7- 1 2001 prentice hall business publishing management accounting, 3/e, atkinson, banker, kaplan,...

7- 1 2001 Prentice Hall Business Publishing Management Accounting, 3/E, Atkinson, Banker, Kaplan, and Young

Cost Information for Pricing and Product Planning

Chapter 7


Introduction

Wendy Stone, the owner of High Performance Springs, was meeting with her marketing manager and her controller.

They were evaluating an offer from Lawson Corporation to purchase a large quantity of springs at $2.48 per pound.


Introduction

The accounting records show that the full cost of the spring is $2.79 per pound.

This cost includes $1.38 of direct materials, $0.76 of direct labor, and $0.65 of manufacturing support costs.

Should High Performance Springs accept this offer?

After reading this chapter, you will be able to...


Learning Objectives

1 Discuss the way a firm chooses its product mix in the short term in response to prices set in the market for its products.

2 Explain the way a firm adjusts its prices in the short term depending on whether capacity is limited.


Learning Objectives

3 Discuss the way a firm determines a long-term benchmark price to guide its pricing strategy.

4 Explain the way a firm evaluates the long-term profitability of its products and market segments.


Learning Objective 1

Discuss the way a firm chooses its product mix in the short term in response to prices set in the market

for its products.


Role of Product Costs in Pricing and Product-Mix Decisions

An understanding of product costs enables managers to make informed decisions related to:

– prices– discounts– utilization of capacity– product mix– deployment of marketing resources


Short- and Long-Term Pricing Considerations

Managers must consider both the short-term and long-term consequences of their decisions.

In the short run, resources committed to activities are likely to be fixed costs.

For short-term decisions, it is also important to consider the availability of capacity.



In the long term, managers have more flexibility to adjust capacity resources to meet demand.

Decisions about whether to introduce new products or eliminate existing products have long-term consequences.



What is a price taker? It is a firm that has little or no influence on

the industry supply and demand forces. It chooses its product mix given the prices

set in the marketplace for its products.



What is a price setter? It is a firm that sets or bids the prices of

its products. It enjoys a significant market share in its

industry segment.


Classification of Pricing and Product-Mix Decisions

DecisionType

Price-TakerFirm

Price-SetterFirm

Short-termdecisions

Long-termdecisions

1 2

4 3


Short-Term Product-Mix Decisions – Price Takers

DecisionType

Price-TakerFirm

Short-termdecisions 1



A firm with a very small market share has little influence over industry supply, demand, and prices.

If the firm charges higher prices, customers go elsewhere.

If it charges lower prices, large firms could engage in a price war.



A price taker should produce and sell as many products as possible as long as costs are less than prices.

What are two important considerations?1 Managers must decide which costs are

relevant.2 Managers may not have much flexibility

to alter the capacities of some of the firm’s resources.



Consider Texmax, a small company in Mexico.

It sells ready-made garments to discount stores in the United States.

Garment type Budgeted productionShirts 12,000Dresses 5,000Skirts 10,000

Blouses 15,000Total 42,000



Production is limited by 19,800 machine hours.Garment Total Hours

Type Hours Production RequiredShirts 0.4 12,000 4,800

Dresses 0.8 5,000 4,000

Skirts 0.5 10,000 5,000

Blouses 0.4 15,000 6,000

Totals 42,000 19,800



Assume the following selling prices and variable costs:

Shirts selling price per unit is $5.00 and variable costs are $4.00.

What is the contribution margin per unit? $1.00



Dresses selling price per unit is $15.20 and variable costs are $10.40.

What is the contribution margin per unit? $4.80 Skirts selling price per unit is $9.00 and

variable costs are $6.80. What is the contribution margin per unit? $2.20



Blouses selling price per unit is $8.00 and variable costs are $4.40.

What is the contribution margin per unit? $3.60 Assume that, in addition to the originally

budgeted amount, another 2,000 blouses could be produced and sold at the existing price.



Should Texmax produce and sell these additional blouses?

Yes, because blouses have the highest contribution margin per machine hour.

– Shirts: $1.00 ÷ 0.4 = $2.50– Dresses: $4.80 ÷ 0.8 = $6.00– Skirts: $2.20 ÷ 0.5 = $4.40– Blouses: $3.60 ÷ 0.4 = $9.00



The contribution margin per unit of the constrained resource is the criterion used to decide which products are most profitable to produce and sell at the prevailing prices.



How should the 19,800 machine hours be used?

– Blouses: 17,000 × .04 = 6,800– Dresses: 5,000 × 0.8 = 4,000– Skirts: 10,000 × 0.5 = 5,000– Shirts: 10,000 × 0.4 = 4,000 Notice that only 10,000 shirts can be

produced.



What is an opportunity cost? It is the amount of lost profit when the

opportunity afforded by one alternative is sacrificed to pursue another alternative.

In order to produce the additional 2,000 blouses, Texmax must decrease the production of shirts by 2,000.



Each shirt contributes $1.00, so cutting back the production of 2,000 shirts causes a sacrifice of $2,000 in profits.

