CHAPTER TWO

RELEVANT INFORMATION, PRICING AND DECISION MAKING

Decision making is a fundamental part of management. The managerial accountant’s role in the decision-making process
is to provide relevant information to the managers who make the decisions. Thus, the managerial accountant needs a good
understanding of the decisions faced by those managers. A key function of a Financial Manager is to both facilitate and
part take in the decision-making process.

Decision-making is the process of choosing the best course of action from the alternative available. That is, when you are
faced with making a decision (or choice), you need to perform a number of tasks before making the final decision
(choice).

Decision Making Process

The formal method used by managers for making a choice involves the following decision-making process.

1. Recognize and define the problem

2. Identify alternatives as possible solution to the problem
3. Identify the cost and benefit associated with each feasible alternative
4. Total the relevant costs and benefits for each alternative
5. Assess qualitative factors
6. Select the alternative with the greatest overall benefits
7. Implement the alternative selected
8. Follow-up

The concept of Relevance

Relevance is one of the key characteristics of good management accounting information. This means that management
accounting information produced for each manager must relate to the decisions which he/she will have to make. Before
the management of an enterprise can make an informed decision on any matter, they need to incorporate all of the relevant
costs which apply to the specific decision at hand in their decision-making process. To include any non-relevant
information or to exclude any relevant information will result in management basing their decision on misleading
information and ultimately to poor decisions being taken.

Relevant Costs and Relevant Revenue

Relevant costs are expected future costs and relevant revenues are expected future revenues that differ among the
alternative courses of action being considered. Revenues and costs that are not relevant are said to be irrelevant. Be sure
you understand that to be relevant costs and revenues must

 Occur in the future—every decision deals with selecting a course of action based on its expected future results.
The Consequences of decisions are borne in the future, not the past. To be relevant to a decision, cost or revenue
information must involve a future event.
 Differ among the alternative courses of action—costs and revenues that do not differ will not matter and, hence,
will have no bearing on the decision being made. Relevant information must involve costs or revenue that differs
among the alternatives. Costs or revenues that are the same across all the available alternatives have no bearing
on the decision.

Importance of Identifying Relevant Costs and Benefits

Why it is important for the managerial accountant to isolate the relevant costs and benefit in a decision analysis? The
reasons are two. First, generating information is a costly process. The relevant data must be sought, and this requires
time and effort. By focusing on only the relevant information, the managerial accountant can simplify and shorten the
data-gathering process.

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Second, People can effectively use only a limited amount of information. Beyond this, they experience information
overload, and their decision-making effectiveness declines. By routinely providing only information about relevant costs
and benefits, the managerial accountant can reduce the likelihood of information overload.

Now let us see how we are going to use the relevant information to make decision through example and we will start with
the special order and we will proceed using the above order of decision-making area.

Generally, the term that are used to describe the relevant costs are:
1. Avoidable costs. -those costs that would not be incurred if the activity to which they related did not exist. All
incremental costs are also referred as avoidable costs. What are incremental costs? This are costs which are
specifically incurred by following a course of action and which are avoidable if such action is not taken. That is, there
are costs that are directly affected by the decision or occur as direct consequences of making a decision (they are costs
that will be incurred if the decision is implemented but not incurred if the decision is rejected or not implemented).
Such costs are known as incremental costs and considered as relevant cost for decision. They are also termed as
avoidable costs. Because, such costs can be avoided or would not be incurred, if the activity to which it relates did
not exist.
2. Opportunity costs. - Opportunity costs are the benefit which could have been earned, but which has been given up, by
choosing one option instead of another option. In other words, it is the value of an option, which cannot be selected
because of choosing a different option. You may find the idea of opportunity costs difficult to grasp at first. This is
because they are costs, which are not included in the accounting books and records of an enterprise. They are,
however, relevant in certain decision-making situation and you must bear in mind the fact that exists when assessing
any such situations.

