Rev Mgt Cost Aspects

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2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed.,Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Informationfor

Pricingand

Product Planning

Chapter 6


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2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed.,Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University 6-2

Role Of Product Costs In Pricing

And Product Mix Decisions Understanding how to analyze product costs is

important for making pricing decisions:

At most firms whose managers make decisions aboutestablishing or accepting a price for their products,managers need to make decisions about, for example,whether they should offer discounts for large orders orto valued customers

Even when prices are set by overall market supply anddemand forces and the firm has little or no influence onproduct prices, management still has to decide thebest mix of products to manufacture and sell


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Role of Product Costs

Product cost analysis is also significant when afirm is deciding how best to deploy marketingand promotion resources

How much commission (or how many otherincentives) to provide the sales force for differentproducts

How large a discount to offer off list prices

This chapter examines some of the moretraditional methods of pricing and considersshort- and long-run factors


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Short-term and Long-termPricing Considerations (1 of 3)

Managers must consider both the short-termand long-term consequences of their decisions

The costs of many resources committed to

activities are likely to be committed costs in theshort-term because firms cannot easily alter thecapacities made available for many productionand support activities So for short-term decisions, it is important to pay

special attention to whether surplus capacity isavailable for additional production, or whethershortages of available capacity limit additionalproduction alternatives


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Of special concern when evaluating a particularorder is how long a firm must commit itsproduction capacity to fill that order

The length of time is relevant because a long-term capacity commitment to a marginallyprofitable order may:

Prevent the firm from deploying its capacity for more

profitable products or orders, should demand for themarise in the future

Force the firm to add expensive new capacity tohandle future sales increases


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If production is constrained by inadequate capacity,managers need to consider whether overtime productionor the use of subcontractors can help augment capacityin the short term

In the long term, managers have considerably more

flexibility to adjust the capacities of activity resources tomatch the demand for them in producing variousproducts

Decisions about whether to introduce new products oreliminate existing products have long-term

consequences The emphasis is, therefore, on analyzing how such

product decisions will affect the demand placed onthe firms capacity resources


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Ability To Influence Prices (1 of 2)

We also classify decisions based on whether thefirm can influence the price of its products If the firm is one of a large number of firms in an

industry, and if there is little to distinguish the productsof different firms from each other:

Economic theory states that prices will be set by the aggregatemarket forces of supply and demand

No single firm can influence prices significantly by its owndecisions

The result will be similar if prices are set by one or more largefirms leading an industry, while a smaller firm on the fringemust match the prices set by the industry leaders

Such a firm is a price taker, and it chooses its productmix given the prices set in the marketplace for itsproducts


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Ability To Influence Prices (2 of 2)

In contrast, firms in an industry with relatively littlecompetition, who enjoy large market shares andexercise leadership in an industry, must decide whatprices to set for their products

Firms in industries in which products are highlycustomized or otherwise differentiated from each other(because of special features, characteristics, orcustomer service) also need to set the prices for theirdifferentiated products

Such firms are price setters; they announce theirprices, customers place orders, and production follows


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Price Takers

A small firm, or a firm with a negligible market share in thisindustry, behaves as a price taker It takes the industry prices for its products as given and then

decides how many units of each product it should produce and sell

If the small firm demands a higher price for any of its products, it

risks losing its customers to other competing firms in the industry,unless it can successfully differentiate its products by offeringspecial features or services

Conversely, if the small firm seeks to increase its market share byasking a price lower than the industry prices, then it risks a pricewar that would make the firm, and the entire industry, worse offthan if the firm had complied with industry prices

This action is most painful to smaller firms that have fewerresources to rely on should an unprofitable price war occur


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2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed.,Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

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Short-Term Decisions for Price Takers

A price taker should produce and sell as much as it canof all products whose costs are less than industry prices

Although this may appear to be a simple decision rule,two important considerations complicate matters First, managers must decide which costs are relevant to the

short-term product mix decision Should all the product costs identified in Chapter 3 be

considered?

Should only those costs that vary in the short term beconsidered?

