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Chapter 15 Outline

Cost Analysis and Pricing Decisions


  1. Major Influences on Pricing Decisions
    1. Consumer demand influences: Consumer 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.
    2. Consider competitorsí strategies: A company cannot set prices without considering the products and pricing strategies of competitors.
    3. 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 influences.
    4. 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.
  1. Economic Profit-Maximizing Model
    1. One more unit incurs marginal costs: 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).
    2. 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.
    3. Several limitations: There are several limitations to using the economistís model in practice:
    1. 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.
    2. Limited use: The model is not valid for all forms of markets (an oligopolistic market, for example, which has only a few sellers).
    3. 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.
  1. Role of Accounting Product Costs in Pricing
    1. Product costs provide start: 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.
    2. 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 target price.
    3. Price = Cost + (Markup percentage X Cost)


    4. 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 profitability.
    5. 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.
    6. 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 adjusted accordingly.
  1. Determining the Markup
    1. Markup % covers costs and provides return: 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:
    2. Target Profit= Average Invested Capital X Target ROI


    3. Then use target profit: The target profit is then employed to derive the markup percentage for the companyís pricing policy:
    4. 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

    5. 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 determination.
  1. Other Issues
    1. Labor & materials marked up: 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.
    2. 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.
    1. 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.
    2. 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 cost.
    1. 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 share).
    2. 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.
    3. 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.
    4. 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).


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