Chapter 15

Target Costing and

Cost Analysis for
Pricing Decisions

McGraw-Hill/Irwin Copyright © by The McGraw-Hill Companies, Inc. All rights reserved.

 Major Influences on
Pricing Decisions
Customer Political, legal,
demand and image issues

Pricing
Decisions

Competitors Costs

15-2
 How Are Prices Set?

Prices are determined by the market, subject

to costs that must be covered in the long run.

Market
Costs
Forces

Prices are based on costs, subject to

reactions of customers and competitors.

15-3
 Economic Profit-Maximizing
Pricing

Firms usually have flexibility in setting prices.

The quantity sold usually

declines as the price is increased.

15-4
 Total Revenue Curve
Dollars
Total revenue

Curve is increasing throughout

its range, but at a declining rate.

Quantity sold
per month
15-5
 Demand Schedule and Marginal
Dollars
Revenue Curve
per unit

Sales price must decrease

to sell higher quantity.

Demand
Revenue per Marginal
unit decreases revenue
as quantity increases. Quantity sold
per month
15-6
 Total Cost Curve
Dollars

Total cost increases

at an increasing rate.

Total cost increases

at a declining rate.
Quantity made
per month
15-7
 Marginal Cost Curve
Dollars
per unit
Marginal
cost
Quantity where
marginal cost
begins to increase.

Quantity made
per month
15-8
Determining the Profit-Maximizing
Price and Quantity
Dollars
per unit

p*

Demand
Marginal
cost Marginal Quantity made
revenue and sold
q* per month
15-9
Determining the Profit-Maximizing
Price and Quantity
Dollars
per unit Profit is maximized where
marginal cost equals
marginal revenue, resulting
p* in price p* and quantity q*.

Demand
Marginal
cost Marginal Quantity made
revenue and sold
q* per month
15-10
Determining the Profit-Maximizing
Price and Quantity
Dollars Total cost
Total revenue

Total profit at the

profit-maximizing
quantity and price,
q* and p*.

Quantity made
and sold
q* per month
15-11
 Price Elasticity

The impact of
price changes on
sales volume

Demand is elastic if Demand is inelastic if

a price increase has a a price increase has
large negative impact little or no impact
on sales volume. on sales volume.

15-12
 Cross Elasticity

The extent to
which a change in
a product’s price affects the
demand for other
substitute products.

15-13
 Limitations of the
Profit-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.

15-14
 Role of Accounting
Product Costs in Pricing
Exh.
15-4

Optimal Decisions Suboptimal Decisions

Economic pricing model Cost-based pricing
Sophisticated decision Simplified decision
model and information model and information
requirements requirements

Marginal-cost and Accounting product-

marginal-revenue data cost data
More costly Less costly
The best approach, in terms of costs and
benefits, typically lies between the extremes.
15-15
 Cost-Plus Pricing

Price = cost + (markup percentage × cost)

Full-absorption Variable
manufacturing manufacturing
cost? cost?

Total cost, Total variable cost,

including selling including selling
and administrative? and administrative?
15-16
 Cost-Plus Pricing - Example
Variable mfg. cost $ 400
Fixed mfg. cost 250
Full-absorption mfg. cost $ 650
Variable S & A cost 50
Fixed S & A cost 100
Total cost $ 800

We will use this unit cost information to illustrate the

relationship between cost and markup necessary to
achieve the desired unit sales price of $925.

15-17
 Cost-Plus Pricing - Example
Variable mfg. cost $ 400
Markup on
Fixed mfg. cost 250
variable
Full-absorption mfg. cost $ 650
manufacturing
Variable S & A cost 50
cost
Fixed S & A cost 100
Total cost $ 800

Price = cost + (markup percentage × cost)

Price = $400 + (131.25% × $400) = $925

15-18
 Cost-Plus Pricing - Example
Markup on
Variable mfg. cost $ 400 total var. cost
Fixed mfg. cost 250 As cost base
Full-absorption mfg. cost $ 650 increases, the
Variable S & A cost 50 required markup
Fixed S & A cost 100 percentage
Total cost $ 800 declines.

Price = cost + (markup percentage × cost)

Price = $450 + (105.56% × $450) = $925

15-19
 Cost-Plus Pricing - Example
Markup on
Variable mfg. cost $ 400 full mfg. cost
Fixed mfg. cost 250 As cost base
Full-absorption mfg. cost $ 650 increases, the
Variable S & A cost 50 required markup
Fixed S & A cost 100 percentage
Total cost $ 800 declines.

