CHAPTER 12:

Relevant Costs for

Decision Making

Prepared by
Shannon Butler,
CPA, CA
Carleton University
 Learning Objectives 1

1. Distinguish between relevant and irrelevant costs in

decision making.
2. Prepare analyses for various decision situations.
3. Determine the most profitable use of a constrained
resource and the value of obtaining more of the
constrained resource.

© 2021 McGraw-Hill Limited 12-2

 Learning Objectives 2
4. (Appendix 12A) Compute selling prices based on
costs using the absorption and variable costing
approaches.
5. Appendix 12A) Understand how customers’
sensitivity to changes in pricing should influence
pricing decisions.
6. Appendix 12A) Analyze pricing decisions using
value-based pricing.
7. Appendix 12A) Compute target costs based on
selling prices.

© 2021 McGraw-Hill Limited 12-3

 Identifying Relevant Costs and
Benefits
• A relevant cost is a cost that differs between alternatives.
• An avoidable cost is a cost that can be eliminated, in whole
or in part, by choosing one alternative over another.
• Avoidable costs are relevant costs; Unavoidable costs are
irrelevant costs.
• Two broad categories of costs that are never relevant in
any decision are:
• Sunk costs.
• Future costs that do not differ between the alternatives.

© 2021 McGraw-Hill Limited 12-4

Relevant Cost Analysis: A Two-Step
Process
• To identify the costs and benefits that are relevant in
a particular decision situation, these steps can be
followed:
1. Eliminate costs and benefits that do not differ
between alternatives.
2. Use the remaining costs and benefits that
differ between alternatives in making the
decision. The costs that remain are the
differential, or avoidable, costs.

© 2021 McGraw-Hill Limited 12-5

 Different Costs for Different
Purposes

• Costs that are relevant in one decision

situation may not be relevant in another
context.

© 2021 McGraw-Hill Limited 12-7

 Identifying Relevant Costs 1
Sarah, a Toronto student, is considering visiting her friend in
Windsor. She can drive or take the train. By car, it is 230 kilometers
to her friend’s apartment. She is trying to decide which alternative is
less expensive and has gathered the following information:
Automobile Costs (based on 10,000 miles driven per year)
Annual Cost per
Cost of Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.050
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.569
$1.60 per gallon ÷ 32 MPG

$18,000 cost – $4,000 salvage value ÷ 5 years

© 2021 McGraw-Hill Limited 12-8
 Identifying Relevant Costs 2
Automobile Costs (based on 10,000 kilometers driven per year)
Annual Cost per
Cost of km
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.050
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.569

Some Additional Information

7 Reduction in resale value of car per km of wear $ 0.026
8 Round-tip train fare $ 104
9 Benefits of relaxing on train trip ????
10 Cost of putting dog in kennel while gone $ 40
11 Benefit of having car in Windsor ????
12 Hassle of parking car in Windsor ????
13 Per day cost of parking car in Windsor $ 25

© 2021 McGraw-Hill Limited 12-9

 Identifying Relevant Costs 7
From a financial standpoint, Sarah would be better
off taking the train to visit her friend. Some of the
non-financial factor may influence her final decision.

Relevant Financial Cost of Taking the Train

Round-trip ticket $ 104.00

© 2021 McGraw-Hill Limited 12-10

 Total and Differential Cost
Approaches 1
The management of a company is considering a new labour saving machine that
rents for $3,000 per year. Data about the company’s annual sales and costs with
and without the new machine are:
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labour (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
Other 62,000 62,000 -
Rent on new machine - 3,000 (3,000)
Total fixed expenses 62,000 65,000 (3,000)
Operating income $ 18,000 $ 30,000 12,000

