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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Target Costing andCost Analysis forPricing Decisions
Target Costing andCost Analysis forPricing Decisions
Chapter 15
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objective
1
Learning Objective
1
15-3
Major Influences onMajor Influences onPricing DecisionsPricing Decisions
PricingDecisions
Political, legal, and image issues
Competitors Costs
Customerdemand
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objective
2
Learning Objective
2
15-5
How Are Prices Set?How Are Prices Set?
CostsMarketForces
Prices are determined by the market, subjectto costs that must be covered in the long run.
Prices are based on costs, subject toreactions of customers and competitors.
15-6
Economic Profit-Maximizing Economic Profit-Maximizing PricingPricing
Firms usually have flexibility in setting prices.Firms usually have flexibility in setting prices.
The quantity sold usually declines as the price is increased.
The quantity sold usually declines as the price is increased.
15-7
Total Revenue CurveTotal Revenue Curve
Total revenue
Curve is increasing throughoutits range, but at a declining rate.
Dollars
Quantity soldper month
15-8
Demand Schedule and Marginal Demand Schedule and Marginal Revenue CurveRevenue Curve
Demand
Sales price must decreaseto sell higher quantity.
Dollarsper unit
Quantity soldper month
Marginalrevenue
Revenue perunit decreases
as quantity increases.
15-9
Total Cost CurveTotal Cost Curve
Dollars
Quantity madeper month
Total cost increasesat a declining rate.
Total cost increasesat an increasing rate.
15-10
Quantity madeper month
Marginal Cost CurveMarginal Cost Curve
Marginalcost
Dollarsper unit
Quantity wheremarginal cost
begins to increase.
15-11
Quantity made
and soldper month
Determining the Profit-Maximizing Determining the Profit-Maximizing Price and QuantityPrice and Quantity
Dollarsper unit
Demand
Marginalrevenue
Marginalcost
q*
p*
15-12
Quantity made
and soldper month
Determining the Profit-Maximizing Determining the Profit-Maximizing Price and QuantityPrice and Quantity
Dollarsper unit
Demand
Marginalrevenue
q*
p*
Marginalcost
Profit is maximized where marginal cost equals
marginal revenue, resultingin price p* and quantity q*.
15-13
Determining the Profit-Maximizing Determining the Profit-Maximizing Price and QuantityPrice and Quantity
Total revenueDollars Total cost
Total profit at the profit-maximizingquantity and price,
q* and p*.
Quantity made
and soldper month
q*
15-14
Price ElasticityPrice Elasticity
The impact ofprice changes on
sales volume
Demand is elastic ifa price increase has alarge negative impact
on sales volume.
Demand is inelastic ifa price increase has
little or no impact on sales volume.
15-15
Cross ElasticityCross Elasticity
The extent towhich a change in
a product’s price affects thedemand for other
substitute products.
15-16
Limitations of theLimitations of theProfit-Maximizing ModelProfit-Maximizing Model
A firm’s 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.
15-17
Role of AccountingRole of AccountingProduct Costs in PricingProduct Costs in Pricing
Sophisticated decisionmodel and information
requirements
Simplified decisionmodel and information
requirements
Optimal Decisions Suboptimal Decisions
Economic pricing model Cost-based pricing
Marginal-cost andmarginal-revenue data
Accounting product-cost data
More costly Less costlyThe best approach, in terms of costs and
benefits, typically lies between the extremes.
Exh. 15-4
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objective
3
Learning Objective
3
15-19
Cost-Plus PricingCost-Plus Pricing
Price = cost + (markup percentage × cost)
Variablemanufacturing
cost?
Full-absorptionmanufacturing
cost?
Total cost,including selling
and administrative?
Total variable cost,including selling
and administrative?
15-20
Cost-Plus Pricing - ExampleCost-Plus Pricing - Example
Variable mfg. cost $ 400Fixed mfg. cost 250Full-absorption mfg. cost $ 650Variable S & A cost 50Fixed S & A cost 100Total cost $ 800
We will use this unit cost information to illustrate therelationship between cost and markup necessary to
achieve the desired unit sales price of $925.