Price = cost + (markup percentage × cost)

Price = $650 + (42.31% × $650) = $925

15-20
 Cost-Plus Pricing - Example
Markup on
Variable mfg. cost $ 400 total cost
Fixed mfg. cost 250 As cost base
Full-absorption mfg. cost $ 650 increases, the
Variable S & A cost 50 required markup
Fixed S & A cost 100 percentage
Total cost $ 800 declines.

Price = cost + (markup percentage × cost)

Price = $800 + (15.63% × $800) = $925

15-21
Absorption-Cost Pricing Formulas
Advantages Disadvantages
! Price covers all costs. Full-absorption unit
price obscures the
" Perceived as distinction between
equitable. variable and fixed
# Comparison with costs.
competitors.
$ Absorption cost used
for external reporting.

15-22
 Variable-Cost Pricing Formulas

Advantages Disadvantage
! Do not obscure cost Fixed costs may be
behavior patterns. overlooked in pricing
decisions, resulting in
" Do not require fixed prices that are too
cost allocations. low to cover total
# More useful for costs.
managers.

15-23
 Determining the Markup:
Return-on-Investment Pricing

Solve for the

markup
percentage that
will yield the
desired return on
investment.

15-24
 Determining the Markup:
Return-on-Investment Pricing
Recall the example using a 131.25 percent markup
on variable manufacturing cost.

Price = cost + (markup percentage × cost)

Price = $400 + (131.25% × $400) = $925

Let’s solve for the 131.25 percent markup. Invested

capital is $300,000, the desired ROI is 20 percent,
and annual sales volume is 480 units.

15-25
 Determining the Markup:
Return-on-Investment Pricing
Step 1: Solve for the income that
will result in an ROI of 20 percent.

Income
ROI =
Invested Capital
Income
20% =
$300,000
Income = 20% × $300,000
Income = $60,000
15-26
 Determining the Markup:
Return-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 $ 400

Fixed mfg. cost 250
Full-absorption mfg. cost $ 650
Variable S & A cost 50
Fixed S & A cost 100
Total cost $ 800
15-27
 Determining the Markup:
Return-on-Investment Pricing
Step 2: Solve for the unit sales price
necessary to result in an income of $60,000.

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

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

$60,000
Unit sales price - $800 unit cost =
480 units
Unit sales price - $800 unit cost = $125 per unit
Unit sales price = $925
15-28
 Determining the Markup:
Return-on-Investment Pricing
Step 3: Compute the markup percentage on
the $400 variable manufacturing cost.

Markup Unit sales price - Unit variable cost

=
percentage Unit variable cost
Markup $925 per unit - $400 per unit
=
percentage $400 per unit
Markup
= 131.25 percent
percentage

15-29
Strategic 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.

15-30
 Target Costing

Market research
determines the price Management computes
at which a new a manufacturing cost that
product will sell. will provide an acceptable
profit margin.

Engineers and cost analysts design a product

that can be made for the allowable cost.
15-31
 Target Costing

Price led Cross-functional

costing teams
Key
Life-cycle principles Value-chain
costs of target orientation
costing
Focus on Focus on
process product
design Focus design
on the
customer
15-32
 The Role Of Activity-Based
Costing In Setting A
Target Cost.

Production Process

Component Activities

15-33
 Product Cost Distortion

High-volume products
May be overcosted

Low-volume products
May be undercosted

15-34
 Value Engineering
and Target Costing
Target cost information
l Product design
l Product costs
l Production processes

Value Engineering (VE)

l Cost reduction
l Design improvement
l Process improvement

15-35
 Time and Material Pricing

• Price is the sum of

labor and material
charges.

• Used by
construction
companies,
printers, and
professional
service firms.
15-36
 Time and Material Pricing
Time charges:
Hourly Overhead Hourly charge Total
labor + cost per + to provide × labor hours
cost labor hour profit margin required

Material Charges:
Total Overhead Total
material per dollar material
cost
+ of material × cost
incurred cost incurred
15-37
 Competitive Bidding

Low probability High bid High profit if

of winning bid price winning bid

High probability Low bid Low profit if

of winning bid price winning bid

15-38
 Competitive Bidding
Guidelines for Bidding
! Low bid price
! Any bid price in excess of
Bidder has
incremental costs of job
excess capacity will contribute to fixed
costs and profit.
! High bid price
! Bid price should be full
Bidder has no cost plus normal profit
excess capacity margin as winning bid will
displace existing work.
15-39
Legal Restrictions On Setting Prices
• Price discrimination

• Predatory pricing

15-40
End of Chapter 15

What is the
right price?

15-41