© John Wiley & Sons, 2011 Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e Slide # 1 Cost Management Measuring, Monitoring, and Motivating Performance Chapter 13 Strategic Pricing and Cost Management

© John Wiley & Sons, 2011Slide # 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? Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

© John Wiley & Sons, 2011Slide # 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. Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

© John Wiley & Sons, 2011Slide # 4 Q1: Manufacturing Value Chain Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

© John Wiley & Sons, 2011Slide # 5 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. Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

© John Wiley & Sons, 2011Slide # 6 Q1: Target Costing Design Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

© John Wiley & Sons, 2011Slide # 7 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. Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

© John Wiley & Sons, 2011Slide # 8 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 Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

© John Wiley & Sons, 2011Slide # 9 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? Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

© John Wiley & Sons, 2011Slide # 10 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. Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

© John Wiley & Sons, 2011Slide # 11 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. Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

Set of accounting principles and methods that support lean business practices Combines value chain analysis, cellular manufacturing, JIT inventory, activity based management, and target & kaizen costing Value stream analysis analyzes business processes to identify the cost of individual value- added activities –Establishes cellular manufacturing sytems –Utilizes kanban (demand-pull) systems –Allows for low inventory levels © John Wiley & Sons, 2011Slide # 12 Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e Q5: Lean Accounting

Takt time – maximum time available to produce each unit Day-by-the-Hour – compares units demanded compared to units produced First Time Through (FTT) – percent of units which are produced correctly the first time (before rework) WIP to SWIP – measures actual level of WIP inventory relative to standard levels Operational Equipment Effectiveness (OEE) – measured primarily for bottleneck machines © John Wiley & Sons, 2011Slide # 13 Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e Q5: Lean Accounting Performance Measurements

Sigma Industries produces metal detection devices. Customer demand for the third quarter of 2011 (13 weeks) is expected to be 11,960 devices. Sigma produces metal detection devices five days a week in two manufacturing cells. Employees build devices 8 hours per day. © John Wiley & Sons, 2011Slide # 14 Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e Q5: Lean Accounting Measurements Example 1. Calculate the takt time. 11,960 devices = 184 devices per day / 2 cells = 92 devices per cell per day 65 daysor 11.5 devices per hour (13 weeks * 5days/week) Day-by-the-Hour results – negative variance of 0.5 devices First Time Through – 11 devices less 2 rework devices = 9 good devices then, 9 good devices / 11 devices = 81.2% FTT 2. After one hour, one cell produced 11 devices with 2 requiring rework. Calculate the Day-by-the-Hour variance and the FTT rate 3. If the FTT goal was 90%, what conclusions can you make about the manufacturing cell for the first hour of the day?

Should not be used solely to evaluate manager or employee performance Instead lean accounting measurements should be used as –Diagnostic controls to identify & correct out-of-control situations –Interactive controls to drive continuous improvement Can be applied to manufacturing and non- manufacturing environments © John Wiley & Sons, 2011Slide # 15 Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e Q5: Uses of Lean Accounting Measurements

© John Wiley & Sons, 2011Slide # 16 Q6: 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. Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

© John Wiley & Sons, 2011Slide # 17 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. Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

© John Wiley & Sons, 2011Slide # 18 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. Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

© John Wiley & Sons, 2011Slide # 19 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 Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

© John Wiley & Sons, 2011Slide # 20 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 Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

© John Wiley & Sons, 2011Slide # 21 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 Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

© John Wiley & Sons, 2011Slide # 22 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. Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

© John Wiley & Sons, 2011Slide # 23 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 Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

© John Wiley & Sons, 2011Slide # 24 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. Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

© John Wiley & Sons, 2011Slide # 25 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). Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e

© John Wiley & Sons, 2011Slide # 26 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. Chapter 13: Strategic Pricing and Cost Management Eldenburg & Wolcott’s Cost Management, 2e