CHAPTER FOUR

PRICING DECISIONS AND COST MANAGEMENT

Companies are constantly making product and service pricing decision. These are strategic
decision that affects the quantity produced and sold, and therefore cost and revenues. To make
these decisions, managers need to understand cost behavior pattern and cost drivers. They can
then evaluate demand at different prices and manage costs across the value chain and over a
products life cycle to achieve profitability.
Major influences on pricing decision
How companies prices a product or a service ultimately depends on the demand and supply of it.
Three influences on demand and supply are:-
i. Customers: - customer influences price through their effect on the demand for a
product or services, based on factors such as the features of a product and its quality.
ii. Competitors: when there are competitors, knowledge of rivals’ technology, plant
capacity, and operating policies enables a company to estimate its competitors’ costs-
valuable information in setting its own prices.
iii. Costs – costs influence prices because they affect supply. As companies supply more
product the cost of producing each additional unit initially declines but then
eventually increase managers who understand the cost of producing their companies
product set polices that make the products attractive to customers. In computing the
relevant costs for a pricing decision, the manager must consider relevant costs in all
business functions of the value chain.
Costing and pricing for the short run
Short-run pricing decisions typically have a time horizon of less than a year and include decision
such as (a) pricing one time only special order with no long run implications and (b) adjusting
product mix and output volume in a competitive market.
Company’s short run pricing decisions need identify a sufficiently low price at which company
would still make a profit and assumed that (a) company has access to extra capacity and (b) a
competitor with an efficient plant and idle capacity was likely to make a low bid. However, short
run pricing does not always work this way. Companies may experience strong demand for their
products in the short-run, but they may have limited capacity. In these cases, companies
strategically increase prices in the short run to as much as the market will bear.

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In general, short run pricing decisions are responses to short-run demand and supply condition,
and the relevant costs are only those costs that will change in the short run.

Costing and pricing for the long run

Long run pricing decisions have a time horizon of a year or longer and include pricing a product
in a major market in which there is some see way in setting price. Two key differences affect
pricing for the long run versus the short run:-
1. Costs that are often irrelevant for short run pricing decisions, such as fixed costs that
cannot be changed, are generally relevant in the long run because cost can be altered in
the long run.
2. Profit margins in the long run pricing decision are often set to earn a reasonable return on
investment. Short run is opportunistic, prices are decreased when demand is weak and
increased when demand is strong.
Long run pricing is a strategic decision desired to build long run relationship with customers
based on stable and predictable prices. But to change a stable price and earn the target long run
return, a company must, over the long run, know and manage its costs of supplying product to
customers. Thus, relevant costs for long run pricing decision include all future fixed and variable
costs.

Long run pricing approaches

Two different approaches for pricing decision using product cost information are:-
1. Market based approach
2. Cost based/cost plus approach

1. Market based pricing

Market based pricing approach starts by management asking, given that our customers want and
how our competitors will react to what we do, what price should we charge?
Companies operating in a very competitive market, for example, commodities such as steel, oil,
and natural gas, use the market based pricing. An important form of market based pricing is
target pricing. Target price is the estimated price for a product or service that potential customers

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will be willing to pay. This estimate is based on an understanding of customer’s perceived value
for a product or service and how competitors will price competing product or service.
Hence, target operating income is the operating income that a company wants to earn on each
unit of a product or service sold and target price leads to a target cost, target cost per unit is the
estimated long run cost per unit of a product or service that, when sold at the target price, enables
the company to achieve the target operating income.
Thus, Target price - Target operating income = Target cost

Implementing target pricing and target costing

In developing target prices and target cost companies may require to follow the following five
steps:
 Develop a product that satisfy the needs of potential customers
 Choose a target price based on customer’s perceived value for the product and the price
competitors charge, and target operating income per unit.
 Drive a target cost per unit by subtracting the target operating income per unit from the
target price
 Perform cost analysis to analyze which aspects of a product or service to target for cost
reduction.
 Perform value engineering to achieve target cost. Value engineering is a systematic
evaluation of all aspect of the value chain business function with the objective of
reducing cost while satisfying customers’ needs. Value engineering can result in
improvement in product design, change in material specification, and modification in
process method. In this case, Costs can be value adding or non value adding. Value
adding costs are costs that costumers perceive as adding utility or value while non value
adding cost that do not add value to the product and to customers. Value engineering will
focuses on eliminating non value adding cost and reduce as much as possible value
adding cost without affecting quality of the product and customers satisfaction.