© 2021 McGraw-Hill Limited 12-11

 Total and Differential Cost
Approaches 2
As you can see, the only costs that differ between the alternatives are the direct
labour costs savings and the increase in fixed rental costs.
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labour (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
We can efficiently analyze the decision by
Less fixed expense:
looking at the different costs and revenues
Other 62,000 62,000 -
Rent on new machine - 3,000 (3,000)
and arrive at the same solution.
Total fixed expenses 62,000 65,000 (3,000)
Operating income $ 18,000 $ 30,000 12,000
Net Advantage to Renting the New Machine
Decrease in direct labour costs (5,000 units @ $3 per unit) $ 15,000
Increase in fixed rental expenses (3,000)
Net annual cost saving from renting the new machine $ 12,000

© 2021 McGraw-Hill Limited 12-12

 Total and Differential Cost
Approaches 3
• Using the differential approach is desirable for two
reasons:
1.Only rarely will enough information be available
to prepare detailed income statements for both
alternatives.
2.Mingling irrelevant costs with relevant costs may
cause confusion and distract attention away from
the information that is really critical.

© 2021 McGraw-Hill Limited 12-13

 Beware of Allocated Fixed Costs

• Why should we keep the digital watch

segment when it’s showing a $100,000 loss?
• The answer lies in the way we allocate
common fixed costs to our products.
• Our allocations can make a segment look less
profitable than it really is.

© 2021 McGraw-Hill Limited 12-14

 The Make or Buy Decision

• When a company is involved in more than

one activity in the entire value chain, it is
vertically integrated.
• A decision to carry out one of the activities in
the value chain internally, rather than to buy
externally from a supplier is called a “make or
buy” decision.

© 2021 McGraw-Hill Limited 12-15

Strategic Aspects of the Make or Buy
Decision
Advantages
• Smoother flow of parts and materials
• Better quality control
• Realize profits
Disadvantage
• Companies may fail to take advantage of
suppliers who can create economies of scale
advantage by pooling demand from
numerous companies.
© 2021 McGraw-Hill Limited 12-16
 An Example of Make or Buy
• Essex Company manufactures part 4A that is used in
one of its products.
• The unit product cost of this part is:

© 2021 McGraw-Hill Limited 12-17

 The Make or Buy Decision 1
• The special equipment used to manufacture part 4A has
no resale value.
• The total amount of general factory overhead, which is
allocated on the basis of direct labour hours, would be
unaffected by this decision.
• The $30 unit product cost is based on 20,000 parts
produced each year.
• An outside supplier has offered to provide the 20,000
parts at a cost of $25 per part.
Should we accept the supplier’s offer?

© 2021 McGraw-Hill Limited 12-18

 The Make or Buy Decision 2
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials $ 9 180,000

Direct labour 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

20,000 × $9 per unit = $180,000

© 2021 McGraw-Hill Limited 12-20

 The Make or Buy Decision 3
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials $ 9 180,000

Direct labour 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

The special equipment has no resale value and

is a sunk cost.

© 2021 McGraw-Hill Limited 12-21

 The Make or Buy Decision 4

Not avoidable; irrelevant. If the product is dropped, it will

be reallocated to other products.

© 2021 McGraw-Hill Limited 12-22

 The Make or Buy Decision 5
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials $ 9 180,000

Direct labour 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

Should we make or buy part 4A?

© 2021 McGraw-Hill Limited 12-23
 Opportunity Cost
• An opportunity cost is the benefit that is foregone as
a result of pursuing some course of action.
• Opportunity costs are not actual dollar outlays and
are not recorded in the formal accounts of an
organization.
• How would this concept potentially relate to the
Essex Company?

© 2021 McGraw-Hill Limited 12-24

 Special Orders 1

• A special order is a one-time order that is not

considered part of the company’s normal
ongoing business.

• When analyzing a special order, only the

incremental costs and benefits are relevant.

© 2021 McGraw-Hill Limited 12-26

 Special Orders 2
• Jet, Inc. makes a single product whose normal
selling price is $20 per unit.
• A foreign distributor offers to purchase 3,000 units
for $10 per unit.
• This is a one-time order that would not affect the
company’s regular business.
• Annual capacity is 10,000 units, but Jet, Inc. is
currently producing and selling only 5,000 units.

Should Jet accept the offer?

