Cost Accounting Chap12

CHAPTER 12
Pricing Decisions
and
Cost Management
2009 Pearson Prentice Hall. All rights reserved.
Learning Objective 1
Discuss the three major
influences on pricing
Pricing and Business
How companies price a product or service ultimately

depends on the demand and supply for it
Three influences on demand & supply:
Customers
2. Competitors
3. Costs
1.
Influences on Demand & Supply

1.
2.
3.
Customers influence price through their effect

on the demand for a product or service, based on
factors such as quality and product features
Competitors influence price through their
pricing schemes, product features, and production
volume
Costs influence prices because they affect supply
(the lower the cost, the greater the quantity a firm
is willing to supply)
Distinguish between short-run
and long-run pricing decisions.
Time Horizons and Pricing

Short-run pricing decisions have a time horizon of
less than one year and include decisions such as:

Pricing a one-time-only special order with no long-run
implications
Adjusting product mix and output volume in a competitive
market
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
leeway in setting price

Differences Affecting Pricing:

Long Run vs. Short Run
1.
2.
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 costs can be altered in the long run
Profit margins in long-run pricing decisions are
often set to earn a reasonable return on investment.
Short-run pricing is more opportunistic prices are
decreased when demand is weak and increased
when demand is strong
Costing and Pricing

for the Short Run
Pricing for the short run involves a
determination of what are the relevant costs
for this decision.
A key factor in setting short-run prices is
whether the company has excess capacity. If
this exists, any price above variable costs will
contribute to paying fixed costs and to profit.
Costing and Pricing

for the Short Run Example
Lomas Corporation operates a plant with
a monthly capacity of 500,000 cases
of tomato sauce.
Lomas is presently producing
300,000 cases per month.
Del Valle has asked Lomas and two other
companies to bid on supplying 150,000
cases each month for the next four months.
Costing and Pricing

Cost Per Case
Variable manufacturing
Variable marketing and distribution
Fixed manufacturing
Fixed marketing and distribution
Total
$38
13
14
15
$80
Costing and Pricing

If Lomas makes the extra 150,000 cases, the existing
total fixed manufacturing overhead ($4,200,000 per
month) would continue, plus an additional $165,000
of fixed overhead will be incurred per month.
Total fixed marketing and distribution
costs will not change.
What price should Lomas bid?
Costing and Pricing

Relevant Costs
Variable manufacturing
Fixed manufacturing
Total
$38.00
1.10
$39.10
$165,000 150,000 = $1.10

Any bid above $39.10 will improve
Lomass profitability in the short run.
Costing and Pricing

Suppose that Lomas believes that Del Valle
will sell the tomato sauce in Lomass current
markets but at a lower price than Lomas.
Relevant costs of the bidding decision
should include revenues lost on sales
to existing customers.
Costing and Pricing

for the Long Run
Long-run pricing is the result of a strategic
decision designed to build relationships with
customers based on stable and predictable
pricing.
Alternative Long-Run Pricing

Approaches
Market-Based: price charged is based on what
customers want and how competitors react

Cost-Based: price charged is based on what it cost to
produce, coupled with the ability to recoup the costs
and still achieve a required rate of return
Alternative Long-Run Pricing

Approaches
The market-based approach starts with a customer
focus, asking what the customer wants, how

competitors will react to our decisions, and what price
should be charged. This approach is target pricing.
The cost-based approach starts with an evaluation of
costs and where the selling price should be set in order
to recoup costs and earn a desired return on
investment. This is known as cost-plus pricing.
Markets and Pricing

Highly competitive Markets - use the market-based
approach
Less-Competitive Markets can use either the marketbased or cost-based approach
Non-Competitive Markets use cost-based
approaches
Price products using the
target-costing approach.
Market-Based Approach
Starts with a target price
Target Price estimated price for a product or service
that potential customers will pay

Estimated on customers perceived value for a product
or service and how competitors will price competing
products or services
Understanding the
Market Environment
Understanding customers and competitors is

important because:
Competition from lower cost producers has meant
that prices cannot be increased
2. Products are on the market for shorter periods of time,
leaving less time and opportunity to recover from
pricing mistakes
3. Customers have become more knowledgeable and
demand quality products at reasonable prices
1.
Five Steps in Developing

