Target Costing and Cost Analysis for Pricing Decisions

1. Chapter 15 Target Costing andCost Analysis forPricing Decisions

2. Learning Objective1

3. Customerdemand Political, legal, and image issues Competitors Costs Major Influences onPricing Decisions PricingDecisions

4. Learning Objective2

5. Costs MarketForces How Are Prices Set? 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.

6. Economic Profit-Maximizing Pricing Firms usually have flexibility in setting prices. The quantity sold usually declines as the price is increased.

7. Total Revenue Curve Dollars Total revenue Curve is increasing throughoutits range, but at a declining rate. Quantity soldper month

8. Demand Schedule and Marginal Revenue Curve Dollarsper unit Sales price must decreaseto sell higher quantity. Demand Revenue perunit decreasesas quantity increases. Marginalrevenue Quantity soldper month

9. Total Cost Curve Dollars Total cost increasesat anincreasingrate. Total cost increasesat adecliningrate. Quantity madeper month

10. Marginal Cost Curve Dollarsper unit Marginalcost Quantity wheremarginal costbegins to increase. Quantity madeper month

11. Determining the Profit-Maximizing Price and Quantity Dollarsper unit p* Demand Marginalcost Marginalrevenue Quantity made and soldper month q*

12. Determining the Profit-Maximizing Price and Quantity Dollarsper unit Profit is maximized where marginal cost equalsmarginal revenue, resultingin price p* and quantity q*. p* Demand Marginalcost Marginalrevenue Quantity made and soldper month q*

13. Determining the Profit-Maximizing Price and Quantity Total cost Dollars Total revenue Total profit at the profit-maximizingquantity and price,q* and p*. Quantity made and soldper month q*

14. Price Elasticity The impact ofprice changes onsales volume Demand iselasticifa price increase has alarge negative impacton sales volume. Demand isinelasticifa price increase haslittle or no impact on sales volume.

15. Cross Elasticity The extent towhich a change in a product’s price affects thedemand for othersubstitute products.

16. Limitations of theProfit-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.

17. Role of AccountingProduct Costs in Pricing Exh. 15-4 Optimal Decisions Suboptimal Decisions Economic pricing model Cost-based pricing Sophisticated decisionmodel and informationrequirements Simplified decisionmodel and informationrequirements Marginal-cost andmarginal-revenue data Accounting product-cost data More costly Less costly The best approach, in terms of costs andbenefits, typically lies between the extremes.

18. Learning Objective3

19. Price = cost + (markup percentage × cost) Cost-Plus Pricing Full-absorptionmanufacturingcost? Variablemanufacturingcost? Total cost,including sellingand administrative? Total variable cost,including sellingand administrative?

20. Cost-Plus Pricing - Example Variable mfg. cost $ 400 Fixed mfg. cost 250 Full-absorption mfg. cost $ 650 Variable S & A cost 50 Fixed S & A cost 100 Total cost $ 800 We will use this unit cost information to illustrate therelationship between cost and markup necessary toachieve the desired unit sales price of $925.

21. Cost-Plus Pricing - Example Variable mfg. cost $ 400 Fixed mfg. cost 250 Full-absorption mfg. cost $ 650 Variable S & A cost 50 Fixed S & A cost 100 Total cost $ 800 Markup onvariablemanufacturingcost Price = cost + (markup percentage × cost) Price = $400 + (131.25% × $400) = $925

22. Cost-Plus Pricing - Example Markup ontotal var. cost As cost baseincreases, therequired markuppercentagedeclines. Variable mfg. cost $ 400 Fixed mfg. cost 250 Full-absorption mfg. cost $ 650 Variable S & A cost 50 Fixed S & A cost 100 Total cost $ 800 Price = cost + (markup percentage × cost) Price = $450 + (105.56% × $450) = $925

