Cost Accounting

Sixteenth Edition

Chapter 13
Pricing Decisions
and
Cost Management

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Major Factors that Affect Pricing
Decisions
• How companies price a product or service ultimately
depends on the demand and supply for it.
• Three influences on demand and supply are:
– Customers
– Competitors
– Costs

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Three Influences on Demand and
Supply
1. Customers influence price through their effect on the
demand for a product or service, based on factors such
as product features and quality.
2. Competitors influence price through their technologies,
plant capacities, and operating strategies which affect
their costs.
3. Costs influence prices because they affect supply. The
lower the cost of producing a product, the greater the
quantity a firm is willing to supply.

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Costing and Pricing For the Long-Run
• Short-run pricing decisions have a time horizon of less
than one year and include decisions such as:
¡ Pricing a one-time-only special order with no long-run implications
¡ Adjusting product mix and output volume in a competitive market.

• Long-run pricing is a strategic decision designed to build

long-run relationships with customers based on stable
and predictable prices. Managers prefer a stable price
because it reduces the need for continuous monitoring
of prices, improves planning and builds long-run buyer–
seller relationships.

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Cost Allocation
• Recall that indirect costs of a particular cost object are
costs that are related to that cost object but cannot be
traced to it in an economically feasible (cost-effective) way.
• These costs often comprise a large percentage of the
overall costs assigned to cost objects.
• Cost allocations and product profitability analyses affect
the products promoted by a company. To increase profits,
managers focus on high-margin products.

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Purposes of Cost Allocation
Exhibit 13.1 Purposes of Cost Allocation

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Alternative Long-Run Pricing
Approaches
How should managers use product cost information to price
their products? There are two different approaches for
pricing decisions:
• The MARKET-BASED APPROACH asks: Given what our
customers want and how competitors will react to what we
do, what price should we charge?
• The COST-BASED APPROACH asks: Given what it costs
us to make this product, what price should we charge that
will recoup our costs and achieve a target return on
investment?

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Market-based Approach: Target
Costing for Target Pricing (1 of 3)
Before setting prices under any approach, managers need to
understand customers and competitors for three reasons:
1. Lower-cost competitors continually restrain prices.
2. Products have shorter lives, which leaves companies
less time and opportunity to recover from pricing
mistakes, loss of market share and loss of
profitability.
3. Customers are more knowledgeable because they
have easy access to price and other information
online and demand high-quality products at low
prices.

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Market-based Approach: Target
Costing for Target Pricing (2 of 3)
• Starts with a target price which is the estimated price for a
product or service that potential customers are willing to
pay
• The target price is estimated based on
1. An understanding of customers’ perceived value for a
product or service, and
2. How competitors will price competing products or
services.

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Market-based Approach: Target
Costing for Target Pricing (3 of 3)
FOUR STEPS IN DEVELOPING TARGET PRICES AND
TARGET COSTS
1. Develop a product that satisfies the needs of potential
customers.
2. Choose a target price.
3. Derive a target cost per unit by subtracting target
operating income per unit from the target price.
4. Perform value engineering to achieve target cost.

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Value Engineering, Cost Incurrence,
and Locked-in Costs (1 of 5)
VALUE ENGINEERING
• Value engineering is a systematic evaluation of all aspects
of the value chain, with the objective of reducing costs and
achieving a quality level that satisfies customers.
• Value engineering entails improvements in product
designs, changes in materials specifications, and
modifications in process methods.
• To implement value engineering, managers must
distinguish value-added activities and costs from non-
value-added activities and costs.

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Value Engineering, Cost Incurrence,
and Locked-in Costs (2 of 5)
VALUE ENGINEERING TERMINOLGY
• Value-added costs is a cost that, if eliminated, would
reduce the actual or perceived value or utility (usefulness)
customers experience from using the product or service.
• Non-value-added costs are costs that, if eliminated, would
not reduce the actual or perceived value or utility
(usefulness) customers gain from using the product or
service. It is a cost the customer is unwilling to pay for.

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Value Engineering, Cost Incurrence,
and Locked-in Costs (3 of 5)
VALUE ENGINEERING TERMINOLGY
• 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 will be incurred in the future
based on decisions that have already been made.
• The best opportunity to manage costs is before they are
locked in.

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Value Engineering, Cost Incurrence,
and Locked-in Costs (5 of 5)
To summarize, the key steps in value-engineering are:
1. Understanding customer requirements and value-added
and non-value added costs.
2. Anticipating how costs are locked in before they are
incurred.
3. Using cross-functional teams to redesign products and
processes to reduce costs while meeting customers
needs.

