Pricing Decisions

and
Cost Management

2012 Pearson Prentice Hall. All rights reserved.

Pricing and Business

How companies price a product or service ultimately

depends on the DEMAND AND SUPPLY for it.
Three influences on demand and supply:
Customers
2. Competitors
3. Costs
1.

2012 Pearson Prentice Hall. All rights reserved.

Influences on Demand and Supply

Customersinfluence price through their effect on the
demand for a product or service, based on factors such
as quality and product features
2. Competitorsinfluence price through their pricing
schemes, product features, and production volume
(demand & supply)
3. Costsinfluence prices because they affect SUPPLY (the
lower the cost, the greater the quantity a firm is willing
to supply)
1.

2012 Pearson Prentice Hall. All rights reserved.

Time Horizons and Pricing

Short-run pricing decisions have a time horizon of less

than one year and include decisions such as:

1.

Pricing a one-time-only special order with no long-run implications

THE ISSUE IS MARGINAL PRICE > MARGINAL COSTS

2.

Adjusting product mix and output volume in a competitive market

Long-run pricing decisions have a time horizon of one

year or longer and include decisions such as:

Pricing a product in a major market where there is some leeway in

setting price

2012 Pearson Prentice Hall. All rights reserved.

Differences Affecting Pricing:

Long Run vs. Short Run
1.

2.

Costs that are often irrelevant for short-run policy

decisions, such as fixed costs that cannot be changed, are
generally relevant in the long run because costs can be
altered in the long run. ALL COSTS MUST BE
COVERED!
Profit margins in long-run pricing decisions are often set
to earn a reasonable return on investmentprices are
decreased when demand is weak and increased when
demand is strong.
2012 Pearson Prentice Hall. All rights reserved.

Alternative Long-Run Pricing

Approaches
Market-based: price charged is based on what

customers want and how competitors react.

Cost-based: price charged is based on what it costs to
produce, coupled with the ability to recoup the costs
and still achieve a required rate of return.

2012 Pearson Prentice Hall. All rights reserved.

ABC Manufacturing Cost Illustration Exhibit 12-1 Page 438

Just Shows the MFG Costs

2012 Pearson Prentice Hall. All rights reserved.

Exhibit 12-2 Product Profitability Using ABC Costing: Illustration

NOTE: THE OPERATING COSTS ARE THOSE INCURRED THROUGHOUT THE
VALUE CHAIN EXCEPT MFG. COSTS( R&D, DESIGN, MARKETING,
DISTRIBUTION AND CUSTOMER SERVICE)

2012 Pearson Prentice Hall. All rights reserved.

Markets and Pricing

1. Competitive markets use the market-based approach
2. Less-competitive markets can use either the market-

based or cost-based approach

3. Noncompetitive markets use cost-based approaches

2012 Pearson Prentice Hall. All rights reserved.

Market-Based Approach( Competitive Market)

Starts with a target price
Target priceestimated price for a product or service

that potential customers will pay

Estimated on customers perceived value for a product
or service and how competitors will price competing
products or services

2012 Pearson Prentice Hall. All rights reserved.

10

Understanding the Market Environment

Understanding customers and competitors is important

because:

Competition from lower cost producers has meant that

prices cannot be increased.
2. Products are on the market for shorter periods of time,
leaving less time and opportunity to recover from pricing
mistakes.
3. Customers have become more knowledgeable and demand
quality products at reasonable prices.
AS I HAVE SAID REPEATEDLY, BUSINESS IS
EXTREMELY COMPETITVIE. IF A BUSINESS IS TO
SURVIVE, IT MUST CONTINUALLY IMPROVE!
1.

2012 Pearson Prentice Hall. All rights reserved.

11

WHAT IS BUSINESS

Very simply, Business is :

1.
2.
3.

Identify or create a need

Develop a product or service that satisfies the need
Bring the product or service to the market at a price
That produces a profit that compensates the owners
for the entrepreneur risk.