Non-Relevant cost
Non-relevant costs are costs which are either not a future cash flows or which are costs which will be incurred any way,
regardless of the decision taken. For example, expenses for full time salaries, heat and light, and the apportionment of
other administrating costs are usually unaffected by the decision and are considered as irrelevant for the decision.

The common types of non-relevant costs are explained as follow:

1. Non-Incremental costs: - These are costs which will not be affected by the decision at hand. Non-incremental costs
are non-relevant costs because they are not related to the decision at hand (that is non-incremental costs will remain
the same no matter what decision is taken). An example of non-incremental costs would be fixed costs, which by
their very nature shouldn’t be affected by decisions (at least in the short term). If, however, a decision gives rise to a
specific increase in fixed costs then the increase in fixed costs would be an incremental (or additional) and, hence,
considered as relevant cost.

2. Sunk Costs: - A sunk cost is a cost that has already been incurred and cannot be altered by any future decision. If
sunk costs are not affected by a decision, then they must not be considered for decision-making purposes. Generally
Sunk costs are considered as non-relevant for a particular decision. For example, assume that an organization, which
incurs market research costs, in studying the market for introducing a new product. After studying the market, the
final decision on whether or not to launch the product, would regard these market research costs as ‘sunk’ (that is
irrecoverable past cost) and thus, not incorporate them in making the launch decision.

3. Committed cost: - These are future cash flows that will be incurred anyway, whether decision is taken now about
alternative opportunities. Such costs are usually the result of the contract already entered by the organization.
Generally, committed costs are similar to sunk costs in that they exist because of previous decisions. Committed costs
are different from sunk costs because they are costs that have been committed by management. However, the costs
committed contractually are effectively a sunk cost.

4. Notional Costs: - Notional costs are hypothetical accounting costs to reflect the use of a benefit for which no actual
cash expense is incurred. Notional costs are also called Imputed cost. The primary objective of charging notional
costs is to enable management to make clearer internal decisions by making sure that internal decision making
become more realistic. Notional charges are typically used to charge responsibility centers. Were as, notional interest
is often charged for the use of internally generated funds. Examples of using notional costs, to enhance internal
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 management making decision, are intra division charges to enable management to see the performance of certain
departments.

5. Spare Capacity Costs: - Because of the recent advancements in manufacturing technology, most enterprises have
greatly increased their efficiency and as a result are often operating at a capacity, which is below full capacity.
Operating with spare capacity can have a significant impact on the relevant costs on any short-term production
decision the management of such an enterprise might have to make. If spare capacity exists in an enterprise, some
costs which are generally considered incremental may in fact be non-incremental and thus, no-relevant, in the short
term. For example, if an enterprise is operating at less than full capacity then its work force would be a non-relevant
cost for a decision on whether to accept or reject a once-off special order. The labor cost is non-relevant because the
wages will have to be paid whether the order is accepter or not. If the special order involved and element of overtime
then the cost of such overtime would be of course be a relevant cost (as it is an incremental cost) for the decision.

Qualitative and Quantitative Relevant Information

Managers divide the outcomes of decisions into two broad categories: quantitative and qualitative. Quantitative factors
are outcomes that are measured in numerical terms. Some quantitative factors are financial; they can be expressed in
monetary terms. Examples include the cost of direct materials, direct manufacturing labor, and marketing. Other
quantitative factors are nonfinancial; they can be measured numerically, but they are not expressed in monetary terms.
Reduction in new product-development time and the percentage of on-time flight arrivals are examples of quantitative
nonfinancial factors. Qualitative factors are outcomes that are difficult to measure accurately in numerical terms.
Employee morale is an example.

Relevant-cost analysis generally emphasizes quantitative factors that can be expressed in financial terms. But just because
qualitative factors and quantitative nonfinancial factors cannot be measured easily in financial terms does not make them
unimportant. In fact, managers must wisely weigh these factors. In the Precision Sporting Goods example, managers
carefully considered the negative effect on employee morale of laying-off materials handling workers, a qualitative factor,
before choosing the reorganize alternative. Comparing and trading off nonfinancial and financial considerations is seldom
easy.

i. SPECIAL ORDER
Managers must often evaluate when a special order should be accepted, and if the order is accepted, the price that should
be charged. A special order is a one-time order that is not considered part of the company’s normal ongoing business.

