Chapter 15

Target Costing and

Cost Analysis for
Pricing Decisions

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning
Objective
1

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Major Influences on
Pricing Decisions
Customer
demand

Political, legal,
and image issues

Pricing
Decisions

Competitors

Costs
1-3

Learning
Objective
2

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

How Are Prices Set?

Prices are determined by the market, subject
to costs that must be covered in the long run.

Costs

Market
Forces

Prices are based on costs, subject to

reactions of customers and competitors.
1-5

Economic Profit-Maximizing
Pricing
Firms usually have flexibility in setting prices.

The quantity sold usually

declines as the price is increased.

1-6

Total Revenue Curve

Dollars

Total revenue

Curve is increasing throughout

its range, but at a declining rate.

Quantity sold
per month
1-7

Demand Schedule and Marginal

Revenue Curve
Dollars
per unit
Sales price must decrease
to sell higher quantity.

Demand
Revenue per
Marginal
unit decreases
revenue
as quantity increases.

Quantity sold
per month
1-8

Total Cost Curve

Dollars

Total cost increases

at an increasing rate.
Total cost increases
at a declining rate.

Quantity made
per month
1-9

Marginal Cost Curve

Dollars
per unit

Marginal
cost
Quantity where
marginal cost
begins to increase.

Quantity made
per month
1-10

Determining the ProfitMaximizing Price and Quantity

Dollars
per unit

p*
Demand

Marginal
cost
q*

Marginal Quantity made

revenue
and sold
per month
1-11

Determining the ProfitMaximizing Price and Quantity

Dollars
per unit

Profit is maximized where

marginal cost equals
marginal revenue, resulting
in price p* and quantity q*.

p*

Demand

Marginal
cost
q*

Marginal Quantity made

revenue
and sold
per month
1-12

Determining the ProfitMaximizing Price and Quantity

Total cost
Total revenue

Dollars

Total profit at the

profit-maximizing
quantity and price,
q* and p*.

q*

Quantity made
and sold
per month
1-13

Price Elasticity
The impact of
price changes on
sales volume
Demand is elastic if
a price increase has a
large negative impact
on sales volume.

Demand is inelastic if
a price increase has
little or no impact
on sales volume.
1-14

Cross Elasticity

The extent to
which a change in
a products price affects the
demand for other
substitute products.

1-15

Limitations of the
Profit-Maximizing Model
A firms demand and marginal revenue
curves are difficult to discern with
precision.
The marginal revenue, marginal cost
paradigm is not valid for all forms of
markets.
Marginal cost is difficult to measure.
1-16

Role of Accounting
Product Costs in Pricing

Exh.
15-4

Optimal Decisions

Suboptimal Decisions

Economic pricing model

Cost-based pricing

Sophisticated decision
model and information
requirements

Simplified decision
model and information
requirements

Marginal-cost and
Accounting productmarginal-revenue data
cost data
More costly
Less costly
The best approach, in terms of costs and
benefits, typically lies between the extremes.
1-17

Learning
Objective
3

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Cost-Plus Pricing
Price = cost + (markup percentage
cost)
Full-absorption
manufacturing
cost?

Variable
manufacturing
cost?

Total cost,
including selling
and administrative?

Total variable cost,

including selling
and administrative?
1-19

Cost-Plus Pricing - Example

Variable mfg. cost
Fixed mfg. cost
Full-absorption mfg. cost
Variable S & A cost
Fixed S & A cost
Total cost

$ 400
250
$ 650
50
100
$ 800

We will use this unit cost information to illustrate the

relationship between cost and markup necessary to
achieve the desired unit sales price of $925.
1-20

Cost-Plus Pricing - Example

Variable mfg. cost
Fixed mfg. cost
Full-absorption mfg. cost
Variable S & A cost
Fixed S & A cost
Total cost

$ 400
250
$ 650
50
100
$ 800

Markup on
variable
manufacturing
cost

Price = cost + (markup percentage cost)

Price = $400 + (131.25% $400) = $925
1-21

Cost-Plus Pricing - Example

Variable mfg. cost
Fixed mfg. cost
Full-absorption mfg. cost
Variable S & A cost
Fixed S & A cost
Total cost

$ 400
250
$ 650
50
100
$ 800

Markup on
total var. cost
As cost base
increases, the
required markup
percentage
declines.

Price = cost + (markup percentage cost)

Price = $450 + (105.56% $450) = $925
1-22

Cost-Plus Pricing - Example

Variable mfg. cost
Fixed mfg. cost
Full-absorption mfg. cost
Variable S & A cost
Fixed S & A cost
Total cost

$ 400
250
$ 650
50
100
$ 800

Markup on
full mfg. cost
As cost base
increases, the
required markup
percentage
declines.

Price = cost + (markup percentage cost)

Price = $650 + (42.31% $650) = $925
1-23

Cost-Plus Pricing - Example

Variable mfg. cost
Fixed mfg. cost
Full-absorption mfg. cost
Variable S & A cost
Fixed S & A cost
Total cost

$ 400
250
$ 650
50
100
$ 800

Markup on
total cost
As cost base
increases, the
required markup
percentage
declines.

