M4 A:

- Product Life Cycle Management

M4B:
- Market/Demand-Based Pricing (Target
Pricing, Target Costing, Profit-Maximizing)

- Cost-Based Pricing (Cost Plus, Time and

Material Pricing)

- Special Orders and Short-Run Pricing

Decisions

M4C:
- Product Bundling Product Bundling (Stand-
alone, Incremental, Shapley Value)

- Product Mix Decisions (Optimal Mix,

Optimal Contribution Margin)

- Linear Programming (Graphic Method,

Algebraic Method)

- Profit-Related Variances (Static-budget,

Flexible-budget, Sales-volume, Sales-mix,
Sales-quantity, Market-share, Market-size)
PRODUCT LIFE CYCLE
MANAGAMENT
Reference: Hansen & Mowen CH16

PRODUCT LIFE CYCLE

o Time a product exists from conception to
abandonment.

LIFE CYCLE COST MANAGEMENT

o Focuses on managing value-chain activities.
o Emphasizes cost reduction, not cost control.

LIFE CYCLE COSTS

o All costs associated with the product for its
entire life cycle. ILLUSTRATIVE PROBLEM:
o Development (Planning, design, and Consider a life-cycle average sales price of $55,000
testing) or Nonrecurring costs per unit.
o Production (Conversion) or Manufacturing If the desired life-cycle contribution is 45%, what is
Costs the allowable cost over the life cycle of the product?
o Logistic Support (Advertising, distribution,
warranty) $55,000 – ($55,000 * .45) = $30,250

SHORT LIFE CYCLES - Products must recover PRODUCTION COSTS

all life-cycle costs and provide an acceptable profit. (Units produced x Unit Production Cost)
If a firm’s products have long life cycles, profit
performance can be increased by such actions as
redesigning, changing prices, reducing costs, and LIFE CYCLE BUDGET
altering the product mix. o estimates revenues and costs of a product
over its entire life
Formula: Development + Production + Logistic
FEATURES THAT MAKE LIFE-CYCLE
BUDGETING IMPORTANT:
WHOLE LIFE CYCLE o Nonproduction costs
POST PURCHASE COST  These costs are less visible on a
o incurred by the customer after buying the product-by-product basis.
product.  When nonproduction costs are
o not found in company’s FS significant, identifying these costs by
product is essential for target pricing,
VALUE CHAIN target costing, value engineering and
o set of activities required to design, develop, cost management.
produce, market, and service a product (or o Development period for R&D and design
service)  When a high percentage of total life-
cycle costs are incurred before any
Formula: (Life Cycle Costs + Post purchases production begins and before any
Costs) revenues are received, it is crucial for
company to have revenue and cost
predictions.
o Other predicted costs
  Many of the production, marketing,
distribution, and customer service
costs are locked in during R&D and
design stage.
 Life-cycle budgeting facilities value
engineering at the design stage before
costs are locked in.

PRICING DECISIONS & COST If Lomas makes the extra 150,000 cases, the
MANAGEMENT existing total fixed manufacturing overhead
Reference: Horngren CH12 ($4,200,000 per month) would continue, plus an
additional $165,000 of fixed overhead will be
THREE MAJOR INFLUENCES ON PRICING incurred per month
o Customers – influences prices through their
effect on demand Total fixed marketing and distribution costs will not
o Competitors – influence prices through change.
their actions
o Costs – influence prices because they affect What price should Lomas bid?
supply

