CHAPTER SIX

PRICING DECISIONS
.

AND
COST MANAGEMENT
03/29/2023 By: Gizachew S. 1
 LEARNING OBJECTIVES
After completing this chapter you will be able to:
Discuss the three major factors that affect pricing decisions
Understand how companies make long-run pricing
decisions
Price products using the target costing approach
Apply the concepts of cost incurrence and locked-in costs
Price products using the cost-plus approach
Use life-cycle budgeting and costing when making pricing
decisions
Explain the effects of legal restrictions on pricing and the
broader notion of price discrimination
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 6.1. Major Factors That Affect Pricing
Decisions
How managers price a product or a service ultimately
depends on demand and supply.
Three influences on demand and supply are
customers, competitors, and costs
 Customers

 Competitors

 Costs

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 Cont…
1. 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.
Example, companies must always examine pricing
decisions through the eyes of their customers and then
manage costs to earn a profit.
2. Competitors
Managers must always be aware of the actions of their
competitors.

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 Cont…
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.

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 Cont…
3. 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.

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6.2. Costing and Pricing for the short and
Long Run
Short-run pricing decisions have a time horizon of
less than a year and include decisions such as
a) pricing a one-time-only special order with no
long-run implications and
b) adjusting product mix and output volume in a
competitive market.
Long-run pricing decisions have a time horizon of a
year or longer
 pricing a product in a major market where price
setting has some leeway

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 Cont…
1. Costs that are often irrelevant for short-run pricing
decisions (fixed costs) are often relevant in the long run.
2. Profit margins in long-run pricing decisions are often set
to earn a reasonable return on investment.
Costing and Pricing for the Short Run Example
i. Lomas Corporation operates a plant with a monthly
capacity of 500,000 cases of tomato sauce. Lomas is
presently producing 300,000 cases per month. Del Valle
has asked Lomas and two other companies to bid on
supplying 150,000 cases each month for the next four
months.

03/29/2023 By: Gizachew S. 8

 Cont…
Cost Per Case
Variable manufacturing Br. 38
Variable marketing and distribution 13
Fixed manufacturing 14
Fixed marketing and distribution 15
Total Br. 80
If Lomas makes the extra 150,000 cases, the existing
total fixed manufacturing overhead (Br. 4,200,000 per
month) would continue, plus an additional Br. 165,000 of
fixed overhead will be incurred per month.

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 Cont…
 Total fixed marketing and distribution costs will not
change. What price should Lomas bid?
Relevant Costs
Variable manufacturing Br. 38.00
Fixed manufacturing 1.10
Total Br. 39.10
Br. 165,000 ÷ 150,000 = Br. 1.10
Any bid above Br. 39.10 will improve Lomas’s profitability
in the short run.

03/29/2023 By: Gizachew S. 10

 Cont…
 Suppose that Lomas believes that Del Valle will sell the
tomato sauce in Lomas’s current markets but at a lower
price than Lomas.
 Relevant costs of the bidding decision should include
revenues lost on sales to existing customers.
Costing and Pricing for the Long Run – Example
 Latisha Computer Corporation manufactures two brands
of computers: Simple Computer (SC) and Complex
Computer (CC).
 Latisha uses a long-run time horizon to price Complex
Computer (CC).

03/29/2023 By: Gizachew S. 11

 Cont…
 Direct materials costs vary with the number of units
produced.
 Direct manufacturing labor costs vary with direct
manufacturing labor-hours.
 Ordering and receiving, testing and inspection, and
rework costs vary with their chosen cost drivers.
Ordering: Br. 78 per order
Testing: Br. 2 per inspection hour
Rework: Br. 38 per unit reworked

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 Cont…
Cost per Unit
Direct materials Br. 450.00
Direct labor:
3.50 hours @ Br. 19 per hour 66.50
Total Br. 516.50
Number of orders placed: 17,000
Number of testing hours: 3,000,000
Number of units reworked: 8,000

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 Cont…
 The direct fixed costs of machines used exclusively for the
manufacture of Complex Computer total Br. 7,000,000.
What is the cost of producing 100,000 units of Complex
Computer?
Direct material and labor Br. 51,650,000
Direct fixed costs 7,000,000
Ordering (17,000 × Br. 78) 1,326,000
Testing (3,000,000 × Br. 2) 6,000,000
Rework (8,000 × Br. 38) 304,000
Total Br. 66,280,000
Br. 66,280,000 ÷ 100,000 units = Br. 662.80/unit

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Alternative Long-Run Pricing Approaches
.

