Session 17A

8/8/2019 Session 17A

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Accounting 102

Session 17


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Pricingand

Cost Management


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Pricing Decisions

Basic Factors Influencing the Pricing Decision (the Three Cs)

Customers What features and quality do the customers want? What is the magnitude of their demand for particular kinds of

products? How elastic is that demand?

Competitors

Who are the existing competitors on a product line? What are the characteristics of their products? What are their current production volumes and capacities? What are their pricing schemes?

Costs What are the production costs and their characteristics (variable

vs fixed)? What are the costs of serving different customer groups?

What are the competitors costs?


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Pricing Decisions

The analysis underlying a pricing decision is fundamentally the same asthat underlying any other decision:

Identify the goal to be achieved;

and

Select the price that will best enable the firm to achieve its

objective, after considering all of the relevant factors.


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Short-run vs Long-run Pricing

Short-run

Short-run pricing decisions have a time horizon of less than one year andinclude decisions such as:

Pricing of one-time-only special orders with no long-run implicationAdjusting product mix and output volume in a competitive market

Long-runLong-run pricing decisions have a time horizon of one year or longer andinclude decisions such as:

Pricing a product in a major market where there is some flexibility (e.g.

when the demand is relatively inelastic)


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Differences Affecting Pricing: Long Run vs. Short Run

1) Costs that are often irrelevant for short-run policy decisions, suchas fixed costs that cannot be changed, are generally relevant inthe long run because such costs can be altered in the long run

2) Profit margins in long-run pricing decisions are often set to earn areasonable return on investment prices are decreased when

demand is weak and increased when demand is strong


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Approaches to Long-run Pricing

Most pricing decisions are a combination of two polar cases:

1) Cost Based Pricing

Cost based pricing is typically used when there is no established market for a

product or service (e.g., when the product is custom made) or when there isrelatively little competition in the market.

In these cases, the price is derived as:

Price/unit = Cost/unit x Mark-up rate (%)

Or, analogously

Price/unit = Cost/unit + Profit/unit ($)

For long-run price determination, it is best to apply the mark-up rate (%) to thefull product-related costs (including marketing)

To ensure that all costs are recovered

To stabilize prices by preventing managers from reducing the price tovariable cost

However, it is important to bear in mind that, for short-term pricing or for

strategic purposes, full-cost-plus pricing often is not be appropriate/desirable.


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Determining the Mark-up Rate (Amount)

The mark-up rate should be based on consideration of two factors:

1) The firms required profit based on its target return on investedcapital

2) Anticipated product costs (fixed and variable) and anticipatedvolume of sales (and production).

Full Cost/Unit

Required Profit/Unit+1=Mark-up Rate (%)


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Pricing decisions based solely on considerations of costs may besuboptimal in the short- and/or long-run.

Because market factors such as demand and price elasticity are

not taken into account, the cost-based price may be too high ortoo low.


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2) Market Based Pricing

Top down Market driven and customer focused

What do our customers want and how can it be delivered tothem profitably?

Just as cost-based pricing is likely to be suboptimal, so too are pricesbased exclusively on market considerations.

A market-based price may not be sufficient to enable the firm torecover its costs either in the short run or in the long run.


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Target Pricing

An important form of market-based pricing is target pricing.

The target price(s) is (are) derived based on consideration of bothmarket factors (the demand for a product having the characteristicsof that offered by the firm as well as the competitors pricing

strategy) and the firms particular short-run and long-runobjectives.

Target Costing

Target costing is typically used in conjunction with target pricing.

Given the target price and the firms profit objectives/expectations:

Target Cost = Target Price Desired Margin

One of the primary purposes of target costing is to identifyopportunities for cost reductions before production begins (in thedesign and production planning phases when modifications are relatively

easy to implement.)


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Target Costing Incurred Costs vs Locked-in Costs

Incurred Costsare the actual costs (of resources used) recorded by thecost accounting systems.

Locked-in costsare costs that have not been incurred yet, but will beincurred in the future, because of decisions that have been made.

The rule of thumb is that, once the production specifications have beendeveloped, approximately 80% of a products costs are locked-in.

Therefore, most of the opportunities for cost reduction occur in theinitial product design and production planning phases of a products

life cycle, even though those phases, themselves, may account foronly a relatively small proportion of the actual costs incurred.

Examples:

Betterdesign can reduce scrap, rework, customer service, andwarranty costs

Simplerdesign can reduce direct labor, machine time, testing andinspection costs

Fewer partscan reduce parts order and handling/inventory costs.


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Iterative Steps in Target Costing

1) Identify a product concept that will satisfy some customer demand.