Example 1: A company produces a single product and has budgeted for the production of 100,000 units during the
next quarter. The costs estimate for the quarter are as follows:
Direct labor…………………$ 600,000

Direct materials……………… 200,000

Variable overheads………….200,000

Fixed overheads…………… …400,000

$ 1,400,000

The company has agreed to sell 80,000 units during the coming period at the generally accepted market price of $18
per unit. It appears unlikely that orders will be received for the remaining 20,000 units at a selling price of $18 per
unit, but a customer is prepared to purchase them at a selling price of $12 per units. Should the company accept the
offer?

Additional Information: A study of the cost estimates indicates that during the next quarter the fixed overheads will
remain the same irrespective of whether or not the special order is accepted.
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 Solution: Using Incremental Approach
Incremental Revenue ($12*20,000) ……………………….……. $240,000
Less: Incremental Cost ($10*20,000) ……………………………………... (200,000)
Difference: Net Operating Income increase (decrease).... $40,000

Decision: Based on this analysis the company should accept the special order since the special order will add the
operating income of the company by $40,000; this may because there are unused capacities of the company with regards
to Fixed overhead Costs.

Summary: The decision to accept or reject a specially priced order is common in both service industry and
manufacturing firms. Manufacturers often are faced with decision about selling products in a special order at less than
full price. The correct analysis of such decisions focuses on the relevant costs and benefits. Fixed costs, which often are
allocated to individual units of product or service, are usually irrelevant. Fixed costs typically will not change in total,
whether the order is accepted or rejected.

When excess capacity exists, the only relevant costs usually will be the variable costs associated with the special order.
When there is no excess capacity, the opportunity cost of using the firm’s facilities for the special order are also relevant
to the decision.

ii. Deletion or addition of product, service or department

Decision relating to whether product line, service or department of a company should be dropped and new ones added are
among the most difficult that a manager has to make. Ultimately, however, any final decision to drop a business segment
or to add a new one is going to hinge primarily on the impact the decision will have on net operating income. To assess
this impact, costs must be carefully analyzed. There are two main classifications of expenses in this decision-making
analysis. Unavoidable expenses, expenses that will continue to be incurred even if a subunit or activity is eliminated.
Avoidable expenses, expenses that will no longer be incurred if a particular action is taken. All variable costs are
avoidable. In making such kind of decision, the main consideration is the contribution margin that can be given up if the
product line or factory is drooped and the fixed costs that can be avoided or that would be saved if the product line or
factor is dropped.

Generally, if the contribution margin given up by dropping the product line, department, or factory is less than the fixed
costs that can be avoidable, then it is better to drop the segment or the product or the department. Similarly; if
contribution margin given up by dropping the product line, department, or factory is greater than the fixed cost that can be
avoidable the product or the segment should be kept to continue in function.

Example 2: The following table provides sales and cost information for the preceding month for the Xyz Drug
company and its three major product lines—drugs, cosmetics, and house-wares.
Product Line

House-
Total Drugs Cosmetics Wares
Sales 250,000 125,000 75,000 50,000
Variable expenses 105,000 50,000 25,000 30,000
Contribution margin 145,000 75,000 50,000 20,000
Fixed expenses:
Salaries 50,000 29,500 12,500 8,000
Advertising 15,000 1,000 7,500 6,500
Utilities 2,000 500 500 1,000
Depreciation—fixtures 5,000 1,000 2,000 2,000
Rent 20,000 10,000 6,000 4,000
Insurance 3,000 2,000 500 500
General administrative 30,000 15,000 9,000 6,000
Total fixed expenses 125,000 59,000 38,000 28,000
Net operating income (loss) 20,000 16,000 12,000 (8,000)
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 Suppose the Xyz Drug company has analyzed the fixed costs being charged to the three product lines and has
determined the following:
1. The salaries expense represents salaries paid to employee working directly on the product.
2. The advertising expense represents advertisements that are specific to each product line and are avoidable if the
line is dropped.
3. The utility expense represents utilities costs for the entire company.
4. The depreciation expense represents depreciation of fixtures used to display the various product lines.
5. The rent expense represents rent on the entire building housing the company; it is allocated to the product lines on
the basis of sales dollars.
6. The insurance expense is for insurance carried on inventories with in each of the three product lines.
7. The general administrative expense represents the costs of accounting, purchasing, and general management,
which are allocated to the product lines on the basis of sales dollars.

