1. Target Costing and Cost Analysis for Pricing Decisions
Chapter 15
Target Costing and Cost Analysis for Pricing Decisions

2. Learning Objective 1

3. Major Influences on Pricing Decisions
Political, legal, and image issues
Competitors
Costs
Customer demand
Pricing Decisions

4. Learning Objective 2

5. 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
Prices are based on costs, subject to reactions of customers and competitors.

6. Economic Profit-Maximizing Pricing
Firms usually have flexibility in setting prices.
The quantity sold usually declines as the price is increased.

7. Quantity sold per month
Total Revenue Curve
Dollars
Total revenue
Curve is increasing throughout its range, but at a declining rate.
Quantity sold per month

8. Demand Schedule and Marginal Revenue Curve
Dollars per unit
Sales price must decrease to sell higher quantity.
Demand
Revenue per unit decreases as quantity increases.
Marginal revenue
Quantity sold per month

9. Total Cost Curve Dollars Total cost increases at an increasing rate.
Total cost increases at a declining rate.
Quantity made per month

10. Marginal Cost Curve Dollars per unit Marginal cost
Quantity where marginal cost begins to increase.
Quantity made per month

11. Determining the Profit-Maximizing Price and Quantity
Dollars per unit p*
Demand
Marginal cost
Marginal revenue
Quantity made and sold per month q*

12. 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
Marginal cost
Marginal revenue
Quantity made and sold per month q*

13. Determining the Profit-Maximizing Price and Quantity
Total cost
Dollars
Total revenue
Total profit at the profit-maximizing quantity and price, q* and p*.
Quantity made and sold per month q*

14. 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.

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

16. 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.

17. 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
More costly
Less costly
The best approach, in terms of costs and benefits, typically lies between the extremes.

18. Learning Objective 3

19. Cost-Plus Pricing Price = cost + (markup percentage × cost)
Full-absorption manufacturing cost?
Variable manufacturing cost?
Total cost, including selling and administrative?
Total variable cost, including selling and administrative?

20. Cost-Plus Pricing - Example
Variable mfg. cost $ 400
Fixed mfg. cost
Full-absorption mfg. cost $ 650
Variable S & A cost
Fixed S & A cost
Total cost $ 800
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.

21. Cost-Plus Pricing - Example
Variable mfg. cost $ 400
Fixed mfg. cost
Full-absorption mfg. cost $ 650
Variable S & A cost
Fixed S & A cost
Total cost $ 800
Markup on variable manufacturing cost
Price = cost + (markup percentage × cost)
Price = $ (131.25% × $400) = $925

22. 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
Full-absorption mfg. cost $ 650
Variable S & A cost
Fixed S & A cost
Total cost $ 800
Price = cost + (markup percentage × cost)
Price = $ (105.56% × $450) = $925

23. 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
Full-absorption mfg. cost $ 650
Variable S & A cost
Fixed S & A cost
Total cost $ 800
Price = cost + (markup percentage × cost)
Price = $ (42.31% × $650) = $925

24. Cost-Plus Pricing - Example
Markup on total cost
As cost base increases, the required markup percentage declines.
Variable mfg. cost $ 400
Fixed mfg. cost
Full-absorption mfg. cost $ 650
Variable S & A cost
Fixed S & A cost
Total cost $ 800
Price = cost + (markup percentage × cost)
Price = $ (15.63% × $800) = $925

25. 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.

26. 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.

27. Determining the Markup: Return-on-Investment Pricing
Solve for the markup percentage that will yield the desired return on investment.

28. Determining the Markup: Return-on-Investment Pricing
Recall the example using a percent markup on variable manufacturing cost.
Price = cost + (markup percentage × cost)
Price = $ (131.25% × $400) = $925
Let’s solve for the percent markup. Invested capital is $300,000, the desired ROI is 20 percent, and annual sales volume is 480 units.

29. 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
Income = 20% × $300,000
Income = $60,000

30. 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
Full-absorption mfg. cost $ 650
Variable S & A cost
Fixed S & A cost
Total cost $ 800

31. 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, units
Unit sales price - $800 unit cost =
Unit sales price - $800 unit cost = $125 per unit
Unit sales price = $925

32. 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 =
Markup percentage
= percent

33. Learning Objective 4

34. 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.

35. Learning Objective 5

36. 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.
Engineers and cost analysts design a product that can be made for the allowable cost.

37. 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

38. Learning Objective 6

39. The Role Of Activity-Based
Costing In Setting A
Target Cost.
Production Process
Component Activities

40. Learning Objective 7

41. Product Cost Distortion
High-volume products
May be overcosted
Low-volume products
May be undercosted

42. Learning Objective 8

43. Value Engineering and Target Costing
Target cost information
Product design
Product costs
Production processes
Value Engineering (VE)
Cost reduction
Design improvement
Process improvement

44. Learning Objective 9

45. Time and Material Pricing
Price is the sum of labor and material charges.
Used by construction companies, printers, and professional service firms.

46. 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 ×

47. Learning Objective 10

48. Competitive Bidding High bid price Low bid price
Low probability of winning bid
High profit if winning bid
Low bid price
High probability of winning bid
Low profit if winning bid

49. 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
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

50. Learning Objective 11

51. Legal Restrictions On Setting Prices
Price discrimination
Predatory pricing

52. End of Chapter 15
What is the right price?