COST MANAGEMENT Accounting & Control Hansen▪Mowen▪Guan COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. Cengage Learning and South-Western are trademarks used herein under license. 1 Chapter 19 Pricing and Profitability Analysis

2 Study Objectives 1.Discuss basic pricing concepts. 2.Calculate a markup on cost and a target cost. 3.Discuss the impact of the legal system and ethics on pricing. 4.Calculate measures of profit using absorption and variable costing. 5.Determine the profitability of segments. 6.Compute the sales price, price volume, contribution margin, contribution margin volume, sales mix, market share, and market size variances. 7.Describe some of the limitations of profit measurement.

3 Basic Pricing Concepts Market Structure and Price Perfect Competition: Many buyers and sellers; no one of which is large enough to influence the market. Monopolistic Competition: Has both the characteristics of both monopoly and perfect competition. Oligopoly: Few sellers. Monopoly: Barriers to entry are so high that there is only one firm in the market.

4 Market Structure and Price

5 Pricing Policies Cost-based pricing –Established using “cost plus markup” Target costing and pricing –Determine the cost of a product or service based on the price (target price) that customers are willing to pay –Effectively used in conjunction with marketing decisions Penetration pricing Price skimming

6 Cost-Plus Pricing AudioPro Company sells and installs audio equipment in homes, cars, and trucks. AudioPro’s income statement for last year is as follows: Revenues$350,350 Cost of goods sold: Direct materials$122,500 Direct labor73,500 Overhead 49, ,000 Gross profit$105,350 Selling and administrative expenses 25,000 Operating income$ 80,350 Pricing Policies

7 The firm wants to earn the same amount of profit on each job as was earned last year: Markup on COGS = (Selling and administrative expenses + Operating income) ÷ COGS Markup on COGS =($25,000 + $80,350) ÷ $245,000 Markup on COGS =0.43 or 43% Cost-Plus Pricing Pricing Policies

8 The markup can be calculated using a variety of bases. The calculation for markup on direct materials is as follows: Markup on DM = (Direct labor + Overhead + Selling and administrative expense + Operating income) ÷ Direct materials Markup on DM =($73,500 + $49,000 + $25,000 + $80,350) ÷ $122,500 Markup on DM =1.86 or 186% Cost-Plus Pricing Pricing Policies

9 AudioPro wants to expand the company’s product line to include automobile alarm systems and electronic car door openers. The cost for the sale and installation of one electronic remote car door opener is as follows: Direct materials (component and two remote controls)$ Direct labor (2.5 hours x $12)30.00 Overhead (65% of direct labor cost) Estimated cost of one job$ Plus 43% markup on COGS Bid price$ Cost-Plus Pricing Pricing Policies

10 Target Costing and Pricing Pricing Policies Determine the cost of a product or service based on the price that the customers are willing to pay. Direct materials (component and two remotes)$ Include one remote instead of two$35.00 Direct labor (2.5 hours x $12)30.00 Train workers to reduce time (2 hours x $12)24.00 Overhead (65% of direct labor cost) Reduce overhead (50% of direct labor cost)12.00 Estimated cost of one job$ Revised cost of one job$ Plus 43% markup on COGS Bid price$127.99$ Other installers price the remote car door opener at $110. Possible actions: Bid price is now competitive; markup preserved

11 The Legal System and Pricing Predatory pricing –The practice of setting prices below cost for the purpose of injuring competitors and eliminating competition Dumping –Predatory pricing on the international market –Companies sell below cost in other countries; the domestic industry is injured.

12 The Legal System and Pricing Price discrimination –Charging different prices to different customers for essentially the same product. –Robinson-Patman Act of 1936 prohibits Manufacturers or suppliers are covered by the act Price discrimination is allowed if –If the competitive situation demands it and –If costs (including costs of manufacture, sale, or delivery) can justify the lower price

13 Cobalt, Inc. manufactures vitamin supplements that costs an average of $163 per case. Cobalt sold 250,000 cases last year as follows: Customer Price per Case Cases Sold Large drug store chain$200125,000 Small local pharmacies232100,000 Individual health clubs25025,000 Cobalt is practicing price discrimination … is it justifiable? The Legal System and Pricing

14 The Legal System and Pricing Profits vary within a narrow 1 percent range. The cost differences among the three classes of customer appear to explain the price differences.

15 Measuring Profit Absorption Costing –Also referred to as full costing –Required for external financial reporting –Assigns all manufacturing costs, direct materials, direct labor, variable overhead, and a share of fixed overhead to each unit of product –Each unit of product absorbs some of the fixed manufacturing overhead in addition to the variable costs incurred to manufacture it.