Required: Should the company keep the house-wares product line or drop it?

Solution: With the above information, management can determine that $15,000 of the fixed expenses associated with
the houseware’s product line are avoidable and $13,000 are not:

Total Costs Not

Fixed expenses Assigned to Avoidable Avoidable
Housewares
Salaries $ 8,000 $ 8,000
Advertising 6,500 6,500
Utilities 1,000 $1,000
Depreciation-fixtures 2,000 2,000
Rent 4,000 4,000
Insurance 500 500
General administrative 6,000 ___6,000 _________
Total $28,000 $13,000 $15,000
As stated earlier, if the housewares product line were dropped, the company would lose the product’s contribution
margin of $20,000, but would save its associated avoidable fixed expenses. We now know that those avoidable fixed
expenses total $15,000. Therefore, dropping the housewares product line would result in a $5,000 reduction in net
operating income as shown below:

Contribution margin lost if the housewares line is discontinued (see above) …………………... $ (20,000)
Less fixed costs that can be avoided if the housewares line is discontinued (see above) …. 15,000
Decrease in overall company net operating income ……………………………………………………… $ (5,000)

Conclusion: As the above analysis show that if the housewares product line is dropped, then overall company net
operating income will decrease by $5,000 each period so the company should not drop the product line rather it should
keep the product line.

Why keep a product line that is showing a loss? If you look at the first table of this example it shows that the product
line has a loss of (8,000) based on this simple analysis you may mistakenly conclude it should be dropped but after the
analysis we have conducted in the second table we have noticed that it should not be drooped otherwise the company
would loss $5,000 operating income. The explanation for this apparent inconsistency lies in part with the common
fixed costs that are being allocated to the product lines. In this instance, allocating the common fixed costs among all
product lines makes the house-wares product line appear to be unprofitable. However, as we have shown above,
dropping the product line would not avoid all the allocated fixed costs; as a result, if the product line is dropped the net
operating income of the company would decrease by $5,000.

iii. Make or Buy Decision (In-sourcing or out-sourcing Decision)

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Make or buy decision involves a decision by an organization about whether it should make a product or carry out an
activity with its own internal resource, or whether it should pay another organization to make the product or carry out the
activity. An example for such types of decision usually includes whether a company should manufacture its own
component, or else buy the components from the outside supplier.

Out-sourcing is the process of purchasing goods or services from vender’s rather than producing the same good or
providing the same services within the organization, which is referred as in- sourcing. Even though, cost is the major
factor in deciding make or buy decision, usually qualitative factors will dictate managers make or buy decision. The
major qualitative factor in such situation includes;

 Lack of know-how and technology to produce the component.

 The need to maintain the long-term relationship with its existing suppliers,
 The need to retain the quality control of the product and delivery to production area
 The need to avoid too much dependency on the suppliers
 Reduction of cost……etc.

For example, if the company decides to make the component, it will give the management more direct control over the
work or production of the component. Similarly, if the company decides to buy from the suppliers, they might get the
benefit that the external organization has a special skill and experts in the production of the component. Thus, make or
buy decision should certainly not be based exclusively on cost consideration.

