CHAPTER 12 PRICING DECISIONS AND COST MANAGEMENT 12-1 The three major influences on pricing decisions are 1.

Customers 2. Competitors 3. Costs 12-3 1. 2. Two examples of pricing decisions with a short-run focus: Pricing for a one-time-only special order with no long-term implications. Adjusting product mix and volume in a competitive market.

12-5 Two alternative starting points for long-run pricing decisions are 1. Market-based pricing, an important form of which is target pricing. The market-based approach asks, Given what our customers want and how our competitors will react to what we do, what price should we charge? 2. Cost-based pricing which asks, What does it cost us to make this product and, hence, what price should we charge that will recoup our costs and achieve a target return on investment? 12-6 A 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 targeted operating income per unit. 12-7 Value engineering is a systematic evaluation of all aspects of the value-chain business functions, with the objective of reducing costs while satisfying customer needs. Value engineering via improvement in product and process designs is a principal technique that companies use to achieve target costs per unit. 12-8 A value-added cost is a cost that customers perceive as adding value, or utility, to a product or service. Examples are costs of materials, direct labor, tools, and machinery. A nonvalue-added cost is a cost that customers do not perceive as adding value, or utility, to a product or service. Examples of nonvalue-added costs are costs of rework, scrap, expediting, and breakdown maintenance.

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12-10 Cost-plus pricing is a pricing approach in which managers add a markup to cost in order to determine price. 12-11 Cost-plus pricing methods vary depending on the bases used to calculate prices. Examples are (a) variable manufacturing costs; (b) manufacturing function costs; (c) variable product costs; and (d) full product costs. 12-12 Two examples where the difference in the costs of two products or services is much smaller than the differences in their prices follow: 1. The difference in prices charged for a telephone call, hotel room, or car rental during busy versus slack periods is often much greater than the difference in costs to provide these services. 2. The difference in costs for an airplane seat sold to a passenger traveling on business or a passenger traveling for pleasure is roughly the same. However, airline companies routinely charge business travelersthose who are likely to start and complete their travel during the same week excluding the weekenda much higher price than pleasure travelers who generally stay at their destinations over at least one weekend. 12-13 Life-cycle budgeting is an estimate of the revenues and costs attributable to each product from its initial R&D to its final customer servicing and support. 12-14 Three benefits of using a product life-cycle reporting format are: 1. The full set of revenues and costs associated with each product becomes more visible. 2. Differences among products in the percentage of total costs committed at early stages in the life cycle are highlighted. 3. Interrelationships among business function cost categories are highlighted. 12-15 Predatory pricing occurs when a business deliberately prices below its costs in an effort to drive competitors out of the market and restrict supply, and then raises prices rather than enlarge demand. Under U.S. laws, dumping occurs when a non-U.S. company sells a product in the United States at a price below the market value in the country where it is produced, and this lower price materially injures or threatens to materially injure an industry in the United States. Collusive pricing occurs when companies in an industry conspire in their pricing and production decisions to achieve a price above the competitive price and so restrain trade.

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12-16 (2030 min.) 1.

Relevant-cost approach to pricing decisions, special order. $3,800 $1,500 800 700 190 3,190 $ 610

Relevant revenues, $3.80 1,000 Relevant costs Direct materials, $1.50 1,000 Direct manufacturing labor, $0.80 1,000 Variable manufacturing overhead, $0.70 1,000 Variable selling costs, 0.05 $3,800 Total relevant costs Increase in operating income

This calculation assumes that: a. The monthly fixed manufacturing overhead of $150,000 and $65,000 of monthly fixed marketing costs will be unchanged by acceptance of the 1,000 unit order. b. The price charged and the volumes sold to other customers are not affected by the special order. Chapter 12 uses the phrase one-time-only special order to describe this special case. 2. The presidents reasoning is defective on at least two counts: a. The inclusion of irrelevant costsassuming the monthly fixed manufacturing overhead of $150,000 will be unchanged; it is irrelevant to the decision. b. The exclusion of relevant costsvariable selling costs (5% of the selling price) are excluded. Key issues are: a. Will the existing customer base demand price reductions? If this 1,000-tape order is not independent of other sales, cutting the price from $5.00 to $3.80 can have a large negative effect on total revenues. b. Is the 1,000-tape order a one-time-only order, or is there the possibility of sales in subsequent months? The fact that the customer is not in Dill Companys normal marketing channels does not necessarily mean it is a one-time-only order. Indeed, the sale could well open a new marketing channel. Dill Company should be reluctant to consider only short-run variable costs for pricing long-run business.

3.