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Possible Undesirable Effects of Value
Engineering and Target Costing
Unless managed properly, value engineering and target
costing can have undesirable effects:
1. Employees may feel frustrated if they fail to attain
targets.
2. The cross-functional team may add too many
features just to accommodate the different wishes
of team members.
3. A product may be in development for a long time as
the team repeatedly evaluates alternative designs.
4. Organizational conflicts may develop as the burden
of cutting costs falls unequally on different business
functions in the company’s value chain.

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Avoiding Possible Undesirable Effects
To avoid those possible undesirable effects, target-costing
efforts should always:
1. Encourage employee participation and celebrate small
improvements toward achieving the target cost.
2. Focus on the customer.
3. Pay attention to schedules.
4. Set cost-cutting targets for all value-chain functions to
encourage a culture of teamwork and cooperation.

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Cost-plus Pricing (1 of 5)
Instead of using the market-based approach for long-run
pricing decisions, managers sometimes use a cost-based
approach.
• The general formula for setting a cost-based selling price
adds a markup component to the cost base.
• Usually, it is only a starting point in the price-setting
process.
• Markup is somewhat flexible, based partially on customers
and competitors.
• Because a markup is added, cost-based pricing is often
called cost-plus pricing, where the plus refers to the
markup component.

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Cost-plus Pricing (2 of 5)
Cost-plus pricing can be determined several ways:
• Choose a markup to earn a target rate of return on
investment, which is the target annual operating income
divided by invested capital
• Computing the specific amount of capital invested in a
product is challenging because it requires difficult and
arbitrary allocations of investments in equipment and
buildings to individual products.

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Cost-plus Pricing (3 of 5)
• Because computing the specific amount of capital invested
in a product is challenging, sometimes managers use
alternate cost bases to set prospective selling prices:
– Variable manufacturing cost
– Variable cost
– Manufacturing cost
– Full cost

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COST-PLUS PRICING (4 of 5)
COMMON BUSINESS PRACTICE:
Many managers use full cost for their cost-based pricing
decisions because:
It allows for full recovery of all costs of the product.
It allows for price stability.
It is a simple approach.

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Cost-plus Pricing (5 of 5)
• The selling prices computed under cost-plus pricing are
prospective prices.
• The target-pricing approach reduces the need to go back
and forth among prospective cost-plus prices, customer
reactions, and design modifications.
• Target-pricing first determines product characteristics and
target price on the basis of customer preferences and
expected competitor responses and then computes a
target cost.

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Life-cycle Product Budgeting and
Costing
• Managers sometimes need to consider target prices and target
costs over a multiple-year product life cycle.
• Product life cycle spans the time from initial R&D on a product
to when customer service and support are no longer offered on
that product.
• In life-cycle budgeting, managers estimate the revenues and
business function costs across the entire value-chain from its
initial R&D to its final customer service and support.
• Life-cycle costing tracks and accumulates business function
costs across the entire value chain from a product’s initial R&D
to its final customer service and support.
• Life-cycle budgeting and life-cycle costing span several years.

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Life-cycle Budgeting and Pricing
Decisions
Budgeted life-cycle costs provide useful information for
strategically evaluating pricing decisions. These two features
of costs make life-cycle budgeting particularly important.
• The development period for R&D and design is long and
costly.
• Many costs are locked in at the R&D and design stages,
even if R&D and design costs are themselves small.

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Managing Environmental and
Sustainability Costs
Managing environmental costs is a critical area where managers
apply life-cycle costing and value engineering.
Environmental costs that are incurred over several years of the
product’s life cycle are often locked in at the product- and process-
design stage.
A new organization, the Sustainability Accounting Standards
Board (SASB) has begun defining standards for environmental,
social, and governance (ESG) performance for different industries.
When measured over multiple periods, companies that have
higher relevant ESG ratings have higher future profitability and
financial performance, perhaps because of customer loyalty and
satisfaction, employee engagement, or brand and reputation.

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Customer Life-cycle Costing
Customer life-cycle costs focus on the total costs incurred by
a customer to acquires, use, maintain, and dispose of a
product or service.
These costs influence the prices a company can charge for
its products.
As an example, Maytag can charge higher prices for
appliances that save electricity and have low maintenance
costs.

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Non-cost Factors in Pricing Decisions
• Price discrimination is the practice of charging different
customers different prices for the same product or service.
¡ Legal implications
• Peak-load pricing is the practice of charging a higher price
for the same product or service when demand approaches
the physical limit of the capacity to produce that product or
service.
• International price differences arise because of differences
in the purchasing power of consumers in different
countries and government restrictions that may limit the
prices that companies can charge.

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Antitrust Laws and Pricing Decisions
Legal considerations also affect pricing decisions. Two key
features of price-discrimination laws are:
1. Price discrimination is permissible if differences in prices
can be justified by differences in costs.
2. The price discrimination is illegal only if the intent is to
lessen or prevent competition.
Additional legal issues include:
§ Predatory pricing
§ The “appropriate measure of costs”
§ Dumping
§ Collusive Pricing
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