Target Costing and Cost Analysis for Pricing Decisions Chapter 15 Target Costing and Cost Analysis for Pricing Decisions Chapter 15: Target Costing and Cost Analysis for Pricing Decisions. MBA 631 Dr. Luchs Ball State University

Learning Objective 1 Learning Objective 1. List and describe the four major influences on pricing decisions. 15-2

Major Influences on Pricing Decisions Political, legal, and image issues Competitors Costs Customer demand Pricing Decisions Setting the price for an organization’s product or service is one of the most important decisions a manager faces. It is also one of the most difficult, due to the number and variety of factors that must be considered. Customer demand is a very important consideration in pricing decisions. Decisions regarding customers mean that management must find that proper balance between perfect quality and perfect price. The higher the quality, the higher the price. Lower quality means lower price. It is critical for management to find the proper balance that their customers want. Competition is another consideration in pricing decisions. If a competitor lowers its price for a similar product, you may have to match their price, or risk losing market share to them. Costs must be held below the market price of the product. In some businesses, the market determines the price. Management can only charge the market price, and they must insure that their costs are below that price in order to make a profit. In the legal area, there are certain laws regarding pricing policies that management must follow. For example, the law prohibits from discriminating against customers when setting prices. Collusion with other businesses in setting prices is also illegal. Public perception of unfair prices could cause political pressure on legislatures for regulatory relief from high prices. The company’s business image and reputation may rest on their pricing policies. Some businesses sell service with higher prices. Others rely on low prices period. 15-3

Learning Objective 2 Learning Objective 2. Explain and use the economic, profit-maximizing pricing model. 15-4

How Are Prices Set? Market Forces Costs Prices are determined by the market, subject to costs that must be covered in the long run. Costs Market Forces Some businesses are called price takers, which means their products’ prices are determined totally by the market. Some agricultural commodities and precious metals are examples of such products. In most cases, however, firms have some flexibility in setting prices. Prices are based on costs, subject to reactions of customers and competitors. 15-5

Economic Profit-Maximizing Pricing Firms usually have flexibility in setting prices. The quantity sold usually declines as the price is increased. In most cases, however, firms have some flexibility in setting prices. Generally speaking though, as the price of a product or service is increased, the quantity demanded declines, and vice versa. 15-6

Quantity sold per month Total Revenue Curve Dollars Total revenue Curve is increasing throughout its range, but at a declining rate. The trade-off between a higher price and a higher sales quantity can be shown in the shape of the firm’s total revenue curve, which graphs the relationship between total sales revenue and quantity sold. Notice that while the revenue is increasing in total dollars, the demand becomes slower as the quantity sold increases. Quantity sold per month 15-7

Demand Schedule and Marginal Revenue Curve Dollars per unit Sales price must decrease to sell higher quantity. Demand The demand curve shows the relationship between the sales price and the quantity of units demanded. The demand curve decreases throughout its range, because any decrease in the sales price brings about an increase in the monthly sales quantity. The demand curve is also called the average revenue curve, since it shows the average price at which any particular quantity can be sold. The marginal revenue curve shows the change in total revenue that accompanies a change in the quantity sold. The marginal revenue curve is decreasing throughout its range to show that total revenue increases at a declining rate as monthly sales quantity increases. Revenue per unit decreases as quantity increases. Marginal revenue Quantity sold per month 15-8

Total Cost Curve Dollars Total cost increases at an increasing rate. The total cost curve graphs the relationship between total cost and the quantity produced and sold each month. Total cost increases throughout its range, and the rate of increase increases toward the end. Total cost increases at a declining rate. Quantity made per month 15-9

Marginal Cost Curve Dollars per unit Marginal cost Quantity where marginal cost begins to increase. Closely related to the total cost curve is the marginal cost curve. The marginal cost curve shows the change in total cost that accompanies a change in quantity produced and sold. Marginal cost declines as quantity increases from zero to c units; then it increases as quantity increases beyond c units. Quantity made per month 15-10

Determining the Profit-Maximizing Price and Quantity Dollars per unit p* Demand Now we have the tools we need to determine the profit-maximizing price and quantity. In this slide, we combine the revenue and cost data presented in the previous slides. Marginal cost Marginal revenue Quantity made and sold per month q* 15-11