If an organization has the freedom of choice about whether to make internally or buy externally and has no scare resource
that put a restriction on what it can do itself, the relevant costs for the decisions will be the differential costs between the
make and buy options. That is, we to identify and compare the relevant cost of making the part with the relevant cost of
buying from outside. If the relevant costs of making a part is greater than the relevant cost of buying the part from
outside, then the company is advised to buy from outside. In addition, if the relevant cost of making a part is less than the
relevant cost of buying the part from outside, then the company is advised to make the component internally.

Example 3: Suppose that Xyz mountain cycles company is producing the heavy-duty gear shifters used in its
most popular line of mountain bikes. The company’s accounting department reports the following costs of
producing 8,000 units of the shifter internally each year:
Per Unit 8,000 Units

Direct materials $6 $48,000

Direct labor 4 32,000
Variable overhead 1 8,000
Supervisor’s (avoidable if the Co. buys) 3 24,000
Depreciation of special equipment 2 16,000
Allocated general overhead 5 40,000
Total Cost $21 $ 168,000
An outside supplier has offered to sell 8,000 shifters a year to Xyz mountain cycle company at a price of only
$19 each. Required: Should the company stop producing the shifters internally and buy them from the outside
supplier?

Solution:
Total Relevant
Costs—8,000 units
Make Buy
Direct materials $48,000
Direct labor 32,000
Variable overhead 8,000
Supervisor ‘s Salary 24,000

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 Depreciation of special equipment (not relevant)
Allocated general overhead (not relevant)
Outside purchase price $152,000
Total Cost $112,000 $152,000

Conclusion: Since it costs $40,000 less to make the shifters internally than to buy them from the outside
supplier, Xyz mountain cycles company should reject the outside supplier’s offer. However, the company may
wish to consider one additional factor before coming to a final decision—the opportunity cost of the space now
being used to product the shifters. Now let’s consider the following two possible situations.

1. If the space now being used to produce the shifters would otherwise be idle, then Xyz Mountain
Company should continue to produce its own shifters and the supplier’s offer should be rejected, as
stated above. Idle space that has no alternative use has an opportunity cost of zero.

2. But what if the space now being used to produce shifters could be used for some other purpose? In that
case, the space would have an opportunity cost equal to the segment margin that could be derived from
the best alternative use of the space.

To illustrate assume that the space now being used to produce shifters could be used to produce a new cross-
country bike that would generate a segment margin of $60,000 per year. Under this conditions, Xyz mountain
cycle company should act the supplier’s offer and use the available space to produce the new product line:

Make Buy

Total annual cost…………………………………………………………………… $112,000 $152,000

Opportunity cost—segment margin forgone on a potential new product line 60,000
Total Cost……………………………………………………………. $172,000 $152,000
Decision: Xyz company should accept the supplier offer because there is $20,000 difference in favor of
purchasing from the outside supplier. The company should not produce the shifter internally.

iv. Product mix under capacity constraint

Management routinely faces the problem of deciding how constrained resources are going to be use. A department store,
for example, has a limited amount of floor space and therefore cannot stock every product that may be available. A
manufacturer has a limited number of machine-hours and a limited number of direct labor hours. When a limited resource
of some type restricts the company’s ability to satisfy demand, the company has a constraint. Since the company cannot
fully satisfy demand, mangers must decide which products or services should be cut back. In other words, managers must
decide which products or services make the best use the constrained resource. Fixed costs are usually unaffected by such
choices, so the course of action that will maximize the company’s total contribution margin should ordinarily be selected

Example 4: LTM private company makes two products, B and S. Unit variable costs are as follows;
B S

Direct material………………………. $1 $3
Direct labor ($3 per hour) ………… 6 3
Variable overhead…………………. 1 1
Total unit variable cost……………. $8 $7
The sales price per unit is $14 per B and $11 per S, during July the available direct labor limited to 8,000 hours.
Sales demand in July is expected to be 3,000 units for B and 5,000 units for S

Required: Determine the operating income-maximizing production levels

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 Solution
Step 1: Confirm to what extent the limiting factor is short to meet the demand.
B S Total

Labor hour per unit 2 hour 1 hour

Sales demand 3,000 unit 5,000 unit
Labor hours needed 6,000 hour 5,000 hour 11,000 hour
Labor hour available 8,000 hour
Shortfall 3,000 hour
From the above table, we came to know that labor is the limiting factor on the production of the company.

