MANAGEMENT

ACCOUNTING FOR
BUSINESS
SEVENTH EDITION

COLIN DRURY

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 Part Two:
Information for Decision-Making

Chapter Five:
Pricing Decisions and Profitability Analysis

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Pricing Decisions-Learning Objectives:

• Explain the relevant cost information that should be present in price-

setting firms for both short-term and long-term decisions;

•Describe product and customer profitability analysis and the

information that should be included fro managing the product and
customer mix;

•Describe the target costing approach to pricing;

•Describe the different cost-pricing methods for deriving selling prices;

•Identify and describe the different pricing policies

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 5.1

Role of Cost Information in Pricing Decisions

•Price takers are those firms that have little control over the prices of their
products or services Prices are set by overall market supply and demand forces.
•For price takers cost information is of vital importance in deciding on the
output and mix of products and services.
• Price setters are those firms that have some discretion over the setting
of selling prices for their products or services. Usually firms that have
highly customised /differentiated products/services-
•Cost information is of vital importance to price setters in making pricing
decisions.
•Firms may be price setters for some of their products/services and
price takes for others.

Four situations will be considered:

1. a price-setting firm facing short-run pricing decisions
2. a price-setting firm facing long-run pricing decisions
3. a price-taking firm facing short-run product mix decisions
4. a price-taking firm facing long-run product mix decisions.

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example
 5.2
A Price-Setting Firm Facing Short-Run Pricing
Decisions
•Applies where companies are faced with the opportunity of bidding
for one-time special orders in competition with other suppliers (see
Chapter 4 Relevant Costs and Revenues).
•In this situation only the incremental cost of undertaking the order
should be taken into account. It is likely that most of the resources to fulfil the
order will already have been acquired and the cost of these resources will be incurred whether
or not the bid is accepted by the customer-.
•Given the short-term one-off nature of the opportunity many costs
will be non-incremental
•Bids should be made at prices that exceed the incremental cost
(Any excess of revenues over incremental costs will provide a contribution to committed fixed
costs that would not otherwise have been obtained) and must meet the following
conditions:
1.Sufficient capacity must be available to fulfil the order.
2.The bid price should not affect future selling prices and the
customer should not expect repeat business at short-term
incremental costs.
3.The order will utilize unused capacity for only a short period and
capacity will be released for use on more profitable opportunities.

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 5.3a

A Price-Setting Firm Facing Long-Run Pricing

Decisions
• Three scenarios (approaches) considered:

1.Pricing customized products using cost-plus pricing.

2.Pricing non-customized products using cost-plus pricing or demand
estimates.
3.Pricing non-customized products using target costing.

•In the long-term a firm can adjust the supply of resources that are
committed to it – therefore a product or service should be priced to
cover all of the resources that are committed to it.

•Price setters have stronger grounds for adopting activity-based

costing (ABC). They can dictate the price but need to ensure profitability on a range of
products see note 1 next slide.

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 5.3b

Pricing customized products/services using cost-plus

pricing

1.An accurate costing system is required since undercosting will result

in acceptance of unprofitable business and overcosting in the loss of
profitable business. Hence the need for ABC.

2.To determine the selling price a full cost/long-run cost should be

calculated and a mark-up added (i.e. a cost-plus selling price is
determined – see slides 5.6a to 5.6c for a more detailed explanation).

3.Cost assignment for pricing should be based on direct cost tracing or

cause-and-effect assignments – arbitrary allocations (e.g. some
business/facility-sustaining costs) (e.g. rental of facilities or admin costs should be
allocated using behavioural drivers or covered within the mark-up.

4.ABC provides a better understanding of cost behaviour for

negotiating with customers the price and size of orders.

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 5.3c

A price setting firm facing

long-run pricing decisions (cont.)

• Pricing non-customized products (cost-plus pricing):

1. Pricing decision involves large volumes to many customers of a single

product/service.
2. Cost-plus pricing requires an estimate of sales volume to determine unit
cost in order to derive the cost-plus price.
3. Recommended that cost-plus prices are estimated for a range of potential
sales volumes (see Example (a) on slide 5.3d).

• Pricing non-customized products (using demand estimates):

1. If approximations of demand can be derived they may be preferable to

using the cost-plus pricing approach. (‘Crude estimates of demand may
serve instead of careful estimates of demand but cost gives remarkably
little insight into demand.’ – Baxter and Oxendfelt)
2. See Example (b) on slide 5.3d for an illustration of the approach. (Note
that profits are maximized at a SP of £80 and how the information can be
used for showing the effects of other pricing policies.)