Market-based

Cost-based
(also called cost-plus)

03/29/2023 By: Gizachew S. 15

 Cont…
The market-based approach to pricing starts by asking,
“Given what our customers want and how our competitors
will react to what we do, what price should we charge?”
Based on this price, managers control costs to earn a target
return on investment.
Companies operating in competitive markets (for example,
commodities such as steel, oil, and natural gas) use the
market-based approach.
The items produced or services provided by one company are
very similar to items produced or services provided by others.
Companies in these markets must accept the prices set by the
market.

03/29/2023 By: Gizachew S. 16

 Cont…
The cost-based approach to pricing starts by asking,
“Given what it costs us to make this product, what
price should we charge that will recoup our costs and
achieve a target return on investment?
Companies operating in markets that are not
competitive favor cost-based approaches. That’s
because these companies do not need to respond or
react to competitors’ prices. The margin they add to
costs to determine price depends on the value
customers place on the product or service.
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 Target Price and Target Cost
Target price is the estimated price for a product (or service) that
potential customers will be willing to pay.
Target Price – Target operating income per unit
= Target cost per unit
Steps in developing target prices and target costs:
1. Develop a product that satisfies the needs of potential customers.
2. Choose a target price.
3. Derive a target cost per unit by subtracting target operating
income per unit from the target price.
4. Perform cost analysis
5. Perform value engineering to achieve target costs.

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 Cont…
Target operating income per unit is the operating
income that a company aims to earn per unit of a
product or service sold.
Target cost per unit is the estimated long-run cost per
unit of a product or service that enables the company
to achieve its target operating income per unit when
selling at the target price.
Target cost per unit is the target price minus target
operating income per unit and is often lower than the
existing full cost of the product.

03/29/2023 By: Gizachew S. 19

 Implementing Target Pricing and Target
Costing
Latisha’s management wants a 15% target operating
income on sales revenues of CC.
Target sales revenue is Br. 750 per unit. What is the target
cost per unit?
Br. 750 × .15 = Br. 112.50, Br. 750 – Br.112.50 = Br.
637.50
Current full cost per unit of CC is Br. 662.80
Value engineering is a systematic evaluation of all aspects
of the value-chain business function with the objective of
reducing costs.
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Value Engineering, Cost Incurrence, and Locked-In Costs
 To implement value engineering, managers distinguish
value-added activities and costs from non value-added
activities and costs.
A value-added cost if eliminated, is a cost that customers
perceive as adding value, or utility, to a product or
service:
Examples are costs of specific product features and
attributes desired by customers, such as reliability,
adequate memory, preloaded software, clear images, and,
prompt customer service
 A non value-added cost is a cost that customers do not
perceive as adding value, or utility, to a product or
service.
03/29/2023 By: Gizachew S. 21
 Cont…
 Examples of non value-added costs are costs of producing
defective products and cost of machine breakdowns.
 Successful companies keep non value-added costs to a
minimum
 Cost Incurrence describes when a resource is sacrificed or
forgone to meet a specific objective.
 Costing systems measure cost incurrence

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 Locked-in Costs
These are those costs that have not yet been
incurred but which, based on decisions that
have already been made, will be incurred
in the future (designed-in costs).
It is difficult to alter or reduce

costs that are already locked in.

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Cost Incurrence and Locked-in Costs

o s t Curve
- in C
Cumulative Costs per Unit

Lo cke d

r ve
e Cu
nc
rre
n cu
I
st-
Co
Value-Chain
Functions

R&D and Manufacturing Mkt., Dist.,

Design & Cust. Svc.
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Value-Chain Analysis and Cross-Functional Teams
 At the end of the design stage, direct materials, direct
manufacturing labor, and many manufacturing,
marketing, distribution, and customer-service costs
are all locked in.
 When a sizable fraction of the costs are locked in at
the design stage, the focus of value engineering is on
making innovations and modifying designs at the
product design stage.