Second, in the short-term, managers may have little flexibility toalter the capacities of some of the firms resources The available equipment capacity may limit the ability of a

firm to produce and sell more products whose costs are lowerthan their prices


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2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed.,

Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University6-11

Garment Manufacturer(1 of 3)

Consider a company that sells five types of ready-madegarments to discount stores such as Kmart and Wal-Mart

The company is operating at full capacity and iscontemplating short-term adjustments to its product mix

It is necessary for the company to determine: What costs will vary with production levels in this period

What costs will remain fixed when a change occurs in theproduction mix

The costs of utilities, plant administration, maintenance,

and depreciation for the machinery and plant facility willnot alter with a change in the product mix, because theplant is operating at full capacity


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Varying with the quantity of each garmentproduced are:

The costs of direct materials

The direct labor that is paid on a piece-rate basis

Inspectors are paid a monthly fixed salary, butthey are employed as required to support theproduction of different garments

If production increases, the company may have to hire

more inspectors Therefore, inspection labor costs also vary with quantity

of production of different garments


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If its capacity were unlimited, the company could producegarments to fill the maximum demand for them

Capacity is constrained, however, and therefore thecompany must decide how best to deploy this limitedresource

The capacity is fixed in the short-term, so the companymust plan production to maximize the contribution to profitearned for every available machine hour used Therefore, the company should rank-order the products by their

contribution per machine hour Not by their contribution per unit

Contribution per machine hour is obtained by dividing thecontribution per unit by the number of machine hours per unit


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The Impact Of Opportunity Costs (1 of 2)

If the garment manufacturer receives a special orderrequest, it would have to decide the minimum price itwould accept

Its out-of-pocket costs will increase in the short-term bythe amount of flexible costs required for the order, but asimple comparison of the price with flexible costs is notadequate for this decision

Because its production capacity is limited, the companymust cut back the production of some other garment toenable it to produce the goods for the special order

Giving up the production of some profitable productresults in an opportunity cost, which equals the lost profiton the garments that the company can no longer make


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The Impact Of Opportunity Costs (2 of 2)

The lost profit in this case would be thecontribution on the goods it will not make

In deciding which products to take off of the

production schedule, the company should onceagain look at the contribution per machine hour

The product with the lowest contribution perhour should be sacrificed

The profit (contribution) lost on those productswould need to be covered by the price of thespecial order


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Short-Term Pricing Decisionsfor Price Setters

In many businesses, potential customers request thatsuppliers bid a price for an order before they decide onthe supplier with whom they will place the order

In this section, we examine the relationship betweencosts and prices bid by a supplier for special orders thatdo not involve long-term relationships with the customer

For example, we will use a tool and die company thatmanufactures customized steel tools and dies for a wide

variety of manufacturing businesses A new customer has asked for a bid on a set of

customized tools


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Determining a Bid Price (1 of 3)

Based on the tool design, production engineers determinethe routing through different production departments andestimate the quantity of different materials required for theorder and the number of labor hours required in eachdepartment

This information is used to prepare a job bid sheet asdescribed in Chapter 3

Then the company uses this information, and materialsprices and labor wage rates, to estimate the directmaterials and direct labor costs

Support activity costs are assigned to the job based onactivity cost drivers and the corresponding activity costdriver rates as described in Chapter 4


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Determining a Bid Price (2 of 3) Assume that the full costs for the job are estimated to be

$28,500 consisting of: $ 8,400 of direct materials

$ 9,900 of direct labor

$10,200 of support activity costs, consisting of:

$ 3,400 of Supervision

$ 3,700 of batch related expenses

$ 3,100 of business sustaining expenses

Setting the price of a product also means determining amarkup percentage above cost, an approach known as

cost-plus pricing The markup percentage is determined by a companys desiredprofit margin and overall rate of return

The company has decided the markup percentage is normally tobe 40% of full costs


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Determining a Bid Price (3 of 3)

If the bid request came from a regular customer, the bidprice would have been $39,900= 1.40 x $28,500

But for this special order from a new customer, what isthe minimum acceptable price?

