CHAPTER II

COST ANALYSIS FOR PRICING DECISIONS

Setting the price for an organization’s product or service is one of the most
important decisions a manager faces. It is also one of the most difficult, due to the
number and variety of factors that must be considered. The pricing decision arises
in virtually all types of organizations. Manufacturers set prices for the products
they manufacture; merchandising companies set prices for the goods; service firms
set prices for such services as insurance policies, train tickets, theme park
admissions, and bank loans. Nonprofit organizations often set prices also. For
example, governmental units price vehicle registrations, park-use fees, and utility
services. The optional approach to pricing often depends on the situation. Pricing a
mature product or service that a firm has sold for a long time may be quite different
from pricing a new product or service. Public utilities and TV cable companies face
political considerations in pricing their products and services, since their prices
often must be approved by a governmental commission.
Major Influences on Pricing Decisions
Four major influences govern the prices set by companies:
1. Customer demand
2. Actions of competitors
3. Costs
4. Political, legal, and image related issues.
Customer Demand
The demands of customers are of paramount importance in all phases of business
operations, from the design of a product to the setting of its price. Product-design
issues and pricing considerations are interrelated, so they must be examined
simultaneously. For example, if customers want a high-quality sailboat, this will
entail greater production time and more expensive raw materials. The result almost
certainly will be a higher price. On the other hand, management must be careful
not to price its product out of the market. Discerning customer demand is a
critically important and continuous process. Companies routinely obtain

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information from market research, such as customer surveys and test-marketing
campaigns, and through feedback from sales personnel. To be successful,
companies must provide the products its customers want at a price they perceive to
be appropriate.
Actions of Competitors
Although managers would like the company to have the sailing market to itself, they
are not so fortunate. Domestic and foreign competitors are striving to sell their
products to the same customers. Thus, as companies’ management designs
products and sets prices, it must keep a watchful eye on the firm’s competitors. If a
competitor reduces its price on sailboats of a particular type, companies may have
to follow suit to avoid losing its market share. Yet the company cannot follow its
competitors blindly either. Predicting competitive reactions to its product-design
and pricing strategy is a difficult but important task for companies’ management.
In considering the reactions of customers and competitors, management must be
careful to properly define its product.
Costs
The role of costs in price setting varies widely among industries. In some industries,
prices are determined almost entirely by market forces. An example is the
agricultural industry, where grain and meat prices are market-driven. Farmers
must meet the market price. To make a profit, they must produce at a cost below
the market price. This is not always possible, so some periods of loss inevitably
result. In other industries, managers set prices at least partially on the basis of
production costs. For example, cost based pricing is used in the aircraft, household
appliance, and gasoline industries. Prices are set by adding a markup to production
costs. Managers have some latitude in determining the markup, so market forces
influence prices as well. In public utilities, such as electricity and natural gas
companies, prices generally are set by a regulatory agency of the state government.
Production costs are of prime importance in justifying utility rates. Typically, a
public utility will make a request to the Public Utility Commission for a rate
increase on the basis of its current and projected production costs.

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Balance of market Forces and Cost-Based Pricing
In most industries, both market forces and cost considerations heavily influence
prices. No organization or industry can price its products below their production
costs indefinitely. And no company’s management can set prices blindly at cost plus
a markup without keeping an eye on the market. In most cases, pricing can be
viewed in either of the following ways.

How are prices set?

Prices are determined by Prices are based on costs,
the market, subject to subject to the constraint
the constraint that costs Market that the reactions of
Costs
must be covered in the forces customers and competitors
long run. must be heeded.