Determining the Profit-Maximizing Price and Quantity Dollars per unit Profit is maximized where marginal cost equals marginal revenue, resulting in price p* and quantity q*. p* Demand The profit-maximizing sales quantity is determined by the intersection of the marginal cost and marginal revenue curves. This optimal quantity is denoted by q star on the graph. The profit-maximizing price, denoted by p star, is determined from the demand curve for the quantity, q star. Marginal cost Marginal revenue Quantity made and sold per month q* 15-12

Determining the Profit-Maximizing Price and Quantity Total cost Dollars Total revenue Total profit at the profit-maximizing quantity and price, q* and p*. Examine the total revenue and total cost curves shown in the slide. At the profit-maximizing quantity and price, the distance between these curves, which is equal to total profit, is maximized. Quantity made and sold per month q* 15-13

The impact of price changes on sales volume 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. The impact of price changes on sales volume is called the price elasticity. Demand is elastic if a price increase has a large negative impact on sales volume, and vice versa. Demand is inelastic if price changes have little or no impact on sales quantity. 15-14

Cross Elasticity The extent to which a change in a product’s price affects the demand for other substitute products. Cross elasticity refers to the extent to which a change in a product’s price affects the demand for other substitute products. 15-15

Limitations of the Profit-Maximizing Model A firm’s 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. The firm’s demand and marginal revenue curves are difficult to discern with precision. Although market research is designed to gather data about product demand, it rarely enables management to predict completely the effects of price changes on the quantity demanded. Many other factors affect product demand in addition to price. Product design and quality, advertising and promotion, and company reputation also significantly influence consumer demand for a product. the marginal-revenue, marginal-cost paradigm is not valid for all forms of market organization. In an oligopolistic market, where a small number of sellers compete among themselves, the simple economic pricing model is no longer appropriate. In an oligopoly, such as the automobile industry, the reactions of competitors to a firm’s pricing policies must be taken into account. While economists have studied oligopolistic pricing, the state of the theory is not sufficient to provide a thorough understanding of the impact of prices on demand. The third limitation of the economic pricing model involves the difficulty of measuring marginal cost. Cost-accounting systems are not designed to measure the marginal changes in cost incurred as production and sales increase unit by unit. To measure marginal costs would entail a very costly information system. Most managers believe that any improvements in pricing decisions made possible by marginal-cost data would not be sufficient to defray the cost of obtaining the information. 15-16

Role of Accounting Product Costs in Pricing Exh. 15-4 Optimal Decisions Suboptimal Decisions Economic pricing model Cost-based pricing Sophisticated decision model and information requirements Simplified decision model and information requirements Marginal-cost and marginal-revenue data Accounting product- cost data Most managers base prices on accounting product costs, at least to some extent. There are several reasons for this. First, most companies sell many products or services. There simply is not time enough to do a thorough demand and marginal-cost analysis for every product or service. Managers must rely on a quick and straightforward method for setting prices, and cost-based pricing formulas provide it. Second, even though market considerations ultimately may determine the final product price, a cost-based pricing formula gives the manager a place to start. Finally, and most importantly, the cost of a product or service provides a floor below which the price cannot be set in the long run. Although a product may be “given away” initially, at a price below cost, a product’s price ultimately must cover its costs in order for the firm to remain in business. Even a nonprofit organization, unless it is heavily subsidized, cannot forever price products or services below their costs. The best approach, in terms of costs and benefits, typically lies between the extremes. More costly Less costly The best approach, in terms of costs and benefits, typically lies between the extremes. 15-17

Learning Objective 3 Learning Objective 3. Set prices using cost-plus pricing formulas. 15-18

Cost-Plus Pricing Price = cost + (markup percentage × cost) Full-absorption manufacturing cost? Variable manufacturing cost? Cost-based pricing formulas typically have the form shown on the slide, cost plus the percentage markup equals the sales price. Managers face the problem of what costs should be used to mark up the product to a sales price. Should they mark up the full absorption cost that GAAP requires? Should they mark up the variable costs of manufacture? Should sales and administrative costs be included in the mark up? Total cost, including selling and administrative? Total variable cost, including selling and administrative? 15-19