16 Lasersave, Inc., a company that recycles used toner cartridges for laser printers. During August the firm manufactured 1,000 cartridges at the following costs: Direct materials$ 5,000 Direct labor15,000 Variable overhead3,000 Fixed overhead 20,000 Total manufacturing cost$43,000 During August, these cartridges were sold at $60 each. Variable marketing cost was $1.25 per unit. Fixed expenses were $12,000. Absorption-Costing Measuring Profit

17 Measuring Profit Absorption-Costing *Direct materials ($5 x 1,000) $ 5,000 Direct labor ($15 x 1,000) 15,000 Variable overhead ($3 x 1,000) 3,000 Fixed overhead 20,000 Total manufacturing overhead and cost of goods sold $43,000 1,000 units produced; 1,000 units sold

18 *Direct materials ($5 x 1,250) $ 6,250 Direct labor ($15 x 1,250) 18,750 Variable overhead ($3 x 1,250) 3,750 Fixed overhead ($16 per unit) 20,000 Total manufacturing overhead $48,750 Add: Beginning inventory 0 Less: Ending inventory (9,750) Cost of goods sold $39,000 Measuring Profit Absorption-Costing Production exceeded sales by 250 units; fixed overhead of $16 per unit is carried in inventory thus reducing cost of goods sold and increasing net income 1,250 units produced; 1,000 units sold

19 Measuring Profit Variable-costing Also referred to as direct costing Assigns only unit-level variable manufacturing costs to the product –Direct materials –Direct labor –Variable overhead Fixed overhead is treated as a period cost

20 *Direct materials $ 5,000 Direct labor 15,000 Variable overhead 3,000 Total variable manufacturing expenses $23,000 Add: Variable marketing expenses 1,250 Total variable expenses $24,250 Measuring Profit

21 Measuring Profit *1,300 × $39 = $50,700

22 Measuring Profit

23 Alden Company manufactures two products: basic fax machines and multi-function fax machines. The multi-function fax uses more advanced technology; therefore, it is more expensive to manufacture. Profit by Product Line Basic Multi-Function Number of units20,00010,000 Direct labor hours40,00015,000 Price$200$350 Prime cost per unit$55$95 Overhead per unit$30$22.50 Profitability of Segments

24 Profitability of Segments Profit by Product Line

25 Profitability of Segments Profit by Product Line

26 Profitability of Segments Profit by Product Line

27 Profitability of Segments Profit by Product Line

28 Alpha Beta Gamma Delta Total Sales$ 90$ 60$ 30$120$300 Cost of goods sold Gross profit$ 55$ 40$ 19$ 22$136 Division expenses Corporate expenses Operating income (loss)$ 32$ 28$ 3$ -2$ 61 Profitability of Segments Divisional Profit

29 Profitability of Segments Customer profitability Companies that assess the profitability of various customer groups can more accurately target their markets and increase profits. 1)Identify the customer 2)Determine which customers add value to the company

30 Analysis of Profit-Related Variances Overall Sales Variance [actual vs. expected revenue] Sales Price VariancePrice Volume Variance

31 Analysis of Profit-Related Variances The sales price and price volume variances are labeled favorable if the variance increases profit above the amount expected. They are labeled unfavorable if the variance decreases profit below the amount expected.

32 Analysis of Profit-Related Variances Contribution Margin Variance [actual vs. expected contribution margin] Sales Mix Variance Contribution Margin Volume Variance

33 Analysis of Profit-Related Variances Sales Mix Variance = The sales mix variance is favorable if the sales mix is weighted to the more profitable products. The contribution margin volume variance gives management information about gained or lost profit due to changes in the quantity of sales.

34 Analysis of Profit-Related Variances

35 Analysis of Profit-Related Variances contribution margin variance $14,375 − $13,500 = $875 favorable sales mix variance contribution margin volume variance (2,000 − 1,875) × $6.75 = $1, favorable= $ unfavorable Birdwell, Inc.:

36 Analysis of Profit-Related Variances Market share variance = Market size variance =

37 Limitations of Profit Measurement Limitations of profitability analysis –Focus on past performance –Emphasis on quantifiable measures –Impact on behavior Successful firms measure far more than accounting profit.

COST MANAGEMENT Accounting & Control Hansen▪Mowen▪Guan COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. Cengage Learning and South-Western are trademarks used herein under license. 38 End Chapter 19