12-18 (15-20 min.) Short-run pricing, capacity constraints. 1. Per kilogram of hard cheese: Milk (10 liters $1.50 per liter) Direct manufacturing labor Variable manufacturing overhead Fixed manufacturing cost allocated Total manufacturing cost $15 5 3 6 $29

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If Vermont Hills can get all the Holstein milk it needs, and has sufficient production capacity, then, the minimum price per kilo it should charge for the hard cheese is the variable cost per kilo = $15+5+3 = $23 per kilo. 2. If milk is in short supply, then each kilo of hard cheese displaces 2.5 kilos of soft cheese (10 liters of milk per kilo of hard cheese versus 4 liters of milk per kilo of soft cheese). Then, for the hard cheese, the minimum price Vermont should charge is the variable cost per kilo of hard cheese plus the contribution margin from 2.5 kilos of soft cheese, or, $23 + (2.5 $8 per kilo) = $43 per kilo That is, if milk is in short supply, Vermont should not agree to produce any hard cheese unless the buyer is willing to pay at least $43 per kilo. 12-19 (2530 min.) Value-added, nonvalue-added costs. 1. Category Value-added costs Nonvalue-added costs Examples a. Materials and labor for regular repairs b. Rework costs c. Expediting costs caused by work delays g. Breakdown maintenance of equipment Total d. Materials handling costs e. Materials procurement and inspection costs f. Preventive maintenance of equipment Total $ 800,000 $ 75,000 60,000 55,000 $190,000 $ 50,000 35,000 15,000 $100,000

Gray area

Classifications of value-added, nonvalue-added, and gray area costs are often not clear-cut. Other classifications of some of the cost categories are also plausible. For example, some students may include materials handling, materials procurement, and inspection costs and preventive maintenance as value-added costs (costs that customers perceive as adding value and as being necessary for good repair service) rather than as in the gray area. Preventive maintenance, for instance, might be regarded as value-added because it helps prevent nonvalueadding breakdown maintenance.

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2. Total costs in the gray area are $100,000. Of this, we assume 65%, or $65,000, are value-added and 35%, or $35,000, are nonvalue-added. Total value-added costs: $800,000 + $65,000 $ 865,000 Total nonvalue-added costs: $190,000 + $35,000 225,000 Total costs $1,090,000 Nonvalue-added costs are $225,000 $1,090,000 = 20.64% of total costs. Value-added costs are $865,000 $1,090,000 = 79.36% of total costs. 3.
Program (a) Quality improvement programs to reduce rework costs by 75% (0.75 $75,000) reduce expediting costs by 75% (0.75 $60,000) reduce materials and labor costs by 5% (0.05 $800,000) Total effect (b) Working with suppliers to reduce materials procurement and inspection costs by 20% (0.20 $35,000) reduce materials handling costs by 25% (0.25 $50,000) Total effect Transferring 65% of gray area costs (0.65 $19,500 = $12,675) as value-added and 35% (0.35 $19,500 = $6,825) as nonvalue-added Effect on value-added and nonvalue-added costs (c) Maintenance programs to increase preventive maintenance costs by 50% (0.50 $15,000) decrease breakdown maintenance costs by 40% (0.40 $55,000) Total effect Transferring 65% of gray area costs (0.65 $7,500 = $4,875) as value-added and 35% (0.35 $7,500 = $2,625) as nonvalue-added Effect on value-added and nonvalue-added costs Total effect of all programs Value-added and nonvalue-added costs calculated in requirement 2 Expected value-added and nonvalue-added costs as a result of implementing these programs Effect on Costs Classified as ValueNonvalueGray Added Added Area $56,250 45,000 $ 40,000 $ 40,000 $101,250

$7,000 12,500 19,500 $ 12,675 $ 12,675 $ 6,825 $6,825 + 19,500 $ 0

+$7,500 $22,000 22,000 +$ 4,875 +$ 4,875 $ 47,800 865,000 $817,200 + 2,625 $19,375 $127,450 225,000 $ 97,550 + $7,500 7,500 $ 0

If these programs are implemented in 2007, total costs would decrease from $1,090,000 (requirement 2) to $817,200 + $97,550 = $914,750, and the percentage of nonvalue-added costs would decrease from 20.64% (requirement 2) to $97,550 914,750 = 10.66%. These are significant improvements in Marinos performance.

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12-24 (2025 min.) Cost-plus, target pricing, working backwards. 1. Investment Return on investment Operating income (20% $2,400,000) Operating income per unit of RF17 ($480,000 20,000) Full cost per unit of RF17 Selling price ($300 + $24) Markup percentage on full cost ($24 $300) With a 50% markup on variable costs, Selling price of RF17 = Variable cost per unit of RF17 1.50, so: Variable costs per unit of RF17 = 2. Selling price of RF17 $324 = = $216 1.50 1.50 $84 $1,680,000 18,000 $6,264,000 3,888,000 2,376,000 1,680,000 $ 696,000 $2,400,000 20% $480,000 $24 $300 $324 8%

Fixed costs per unit = $300 $216 = Total fixed costs = $84 per unit 20,000 units = At a price of $38, sales = 20,000 units 0.90 Revenues ($348 18,000) Variable costs ($216 18,000) Contribution margin ($132 18,000) Fixed costs Operating income

If Waterbuy increases the selling price of RF17 to $348, its operating income will be $696,000. This would be more than the $480,000 operating income Waterbury earns by selling 20,000 units at a price of $324, so, if its forecast is accurate, and based on financial considerations alone, Waterbury should increase the selling price to $348. 3. Target investment in 2008 Target return on investment Target operating income in 2008, 20% $2,100,000 Anticipated revenues in 2008, $315 20,000 Less target operating income in 2008 Target full costs in 2008 Less: total target fixed costs Total target variable costs in 2008 Target variable cost per unit in 2008, $4,200,000 20,000 = $210 $2,100,000 20% $420,000 $6,300,000 420,000 $5,880,000 1,680,000 $4,200,000

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