1. The Role of Costs in Pricing Decisions
Chapter 10
The Role of Costs in Pricing Decisions

2. Questions About Using Costs
1. Whose costs?
Customers/users (value analysis)
Competitors’ (competitive analysis)
Producer’s/seller’s
Suppliers’ (value analysis)
2. Which costs are relevant to the decision?
3. What is the role of costs in pricing?

3. Role Of Costs In Pricing
Cost is probably the least important of the considerations in … setting product prices … Costs cannot be ignored in … pricing. Distribution [and Marketing] costs are of the same importance … as are production or acquisition costs. The common practice of adding a percentage (usually of manufacturing cost to cover selling and administrative expense is a wholly inadequate recognition of this fact.
From: Handbook of Modern Accounting.
2nd Edition, McGraw-Hill, 1977, p

4. Understanding Customers’ Costs
1. What costs incurred by customers are caused by their requirements?
2. What costs do the customers actually incur?
3. How does the seller affect those customers’ costs?
4. How do competitors affect customers’ costs?
Costs must be understood not only in an accounting sense but in an activity sense.

5. Cost Concepts
It is important to clarify what is meant by direct and indirect:
Directly traceable or attributable costs can be readily determined as contributing to the product or service’s cost (test of separability).
Indirect traceable costs can be objectively traced to a segment if the costs can be identified with that segment or product.
Managers need to exert the will to understand how costs are incurred and how they behave as activity levels change in their organizations.

6. Cost Concepts
Common costs support a number of activities or profit segments and cannot be objectively traced to a product or segment based on a direct physical relationship to that product or segment
Opportunity costs reflect the “cost” of not choosing the best alternative or opportunity

7. Cost Concepts
Cash costs can lead to cash (or out-of-pocket) outlays or bookkeeping (depreciation or amortization) entries
Noncash costs do impact the cash flows but do not reflect actual monetary outlays in a particular accounting period

8. Cost Behavior How do costs vary with changes in activity rate?
For what reason (i.e., product, segment, customer, … ) are these costs incurred?
DIRECT VARIABLE COSTS:
Vary directly with activity level;
the major criterion of a direct variable cost is that it be traceably and tangibly generated by, and identified with a particular activity.
E.g., raw materials, sales expenses, utilities.

9. Cost Behavior How do costs vary with changes in activity rate?
For what reason (i.e., product, segment, customer, … ) are these costs incurred?
SEMIVARIABLE COSTS:
Costs that vary with activity rates, but are not zero at a zero activity rate. These costs consist of a base amount that is constant in relation to activity and a variable amount that varies directly with activity.
E. g., data processing, supplies, maintenance.

10. Cost Behavior How do costs vary with changes in activity rate?
For what reason (i.e., product, segment, customer, … ) are these costs incurred?
PERIOD FIXED COSTS:
These costs do not vary with activity. They remain fixed over a period of time due to previous decisions. Some fixed costs may be traceable to specific activities by reasonable objective means. Other fixed costs are general and not easily traceable to an activity.

11. Cost Behavior PERIOD FIXED COSTS:
Specific programmed costs are those costs used to generate additional revenues and can be charged to the product line or activity that is recipient of the incurred cost
General programmed costs are those that are incurred for the entire company and are common to the various products or activities
Constant costs are common and are incurred as long as the firm is in business and cannot be traced to a particular service or product

12. The Issue of Recovering Costs
Costs incurred solely for and because of a particular business segment should be recovered… but should indirect and common period costs be recovered?
The determination of the contribution each product or service should make to the recovery of indirect period costs is a managerial decision, and should not be determined by an inflexible and arbitrary allocation rule

13. Full-Cost Method of Pricing
A percentage of variable costs is added to the average variable costs to determine selling price
Why do sellers resort to this pricing method?
They do not know consumer preferences
They do not know how rival sellers will react to price changes
They do not know the degree to which demand is sensitive to price changes
There is a belief that prices ought to equal full cost

14. The Nature of Overhead
Overhead is that portion of period costs that cannot be objectively traced to particular operations, products, or other profit segments
Overhead distribution involves assigning overhead costs to individual units within a profit segment

15. Profitability Analysis
Elements of profitability:
Price per unit (P).
Volume (units) sold per period (Q).
Costs.
Variable per unit (or activity) (VC).
Fixed per period (FC).
Monetary sales mix - The relative mix of revenues received across multiple product or service offerings.

16. Breakeven Concept

17. Breakeven Formulas Breakeven quantity:
where BEQ = break-even sales quantity
FC = fixed costs
P = selling price
VC = variable costs

18. Breakeven Formulas Breakeven sales revenue
where BES = break-even sales revenue
FC = fixed costs
PV = Profit-Volume Ratio:

19. Break-Even Analysis
A change in fixed costs affects only the break-even point
A change in the price and/or variable costs affects both the break-even point and the PV
An increase in prices and/or decrease in variable costs can offset an increase in fixed expenses (assuming volume remains unaffected)

20. Break-Even Analysis Profit = (sales revenues PV) – fixed costs
Two products can have identical break-even points but will still earn profits or losses at their own PV rate
Above or below the identical break-even points, the ratio of two products’ profits or losses will be proportionate to the rate of their PV rates
Above or below the break-even point, profits or losses are generated by the PV rate

21. Break-Even Analysis
When the objective is to determine a price for a target PV, divide the appropriate variable costs by the complement of the target PV
PV = target profit + fixed expenses
sales revenues
Price = variable costs
1-PV

22. Limitations of Break-Even Analysis
The assumption that variable costs remain proportional to volume at all output levels
The assumption that price is constant over relevant volume levels
Costs used the in the analysis may be relevant over a limited range of volume