Political, Legal, and Image-Related Issues

Beyond the important effects on prices of market forces and costs are a range of
environmental considerations. In the legal area, managers must adhere to certain
laws. The law generally prohibits companies from discriminating among their
customers in setting prices. Also prohibited is collusion in price setting, where the
major firms in an industry all agree to set their prices at high levels.
Political considerations also can be relevant. For example, if the firms in an industry
are perceived by the public as reaping unfairly large profits, there may be political
pressure on legislators to tax those profits differentially or to intervene in some way
to regulate prices.
Companies also consider their public image in the price-setting process. A firm with
a reputation for very-high-quality products may set the price of a new product high
to be consistent with its image.
Differential analysis and pricing decisions
Definition and Explanation of Differential Cost and Differential Revenue:
Decisions involve choosing between alternatives. In business, each alternative will
have certain costs and benefits that must be compared to the costs and benefits of
the other available alternatives. A difference in cost between any two alternatives is

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known as differential cost. A difference in revenue between any two alternatives is
known as differential revenues. Differential cost includes both cost increase
(incremental cost) and cost decrease (decremental cost). In general the difference
(cost and revenue) between alternatives are relevant in decision making. Those
items that are the same under all alternatives can be ignored.
The accountant's differential cost concept can be compared to the economist's
marginal cost concept. In speaking of changes in cost and revenue, the economists
employ the term marginal cost and marginal revenue. The revenue that can be
obtained from selling one more unit of product is called marginal revenue, and the
cost involved in producing one more unit of a product is called marginal cost. The
economists marginal cost is basically the same as the accountant's differential
concept applied to a single unit of output.
Example:
Differential cost can be either variable or fixed. To illustrate assume that a
company is thinking about changing its marketing method from distribution
through retailers to distribution by door to door direct sale. Present cost and
revenues are compared to projected costs and revenues in the following table.
Retailer DirectSale Differential
Description Distribution Distribution Costs and
(Present) (Proposed) Revenues
Revenue (variable) $700,000 $800,000 $100,000
--------- --------- ---------
Cost of goods sold (V) 350,000 400,000 50,000
Advertising (V) 80,000 45,000 (35000)
Commissions (F)* -0- 40,000 40,000
Warehouse depreciation (V)** 50,000 80,000 30,000
Other Expenses (F) 60,000 60,000 -0-
---------- ---------- ----------
Total 540,000 625,000 85,000
---------- ---------- ----------
Net Operating Income $160,000 $175,000 $15,000
======= ======= =======
*F=Fixed **V = Variable

According to the above analysis, the differential revenue is $100,000 and the
differential cost is $85,000, leaving a positive differential net operating income of

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$15,000 under the proposed marketing plan. The net operating income under the
present distribution is $160,000, whereas the net operating income under door to
door direct selling is estimated to be $175,000. Therefore the door to door direct
distribution method is preferred, since it would result in $15,000 higher net
operating income. Note that we would have arrive at exactly the same conclusion by
simply focusing on the differential revenue, differential cost, and differential net
operating income, which also shows a net operating advantage of $15,000 for the
direct selling method. The company can ignore other expenses of $60,000. Because
it has no effect on the decision. If it were removed from the calculation, the door to
door selling method would still be preferred by $15,000. This is an extremely
important principle in management accounting.
Sunk Cost:
A sunk cost is a cost that has already been incurred and that cannot be changed
by any decision made now or in future.
Example:
Sunk costs cannot be changed by any decision. These are not differential costs
and should be ignored in decision making. To illustrate a sunk cost, assume that a
company paid $50,000 several years ago for a special purpose machine. The
machine was used to make a product that is now obsolete and is no longer being
sold. Even though in hindsight the purchase of the machine may have been unwise,
no amount of regret can undo that decision. And it would be folly to continue
making the obsolete product to recover the original cost of the machine. In short,
the $50,000 originally paid for the machine has already been incurred and cannot
be differential cost in any future decision. For this reason, such costs are said to be
sunk costs and should be ignored in decision making
Characteristics of differential costing
1. In order to ascertain the differential costs, only total cost is needed and not cost
per unit.
2. Existing level is taken to be the base for comparison with some future or
forecasted level.
3. Differential cost is the economist’s concept of marginal cost.
4. It may be referred to as incremental cost when the difference in cost is due to

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 increase in the level of production and decremental costs when difference in cost is
due to decrease in the level of production.
5. It does not form part of the accounting records, but may be incorporated in
budgets.
6. It is not necessary to adopt marginal cost technique for differential cost analysis
because it can be worked out on the method of absorption costing or standing
costing.
7. What is said of the differential cost above, applies to differential revenue also.

