Chapter 15

Target Costing and

Cost Analysis for
Pricing Decisions

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McGraw-Hill/Irwin
Learning Objective 15-1 – List and describe the four major
influences on pricing decisions.

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15-2
 Major Influences on
Pricing Decisions
Customer Political, legal,
demand and image issues

Pricing
Decisions

Competitors Costs
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 How are Prices Set?

Costs Market
Forces

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Learning Objective 15-2 – Explain and use the economic,
profit-maximizing pricing model.

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 Economic Profit-Maximizing Pricing

Firms
Firms usually
usually have
have flexibility
flexibility in
in setting
setting prices.
prices.

The
The quantity
quantity sold
sold usually
usually
declines
declines as
as the
the price
price is
is increased.
increased.

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 Total Revenue Curve

Dollars
Total revenue

Curve is increasing throughout

its range, but at a declining rate

Quantity sold
per month
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 Demand (or Average Revenue) Curve and
Marginal Revenue Curve
Dollars
per unit

Sales price must decrease

to sell higher quantity

Demand
Revenue per Marginal (or Average
unit decreases revenue Revenue)
as quantity increases Quantity sold
per month
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 Total Cost Curve
Dollars

Total cost increases

at an increasing rate

Total cost increases

at a declining rate
Quantity made
per month
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 Marginal Cost Curve
Dollars
per unit
Marginal
cost
Quantity where
marginal cost
begins to increase

Quantity made
c per month
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 Determining the Profit-Maximizing
Price and Quantity (1/3)
Dollars
per unit

p*

Demand
Marginal
cost Marginal Quantity made
revenue
q* and sold
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per month
 Determining the Profit-Maximizing
Price and Quantity (2/3)
Dollars
per unit Profit is maximized where
marginal cost equals
marginal revenue, resulting
p* in price p* and quantity q*.

Demand
Marginal
cost Marginal Quantity made
revenue
q* and sold
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per month
 Determining the Profit-Maximizing
Price and Quantity (3/3)
Dollars Total cost
Total revenue

Total profit at the

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

Quantity made

q* and sold
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per month
 Price Elasticity

The impact of
price changes on
sales volume

Demand is elastic if Demand is inelastic if

a price increase has a a price increase has
large negative impact little or no impact
on sales volume. on sales volume.
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 Cross Elasticity

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

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

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 Cost-Benefit Trade-Off in Information
Production

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 Role of Accounting
Product Costs in Pricing
Optimal Decisions Suboptimal Decisions
Economic pricing model Cost-based pricing
Sophisticated decision Simplified decision
model and information model and information
requirements requirements

Marginal-cost and Accounting product-

marginal-revenue data cost data
More costly Less costly
The best approach, in terms of costs and
benefits, typically lies between the extremes.
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Learning Objective 15-3 – Set prices using cost-plus pricing
formulas.

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 Cost-Plus Pricing

Price = cost + (markup percentage × cost)

• Depending on how cost is defined, the markup

percentage may differ.
• Several different definitions of cost, each
combined with a different markup percentage,
can result in the same price for a product or
service.

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 Cost-Plus Pricing – Example (1/5)

Variable mfg. cost $ 400

Fixed mfg. cost 250
Full-absorption mfg. cost $ 650
Variable S & A cost 50
Fixed S & A cost 100
Total cost $ 800

We
We will
will use
use this
this unit
unit cost
cost information
information toto illustrate
illustrate the
the
relationship
relationship between
between cost
cost and
and markup
markup necessary
necessary to to
achieve
achieve thethe desired
desired unit
unit sales
sales price
price ofof $925.
$925.

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 Cost-Plus Pricing – Example (2/5)

Variable mfg. cost $ 400

Markup on
Fixed mfg. cost 250
variable
Full-absorption mfg. cost $ 650
manufacturing
Variable S & A cost 50
cost.
Fixed S & A cost 100
Total cost $ 800

Price = cost + (markup percentage × cost)

Price = $400 + (131.25% × $400) = $925
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 Cost-Plus Pricing – Example (3/5)
Markup on
Variable mfg. cost $ 400 total var. cost
Fixed mfg. cost 250 As cost base
Full-absorption mfg. cost $ 650 increases, the
Variable S & A cost 50 required markup
Fixed S & A cost 100 percentage
Total cost $ 800 declines.

Price = cost + (markup percentage × cost)

Price = $450 + (105.56% × $450) = $925
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 Cost-Plus Pricing – Example (4/5)
Markup on
Variable mfg. cost $ 400 full mfg. cost
Fixed mfg. cost 250 As cost base
Full-absorption mfg. cost $ 650 increases, the
Variable S & A cost 50 required markup
Fixed S & A cost 100 percentage
Total cost $ 800 declines.

Price = cost + (markup percentage × cost)

Price = $650 + (42.31% × $650) = $925
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 Cost-Plus Pricing – Example (5/5)
Markup on
Variable mfg. cost $ 400 total cost
Fixed mfg. cost 250 As cost base
Full-absorption mfg. cost $ 650 increases, the
Variable S & A cost 50 required markup
Fixed S & A cost 100 percentage
Total cost $ 800 declines.

