Chapter 5: Pricing Decisions and Cost Management

Learning Objectives

After studying this chapter, you should be able to:

1. Compute a target cost when the market determines a product price.
2. Compute a target selling price using cost-plus pricing.
3. Use time-and-material pricing to determine the cost of services provided.

In this chapter, we examine one of the two types of pricing situations. That is, pricing for goods
sold or services provided to external parties. The second type, pricing decisions managers face
when they sell goods to other divisions within the company, examine in chapter 7. The content
and organization of this chapter are as follows.

5.1. Major Influences on Pricing Decisions

Establishing the price for any good or service is affected by many factors. Consider for a moment
how managers at manufacturing might price their latest line of products, or how decision makers
at service providers would determine how much to charge for a monthly subscription of for
example, internet service. How companies price a product or a service ultimately depends on the
demand and supply for it. Three influences on demand and supply are customers, competitors,
and costs.

Customers: Customers influence price through their effect on the demand for a product or
service, based on factors such as the features of a product and its quality. Companies must
always examine pricing decisions through the eyes of their customers and then manage costs to
earn a profit.

Competitors: No business operates in a vacuum. Companies must always be aware of the

actions of their competitors. At one extreme, alternative or substitute products of competitors
hurt demand and force a company to lower prices. At the other extreme, a company without a
competitor is free to set higher prices. When there are competitors, companies try to learn about
competitors’ technologies, plant capacities, and operating strategies to estimate competitors’
costs - valuable information when setting prices. Because competition spans international
borders, fluctuations in exchange rates between different countries’ currencies affect costs and
pricing decisions. For example, if the Birr weakens against the U.S. dollar, Ethiopian products
become cheaper for American consumers and, consequently, more competitive in U.S. markets.
Costs: Costs influence prices because they affect supply. The lower the cost of producing a
product, the greater the quantity of product the company is willing to supply. Generally, as
companies increase supply, the cost of producing an additional unit initially declines but
eventually increases. Companies supply products as long as the revenue from selling additional
units exceeds the cost of producing them. Managers who understand the cost of producing
products set prices that make the products attractive to customers while maximizing operating
income.

5.2.Weighing Customers, Competitors, and Costs

Studies indicate that companies weigh customers, competitors, and costs differently when
making pricing decisions. At one extreme, companies operating in a perfectly competitive
market sell very similar commodity-type products, such as wheat, rice, steel, and aluminum.
These companies have no control over setting prices and must accept the price determined by a
market consisting of many participants. Cost information is only helpful in deciding the quantity
of output to produce to maximize operating income.

In less-competitive markets, such as those for cameras, televisions, and cellular phones, products
are differentiated, and all three factors affect prices: The value customers place on a product and
the prices charged for competing products affect demand, and the costs of producing and
delivering the product influence supply.

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. In the extreme, there are monopolies. A monopolist has no competitors and has
much more leeway to set high prices. Nevertheless, there are limits. The higher the price a
monopolist sets, the lower the demand for the monopolist’s product as customers seek substitute
products.

The following diagram indicates the many factors that can affect pricing decisions. In the long
run, a company must price its product to cover its costs and earn a reasonable profit. But to price
its product appropriately, it must have a good understanding of market forces at work. In most
cases, a company does not set the prices. Instead the price is set by the competitive market (the
laws of supply and demand). For example, gasoline companies cannot set the price of gasoline
by themselves. These companies are called price takers because the price of gasoline is set by
market forces (the supply of oil and the demand by customers). This is the case for any product
that is not easily differentiated from competing products, such as farm products (corn or wheat)
or minerals (coal or sand).
In other situations, the company sets the prices. This would be the case
5.2.1. where the product is specially made for a customer,
5.2.2. when there are few or no other producers capable of manufacturing a similar item. An
example would be a company that has a patent or copyright on a unique process, such
as the case of computer chips by Intel.
5.2.3. when a company can effectively differentiate its product or service from others. Even
in a competitive market, be able to differentiate its product and charge a premium.

5.3.Target Costing
In a competitive market, as discussed above, price of an item is affected greatly by the laws of
supply and demand, so no company in this industry can affect the price to a significant degree.
Therefore, to earn a profit, companies in this industry must focus on controlling costs. This
requires setting a target cost that provides a desired profit. The following formula shows the
relationship and importance of a target cost to the price and desired profit.

In a competitive market, a company chooses the segment of the market it wants to compete in –
that is, its market niche. For example, it may choose between selling luxury goods or economy
goods in order to focus its efforts on one segment or the other.