© 2021 McGraw-Hill Limited 12-27
 Special Orders 3
Jet, Inc.
Contribution Income Statement
Revenue (5,000 × $20) $ 100,000
Variable costs:
Direct materials $ 20,000
Direct labour 5,000
Manufacturing overhead 10,000 $8 variable cost
Marketing costs 5,000
Total variable costs 40,000
Contribution margin 60,000
Fixed costs:
Manufacturing overhead $ 28,000
Marketing costs 20,000
Total fixed costs 48,000
Net operating income $ 12,000
© 2021 McGraw-Hill Limited 12-28
 Special Orders 4
If Jet accepts the special order, the incremental revenue will exceed
the incremental costs. In other words, net operating income will
increase by $6,000. This suggests that Jet should accept the
order.

Note: This answer assumes that the fixed costs are unavoidable
and that variable marketing costs must be incurred on the
special order.
© 2021 McGraw-Hill Limited 12-30
 Quick Check 

Northern Optical ordinarily sells the X-lens for $50. The

variable production cost is $10, the fixed production cost is
$18 per unit, and the variable selling cost is $1. A customer
has requested a special order for 10,000 units of the X-lens
to be imprinted with the customer’s logo. This special order
would not involve any selling costs, but Northern Optical
would have to purchase an imprinting machine for $50,000.
(see the next page)

© 2021 McGraw-Hill Limited 12-31

 Quick Check 
What is the rock bottom minimum price below which
Northern Optical should not go in its negotiations with the
customer? In other words, below what price would
Northern Optical actually be losing money on the sale?
There is ample idle capacity to fulfill the order and the
imprinting machine has no further use after this order.
a. $50
b. $10
c. $15
d. $29

© 2021 McGraw-Hill Limited 12-32

 Quick Check 
What is the rock bottom minimum price below which
Northern Optical should not go in its negotiations with
the customer? In other words, below what price would
Northern Optical actually be losing money on the sale?
There is ample idle capacity to fulfill the order and the
imprinting machine has no further use after this order.

Answer: Variable production cost $100,000

c. $15 Additional fixed cost + 50,000
Total relevant cost $150,000
Number of units 10,000
Average cost per unit = $15
© 2021 McGraw-Hill Limited 12-33
 Joint Product Costs
• In some industries, a number of end products
are produced from a single raw material input.
• Two or more products produced from a
common input are called joint products.
• The point in the manufacturing process where
each joint product can be recognized as a
separate product is called the split-off point.

© 2021 McGraw-Hill Limited 12-34

 Joint Products 1
Joint
Costs Oil

Common
Joint
Production Gasoline
Input
Process

Chemicals

Split-Off
Point
© 2021 McGraw-Hill Limited 12-35
 Sell products at split off

OIL GAS CHEMICAL

Sell at split off 200 150 80

 Joint Products 2
Joint
Costs Oil
Separate Final
Processing Sale

Common
Joint Final
Production Gasoline
Input Sale
Process

Separate Final
Chemicals
Processing
Sale

Split-Off Separate
Point Product
Costs
© 2021 McGraw-Hill Limited 12-37
 After processing further

OIL GAS CHEMICAL

Sell after processing 350 250 140

Sell at split off 200 150 80

Extra Revenue 150 100 60

Processing Costs 120 110 45

Extra profit or (loss) 30 -10 15

YES NO YES
 Joint Products 3
Exhibit 12-6

Joint
Input

© 2021 McGraw-Hill Limited 12-39

 The Pitfalls of Allocation

• Joint costs are often allocated to end products on

the basis of the relative sales value of each
product or on some other basis.
• Although allocation is needed for some purposes
such as balance sheet inventory valuation,
allocations of this kind are very dangerous for
decision making.

© 2021 McGraw-Hill Limited 12-40

 Sell or Process Further

• Joint costs are irrelevant in decisions regarding

what to do with a product from the split-off point
forward.

• It will always be profitable to continue

processing a joint product after the split-off point
so long as the incremental revenue exceeds the
incremental processing costs incurred after the
split-off point.

© 2021 McGraw-Hill Limited 12-41

Sell or Process Further: An Example

• Sawmill, Inc. cuts logs from which unfinished

lumber and sawdust are the immediate joint
products.
• Unfinished lumber is sold “as is” or processed
further into finished lumber.
• Sawdust can also be sold “as is” to gardening
wholesalers or processed further into “presto-logs.”

© 2021 McGraw-Hill Limited 12-42

 Sell or Process Further 1

• Data about Sawmill’s joint products includes:

Per Log
Lumber Sawdust
Sales value at the split-off point $ 140 $ 40

Sales value after further processing 270 50

Allocated joint product costs 176 24
Cost of further processing 50 20

© 2021 McGraw-Hill Limited 12-43

Joint Products 2
 Sell or Process Further 2
Analysis of Sell or Process Further
Per Log
Lumber Sawdust

Sales value after further processing $ 270 $ 50

Sales value at the split-off point 140 40
Incremental revenue 130 10

© 2021 McGraw-Hill Limited 12-46

 Sell or Process Further 3
Analysis of Sell or Process Further
Per Log
Lumber Sawdust

Sales value after further processing $ 270 $ 50

Sales value at the split-off point 140 40
Incremental revenue 130 10
Cost of further processing 50 20
Profit (loss) from further processing $ 80 $ (10)

© 2021 McGraw-Hill Limited 12-47

 Sell or Process Further 4
Analysis of Sell or Process Further
Per Log
Lumber Sawdust

Sales value after further processing $ 270 $ 50

Sales value at the split-off point 140 40
Incremental revenue 130 10
Cost of further processing 50 20
Profit (loss) from further processing $ 80 $ (10)

Should we process the lumber further

and sell the sawdust “as is?”

© 2021 McGraw-Hill Limited 12-48

 Utilization of a Constrained
Resource
• When a limited resource of some type restricts the
company’s ability to satisfy demand, the company is
said to have a constraint.
• The theory of constraints (TOC) maintains that
effectively managing a constraint is important to the
financial success of an organization.
• The challenge is deciding how to best utilize the
constrained resource to maximize the company’s
profits.

© 2021 McGraw-Hill Limited 12-49

 Contribution Margin in Relation
to a Constrained Resource
• When a constraint exists, a company should select a
product mix that maximizes the total contribution
margin earned since fixed costs usually remain
unchanged.
• A company should not necessarily promote those
products that have the highest unit contribution
margin.
• Rather, it should promote those products that earn
the highest contribution margin in relation to the
constraining resource.

© 2021 McGraw-Hill Limited 12-50

 An Example: Contribution Margin in
Relation to a Constrained Resource 1
Ensign Company produces two products and selected
data are shown below:
Product
1 2
Selling price per unit $ 60 $ 50
Less variable expenses per unit 36 35
Contribution margin per unit $ 24 $ 15
Current demand per week (units) 2,000 2,200
Contribution margin ratio 40% 30%
Processing time required
on machine A1 per unit 1.00 min. 0.50 min.

© 2021 McGraw-Hill Limited 12-51

 An Example: Contribution Margin in
Relation to a Constrained Resource 2
• Machine A1 is the constrained resource and is
being used at 100% of its capacity.
• There is excess capacity on all other
machines.
•Machine A1 has a capacity of 2,400 minutes
per week.
Should Ensign focus its efforts on Product 1 or
Product 2?

© 2021 McGraw-Hill Limited 12-52

 Quick Check 

How many units of each product can be

processed through Machine A1 in one minute?

Product 1 Product 2
a. 1 unit 0.5 unit
b. 1 unit 2.0 units
c. 2 units 1.0 unit
d. 2 units 0.5 unit

© 2021 McGraw-Hill Limited 12-53

 Quick Check 

How many units of each product can be

processed through Machine A1 in one minute?

Answer:
Product 1 Product 2
b. 1 unit 2.0 units

© 2021 McGraw-Hill Limited 12-54

 Quick Check 

What generates more profit for the company, using

one minute of machine A1 to process Product 1 or
using one minute of machine A1 to process Product 2?
a. Product 1
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.

© 2021 McGraw-Hill Limited 12-55

 Quick Check 
With one minute of machine A1, we could make 1
What generates
unit of Productmore profit
1, with for the company,
a contribution using
margin of $24,
oneorminute
2 unitsofofmachine
ProductA12,toeach
process
withProduct 1 or
a contribution
using one minute ofmargin
machineofA1 to process Product 2?
$15.
2 × $15 = $30 > $24
Answer:
b. Product 2

© 2021 McGraw-Hill Limited 12-56

 CM in Relation to a Constrained
Resource – An Example Part 1
• The key is the contribution margin per unit of
the constrained resource.
Product
1 2
Contribution margin per unit $ 24 $ 15
Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min.
Contribution margin per minute $ 24 $ 30

Product 2 should be emphasized. Provides more valuable

use of the constrained resource machine A1, yielding a
contribution margin of $30 per minute as opposed to $24 for
Product 1.
© 2021 McGraw-Hill Limited 12-57
 CM in Relation to a Constrained
Resource – An Example Part 2
• The key is the contribution margin per unit of
the constrained resource.
Product
1 2
Contribution margin per unit $ 24 $ 15
Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min.
Contribution margin per minute $ 24 $ 30

If there are no other considerations, the best plan

would be to produce to meet current demand for
Product 2 and then use remaining capacity to make
Product 1.
© 2021 McGraw-Hill Limited 12-58
CM in Relation to a Constrained
Resource – An Example Part 3
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

© 2021 McGraw-Hill Limited 12-59

CM in Relation to a Constrained
Resource – An Example Part 4
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
Time available for Product 1 1,300 min.

© 2021 McGraw-Hill Limited 12-60

CM in Relation to a Constrained
Resource – An Example Part 5
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
Time available for Product 1 1,300 min.
Time required per unit ÷ 1.00 min.
Production of Product 1 1,300 units

© 2021 McGraw-Hill Limited 12-61

 CM in Relation to a Constrained
Resource – An Example Part 6
According to the plan, we will produce 2,200 units
of Product 2 and 1,300 of Product 1. Our
contribution margin looks like this.

The total contribution margin for Ensign is $64,200.

© 2021 McGraw-Hill Limited 12-62

 Quick Check 
Colonial Heritage makes reproduction colonial
furniture from select hardwoods.
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will only be able

to supply 2,000 board feet this month. Is this enough
hardwood to satisfy demand?
a. Yes
b. No
© 2021 McGraw-Hill Limited 12-64
 Quick Check 
Colonial Heritage makes reproduction colonial
furniture from select hardwoods.
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will only be

able to supply 2,000 board feet this month. Is this
enough hardwood to satisfy demand?
Answer:
b. No (2 × 600) + (10 × 100 ) = 2,200 > 2,000
© 2021 McGraw-Hill Limited 12-65
 Quick Check 
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will only be

able to supply 2,000 board feet this month. What plan
would maximize profits?
a. 500 chairs and 100 tables
b. 600 chairs and 80 tables
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables

© 2021 McGraw-Hill Limited 12-66

 Quick Check 
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will only be

able to supply 2,000 board feet this month. What plan
would maximize profits?

Answer:
b. 600 chairs and 80 tables

© 2021 McGraw-Hill Limited 12-68

 Quick Check 
As before, Colonial Heritage’s supplier of hardwood will
only be able to supply 2,000 board feet this month.
Assume the company follows the plan we have proposed.
Up to how much should Colonial Heritage be willing to
pay above the usual price to obtain more hardwood?
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero

© 2021 McGraw-Hill Limited 12-70

 Quick Check 
As before, Colonial Heritage’s supplier of hardwood will
The
onlyadditional wood2,000
be able to supply would be used
board to make
feet this month.tables.
Assume
In the company
this use, each boardfollows
footthe
of plan we havewood
additional proposed.
will
Up to how
allow themuch shouldto
company Colonial
earn anHeritage be willing
additional $20 ofto
pay above contribution
the usual pricemargin
to obtainand
moreprofit.
hardwood?
Answer:
c. $20 per board foot