One of the critical factors to consider is the level ofavailable capacity

The example looks at two cases: There is surplus machine capacity available in the short term to

complete the production of the job

Existing demand for the companys services already uses allavailable capacity and the only way to manufacture thecustomized tools for the special order is by working overtime oradding an extra shift


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Available Surplus Capacity

The companys incremental costs of filling the order will be$ 22,000 (material, direct labor, batch related expenses) The costs of supervision and business-sustaining support

activities will not increase if excess capacity of theseresources is available to meet the production needs of theorder

The price that the company should bid must cover theincremental costs for the job to be profitable In other words, the minimum acceptable price is $22,000 since

surplus production capacity is available

This is the price at which the company will break even on

the order The company would likely add a profit margin above

incremental costs and make the bid price something higherthan $22,000, depending on competitive and demandconditions


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No Available Surplus Capacity (1 of 3)

If surplus machine capacity is not available, thecompany will have to incur additional costs toacquire the needed capacity

Companies often meet such short-term capacity

requirements by operating its plant overtime Paying its supervisors overtime wages

Incurring additional expenditures for heating, lighting,cleaning, and security

More machine maintenance and plant engineeringactivities will be necessary

Experience has shown that the incidence of machinebreakdowns increases during the overtime shift


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Under its machinery leasing contract, thecompany also incurs additional rental costs for theextra use of machines when it adds an overtimeshift

Assume management estimates the order wouldcause: $5,100 of incremental supervision costs (including

overtime premium)

$5,400 of incremental business-sustaining costs

Thus, the total cost of overtime required tomanufacture customized tools for the order is$10,500 ($5100 + $5400)


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Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

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Therefore, the minimum acceptable price in thiscase is $32,500 ($22,000 + $10,500)

The actual price will depend on the amount of markupcharged over the incremental costs

The principle illustrated here is the same as thatdescribed in the previous case: the minimumacceptable price must cover all incrementalcosts

When the firm must acquire additional capacity tosatisfy the order, there are more incremental costsinvolved in the decision to accept or reject the order


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Long-Term Pricing Decisionsfor Price Setters

You may have noticed that the relevant costs forthe short-term special order pricing decisiondiffer from the full costs of the job

Most firms rely on full-cost information reportswhen setting prices

Typically, the accounting department provides costreports to the marketing department, which then addsappropriate markups to the costs to determinebenchmark or target prices for all products normallysold by the firm


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Use of Full Costs in Pricing (1 of 3)

There is economic justification for using fullcosts for pricing decisions in three types ofcircumstances:1. Many contracts for the development and production

of customized products and many contracts withgovernmental agencies specify that prices shouldequal full costs plus a markup, and prices set inregulated industries are based on full costs

2. When a firm enters into a long-term contractual

relationship with a customer to supply a product, ithas great flexibility in adjusting the level ofcommitment for all resources


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Most activity costs will depend on the productiondecisions under the long-term contract, and fullcosts are relevant for the long-term pricingdecision

3. In many industries, firms make short-termadjustments in prices, often by offering discountsfrom list prices instead of rigidly employing a fixedprice based on full costs

When demand for their products is low, thefirms recognize the greater likelihood of surpluscapacity in the short term


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They adjust the prices of their products downwardto acquire additional business based on the lowerincremental costs they incur when surplus capacityis available

When demand for their products is high, theyrecognize the greater likelihood that the existingcapacity of activity resources is inadequate tosatisfy all of the demand

They adjust the prices upward based on the higherincremental costs they incur when capacity is fullyutilize, thereby rationing the available capacity tothe highest profit opportunity


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Fluctuating Prices (1 of 2)

Because demand conditions fluctuate over time,prices also fluctuate with demand conditions overtime Most hotels offer special weekend rates that are

considerably lower than their weekday rates Many amusement parks offer lower prices on

weekdays when demand is expected to be low

Airfares between New York and London are higher insummer, when the demand is higher, than in winter,

when the demand is lower Long-distance telephone rates are lower in the

evenings and on the weekends when the demand islower


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Fluctuating Prices (2 of 2)

Although fluctuating short-term prices are based on theappropriate incremental costs, over the long term theiraverage tends to equal the price based on the full coststhat will be recovered in a long-term contract

In other words, the price determined by adding on amarkup to the full costs of a product serves as abenchmark or target price from which the firm can adjustprices up or down depending on demand conditions

Most firms use full cost-based prices as target prices,giving sales managers limited authority to modify pricesas required by the prevailing competitive conditions


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The Markup Rate (1 of 2)

Just as prices depend on demand conditions, markupsincrease with the strength of demand If more customers demand more of a product, then the firm is

able to command a higher markup

Markups also depend on the elasticity of demand Demand is said to be elastic if customers are very sensitive tothe price, that is, if a small increase in the price results in a largedecrease in the demand

Markups are smaller when demand is more elastic

Markups also fluctuate with the intensity of competition If competition is intense, it is more difficult for a firm to sustain a

price much higher than its incremental costs


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The Markup Rate (2 of 2)