Under certain conditions a product may be sold at two or more different prices in
different markets.
1. This possibility may enable management to minimize the risk of loss from
having idle personnel and plant capacity.
2. Only the differential cost of producing the items needs to be matched
against the differential revenue provided when deciding whether to accept
an offer at lower-than-normal price (average costs should be ignored).
3. If the differential cost is lower than the differential revenue, the offer should
be accepted unless there is an alternative use for the facilities that would be
even more profitable.
4. Variable costs set a floor for the selling price.

To illustrate relevant, differential, and sunk costs, assume that Joanna Bennett
invested $400 in a tiller so she could till gardens to earn $1,500 during the
summer. Not long afterward, Bennett was offered a job at a horse stable feeding
horses and cleaning stalls for $1,200 for the summer. The costs that she would
incur in tilling are $100 for transportation and $150 for supplies. The costs she
would incur at the horse stable are $100 for transportation and $50 for supplies.
If Bennett works at the stable, she would still have the tiller, which she could loan
to her parents and friends at no charge.
The tiller cost of $400 is not relevant to the decision because it is a sunk cost. The
transportation cost of $100 is also not relevant because it is the same for both
alternatives. These costs and revenues are relevant (note: differential means
difference):

Performing
Working at horse
tilling Differential
stable
service

Revenues $1,500 $1,200 $300

Costs 150 50 100

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 Net benefit in favor of
$200
tilling service

Based on this differential analysis, Joanna Bennett should perform her tilling
service rather than work at the stable. Of course, this analysis considers only
cash flows; nonmonetary considerations, such as her love for horses, could sway
the decision.
To illustrate the application of differential analysis to specific decision problems,
we consider five decisions:
1. setting prices of products
2. accepting or rejecting special orders;
3. adding or eliminating products, segments, or customers;
4. processing or selling joint products; and
5. deciding whether to make products or buy them.
Although these five decisions are not the only applications of differential analysis,
they represent typical short-term business decisions using differential analysis.
Our discussion ignores income taxes.
When applying differential analysis to pricing decisions, each possible price for a
given product represents an alternative course of action. The sales revenues for
each alternative and the costs that differ between alternatives are the relevant
amounts in these decisions. Total fixed costs often remain the same between
pricing alternatives and, if so, may be ignored. In selecting a price for a product,
the goal is to select the price at which total future revenues exceed total future
costs by the greatest amount, thus maximizing income.
A high price is not necessarily the price that maximizes income. The product may
have many substitutes. If a company sets a high price, the number of units sold
may decline substantially as customers switch to lower-priced competitive
products. Thus, in the maximization of income, the expected volume of sales at
each price is as important as the contribution margin per unit of product sold. In
making any pricing decision, management should seek the combination of price
and volume that produces the largest total contribution margin. This combination
is often difficult to identify in an actual situation because management may have
to estimate the number of units that can be sold at each price.
For example, assume that a company selling fried chicken in the New York market
estimates product demand for its large bucket of chicken for a particular period to
be:
Choice Demand
1 15,000 units at $6 per unit
2 12,000 units at $7 per unit
3 10,000 units at $8 per unit
4 7,000 units at $9 per unit

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The company’s fixed costs of $20,000 per year are not affected by the different
volume alternatives. Variable costs are $5 per unit. What price should be set for
the product? Based on the calculations shown in the table below, the company
should select a price of $8 per unit because choice (3) results in the greatest total
contribution margin and net income. In the short run, maximizing total
contribution margin maximizes profits.
Choice Sales – Var. Contribution Number Total Fixed Net income
Price Cost = Margin per of units    margin costs (loss)
unit x =

1 $6 $5 $1 15,000 $15,000 $20,000 $(5,000)