Step 2: Identify the contribution earned by each product per unit of scares resource, that is , per labor hour
worked.
B S
Sales $14 $11
price………………………………………………………………….
Variable $8 $7
cost…………………………………………………………………
Unit contribution $6 $4
margin………………………………………………
Labor hour per 2 hour 1 hour
unit………………………………………………………
Contribution per labor hour (+unit of Constraint factor) (6÷2) =$3 (4÷1) =$4
N.B. Although B’s has a higher unit contribution that S’s, two S can be made in the time it
takes to make one B. Because labor is in short supply, it is more profitable to make S than B
Step 3: Work out the budgeted production and sales. Sufficient S will be made to meet the full sales demand, and
the remaining labor hours available will then be used to make B.
Units Hours needed Unit contribution Total
Product
S 5,000 5,000 $4 $20,000
B 1,500 3,000 $6 $9,000
Total 8,000 $29,000
Less Fixed Cost ($20,000)
Operating income $9,000
So, the company should produce 5,000 units of S and 1,500 units of product B, in order to maximize the operating
income given that there is a constraint of labor hours.

Note that, it is not more profitable to begin by making as many units as possible of the product with the bigger unit
contribution. We could make 3,000 unit of B in 6,000 hours and 2,000 units of S in 2,000 hours. However, the
operating income would be only $6,000. Therefore, unit contribution is not the correct way to decide priorities,
because it takes two hours to earn $6 from B and one hour to earn $4 from S, product S will result in a profitable
use of scares resource that is labor hour.

v. Sells or process further

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 This is the Short-term, non-routine decision about whether to sell a product at a particular stage of production or to
process it further in the hope of obtaining additional revenue. When two or more products are produced simultaneously
from the same input by a joint process, these products are called JOINT PRODUCTS. The term JOINT COSTS is used
to describe all the manufacturing costs incurred prior to the point where the joint products are identified as individual
products, referred to as the SPLIT-OFF POINT. At the split-off point some of the joint products are in final form and
salable to the consumer, whereas others require additional processing. In many cases, the company might have the option
to sell the products at the split-off point or process them further for increased revenue. In connection with this type of
decision, joint costs are considered irrelevant, since the joint costs have already been incurred at the time of the decision,
and therefore are SUNK COSTS. The decision will rely exclusively on additional revenue compared to the additional
costs incurred due to further processing. A separable processing cost is incurred on a joint product after the split-off point
of a joint production process.

Example 5: International chocolate company import cocoa beans and processes them into cocoa powered and cocoa
butter. Only a portion of the cocoa powder is used by international chocolate company in the production of chocolate
candy. The remainder of the cocoa powder is sold to an ice cream producer. Mr. John, the president of the company is
considering the possibility of processing the remaining cocoa powder into an instant cocoa mix. The company purchases
the cocoa bean costing $500 per 1-ton in batch and incurred joint production process costing of $600 per ton. The joint
production will result cocoa butter with sale value of $750 for 1,500 pound and cocoa powder with sales value of $500
for 500 pounds immediately after a split of point. The company should incur a separable process costing of $800 to
process further the cocoa powder after the split off point and this separable process will result a product call Instant
cocoa mix with the sales value of $2,000 for 500 pounds. The information can be presented in graphic form as follows.