2012 Pearson Prentice Hall. All rights reserved.

12

Five Steps in Developing Target Prices and Target Costs

Develop a product that satisfies the needs of potential
customers.
Choose a target price BASED ON MARKET
KNOWLEDGE.
Derive a target cost per unit:

1.
2.
3.

4.
5.

Target price per unit minus target operating income per unit

Perform cost analysis.

Perform value engineering to achieve target cost. IN
ESSENCE THE COMPANY IS FORCED TO DELIVER THE PRODUCT
FOR THE TARGET COST, OR RISK NOT MAKING THE TARGETED
PROFIT. THUS SUFFERING THE RELATED FALLOUT FROM
SHAREHOLDERS.
2012 Pearson Prentice Hall. All rights reserved.

13

Value Engineering
Value engineering is a systematic evaluation of all aspects

of the value chain, with the objective of reducing costs

while improving quality and satisfying customer needs.
Managers must distinguish value-added activities and

costs from non-value-added activities and costs.

2012 Pearson Prentice Hall. All rights reserved.

14

Value Engineering Terminology

Value-added costsa cost that, if eliminated, would

reduce the actual or perceived value or utility

(usefulness) customers obtain from using the product
or service. A cost a customer is willing to pay for.
Non-value-added costs a cost that, if eliminated,
would not reduce the actual or perceived value or
utility customers obtain from using the product or
service. It is a cost the customer is unwilling to pay
for. Particularly the entitys incompetence.
2012 Pearson Prentice Hall. All rights reserved.

15

Value Engineering Terminology

Cost incurrence describes when a resource is consumed

(or benefit foregone) to meet a specific objective

Locked-in costs (designed-in costs)are costs that have not

yet been incurred but, based on decisions that have already

been made, will be incurred in the future
Locked-in costs are a key to managing costs well,

because once these are locked in, Management cant

easy adjust these costs

2012 Pearson Prentice Hall. All rights reserved.

16

Cost Incurrence and Locked-In Costs Graph

Approximately 87%(780/900) of the cost are locked-in in the
R&D and Design phase

2012 Pearson Prentice Hall. All rights reserved.

17

Problems with Value Engineering and Target Costing

Employees may feel frustrated if they fail to attain

targets. Too much Victimitis
2. A cross-functional team( marketing, product designers,
manufacturing engineers, purchasing, suppliers, dealers,
and management accountants) may add too many
features just to accommodate the wishes of team
members.
3. A product may be in development for a long time as
alternative designs are repeatedly evaluated. Paralysis
by Analysis!
4. Organizational conflicts may develop as the burden of
cutting costs falls unequally on different business
functions in the firms value chain.
1.

2012 Pearson Prentice Hall. All rights reserved.

18

Target Costing Illustration Exhibit 12-4

2012 depicts results of value engineering Based on Target price of $800 & $80 Target
operating income; target cost must be $720. Was $900 before value engineering

2012 Pearson Prentice Hall. All rights reserved.

19

Exhibit 12-5 Target Costing Illustration

Note; the operating costs were reduced by value engineering to $180 from $220 and
MFG Costs reduced by $140( Total Reduction $180= $900-$720)

2012 Pearson Prentice Hall. All rights reserved.

20

Cost-Based (Cost-Plus) Pricing

The general formula adds a markup component to

the cost base to determine a prospective selling price.

Usually, it is only a starting point in the price-setting
process.
Markup is somewhat flexible, based partially on
customers and competitors.

2012 Pearson Prentice Hall. All rights reserved.

21

Forms of Cost-Plus Pricing

Setting a target rate of return on investment: the target

annual operating return that an organization aims to

achieve, divided by invested capital(See page 446)
What does the invested capital consists of?
Selecting different cost bases for the cost-plus

calculation:
Variable manufacturing cost
2. Variable cost
3. Manufacturing cost
4. Full cost
1.

2012 Pearson Prentice Hall. All rights reserved.

22

Common Business Practice

Most firms use full cost for their cost-based pricing

decisions, because:
It allows for full recovery of all costs of the product
2. It allows for price stability as it prevents salespersons
from reducing prices
3. It is a simple approach, as it doesnt require extensive
analysis to determine variable vs. fixed costs
1.