Target Prices and Target Costs
Develop a product that satisfies the needs of
potential customers: Find a need and fill it
Choose a target price: based on research of
competitors products and what the customer is
willing to pay.
Derive a target cost per unit: Determine the target
operating income per unit and subtract that from
the target price to arrive at target cost per unit.
1.
2.
3.
Target Price per unit minus Target Operating Income per

unit
Five Steps in Developing

Target Prices and Target Costs
4.
5.
Perform cost analysis: This step analyzes which

aspects of a product or service to target for cost
reductions.
Perform value engineering to achieve target cost:
Value engineering is a systematic evaluation of all
aspects of the value chain. The objective is to reduce
costs while achieving a quality level that will satisfy
customers.
Costing and Pricing

for the Long Run Example
Latisha Computer Corporation manufactures
two brands of computers: Simple Computer (SC)
and Complex Computer (CC).
Latisha uses a long-run time horizon to price
Complex Computer (CC).
Costing and Pricing

Direct materials costs vary with the
number of units produced.
Direct manufacturing labor costs vary
with direct manufacturing labor-hours.
Ordering and receiving, testing and
inspection, and rework costs vary
with their chosen cost drivers.
Costing and Pricing

Ordering:
$78 per order
Testing:
$2 per inspection hour
Rework:
$38 per unit reworked
Cost per Unit
Direct materials
$450.00
Direct labor:
3.50 hours @ $19 per hour
66.50
Total
$516.50
Costing and Pricing

Number of orders placed:
17,000
Number of testing hours:
3,000,000
Number of units reworked:
8,000
The direct fixed costs of machines used
exclusively for the manufacture of
Complex Computer total $7,000,000.
What is the cost of producing 100,000
units of Complex Computer?
Costing and Pricing

Direct material and labor
$51,650,000
Direct fixed costs
7,000,000
Ordering (17,000 $78)
1,326,000
Testing (3,000,000 $2)
6,000,000
Rework (8,000 $38)
304,000
Total
$66,280,000
$66,280,000 100,000 units = $662.80/unit
Implementing Target Pricing

and Target Costing
Latishas management wants a 15% target
operating income on sales revenues of CC.
Target sales revenue is $750 per unit.

What is the target cost per unit?
$750 .15 = $112.50, $750 $112.50 = $637.50
Current full cost per unit of CC is $662.80

Apply the concepts of cost
incurrence and locked-in costs.
Value Engineering
Value Engineering is a systematic evaluation of all
aspects of the value-chain, with the objective of

reducing costs while improving quality and satisfying
customer needs
Managers must distinguish value-added activities and
costs from non-value-added activities and costs
Value Engineering Terminology

Value-Added Costs a cost that, if eliminated,
would reduce the actual or perceived value or utility

(usefulness) customers obtain from using the
product or service.
Non-Value-Added Costs a cost that, if eliminated,
would not reduce the actual or perceived value or
utility customers obtain from using the product or
service. It is a cost the customer is unwilling to pay
for.
Cost Incurrence
This describes when a resource is sacrificed
or forgone to meet a specific objective.
Research and development
Design
Manufacturing
Marketing
Distribution
Customer support
Locked-in Costs
These are those costs that have not yet been
incurred but which, based on decisions that
have already been made, will be incurred
in the future (designed-in costs).
It is difficult to alter or reduce
costs that are already locked in.
Locked-in Costs
costs are frequently locked in during the
design phase. Once the design of the
product is finalized, the cost of the product is
determined to a large degree.
cost reductions can be most readily attained
through value-chain analysis and the use of
cross-functional teams. By forming a team of
representatives from all segments of the
value chain, the product can be designed to
reduce costs while retaining features that
customers value.
Cost Incurrence
and Locked-In Costs Graph
Five key elements

1. Understanding customer requirements and
competitor actions
2. Selecting a target price and determining target
cost
3. Anticipating how costs are locked in before they
are incurred
4. Improving product and process designs and
efficiency to achieve target costs and better quality
5. Using cross-functional teams to coordinate
actions across the value chain
Target Costing Illustration
Target Costing Illustration,

Continued
Price products using

the cost-plus approach
Cost-Based (Cost-Plus) Pricing

The general formula: adds a markup component to the
cost base to determine a prospective selling price

Usually only a starting point in the price-setting
process
Markup is somewhat flexible, based partially on
customers and competitors
Forms of Cost-Plus Pricing

Setting a Target Rate of Return on Investment: the
Target Annual Operating Return that an

organization aims to achieve, divided by Invested
Capital
Selecting different cost bases for the cost-plus
calculation:
Variable Manufacturing Cost
Variable Cost
Manufacturing Cost
Full Cost
Common Business Practice

