Transcript Hilton 5th Edition Chapter Fifteen

Chapter 15
Target Costing and
Cost Analysis for
Pricing Decisions
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning
Objective
1
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Major Influences on
Pricing Decisions
Customer
demand
Political, legal,
and image issues
Pricing
Decisions
Competitors
Costs
15-3
Learning
Objective
2
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
How Are Prices Set?
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.
15-5
Economic Profit-Maximizing
Pricing
Firms usually have flexibility in setting prices.
The quantity sold usually
declines as the price is increased.
15-6
Total Revenue Curve
Dollars
Total revenue
Curve is increasing throughout
its range, but at a declining rate.
Quantity sold
per month
15-7
Demand Schedule and Marginal
Revenue
Curve
Dollars
per unit
Sales price must decrease
to sell higher quantity.
Demand
Revenue per
Marginal
unit decreases
revenue
as quantity increases.
Quantity sold
per month
15-8
Total Cost Curve
Dollars
Total cost increases
at an increasing rate.
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.
Quantity made
per month
15-10
Determining the Profit-Maximizing
Price and Quantity
Dollars
per unit
p*
Demand
Marginal
cost
q*
Marginal Quantity made
revenue
and sold
per month
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
Marginal
cost
q*
Marginal Quantity made
revenue
and sold
per month
15-12
Determining the Profit-Maximizing
Price and Quantity
Total cost
Total revenue
Dollars
Total profit at the
profit-maximizing
quantity and price,
q* and p*.
q*
Quantity made
and sold
per month
15-13
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.
15-14
Cross Elasticity
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.
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
Accounting productmarginal-revenue data
cost data
More costly
Less costly
The best approach, in terms of costs and
benefits, typically lies between the extremes.
15-17
Learning
Objective
3
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
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?
15-19
Cost-Plus Pricing - Example
Variable mfg. cost
Fixed mfg. cost
Full-absorption mfg. cost
Variable S & A cost
Fixed S & A cost
Total cost
$ 400
250
$ 650
50
100
$ 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.
15-20
Cost-Plus Pricing - Example
Variable mfg. cost
Fixed mfg. cost
Full-absorption mfg. cost
Variable S & A cost
Fixed S & A cost
Total cost
$ 400
250
$ 650
50
100
$ 800
Markup on
variable
manufacturing
cost
Price = cost + (markup percentage × cost)
Price = $400 + (131.25% × $400) = $925
15-21
Cost-Plus Pricing - Example
Variable mfg. cost
Fixed mfg. cost
Full-absorption mfg. cost
Variable S & A cost
Fixed S & A cost
Total cost
$ 400
250
$ 650
50
100
$ 800
Markup on
total var. cost
As cost base
increases, the
required markup
percentage
declines.
Price = cost + (markup percentage × cost)
Price = $450 + (105.56% × $450) = $925
15-22
Cost-Plus Pricing - Example
Variable mfg. cost
Fixed mfg. cost
Full-absorption mfg. cost
Variable S & A cost
Fixed S & A cost
Total cost
$ 400
250
$ 650
50
100
$ 800
Markup on
full mfg. cost
As cost base
increases, the
required markup
percentage
declines.
Price = cost + (markup percentage × cost)
Price = $650 + (42.31% × $650) = $925
15-23
Cost-Plus Pricing - Example
Variable mfg. cost
Fixed mfg. cost
Full-absorption mfg. cost
Variable S & A cost
Fixed S & A cost
Total cost
$ 400
250
$ 650
50
100
$ 800
Markup on
total cost
As cost base
increases, the
required markup
percentage
declines.
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.
Disadvantages
Full-absorption unit
price obscures the
distinction between
variable and fixed
costs.
Absorption cost used
for external reporting.
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.
15-26
Determining the Markup:
Return-on-Investment Pricing
Solve for the
markup
percentage that
will yield the
desired return on
investment.
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
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.
Income
ROI =
Invested Capital
Income
20% =
$300,000
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
Fixed mfg. cost
Full-absorption mfg. cost
Variable S & A cost
Fixed S & A cost
Total cost
$ 400
250
$ 650
50
100
$ 800
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
Unit sales price - $800 unit cost =
480 units
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
Markup
percentage
= 131.25 percent
15-32
Learning
Objective
4
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
15-34
Learning
Objective
5
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
15-36
Target Costing
Price led
costing
Life-cycle
costs
Focus on
process
design
Cross-functional
teams
Key
principles
of target
costing
Focus
on the
customer
Value-chain
orientation
Focus on
product
design
15-37
Learning
Objective
6
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
The Role Of Activity-Based
Costing In Setting A
Target Cost.
Production Process
Component Activities
15-39
Learning
Objective
7
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Product Cost Distortion
High-volume products
May be overcosted
Low-volume products
May be undercosted
15-41
Learning
Objective
8
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Value Engineering
and Target Costing
Target cost information
 Product design
 Product costs
 Production processes
Value Engineering (VE)
 Cost reduction
 Design improvement
 Process improvement
15-43
Learning
Objective
9
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Time and Material Pricing
• Price is the sum of
labor and material
charges.
• Used by
construction
companies,
printers, and
professional
service 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
×
Total
material
cost
incurred
15-46
Learning
Objective
10
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Competitive Bidding
Low probability
of winning bid
High bid
price
High profit if
winning bid
High probability
of winning bid
Low bid
price
Low profit if
winning bid
15-48
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
15-49
Learning
Objective
11
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Legal Restrictions On Setting Prices
• Price discrimination
• Predatory pricing
15-51
End of Chapter 15
What is the
right price?
15-52