© 2021 McGraw-Hill Limited 12-71

 Managing Constraints
• Profits can be increased by effectively managing constraint.
One aspect of managing constraints is to decide how best to
utilize them.
• Managers should focus on managing bottlenecks and find
ways to increase the capacity at the bottlenecks, which can
be accomplished in a number of ways:
• Improve the process
• Add overtime or another shift
• Hire new workers or acquire more machines
• Subcontract production
• Reduce amount of defective units produced
• Add workers transferred from non-bottleneck departments

© 2021 McGraw-Hill Limited 12-73

© 2021 McGraw-Hill Limited 76
The Problem of Multiple Constraints

• What if a firm has more than one potential

constraint?
• How would it find the right combination of
products to produce?
• The right combination of products or “mix” of
products can be found using a quantitative
method called linear programming.

© 2021 McGraw-Hill Limited 12-77

 End of Chapter Summary
• Relevant costs and benefits are those that will be incurred
in the future and that differ among the alternatives under
consideration.
• Sunk costs are irrelevant (incurred in the past), while
avoidable, differential, and opportunity costs are all
relevant.
• Different decision situations often faced by managers are:
adding or dropping product lines/segments, making versus
buying decisions, accepting or rejecting special orders,
and selling versus processing joint products further.

© 2021 McGraw-Hill Limited 12-78

 Appendix 12A

Pricing Products and Services

© 2021 McGraw-Hill Limited 12-79

 Cost-Plus Pricing
• The usual approach in pricing is to mark up cost. A
product’s markup is the difference between its
selling price and its cost. The markup is usually
expressed as a percentage of cost.

Selling Price = Cost + (Markup percentage × Cost)

• Cost-Plus Pricing: A pricing method in which a
predetermine markup is applied to a cost base to
determine the target selling price.

© 2021 McGraw-Hill Limited 12-80

 Setting a Target Selling Price –
Absorption Costing 1

• Under the absorption approach to cost-plus

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

© 2021 McGraw-Hill Limited 12-81

 Setting a Target Selling Price –
Absorption Costing 2
Here is information provided by the management of
Ritter Company.
Per Unit Total
Direct materials $ 6
Direct labour 4
Variable manufacturing overhead 3
Fixed manufacturing overhead $ 70,000
Variable S & A expenses 2
Fixed S & A expenses 60,000

Assuming Ritter will produce and sell 10,000 units of

the new product, and that Ritter typically uses a 50%
markup percentage, let’s determine the unit product
cost.
© 2021 McGraw-Hill Limited 12-82
 Setting a Target Selling Price –
Absorption Costing 3
Per Unit
Direct materials $ 6
Direct labour 4
Variable manufacturing overhead 3
Fixed manufacturing overhead 7
Unit product cost $ 20

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

Ritter has a policy of marking up unit product costs by

50%. Let’s calculate the target selling price.

© 2021 McGraw-Hill Limited 12-83

Setting a Target Selling Price –
Absorption Costing 4
Ritter would establish a target selling price to cover
selling, general, and administrative expenses and
contribute to profit $30 per unit.
Per Unit
Direct materials $ 6
Direct labour 4
Variable manufacturing overhead 3
Fixed manufacturing overhead 7
Unit product cost $ 20
50% markup 10
Target selling price $ 30

© 2021 McGraw-Hill Limited 12-84

Determining the Markup Percentage
1
• The markup percentage can be based on an
industry “rule of thumb,” company tradition, or it
can be explicitly calculated.
• The equation to calculate the markup percentage
is:

© 2021 McGraw-Hill Limited 12-85

Determining the Markup Percentage
2

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.

© 2021 McGraw-Hill Limited 12-86

Determining the Markup Percentage
3

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

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

© 2021 McGraw-Hill Limited 12-87

 Problems with the Absorption
Costing Approach 1
• The absorption costing approach 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.