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 Here is an example with several different types of costs considered. 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. 15-20

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 Markup on variable manufacturing cost If we marked up the variable costs of manufacturing, the markup percentage is 131.25% in order to achieve the desired sales price of $925. Price = cost + (markup percentage × cost) Price = $400 + (131.25% × $400) = $925 15-21

Cost-Plus Pricing - Example Markup on total var. cost As cost base increases, the required markup percentage declines. 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 If we marked up the total variable costs of manufacturing, the markup percentage is 105.56% in order to achieve a sales price of $925. Price = cost + (markup percentage × cost) Price = $450 + (105.56% × $450) = $925 15-22

Cost-Plus Pricing - Example Markup on full mfg. cost As cost base increases, the required markup percentage declines. 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 If we marked up the full absorption costs of manufacturing, the markup percentage is 42.31% in order to achieve the desired sales price. Price = cost + (markup percentage × cost) Price = $650 + (42.31% × $650) = $925 15-23

Cost-Plus Pricing - Example Markup on total cost As cost base increases, the required markup percentage declines. 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 If we marked up the total cost, the markup percentage is 15.63% to achieve $925. Price = cost + (markup percentage × cost) Price = $800 + (15.63% × $800) = $925 15-24

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. Most companies that use cost-plus pricing use either absorption manufacturing cost or total cost as the basis for pricing products or services. The reasons generally given for this tendency are, in the long run, the price must cover all costs and a normal profit margin. Basing the cost-plus formula on only variable costs could encourage managers to set too low a price in order to boost sales. Absorption-cost or total-cost pricing formulas provide a justifiable price that tends to be perceived as equitable by all parties. Consumers generally understand that a company must make a profit on its product or service in order to remain in business. When a company’s competitors have similar operations and cost structures, cost-plus pricing based on full costs gives management an idea of how competitors may set prices. Absorption-cost information is provided by a firm’s cost-accounting system, because it is required for external financial reporting under generally accepted accounting principles. Since absorption-cost information already exists, it is cost-effective to use it for pricing. The primary disadvantage of absorption-cost or total-cost pricing formulas is that they obscure the cost behavior pattern of the firm. Since absorption-cost and total-cost data include allocated fixed costs, it is not clear from these data how the firm’s total costs will change as volume changes. Another way of stating this criticism is that absorption cost data are not consistent with cost-volume-profit analysis. CVP analysis emphasizes the distinction between fixed and variable costs. This approach enables managers to predict the effects of changes in prices and sales volume on profit. Absorption-cost and total cost information obscures the distinction between variable and fixed costs. 15-25

Variable-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. To avoid blurring the effects of cost behavior on profit, some managers prefer to use cost-plus pricing formulas based on either variable manufacturing costs or total variable costs. Variable-cost data do not obscure the cost behavior pattern by unitizing fixed costs and making them appear variable. Thus, variable-cost information is more consistent with cost-volume-profit analysis often used by managers to see the profit implications of changes in price and volume. Variable-cost data do not require allocation of common fixed costs to individual product lines. Variable-cost data are exactly the type of information managers need when facing certain decisions, such as whether to accept a special order. The primary disadvantage of the variable-cost pricing formula was described earlier. If managers perceive the variable cost of a product or service as the floor for the price, they may tend to set the price too low for the firm to cover its fixed costs. Eventually this can spell disaster. Therefore, if variable-cost data are used as the basis for cost-plus pricing, managers must understand the need for higher markups to ensure that all costs are covered. 15-26

Determining the Markup: Return-on-Investment Pricing Solve for the markup percentage that will yield the desired return on investment. A common approach to determining the profit margin in cost-plus pricing is to base profit on the firm’s target return on investment, or, ROI. 15-27

Determining the Markup: Return-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 In a previous mark up example we had a 131.25% markup on variable costs of manufacturing. We have a desired return of 20% on an investment of $300,000. 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. 15-28

Determining the Markup: Return-on-Investment Pricing Step 1: Solve for the income that will result in an ROI of 20 percent. ROI = Income Invested Capital 20% = Income $300,000 We would need an income of $60,000 to achieve an ROI of 20%. Income = 20% × $300,000 Income = $60,000 15-29

