TOPIC 2

COST ANALYSIS FOR

PRICING DECISION

POLYTECHIC MALAYSIA EDITION

 2.1
Demonstrate the process of making decisions by considering
pricing of products and services

2.2 Determine the computation of the selling price of a product

and services

2.3 Apply target costing in pricing decision

2.4
Conclusions
Review Questions

2.1
PROCESS OF MAKING DECISIONS BY CONSIDERING
PRICING OF PRODUCTS AND SERVICES

Pricing strategies are important for companies to set the right price to maximize sales and profit.
Company can choose the most suitable pricing strategies that can help them to achieve their goals
and objectives.

2.1.1 OBJECTIVES OF PRICING

The objective of pricing explained as figure 1.

To set a consistent target for short term period, in order for business to
sustain in the economy

To obtain/increase share in the market

To make sure the consistency of price in the market in order to maintain

price stability

To establish profit margin that directly associate to sales and cost

To meet the competition of other competitors in the market

Figure 1: Objective of pricing

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2.1.2 FACTORS INFLUENCE THE PRICING OF PRODUCT OR SERVICE

Pricing decisions are the decisions a business make when setting prices for their products or
services.

Pricing a products or services considered part of a company is marketing strategy because it

influences its relationship with customers. When prices are fair and competitive, customers come
back, increasing the profitability of the business.

In making pricing decisions there are a few factors influence the decisions as mention in figure 2.

the required rate of return /the level acceptable level of price setting / the
of profit required anticipated price by customer

the appropriate quality/condition of

the factors of demand and supply
the product/service

the presence of replacement /

number of competitors in the
market

Figure 2: Factors Influence the Pricing of Product or Service

2.1.3 PRICE ELASTICITY OF DEMAND AND PROFIT MAXIMIZATION PRICE

Price Elasticity of demand measures the sensitivity/ responsiveness of the quantity demanded
due to a change in its price. It also defined as ratio of the rate of changes in quantity demanded to
changes in its price.

Changes in quantity of demand

Formula for PED =
Changes in Price

Q1-Q0 P0
Q0 x P1-P0

Q1 = New Quantity Demanded

Q0 = Original Quantity Demanded
P0 = Original Price
P1 = New Price

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Example :
The quantity demand for marker pen is 10 when the price is RM4. But the if the price increase to
RM6, the quantity demand decrease to 6. Calculate the price elasticity of demand for marker pen.

Solution :
= Q1-Q0 x P0
Profit Maximizing Price
Q0 P1-P0
= 6 - 10 x 4 MR = MC
10 6-4 Q1 = OPTIMUM QUANTITY
P = OPTIMUM PRICE
= 0.8 C = COST

Profit Maximizing Price is the method used to determine the best REVENUE = P X Q1
combination of price and quantity output for a product in order to TOTAL COST = C X Q1
gain maximum profit. The firm will reach maximum profit when REVENUE – TOTAL COST = PROFIT
Marginal Revenue = Marginal Cost.
 Marginal Revenue is the revenue gained by producing additional unit of a product
 Marginal Cost is the additional cost incur by producing additional unit of a product

2.1.4 PRICING STRATEGIES

a) Full Cost-plus pricing

Price-setting method under which you add together the direct material cost, direct
labor cost, selling and administrative costs, and overhead costs for a product, and
add to it a markup percentage (to create a profit margin) in order to derive the price
of the product. The pricing formula is:

(Total production costs + Selling and administration costs + Markup)

Number of units expected to sell

This method commonly used in situations where products and services provided
based on the specific requirements of the customer

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b) Marginal Cost-plus pricing
Marginal cost pricing is the practice of setting the price of a product at or slightly
above the variable cost to produce it. This approach typically relates to short-term
price setting situations. This situation usually arises in either of the following
circumstances:
i. A company has a small amount of remaining unused production capacity
available that it wishes to use (which a company is more likely to be
financially healthy - it simply wishes to maximize its profitability with a few
more unit sales) ; or

ii. A company is unable to sell at a higher price (one of desperation, where a

company can achieve sales by no other means, the sales are intended to
be on an incremental basis; they are not intended to be a long-term pricing
strategy, since prices set this low cannot be expected to offset the fixed costs
of a business)

The variable cost of a product is usually only the direct materials required to build
it. Direct labor is rarely completely variable, since a minimum number of people are
required to crew a production line, irrespective of the number of units produced.

