focus on process design

Focus on the customer

Focus on product design

Learning Objective 6

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Role Of Activity-Based ActivityCosting In Setting A Target Cost.

Production Process Component Activities

Learning Objective 7

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Product Cost Distortion

High-volume products May be overcosted

Low-volume products May be undercosted

Learning Objective 8

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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

Total material cost incurred

Learning Objective 10

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Competitive Bidding
Low probability of winning bid

High bid price

High profit if winning bid

High probability of winning bid

Low bid price

Low profit if winning bid

Competitive Bidding
Guidelines for Bidding
Bidder has excess capacity Low bid price  Any bid price in excess of incremental costs of job will contribute to fixed costs and profit.


Bidder has no excess capacity

High bid price  Bid price should be full cost plus normal profit margin as winning bid will displace existing work.


Learning Objective 11

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Legal Restrictions On Setting Prices

Price discrimination Predatory pricing

End of Chapter 15
What is the right price?