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 Now we calculate the unit sales price. 15-30

Determining the Markup: Return-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 $60,000 480 units We need a unit sales price of $925 to achieve the desired ROI. Unit sales price - $800 unit cost = Unit sales price - $800 unit cost = $125 per unit Unit sales price = $925 15-31

Determining the Markup: Return-on-Investment Pricing Step 3: Compute the markup percentage on the $400 variable manufacturing cost. Markup percentage Unit sales price - Unit variable cost Unit variable cost = Markup percentage $925 per unit - $400 per unit $400 per unit The markup percentage to achieve the desired ROI is 131.25%. = Markup percentage = 131.25 percent 15-32

Learning Objective 4 Learning Objective 4r. Discuss the issues involved in the strategic pricing of new products. 15-33

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. Pricing a new product is an especially challenging decision problem. The newer the concept of the product, the more difficult the pricing decision is. Pricing a new product is harder than pricing a mature product because of the magnitude of the uncertainties involved. New products entail many uncertainties. For example, what obstacles will be encountered in manufacturing the product, and what will the costs of production be? Moreover, after the product is available, will anyone want to buy it, and at what price? In addition to the production and demand uncertainties, new products pose another sort of challenge. There are two widely differing strategies that a manufacturer of a new product can adopt. One strategy is called skimming pricing, in which the initial product price is set high, and short-term profits are reaped on the new product. The initial market will be small, due in part to the high initial price. This pricing approach often is used for unique products, where there are people who “must have it” whatever the price. As the product gains acceptance and its appeal broadens, the price is lowered gradually. Eventually the product is priced in a range that appeals to several kinds of buyers. An example of a product for which skimming pricing was used is the high definition television. Initially High Definition Televisions were priced quite high and were affordable by only a few buyers. Eventually the price was lowered, and HDTVs were purchased by a wide range of consumers. An alternative initial pricing strategy is called penetration pricing, in which the initial price is set relatively low. By setting a low price for a new product, management hopes to penetrate a new market deeply, quickly gaining a large market share. This pricing approach often is used for products that are of good quality, but do not stand out as vastly better than competing products. The decision between skimming and penetration pricing depends on the type of product and involves trade-offs of price versus volume. Skimming pricing results in much slower acceptance of a new product, but higher unit profits. Penetration pricing results in greater initial sales volume, but lower unit profits. 15-34

Learning Objective 5 Learning Objective 4. List and discuss the key principles of target costing. 15-35

Market research determines the price at which a new product will sell. 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. When using target costing, the company first uses market research to determine the price at which a new product can be sold. Given the likely sales price, management computes the cost for which the product must be manufactured in order to provide the firm with an acceptable profit margin. Finally, engineers and cost analysts work together to design a product that can be manufactured for the allowable cost. This process, called target costing, is used widely by companies in the development stages of new products. A new product’s target cost is the projected long-run cost that will enable a firm to enter and remain in the market for the product and compete successfully with the firm’s competitors. Engineers and cost analysts design a product that can be made for the allowable cost. 15-36