2012 Pearson Prentice Hall. All rights reserved.

23

Life-Cycle Product
Budgeting and Costing
Product life-cycle spans the time from initial R&D on

a product to when customer service and support are no

long offered on that product (orphaned).
Life-cycle budgeting involves estimating the
revenues and individual value-chain costs attributable
to each product from its initial R&D to its final
customer service and support.
Life-cycle costing tracks and accumulates individual
value-chain costs attributable to each product from its
initial R&D to its final customer service and support.
2012 Pearson Prentice Hall. All rights reserved.

24

Important Considerations for Life-Cycle Budgeting

1. Nonproduction costs are large.( R&D, design,

marketing, distribution and customer

service/support)
2. Development period for R&D and design is long and
costly.
3. Many costs are locked in at the R&D and design
stages, even if R&D and design costs are themselves
small. Once locked in, MGT cant easily adjust to
respond to the changing market place
2012 Pearson Prentice Hall. All rights reserved.

25

Life Cycle Budgeting, Illustrated Exhibit 12-6

$480 is most profitable price alternative

2012 Pearson Prentice Hall. All rights reserved.

26

Budgeting Life-Cycle General Ledger Software Alternative A

Using mid-year present value convention R&D & Design Costs
would actually be incurred before product is introduced.
Alternative A

Budgeting Life-Cyclde for General Ledger Software

Alternative A
Selling price per package
$
400
sales Quantity in unites
5,000
Yr1
Life Cycle revenues
$
333,333 $

Yr2
333,333

Yr3
$ 333,333

Yr4
$ 333,333

Yr5
$ 333,333

Yr6
$ 333,333

Total
$ 2,000,000

R&D
Design cost
Production Costs
Marketing costs
Distribution Costs
Customer Service Costs
Total life cycle costs
Life Cycle operating Costs

40,000
26,667
37,500
31,667
21,667
38,333
195,833
137,500

40,000
26,667
37,500
31,667
21,667
38,333
$ 195,833
$ 137,500

40,000
26,667
37,500
31,667
21,667
38,333
$ 195,833
$ 137,500

40,000
26,667
37,500
31,667
21,667
38,333
$ 195,833
$ 137,500

40,000
26,667
37,500
31,667
21,667
38,333
$ 195,833
$ 137,500

240,000
160,000
225,000
190,000
130,000
230,000
1,175,000
$ 825,000

$
$

Present value factor @15%

Time Value of Life-Cycle Income $

40,000
26,667
37,500
31,667
21,667
38,333
195,833
137,500

$
$

0.9325
128,219

0.8109
$

111,495

0.7051
$

96,952

0.6131
$

84,306

2012 Pearson Prentice Hall. All rights reserved.

0.5332
$

73,310

0.4636
$

63,748

558,031
27

Budgeting Life-Cycle General Ledger Software Alternative B

Using mid-year present value convention Using mid-year present value convention
R&D & Design Costs would actually be incurred before product is introduced.

Alternative B

Budgeting Life-Cyclde for General Ledger Software

Alternative B
Selling price per package
$
480
sales Quantity in unites
4,000
Yr1
Life Cycle revenues
$
320,000 $

Yr2
Yr3
Yr4
Yr5
Yr6
Total
320,000 $ 320,000 $ 320,000 $ 320,000 $ 320,000 $ 1,920,000

R&D
Design cost
Production Costs
Marketing costs
Distribution Costs
Customer Service Costs
Total life cycle costs
Life Cycle operating Costs

40,000
40,000
40,000
40,000
40,000
240,000
26,667
26,667
26,667
26,667
26,667
160,000
33,333
33,333
33,333
33,333
33,333
200,000
27,667
27,667
27,667
27,667
27,667
166,000
19,000
19,000
19,000
19,000
19,000
114,000
33,333
33,333
33,333
33,333
33,333
200,000
180,000 $ 180,000 $ 180,000 $ 180,000 $ 180,000
1,080,000
140,000 $ 140,000 $ 140,000 $ 140,000 $ 140,000 $ 840,000

