© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 1 Cost Management Measuring, Monitoring, and Motivating Performance Prepared by Gail Kaciuba Midwestern State University Chapter 13 Joint Management of Revenues and Costs

© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 2 Chapter 13: Joint Management of Revenues and Costs Learning objectives Q1: How is value chain analysis used to improve operations? Q2: What is target costing and how is it performed? Q3: What is kaizen costing and how does it compare to target costing? Q4: What is life cycle costing? Q5: How are cost-based prices established? Q6: How are market-based prices established? Q7: What are the uses and limitations of cost-based and market- based pricing? Q8: What additional factors affect prices?

© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 3 Q1: Value Chain Analysis The value chain is the series of sequential business processes an organization completes in order to deliver goods and services to customers. To manage costs, companies analyze the activities in the value chain. Non-value-added activities are those that can be reduced or eliminated without affecting the value of the goods to the customer. Value-added activities are necessary activities and support the value of the goods to the customer.

© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 4 Q2: Target Costing In competitive markets, companies may have no control over selling prices. – Target cost Selling price = Required profit margin The selling price is used to back into the target cost of the product. The company’s only method to manage profits, then, is to manage costs.

© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 5 Q2: Target Costing Target costing takes place before the decision to produce the product is final. It is most likely to be successful when: production and design processes are complex, relationships with suppliers are flexible, and potential customers may be willing to pay for product attributes that will differentiate the product from the competition.

© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 6 Q2: Target Costing Example Ted’s Trailers is considering the design, production, and distribution of a new motorcycle trailer. The selling price of similar trailers is $1,200. Ted believes he can sell 10,000 trailers at this price, and he demands a margin of 25% of selling price on all products. Compute the target cost of the trailers. Target cost = $1,200 – ($1,200 x 25%) = $900

© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 7 Q2: Target Costing Example The estimated production costs for the new trailer are shown below. Discuss the types of issues that Ted should investigate as he seeks to reduce these estimated costs to meet the target cost. Can the product be redesigned so that the quantity of materials and/or labor can be reduced? Can the purchase price of any of the ma- terials be re-negotiated with the supplier(s)? Can the production process be redesigned so that the quantity of materials and/or labor can be reduced? Can the design of the product be changed to incorporate features that the customer would be willing to pay for? Can variable selling expenses, for example, commissions, be reduced on this new product? Can more than 10,000 units be produced and sold so that the allocation of fixed costs per unit decreases?

© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 8 Q3: Kaizen Costing In kaizen costing, explicit cost reductions are planned over time. Kaizen costing takes place after the production process has begun. Kaizen costing is a continuous improvement process that takes place over a longer planning horizon than target costing.

© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 9 Q4: Life Cycle Costing Life cycle costing takes the product’s selling prices and costs over its entire life cycle into consideration. It is useful in industries with products that are expected to produce losses when first introduced, but rapid technological changes and increased volume are expected in future years. Initial production and process design costs will be viewed as costs to be matched against the revenues generated over the product’s entire life.

© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 10 Q5: Cost-Based Pricing A selling price that is computed as the product’s cost plus a markup is known as a cost-based price. The costs included in the base cost can be variable costs only or variable plus fixed costs. Some companies include only production costs in the cost base and others include production, selling, and administrative costs.

© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 11 Q6: Market-Based Pricing A product’s selling price depends on the degree of competition and the degree to which the company’s product is differentiated from competitor’s products. Market-based prices are based on customer demand for the product. The sensitivity of customer demand to changes in the selling price is called the price elasticity of demand.

© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 12 Q6: Market-Based Pricing An increase in selling price should decrease customer demand for the product so that fewer units are sold. When the decrease in units sales offsets the increased selling price, the price increase causes total revenue to decrease. This is known as elastic demand. When the decrease in units sales does not offset the increased selling price, the price increase causes total revenue to increase. This is known as inelastic demand.

© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 13 Q6: Market-Based Pricing Elastic demand: Total Revenue = Selling price x Quantity of units sold Inelastic demand: Total Revenue = Selling price x Quantity of units sold

© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 14 Q6: Price Elasticity of Demand The price elasticity of demand is calculated as follows: Price elasticity of demand = ln(1 + % change in quantity sold) ln(1 + % change in price) This elasticity can be used to compute the profit-maximizing price: = Profit- maximizing price Elasticity Elasticity +1 x Variable cost

© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 15 Q6: Market-Based Pricing Example Ted’s Trailers sells horse trailers in a competitive market. The variable costs of producing the one-horse trailer are $850 per unit. Information from prior years’ indicates that a 10% increase in the trailer’s selling price results in a 15% decrease in customer demand. Calculate the price elasticity of demand and the profit-maximizing price for the one-horse trailer. Price elasticity of demand = ln( ) ln( ) = = = Profit- maximizing price x $850 = $2,055

© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 16 Q7: Uses & Limitations of Cost-Based Pricing Cost-based pricing is inappropriate in highly competitive markets. If products are priced based on allocated fixed costs, and the price is too high for the market, the quantity sold will decrease. This decrease in sales will cause an increase in the fixed costs allocated to each unit. The increase in allocated fixed costs will cause even higher prices and unit sales will decline even further. This is known as the death spiral.

© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 17 Q7: Uses & Limitations of Cost-Based Pricing Cost-based pricing is best used when a company produces highly customized products. However, there can still be problems in these instances. If the determined price is too high the customer will not buy the customized product. The determined price may be lower than the customer would have paid

© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 18 Q8: Other Factors that Affect Pricing In peak-load pricing, companies charge higher prices when they are at higher capacities. When companies set high prices for newly- introduced products, and gradually lower prices to entice customers who would not have purchased at the higher price, this is known as price skimming. When prices are set unusually high to take advantage of specific situations, this is known as price gouging.

© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 19 Q8: Other Factors that Affect Pricing Under penetration pricing, companies charge lower prices for newly introduced products. When this is done to decrease consumer uncertainty about the new product it is legal. When this is done with the intent to eliminate all competition, it is illegal and is known as predatory pricing. Companies set prices for the interdepart- mental transfer of goods and services known as transfer prices (chapter 15).

© John Wiley & Sons, 2005 Chapter 13: Joint Management of Revenues and Costs Eldenburg & Wolcott’s Cost Management, 1eSlide # 20 Q8: Other Factors that Affect Pricing When for-profit companies charge different prices to different customers and it is not based on differential costs, this is illegal and is known as price discrimination. Not-for-profit companies can legally charge different prices to customers based on their ability to pay. Collusive pricing, where competitors get together to determine prices, is not legal. Foreign-based companies selling products at prices lower than in the home country is known as dumping.