SHORT RUN DECISIONS

o Time horizon of less than a year
o Pricing one time only special order
o Adjusting product mix and output volume
o Costs that are often irrelevant for short-run
pricing decisions (fixed cost) are often
relevant in the long run
Supposes that Lomas believes that Del Valle will
LONG RUN DECISIONS sell the tomato sauce in Loma’s current markets but
o Involve a time horizon of a year or longer at a lower price than Lomas.
o Pricing a product in a major market where
price setting has some leeway Relevant costs of the bidding decision should
o Profit margins in long-run pricing decisions include revenues lost on sales to existing customers.
are often set to earn a reasonable ROI
EXAMPLE: COSTING AND PRICING FOR
EXAMPLE: COSTING AND PRICING FOR THE LONG RUN
THE SHORT RUN
Latisha Computer manufactures two brands of
Lomas Corporation operates a plant with a monthly computers:
capacity of 500,000 cases of tomato sauce. - Simple Computer (SC)
Lomas is presently producing 300,000 cases per - Complex Computer (CC)
month. Latisha uses a long-run time horizon to price
Del Valle has asked Lomas and two other Complex Computer (CC).
companies to bid on supplying 150,000 cases each
month for the next four months. Direct material costs vary with the number of units
produced.
Direct manufacturing labor costs vary with direct
manufacturing labor hours.
Ordering and receiving, testing and inspection, and
rework costs vary with their chosen cost drivers.
 TARGET PRICE – estimated price for a product
(service) that potential customers will be willing to
pay.

Target Price - Target operating income per unit

= Target cost per unit

TARGET OI PER UNIT – OI that a company

aims to earn per unit of a product or service.

TARGET COST PER UNIT – estimated long-run

cost per unit of a product or service that enables the
company to achieve its target operating income per
unit when selling at the target price.
- Lower than the existing full cost of the
product.

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.
4. Perform value engineering to achieve target
costs.

ALTERNATIVE LONG RUN

PRICING APPROACHES
o Market-based VALUE ENGINEERING – systematic evaluation
o Cost-based (also called cost-plus) of all aspects of the value-chain business function
with the objective of reducing costs.

VALUE ADDED COSTS – customer perceive as

TARGET PRICE AND TARGET adding value.
COSTS
o Market-based pricing starts with a target NON-VALUE-ADDED COSTS – cost that
price. customers do not perceive as adding value
o Reverse-engineering – disassembling and COST INCURRENCE – describes when a
analyzing competitor’s products to resource is sacrificed or forgone to meet a specific
determine product designs and materials and objective.
to be acquainted with the technologies
competitors use. LOCKED IN COSTS – have not yet been incurred
but which, based on decision that have already been
made, will be incurred in the future (Designed-in of the market and restrict supply, and then raises
costs) and it is difficult to alter or reduce costs that prices rather than enlarge demand.
are already locked in.
DUMPING - non-U.S. company sells a product in
At the end of the design stage, direct materials, the United States at a price below the market value
direct manufacturing labor, and many in the country where it is produced, and this lower
manufacturing, marketing, distribution, and price materially injures or threatens to materially
customer-service costs are all locked in. injure an industry in the United States.

LIFE CYCLE BUDGETING & COLLUSIVE PRICING - companies in an

industry conspire in their pricing and production
PRICING DECISIONS decisions to achieve a price above the competitive
Reference: Horngren CH12 price and so restrain trade.

CUSTOMER LIFE-CYCLE COSTING - total

costs incurred by a customer to acquire, use,
maintain, and dispose of a product or service.

ADDITIONAL CONSIDERATIONS FOR

PRICING DECISIONS

PRICE DISCRIMINATION - practice of charging

different customers different prices for the same
product or service.

PEAK-LOAD PRICING – practice of charging a

higher price for the same product or service when
the demand for the product or service approaches
the physical limit of the capacity to produce that
product or service.

INTERNATIONAL CONSIDERATIONS

ANTITRUST LAWS – legal considerations also

affect pricing decisions. Under the U.S. Robinson-
Patman Act, a manufacturer cannot price
discriminate between two customers if the intent is
to lessen or prevent competition for customers.

1. Price discrimination is permissible if

differences in prices can be justified by
differences in costs.
2. Price discrimination is illegal only if the
intent is to lessen or prevent competition.
PROFIT MAXIMIZING PRICE
VIOLATIONS OF ANTITRUST LAWS: Reference: NOREEN

PREDATORY PRICING - deliberately prices ELASTICITY OF DEMAND

below its costs in an effort to drive competitors out
 o measures the degree to which a change in - impact of price changes on sales volume
price affects the unit sales of a product or - Demand is elastic if a price increase has a
service large negative impact on sales volume
- Demand is inelastic if price changes have
FORMULA: little or no impact on sales quantity
- Cross Elasticity refers to the extent to which
a change in a product’s price affects the
demand for other substitute products

PROFIT MAXIMIZING MARKUP ON

VARIABLE COSTS

This formula assumes that the price elasticity of

demand is constant.