23. Cost-Plus Pricing - Example Markup onfull mfg. cost As cost baseincreases, therequired markuppercentagedeclines. Variable mfg. cost $ 400 Fixed mfg. cost 250 Full-absorption mfg. cost $ 650 Variable S & A cost 50 Fixed S & A cost 100 Total cost $ 800 Price = cost + (markup percentage × cost) Price = $650 + (42.31% × $650) = $925

24. Cost-Plus Pricing - Example Markup ontotal cost As cost baseincreases, therequired markuppercentagedeclines. Variable mfg. cost $ 400 Fixed mfg. cost 250 Full-absorption mfg. cost $ 650 Variable S & A cost 50 Fixed S & A cost 100 Total cost $ 800 Price = cost + (markup percentage × cost) Price = $800 + (15.63% × $800) = $925

25. Advantages 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. Absorption-Cost Pricing Formulas

26. 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. Variable-Cost Pricing Formulas

27. Determining the Markup:Return-on-Investment Pricing Solve for the markup percentage that will yield the desired return on investment.

28. Determining the Markup:Return-on-Investment Pricing Recall the example using a 131.25 percent markupon variable manufacturing cost. Price = cost + (markup percentage × cost) Price = $400 + (131.25% × $400) = $925 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.

29. Income Invested Capital ROI = Income $300,000 20% = Determining the Markup:Return-on-Investment Pricing Step 1: Solve for the income thatwill result in an ROI of 20 percent. Income = 20% × $300,000 Income = $60,000

30. Determining the Markup:Return-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. Variable mfg. cost $ 400 Fixed mfg. cost 250 Full-absorption mfg. cost $ 650 Variable S & A cost 50 Fixed S & A cost 100 Total cost $ 800

31. Determining the Markup:Return-on-Investment Pricing Step 2: Solve for the unit sales price necessary to result in an income of $60,000. 480 units × (Unit profit margin) = $60,000 480 units × (Unit sales price - $800 unit cost)= $60,000 $60,000 480 units Unit sales price - $800 unit cost= Unit sales price - $800 unit cost = $125 per unit Unit sales price =$925

32. Determining the Markup:Return-on-Investment Pricing Step 3: Compute the markup percentage on the $400 variable manufacturing cost. Markuppercentage Unit sales price - Unit variable cost Unit variable cost = Markuppercentage $925 per unit - $400 per unit $400 per unit = Markuppercentage = 131.25 percent

33. Learning Objective4

34. Strategic 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.

35. Learning Objective5

36. Target Costing Market researchdetermines the priceat 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.

37. Price led costing Cross-functionalteams Life-cyclecosts Value-chainorientation Focus onprocessdesign Focus onproductdesign Focuson the customer Target Costing Keyprinciplesof targetcosting

38. Learning Objective6

39. The Role Of Activity-Based Costing In Setting A Target Cost. Production Process Component Activities

40. Learning Objective7

41. Product Cost Distortion High-volume products May be overcosted Low-volume products May be undercosted

42. Learning Objective8

43. Value Engineeringand Target Costing Target cost information • Product design • Product costs • Production processes Value Engineering (VE) • Cost reduction • Design improvement • Process improvement

44. Learning Objective9

45. Time and Material Pricing • Price is the sum of labor and material charges. • Used by construction companies, printers, and professional service firms.

46. Hourlylaborcost Overheadcost perlabor hour Hourly chargeto provideprofit margin + + × Material Charges: Total materialcostincurred Overheadper dollarof materialcost Total materialcostincurred × + Time and Material Pricing Time charges: Totallabor hoursrequired

47. Learning Objective10

48. Competitive Bidding High bidprice Low probabilityof winning bid High profit ifwinning bid Low bidprice Low profit ifwinning bid High probabilityof winning bid

49. Bidder hasexcess capacity Bidder hasnoexcess capacity Competitive Bidding Guidelines for Bidding • Low bid price • Any bid price in excess of incremental costs of job will contribute to fixed costs and profit. • High bid price • Bid price should be full cost plus normal profit margin as winning bid will displace existing work.

50. Learning Objective11