target costing and cost analysis for pricing decisions

Target Costing andCost Analysis forPricing Decisions

Chapter 15

MBA 631Dr. LuchsBall State University

Learning Objective

1

15-2

Major Influences onMajor Influences onPricing DecisionsPricing Decisions

PricingDecisions

Political, legal, and image issues

Competitors Costs

Customerdemand

15-3

Learning Objective

2

15-4

How Are Prices Set?How Are Prices Set?

Costs MarketForces

Prices are determined by the market, subjectto costs that must be covered in the long run.

Prices are based on costs, subject toreactions of customers and competitors.

15-5

Economic Profit-Maximizing Economic Profit-Maximizing PricingPricing

Firms usually have flexibility in setting prices.

The quantity sold usually declines as the price is increased.

15-6

Total Revenue CurveTotal Revenue Curve

Total revenue

Curve is increasing throughoutits range, but at a declining rate.

Dollars

Quantity soldper month

15-7

Demand Schedule and Marginal Demand Schedule and Marginal Revenue CurveRevenue Curve

Demand

Sales price must decreaseto sell higher quantity.

Dollarsper unit

Quantity soldper month

Marginalrevenue

Revenue perunit decreases

as quantity increases.

15-8

Total Cost CurveTotal Cost Curve

Dollars

Quantity madeper month

Total cost increasesat a declining rate.

Total cost increasesat an increasing rate.

15-9

Quantity madeper month

Marginal Cost CurveMarginal Cost Curve

Marginalcost

Dollarsper unit

Quantity wheremarginal cost

begins to increase.

15-10

Quantity made

and soldper month

Determining the Profit-Maximizing Determining the Profit-Maximizing Price and QuantityPrice and Quantity

Dollarsper unit

Demand

Marginalrevenue

Marginalcost

q*

p*

15-11

Quantity made

and soldper month

Determining the Profit-Maximizing Determining the Profit-Maximizing Price and QuantityPrice and Quantity

Dollarsper unit

Demand

Marginalrevenue

q*

p*

Marginalcost

Profit is maximized where marginal cost equals

marginal revenue, resultingin price p* and quantity q*.

15-12

Determining the Profit-Maximizing Determining the Profit-Maximizing Price and QuantityPrice and Quantity

Total revenueDollars Total cost

Total profit at the profit-maximizingquantity and price,

q* and p*.

Quantity made

and soldper month

q*15-13

Price ElasticityPrice Elasticity

The impact ofprice changes on

sales volume

Demand is elastic ifa price increase has alarge negative impact

on sales volume.

Demand is inelastic ifa price increase has

little or no impact on sales volume.

15-14

Cross ElasticityCross Elasticity

The extent towhich a change in

a product’s price affects thedemand for other

substitute products.

15-15

Limitations of theLimitations of theProfit-Maximizing ModelProfit-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 AccountingRole of AccountingProduct Costs in PricingProduct Costs in Pricing

Sophisticated decisionmodel and information

requirements

Simplified decisionmodel and information

requirements

Optimal Decisions Suboptimal Decisions

Economic pricing model Cost-based pricing

Marginal-cost andmarginal-revenue data

Accounting product-cost data

More costly Less costlyThe best approach, in terms of costs and

benefits, typically lies between the extremes.

Exh. 15-4

15-17

Learning Objective

3

15-18

Cost-Plus PricingCost-Plus Pricing

Price = cost + (markup percentage × cost)

Variablemanufacturing

cost?

Full-absorptionmanufacturing

cost?

Total cost,including selling

and administrative?

Total variable cost,including selling

and administrative?15-19

Cost-Plus Pricing - ExampleCost-Plus Pricing - Example

Variable mfg. cost $ 400Fixed mfg. cost 250Full-absorption mfg. cost $ 650Variable S & A cost 50Fixed S & A cost 100Total cost $ 800

We will use this unit cost information to illustrate therelationship between cost and markup necessary to

achieve the desired unit sales price of $925.

15-20

Cost-Plus Pricing - ExampleCost-Plus Pricing - Example

Variable mfg. cost $ 400Fixed mfg. cost 250Full-absorption mfg. cost $ 650Variable S & A cost 50Fixed S & A cost 100Total cost $ 800

Price = cost + (markup percentage × cost)Price = $400 + (131.25% × $400) = $925

Markup onvariable

manufacturingcost

15-21

Cost-Plus Pricing - ExampleCost-Plus Pricing - Example

Variable mfg. cost $ 400Fixed mfg. cost 250Full-absorption mfg. cost $ 650Variable S & A cost 50Fixed S & A cost 100Total cost $ 800

Price = cost + (markup percentage × cost)Price = $450 + (105.56% × $450) = $925

Markup ontotal var. costAs cost baseincreases, the

required markuppercentagedeclines.