Reference: HILTON

Companies are sometimes price takers, which

means their products’ prices are determined totally
by the market.

TOTAL REVENUE CURVE – tradeoff between a

higher price and a higher sales quantity can be
shown in the shape of the firm’s total revenue curve

DEMAND CURVE
- shows the relationship between the sales
price and quantity of units demanded
- decreases throughout its range, because any
decrease in the sales price brings about an
increase in the monthly sales quantity
- average revenue curve

MARGINAL REVENUE CURVE

- shows the change in total revenue that
accompanies a change in the quantity sold
- decreasing throughout its range to show that
total revenue increases at a declining rate as
monthly sales quantity increases

COST – BASED PRICING

TOTAL COST CURVE Reference: HILTON
- graphs the relationship between total cost and
the quantity produced and sold each month
- rate of increase in total cost declines as
quantity increases from zero to c units

PRICE ELASTICITY
COST-PLUS PRICING

BASIS OF MARKUP:
1. Variable Manufacturing Costs
2. Absorption / Full Costs
3. Total Costs = VC + FC
4. Total Variable Costs
RETURN ON INVESTMENT PRICING

Absorption Manufacturing Cost

Suppose the year’s average amount of capital (Variable Manufacturing cost + Applied Fixed
invested in the Wave Darter product line is Manufacturing Cost)
$300,000.
Total Cost
(Absorption Manufacturing Cost + Variable
Selling & Ad + Fixed Selling & Ad)

Total Variable Cost

(Variable Selling Cost + Variable Manufacturing
COST – PLUS PRICING BASED ON TOTAL Cost)
COSTS

The total cost of a Wave Darter is $800 per unit.

To earn a profit of $60,000 on annual sales of 480
sailboats, the company must make a profit of $125
per boat ($125 = $60,000/480).
This entails a markup percentage of 15.63 percent
above total cost of $800.

COST – PLUS PRICING BASED ON TOTAL

VARIABLE COSTS
The total variable cost of a Wave Darter is $450 per
unit (Exhibit 15–5). The markup percentage applied
to variable cost must be sufficient to cover both
annual profit of $60,000 and total annual fixed costs
of $168,000.

COST – PLUS PRICING

Reference: HORNGREN CH12
 COST PLUS PRICING METHOD
o For long run pricing decisions
o Adds a markup component to the cost base
FOR SERVICES: TIME &
to determine the prospective selling price. MATERIAL PRICING
o Markup component is determined by the
market. - The price charged for materials equals the
cost of materials plus a markup.
COST PLUS TARGET RATE OF ROI - The price charged for labor represents the
cost of labor plus a markup.
Illustration: - That is, the price charged for each direct cost
Astel uses a 12% markup on the full unit cost of the item includes its own markup.
product when computing the selling price. - The markups are chosen to recover overhead
costs and to earn a profit.
- The labor typically includes the direct cost of
the employee’s time and a charge to cover
various overhead costs.
- Material charge typically includes the direct
cost of the materials used in the job plus a
TARGET RATE OF ROI – target annual operating charge for material handling and storage
income divided by invested capital (i.e., TOTAL
ASSETS). TIME CHARGES

This calculation indicates that Astel needs to earn a

target operating income of $86.40 on each unit of
Provalue II. The markup ($86.40) expressed as a
percentage of the full unit cost of the product ($720)
equals 12% ($86.40 ÷ $720).
MATERIAL CHARGES
- The 18% target rate of return on
investment expresses Astel’s expected
annual operating income as a percentage of
investment.

- The 12% markup expresses operating

income per unit as a percentage of the full
product cost per unit.

ALTERNATIVE COST-PLUS METHODS

 FULL COST
COST – BASED PRICING
1. Full recovery of all costs of the product. Reference: HANSEN CH12
2. Price Stability
3. Simplicity Illustration: Elvin Co.
 o method of determining the cost of a product
or service based on the price (target price)
that customers are willing to pay.

o PRICE DRIVE COSTING

o a method of working backward from price to

find cost.

o Markup on cost of goods sold is 20 percent.