Firms decide on markups for strategic reasons: A firm may choose a low markup for a new product topenetrate the market and win over market share froman established product of a competing firm

Many internet businesses have adopted the strategy

of setting low prices to build the business, acquire abrand name, build a loyal customer base, and garnermarket share

In contrast to this penetration pricing strategy, firmssometimes employ a skimming price strategy, as in

the audio and video equipment industry, whereinitially a higher price is charged to customers whoare willing to pay more for the privilege of possessingthe latest technological innovations


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Long-Term Decisions for Price Takers

Decisions to add a new product or to drop an existingproduct from the portfolio of products usually havesignificant long-term implications for a firms coststructure

Product-sustaining costs are relevant costs for suchdecisions Product design and engineering, vendor and purchasing costs,

part maintenance, and dedicated sales force costs

Batch-related costs are also likely to alter if a change

occurs in the product mix either in favor of or againstproducts manufactured in large batches Setups, materials handling, and first-item inspections


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Use of Full Costs (1 of 3)

Bear in mind that managers cannot easily change theamount of resources committed for many product-sustaining and several batch-related activities in theshort run

The cost consequences of either introducing a newproduct or deleting an existing product evolve over time

Both decisions require careful implementation plansstretching over several periods


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As a result, managers use the full costs of products,including the cost of using various resources to produceand sustain the product

Such resources include the number of setup staff, the

number of product and process engineers, and thenumber of quality inspectors

Managers use the costs of all resources in their product-related decisions, because in the long-term, the firm isable to adjust the capacity of activity resources to matchthe resource levels demanded by the product quantitiesand mix


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Comparing product costs with their market prices revealswhich products are not profitable in the long-term

Over the long-term, firms can adjust activity resourcecapacities to match production requirements

If some products have full costs that exceed the marketprice, the firm must consider several options

Although dropping these products appears is to be anobvious option, customers may expect the companyto maintain a full product line

But a comparison of the prices with costs stillprovides a valuable signal to managers because itindicates the net cost of the strategy to offer a fullproduct line


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Options if Full Cost > Price (1 of 2)

Managers may consider options other thandropping the product

Reengineering or redesigning unprofitable products, toeliminate or reduce costly activities and bring theircosts in line with market prices

For example, they could improve the productionprocesses to reduce setup times and streamlinematerial and product flows

They may want to explore market conditions morecarefully and differentiate their products further toraise prices and bring them in line with the costs


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Options if Full Cost > Price (2 of 2)

Firms may offer customers incentives, such asquantity discounts, to increase order sizes andthereby reduce total batch-related costs

If these steps fail, and if the marketing strategyof offering such a full product line cannot justifythe high net cost of such products, thenmanagers must consider a plan to phase out theproducts from their line

Customers also need to be shifted to substituteproducts still retained in the companys product line


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Profit Increase is Not Automatic

Dropping products will help improve profitabilityonly if the managers:1. Eliminate the activity resources no longer required to

support the discontinued product, or

2. Redeploy the resources from the eliminated products

to produce more of the profitable products that thefirm continues to offer

Costs result from commitments to supplyactivity resources

They do not disappear automatically with thedropping of unprofitable products

Only when companies eliminate or redeploy theresources themselves will actual expenses decrease


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Summary Managers use cost information to assist them in pricing and

in product mix decisions The manner in which they use cost information in making

these decisions depend on whether the firm is a major orminor entity in its industry

A major entity would be able to influence the setting of prices A minor entity would take the industry prices as given and adjust its

product mix in response to the prices it could charge

The role of cost information also depends on the time frameinvolved in the decision

Business-sustaining costs are frequently relevant for long-termdecisions, but less often for short-term decisions

Short-term prices are based on incremental costs that depend onthe availability of activity resource capacity


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Economic Analysis of the

Pricing Decision

Appendix 6-1


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Quantity Decision (1 of 2) Introductory textbooks in economics usually analyze the

profit maximization decision by a firm in terms of thechoice of a quantity to produce. In turn, the quantity choicedetermines the price of the product in the marketplace

Economists present the quantity choice in terms of

equating marginal revenue and marginal cost Marginal revenue is defined as the increase in revenue

corresponding to a unit increase in the quantity produced and sold

Marginal cost is the increase in cost for a unit increase in thequantity produced and sold

