Accounting 102

Session 17

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 Pricing
and
Cost Management

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 Pricing Decisions
Basic Factors Influencing the Pricing Decision (the Three C’s)
Customers
• What features and quality do the customers want?
• What is the magnitude of their demand for particular kinds of
products?
• How elastic is that demand?

Competitors
• Who are the existing competitors on a product line?
• What are the characteristics of their products?
• What are their current production volumes and capacities?
• What are their pricing schemes?

Costs
• What are the production costs and their characteristics (variable
vs fixed)?
• What are the costs of serving different customer groups?
• What are the competitors costs?
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 Pricing Decisions

The analysis underlying a pricing decision is fundamentally the same as

that underlying any other decision:

Identify the goal to be achieved;

and
Select the price that will best enable the firm to achieve its
objective, after considering all of the relevant factors.

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Short-run vs Long-run Pricing
Short-run
Short-run pricing decisions have a time horizon of less than one year and
include decisions such as:
Pricing of one-time-only special orders with no long-run implication
Adjusting product mix and output volume in a competitive market

Long-run
Long-run pricing decisions have a time horizon of one year or longer and
include decisions such as:
Pricing a product in a major market where there is some flexibility (e.g.
when the demand is relatively inelastic)

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Differences Affecting Pricing: Long Run vs. Short Run

1) Costs that are often irrelevant for short-run policy decisions, such
as fixed costs that cannot be changed, are generally relevant in
the long run because such costs can be altered in the long run

2) Profit margins in long-run pricing decisions are often set to earn a

reasonable return on investment – prices are decreased when
demand is weak and increased when demand is strong

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Approaches to Long-run Pricing

Most pricing decisions are a combination of two polar cases:

1) Cost Based Pricing

Cost based pricing is typically used when there is no established market for a
product or service (e.g., when the product is “custom made”) or when there is
relatively little competition in the market.
In these cases, the price is derived as:
Price/unit = Cost/unit x Mark-up rate (%)
Or, analogously
Price/unit = Cost/unit + Profit/unit ($)
For long-run price determination, it is best to apply the mark-up rate (%) to the
full product-related costs (including marketing)
To ensure that all costs are recovered
To stabilize prices by preventing managers from reducing the price to
variable cost
However, it is important to bear in mind that, for short-term pricing or for
strategic purposes, full-cost-plus pricing often is not be appropriate/desirable. 7
Determining the Mark-up Rate (Amount)
The mark-up rate should be based on consideration of two factors:
1) The firm’s required profit – based on its target return on invested
capital
2) Anticipated product costs (fixed and variable) and anticipated
volume of sales (and production).

Required Profit/Unit
Mark-up Rate (%) = 1 +
Full Cost/Unit

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Pricing decisions based solely on considerations of costs may be
suboptimal in the short- and/or long-run.
Because market factors such as demand and price elasticity are
not taken into account, the cost-based price may be “too high” or
“too low”.

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2) Market Based Pricing
– “Top down”
– Market driven and customer focused
– What do our customers want and how can it be delivered to
them profitably?

Just as cost-based pricing is likely to be suboptimal, so too are prices

based exclusively on market considerations.

A market-based price may not be sufficient to enable the firm to

recover its costs either in the short run or in the long run.

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Target Pricing
An important form of market-based pricing is target pricing.
The target price(s) is (are) derived based on consideration of both
market factors (the demand for a product having the characteristics
of that offered by the firm as well as the competitors’ pricing
strategy) and the firm’s particular short-run and long-run
objectives.

Target Costing
Target costing is typically used in conjunction with target pricing.
Given the target price and the firm’s profit objectives/expectations:

Target Cost = Target Price – Desired Margin

One of the primary purposes of target costing is to identify

opportunities for cost reductions before production begins (in the
design and production planning phases when modifications are relatively
easy to implement.)
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Target Costing – Incurred Costs vs Locked-in Costs
• Incurred Costs are the actual costs (of resources used) recorded by the
cost accounting systems.
• Locked-in costs are costs that have not been incurred yet, but will be
incurred in the future, because of decisions that have been made.
– The rule of thumb is that, once the production specifications have been
developed, approximately 80% of a product’s costs are locked-in.
– Therefore, most of the opportunities for cost reduction occur in the
initial product design and production planning phases of a product’s
life cycle, even though those phases, themselves, may account for
only a relatively small proportion of the actual costs incurred.

Examples:
Better design can reduce scrap, rework, customer service, and
warranty costs
Simpler design can reduce direct labor, machine time, testing and
inspection costs
Fewer parts can reduce parts order and handling/inventory costs.
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Iterative Steps in Target Costing

1) Identify a product concept that will satisfy some customer demand.

