Pricing Decisions and

Cost Management

Chapter
12

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 1

 Major Influences on
Pricing Decisions

Customers influence prices through

their effect on demand.
Competitors influence prices through
their actions.
Costs influence prices because they
affect supply.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 2

 Customers, Competitors, & Costs
 Features of a product and its quality
 Alternative or substitute products
 Competitors’ technologies, plant capacities, and
operating strategies
 Competitors’ costs
 Competition across borders - fluctuations in
exchange rates
 Economies of scale – Lower costs

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 3

 Weighing Customers,
Competitors, and Costs
 Companies operating in a perfectly
competitive market selling very similar
products, have no control over setting prices
and must accept the price determined by a
market.
 In less-competitive markets, such as those for
electronics and cellular phones, products are
differentiated, and all three factors affect prices

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 4

 Weighing Customers,
Competitors, and Costs
 As competition lessens even more, the key
factor affecting pricing decisions is the
customer’s willingness to pay based on the
value that customers place on the product or
service, not costs or competitors.
 A monopolist has no competitors and has
much more leeway to set high prices.
Nevertheless, there are limits.
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 5
 Time Horizon of
Pricing Decisions

Short-run decisions Long-run decisions

have a time horizon involve a time horizon
of less than a year: of a year or longer:
 One-time-  pricing a product in
special orders decisions a major market where
 Product price setting has
mix decisions some leeway

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 6

 Time Horizon of
Pricing Decisions

1. Costs that are often 2. Profit margins in

irrelevant for short-run long-run pricing
pricing decisions decisions are often set
(fixed costs) are often to earn a reasonable
relevant in the long run. return on investment.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 7

 Costing and Pricing
for the Short Run – Example
Lomas Corporation operates a plant with
a monthly capacity of 500,000 cases
of tomato sauce.
Lomas is presently producing
300,000 cases per month.
Del Valle has asked Lomas and two other
companies to bid on supplying 150,000
cases each month for the next four months.
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 8
 Costing and Pricing
for the Short Run – Example

Cost Per Case

Variable manufacturing $38
Variable marketing and distribution 13
Fixed manufacturing 14
Fixed marketing and distribution 15
Total $80

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 9

 Costing and Pricing
for the Short Run – Example

If Lomas makes the extra 150,000 cases, the existing

total fixed manufacturing overhead ($4,200,000 per
month) would continue, plus an additional $165,000
of fixed overhead will be incurred per month.
Total fixed marketing and distribution
costs will not change.
What price should Lomas bid?
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 10
 Costing and Pricing
for the Short Run – Example

Relevant Costs
Variable manufacturing $38.00
Fixed manufacturing 1.10
Total $39.10
$165,000 ÷ 150,000 = $1.10
Any bid above $39.10 will improve
Lomas’s profitability in the short run.
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 11
 Costing and Pricing
for the Short Run – Example

Suppose that Lomas believes that Del Valle

will sell the tomato sauce in Lomas’s current
markets but at a lower price than Lomas.
Relevant costs of the bidding decision
should include revenues lost on sales
to existing customers.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 12

 Costing and Pricing
for the Long Run – Example
Latisha Computer Corporation manufactures
two brands of computers: Simple Computer (SC)
and Complex Computer (CC).
Latisha uses a long-run time horizon to price
Complex Computer (CC).

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 13

 Costing and Pricing
for the Long Run – Example

Direct materials 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.
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 14
 Costing and Pricing
for the Long Run – Example
Ordering: $78 per order
Testing: $ 2 per inspection hour
Rework: $38 per unit reworked
Cost per Unit
Direct materials $450.00
Direct labor:
3.50 hours @ $19 per hour 66.50
Total $516.50
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 15
 Costing and Pricing
for the Long Run – Example
Number of orders placed: 17,000
Number of testing hours: 3,000,000
Number of units reworked: 8,000
The direct fixed costs of machines used
exclusively for the manufacture of
Complex Computer total $7,000,000.
What is the cost of producing 100,000
units of Complex Computer?
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 16
 Costing and Pricing
for the Long Run – Example

Direct material and labor $51,650,000

Direct fixed costs 7,000,000
Ordering (17,000 × $78) 1,326,000
Testing (3,000,000 × $2) 6,000,000
Rework (8,000 × $38) 304,000
Total $66,280,000
$66,280,000 ÷ 100,000 units = $662.80/unit
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 Alternative Long-Run
Pricing Approaches

Market-based

Cost-based
(also called cost-plus)