Costs of Producing 2,000 Blouses

Cost Type Per Unit Total

Variable cost $4.40 $ 8,800

Opportunity cost 1.00 2,000

Total $5.40 $10,800


Short-Term Product-Mix Decisions – Price Setters

DecisionType

Price-SetterFirm

Short-termdecisions 2


Short-Term Product-Mix Decisions – Price Setters

Setting the price of a product means determining its full cost and a markup percentage above cost.

This approach is known as cost-plus pricing.

Full costs include the sum of all direct materials, direct labor, and support activity costs.



Explain the way a firm adjusts its prices in the short term depending on whether

capacity is limited.


Capacity Issues

Special orders that do not involve a long-term contract should be priced in relationship to available capacity.

When capacity is available, incremental revenues have to be greater than incremental costs.


Capacity Issues

When capacity is not available, the minimum acceptable price must cover all incremental costs.

This will result in additional costs. How can additional capacity be acquired?– overtime operations– subcontracting


Capacity Issues

What are incremental costs and revenues? They are the amount by which costs or

revenues change if one particular decision is made instead of another.

What is an incremental cost per unit? It is the amount by which total production

costs increase when one additional unit of a product is produced.


Capacity Issues

What are relevant costs or revenues? They are the costs or revenues that differ

across alternatives and therefore must be considered in deciding which alternative is the best.



Discuss the way a firm determines a long-term

benchmark price to guide its pricing strategy.


Long-Term Pricing Decisions – Price Setters

DecisionType

Price-SetterFirm

Long-termdecisions 3



Costs which are relevant for short-term pricing decisions are not the same as those which are relevant for long-term pricing decisions.

Most firms rely on full-cost information reports when setting prices.



There is economic justification for reliance on full costs for pricing decisions in three types of circumstances.

1 When contracts specify full cost of jobs plus markup

2 When a firm enters into a long-term contractual relationship with a customer to supply a product



3 When a firm adjusts its prices up and down to respond to changes in supply and demand, and the price tends to approximate the price on full costs

Most firms use full cost-based prices as target prices.


Benchmark Price

High Demand

Low Demand1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Month

Short-Term Prices Relative to Long-Term Benchmark Price

Pri

ce



Prices depend on demand conditions. Markups increase with the strength of

demand. Markups depend on the elasticity of

demand. Markups also fluctuate with the intensity

of competition.



What is elasticity of demand? Demand is said to be elastic if

customers are very sensitive to the price.

A small increase in price results in a large decrease in demand.



When demand is relatively inelastic, profits will usually increase when prices increase.

Firms often lower markups for strategic reasons.

What are these reasons?– Penetration pricing strategy– Skimming pricing strategy


Pricing Strategies

What is a penetration pricing strategy? It is charging a lower price initially to win

over market share from an established product of a competing firm.

What is a skimming pricing strategy? It is charging a higher price initially from

customers willing to pay more for the privilege of possessing a new product.


Long-Term Pricing Decisions – Price Takers

DecisionType

Price-TakerFirm

Long-termdecisions 4


Long-Term Pricing Decisions – Price Takers

Decisions to add a new product or to drop an existing product from the portfolio of products usually have significant long-term implications for the cost structure of a firm.

Product-sustaining and batch-related costs are likely to change.



Explain the way a firm evaluates the long-term

profitability of its products and market segments.


Long-Term Profitability

When making long-term product mix decisions, managers use the full costs of products that incorporate the cost of using various activity resources.

Comparing product costs with their market prices reveals which products are not profitable in the long term.



If some products have full costs that exceed the market price, the firm must consider several options.

– The impact of dropping products on the cost structure of the firm

– The need to maintain a full product line



– The redeployment or elimination of resources no longer used

– The feasibility of changing resources committed to batch-related and product sustaining activities

Managers also may want to explore market conditions more carefully and differentiate their products further to raise prices and bring them in line with the costs.



When will dropping products help improve profitability?

– When managers eliminate the activity resources no longer required to support the discontinued product

– When managers redeploy the resources from the eliminated products to produce more of the profitable products that the firm continues to offer



Capacity constraints are likely to be less of a concern for product-mix decisions that have long-term effects.

Firms can adjust the level of resources committed to most activities.

Comparison of the price of a product with its activity-based costs provides a valuable evaluation of its long-run profitability.


Conclusion

Should High Performance Springs slash the price of its spring to obtain business from a reputable customer, the Lawson Corporation?

Fixed costs can be ignored, and variable costs alone are relevant only for analyzing a short-term pricing decision.


Conclusion

For long-term pricing decisions, the costs of many more resources are relevant because firms can adjust the supply of most resources over the long-term.


Conclusion

A case for a lower price for Lawson could be made as a part of a penetration pricing strategy.

High Performance Springs must consider the reaction of its existing customers.

It also must consider its competitors, who may cut prices to respond to Precision’s discounting.


End of Chapter 7

7- 1 2001 prentice hall business publishing management accounting, 3/e, atkinson, banker, kaplan,...

Documents

u decisions

productmix decisions

short term

accounting records

young role of product

young learning objectives

young cost information

long term