15-22

Cost-Plus Pricing - ExampleCost-Plus Pricing - Example

Variable mfg. cost $ 400Fixed mfg. cost 250Full-absorption mfg. cost $ 650Variable S & A cost 50Fixed S & A cost 100Total cost $ 800

Price = cost + (markup percentage × cost)Price = $650 + (42.31% × $650) = $925

Markup onfull mfg. costAs cost baseincreases, the

required markuppercentagedeclines.

15-23

Cost-Plus Pricing - ExampleCost-Plus Pricing - Example

Variable mfg. cost $ 400Fixed mfg. cost 250Full-absorption mfg. cost $ 650Variable S & A cost 50Fixed S & A cost 100Total cost $ 800

Price = cost + (markup percentage × cost)Price = $800 + (15.63% × $800) = $925

Markup ontotal cost

As cost baseincreases, the

required markuppercentagedeclines.

15-24

Absorption-Cost Pricing FormulasAbsorption-Cost Pricing FormulasAdvantages

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.

15-25

Variable-Cost Pricing FormulasVariable-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:Determining the Markup:Return-on-Investment PricingReturn-on-Investment Pricing

Solve for the markup percentage that will

yield the desired return on investment.

15-27

Price = cost + (markup percentage × cost)Price = $400 + (131.25% × $400) = $925

Recall the example using a 131.25 percent markupon variable manufacturing cost.

Determining the Markup:Determining the Markup:Return-on-Investment PricingReturn-on-Investment Pricing

Let’s solve for the 131.25 percent markup. Investedcapital is $300,000, the desired ROI is 20 percent,

and annual sales volume is 480 units.

15-28

Determining the Markup:Determining the Markup:Return-on-Investment PricingReturn-on-Investment Pricing

ROI = IncomeInvested Capital

20% = Income$300,000

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

Step 1: Solve for the income thatwill result in an ROI of 20 percent.

15-29

Determining the Markup:Determining the Markup:Return-on-Investment PricingReturn-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 $ 400Fixed mfg. cost 250Full-absorption mfg. cost $ 650Variable S & A cost 50Fixed S & A cost 100Total cost $ 800

15-30

Determining the Markup:Determining the Markup:Return-on-Investment PricingReturn-on-Investment Pricing

480 units × (Unit sales price - $800 unit cost) = $60,000

Unit sales price - $800 unit cost = $60,000 480 units

Unit sales price - $800 unit cost = $125 per unit

480 units × (Unit profit margin) = $60,000

Unit sales price = $925

Step 2: Solve for the unit sales price necessary to result in an income of $60,000.

15-31

Determining the Markup:Determining the Markup:Return-on-Investment PricingReturn-on-Investment Pricing

Markuppercentage

Unit sales price - Unit variable cost Unit variable cost

Step 3: Compute the markup percentage on the $400 variable manufacturing cost.

=

Markuppercentage

$925 per unit - $400 per unit $400 per unit

=

Markuppercentage

= 131.25 percent

15-32

Learning Objective

4

15-33

Strategic Pricing of New ProductsStrategic 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

15-35

Target CostingTarget Costing

Market researchdetermines 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 productthat can be made for the allowable cost.

15-36

Target CostingTarget Costing

Keyprinciplesof targetcosting

Price led costing

Focuson the

customer

Focus onproductdesign

Focus onprocessdesign

Cross-functionalteams

Life-cyclecosts

Value-chainorientation

15-37

Learning Objective

6

15-38

The Role Of Activity-BasedThe Role Of Activity-BasedCosting In Setting ACosting In Setting A

Target Cost.Target Cost.

Production Process

Component Activities

15-39

Learning Objective

7

15-40

Product Cost DistortionProduct Cost Distortion

High-volume productsMay be overcosted

Low-volume productsMay be undercosted

15-41

Learning Objective

8

15-42

Value EngineeringValue Engineeringand Target Costingand 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

15-44

Time and Material PricingTime 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 PricingTime and Material Pricing

Time charges:Total

labor hoursrequired

Hourlylaborcost

+Overheadcost per

labor hour+

Hourly chargeto provide

profit margin×

Material Charges:Total

materialcost

incurred

+Overheadper dollarof material

cost

×Total

materialcost

incurred15-46

Learning Objective

10

15-47

Competitive BiddingCompetitive Bidding

High bidprice

Low probabilityof winning bid

High profit ifwinning bid

Low bidprice

High probabilityof winning bid

Low profit ifwinning bid

15-48

Competitive BiddingCompetitive BiddingGuidelines for Bidding

Bidder hasexcess capacity

Low bid price Any bid price in excess of incremental costs of job will contribute to fixed costs and profit.

Bidder has noexcess capacity

High bid price Bid price should be full cost plus normal profit margin as winning bid will displace existing work.

15-49

Learning Objective

11

15-50

Legal Restrictions On Setting Legal Restrictions On Setting PricesPrices

• Price discrimination

• Predatory pricing

15-51

End of Chapter 15End of Chapter 15

What is the right price?

15-52

Problem 15-41Problem 15-39Problem 15-46Problem 15-45