Pricing Products and

Services
CHAPTER07

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

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Learning Objective 1

Compute the selling price of a product

using the absorption cost-plus pricing.

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The absorption Cost-Plus Pricing

Companies frequently use a pricing approach where
they markup cost. A product’s markup is the difference
between its selling price and its cost and is usually
expressed as a percentage of cost.

Selling price = (1 + Markup percentage) x Cost

If a company wanted to have a 20% markup over cost

and the cost of a product was $50, then the selling price
would be $60.
Selling Price = (1 + .20) x $50
Selling Price = $60

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The Three-Step Process

First, a company needs to calculate its unit product
costs (including direct materials, direct labor,
variable manufacturing overhead, and fixed
manufacturing overhead).
Second, it needs to determine its markup
percentage on absorption cost.
Third, it needs to multiply a product’s unit product
cost by the markup percentage to determine the
product’s selling price.

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The Cost Base

Under the absorption approach to cost-plus pricing,

the cost base is the absorption costing unit product
cost rather than the variable cost.

The cost base includes direct materials,

direct labor, and variable and fixed
manufacturing overhead.

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Determining a Product's Selling Price –
Example
Here is information provided by the management of
Ritter Company.
Per Unit Total
Direct materials $ 6
Direct labor 4
Variable manufacturing overhead 3
Fixed manufacturing overhead $ 70,000
Variable S & A expenses 2
Fixed S & A expenses 60,000

Management will use the absorption costing

approach to cost-plus pricing to determine the
selling price of the product in a three-step
process.
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 12A-7
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Determining a Product’s Selling Price –
Step 1
The first step in the absorption costing approach to
cost-plus pricing is to compute the unit product cost.

Per Unit
Direct materials $ 6
Direct labor 4
Variable manufacturing overhead 3
Fixed manufacturing overhead 7
Unit product cost $ 20

($70,000 ÷ 10,000 units = $7 per unit)

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Determining the Markup Percentage –
Step 2
The second step in the absorption costing approach to
cost-plus pricing is to determine the mark-up
percentage.
The equation for calculating the markup percentage on
absorption cost is shown below.

Markup %
(Required ROI × Investment) + S & A expenses
on absorption = Unit sales × Unit product cost
cost

The markup must be high enough to cover S & A

expenses and to provide an adequate return on
investment.
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 12A-9
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Determining the Markup Percentage –
Step 2 – Example

Let’s assume that Ritter must invest $100,000 in the

product and market 10,000 units of product each
year. The company requires a 20% ROI on all
investments. Let’s determine Ritter’s markup
percentage on absorption cost.

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Determining the Markup Percentage –
Step 2 – Example Calculation

Markup %
on absorption = (20% × $100,000) + ($2 × 10,000 + $60,000)
cost 10,000 × $20
Variable S & A per unit Total fixed S & A

Markup %
($20,000 + $80,000)
on absorption = $200,000
= 50%
cost

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Determining a Product’s Selling Price –
Step 3
The third step in the absorption costing approach to cost-
plus pricing is to determine the product's selling price by
multiplying its unit product cost by the sum of 1 + the
markup percentage.
Per Unit
Direct materials $ 6
Direct labor 4
Variable manufacturing overhead 3
Fixed manufacturing overhead 7
Unit product cost $ 20
50% markup 10
Selling price $ 30

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Problems with the Absorption Costing
Approach

The absorption costing approach essentially assumes

that customers need the forecasted unit sales and will
pay whatever price the company decides to charge.
This is flawed logic simply because customers have a
choice.

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Problems with the Absorption Costing
Approach – Example
Let’s assume that Ritter sells only 7,000 units at
$30 per unit, instead of the forecasted 10,000
units. Here is the income statement.
RITTER COMPANY
Income Statement
For the Year Ended December 31, 2017
Sales (7,000 units × $30) $ 210,000
Cost of goods sold (7,000 units × $23) 161,000
Gross margin 49,000
SG&A expenses 74,000
Net operating loss $ (25,000)