Price = cost + (markup percentage × cost)

Price = $800 + (15.63% × $800) = $925
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 Absorption-Cost Pricing Formulas
Advantages Disadvantages
Price covers all costs. Full-absorption unit
price obscures the
Perceived as equitable. distinction between
Comparison with variable and fixed
competitors. costs.
Absorption cost used
for external reporting.
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 Variable-Cost Pricing Formulas

Advantages Disadvantage
Does not obscure Fixed costs may be
cost behavior overlooked in
patterns. pricing decisions,
resulting in prices
Does not require that are too low to
fixed cost cover total costs.
allocations.
More useful for
managers.
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 Determining the Markup:
Return-on-Investment Pricing (1/6)

Solve for the markup percentage that

will yield the desired return on
investment.

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 Determining the Markup:
Return-on-Investment Pricing (2/6)

Recall
Recall the
the example
example using
using aa 131.25
131.25 percent
percent markup
markup
on
on variable
variable manufacturing
manufacturing cost.
cost.

Price = cost + (markup percentage × cost)

Price = $400 + (131.25% × $400) = $925

Let’s
Let’s solve
solve for
for the
the 131.25
131.25 percent
percent markup.
markup. Invested
Invested
capital
capital is
is $300,000,
$300,000, thethe desired
desired ROI
ROI is
is 20
20 percent,
percent,
and
and annual
annual sales
sales volume
volume is
is 480
480 units.
units.
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 Determining the Markup:
Return-on-Investment Pricing (3/6)
Step
Step 1:1: Solve
Solve forfor the
the income
income that
that
will
will result
result in
in an
an ROI
ROI of
of 20
20 percent.
percent.
Income
ROI =
Invested Capital
Income
20% =
$300,000
Income = 20% × $300,000
Income = $60,000
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 Determining the Markup:
Return-on-Investment Pricing (4/6)
Step
Step 2:
2: Recall
Recall the
the unit
unit cost
cost information
information below.
below.
Solve
Solve for
for the
the unit
unit sales
sales price
price necessary
necessary to
to
result
result in
in an
an income
income ofof $60,000.
$60,000.

Variable mfg. cost $ 400

Fixed mfg. cost 250
Full-absorption mfg. cost $ 650
Variable S & A cost 50
Fixed S & A cost 100
Total cost $ 800
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 Determining the Markup:
Return-on-Investment Pricing (5/6)
Step
Step 2:
2: Solve
Solve for
for the
the unit
unit sales
sales price
price
necessary
necessary to
to result
result in
in an
an income
income ofof $60,000.
$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
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 Determining the Markup:
Return-on-Investment Pricing (6/6)
Step
Step 3:
3: Compute
Compute the
the markup
markup percentage
percentage on
on
the
the $400
$400 variable
variable manufacturing
manufacturing cost.
cost.

Markup Unit sales price − Unit variable cost

=
percentage Unit variable cost
Markup $925 per unit − $400 per unit
=
percentage $400 per unit
Markup
= 131.25 percent
percentage
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Learning Objective 15-4 – Discuss the issues involved in
the strategic pricing of new products.

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 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.

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Learning Objective 15-5 – List and discuss the key
principles of target costing.

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 Target Costing (1/2)

Market research
determines the price Management computes
at which a new a manufacturing cost that
product will sell. will provide an acceptable
profit margin.

Engineers and cost analysts design a

product
that can be made for the allowable
cost.

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 Target Costing (2/2)
Price led Cross-functional
costing teams
Key
Life-cycle principles Value-chain
costs of target orientation
costing
Focus on Focus on
process product
design Focus design
on the
customer
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Learning Objective 15-6 – Explain the role of activity-based
costing in setting a target cost.

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 The Role of Activity-Based
Costing in Setting a Target Cost

Production Process

Component Activities

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Learning Objective 15-7 – Explain how product-cost
distortion can undermine a firm’s pricing strategy.

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 Product Cost Distortion

High-volume products
may be overcosted

Low-volume
products
may be undercosted

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Learning Objective 15-8 – Explain the process of value
engineering and its role in target costing.

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 Value Engineering
Target Costing and Value Engineering
sting

Target
Target cost
cost information
information
 Product
Product design
design
 Product
Product costs
costs
 Production
Production processes
processes

Value
Value Engineering
Engineering (VE)
(VE)
 Cost
Cost reduction
reduction
 Design
Design improvement
improvement
 Process
Process improvement
improvement
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Learning Objective 15-9 – Determine prices using the time
and material pricing approach.

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 Time and Material Pricing (1/2)

Price is the sum of labor and material

charges.
Used by construction companies,
printers, and professional service firms.

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 Time and Material Pricing (2/2)
Time charges:
Hourly Overhead Hourly charge Total
labor + cost per + to provide × labor hours
cost labor hour profit margin required

Material Charges:
Total Overhead Total
material per dollar material
cost
+ of material × cost
incurred cost incurred
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Learning Objective 15-10 – Set prices in special-order or
competitive-bidding situations by analyzing the relevant
costs.

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 Competitive Bidding (1/2)

Low probability High bid High profit if

of winning bid price winning bid

High probability Low bid Low profit if

of winning bid price winning bid

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 Competitive Bidding (2/2)
Guidelines
Guidelines for
for Bidding
Bidding
• Low bid price
• Any bid price in excess
Bidder has
of incremental costs of
excess capacity job will contribute to
fixed costs and profit.
• High bid price
• Bid price should be full
Bidder has no cost plus normal profit
excess capacity margin as winning bid will
displace existing work.
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Learning Objective 15-11 – Describe the legal restrictions
on setting prices.

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 Legal Restrictions On Setting Prices

Price discrimination

Predatory pricing

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 End Chapter 15

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