$
$

Present value factor @15%

Time Value of Life-Cycle Income $

40,000
26,667
33,333
27,667
19,000
33,333
180,000 $
140,000 $
0.9325

0.8109

130,551 $

113,522 $

0.7051
98,715 $

0.6131
85,839 $

2012 Pearson Prentice Hall. All rights reserved.

0.5332
74,643 $

0.4636
64,907 $

568,177

28

Budgeting Life-Cycle General Ledger Software Alternative C

Using mid-year present value convention Using mid-year
present value convention R&D & Design Costs would actually
be incurred before product is introduced.
Alternative C
Alternative C
Selling price per package
sales Quantity in unites
Life Cycle revenues
R&D
Design cost
Production Costs
Marketing costs
Distribution Costs
Customer Service Costs
Total life cycle costs
Life Cycle operating Costs

600
2,500
Yr1
250,000 $

$
$

40,000
26,667
27,083
21,667
15,000
25,833
156,250 $
93,750 $

Present value factor @15%

Time Value of Life-Cycle Income $

0.9325
87,422 $

Yr2
Yr3
Yr4
Yr5
Yr6
Total
250,000 $ 250,000 $ 250,000 $ 250,000 $ 250,000 $ 1,500,000
40,000
40,000
40,000
40,000
40,000
26,667
26,667
26,667
26,667
26,667
27,083
27,083
27,083
27,083
27,083
21,667
21,667
21,667
21,667
21,667
15,000
15,000
15,000
15,000
15,000
25,833
25,833
25,833
25,833
25,833
156,250 $ 156,250 $ 156,250 $ 156,250 $ 156,250
93,750 $ 93,750 $ 93,750 $ 93,750 $ 93,750 $
0.8109
76,019 $

0.7051
66,104 $

0.6131
57,482 $

2012 Pearson Prentice Hall. All rights reserved.

0.5332
49,984 $

240,000
160,000
162,500
130,000
90,000
155,000
937,500
562,500

0.4636
43,464 $

380,476
29

Recap of Life Cycle Example

Recap

Recape
Alternative A
Alternative B
Alternative C

Life-Cycle Income Present Value of Life Cycle Income

$ 825,000 $
558,031
$ 840,000 $ 568,177 most profitable
$ 562,500 $
380,476
2012 Pearson Prentice Hall. All rights reserved.

30

Other Important Considerations in Pricing Decisions

Price discriminationthe practice of charging different

customers different prices for the same product or service

Legal implications
a) Price discrimination is legal if differences in price can
be justified on cost differences- generally variable
costs.
b) Price discrimination is illegal if the intent is to lessen
or prevent competition.
Peak-load pricing the practice of charging a higher price for
the same product or service when the demand for it approaches
the physical limit of the capacity to produce that product or
service. E.g. Hotels in New Orleans charge higher rates and require
guests to book the room from Friday through Sunday of Mardi Gras
Weekend
2012 Pearson Prentice Hall. All rights reserved.

31

The Legal Dimension of

Price Setting
Price discrimination is illegal if the intent is to:
1. lessen or
2. prevent competition for customers.
Predatory pricing is deliberately lowering prices below

costs in an effort to drive competitors out of the market and

restrict supply, and then raising prices.
2012 Pearson Prentice Hall. All rights reserved.

32

The Legal Dimension of

Price Setting
Dumping a non-U.S. firm sells a product in the

United States at a price below the market value in

the country where it is produced, and this lower
price materially injures or threatens to materially
injure an industry in the United States.
Collusive pricing occurs when companies in an
industry conspire in their pricing and production
decisions to achieve a price above the competitive
price and so restrain trade.
2012 Pearson Prentice Hall. All rights reserved.

33

Slides Modified
by
Patrick M. Lynch, CPA, CFE, CFF, CrFA, CPCU,CLU, MS Taxation
PMLYNCH@LOYNO.EDU

2012 Pearson Prentice Hall. All rights reserved.

34

 2012 Pearson Prentice Hall. All rights reserved.

35