Example6.6: Astel Company is a manufacturer of personal computer .Astel expects its

competitors to lower prices of PC. Astels management believes that it must respond by reducing
price by 20% from Br. 1000 per unit to Br.800 per unit. At this low price, Astels marketing
manager forecast an increase in annual sales from 150,000 to 200,000 units. Astel management

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wants a 10% target operating income on sales revenue. The total production cost at the moment
for 150,000 units is Br. 135 million.
Required compute
a) The total target revenue
b) Total target operating income
c) Target operating income per unit
d) Current target cost per unit
Solution
a) Total target revenue ═ target price per unit x target annual unit sold
═ Br.800 per unit x 200,000 units ═ Br.160, 000,000
b) Total target operating income═ target rate x Total target revenue
═ 10% x Br.160, 000,000═ Br.16, 000,000
c) Target operating income per unit═ Total target operating income/ annual unit sold
═ Br.16, 000,000/200,000 units ═ Br.80
d) Current cost per unit═ target price per unit less target operating income per unit
═ Br.800 per unit - Br.80 ═ Br.720
2. Cost-plus pricing
Accounting information may be used in pricing decisions, particularly where the firm is a market
leader or price-maker. In these cases, firms may adopt cost-plus pricing, in which a margin is
added to the total product/service cost in order to determine the selling price. In many
organizations, however, prices are set by market leaders and competition requires that prices
follow the market (i.e. the firms are price-takers). Nevertheless, even in those cases an
understanding of cost helps in making management decisions about what product/services to
produce, how many units to make and whether the price that exists in the market warrants the
business risk involved in any decision to sell in that market. An understanding of the firm’s
marketing strategy is therefore, essential in using cost information for pricing decisions.
In the long term, the prices that businesses charge must cover all of its costs. If it is unable to
do so, it will make losses and may not survive. For every product/service, the full cost must be
calculated, to which the desired profit margin is added. Full cost includes an allocation to each
product/service of all the costs of the business, including producing and delivering a good or
service, and all its marketing, selling, finance and administration costs.

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The general formula for setting a cost based price adds a markup component to the
cost base to determine the prospective selling price. One way to determine the markup
percentage is to choose a markup to earn a target rate of return on investment.
The target rate of return on investment is the target annul operating income that an organization
aims to achieve divided by invested capital (asset)
i.e. TRR = Target operating income
Invested capital
Therefore, Target operating income=TRR*Invested capital

Let illustrate a cost – plus pricing formula on top company. Assume top’s engineers have
redesigned product CD into 2CD and that top uses a 12% markup on the full unit cost of the
product in developing the prospective selling price. The target product 2CD profitability for
2000 is as follows:

Estimated total amounts Estimated total amount

for 200,000 units (1) per unit (2) = (1) 
200,000
Revenues Bir 160,000,000 Bir 800
Cost of goods sold 108,000,000 540
Operating costs 36,000,000 180
Total cost of product Bir 144,000,000 720
Operating income 16,000,000 Bir 80

Suppose that top’s target rate of return on investment is 18% and 2CD’s capital investment is Bir
96 million. The target annual operating income for 2CD is:
Invested capital ……………………………….. Bir 96,000,000
Target rate of return on investment……………. 18%
Target Annual Operating income [0.18  Bir 96mln]…Bir17,280,000
Target operating income per unit of 2A
[Bir17,280,000  200,000 units] …………. Bir 86.40

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This calculation indicates that top needs to earn a target operating income of Bir86.40 on each
unit of 2A. The mark up of Bir 86.40 expressed as a percentage of the full production cost per
unit of Bir720 equals 12% (Bir 86.40  Bir 720]
Thus the prospective selling price of product 2A is Bir806.40 (Full unit cost of 2A, Bir 720 plus
the markup component of 12% (0.12  Bir 720= Bir 86.40).