Accounting 202 Home
Chapter 15 Outline
Cost Analysis and Pricing Decisions
- Major Influences on Pricing Decisions
demand is a major influence on all aspects of the operations.
Consideration is given to the price that customers are willing to pay, the
quality desired, and any accompanying trade-offs. Companies routinely use
market research and test marketing to gain such information.
Consider competitorsí strategies: A company cannot set prices
without considering the products and pricing strategies of competitors.
Costsí importance is industry specific: Costs are a factor in
the pricing process, more in some industries than in others. In agriculture,
for example, grain and meat prices are market-driven. In many other cases
(gasoline and automobiles), prices are set by adding a markup to cost.
Generally speaking, prices are set by considering both cost and market
Firms conscious of other factors: Firms are also conscious of political,
legal, and image-related issues when setting prices. Price discrimination,
regulatory agencies, and concerns about reputation are often a factor.
- Consumer demand influences
- Economic Profit-Maximizing Model
: Marginal cost is the
addition to total cost from the production of one additional unit. Marginal
revenue, in contrast, is the addition to total revenue from the sale of
the next additional unit of product. Profits are maximized if a company
sells a quantity that coincides with the intersection of the marginal
revenue and marginal cost curves. That quantity, when plotted against the
demand curve, derives the optimal price (e.g., see Exhibit 15-3).
Elastic demand is price sensitive: The impact of price changes on
sales volume is known as price elasticity. Demand is elastic if a price
increase has a large negative impact on sales volume and vice versa. The
measurement of price elasticity is an important objective of market research,
as a good understanding of this concept helps managers determine the best
price for a product.
Several limitations: There are several limitations to using the
economistís model in practice:
- One more unit incurs marginal costs
- Market research seldom sufficient: Market research is seldom
sufficient to predict the exact effect of a price change on demand, because
many other factors (e.g., product design, advertising, company image,
and quality) are also influential.
- Limited use: The model is not valid for all forms of markets (an oligopolistic
market, for example, which has only a few sellers).
- Marginal costs too expensive: Practically speaking, costs accounting
systems cannot provide the marginal cost information needed in the model for
a companyís various product lines.
- Role of Accounting Product Costs in Pricing
: Product costs give managers a starting
point when setting pricing policies. Although the lowest price could be zero
(as in a free sample promotion), all costs must be covered for an
organization to break even in the long run. No organization can price it
products below total cost indefinitely and continue to stay in business.
Therefore, the price floor is the total cost, and the price ceiling is the
amount that consumers are willing to pay. Most prices fall somewhere
in-between these two points.
General cost-plus formula: There are several ways to define the cost
factor in formula, and for each, the markup is adjusted to yield the same
- Product costs provide start
Price = Cost + (Markup percentage X Cost)
Long-term costs = absorption cost: For long-term pricing, cost may be
defined as absorption cost (direct materials, direct labor, variable
manufacturing overhead, and fixed manufacturing overhead). Because all
manufacturing costs are considered here, this definition of cost reminds
managers that all elements of production must be covered by a firmís selling
price. Also these data are readily available because the absorption cost is
used for valuing inventory on the balance sheet. A disadvantage to using
absorption cost is the inconsistency with cost-volume-profit analysis, which
allows managers to study the effects of changes in sales and prices on
Total cost a factor: Managers may also use total cost as the cost
factor in the formula. Total cost would include absorption manufacturing cost
plus selling and administrative costs.
No fixed costs not considered: Variable-pricing formulas define cost
as all variable costs. Some managers prefer this method because of its
consistency with cost-volume-profit analysis and special-order decision
making. On the negative side, prices may be set too low because in the long
run, all costs must be covered by the selling price. Variable costs may be
defined as variable manufacturing cost or total variable cost, with the markup
- Determining the Markup
: Regardless of the
definition of cost, a markup percentage determines a price that will
cover all costs and provide a return to the company (i.e., return-on-investment
pricing). The following formula is used to calculate the target profit
needed in the markup calculation, namely:
- Markup % covers costs and provides return
Target Profit= Average Invested Capital X Target ROI
Then use target profit: The target profit is then employed to derive
the markup percentage for the companyís pricing policy:
Markup % = (Target Profit + Any Total Annual Costs Not in Base)
Annual Volume X Cost per unit*
* Cost as defined in the chosen cost-pricing formula
Not applicable to all markets: Like the economistís model, the
accountantís cost-plus model is not applicable to all markets, for example,
in agriculture where the individual producer cannot affect prices. Also the
model cannot be applied without due consideration of other variables in the
marketplace such as product life-cycle, competition, and promotion. Therefore,
the cost-plus formula is often used only as a starting point in price
- Other Issues
: Time and materials pricing is
used by home builders, print shops, repair shops, consultants, and other
similar "job-oriented" businesses. The cost of labor and materials
used on a job is marked up by a factor to cover the overhead and desired
profit margin. The overhead charges and profit margin are often
"buried" in the labor rate.
Competitive bidding sealed: Competitive bidding requires the
submission of sealed bids in an effort to secure a contract for a project or
product. The higher the bid price, the greater the profit for the contractor if
the contractor gets the job. Of course, a high-priced bid lowers
the probability of being the ultimate selection.
- Labor & materials marked up
- Cover variable cost when excess exists: With excess capacity, a firm
should cover a variable costs in its bid price and be willing to settle for
a contribution to fixed costs.
- No excess capacity consider total costs: If there is no excess
capacity, a firm should attempt to obtain a price in excess of total job
- New product pricing more uncertain: Strategic pricing of new
products is more difficult than pricing an existing product because of
the uncertainty associated with production and demand. Two pricing
strategies are frequently used: price skimming (setting the initial
price high to reap profits before competition enters the market) and penetration
pricing (settling the initial price low to quickly gain a large market
- Target costing uses market research: A number of firms use target
costing in product pricing. Under this approach, a company uses market
research to determine the price at which a product will sell. It then
subtracts an estimated profit margin to yield the target cost. Finally,
engineers and cost analysts work together to design a product that can be
manufactured for the allowable cost.
- ABC eliminates distortion: Activity-based costing helps eliminate
cost distortion. Because pricing decisions are often based on cost,
incorrect costs could lead to significant error in under- and over-pricing a
product, perhaps resulting in (1) a sale below cost, or (2) a price that is
set too high and eventual lost customers.
- Legal limitations: Businesses must stay within the legal framework
of pricing as regulated by the RobinsonóPatman Act, the Clayton Act, and
the Sherman Act. Careful records must be kept to document that a company
does not engage in price discrimination (charging different prices to
different customers for the same goods and services) and predatory
pricing (temporarily cutting a price to boost demand, with the intention
of later restricting supply and raising the price).