© 2021 McGraw-Hill Limited 12-88

 Problems with the Absorption
Costing Approach 2
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, 2013
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
© 2021 McGraw-Hill Limited 12-89
 Problems with the Absorption
Costing Approach 3
Let’s assume that Ritter sells only 7,000 units at $30 per
unit, instead of the forecasted 10,000 units. Here is the
Absorption costing approach
income statement.
to pricing is
a safe approach only if customers choose
RITTER COMPANY
to buy at least as Statement
Income many units as managers
For the Year Ended December 31, 2013
forecasted they would
Sales (7,000 units × $30) $
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
© 2021 McGraw-Hill Limited 12-90
 Setting a Target Selling Price –
Variable Costing
• Some companies use a variable costing approach to
determine the target selling price based on either
variable manufacturing costs or total variable costs.
• The key advantages of the variable costing approach
are:
1. It is consistent with cost-volume-profit analysis and
2. It avoids the need to arbitrarily allocate common
fixed costs to specific products.

© 2021 McGraw-Hill Limited 12-91

Setting a Target Selling Price for Service
Companies Using Time and Materials
Pricing

Time and material pricing:

• A pricing method, often used in service
firms, in which two pricing rates are
established- one based on direct labour time
and the other based on direct material used.

© 2021 McGraw-Hill Limited 12-92

 Pricing and Customer Latitude
• Customers have latitude in their purchasing
decisions.
• They can purchase a competitor’s product or
allocate their spending budget to some other
product altogether.
• This latitude should be taken into account
when setting prices.

© 2021 McGraw-Hill Limited 12-93

 Value-Based Pricing
• An alternative to cost-plus pricing is value-based
pricing.
• Companies that use value-based pricing establish
selling prices based on the economic value of the
benefits that their products and services provide
to customers. 
• One approach to value-based pricing relies on a
concept known as the economic value to the
customer (EVC).

© 2021 McGraw-Hill Limited 12-94

Economic Value to the Customer
• A product’s economic value to the customer is
the price of the customer’s best available
alternative plus the value of what differentiates
the product from that alternative.
• The price of the best available alternative is
known as the reference value, whereas the value
of what differentiates a product from the best
available alternative is known as
the differentiation value.

© 2021 McGraw-Hill Limited 12-95

 Differentiation Value
• A product’s differentiation value can arise in either
of two ways.
• First, a product may differentiate itself by
enabling customers to generate more sales and
contribution margin than the best available
alternative.
• Second, a product may differentiate itself by
enabling customers to realize greater cost
savings than the best available alternative.  

© 2021 McGraw-Hill Limited 12-96

 EVC

© 2021 McGraw-Hill Limited 12-97

 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 the target
price is shown below:

Target cost = Anticipated selling price – Desired profit

© 2021 McGraw-Hill Limited 12-98

Reasons for Using Target Costing 1

• The target costing approach was developed in recognition of

two important characteristics of markets and costs:
1. The market (i.e., supply and demand) determines price.
2. Most of the cost of a product is determined in the design
stage.
• Target costing was developed in recognition of these two
characteristics. More specifically, Target costing begins the
product development process by recognizing and responding
to existing market prices.

© 2021 McGraw-Hill Limited 12-99

Reasons for Using Target Costing 2

• The difference between target costing and

other approaches to product development is
profound.
• Instead of designing the product,
determining the cost, and setting the price,
the target cost is set first and then the
product is designed so that the target cost is
attained.

© 2021 McGraw-Hill Limited 12-100

 Target Costing 1
• Handy Appliance feels there is a niche for a hand
mixer with certain 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 $2,000,000 is required to gear up
for production.
• The company requires a 15% ROI on invested
funds.
• Let see how we determine the target cost.

© 2021 McGraw-Hill Limited 12-101

 Target Costing 2

• Each functional area within Handy Appliance would

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

© 2021 McGraw-Hill Limited 12-102