2 $7 $5 2 12,000 24,000 20,000 4,000

3 $8 $5 3 10,000 30,000 20,000 10,000

4 $9 $5 4 7,000 28,000 20,000 8,000

Accept or Reject Special Orders

Sometimes management has an opportunity to sell its product in two or more
markets at two or more different prices. Movie theaters, for example, sell tickets at
discount prices to particular groups of people—children, students, and senior
citizens. Differential analysis can determine whether companies should sell their
products at prices below regular levels.
Good business management requires keeping the cost of idleness at a minimum.
When operating at less than full capacity, management should seek additional
business. Management may decide to accept such additional business at prices
lower than average unit costs if the differential revenues from the additional
business exceed the differential costs. By accepting special orders at a discount,
businesses can keep people employed that they would otherwise lay off.
To illustrate, assume Rios Company produces and sells a single product with a
variable cost of $8 per unit. Annual capacity is 10,000 units, and annual fixed
costs total $48,000. The selling price is $20 per unit and production and sales are
budgeted at 5,000 units. Thus, budgeted income before income taxes is $12,000,
as shown below.
Rios company
Income statement
For the period ending May 31

Revenue (5,000 units at $20) $100,000

Variable costs:
  Direct materials cost ($4 per unit) $20,000

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   Labor ($1 per unit) 5,000
   Overhead ($2 per unit) 10,000
  Marketing and administrative costs ($1
5,000
per unit)
    Total variable costs ($8 per unit) $40,000
Fixed costs:
  Overhead $28,000

  Marketing and administrative costs 20,000

    Total fixed costs 48,000

     Total costs ($17.60 per unit) 88,000

Net income $12,000

Assume the company receives an order from a foreign distributor for 3,000 units
at $10 per unit. This $10 price is not only half of the regular selling price per unit,
but also less than the $17.60 average cost per unit ($88,000/5,000 units).
However, the $10 price offered exceeds the variable cost per unit by $2. If the
company accepts the order, net income increases to $18,000.
Revenue would increase to $130,000 with the special order. Each of the variable
costs increases in total by 60% because total volume increases by 60% (3,000
units in the special order/5,000 units regularly produced).  The revised income
statement would appear as follows:

Rios company
Income statement (with Special Order)
For the period ending May 31
Revenue (5,000 units at
$130,000
$20 + 3,000 units at $10)
Variable costs:
  Direct materials cost ($4) $32,000
  Labor ($1) 8,000
  Overhead ($2) 16,000
  Marketing and administrative
8,000
costs ($1)

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    Total variable costs ($8 per $64,00
unit) 0
Fixed costs:
  Manufacturing overhead $28,000
  Marketing and administrative
20,000
costs
   Total fixed costs 48,000
     Total costs ($14 per unit) 112,000
Net income $18,000
Note that the fixed costs do not increase with the special order. Because the
special order does not increase the fixed costs, the special order’s revenues need
only cover its variable costs.
If Rios Company continues to operate at 50% capacity (producing 5,000 units
without the special order) it would generate income of only $12,000. By accepting
the special order, net income increases by $6,000 ($18,000 net income with
special order – $12,000 net income without special order).
Differential analysis would provide the following calculations:
Accept Reject
  Differential
order order
Revenues $130,000 $100,000 $30,000
Costs 112,000 88,000 24,000
Net benefit of accepting
$6,000
order

Variable costs set a floor for the selling price in special-order situations. Even if
the price exceeds variable costs only slightly, the additional business increases
net income, assuming fixed costs do not change. However, pricing just above
variable costs of special-order business often brings only short-term increases in
net income. In the long run, companies must cover all of their costs, not just the
variable costs.
Adding or Eliminating
Periodically, management has to decide whether to add or eliminate certain
products, segments, or customers. If you have watched a store or a plant open or
close in your area, you have seen the results of these decisions. Differential
analysis is useful in this decision making because a company’s income statement
does not automatically associate costs with certain products, segments, or
customers. Thus, companies must reclassify costs as those that the action would
change and those that it would not change.