Notice that the 20 percent markup covers
both profit and selling and administrative PRODUCT BUNDLING
expenses. The markup is not pure profit. (STANDALONE, INCREMENTAL
& SHAPLEY VALUE)
Reference: HORNGREN CH15

COMMON COSTS – cost of operating a facility,

activity, or like cost object that is shared by two or
more users.
To see how the markup can be used in bidding,
suppose that Clare can bid on a job for a local
insurance company. The job requires Elvin REVENUE ALLOCATION – occurs when
Company to assemble 100 computers according to revenues are related to a particular revenue object
certain specifications. She estimates the following but cannot be traced.
costs:
BUNDLED PRODUCT – package of 2 or more
products (SERVICES) that is sold for a single price
but whose individual components may be sold
separately

STAND ALONE REVENUE – ALLOCATION

METHOD
o Determines the weights for cost allocation
by considering each user of the cost as a
separate entity.
o Emphasize the fairness or equity criterion
o Stand-alone refers to the product as a
separate (nonsuite) item.

THREE TYPES OF WEIGHTS

1. Selling Price
TARGET COSTING AND 2. Unit Costs
PRICING 3. Physical Units
Reference: HANSEN CH12

TARGET COSTING
 Which method is preferred?

Selling prices method - is best because the weights

explicitly consider the prices customers are willing
to pay for the individual products.

Weighting approaches that use revenue information

better capture “benefits received” by customers than
unit costs or physical units.

Physical - units revenue-allocation method - used

A. SELLING PRICES – using the individual when any of the other methods cannot be used (such
selling prices of $125 for Word Master and as when selling prices are unstable or unit costs are
$225 for Finance Master, the weights for difficult to calculate for individual products).
allocating the $280 suite revenues between
the products are as follows: INCREMENTAL REVENUE – ALLOCATION
METHOD

o Ranks individual products in a bundle

according to criteria determined by
management – such as the product in the
bundle with the most sales – then uses this
ranking to allocate bundled revenues to
B. UNITS COSTS – method uses the cost of individual products
the individual products (manufacturing cost o Primary Product – first ranked product
per unit) o First – incremental – second ranked
product
o Second – incremental – third ranked
product

C. PHYSICAL UNITS – gives each product

unit in the suite the same weight when
allocating suite revenue to individual
Bundled price: $280
products.
Excess allocated to first and second ranked
products.

If Dynamic Software sells equal quantities of

WordMaster and FinanceMaster, then the Shapley
value method allocates to each product the average
of the revenues allocated as the primary and first-
incremental products:

SHAPLEY AVERAGE METHOD

 PRODUCT MIX DECISIONS
(Optimal Mix, Optimal
Contribution Margin)
Reference: Hansen & Mowen CH12
But what if, in the most recent quarter, the firm sells
80,000 units of WordMaster and 20,000 units of Constraints - limited resources and limited
FinanceMaster. Because Dynamic Software sells demand for each product.
four times as many units of WordMaster, its
managers believe that the sales of the Word + a. One Constrained Resource
Finance suite are four times more likely to be driven
by WordMaster as the primary product. The firm owns eight machines that together provide
40,000 hours of machine time per year.
WEIGHTED SHAPLEY VALUE METHOD Gear X requires two hours of machine time, and
Gear Y requires 0.5 hour of machine time.
Assuming no other constraints, what is the
optimal mix of gears?

Since each unit of Gear X requires two hours of

When there are more than two products in the suite, machine time, a total of 20,000 units can be
the incremental revenue-allocation method allocates produced per year (40,000/2). At $25 per unit,
suite revenues sequentially. Assume WordMaster is Jorgenson can earn a total contribution margin of
the primary prod- uct in Dynamic Software’s three- $500,000.
product suite (Word + Finance + Data).
FinanceMaster is the first-incremental product, and Gear Y requires only 0.5 hour of machine time per
DataMaster is the second-incremental product. This unit; therefore, 80,000 (40,000/0.5) gears can be
suite sells for $380. The allocation of the $380 suite produced. At $10 per unit, the total contribution
revenues proceeds as follows: margin is $800,000. Producing only Gear Y yields a
higher profit level than producing only Gear X—
even though the unit contribution margin for X is
2.5 times larger than that for Y.