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 Alternative Long-Run
Pricing Approaches
 Market-based approach
“Given what our customers want and how our
competitors will react to what we do, what
price should we charge?”
Managers control costs to earn a target return
on investment.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 19

 Alternative Long-Run
Pricing Approaches
 Cost-based approach
“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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 Target Price and Target Cost

Target price is the estimated price for

a product (or service) that potential
customers will be willing to pay.
Target Price
– Target operating income per unit
= Target cost per unit

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 Target Price and Target Cost

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.
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 22
 Implementing Target Pricing
and Target Costing

Latisha’s management wants a 15% target

operating income on sales revenues of CC.
Target sales revenue is $750 per unit.
What is the target cost per unit?
$750 × .15 = $112.50, $750 – $112.50 = $637.50
Current full cost per unit of CC is $662.80
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 23
 Implementing Target Pricing
and Target Costing

Value engineering is a systematic

evaluation of all aspects of the
value-chain business function with
the objective of reducing costs.

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 Value-Added Costs

A value-added cost is a cost that customers perceive

as adding value, or utility, to a product or service:
Adequate memory
Pre-loaded software
Reliability
Easy-to-use keyboards
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 Nonvalue-Added Costs

A nonvalue-added cost is a cost that

customers do not perceive as adding
value, or utility, to a product or service.
Cost of expediting
Rework
Repair

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 Cost Incurrence

This describes when a resource is sacrificed

or forgone to meet a specific objective.
Research and development Design
Manufacturing Marketing
Distribution Customer support

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 Locked-in Costs

These are those costs that have not yet been

incurred but which, based on decisions that
have already been made, will be incurred
in the future (designed-in costs).

It is difficult to alter or reduce

costs that are already locked in.

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 Cost Incurrence and
Locked-in Costs

At the end of the design stage, direct materials,

direct manufacturing labor, and many
manufacturing, marketing, distribution,
and customer-service costs are all locked in.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 29

 Cost Incurrence and
Locked-in Costs

When a sizable fraction of the costs are locked in

at the design stage, the focus of value engineering
is on making innovations and modifying designs
at the product design stage.

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 Cost-Plus Pricing

The general formula for setting a

cost-based price is to add a markup
component to the cost base.
Cost base $ X
Markup component Y
Prospective selling price $X + Y

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 Cost-Plus Pricing

Assume that Latisha’s engineers

have redesigned CC into CCI at
a new cost of $637.50.
The company desires a 20% markup
on the full unit cost.
What is the prospective selling price?

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 32

 Cost-Plus Pricing

Cost base: $637.50

Markup component: (637.50 × .20) 127.50
Prospective selling price: $765.00

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 Cost-Plus Pricing

Assume that the capital investment needed for

CCI is $75 million, and the company (pretax)
target rate of return on investment is 17%.
What is the target annual operating income
that Latisha needs to earn from CCI?
$75,000,000 × .17 = $12,750,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 34

 Cost-Plus Pricing

What is the target operating income per unit?

$12,750,000 ÷ 100,000 units = $127.50/unit

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 Cost-Plus Pricing

The 17% target rate of return on investment

expresses the company’s expected annual
operating income as a percentage of investment.
The 20% markup expresses operating
income per unit as a percentage of the
full product cost per unit.

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 Advantages of Using Full Costs

Full recovery of all costs of the product

Price stability

Simplicity

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 Alternative Cost-Plus Methods

Variable manufacturing costs

Variable costs of the product

Manufacturing function costs

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 Other Considerations in
Pricing Decisions

Price discrimination

Peak-load pricing

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 Price Discrimination
 Price discrimination is the practice of charging
different customers different prices for the
same product or service.
Airline tickets sold to business travelers vs pleasure
travelers.
Business travelers must travel - demand for air
travel is relatively insensitive to price.
Airlines can earn higher operating incomes by
charging business travelers higher prices.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 40

 Price Discrimination
Pleasure travelers, in contrast, pay for their tickets
themselves, pleasure travelers’ demand is price-
elastic
lowering prices stimulates demand.
Airlines can earn higher operating incomes by
charging pleasure travelers lower prices.
 Prices differ even though there is no difference
in cost in serving the two customer segments.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 41

 Peak-Load Pricing
 Peak-load pricing is the 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.
 When demand is high and production
capacity is limited, customers are willing to
pay more to get the product or service.
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 12 - 42
 Peak-Load Pricing
 In contrast, slack or excess capacity leads
companies to lower prices in order to
stimulate demand and utilize capacity.

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 End of Chapter 12
Practice Questions
12-16, 12-17, 12-23,
12-24, 12-26,
12-27, 12-28, 12-29,
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