c) Relevant Cost
A relevant cost is a cost that only relates to a specific management decision, and
which will change in the future because of that decision. The relevant cost concept
is extremely useful for eliminating extraneous information from a particular decision-
making process. In addition, by eliminating irrelevant costs from a decision,
management prevented from focusing on information that might otherwise
incorrectly affect its decision.

d) Price Skimming
Pricing strategy in which a marketer sets a relatively high initial price for a product
or service at first, then lowers the price over time. It is a temporal version of price
discrimination/yield management. It allows the firm to recover its sunk costs quickly
before competition steps in and lowers the market price.

e) Penetration Pricing
Strategy used by businesses to attract customers to a new product or service by
offering a lower price during its initial offering. The lower price helps a new product
or service penetrate the market and attract customers away from competitors.

f) Complementary Product
Method in which one of the products priced to maximize the sales volume and which
in turn stimulates the demand of other product. One product is priced low, just to
cover the costs with little or no profit margin while the other product is priced high
with a very high profit margin. For example Printer & cartridge. This strategy is
successful because once you have bought a printer; you are required to buy the
complementary cartridge unless you are willing to buy in a new printer itself. Also,
Companies avoid competitors selling ink for their printers by having unique
cartridges.

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 g) Product-line Pricing
Product line pricing involves the separation of goods and services into cost
categories in order to create various perceived quality levels in the minds of
consumers. Product line is a group of related products, differentiating by features
and price. Setting products at different price points allows the would-be customers
to orient themselves towards the one most likely to fit their needs and spending
capabilities.

h) Volume Discounting
A certain discount applied to unit numbers that fall within a particular pricing tier.

i) Differential or Price Discrimination

A selling strategy that charges customers different prices for the same product or
service, based on what the seller thinks they can get the customer to agree to. In
pure price discrimination, the seller charges each customer the maximum price he
or she will pay.

2.2
THE COMPUTATION OF THE SELLING PRICE OF A
PRODUCT AND SERVICES PROCESS

2.2.1 CALCULATE PRICE USING MARGINAL COST-PLUS PRICING AND FULL-

COST PRICING

Determining pricing is one of the toughest decisions a business owner ever faces. Price too high
and inventory does not move; price too cheap and profits are difficult to gain.

Marginal cost pricing designed to move inventory fast while on the other hand full-cost pricing is
an ordinary strategy that reflects the overhead into the product pricing.

Marginal Cost-Plus Pricing Full Cost Pricing

The incremental costs incurred Price-setting method under
in producing additional units of which you add together all
a good or service. the cost involved in making a
product or services
Only variable costs charged
to cost units and fixed costs of All fixed and variable costs are
the period written off in full used to compute the
against the aggregate total cost per unit.
contribution.

Both approaches are functional under the right situations, and each provide contrast objective for
the business. An example on how both approaches underline the different solution stated as
example 1.

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Example 1:

Suka Ramai Sdn Bhd produce metal chair and distribute them all over west Malaysia. The
management accountant prices the product at cost plus. The following are related data for the
production:

Element of cost Cost Cost per

unit
Materials RM40/kg RM80
Direct labour RM30/hour RM45
Manufacturing Overhead 40% is fixed RM40
Administrative Overhead 30% is variable RM20

The company expects a profit margin of 20%. Calculate the price per unit product using:

a) Marginal Cost-plus Pricing

b) Full-cost Pricing

Solution 1:
a) Marginal Cost-plus Pricing

Marginal Cost = RM80 + RM45 + (RM40 x 60%) + (RM20 x 30%)

= RM155
Price = RM155 + (RM155 x 20%)
= RM186

b) Full-cost Pricing

Total Cost = RM80 + RM45 + RM40+ RM20

= RM185

Price = RM185 + (RM185 x 20%)

= RM222

2.2.2 CALCULATE THE OPTIMUM SELLING PRICE AND QUANTITY FOR AN

ORGANIZATION, EQUATING MARGINAL COST AND MARGINAL REVENUE

Optimum selling price is the price at which profit is maximized that considered both fixed and
variable costs calculated in determining the selling price.

In other word, when marginal cost equals to marginal revenue, profit is maximized. Thus, on the
point of marginal revenue is greater than marginal cost that means profit would increase.

Profit Maximisation
MARGINAL REVENUE = MARGINAL COSTS

An example on attaining optimum selling price shown in example 2 and 3.