2) Derive a target price based on an analysis of the product market.
For example:
– Define a product’s “functionality” as a bundle of features
e.g. some of the features of a car are its size, its gas mileage,
and interior noise.
– Use marketing research techniques to determine the value that
customers attach to each feature by decomposing the market price of
comparable products into a sum of product features, e.g.
Total Price = P1*Feature1 + P2*Feature2 + …
– After estimating P1, P2, etc. estimate the target price of the firm’s
product based its features
3) Determine the desired profit margin for the product based on the firm’s profit
expectations (and any other objectives that the firm may have).

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3) Determine the target cost
Target Cost = Target Price – Desired Profit Margin

4) Conduct “value engineering” as a part of the process whose objective

is to achieve target costs
Form a value engineering team, consisting of representatives from
design, engineering, production, marketing, accounting, etc., to
analyze the cost-effectiveness of different product features.
The objective is to identify alternatives that will enable the firm
to achieve the target cost and increase the product’s value by
a) eliminating unnecessary functions
Products often include features that customers don’t value.
e.g. Think about the buttons on your VCR or cell phone
that you don’t use.
b) improving the design to reduce cost without sacrificing
functionality (marketability)
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5) If the target cost is achieved, stop.
If not refine the design and return to step 1.

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Target Costing and Kaizen Costing

Target costing is often used in conjunction with kaizen costing as the

basic elements of what is often referred to as a “Total Cost Management
system”.
As noted earlier, the purpose of target costing is to identify
opportunities for cost reductions before production begins – at the
design and production planning phases.
In contrast, the purpose of kaizen costing is to generate cost reductions in
the production phase using the budgeting process as the vehicle.
The term, “kaizen” refers to a Japanese philosophy that focuses on
continuous improvement. Kaizen costing is the application of kaizen
techniques as a means of reducing product costs by a pre-specified
amount.
In a kaizen costing system, pre-specified cost reductions are
systematically incorporated into the budgeting process to induce
management to search for new, innovative, less costly ways acquire
raw materials, to produce goods and to market the product
effectively. 16
Example: (P12-24 from the text)

Waterbury Inc., manufactures and sells RF17, a specialty raft used for
whitewater rafting. In 2007, it reported the following:

Units produced and sold 20,000

Full cost per unit $300
Markup on variable cost 50%

Investment $2,400,000
Rate of return on investment 20%

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Cost-Plus Pricing

1) What was the selling price for 2007?

Remember Price = Cost + Profit

Full cost per unit 300

2,400,000 x 20%
Income earned in 2007 per unit = = $ 24
20,000

Selling price per unit $324

2) What was the percentage markup on full cost?

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Percentage markup on full cost = = 8% (108%)
300

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3) What was the variable cost per unit?

Percentage markup on variable cost = 50%

P = VC x (1 + 0.5) = 324

324
VC = = $216
(1.5)

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Target Pricing

Waterbury is considering raising its selling price to $348. However, at

this selling price, its sales volume is predicted to fall by 10%. If
Waterbury’s cost structure (total fixed costs and variable costs per unit)
remain unchanged, should it raise its selling price?

a) Determine Waterbury’s total fixed costs:

Full cost per unit $300

Variable cost per unit 216
Fixed cost per unit $ 84
Units produced & sold 20,000

Total fixed costs $1,680,000

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b) Effect of raising selling price from $324 to $348:

Expected sales volume 20,000 x (1 – 0.10) 18,000 units

Profitability

Selling Price = $348

Contribution Margin (348 – 216) x 18,000 = 2,376,000

Fixed Costs 1,680,000

Operating Profit 696,000

ROI (at P = $348) = 696,000 = 29%

2,400,000

By increasing the price, Waterbury’s return will increase from 20% to

29%, in spite of the decline in sales volume.

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If Waterbury’s goal is to earn a pre-tax return on investment of 20%, what
should it set its selling price at, assuming that the decline in demand is the result
of market forces?

We can answer this question using CVP analysis:

Target Profit + Fixed Costs

P = VC +
Q

(2,400,000 x 20%) + 1,680,000

= 216 +
18,000

= 336

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Target Costing

In 2008, due to increased competition, Waterbury must reduce its selling

price to $315 in order to sell 20,000 units. The manager of the raft
division expects to be able to reduce the investment in the division to
$2,100,000 but still requires a 20% rate of return on investment. If fixed
costs cannot be reduced in this time frame, what is the target variable
cost per unit?

Using CVP analysis:

Target Profit + Fixed Costs

VC = P –
Q

(2,100,000 x 20%) + 1,680,000

= 315 –
20,000

= 210

For comparison, VC for 2007 were $216/unit

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