Price = cost + (markup percentage cost)

Price = $800 + (15.63% $800) = $925
1-24

Absorption-Cost Pricing
Formulas
Advantages
Price covers all costs.
Perceived as
equitable.

Comparison with
competitors.

Disadvantages
Full-absorption unit
price obscures the
distinction between
variable and fixed
costs.

Absorption cost used

for external reporting.

1-25

Variable-Cost Pricing Formulas

Advantages
Do not obscure cost
behavior patterns.
Do not require fixed
cost allocations.
More useful for
managers.

Disadvantage
Fixed costs may be
overlooked in pricing
decisions, resulting in
prices that are too
low to cover total
costs.

1-26

Determining the Markup:

Return-on-Investment Pricing
Solve for the
markup
percentage that
will yield the
desired return on
investment.
1-27

Determining the Markup:

Return-on-Investment Pricing
Recall the example using a 131.25 percent markup
on variable manufacturing cost.
Price = cost + (markup percentage cost)
Price = $400 + (131.25% $400) = $925

Lets solve for the 131.25 percent markup. Invested

capital is $300,000, the desired ROI is 20 percent,
and annual sales volume is 480 units.
1-28

Determining the Markup:

Return-on-Investment Pricing
Step 1: Solve for the income that
will result in an ROI of 20 percent.

Income
ROI =
Invested Capital
Income
20% =
$300,000
Income = 20% $300,000
Income = $60,000
1-29

Determining the Markup:

Return-on-Investment Pricing
Step 2: Recall the unit cost information below.
Solve for the unit sales price necessary to
result in an income of $60,000.

Variable mfg. cost

Fixed mfg. cost
Full-absorption mfg. cost
Variable S & A cost
Fixed S & A cost
Total cost

$ 400
250
$ 650
50
100
$ 800
1-30

Determining the Markup:

Return-on-Investment Pricing
Step 2: Solve for the unit sales price
necessary to result in an income of $60,000.
480 units (Unit profit margin) = $60,000

480 units (Unit sales price - $800 unit cost) = $60,000

$60,000
Unit sales price - $800 unit cost =
480 units
Unit sales price - $800 unit cost = $125 per unit

Unit sales price = $925

1-31

Determining the Markup:

Return-on-Investment Pricing
Step 3: Compute the markup percentage on
the $400 variable manufacturing cost.

Markup
percentage

Unit sales price - Unit variable cost

Unit variable cost

Markup
percentage

$925 per unit - $400 per unit

$400 per unit

Markup
percentage

= 131.25 percent
1-32

Learning
Objective
4

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Strategic Pricing of New Products

Uncertainties make pricing difficult.
Production costs.
Market acceptance.

Pricing Strategies:
Skimming initial price is high with intent to
gradually lower the price to appeal to a broader
market.
Market Penetration initial price is low with
intent to quickly gain market share.

1-34

Learning
Objective
5

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Target Costing

Market research
determines the price
at which a new
product will sell.

Management computes
a manufacturing cost that
will provide an acceptable
profit margin.

Engineers and cost analysts design a product

that can be made for the allowable cost.
1-36

Target Costing
Price led
costing
Life-cycle
costs

Focus on
process
design

Cross-functional
teams

Key
principles
of target
costing

Focus
on the
customer

Value-chain
orientation

Focus on
product
design
1-37

Learning
Objective
6

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

The Role Of Activity-Based Costing In Setting

A Target Cost.

Production Process

Component Activities

1-39

Learning
Objective
7

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Product Cost Distortion

High-volume products
May be overcosted

Low-volume products
May be undercosted

1-41

Learning
Objective
8

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Value Engineering
and Target Costing
Target cost information
Product design
Product costs
Production processes
Value Engineering (VE)
Cost reduction
Design improvement
Process improvement
1-43

Learning
Objective
9

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Time and Material Pricing

Price is the sum of
labor and material
charges.
Used by
construction
companies,
printers, and
professional
service firms.
1-45

Time and Material Pricing

Time charges:
Hourly
labor
cost

Overhead
cost per
labor hour

Hourly charge
to provide
profit margin

Total
labor hours
required

Material Charges:
Total
material
+
cost
incurred

Overhead
per dollar
of material
cost

Total
material
cost
incurred
1-46

Learning
Objective
10

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Competitive Bidding
Low probability
of winning bid

High bid
price

High profit if
winning bid

High probability
of winning bid

Low bid
price

Low profit if
winning bid

1-48

Competitive Bidding
Guidelines for Bidding
Low bid price
Any bid price in excess of
incremental costs of job
will contribute to fixed
costs and profit.

Bidder has
excess capacity

High bid price

Bid price should be full
cost plus normal profit
margin as winning bid will
displace existing work.

Bidder has no
excess capacity

1-49

Learning
Objective
11

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Legal Restrictions On Setting

Prices
Price discrimination
Predatory pricing

1-51

End of Chapter 15
What is the
right price?

1-52