$ (25,000)
ROI = = -25%
$ 100,000
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Problems with the Absorption Costing
Approach – Example Calculation
Let’s assume that Ritter sells only 7,000 units at
$30 per unit, instead of the forecasted 10,000.
units. Here is the income statement.
Absorption costing approach to pricing is a safe
RITTER COMPANY
approach onlyIncome if customers
Statement
choose to buy at
least asFormany units
the Year Endedas managers
December forecasted
31, 2011
Sales (7,000 unitsthey
× $30) would buy. $ 210,000
Cost of goods sold (7,000 units × $23) 161,000
Gross margin 49,000
SG&A expenses 74,000
Net operating loss $ (25,000)

$ (25,000)
ROI = = -25%
$ 100,000
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Learning Objective 2

Compute the selling price of a product

using the marginal cost – plus pricing

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 12A-16
7-9

Marginal Cost-Plus Pricing

Selling price = (1 + Markup percentage) x Cost

If a company wanted to have a 20% markup over cost

and the cost of a product was $50, then the selling price
would be $60.
Selling Price = (1 + .20) x $50
Selling Price = $60

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 12A-17

The Three-Step Process

First, a company needs to calculate its unit variable
costs (including direct materials, direct labor,
variable manufacturing overhead and variable
selling and administrative expesnes).
Second, it needs to determine its markup
percentage on marginal cost
Third, it needs to multiply a product’s unit variable
cost by the markup percentage to determine the
product’s selling price

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 12A-18

The Cost Base

Under the marginal approach to cost-plus

pricing, the cost base is the unit variable cost
rather than the absorption costing unit product
cost .

The cost base includes direct materials,

direct labor, variable manufacturing
overhead cost , variable selling expenses
and variable administrative expenses.
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 12A-19

Determining a Product's Selling Price –

Example
Here is information provided by the management of
Ritter Company
Per Unit Total
Direct materials $ 6
Direct labor 4
Variable manufacturing overhead 3
Fixed manufacturing overhead $ 70,000
Variable S & A expenses 2
Fixed S & A expenses 60,000

Management will use the marginal costing

approach to cost-plus pricing to determine the
selling price of the product in a three-step
process.
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further distribution permitted without the prior written consent of McGraw-Hill Education.
 12A-20

Determining a Product’s Selling Price –

Step 1
The first step in the marginal costing approach to
cost-plus pricing is to compute the unit variable cost.

Per Unit
Direct materials $ 6
Direct labor 4
Variable manufacturing overhead 3
Variable selling and administrative expenses
2
unit variable cost $ 15

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 12A-21

Determining the Markup Percentage –

Step 2
The second step in the marginal costing approach to
cost-plus pricing is to determine the mark-up
percentage.
The equation for calculating the markup percentage on
marginal cost is shown below.

Markup %
(Required ROI × Investment) + total fixed costs
on marginal cost=
Unit sales × variable cost per unit

The markup must be high enough to cover total fixed

costs and to provide an adequate return on investment.
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 12A-22

Determining the Markup Percentage –

Step 2 – Example

Let’s assume that Ritter must invest $100,000 in the

product and market 10,000 units of product each
year. The company requires a 20% ROI on all
investments. Let’s determine Ritter’s markup
percentage on marginal cost.

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 12A-23

Determining the Markup Percentage –

Step 2 – Example Calculation
Markup %
on marginal (20% × $100,000) + (70.000+ $60,000)
= 10,000 × $15
cost
Total fixed manufacturing overhead costs Total fixed S & A

Markup %
on marginal ($20,000 + $130,000)
cost = $150,000
= 100%

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 12A-24

Determining a Product’s Selling Price –

Step 3
The third step in the marginal costing approach to cost-plus
pricing is to determine the product's selling price by
multiplying its unit variable cost by the sum of 1 + the
markup percentage. Per Unit
Direct materials $ 6
Direct labor 4
Variable manufacturing overhead 3
Variable S & A 2
Unit variable cost $ 15
100% markup 15
Selling price $ 30

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Learning Objective 3

Compute the target cost for

a new product or service.

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Target Costing
Target costing is the process of determining the maximum
allowable cost for a new product and then developing a
prototype that can be made for that maximum target cost
figure. The equation for determining a target price is shown
below:
Target cost = Anticipated selling price – Desired profit

Once the target cost is determined, the product

development team is given the responsibility of
designing the product so that it can be made for no
more than the target cost.
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Reasons for Using Target Costing – Part 1

Two characteristics of prices and product costs

include:
1. The market (i.e., supply and demand)
determines price.
2. Most of the cost of a product is determined in
the design stage.