Once the company has identified its segment of the market, it conducts market research to
determine the target price. This target price is the price that the company believes would place it
in the optimal position for its target audience. Once the company has determined this target
price, it can determine its target cost by setting a desired profit. The difference between the target
price and the desired profit is the target cost of the product. After the company determines the
target cost, it assembles a team of employees with expertise in a variety of areas (production and
operations, marketing, and finance). The team’s task is to design and develop a product that can
meet quality specifications while not exceeding the target cost. The target cost includes all
product and period costs necessary to make and market the product or service.

To illustrate, assume that Fine Company is considering introducing a fashion phones cover.
Market research indicates that 200,000 units can be sold if the price is no more than $20. If Fine
decides to produce the covers, it will need to invest $1,000,000 in new production equipment.
Fine requires a minimum rate of return of 25% on all investments. Determine the target cost per
unit for the cover.

Solution:
The desired profit for this new product line is $250,000 ($1,000,000x25%)
Each cover must result in $1.25 of profit ($250,000/200,000 units)
Target cost per unit = Market price – Desired profit

= $20 –$1.25
= $18.75 per unit

5.4.Cost-Plus Pricing
As discussed, in a competitive, common-product environment the market price is already set, and
the company instead must set a target cost. But, in a less competitive or noncompetitive
environment, the company may be faced with the task of setting its own price. When the
company sets the price, price is commonly a function of the cost of the product or service. That
is, the typical approach is to use cost-plus pricing. This approach involves establishing a cost
base and adding to this cost base a markup to determine a target selling price.

This is the selling price that will provide the desired profit when the seller has the ability to
determine the product’s price. The size of the markup (the “plus”) depends on the desired return
on investment (ROI = Net income ÷ Invested assets) for the product line, product, or service. In
determining the proper markup, the company must also consider competitive and market
conditions, political and legal issues, and other relevant risk factors. The cost-plus pricing
formula is expressed as follows.

To illustrate, assume that a Company is in the process of setting a selling price on its new
product. The per unit variable cost estimates for the new product is as follows.
In addition, the Company has the following fixed cost per unit at a budgeted sales volume of
10,000 units.

The Company decided to price its new product to earn a 20% return on its $1,000,000 investment
(ROI). Therefore, it expects to receive income of $200,000 (20%x$1,000,000) on its investment.
On a per unit basis, the desired ROI is $20 ($200,000 ÷ 10,000 units). Given the per unit costs
shown above, it computes the sales price to be $132 as follows:

The formula to compute the markup percent-age to achieve a desired ROI of $20 per unit is as
follows.

Using a 17.86% markup on cost, the Company would compute the target selling price as follows.

Limitations of Cost-Plus Pricing

The cost-plus pricing approach has a major advantage: It is simple to compute. However, the
cost model does not give consideration to the demand side. That is, will customers pay the price
computed above? In addition, sales volume plays a large role in determining per unit costs. The
lower the sales volume, for example, the higher the price the Company must charge to meet its
desired ROI. To illustrate, if the budgeted sales volume was 8,000 instead of 10,000,Company’s
variable cost per unit would remain the same. However, the fixed cost per unit would change as
follows.

As indicated above, the fixed cost per unit for 10,000 units was $52. However, at a lower sales
volume of 8,000 units, the fixed cost per unit increases to $65. Company’s desired 20% ROI now
results in a $25 ROI per unit [(20%x$1,000,000) ÷ 8,000]. The Company computes the selling
price at 8,000 units as follows.

As revealed, the lower the budgeted volume, the higher the per unit price. The reason: Fixed
costs and ROI are spread over fewer units, and therefore the fixed cost and ROI per unit increase.
In this case, at 8,000 units, the Company would have to mark up its total unit costs 20% to earn a
desired ROI of $25 per unit, as shown below.

The target selling price would then be $150, as indicated earlier:

The opposite effect will occur if budgeted volume is higher (say, at 12,000 units) because fixed
costs and ROI can be spread over more units. As a result, the cost-plus model of pricing will
achieve its desired ROI only when the Company sells the quantity it budgeted. If actual volume
is much less than budgeted volume, the Company may sustain losses unless it can raise its prices.

5.5. Variable Cost Pricing

In determining the target price for the above Company’s product, we calculated the cost base by
including all costs incurred. This approach is referred to as full-cost pricing. Instead of using full
costs to set prices, some companies simply add a markup to their variable costs. Using variable-
cost pricing as the basis for setting prices avoids the problem of using uncertain cost information
related to fixed-cost-per-unit computations (as shown above, changes in fixed cost per unit from
$52 to $65 as sales volume changes from 10,000 units to 8,000 units).
Variable-cost pricing also is helpful in pricing special orders or when excess capacity exists. The
major disadvantage of variable-cost pricing is that managers may set the price too low and
consequently fail to cover their fixed costs. In the long run, failure to cover fixed costs will lead
to losses. As a result, companies that use variable-cost pricing must adjust their markups to make
sure that the price set will provide a fair return.