We will use this unit cost information to illustrate therelationship between cost and markup necessary to
achieve the desired unit sales price of $925.
15-21
Cost-Plus Pricing - ExampleCost-Plus Pricing - Example
Variable mfg. cost $ 400Fixed mfg. cost 250Full-absorption mfg. cost $ 650Variable S & A cost 50Fixed S & A cost 100Total cost $ 800
Price = cost + (markup percentage × cost)
Price = $400 + (131.25% × $400) = $925
Markup onvariable
manufacturingcost
15-22
Cost-Plus Pricing - ExampleCost-Plus Pricing - Example
Variable mfg. cost $ 400Fixed mfg. cost 250Full-absorption mfg. cost $ 650Variable S & A cost 50Fixed S & A cost 100Total cost $ 800
Price = cost + (markup percentage × cost)
Price = $450 + (105.56% × $450) = $925
Markup ontotal var. cost
As cost baseincreases, the
required markuppercentagedeclines.
15-23
Cost-Plus Pricing - ExampleCost-Plus Pricing - Example
Variable mfg. cost $ 400Fixed mfg. cost 250Full-absorption mfg. cost $ 650Variable S & A cost 50Fixed S & A cost 100Total cost $ 800
Price = cost + (markup percentage × cost)
Price = $650 + (42.31% × $650) = $925
Markup onfull mfg. cost
As cost baseincreases, the
required markuppercentagedeclines.
15-24
Cost-Plus Pricing - ExampleCost-Plus Pricing - Example
Variable mfg. cost $ 400Fixed mfg. cost 250Full-absorption mfg. cost $ 650Variable S & A cost 50Fixed S & A cost 100Total cost $ 800
Price = cost + (markup percentage × cost)
Price = $800 + (15.63% × $800) = $925
Markup ontotal cost
As cost baseincreases, the
required markuppercentagedeclines.
15-25
Absorption-Cost Pricing FormulasAbsorption-Cost Pricing FormulasAdvantages
Price covers all costs.
Perceived as equitable.
Comparison with competitors.
Absorption cost used for external reporting.
Disadvantages
Full-absorption unit price obscures the distinction between variable and fixed
costs.
15-26
Variable-Cost Pricing FormulasVariable-Cost Pricing Formulas
Advantages
Do not obscure cost behavior patterns.
Do not require fixed cost allocations.
More useful for managers.
Disadvantage
Fixed costs may be overlooked in pricing decisions, resulting in
prices that are too low to cover total
costs.
15-27
Determining the Markup:Determining the Markup:Return-on-Investment PricingReturn-on-Investment Pricing
Solve for the markup percentage that will
yield the desired return on investment.
15-28
Price = cost + (markup percentage × cost)
Price = $400 + (131.25% × $400) = $925
Recall the example using a 131.25 percent markupon variable manufacturing cost.
Recall the example using a 131.25 percent markupon variable manufacturing cost.
Determining the Markup:Determining the Markup:Return-on-Investment PricingReturn-on-Investment Pricing
Let’s solve for the 131.25 percent markup. Investedcapital is $300,000, the desired ROI is 20 percent,
and annual sales volume is 480 units.
Let’s solve for the 131.25 percent markup. Investedcapital is $300,000, the desired ROI is 20 percent,
and annual sales volume is 480 units.
15-29
Determining the Markup:Determining the Markup:Return-on-Investment PricingReturn-on-Investment Pricing
ROI = Income
Invested Capital
20% = Income
$300,000
Income = 20% × $300,000
Income = $60,000
Step 1: Solve for the income thatwill result in an ROI of 20 percent.
Step 1: Solve for the income thatwill result in an ROI of 20 percent.
15-30
Determining the Markup:Determining the Markup:Return-on-Investment PricingReturn-on-Investment Pricing
Step 2: Recall the unit cost information below.Solve for the unit sales price necessary to result in an income of $60,000.
Step 2: Recall the unit cost information below.Solve for the unit sales price necessary to result in an income of $60,000.
Variable mfg. cost $ 400Fixed mfg. cost 250Full-absorption mfg. cost $ 650Variable S & A cost 50Fixed S & A cost 100Total cost $ 800
15-31
Determining the Markup:Determining the Markup:Return-on-Investment PricingReturn-on-Investment Pricing
480 units × (Unit sales price - $800 unit cost) = $60,000
Unit sales price - $800 unit cost = $60,000 480 units
Unit sales price - $800 unit cost = $125 per unit
480 units × (Unit profit margin) = $60,000
Unit sales price = $925
Step 2: Solve for the unit sales price necessary to result in an income of $60,000.
Step 2: Solve for the unit sales price necessary to result in an income of $60,000.
15-32
Determining the Markup:Determining the Markup:Return-on-Investment PricingReturn-on-Investment Pricing
Markuppercentage
Unit sales price - Unit variable cost Unit variable cost
Step 3: Compute the markup percentage on the $400 variable manufacturing cost.
Step 3: Compute the markup percentage on the $400 variable manufacturing cost.
=
Markuppercentage
$925 per unit - $400 per unit $400 per unit
=
Markuppercentage
= 131.25 percent
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objective
4
Learning Objective
4
15-34
Strategic Pricing of New ProductsStrategic 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.
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objective
5
Learning Objective
5
15-36
Target CostingTarget Costing
Market researchdetermines the price
at which a new product will sell.
Management computes a manufacturing cost that will provide an acceptable
profit margin.
Engineers and cost analysts design a productthat can be made for the allowable cost.
15-37
Target CostingTarget Costing
Keyprinciplesof targetcosting
Price led costing
Focuson the
customer
Focus onproductdesign
Focus onprocessdesign
Cross-functionalteams
Life-cyclecosts
Value-chainorientation
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objective
6
Learning Objective
6
15-39
The Role Of Activity-BasedThe Role Of Activity-BasedCosting In Setting ACosting In Setting A
Target Cost.Target Cost.
Production Process
Component Activities
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
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Learning Objective
7
Learning Objective
7
15-41
Product Cost DistortionProduct Cost Distortion
High-volume productsMay be overcosted
Low-volume productsMay be undercosted
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objective
8
Learning Objective
8
15-43
Value EngineeringValue Engineeringand Target Costingand Target Costing
Target cost information Product design Product costs Production processes
Target cost information Product design Product costs Production processes
Value Engineering (VE) Cost reduction Design improvement Process improvement
Value Engineering (VE) Cost reduction Design improvement Process improvement
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objective
9
Learning Objective
9
15-45
Time and Material PricingTime and Material Pricing
• Price is the sum of labor and material charges.
• Used by construction companies, printers, and professional service firms.
15-46
Time and Material PricingTime and Material Pricing
Time charges:
Totallabor hours
required
Hourlylaborcost
+Overheadcost per
labor hour+
Hourly chargeto provide
profit margin×
Material Charges:Total
materialcost
incurred
+
Overheadper dollarof material
cost
×
Total material
costincurred
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objective
10
Learning Objective
10
15-48
Competitive BiddingCompetitive Bidding
High bidprice
Low probabilityof winning bid
High profit ifwinning bid
Low bidprice
High probabilityof winning bid
Low profit ifwinning bid
15-49
Competitive BiddingCompetitive Bidding
Guidelines for BiddingGuidelines for Bidding
Bidder hasexcess capacity
Low bid price Any bid price in excess of incremental costs of job will contribute to fixed costs and profit.
Bidder has noexcess capacity
High bid price Bid price should be full cost plus normal profit margin as winning bid will displace existing work.
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objective
11
Learning Objective
11
15-51
Legal Restrictions On Setting PricesLegal Restrictions On Setting Prices
• Price discrimination
• Predatory pricing
15-52
End of Chapter 15End of Chapter 15
What is the right price?
