Chapter 15

Target Costing and

Cost Analysis for
Pricing Decisions

McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All

 Learning
Objective
1

McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All

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

Pricing
Decisions

Competitors Costs
 Learning
Objective
2

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 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.
 Economic Profit-Maximizing
Pricing

Firms
Firms usually
usually have
have flexibility
flexibility in
in setting
setting prices.
prices.

The
The quantity
quantity sold
sold usually
usually
declines
declines as
as the
the price
price is
is increased.
increased.
 Total Revenue Curve
Dollars
Total revenue

Curve is increasing throughout

its range, but at a declining rate.

Quantity sold
per month
 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
 Total Cost Curve
Dollars

Total cost increases

at an increasing rate.

Total cost increases

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

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

p*

Demand
Marginal
cost Marginal Quantity made
revenue
q* and sold
per month
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
q* and sold
per month
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
q* and sold
per month
 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.
 Cross Elasticity

The extent to
which a change in
a products price affects the
demand for other
substitute products.
 Limitations of the
Profit-Maximizing Model

A firms 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.
 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.
 Learning
Objective
3

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 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?
 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
We will
will use
use this
this unit
unit cost
cost information
information toto illustrate
illustrate the
the
relationship
relationship between
between cost
cost and
and markup
markup necessary
necessary to to
achieve
achieve thethe desired
desired unit
unit sales
sales price
price ofof $925.
$925.
 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
 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
 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
 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
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.
 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.
 Determining the Markup:
Return-on-Investment Pricing

Solve for the markup

percentage that will
yield the desired
return on investment.
 Determining the Markup:
Return-on-Investment Pricing
Recall
Recall the
the example
example using
using aa 131.25
131.25 percent
percent markup
markup
on
on variable
variable manufacturing
manufacturing cost.
cost.

Price = cost + (markup percentage cost)

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

Lets
Lets solve
solve for
for the
the 131.25
131.25 percent
percent markup.
markup. Invested
Invested
capital
capital is
is $300,000,
$300,000, thethe desired
desired ROI
ROI is
is 20
20 percent,
percent,
and
and annual
annual sales
sales volume
volume is
is 480
480 units.
units.
 Determining the Markup:
Return-on-Investment Pricing
Step
Step 1:1: Solve
Solve forfor the
the income
income that
that
will
will result
result in
in an
an ROI
ROI of
of 20
20 percent.
percent.
Income
ROI =
Invested Capital
Income
20% =
$300,000
Income = 20% $300,000
Income = $60,000
 Determining the Markup:
Return-on-Investment Pricing
Step
Step 2:
2: Recall
Recall the
the unit
unit cost
cost information
information below.
below.
Solve
Solve for
for the
the unit
unit sales
sales price
price necessary
necessary to
to
result
result in
in an
an income
income ofof $60,000.
$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
 Determining the Markup:
Return-on-Investment Pricing
Step
Step 2:
2: Solve
Solve for
for the
the unit
unit sales
sales price
price
necessary
necessary to
to result
result in
in an
an income
income ofof $60,000.
$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
 Determining the Markup:
Return-on-Investment Pricing
Step
Step 3:
3: Compute
Compute the
the markup
markup percentage
percentage on
on
the
the $400
$400 variable
variable manufacturing
manufacturing cost.
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
 Learning
Objective
4

McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All

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.
 Learning
Objective
5

McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All

 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.
 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
 Learning
Objective
6

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 The Role Of Activity-Based
Costing In Setting A
Target Cost.

Production Process

Component Activities
 Learning
Objective
7

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 Product Cost Distortion

High-volume products
May be overcosted

Low-volume products
May be undercosted
 Learning
Objective
8

McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All

 Value Engineering
and Target Costing
Target
Target cost
cost information
information
Product

Product design
design
Product

Product costs
costs
Production

Production processes
processes

Value
Value Engineering
Engineering (VE)
(VE)
Cost

Cost reduction
reduction
Design

Design improvement
improvement
Process

Process improvement
improvement
 Learning
Objective
9

McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All

 Time and Material Pricing

Price is the sum of

labor and material
charges.

Used by
construction
companies, printers,
and professional
service firms.
 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
 Learning
Objective
10

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 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
 Competitive Bidding
Guidelines
Guidelines for
for Bidding
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.
 Learning
Objective
11

McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All

Legal Restrictions On Setting Prices
Price discrimination

Predatory pricing
End of Chapter 15

What is the
right price?