Most firms use full cost for their cost-based pricing
decisions, because:
Allows for full recovery of all costs of the product
Allows for price stability
It is a simple approach
Common Business Practice

The price as determined through the cost-plus formula
is a prospective price. If the price under the cost-plus

approach is deemed to be excessive, the markup
percentage may need to be reduced. Reactions to
competitors may require a lower markup percentage.
Use life-cycle budgeting
and costing when making
pricing decisions
Life-Cycle Product
Budgeting and Costing
Product Life-Cycle spans the time from initial R&D on
a product to when customer service and support are no

long offered on that product.
Life-Cycle Budgeting involves estimating the revenues
and individual value-chain costs attributable to each
product from its initial R&D to its final customer
service and support.
Life-Cycle Costing tracks and accumulates individual
value-chain costs attributable to each product from its
initial R&D to its final customer service and support
Life Cycle Budgeting, Illustrated
Important Considerations for

Life-Cycle Budgeting
Development period for R&D and design is long and
costly
Many costs are locked in at the R&D and design stages,
even if R&D and design costs are themselves small
Describe two pricing
practices in which noncost
factors are important when
setting prices
Other Important Considerations in

Pricing Decisions
Price Discrimination the practice of charging
different prices to different customers for the same

product or service.
Legal Implications
Peak-Load Pricing the practice of charging a higher
price for the same product or service when the demand

for it approaches the physical limit of the capacity to
produce that product or service
Explain the effects of
antitrust laws on pricing
The Legal Dimension of

Price Setting
Price discrimination is permissible if differences in
prices can be justified by differences in costs.

Price Discrimination is illegal if the intent is to lessen
or prevent competition for customers
Prohibition of predatory pricing
Predatory Pricing deliberately lowering prices below costs
in an effort to drive competitors out of the market and
restrict supply, and then raising prices
The Legal Dimension of

Price Setting
Prohibition of Dumping a non-US firm sells a
product in the US at a price below the market value

in the country where it is produced, and this lower
price materially injures or threatens to materially
injure an industry in the US.
Prohibition of Collusive Pricing occurs when
companies in an industry conspire in their pricing
and production decisions to achieve a price above
the competitive price and so restrain trade.

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CHAPTER 12

2009 Pearson Prentice Hall. All rights reserved.

2009 Pearson Prentice Hall. All rights reserved.

Pricing and Business

How companies price a product or service ultimately

2009 Pearson Prentice Hall. All rights reserved.

Influences on Demand & Supply

Customers influence price through their effect

2009 Pearson Prentice Hall. All rights reserved.

Time Horizons and Pricing

less than one year and include decisions such as:

Long-run pricing decisions have a time horizon of

one year or longer and include decisions such as:

leeway in setting price

Differences Affecting Pricing:

Costs that are often irrelevant for short-run policy

Costing and Pricing

Costing and Pricing

Costing and Pricing

2009 Pearson Prentice Hall. All rights reserved.

Costing and Pricing

Costing and Pricing

$165,000 150,000 = $1.10

Costing and Pricing

2009 Pearson Prentice Hall. All rights reserved.

Costing and Pricing

2009 Pearson Prentice Hall. All rights reserved.

Alternative Long-Run Pricing

customers want and how competitors react

2009 Pearson Prentice Hall. All rights reserved.

Alternative Long-Run Pricing

focus, asking what the customer wants, how

Markets and Pricing

2009 Pearson Prentice Hall. All rights reserved.

2009 Pearson Prentice Hall. All rights reserved.

that potential customers will pay

2009 Pearson Prentice Hall. All rights reserved.

Understanding customers and competitors is

2009 Pearson Prentice Hall. All rights reserved.

Five Steps in Developing

Target Price per unit minus Target Operating Income per

Five Steps in Developing

Perform cost analysis: This step analyzes which

Costing and Pricing

2009 Pearson Prentice Hall. All rights reserved.

Costing and Pricing

Costing and Pricing

Costing and Pricing

Costing and Pricing

Implementing Target Pricing

Target sales revenue is $750 per unit.

Current full cost per unit of CC is $662.80

2009 Pearson Prentice Hall. All rights reserved.

aspects of the value-chain, with the objective of

2009 Pearson Prentice Hall. All rights reserved.

Value Engineering Terminology

would reduce the actual or perceived value or utility

2009 Pearson Prentice Hall. All rights reserved.

2009 Pearson Prentice Hall. All rights reserved.

Five key elements

Target Costing Illustration

2009 Pearson Prentice Hall. All rights reserved.

Target Costing Illustration,