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 Key principles of target costing Target costing involves seven key principles. Price-led costing. Target costing sets the target cost by first determining the price at which a product can be sold in the marketplace. Subtracting the target profit margin from this target price yields the target cost, that is, the cost at which the product must be manufactured. Focus on the customer. To be successful at target costing, management must listen to the company’s customers. What products do they want? What features are important? How much are they willing to pay for a certain level of product quality? Management needs to aggressively seek customer feedback, and then products must be designed to satisfy customer demand and be sold at a price they are willing to pay. In short, the target costing approach is market driven. Focus on product design. Design engineering is a key element in target costing. Engineers must design a product from the ground up so that it can be produced at its target cost. This design activity includes specifying the raw materials and components to be used as well as the labor, machinery, and other elements of the production process. In short, a product must be designed for manufacturability. Focus on process design. As indicated in the preceding point, every aspect of the production process must be examined to make sure that the product is produced as efficiently as possible. The use of touch labor, technology, global sourcing in procurement, and every aspect of the production process must be designed with the product’s target cost in mind. Cross-functional teams. Manufacturing a product at or below its target cost requires the involvement of people from many different functions in an organization: market research, sales, design engineering, procurement, production engineering, production scheduling, material handling, and cost management. Individuals from all these diverse areas of expertise can make key contributions to the target costing process. Moreover, a cross-functional team is not a set of specialists who contribute their expertise and then leave; they are responsible for the entire product. Life-cycle costs. In specifying a product’s target cost, analysts must be careful to incorporate all of the product’s life-cycle costs. These include the costs of product planning and concept design, preliminary design, detailed design and testing, production, distribution, and customer service. Traditional cost accounting systems have tended to focus only on the production phase and have not paid enough attention to the product’s other life-cycle costs. Value-chain orientation. Sometimes the projected cost of a new product is above the target cost. Then efforts are made to eliminate non-value-added costs to bring the projected cost down. In some cases, a close look at the company’s entire value chain can help managers identify opportunities for cost reduction. 15-37

Learning Objective 6 Learning Objective 6. Explain the role of activity-based costing in setting a target cost. 15-38

The Role Of Activity-Based Costing In Setting A Target Cost. Production Process An activity-based costing system, ABC, can be particularly helpful as product design engineers try to achieve a product’s target cost. ABC enables designers to break down the production process for a new product into its component activities. Then designers can attempt cost improvement in particular activities to bring a new product’s projected cost in line with its target cost. Component Activities 15-39

Learning Objective 7 Learning Objective 7. Explain how product-cost distortion can undermine a firm’s pricing strategy. 15-40

Product Cost Distortion High-volume products May be overcosted Low-volume products May be undercosted Use of a traditional, volume-based product-costing system may result in significant cost distortion among product lines. In many cases, high-volume and relatively simple products are overcosted while low-volume and complex products are undercosted. This results from the fact that high-volume and relatively simple products require proportionately less activity per unit for various manufacturing-support activities than do low-volume and complex products. Yet a traditional product-costing system, in which all overhead is assigned on the basis of a single unit-level activity like direct-labor hours, fails to capture the cost implications of product diversity. In contrast, an activity-based costing (ABC) system does measure the extent to which each product line drives costs in the key production-support activities. Managers should be aware that cost distortion can result in overpricing high volume and relatively simple products, while low-volume and complex products are undercosted. This can undermine any effort to set prices competitively, even under the target-costing approach. The competitive implications of such strategic pricing errors can be disastrous. 15-41

Learning Objective 8 Learning Objective 8. Explain the process of value engineering and its role in target costing. 15-42

Value Engineering and Target Costing Target cost information Product design Product costs Production processes Target costing is an outgrowth of the concept of value engineering, which is a cost reduction and process-improvement technique that utilizes information collected about a product’s design and production processes and then examines various attributes of the design and processes to identify candidates for improvement efforts. Three different stages of VE—zeroth, first, and second ‘looks’ are used in the design phase to increase the functionality of new products. Zeroth look VE is applied at the earliest stages of new product design—the concept proposal stage, when the basic concept of the product is developed and its preliminary quality, cost, and investment targets are established. First look VE is applied during the last half of the concept proposal stage and throughout the product planning phase. During this stage, a product’s quality, functionality, and selling price are determined; a design plan is submitted; and target costs are determined for each of the new vehicle’s major functions . Also, the degree of component commonality is set. First look VE is used at this stage to increase the value of the product by increasing its functionality without increasing its cost. Second look VE is applied during the last half of the product planning stage and the first half of the product development and preparation stage. The components of the vehicle’s major functions are identified, and hand-made prototypes are assembled. At this stage, VE works to improve the value and functionality of existing components, not to create new ones. Value Engineering (VE) Cost reduction Design improvement Process improvement 15-43

Learning Objective 9 Learning Objective 9. Determine prices using the time and material pricing approach. 15-44