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If companies add or eliminate products, they usually increase or decrease variable
costs. The fixed costs may change, but not in many cases. Management bases
decisions to add or eliminate products only on the differential items; that is, the
costs and revenues that change.
To illustrate, assume that the Campus Bookstore is considering eliminating its art
supplies department. If the bookstore dropped the art supplies department, it
would lose revenues of $100,000 annually. The bookstore’s management assigns
costs of $110,000 ($80,000 variable and $30,000 fixed) to the art supplies
department. Therefore, art supplies has an apparent annual loss of $10,000
($100,000 revenue minus $110,000 costs). But careful cost analysis reveals that
if the art supplies department were dropped, the reduction in costs would be
only $80,000 variable costs directly related to the art supplies department and the
$30,000 fixed costs are general bookstore fixed costs allocated to the art supplies
department. These fixed costs would continue to be incurred and would not be
saved by closing the art supplies department. Look at the differential analysis
below.
Departm
  Art Supplies  
ent
Different
  Keep Close
ial
Revenues $100,000 $-0- $100,000
Variable costs 80,000 -0- 80,000
Fixed costs 30,000 30,000 -0-
Net benefit of keeping art
$ 20,000
supplies department
Note that the art supplies department has been contributing $20,000 ($100,000
revenues – $80,000 variable costs) annually toward covering the fixed costs of the
business. Consequently, its elimination could be a costly mistake unless there is
a more profitable use for the vacated facilities.
Sell or Process Further
Sometimes two or more products result from a common raw material or
production process; these products are called joint products. Companies can
process these products further or sell them in their current condition. For
instance, when Chevron refines crude oil, it produces a wide variety of fuels,
solvents, lubricants, and residual petrochemicals.
Management can use differential analysis to decide whether to process a joint
product further or to sell it in its present condition. Joint costs are those costs
incurred up to the point where the joint products split off from each other. These
costs are sunk costs and are not considered when deciding whether to process a
joint product further before selling it or to sell it in its condition at the split-off
point.

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The following example illustrates the issue of whether to process or sell joint
products. Assume that Pacific Paper, Inc., produces two paper products, A and B,
from a common manufacturing process. Each of the products could either be sold
in its present form or processed further and sold at a higher price. Data for both
products follow:
Selling price Cost per unit of Selling price per
Prod
per unit at further unit after further
uct
split-off point processing processing
A $10 $6 $21
B 12 7 18
The differential revenues and costs of further processing of the two products are
as follows:
Different
Differential Net advantage
Prod revenue of
cost of further (disadvantage) of
uct further
processing further processing
processing
A $11 $6 $5
B 6 7 (1)
Based on this analysis, Pacific Paper should process product A further to increase
income by $5 per unit sold. The company should not process product B further
because that would decrease income by $1 per unit sold.
Companies use this same form of differential analysis to decide whether they
should discard their by-products or process them further. By-products are
additional products resulting from the production of a main product and generally
have a small market value compared to the main product. Sometimes companies
consider by-products to be waste materials. For example, the bark from trees cut
into lumber is a by-product of lumber production. Although a by-product,
companies convert this bark into fuel or landscaping material. When the
differential revenue of further processing exceeds the differential cost, firms
should do further processing.
Make or Buy
Managers also apply differential analysis to make-or-buy decisions. A make-or-
buy decision occurs when management must decide whether to make or
purchase a part or material used in manufacturing another product. Management
must compare the price paid for a part with the additional costs incurred to
manufacture the part. When most of the manufacturing costs are fixed and would
exist in any case, it is likely to be more economical to make the part rather than
buy it.
To illustrate the application of differential analysis to make-or-buy decisions,
assume that Small Motor Company manufactures a part costing $6 for use in its
toy automobile engines. Cost components are: materials, $3.00; labor, $1.50;

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fixed overhead costs, $1.05; and variable overhead costs, $0.45. Small could
purchase the part for $5.25. Fixed overhead would presumably continue even if
the part were purchased. The added costs (variable costs only) of manufacturing
amount to $4.95 ($3.00 DM + $1.50 DL + $0.45 Variable OH). This amount is 30
cents per unit less than the purchase price of the part. Therefore, manufacturing
the part should be continued as shown in the following analysis:

  Make Buy Differential

Variable Costs $4.95 $5.25 $0.30
Net advantage of making $0.30
In make-or-buy decisions, management also should consider the opportunity cost
of not utilizing the space for some other purpose. In the previous example, if the
opportunity costs of not using this space in its best alternative use is more than
30 cents per unit times the number of units produced, the part should be
purchased.
In some manufacturing situations, firms avoid a portion of fixed costs by buying
from an outside source. For example, suppose eliminating a part would reduce
production so that a supervisor’s salary could be saved. In such a situation, firms
should treat these fixed costs the same as variable costs in the analysis because
they would be relevant costs.
Sometimes the cost to manufacture may be only slightly less than the cost of
purchasing the part or material. Then management should place considerable
weight on other factors such as the competency of existing personnel to undertake
manufacturing the part or material, the availability of working capital, and the
cost of any loans that may be necessary.
Role of Accounting Product costs in Pricing
Most managers base prices on accounting product costs, at least to some extent.
There are several reasons for this. First, most companies sell many products or
services. There simply is not time enough to do a thorough demand and marginal-
cost analysis for every product or service. Managers must rely on a quick and
straightforward method for setting prices, and cost based pricing formulas provide
it. Second, even though market considerations ultimately may determine the final
product price, a cost based pricing formula gives the manager a place to start.
Finally, and most importantly, the cost of a product or service provides a floor
below which the price cannot be set in the long run. Although a product may be
“given away” initially, at a price below cost, a product’s price ultimately must
cover its costs in order for the firm to remain in business. Even a nonprofit
organization, unless it is heavily subsidized, cannot forever price products or
services below their costs.
Cost-plus pricing
Instead of using the market-based approach for long-run pricing decisions,
managers sometimes use a cost-based approach. The general formula for setting a
cost-based price adds a markup component to the cost base to determine a

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prospective selling price.
Because a markup is added, cost-based pricing is often called cost-plus pricing,
with the plus referring to the markup component. Managers use the cost-plus
pricing formula as a starting point. The markup component is rarely a rigid
number. Instead, it is flexible, depending on the behavior of customers and
competitors. The markup component is ultimately determined by the market.
Absorption-Cost Pricing Formulas
Most companies that use cost-plus pricing use either absorption manufacturing
cost or total cost as the basis for pricing products or services. The reasons
generally given for this tendency are as follows:
1. In the long run, the price must cover all costs and a normal profit margin.
Basing the cost-plus formula on only variable costs could encourage managers
to set too low a price in order to boost sales. This will not happen if managers
understand that a variable cost plus pricing formula requires a higher markup
to cover fixed costs and profit. Nevertheless, many managers argue that people
tend to view the cost base in a a cost-plus pricing formula as the floor for
setting prices. If prices are set too close to variable manufacturing cost, the
firm will fail to cover its fixed costs. Ultimately, such a practice could result in
the failure of the business.
2. Absorption-cost or total-cost pricing formulas provide a justifiable price that
tends to be perceived as equitable by all parties. Consumers generally
understand that a company must make a profit on its product or service in
order to remain in business. Justifying a price as the total cost of production,
sales, and administrative activities, plus a reasonable profit margin, seems
reasonable to buyers.
3. When a company’s competitors have similar operations and cost structures,
cost-plus pricing based on full costs gives management an idea of how
competitors may set prices.
4. Absorption-cost information is provided by a firm’s cost-accounting system,
because it is required for external financial reporting under generally accepted
accounting principles. Since absorption- cost information already exists, it is
cost- effective to use it for pricing. The alternative would involve preparing
special product-cost data specifically for the pricing decision. In a firm with
hundreds of products, such data could be expensive to produce.
The primary disadvantage of absorption-cost or total-cost pricing formulas is that
they obscure the cost behavior pattern of the firm. Since absorption-cost and
total-cost data include allocated fixed costs, it is not clear from these data how the
firm’s total costs will change as volume changes. Another way of stating this
criticism is that absorption cost data are not consistent with cost-volume-profit
analysis. CVP analysis emphasizes the distinction between fixed and variable
costs. This approach enables managers to predict the effects of changes in prices
and sales volume on profit. Absorption cost and total cost information obscures
the distinction between variable and fixed costs.
Variable- Cost Pricing Formula
To avoid blurring the effects of cost behavior on profit, some managers prefer to

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use cost-plus pricing formulas based on either variable manufacturing costs or
total variable costs.
Three advantages are attributed to this pricing approach:
1. Variable-cost data do not obscure the cost behavior pattern by unitizing
fixed costs and making them appear variable. Thus, variable-cost
information is more consistent with cost-volume-profit analysis often used
by managers to see the profit implications of changes in price and volume.
2. Variable cost data do not require allocation of common fixed costs to
individual product lines. For example, the annual salary of Messebo cement
factory marketing manager is a cost that must be borne by all of the
company’s product lines. Arbitrarily allocating a portion of her/his salary to
one of product line is not meaningful.
3. Variable-cost data are exactly the type of information managers need when
facing certain decisions, such as whether to accept a special order.
The primary disadvantage of the variable cost pricing formula was described
earlier. If managers perceive the variable cost of a product or service as the floor
for the price, they may tend to set the price too low for the firm to cover its fixed
costs. Eventually this can spell disaster. Therefore, if variable cost data are used
as the basis for cost-plus pricing, managers must understand the need for higher
markups to ensure that all costs are covered.
Determining Markup
If management uses a variable cost pricing formula, the markup must cover all fixed
costs and a reasonable profit. If management uses an absorption-costing formula, the
markup still must be sufficient to cover the firm’s profit.
Return-on-Investment Pricing
A common approach to determining the profit margin in cost plus pricing is to base
profit on the firm’s target return on investment (ROI).
Average invested capital X Target ROI = Target profit
We will compute the markup percentage for two cost-plus formulas.
1. Cost-plus pricing based on total costs.

Markup percentage on total cost = Target profit

Annual volume X Total cost per unit
2. Cost-plus pricing based on total variable costs

Markup percentage on total variable cost = Target profit X Total annual fixed cost
Annual volume X Total variable cost per unit
General Formula
The general formula for computing the markup percentage in cost-plus pricing to
achieve a target ROI is as follows:

Profit required to + Total annual costs

Markup percentage
achieve target ROI not included in cost
applied to cost base in
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cost-plus pricing formula
 = ______________________________________________
+
Annual volume Cost base per unit
used in cost-plus
pricing formula

Legal Issues Relating to Costs and Sales Prices

Predatory Pricing
Laws in many countries, including the United States, require managers to take
costs into account when they set sales prices. For example, managers will face
charges of predatory pricing if they set prices below costs. Predatory pricing is the
practice of setting the selling price of a product at a low price with the intent of
driving competitors out of the market or creating a barrier to entry for new
competitors. For the practice to be predatory, managers must set the price below cost
and intend to harm competition. In many countries, including the United States,
predatory pricing is anticompetitive and illegal under antitrust laws.
At first, you might wonder what is wrong with setting prices low and intending to
harm competition. It sounds like free enterprise, and setting prices low is normally
good for consumers. The legal problem arises when prices are set sufficiently low to
drive competitors out of the market or keep competitors out of the market. With little
competition left in the market, the company that has set predatory prices is able to
act like a monopolist and hit consumers with high prices. From the consumers’ point
of view, they benefit in the short run when the “predators” set prices low, but these
same consumers suffer in the long run when they face monopoly prices.
One usually finds evidence of predatory pricing when larger companies drive out
smaller companies. For example, a small airline recently added several routes to
compete with one of the large, international airlines. In response, the large airline
dropped its prices below those of the small airline. The small airline went bankrupt
and stopped flying those routes. The large airline then raised its prices.
To qualify as predatory pricing, the “predator” must drop its prices below costs. In
theory, pricing below marginal costs is irrational because the marginal revenue
from each unit sold is less than the marginal cost. Why would a manager set prices
below marginal cost, thereby incurring a loss on each unit sold? Regulators argue

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that managers who set prices below marginal costs are likely to do so to drive out
competition so they can later raise prices to recoup the losses. If you combine the
act of setting prices below costs with intent to harm competition, then you have
predatory pricing.
In theory, setting prices below marginal costs is one of the tests for predatory
pricing. In practice, however, marginal costs are difficult to measure. Therefore,
courts have generally used average variable costs as the floor below which prices
should not be set.
Dumping
Dumping occurs when a company exports its product to consumers in another
country at an export price that is below the domestic price. The harm to consumers
is similar to that imposed by predatory pricing. For example, suppose an electronics
company in a foreign country sells its products in the United States at a price below
what it charges in its domestic market. Eventually, U.S. electronics companies will
be unable to compete and will go out of business. Now the foreign company has an
opportunity to raise its prices above what consumers in the United States paid prior
to the foreign company’s practice of dumping. Consumers may appear to have a
good deal when foreign companies dump their products at a discount, but these
same consumers would suffer if the U.S. companies no longer existed. Market
prices would no longer be competitive.
Many industries, such as airlines, steel, and navigational electronics equipment,
provide goods and services that are important to the U.S. national defense. The U.S.
federal government considers it important to keep at least the capability to produce
such goods and services in the United States.
Policymakers disagree on the merits of prohibiting dumping. On the one hand,
protection of domestic industry has national security benefits and it benefits the
employees of those protected industries. On the other hand, dumping is simply a
practice of free trade and free markets. Restrictions that create oligopoly power
generally hurt consumers.

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Managers in many industries have sought protection against dumping, including
producers of semiconductors, shoes, automobiles, textiles, computers, and lumber.
The remedies to domestic producers are usually tariffs on the dumped products
that bring their prices up to the level of prices charged by domestic companies.
While we have used the United States to demonstrate how dumping works, many
countries must deal with dumping. For example, the European Union (EU) recently
assigned tariffs to shoes imported from China and Vietnam because shoe producers
in those countries were dumping their goods in the EU.
Price Discrimination
Price discrimination is the practice of selling identical goods or services to
different customers at different prices. Price discrimination requires market
segmentation. For example, a movie theater may sell tickets to the same movie at
the same time to students for $7 and nonstudents for $14. In this case, student
status segments the market.
Airlines use price discrimination when they sell tickets to different customers at
different prices for the same flight. Customers who stay at a destination over
Saturday night are sometimes charged a lower fare than customers who fl y the
same flights but do not stay over Saturday night. The airlines’ idea is to segment
customers into a group that is more price sensitive and a group that is less price
sensitive. Business travelers are usually less price sensitive than pleasure travelers
and generally do not stay over Saturday night at their destinations. Managers of
movie theaters segment the market of movie goers into a price-sensitive segment—
students—and a less price-sensitive segment—nonstudents.
Price discrimination benefits companies because it enables them to sell products to
customers who might not otherwise purchase them. For example, if an airline has
empty seats, it would rather sell those seats at a discount than not at all.
Certain types of price discrimination are illegal. For example, price discrimination
on the basis of race, religion, disability, or gender is illegal. Some companies take
advantage of people who have been struck by tragedies, such as tornadoes,

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hurricanes, or personal disasters. Even if not illegal, discriminating against victims
of natural or personal disasters is often considered to be unethical.
Peak-Load Pricing
Peak-load pricing is the practice of setting prices highest when the quantity
demanded for the product approaches the physical capacity to produce it. Many
companies, such as electrical and telephone utilities, engage in peak-load pricing in
providing service at high demand levels. For example, in warm weather geographic
locations, peak loads for electricity occur in the late afternoon hours when the
temperature is highest. For providers of telephone services, the peak loads are often
during the weekdays and daytime hours.
Prices are highest per unit of service at those times and lower at other times. Hence,
you can get lower rates for telephone and electricity services at off-peak times.
Price Fixing
Price fixing is the agreement among business competitors to set prices at a
particular level. Generally, the idea is to “fix” prices at a level higher than
equilibrium prices in competitive markets. The Organization for Petroleum
Exporting Countries (OPEC) provides us with a daily reminder of the effects of price
fixing. OPEC sets prices for its members that are likely above equilibrium prices in
a competitive market for oil.
Price fixing is a particular legal and ethical problem because it is not universally
illegal.
In many developing countries, price fixing is not illegal. Companies with business
units in both developed and developing countries face different sets of rules
depending on where managers are doing business. OPEC, for example, operates
legally in setting oil prices because its activities are not illegal in its member
countries.

Managers must be particularly alert to price fixing because the activities that law
enforcement officials regard as illegal include even informal or unspoken
agreements to fix prices. This appears to be the case in recent allegations of price
fixing in the market for dynamic random access memory (DRAM) chips. Companies

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from Germany, South Korea, and Japan were charged with price fixing in their U.S.
operations.

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