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 5.3d

(a)

(b)

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 5.3e

A price setting firm facing long-run pricing decisions (cont.)

Pricing non-customized products (target costing)

• Target costing is the reverse of cost-plus pricing – the target selling
price is the starting point.

• Four stages are involved:

Stage 1: Determine the target price that customers will be prepared to
pay for the product
Stage 2: Deduct a target profit margin from the target price to
determine the target cost
Stage 3: Estimate the actual cost of the product
Stage 4: If estimated actual cost exceeds the target cost investigate
ways of driving down the actual cost to the target cost.

• Marketing factors and customer research provide the basis for

determining selling price (not cost).

• Emphasizes a team approach to achieving the target cost. Product designers-

to cut out cost or waste, manufacturing engineers-focus on improving product processes, purchasing managers-
research for alternative component suppliers, marketing and finance managers all to focus on individual areas. If
the management are confident that the process of continuous improvement will enable the target cost to be
achieved early in the products life cycle- they may still go ahead if they have not fully achieved the target cost.

• MostForsuited
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to high sales volume products.
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example
 5.4

A Price-Taking Firm Facing Short-Run Product Mix

Decisions
•Applies where opportunities exist for taking on short-term business at a
market-determined selling price.

•Cost information required and the same conditions apply as those

specified for a price setter facing short-term pricing decisions.

•If short-term capacity constraints apply the product mix should be based
on maximizing contribution per limiting factor limiting factors such as materials,
labour and machine hours (see Chapter 4).

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 5.5a

A Price-Taking Firm Facing Long-Run Product Mix

Decisions
•In the long-term a firm can adjust the supply of resources that are
committed to it – therefore the sales revenue from a product or service
should be sufficient to cover all of the resources that are committed to it.

•Periodic profitability analysis is required to ensure that only profitable

products/services are marketed.

•Profitability analysis should be used as an attention-directing

mechanism.

•Ideally ABC hierarchical profitability analysis should be used (see sheet

5.5b).

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 5.5b

An illustration of hierarchical profitability analysis

A price taker firm facing long run pricing decisions- Note 2) fixed costs relating to sales revenue e.g.
advertising that can be related to an individual product. Note 4) e.g. machinery energy/power and any
servicing work. Exhibit 5.1

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 5.6a

Cost-plus pricing – further aspects

• Different cost bases and mark-ups can be used to determine the cost-
plus selling price: (Note a similar example is given on page 107)

Cost base Mark-up

Cost-plus
(£) % selling price
(£)
(1) Direct variable costs 200 150 500
(2) Direct non-
variable costs 100
(3) Total direct costs 300 70 510
(4) Indirect overhead
costs
(such as facility-sustaining costs)
80
(5) Total cost 380 35 513

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 5.6b

Cost-plus pricing
• Target mark-ups seek to provide a contribution to non-assigned costs
and profit.

• Target mark-ups are also adjusted to reflect demand, types of

products, industry norms, competitive position, etc.

• Criticisms of cost-plus pricing:

1. Ignores demand.
2. Does not necessarily ensure that total sales revenue will exceed total
cost. This is in part because the costs are often based on achieving a certain sales volume.
3. Can lead to wrong decisions if budgeted activity is used to unitize
costs.
4. Circular reasoning – volume estimates are required to estimate unit
fixed costs and ultimately price.

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 5.6c

Reasons for Using Cost-Plus Pricing

1. May encourage price stability.

2. Demand can be taken into account by adjusting the target mark-
ups. Management attempt to adjust the price upward or downward after taking account of the
number of sales orders on hand, the extent of competition from other firms, the importance of the
customer in terms of future sales and the policy relating to customer relations. See page 107/108
3. Simplicity.
4. Difficulty in applying sophisticated procedures where a firm
markets hundreds of products/services.
5. Used as a guidance to setting the price but other factors are also
taken into account. See annotation above.
6. Applied to only the relatively minor revenue items.

Pricing Policies
• Price-skimming Exploiting those sections of the market that are relatively insensitive to
price
change
• Penetration pricing Based on charging a low price initially and intending to gain rapid
acceptance
• Pricing policies may vary depending on the different stages of a
product’s life cycle. -The four stages in the life cycle being – introduction, growth, maturity
and decline page 117 to119
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