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Example 2
Suka Hati Sdn Bhd are currently using profit-maximizing price based on Marginal Revenue and
Marginal Cost. The management accountant provide the data regarding their company as below:

Unit Produced Price(RM) / Marginal Marginal Total Cost(RM)

Average Revenue(RM) Cost(RM)
Revenue
10 16 16 10 180
20 14 12 6 200
30 12 8 8 220
40 10 4 9 280
50 8 0 13 300
60 6 -4 16 260
70 4 -8 20 220
*Price, revenue and cost stated per unit

Calculate the optimum selling price and quantity for Suka Hati Sdn Bhd using marginal revenue
and marginal cost approach.

Solution 2:
Unit Produced Price(RM) / Marginal Marginal Total Cost(RM)
Average Revenue(RM) Cost(RM)
Revenue
10 16 16 10 180
20 14 12 6 200
30 12 8 8 220
40 10 4 9 280
50 8 0 13 300
60 6 -4 16 260
70 4 -8 20 220

Marginal Revenue = Marginal Cost = 8

Optimum Price = RM12

Optimum Unit Produce = 30 units

Maximum Profit = Total Revenue – Total Cost

= (30 units x RM12) – RM220
= RM140

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Example 3
From the diagram below, identify the optimum price and optimum output for the company to
maximize the profit using marginal approach:

Solution 3:
Marginal Revenue (MR) = Marginal Cost (MC)
Optimum Price = P1
Optimum output = Q1

2.2.3 DETERMINE PRICES AND OUTPUT LEVELS FOR PROFIT

MAXIMIZATION USING THE DEMAND BASED APPROACH TO PRICING

Demand Based Pricing is a pricing method based on the customer’s demand and the perceived
value of the product. In this method the customer’s responsiveness to purchase the product at
different prices is compared and then an acceptable price is set. Some of the approach use by
company is as follows:

a) Price Skimming - Electronic products (Initial price is set very high, then the price is reduced
gradually - discounted price at Lazada, Shopee)
b) Price Discrimination - Airline ticket prices (different price for different date, tickets during
holiday season would be costlier than off season)
c) Price Penetration - Discounts, inaugural price, first 100 buyers

The price set for product will be different for each circumstance. While the production quantity will
be based on the demand of the product at that period.

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 2.32.3 APPLY TARGET COSTING IN PRICING DECISION

2.3.1 DEFINE TARGET COSTING AND “TARGET COST GAP”

With target costing, a management team has a

Target costing is a system under which a powerful tool for continually monitoring
company plans for the price points, products from the moment they enter the
product costs, and margins that it wants to design phase and onward throughout their
achieve for a new product. If it cannot product life cycles.
manufacture a product at these planned
levels, then it cancels the design project Considered one of the most important
entirely. tools for achieving consistent
profitability in a manufacturing
environment.

Target costing is most applicable to companies that compete by continually issuing a stream of new
or upgraded products into the marketplace (such as consumer goods).

Target Costing = Anticipated Selling Price – Desired Profit

A firm could address the problems discussed above through the implementation of target costing:

The first step is to establish a competitive market price. The company

would consider how much customers are willing to pay and how much
competitors are charging for similar products.

Determine the required profit

A target cost is arrived at by deducting the required profit from the

selling price

Steps must then be taken to close the target cost gap from the
current cost per unit if higher.

Whereas, the target cost gap is the differences between estimated cost and the target cost.
Estimated cost is the calculation of the probable cost of a product or project, based on information
relating to the price of materials, labour, etc.

Target Cost Gap = Estimated Cost – Target Cost

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2.3.2 BENEFITS AND LIMITATIONS OF TARGET COSTING

Benefits of target costing

It is customer-centric as company
It encourages management to
creates product from customers'
continously improve process and
expectation. This expectation
innovate to gain a competitive
could be from price or feature
cost advantage.
perspective or both.

Company becomes proactive in

converting new market
Creates economies of scale
opportunities into real saving. It
because of continuous
assists the company in delivering
improvement from time to time
the best value for money to the
stakeholders

Limitations of target costing

Development process is
Difficult to reach consensus, as
lengthy as product has to go
this involves contribution of
through several alterations to
several people
meet the target cost

Reducing cost may hurt Project team has to work

employees' morale tirelessly to meet target cost

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2.3.3 CALCULATE TARGET SELLING PRICE & TARGET COST

Where the profit margin is based on selling price, target total cost can be calculated as
follows:

Target cost = Selling Price – (Profit % × Selling Price)

Where the profit margin is based on cost, target cost can be found as follows:

Selling Price
Target cost =
1 + profit percentage

Example 4
M&C is a marker pen manufacturer that operates in a very competitive environment. It sells marker
pen to different educational institutions in Malaysia. M&C can only charge RM2 per unit.

a) If the company’s intended profit margin is 15% on sales calculate the target cost per unit.
b) If the company’s intended profit margin is 15% on cost, calculate the target cost per unit.