2) Derive a target price based on an analysis of the product market.

For example:

Define a products functionality as a bundle of features

e.g. some of the features of a car are its size, its gas mileage,and interior noise.

Use marketing research techniques to determine the value that

customers attach to each feature by decomposing the market price ofcomparable products into a sum of product features, e.g.

Total Price = P1*Feature1 + P2*Feature2 +

After estimating P1, P2, etc. estimate the target price of the firms

product based its features

3) Determine the desired profit margin for the product based on the firms profitexpectations (and any other objectives that the firm may have).


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3) Determine the target cost

Target Cost = Target Price Desired Profit Margin

4) Conduct value engineering as a part of the process whose objectiveis to achieve target costs

Form a value engineering team, consisting of representatives fromdesign, engineering, production, marketing, accounting, etc., toanalyze the cost-effectiveness of different product features.

The objective is to identify alternatives that will enable the firmto achieve the target cost and increase the products value by

a) eliminating unnecessary functions

Products often include features that customers dont value.

e.g. Think about the buttons on your VCR or cell phonethat you dont use.

b) improving the design to reduce cost without sacrificingfunctionality (marketability)


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5) If the target cost is achieved, stop.

If not refine the design and return to step 1.


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Target Costing and Kaizen Costing

Target costing is often used in conjunction with kaizen costing as thebasic elements of what is often referred to as a Total Cost Managementsystem.

As noted earlier, the purpose of target costing is to identify

opportunities for cost reductions before production begins at thedesign and production planning phases.

In contrast, the purpose of kaizen costing is to generate cost reductions inthe production phase using the budgeting process as the vehicle.

The term, kaizen refers to a Japanese philosophy that focuses oncontinuous improvement. Kaizen costing is the application of kaizentechniques as a means of reducing product costs by a pre-specifiedamount.

In a kaizen costing system, pre-specified cost reductions aresystematically incorporated into the budgeting process to inducemanagement to search for new, innovative, less costly ways acquireraw materials, to produce goods and to market the producteffectively.


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Example: (P12-24 from the text)

Waterbury Inc., manufactures and sells RF17, a specialty raft used forwhitewater rafting. In 2007, it reported the following:

20%Rate of return on investment

$300Full cost per unit

$2,400,000Investment

50%Markup on variable cost

20,000Units produced and sold


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1) What was the selling price for 2007?

300Full cost per unit

$324Selling price per unit

$ 24=20,000

=2,400,000 x 20%

Income earned in 2007 per unit

2) What was the percentage markup on full cost?

(108%)8%300

=24

=Percentage markup on full cost

Cost-Plus Pricing

Remember Price = Cost + Profit


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3) What was the variable cost per unit?

(1.5)$216=

324=VC

= 324VC x (1 + 0.5)=P

Percentage markup on variable cost = 50%


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Target Pricing

Waterbury is considering raising its selling price to $348. However, atthis selling price, its sales volume is predicted to fall by 10%. IfWaterburys cost structure (total fixed costs and variable costs per unit)remain unchanged, should it raise its selling price?

a) Determine Waterburys total fixed costs:

$1,680,000Total fixed costs

$ 84Fixed cost per unit

20,000Units produced & sold

216Variable cost per unit

$300Full cost per unit


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b) Effect of raising selling price from $324 to $348:

18,000 units20,000 x (1 0.10)Expected sales volume

By increasing the price, Waterburys return will increase from 20% to29%, in spite of the decline in sales volume.

696,000Operating Profit

1,680,000Fixed Costs

(348 216) x 18,000 = 2,376,000Contribution Margin

Selling Price = $348

Profitability

ROI (at P = $348) = 696,000 = 29%

2,400,000


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If Waterburys goal is to earn a pre-tax return on investment of 20%, what

should it set its selling price at, assuming that the decline in demand is the resultof market forces?

We can answer this question using CVP analysis:

336=

18,000

(2,400,000 x 20%) + 1,680,000

Q

Target Profit + Fixed Costs

+216=

+VC=P


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Target Costing

In 2008, due to increased competition, Waterbury must reduce its sellingprice to $315 in order to sell 20,000 units. The manager of the raftdivision expects to be able to reduce the investment in the division to$2,100,000 but still requires a 20% rate of return on investment. If fixedcosts cannot be reduced in this time frame, what is the target variable

cost per unit?

210=

20,000

(2,100,000 x 20%) + 1,680,000

QTarget Profit + Fixed Costs

315=

P=VC

Using CVP analysis:

For comparison, VC for 2007 were $216/unit

Session 17A

Documents

Transcript of Session 17A