cost accounting chap12

8/10/2019 cost accounting chap12

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2009 Pearson Prentice Hall. All rights reserved.

CHAPTER 12Pricing Decisions

andCost Management


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Learning Objective 1

Discuss the three majorinfluences on pricing


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Pricing and BusinessHow companies price a product or service ultimatelydepends on the demand and supply for it

Three influences on demand & supply:1. Customers2. Competitors3. Costs


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Influences on Demand & Supply1. Customers influence price through their effect

on the demand for a product or service, based onfactors such as quality and product features

2. Competitors influence price through theirpricing schemes, product features, and production volume

3. Costs influence prices because they affect supply(the lower the cost, the greater the quantity a firmis willing to supply)


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Distinguish between short-runand long-run pricing decisions.


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Time Horizons and PricingShort-run pricing decisions have a time horizon ofless than one year and include decisions such as:

Pricing a one-time-only special order with no long-runimplications Adjusting product mix and output volume in a competitivemarket

Long-run pricing decisions have a time horizon ofone year or longer and include decisions such as:

Pricing a product in a major market where there is someleeway in setting price


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Differences Affecting Pricing:

Long Run vs. Short Run1. Costs that are often irrelevant for short-run policy

decisions, such as fixed costs that cannot bechanged, are generally relevant in the long runbecause costs can be altered in the long run

2. Profit margins in long-run pricing decisions areoften set to earn a reasonable return on investment.

Short-run pricing is more opportunistic prices aredecreased when demand is weak and increased when demand is strong


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Costing and Pricing

for the Short RunPricing for the short run involves adetermination of what are the relevant costsfor this decision.

A key factor in setting short-run prices iswhether the company has excess capacity. Ifthis exists, any price above variable costs willcontribute to paying fixed costs and to profit.


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Costing and Pricing

for the Short Run ExampleLomas Corporation operates a plant with

a monthly capacity of 500,000 casesof tomato sauce.

Lomas is presently producing300,000 cases per month.

Del Valle has asked Lomas and two othercompanies to bid on supplying 150,000

cases each month for the next four months.


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Costing and Pricing

for the Short Run ExampleCost Per Case

Variable manufacturing $38Variable marketing and distribution 13Fixed manufacturing 14

Fixed marketing and distribution 15Total $80


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Costing and Pricing

for the Short Run ExampleIf Lomas makes the extra 150,000 cases, the existingtotal fixed manufacturing overhead ($4,200,000 permonth) would continue, plus an additional $165,000

of fixed overhead will be incurred per month.

Total fixed marketing and distributioncosts will not change.

What price should Lomas bid?


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Costing and Pricing

for the Short Run ExampleRelevant CostsVariable manufacturing $38.00Fixed manufacturing 1.10Total $39.10

$165,000 150,000 = $1.10

Any bid above $39.10 will improveLomass profitability in the short run.


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Costing and Pricing

for the Short Run ExampleSuppose that Lomas believes that Del Valle

will sell the tomato sauce in Lomass current markets but at a lower price than Lomas.

Relevant costs of the bidding decision

should include revenues lost on salesto existing customers.


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Costing and Pricing

for the Long Run

Long-run pricing is the result of a strategicdecision designed to build relationships withcustomers based on stable and predictablepricing.


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Alternative Long-Run Pricing

Approaches

Market-Based: price charged is based on whatcustomers want and how competitors reactCost-Based: price charged is based on what it cost toproduce, coupled with the ability to recoup the costs

and still achieve a required rate of return


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Alternative Long-Run Pricing

ApproachesThe market-based approach starts with a customerfocus, asking what the customer wants, howcompetitors will react to our decisions, and what priceshould be charged. This approach is target pricing. The cost-based approach starts with an evaluation of

costs and where the selling price should be set in orderto recoup costs and earn a desired return oninvestment. This is known as cost-plus pricing.


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Markets and PricingHighly competitive Markets - use the market-basedapproach

Less-Competitive Markets can use either the market-based or cost-based approachNon-Competitive Markets use cost-basedapproaches


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Price products using the

target-costing approach.


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Market-Based ApproachStarts with a target priceTarget Price estimated price for a product or servicethat potential customers will payEstimated on customers perceived value for a productor service and how competitors will price competingproducts or services


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Understanding the

Market EnvironmentUnderstanding customers and competitors isimportant because:

1. Competition from lower cost producers has meantthat prices cannot be increased

2. Products are on the market for shorter periods of time,leaving less time and opportunity to recover frompricing mistakes

3. Customers have become more knowledgeable anddemand quality products at reasonable prices


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Five Steps in Developing

Target Prices and Target Costs1. Develop a product that satisfies the needs ofpotential customers: Find a need and fill it

2. Choose a target price: based on research ofcompetitors products and what the customer is willing to pay.

3. Derive a target cost per unit: Determine the targetoperating income per unit and subtract that fromthe target price to arrive at target cost per unit.

Target Price per unit minus Target Operating Income perunit


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Five Steps in Developing

Target Prices and Target Costs

4. Perform cost analysis: This step analyzes which

aspects of a product or service to target for costreductions.5. Perform value engineering to achieve target cost:

Value engineering is a systematic evaluation of all

aspects of the value chain. The objective is to reducecosts while achieving a quality level that will satisfycustomers.


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Costing and Pricing

for the Long Run ExampleLatisha Computer Corporation manufactures

two brands of computers: Simple Computer (SC)and Complex Computer (CC).

Latisha uses a long-run time horizon to priceComplex Computer (CC).


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Costing and Pricing

for the Long Run ExampleDirect materials costs vary with the

number of units produced.Direct manufacturing labor costs varywith direct manufacturing labor-hours.

Ordering and receiving, testing andinspection, and rework costs vary

with their chosen cost drivers.


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Costing and Pricing

for the Long Run ExampleOrdering: $78 per orderTesting: $2 per inspection hourRework: $38 per unit reworkedCost per UnitDirect materials $450.00Direct labor:3.50 hours @ $19 per hour 66.50Total $516.50


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Costing and Pricing

for the Long Run Example Number of orders placed: 17,000 Number of testing hours: 3,000,000

Number of units reworked: 8,000The direct fixed costs of machines used

exclusively for the manufacture of

Complex Computer total $7,000,000.What is the cost of producing 100,000

units of Complex Computer?


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Costing and Pricing

for the Long Run ExampleDirect material and labor $51,650,000

Direct fixed costs 7,000,000Ordering (17,000 $78) 1,326,000Testing (3,000,000 $2) 6,000,000Rework (8,000 $38) 304,000Total $66,280,000

$66,280,000 100,000 units = $662.80/unit


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Implementing Target Pricing

and Target CostingLatishas management wants a 15% target

operating income on sales revenues of CC.Target sales revenue is $750 per unit.

What is the target cost per unit?

$750 .15 = $112.50, $750 $112.50 = $637.50

Current full cost per unit of CC is $662.80


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Apply the concepts of costincurrence and locked-in costs.


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Value Engineering Value Engineering is a systematic evaluation of allaspects of the value-chain, with the objective of

reducing costs while improving quality and satisfyingcustomer needsManagers must distinguish value-added activities andcosts from non-value-added activities and costs


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Value Engineering Terminology Value-Added Costs a cost that, if eliminated, would reduce the actual or perceived value or utility

(usefulness) customers obtain from using theproduct or service.Non-Value-Added Costs a cost that, if eliminated, would not reduce the actual or perceived value orutility customers obtain from using the product orservice. It is a cost the customer is unwilling to payfor.


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Cost IncurrenceThis describes when a resource is sacrificed

or forgone to meet a specific objective.Research and development

Manufacturing

Distribution

Design

Marketing

Customer support


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Locked-in CostsThese are those costs that have not yet been

incurred but which, based on decisions thathave already been made, will be incurredin the future (designed-in costs).

It is difficult to alter or reducecosts that are already locked in.


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Locked-in Costs costs are frequently locked in during thedesign phase. Once the design of theproduct is finalized, the cost of the product isdetermined to a large degree.

cost reductions can be most readily attainedthrough value-chain analysis and the use ofcross-functional teams . By forming a team of

representatives from all segments of thevalue chain, the product can be designed toreduce costs while retaining features thatcustomers value.


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Cost Incurrence

and Locked-In Costs Graph


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Five key elements

1. Understanding customer requirements andcompetitor actions2. Selecting a target price and determining targetcost3. Anticipating how costs are locked in before theyare incurred

4. Improving product and process designs andefficiency to achieve target costs and better quality5. Using cross-functional teams to coordinateactions across the value chain


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Target Costing Illustration


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Target Costing Illustration,Continued


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Price products usingthe cost-plus approach


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Cost-Based (Cost-Plus) PricingThe general formula: adds a markup component to thecost base to determine a prospective selling price

Usually only a starting point in the price-settingprocessMarkup is somewhat flexible, based partially oncustomers and competitors


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Forms of Cost-Plus PricingSetting a Target Rate of Return on Investment: theTarget Annual Operating Return that anorganization aims to achieve, divided by InvestedCapitalSelecting different cost bases for the cost -pluscalculation:

Variable Manufacturing Cost Variable CostManufacturing CostFull Cost


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Common Business PracticeMost firms use full cost for their cost-based pricingdecisions, because:

Allows for full recovery of all costs of the product Allows for price stabilityIt is a simple approach


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Use life-cycle budgetingand costing when making

pricing decisions


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Life-Cycle ProductBudgeting and Costing

Product Life-Cycle spans the time from initial R&D ona product to when customer service and support are no

long offered on that product.Life-Cycle Budgeting involves estimating the revenuesand individual value-chain costs attributable to eachproduct from its initial R&D to its final customer

service and support.Life-Cycle Costing tracks and accumulates individual value-chain costs attributable to each product from itsinitial R&D to its final customer service and support


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Life Cycle Budgeting, Illustrated


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Important Considerations forLife-Cycle Budgeting

Development period for R&D and design is long andcostlyMany costs are locked in at the R&D and design stages,even if R&D and design costs are themselves small


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Describe two pricingpractices in which noncostfactors are important when

setting prices


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Other Important Considerations inPricing Decisions

Price Discrimination the practice of chargingdifferent prices to different customers for the sameproduct or service.

Legal ImplicationsPeak-Load Pricing the practice of charging a higherprice for the same product or service when the demandfor it approaches the physical limit of the capacity toproduce that product or service


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Explain the effects ofantitrust laws on pricing


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The Legal Dimension of

Price SettingPrice discrimination is permissible if differences inprices can be justified by differences in costs.

Price Discrimination is illegal if the intent is to lessenor prevent competition for customersProhibition of predatory pricing Predatory Pricing deliberately lowering prices below costs

in an effort to drive competitors out of the market andrestrict supply, and then raising prices


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The Legal Dimension ofPrice Setting

Prohibition of Dumping a non-US firm sells aproduct in the US at a price below the market valuein the country where it is produced, and this lowerprice materially injures or threatens to materiallyinjure an industry in the US.Prohibition of Collusive Pricing occurs whencompanies in an industry conspire in their pricingand production decisions to achieve a price abovethe competitive price and so restrain trade.

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cost accounting chap12