Under variable-cost pricing, the cost base consists of all of the variable costs associated with a
product, including variable selling and administrative costs. Because fixed costs are not included
in the base, the markup must provide for fixed costs (manufacturing, and selling and
administrative) and the target ROI. Variable-cost pricing is more useful for making short-run
decisions because it considers variable cost and fixed cost behavior patterns separately.

The first step in variable-cost pricing is to compute the unit variable cost. The previous example
is used for how variable costs are used as the basis for setting prices.

The second step in variable-cost pricing is to compute the markup percentage. Use the following
formula for the markup percentage. Here, fixed costs include fixed manufacturing overhead of
$28 per unit ($280,000÷10,000) and fixed selling and administrative expenses of $24 per unit
($240,000÷10,000).

Solving, we find:

The third step is to set the target selling price. Using a markup percentage of 120% and the
contribution approach, computes the selling price as follows:

Using a target price of $132 will produce the desired 20% return on investment for the Company
at a volume level of 10,000 units.
Under any of the three pricing approaches we have looked at (full-cost or absorption-cost, and
variable-cost), the desired ROI will be attained only if the budgeted sales volume for the period
is attained. None of these approaches guarantees a profit or a desired ROI. Achieving a desired
ROI is the result of many factors, some of which are beyond the company’s control, such as
market conditions, political and legal issues, customers’ tastes, and competitive actions as
discussed earlier.

Because absorption-cost pricing includes allocated fixed costs, it does not make clear how the
company’s costs will change as volume changes. To avoid blurring the effects of cost behavior
on net income, some managers therefore prefer variable-cost pricing. The specific reasons for
using variable-cost pricing, even though the basic accounting data are less accessible, are as
follows.
 Variable-cost pricing, being based on variable cost, is more consistent with cost-volume-
profit analysis used by managers to measure the profit implications of changes in price and
volume.
 Variable-cost pricing provides the type of data managers need for pricing special orders. It
shows the incremental cost of accepting one more order.
 Variable-cost pricing avoids arbitrary allocation of common fixed costs (such as executive
salaries) to individual product lines.
5.6. Time-and-Material Pricing
Another variation on cost-plus pricing is called time-and-material pricing. Under this approach,
the company sets two pricing rates - one for the labor used on a job and another for the material.
The labor rate includes direct labor time and other employee costs. The material charge is based
on the cost of direct parts and materials used and a material loading charge for related overhead
costs. Time-and-material pricing is widely used in service industries, especially professional
firms such as public accounting, law, engineering, and consulting firms, as well as construction
companies, repair shops, and printers.

Using time-and-material pricing involves three steps: (1) calculate the per hour labor charge, (2)
calculate the charge for obtaining and holding materials, and (3) calculate the charges for a
particular job.

Step 1: Calculate the Labor Charge – the first step for time-and-material pricing is to determine
a charge for labor time. The charge for labor time is ex-pressed as a rate per hour of labor. This
rate includes: (1) the direct labor cost of the employee, including hourly rate or salary and fringe
benefits; (2) selling, administrative, and similar overhead costs; and (3) an allowance for a
desired profit or ROI per hour of employee time. In some industries, such as auto, boat, and farm
equipment repair shops, a company charges the same hourly labor rate regardless of which
employee performs the work. In other industries, a company charges the rate according to
classification or level of the employee. A public accounting firm, for example, would charge the
services of an assistant, senior, manager, or partner at different rates; a law firm would charge
different rates for the work of a paralegal, associate, or partner.

Step 2: Calculate the Material Loading Charge – the charge for materials typically includes the
invoice price of any materials used on the job plus a material loading charge. The material
loading charge covers the costs of purchasing, receiving, handling, and storing materials, plus
any desired profit margin on the materials themselves. The material loading charge is expressed
as a percentage of the total estimated costs of parts and materials for the year. To determine this
percentage, the company does the following: (1) It estimates its total annual costs for purchasing,
receiving, handling, and storing materials. (2) It divides this amount by the total estimated cost of
parts and materials. (3) It adds a desired profit margin on the materials themselves.

Step 3: Calculate Charges for a Particular Job – the charges for any particular job are the sum
of (1) the labor charge, (2) the charge for the materials, and (3) the material loading charge.

To illustrate, suppose data for Harmon Electrical Repair Shop for next year:
Repair-technicians’ wages $130,000
Fringe benefits 30,000
Overhead 20,000
The desired profit margin per labor hour is $10. The material loading charge is 40% of invoice
cost. Harmon estimates that 8,000 labor hours will be worked next year. If Harmon repairs a TV
that takes 4 hours to repair and uses parts costing $50, compute the bill for this job.
Solution: