Chapter 142024

Chapter 14
Pricing Decisions And

Cost Management
Learning Objectives (1 of 2)
1 Discuss the three major factors that affect pricing decisions
2 Understand how companies make long-run pricing
decisions
3 Price products using the target-costing approach
4 Apply the concepts of cost incurrence and locked-in costs
5 Price products using the cost-plus approach
6 Use life-cycle budgeting and costing when making pricing
decisions
7 Describe two pricing practices in which non-cost factors
are important
Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved
Major Factors That Affect Pricing
Decisions
• How companies price a product or service ultimately
depends on the demand and supply for it.
• Demand and supply have three influences:
1. Customers
2. Competitors
3. Costs
Three Influences on Demand and
Supply
1. Customers influence price through their effect on the
demand for a product or service, based on factors such
as product features and quality.
2. Competitors influence price through their technologies,
plant capacities, and operating strategies that affect their
costs.
3. Costs influence prices because they affect supply. The
lower the cost of producing a product, the greater the
quantity a firm is willing to supply.
Costing and Pricing for the Long Run
• Short-run pricing decisions have a time horizon of less
than one year and include
– pricing a one-time-only special order with no long-run
implications and
– adjusting product mix and output volume in a
competitive market.
• Long-run pricing builds long-run relationships with
customers based on stable and predictable prices.
Managers prefer a stable price because it reduces the
need for continuous monitoring of prices, improves
planning, and builds long-run buyer-seller relationships.
Cost Allocation
• Recall that indirect costs of a particular cost object are
costs that are related to that cost object but cannot be
traced to it in an economically feasible (cost-effective) way.
• These costs often comprise a large percentage of the
overall costs assigned to cost objects.
• Cost allocations and product profitability analyses affect
the products promoted by a company. To increase profits,
managers focus on high-margin products.
Purposes of Cost Allocation
Exhibit 14.1 Purposes of Cost Allocation
Purpose Examples
To provide information To decide on the selling price for a product or service
for economic decisions To decide whether to add a new product feature
To motivate managers To encourage the design of products that are simpler
and other employees to manufacture or less costly to service
To encourage sales representatives to emphasize
high-margin products or services
To justify costs or To cost products at a “fair” price, often required by law
compute and government contracts
reimbursement To compute reimbursement for a consulting firm based
amounts on a percentage of the cost savings resulting from the
implementation of its recommendations
To measure income To cost inventories for reporting to external parties
and assets To cost inventories for reporting to tax authorities
Alternative Long-Run Pricing
Approaches
How should managers use product cost information to price
their products? There are two different approaches for
pricing decisions:
• The market-based approach asks: Given what our
customers want and how competitors will react to what we
do, what price should we charge?
• The cost-based approach asks: Given what it costs us to
make this product, what price should we charge that will
recoup our costs and achieve a target return on investment
(also known as cost-plus)?
Market-Based Approach: Target
Costing for Target Pricing (1 of 3)
• Before setting prices under any approach, managers need
to understand customers and competitors for three reasons:
1. Lower-cost competitors continually restrain prices.
2. Products have shorter lives, which leaves companies
less time and opportunity to recover from pricing
mistakes, loss of market share, and loss of profitability.
3. Customers are more knowledgeable because they have
easy access to price and other information online and
demand high-quality products at low prices.
• Starts with a target price which is the estimated price for a
product or service that potential customers are willing to
pay
• The target price is estimated based on
1. an understanding of customers’ perceived value for a
product or service, and
2. how competitors will price competing products or
services.
Four Steps in Developing Target Prices and Target Costs
1. Develop a product that satisfies the needs of potential
customers.
2. Choose a target price.
3. Derive a target cost per unit by subtracting target
operating income per unit from the target price.
4. Perform value engineering to achieve target cost.
Value Engineering, Cost Incurrence,
and Locked-In Costs (1 of 5)
Value Engineering
• Value engineering is a systematic evaluation of all
aspects of the value chain, with the objective of reducing
costs and achieving a quality level that satisfies
customers.
• Value engineering entails improvements in product
designs, changes in materials specifications, and
modifications in process methods.
• To implement value engineering, managers must
distinguish value-added activities and costs from non-
value-added activities and costs.
Value Engineering Terminology
• A value-added cost is a cost that, if eliminated, would
reduce the actual or perceived value or utility (usefulness)
customers experience from using the product or service.
• Non-value-added costs are costs that, if eliminated, would
not reduce the actual or perceived value or utility
(usefulness) customers gain from using the product or
service. It is a cost the customer is unwilling to pay for.
Value Engineering Terminology
• Cost incurrence—describes when a resource is consumed
(or benefit forgone) to meet a specific objective
• Locked-in costs (designed-in costs)—costs that have not
yet been incurred but will be incurred in the future based
on decisions that have already been made
• The best opportunity to manage costs is before they are
locked in.
Exhibit 14.4 Pattern of Cost Incurrence and Locked-In Costs
To summarize, following are the key steps in value-
engineering:
1. Understand customer requirements and value-added and
non-value-added costs.
2. Anticipate how costs are locked in before they are
incurred.
3. Use cross-functional teams to redesign products and
processes to reduce costs while meeting customer
needs.
Possible Undesirable Effects of Value
Engineering and Target Costing
Unless managed properly, value engineering and target
costing can have undesirable effects:
1. Employees may feel frustrated if they fail to attain targets.
2. The cross-functional team may add too many features
just to accommodate the different wishes of team
members.
3. A product may be in development for a long time as the
team repeatedly evaluates alternative designs.
4. Organizational conflicts may develop as the burden of
cutting costs falls unequally on different business
functions in the company’s value chain.
Avoiding Possible Undesirable
Effects
To avoid those possible undesirable effects, target-costing
efforts should always do the following:
1. Encourage employee participation and celebrate small
improvements toward achieving the target cost.
2. Focus on the customer.
3. Pay attention to schedules.
4. Set cost-cutting targets for all value-chain functions to
encourage a culture of teamwork and cooperation.
Cost-Plus Pricing (1 of 5)
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 selling price
adds a markup component to the cost base.
• Usually, it is only a starting point in the price-setting
process.
• Markup is somewhat flexible, based partially on customers
and competitors.
• Because a markup is added, cost-based pricing is often
called cost-plus pricing, where the plus refers to the
markup component.
Cost-plus pricing can be determined several ways:
• Choose a markup to earn a target rate of return on
investment, which is the target annual operating income
divided by invested capital.
• Compute the specific amount of capital invested in a
product, which is challenging because it requires difficult
and arbitrary allocations of investments in equipment and
buildings to individual products.
• Because computing the specific amount of capital invested
in a product is challenging, sometimes managers use
alternate cost bases to set prospective selling prices:
– Variable manufacturing cost
– Variable cost
– Manufacturing cost
– Full cost
Common Business Practice
Many managers use full cost for their cost-based pricing
decisions:
• It allows for full recovery of all costs of the product.
• It allows for price stability.
• It is a simple approach.
• The selling prices computed under cost-plus pricing are
prospective prices.
• The target-pricing approach reduces the need to go back
and forth among prospective cost-plus prices, customer
reactions, and design modifications.
• Target-pricing first determines product characteristics and
target price on the basis of customer preferences and
expected competitor responses and then computes a
target cost.
Life-Cycle Product Budgeting and
Costing
• Managers sometimes need to consider target prices and target
costs over a multiple-year product life cycle.
• Product life cycles span the time from initial R&D to when
customer service and support are no longer offered.
• In life-cycle budgeting, managers estimate the revenues and
business function costs across the entire value-chain, from its
initial R&D to its final customer service and support.
• Life-cycle costing tracks and accumulates business function
costs across the entire value chain, from a product’s initial R&D
to its final customer service and support.
• Life-cycle budgeting and life-cycle costing span several years.
Life-Cycle Budgeting and Pricing
Decisions
Budgeted life-cycle costs provide useful information for
strategically evaluating pricing decisions. These two features
of costs make life-cycle budgeting particularly important.
• The development period for R&D and design is long and
costly.
• Many costs are locked in at the R&D and design stages,
even if R&D and design costs are themselves small.
Managing Environmental and
Sustainability Costs
Managing environmental costs is a critical area where managers
apply life-cycle costing and value engineering.
Environmental costs that are incurred over several years of the
product’s life cycle are often locked in at the product- and
process-design stage.
A new organization, the Sustainability Accounting Standards
Board (SASB) has begun defining standards for environmental,
social, and governance (E S G) performance for different
industries. When measured over multiple periods, companies
that have higher relevant E S G ratings, have higher future
profitability and financial performance, perhaps because of
customer loyalty and satisfaction, employee engagement, or
brand and reputation.
Customer Life-Cycle Costing
Customer life-cycle costs focus on the total costs incurred by
a customer to acquires, use, maintain, and dispose of a
product or service.
These costs influence the prices a company can charge for
its products.
As an example, Maytag can charge higher prices for
appliances that save electricity and have low maintenance
costs.
Non-Cost Factors in Pricing
Decisions (1 of 2)
Predatory pricing—when a company deliberately prices
below its costs in an effort to drive competitors out of the
market to restrict supply and then recoups its losses by
raising prices or enlarging demand
Collusive pricing—when companies in an industry conspire
in their pricing and production decisions to achieve a price
above the competitive price and so restrain trade
Both type of pricing violate U.S. Antitrust Laws and are
illegal.
Non-Cost Factors in Pricing
Decisions (2 of 2)
Price discrimination is the practice of charging different
customers different prices for the same product or service.
• Price discrimination is permissible if differences in prices can be
justified by differences in costs.
• Price discrimination is illegal only if the intent is to lessen or
prevent competition.
Peak-load pricing is the practice of charging a higher price for
the same product or service when demand approaches the
physical limit of the capacity to produce that product or service.
International pricing is a form of price discrimination where
prices charged in different countries may vary much more than the
costs of delivering the product because of differences in
customers’ purchasing power in those different countries.

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Chapter 14

Pricing Decisions And

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