The contribution margin per unit of each product is

not the critical concern. The contribution margin
per unit of scarce resource is the deciding factor.
The product yielding the highest contribution
margin per machine hour should be selected.
Gear X earns $12.50 per machine hour ($25/2), but
Gear Y earns $20 per machine hour ($10/0.5).
Thus, the optimal mix is 80,000 units of Gear Y and
none of Gear X.

b. Multiple Constrained Resource

LINEAR PROGRAMMING
REFERENCE: HANSEN & MOWEN LINEAR PROGRAMMING MODEL:

Linear Programming - method that searches

among possible solutions until it finds the optimal
solution.

MULTIPLE CONSTRAINED RESOURCE:

Assume that there are demand constraints for both
Gear X and Gear Y.
For Gear X, no more than 15,000 units can be sold;
for Gear Y, no more than 40,000 units can be sold. Last two constraints – nonnegativity constraints and
As before, the objective is to maximize Jorgenson’s simply reflect the reality that negative quantities of
total contribution margin subject to the constraints a product cannot be produced.
the company faces.
Constraint set – all constraints taken together.
a. OBJECTIVE FUNCTION - function to be
optimized (i.e. maximize the total contribu- Feasible Solution – satisfies the constraints in the
tion margin. linear programming model.

Feasible Solutions Set – collection of a ll feasible

solutions.
b. CONSTRAINTS
1. Capacity Limitations For example, producing and selling 10,000 units of
2. Demand limitations for each product Gear X and 20,000 units of Gear Y would be a
feasible solution and a member of the feasible set.
Consider the machine-hour constraint first.
Two machine hours are used for each unit of This product mix uses 30,000 machine hours [(2 x
Gear X, and 0.5 machine hour is used for 10,000) + (0.5 x 20,000)], which is under the limit
each unit of Gear Y. for machine hours.
Thus, the total machine hours used can be
expressed as 2X + 0.5Y. The maximum of Additionally, the company can sell the indicated
40,000 machine hours available can be amounts since they do not exceed the demand
expressed mathematically as follows: constraints for each product. If this mix is selected,
the company would earn a contribution margin
totaling $450,000 [($25 x 10,000) + ($10 x
20,000)].

However, the mix of 10,000 units of X and 20,000

Jorgenson’s problem is to select the number of units units of Y is not the best mix. One better solution
of X and Y that maximize total contribution margin would be to produce and sell 12,000 units of X and
subject to the constraints in Equations 10.2, 10.3, 30,000 units of Y. This mix uses 39,000 machine
and 10.4. hours [(2 x 12,000) + (0.5 30,000)] and produces a
total contribution margin of $600,000 [($25 x
12,000) + ($10 x 30,000)]. This feasible solution is
better than the first because it produces $150,000
more in profits. However, even better feasible
solutions exist. The objective is to identify the best.
The best feasible solution—the one that maximizes
the total contribution margin—is called the optimal
solution.
FOUR STEPS – GRAPHICAL METHOD: - Chewies bring a contribution margin of $1
per case
1. Graph each constraint - Chompos result in a contribution margin of
2. Identify the feasible set of solutions $2 per case
3. Identify all corner – point values in the
feasible set
4. Select the corner point that yields the largest
value for the objective function

3. Write the Constraints - limitations of the

firm

Suppose, for example, that management decided to

produce 20,000 cases of Chewies and 6,000 cases of
Chompos.
Graphical solutions are not practical with more than
two or three products. For- tunately, an algorithm The machine-time constraint would appear as
called the simplex method can be used to solve follows:
larger linear programming problems.

REFERENCE: HILTON
GRAPHICAL SOLUTION:
ILLUSTRATIVE PROBLEM:

1. Idenfity the Decision Variables – which are

the variables about which a decision must be
made.

2. Write the Objective Function – algebraic

expression of the firm’s goal.

Maximize total contribution margin.

 The budgeted and actual fixed distribution-
channel costs and corporate-sustaining costs are
$160,500 and $263,000, respectively (see Exhibit
14-6, p. 514).