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Reasons for Using Target Costing – Part 2

Target costing was developed in recognition of

the two characteristics summarized on the
previous screen.
Target costing begins the product development
process by recognizing and responding to
existing market prices. Other approaches allow
engineers to design products without
considering market prices.

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Reasons for Using Target Costing – Part 3

Target costing focuses a company’s cost reduction

efforts in the product design stage of production.
Other approaches attempt to squeeze costs out of the
manufacturing process after they come to the
realization that the cost of a manufactured product
does not bear a profitable relationship to the existing
market price.

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Target Costing: An Example

Handy Appliance feels there is a niche for a hand mixer
with special features. The marketing department believes
that a price of $30 would be about right and that about
40,000 mixers could be sold. An investment of $2 million
is required to gear up for production. The company
requires a 15% ROI on invested funds.
Let’s see how we determine the target cost.

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Target Costing: Example Solution

Projected sales (40,000 units × $30) $ 1,200,000

Desired profit ($2,000,000 × 15%) 300,000
Target cost for 40,000 mixers $ 900,000

Target cost per mixer ($900,000 ÷ 40,000) $ 22.50

Each functional area within Handy Appliance would

be responsible for keeping its actual costs within the
target established for that area.

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Learning Objective 4

Compute the selling price of a product

when company has a special offer.

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Conditions

Big order size

Free capacity
Bidding
discounts

Usually using marginal cost-plus pricing

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An example
Suppose that, A company Y has free capacity with 20.000 units
and the company’s selling price under cost –plus pricing is $24 per
unit. A customer Z orders 10.000 units and requires that the
company offers a special selling price with $19 per unit. Should
the company accept or reject the order?
The marginal cost-plus pricing
The absorption cost-plus pricing
Direct materials per unit $6 per unit
Direct materials per unit $6 per unit
Direct labor per unit $7
Direct labor per unit $7
Variable manufacturing $2
Manufacturing overhead $7 overhead costs per unit
costs per unit
Variable selling and $1
Unit product cost $20 administrative per unit
Markup (20% of cost) $4 Unit variable cost $16
Selling price per unit $24 Markup (50% of cost) $8
Selling price per unit $24

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 12A-35

The selling price for Special orders

Suppose that, Company Y has free capacity with 20.000 units and
the company’s selling price under cost –plus pricing is $24 per
unit. A customer Z orders 10.000 units and requires that the
company offers a special selling price with $19 per unit. Should
theThe absorptionaccept
company cost-plus
orpricing
reject the order?
Direct materials per unit $6 per unit
Direct labor per unit $7

Manufacturing overhead costs per unit $7

Unit product cost $20
Markup (20% of cost) $4
Selling price per unit $24
If Company Y uses the absorption cost-plus pricing:
Sales (10.000 unit x $19 /unit) $190,000
Total manufacturing costs (10.000 units x $20/unit) $ 200,000
Profit ($ 10,000)

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The selling price for Special orders

Suppose that, Company Y has free capacity with 20.000 units and
the company’s selling price under cost –plus pricing is $24 per
unit. A customer Z orders 10.000 units and requires that the
The absorption
company cost-plus
offers pricingselling price with $19 per unit. Should
a special
the company
Direct accept
materials per unit or reject the $6order?
per unit
Direct labor per unit $7
reject
Manufacturing overhead costs per $7
unit
Unit product cost $20
Markup (20% of cost) $4
Selling price per unit $24

If Company Y uses the absorption cost-plus pricing:

Sales (10.000 unit x $19 /unit) $190,000
Total manufacturing costs (10.000 units x $20/unit) $ 200,000
Profit ($ 10,000)

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The selling price for Special orders

Using the marginal cost-plus pricing:

Incremental costs of an additional product among 10,000

units:
Variable costs $16 per unit

The selling price that is required by the customer Z is 19$ so

the company Y should accept the order.

Sales (10.000 units x $19/unit) $190,000

Total variable costs (10.000 unit x $16/unit) $160,000
Profit $30,000
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the selling price for special orders

A format :
Direct materials xx
Direct labors xx
Variable costs xx
Variable selling and administrative costs xx
Variable cost per unit xxx(a cost base) Flexibility
Markup xx
Selling price per unit xx

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End of chapter07

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