If marginal revenue is greater than marginal cost, then increasingthe quantity by one unit will increase profit

If marginal revenue is less than the marginal cost, then it ispossible to increase profit by decreasing production


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Quantity Decision (2 of 2)

In this analysis, the firm chooses the quantitylevel, and the market demand conditionsdetermine the corresponding price

Considered next a firm that must choose a price,not a quantity, to announce to its customers

Customers then react to the price announcedand determine the quantity that they demand

The price decision analysis uses differentialcalculus to analyze the firms pricing decision


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Pricing Decision (1 of 3) Total costs, C, expressed in terms of its fixed and flexible

cost components are: C = f + vQ, Where fis the committed cost, vis the flexible cost per

unit, and Q is the quantity produced in units

Quantity produced is assumed to be the same as quantity

demanded The demand, Q, is represented as a decreasing linear

function of the price P: Q = a bP

In general, we may have nonlinear demand functions, but

the linear form provides a convenient characterization forour analysis

A higher value ofb represents a demand function that ismore sensitive (elastic) to price


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Pricing Decision (2 of 3) An increase of a dollar in the price decreases demand

by b units A higher value ofa reflects a greater strength of demand

for the firms product. For any given price, P, the demandis greater when the parameter, a, has a higher value

The total revenue, R, is given by the price, P, multipliedby the quantity sold, Q. Algebraically, we write this:

R = PQ = P(a bP)

= aP bP2

The profit, , is measured as the difference between therevenue, R, and the cost, C:


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Pricing Decision (3 of 3) = R - C

= PQ - (f + vQ)

= P(a - bP) - F - v(a - bP)

= aP - bP2 - F - va + vbP

To find the profit-maximizing price, P*, we set the firstderivative of profit Pwith respect to Pequal to zero:

d /dP = A 2bP + vb = 0

This equation implies:

P* = (a + vb)/2b = a/2b + v/2


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Long-Term Benchmark Prices (1 of 2)

This simple economic analysis suggests that the pricedepends only on v, the flexible cost per unit Committed costs are not relevant for the pricing decision

A more complex analysis that considers simultaneously

the pricing decision and the long-term decisions of thefirm to commit resources to facility-sustaining, product-sustaining, and other activity capacities indicates that thecosts of these committed resources do play a role in thepricing decision

The costs of these committed activity resources appearto be committed costs in the short-term, but they can bechanged in the long-term


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Long-Term Benchmark Prices (2 of 2)

The prices that a firm sets and adjusts in the short term,based on changing demand conditions, fluctuate arounda long-term benchmark price,pL, that reflects the unitcosts of the activity resource capacities:

pL = a/2b + (v + m)/2

Here m = f Xis the cost per unit of normal capacity,X,of facility-sustaining activities In this case, the degree of price fluctuations around the

benchmark price increases with the proportion ofcommitted costs

As a result, prices appear more volatile in capital-intensive industries where a large proportion of costs arefor facility-sustaining activities E.g., airlines, hotels, and petroleum refining


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Competitive Analysis (1 of 3) In a situation when other firms compete in the same

industry with products that are similar but not identical toeach other, some customers may switch their demand to acompeting supplier if the competitor reduces its price

Therefore, a firms pricing decision must consider theprices that may be set by its competitors

Consider two firms, A and B, and represent the demand,QA, for firm As product as a function of its own price, PA,and the price, PB, set by its competitor:

QA = a b PA + e PB

The demand for firm As product falls by b units for eachdollar increase in its own price, but increases by e units foreach dollar increase in the competitors price, becausefirm A gains some of the market demand that firm B loses


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Competitive Analysis (3 of 3)

If the firm expects its competitor to behave as it doesand expects it to choose the same price as its own, then

we set PA = PB = P*in the equation

a - 2b PA 1 + e PB + vb = 0to obtain:

a - 2bP* + eP* + vb = 0P* = a + vb/2b - e

We refer to this price as the equilibrium price, becauseno firm can increase its profits by choosing a different

price provided the other firm maintains the same price P* This analysis is based on a concept called Nash

equilibrium, for which its discoverer, John Nash, wonthe 1994 Nobel Prize in economics.


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If you have any comments orsuggestions concerning

this PowerPoint presentation, please contact:Terry M. Lease

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Sonoma State University

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Rev Mgt Cost Aspects