STATIC – BUDGET VARIANCE

o Difference between an actual result and the
corresponding budgeted amount in the static
budget.
o The total static-budget variance is $18,960
U (actual contribution margin of $504,360 –
budgeted contribution margin of $523,320).

FLEXIBLE – BUDGET VARIANCE

o CHANGE IN PRICE
o Difference between an actual result and the
corresponding flexible-budget amount based
on actual output level in the budget period.
PROFIT-RELATED VARIANCES o Flexible Budget CM – budgeted CM per
REFERENCE: HORNGREN CH14 unit x actual units sold of each product.

SALES VARIANCE o The $7,200 U flexible-budget variance

arises because actual contri- bution margin
on retail sales of $0.93 per case is lower than
the budgeted amount of $0.98 per case.

SALES VOLUME VARIANCE

o CHANGE IN QUANTITY SOLD (use
budget price for activity or volume
variance)
o Difference between a flexible budget
amount and the static budget amount
 o Why did your budgeted units sold change?
o The sales-volume variance of $11,760 U is Similarly, for the actual sales mix, the composite
the difference between columns 2 and 3 in unit consists of 0.84 units of sales to the wholesale
Exhibit 14-9. In this case, it is unfavorable channel and 0.16 units of sales to the retail channel.
overall because while wholesale unit sales The budgeted contribution margin per composite
were higher than budgeted, retail sales, unit for the actual sales mix is therefore as follows:
which are expected to be twice as profitable
on a per unit basis, were below budget.

The impact of the shift in sales mix is now evident.

Spring obtains a lower budgeted contri- bution
SALES MIX VARIANCE margin per composite unit of $0.0196 ($0.5880 –
o Difference between (1) budgeted $0.5684). For the 900,000 units actually sold, this
contribution margin for the actual sales decrease translates to a $17,640 U sales-mix
mix and (2) budgeted contribution margin variance ($0.0196 per unit * 900,000 units).
for the budgeted sales mix
o CHANGE IN PRODUCT MIX
o A favorable sales-mix variance arises for SALES QUANTITY VARIANCE
the wholesale channel because the 84% o Difference between (1) budgeted
actual sales-mix percentage exceeds the contribution margin based on actual units
80% budgeted sales-mix percentage. sold of all products at the budgeted mix and
o In contrast, the retail channel has an (2) contribution margin in the static
unfavorable variance because the 16% budget (which is based on budgeted units of
actual sales-mix percentage is less than the all products to be sold at budgeted mix)
20% budgeted sales-mix percentage. The o CHANGE IN QUANTITY
sales-mix variance is unfavorable because
actual sales mix shifted toward the less- TWO REASONS:
profitable wholesale channel relative to A. MARKET SIZE VARIANCE
budgeted sales mix. B. MARKET SHARE VARIANCE

This variance is favorable when actual units of all

o COMPOSITE UNIT – hypothetical unit products sold exceed budgeted units of all products
with weights based on the mix of individual sold. Spring sold 10,000 more cases than were
units. budgeted, resulting in a $5,880 F sales-quantity
variance (also equal to budgeted contribution
Given the budgeted sales for June 2012, the margin per com- posite unit for the budgeted sales
composite unit consists of 0.80 units of sales to the mix times additional cases sold, $0.5880 * 10,000).
wholesale channel and 0.20 units of sales to the
retail channel. Therefore, the budgeted contribution
margin per composite unit for the budgeted sales
mix is as follows:
PROFIT-RELATED VARIANCES
REFERENCE: HANSEN CH8

STATIC BUDGET
o Bugdet for particular level of activity.

o To create a meaningful performance report,

actual costs and expected costs must be
compared at the same level of activity. Since
actual output often differs from planned
output, some method is needed to compute
what the costs should have been for the
actual output level.

FLEXIBLE BUDGET
o budget that enables a firm to compute
expected costs for a range of activity levels.

1.Budgeting for the expected level of activity.

This type of flexible budget can help managers deal
with uncertainty by allowing them to see the
expected outcomes for a range of activity levels. It
can be used to generate financial results for a few
plausible scenarios.

2. Budgeting for the actual level of activity. This

type of flexible budget is used after the fact to
compute what costs should have been for the actual
level of activity. Those expected costs are then
compared with the actual costs to assess
performance.