Cocoa butter
sales value:
$750 for 1,500
Cocoa
pounds
Beans
Costing
$500 Joint
per 1- production
ton process
batch costing Cocoa
$600 per Powder Sales
ton Value: $500 Separable
for 500 process
pounds costing
Total Joint Cost: $1,100 $800 Instant
Cocoa mix
sales value;
Required: Should the company sell the cocoa powder immediately or process it further? $2,000 for
500 pounds

Solution
Sales value of instant cocoa mix……………………………………………………………. $2,000
Sales value of cocoa powder………………………………………………………………… 500
Incremental revenue from further processing………………………………………. 1,500
Less: Separable processing cost……………………………………………………………. 800
Net benefit from further processing………………………………………………………. $ 700

Decision: The Co. should decide to process the cocoa powder into instant cocoa mix.

vi. Irrelevance of Past Costs and Equipment Replacement Decisions

At several points in this chapter, when discussing the concept of relevance, we reasoned that past (historical or sunk) costs
are irrelevant to decision making. That’s because a decision cannot change something that has already happened. We now
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 apply this concept to decisions about replacing equipment. We stress the idea that book value—original cost minus
accumulated depreciation—of existing equipment is a past cost that is irrelevant.

Example: Toledo Company, a manufacturer of aircraft components, is considering replacing a metal-cutting machine
with a newer model. The new machine is more efficient than the old machine, but it has a shorter life. Revenues from
aircraft parts ($1.1 million per year) will be unaffected by the replacement decision. Here are the data the management
accountant prepares for the existing (old) machine and the replacement (new) machine:

Note: Toledo Corporation uses straight-line depreciation method.

Required: Should Toledo replace its old machine?

Decision: Note that as higher operating income will be obtained as a result of lower costs of $120,000 by replacing the
machine. The only relevant items are the cash operating costs, the disposal value of the old machine, and the cost of the
new machine.
vii. Pricing decisions:
Another area of special decision is to determine (or set) the best price for a product. Price decision
involves the activity of considering the competitive markets. But in addition to this, pricing must also be
based on future relevant costs to avoid long run profitability problems.

Firms may vary in their pricing techniques, and some of the most known approaches are:

1. Skimming:
This is the method of setting higher prices to a new product. When a firm decides to skim the market, it initially
set quite high price for a new product so that it will attract only a small number of customers. This strategy
provides manufacturers to quickly recover greater portion of their startup costs. However, the method is more
effective only when competitors cannot easily enter into the market.

2. Market penetration:
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 When market penetration is easy, a firm may prefer to use market penetration technique for pricing rather than
skim. In market penetration pricing, a firm sets the initial price of a new product very low enough to capture a
large share of the market. This method is best when a firm has a very high fixed cost with a low variable cost. If
the company can penetrate the market with a high volume and a low price, the fixed cost per unit will decrease
rapidly and overall profitability will increase since the company has large sales volume.
3. Markup pricing:
In markup pricing, a predetermined percentage is included in a product’s cost to cover the seller’s operating
costs, income taxes and reasonable profit. The method could be based either on sales price or cost.
Examples:

(a) If the cost of a product is Birr 60, and the company is having a policy of 75% mark-up on
cost, then the sales price will be Birr 105 (75%*60 +60).
(b) On the other hand, if the policy is 75% mark-up on sales price, the result will Birr 240; that is,
(100% sales price) - (75% mark-up) = 25% cost

Thus, Birr 60 = 25% of sales price

= 60/25%
= Birr 240 sales price
4. Target return pricing
It is based on the assumptions of specified return on investment (ROI) on sales prices. The problem of this
method is the definition of investment.
Example: Assume a company requires 12% (after tax) ROI from its investment. The company has defined
investment as total assets. Further assume that the company has Birr 2 million assets, produces 10,000 units of
output and Birr 20,000 variable & fixed costs. Tax rate is 40%.

Before tax ROI = 12% / (1-40%) = 20%

ROI = 20% * 2,000,000 = 400,000

Selling price per unit = (400000+20,000)/10,000

= Br. 42 sales price

5. Demand oriented pricing

Hotels and restaurants change their pricing strategy depending on the demand of their service/product. For
example, during “KULIBI” celebrations hotels and restaurants around Drie Dawa charge extra normal price on
rooms and services. When the season passes, the price will go down to the normal.

6. Competition based pricing

This strategy is used to compete with competitors. After analyzing the competitor’s manufacturing process, the
price will be set as equal, low or higher of the competitor.

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