Solution 4:

a) Target cost = Selling Price – (Profit % × Selling Price)

= RM2 – (15% x RM2)
= RM1.70

b) Target cost = Selling Price ÷ (1 + Profit %)

= RM2 ÷ (1 + 15%)
= RM1.74

2.4 CONCLUSION

Pricing involves a delicate balancing act. Higher prices result in more revenue per unit but drive down unit sales. Exactly
where to set prices to maximize profit is a difficult problem, but, in general, the markup over cost should be highest for
those products where customers are least sensitive to price.

From the economists’ point of view, the cost base for the markup should be variable cost. In contrast, in the absorption
costing approach the cost base is the absorption costing unit product cost and the markup computed to cover both
nonmanufacturing costs and to provide an adequate return on investment.

Some companies take a different approach to pricing. Instead of starting with costs and then determining prices, they
start with prices and then determine allowable costs. Companies that use target costing estimate what a new product’s
market price is likely to be based on its anticipated features and prices of products already on the market. They subtract
desired profit from the estimated market price to arrive at the product’s target cost.

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Review Questions

2.1 Explain THREE(3) objectives of pricing

2.2 Underline FOUR(4) factors that influence pricing

2.3 Explain the price elasticity of demand and profit maximization price

2.4 Discuss on the following pricing strategies: full-cost plus pricing, marginal-cost plus pricing,

relevant cost, price skimming, penetration pricing, complementary product, product-line

pricing, volume discounting and differential/price discrimination

2.5 What is target costing? How do target costs enter the pricing decisio

2.6 Edward Limited assembles and sells many types of radio. It is considering extending its
product range to include digital radios. These radios produce a better sound quality than
traditional radios and have a large number of potential additional features not possible with
the previous technologies (station scanning, more choice, one touch tuning, station
identification text and song identification text etc).
Assembly workers assembling a variety of components produce a radio. Production
overheads are currently absorbed into product costs on an assembly labour hour basis.
Edward Limited is considering a target costing approach for its new digital radio product.
Required:
(a) Briefly describe the target costing process that Edward Limited should undertake.
(b) Explain the benefits to Edward Limited of adopting a target costing approach at such an
early stage in the product development process.
(c) Assuming a cost gap was identified in the process outline possible steps Edward Limited
could take to reduce this gap.

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2.7 A selling price of RM44 has been set in order to compete with a similar radio on the market
that has comparable features to Edward Limited’s intended product. The board have agreed that
the acceptable margin (after allowing for all production costs) should be 20%. Cost information for
the new radio is as follows:

 Component 1 (Circuit board) – these are bought in and cost RM4.10 each. They are bought
in batches of 4,000 and additional delivery costs are RM2,400 per batch.
 Component 2 (Wiring) – in an ideal situation 25 cm of wiring is needed for each completed
radio. However, there is some waste involved in the process as wire is occasionally cut to
the wrong length or is damaged in the assembly process. Edward Limited estimates that
2% of the purchased wire is lost in the assembly process. Wire costs RM0·50 per metre to
buy.
 Other material – other materials cost RM8.10 per radio.
 Assembly labour – these are skilled people who are difficult to recruit and retain. Edward
Limited has more staff of this type than needed but is prepared to carry this extra cost in
return for the security it gives the business. It takes 30 minutes to assemble a radio and the
assembly workers are paid RM12.60 per hour. It is estimated that 10% of hours paid to the
assembly workers is for idle time.
 Production Overheads – recent historic cost analysis has revealed the following production
overhead data:

Total production overhead Total assembly

(RM) (labour hours)
Month 1 620,000 19,000
Month 2 700,000 23,000

Fixed production overheads are absorbed on an assembly hour basis based on normal annual
activity levels. In a typical year Edward Limited will work 240,000 assembly hours. Required:

(a) Calculate the expected cost per unit for the radio and identify any cost gap that might exist

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