Time and Material Pricing Price is the sum of labor and material charges. Used by construction companies, printers, and professional service firms. Another cost-based approach to pricing is called time and material pricing. Under this approach, the company determines one charge for the labor used on a job and another charge for the materials. The labor typically includes the direct cost of the employee’s time and a charge to cover various overhead costs. The material charge generally includes the direct cost of the materials used in a job plus a charge for material handling and storage. Time and material pricing is used widely by construction companies, printers, repair shops, and professional firms, such as engineering, law, and public accounting firms. 15-45

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 × Time charges are calculated by taking the hourly labor cost adding overhead per hour and a profit margin, then multiplying by the total labor hours used. Material charges take the total material cost and adding it to the overhead per dollar of material coat times the material cost incurred. 15-46

Learning Objective 10 Learning Objective 10. Set prices in special-order or competitive-bidding situations by analyzing the relevant costs. 15-47

Competitive Bidding High bid price Low bid price Low probability of winning bid High profit if winning bid In a competitive bidding situation, two or more companies submit sealed bids for a project, service, or product to a potential buyer. The buyer selects one of the companies for the job on the basis of the bid price and the design specifications for the job. Competitive bidding complicates a manager’s pricing problem, because now the manager is in direct competition with one or more competitors. If all of the companies submitting bids offer a roughly equivalent product or service, the bid price becomes the sole criterion for selecting the contractor. The higher the price that is bid, the greater will be the profit on the job, if the firm gets the contract. However, a higher price also lowers the probability of obtaining the contract to perform the job. Thus, there is a trade-off between bidding high, to make a good profit, and bidding low, to land the contract. Some say there is a “winner’s curse” in competitive bidding, meaning that the company bidding low enough to beat out its competitors probably bid too low to make an acceptable profit on the job. Despite the winner’s curse, competitive bidding is a common form of selecting contractors in many types of business. Low bid price High probability of winning bid Low profit if winning bid 15-48

Guidelines for Bidding Competitive Bidding Guidelines for Bidding Low bid price Any bid price in excess of incremental costs of job will contribute to fixed costs and profit. Bidder has excess capacity If a firm has been operating well below capacity, the job would not preclude the firm from taking on other work, so it would not entail an opportunity cost. And also, the job might be good advertising. A price that just covers the firm’s variable costs and allows for a modest contribution margin would be appropriate. If management expects to have enough work to fully occupy the division, a different approach is appropriate in setting the bid price. The fixed costs of the division are capacity-producing costs, which are costs incurred in order to create productive capacity. Depreciation of buildings and equipment, supervisory salaries, insurance, and property taxes are examples of fixed costs incurred to give a company the capacity to carry on its operations. When such costs are allocated to individual jobs, the cost of each job reflects an estimate of the opportunity cost of using limited capacity to do that particular job. For this reasoning to be valid, however, the organization must be at full capacity. If there is excess capacity, there is no opportunity cost in using that excess capacity. High bid price Bid price should be full cost plus normal profit margin as winning bid will displace existing work. Bidder has no excess capacity 15-49

Learning Objective 11 Learning Objective 11. Describe the legal restrictions on setting prices. 15-50

Legal Restrictions On Setting Prices Price discrimination Predatory pricing Companies are not free to set any price they wish for their products or services. U.S. antitrust laws, including the Robinson-Patman Act, the Clayton Act, and the Sherman Act, restrict certain types of pricing behavior. These laws prohibit price discrimination, which means quoting different prices to different customers for the same product or service. Such price differences are unlawful unless they can be clearly justified by differences in the costs incurred to produce, sell, or deliver the product or service. Managers should keep careful records justifying such cost differences when they exist, because the records may be vital to a legal defense if price differences are challenged in court. Another pricing practice prohibited by law is predatory pricing. This practice involves temporarily cutting a price to broaden demand for a product with the intention of later restricting the supply and raising the price again. In determining whether a price is predatory, the courts examine a business’s cost records. If the product is sold below cost, the pricing is deemed to be predatory. The laws and court cases are ambiguous as to the appropriate definition of cost. However, various court decisions make it harder to prove predatory pricing. Nevertheless, this is one area where a price-setting decision maker is well advised to have an accountant on the left and a lawyer on the right before setting prices that could be deemed predatory. 15-51

End of Chapter 15 What is the right price? Problem 15-41 Problem 15-39 The price of admission to this chapter has expired. 15-52