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 Cost-Plus Pricing
 Instead of using the market-based approach for long-run
pricing decisions, managers sometimes use a cost-based
approach.
 The general formula for setting a cost-based price adds a
markup component to the cost base to determine a prospective
selling price
Cost base Br. X
Markup component Y
Prospective selling price Br. X + Y

 Assume that Latisha’s engineers have redesigned CC into CCI

at a new cost of Br. 637.50. The company desires a 20%
markup on the full unit cost. What is the prospective selling
price?
03/29/2023 By: Gizachew S. 26
 Cont…
Cost base: Br. 637.50
Markup component: (637.50 × .20) 127.50
Prospective selling price: Br. 765.00
 Assume that the capital investment needed for CCI is
Br. 75 million, and the company (pretax) target rate of
return on investment is 17%. What is the target annual
operating income that Latisha needs to earn from
CCI?
= Br. 75,000,000 × .17 = Br. 12,750,000

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 Cont…
What is the target operating income per unit?
= Br. 12,750,000 ÷ 100,000 units = Br. 127.50/unit
The target rate of return on investment is the target
annual operating income divided by invested capital.
 Invested is long-term assets plus current assets.
 The 17% target rate of return on investment expresses
the company’s expected annual operating income as a
percentage of investment.
 The 20% markup expresses operating income per unit
as a percentage of the full product cost per unit.

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 Advantages of Using Full Costs
managers use the full cost of the product for cost-based pricing
decisions—that is, they include both fixed and variable costs
when calculating the cost per unit.
Managers include fixed cost per unit in the cost base for several
reasons:
A. Full recovery of all costs of the product - In the long run, the
price of a product must exceed the full cost of the product if a
company is to remain in business.
B. Price stability-Managers believe that using the full cost of the
product as the basis for pricing decisions promotes price
stability
C. Simplicity- A full-cost formula for pricing does not require a
detailed analysis of costbehavior patterns to separate product
costs into fixed and variable components
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Alternative Cost-Plus Methods
Variable manufacturing costs
Variable costs of the product
Manufacturing function costs

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 Life-Cycle Product Budgeting and Costing
Life-Cycle Budgeting
 The product life cycle spans the time from original
research and development, through sales, to when
customer support is no longer offered for that product.
 A life-cycle budget estimates revenues and costs of a
product over its entire life.
 Features that make life-cycle budgeting important:
 Non production costs
 Development period for R&D and design
 Other predicted costs

03/29/2023 By: Gizachew S. 31

 Non production Costs
 These costs are less visible on a product-by-product
basis.
 When no production costs are significant, identifying
these costs by product is essential for target pricing,
target costing, value engineering, and cost management.
Development Period
 When a high percentage of total life-cycle costs are
incurred before any production begins and before any
revenues are received, it is crucial for the company to
have as accurate a set of revenue and cost predictions
for the product as possible.
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 Predicted Costs
 Many of the production, marketing, distribution and
customer service costs are locked in during the R&D
and design stage.
 Life-cycle budgeting facilitates value engineering at
the design stage before costs are locked in.
Life-Cycle Budgeting and Costing
 Consider a life-cycle average sales price of Br. 55,000
per unit. If the desired life-cycle contribution is 45%,
what is the allowable cost over the life cycle of the
product?
= Br. 55,000 – (Br. 55,000 × .45) = Br. 30,250
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Other Considerations in Pricing Decisions
In some cases, cost is not a major factor in setting
prices. We explore some of the ways that market
structures and laws and regulations influence price
setting outside of cost.

Price discrimination

Peak-load pricing
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 Price Discrimination Laws
Price discrimination is the practice of charging
different customers different prices for the same
product or service.

Under the U.S. Robinson-Patman Act, a manufacturer

cannot price-discriminate between two customers if
the intent is to lessen or prevent competition for customers.

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  They apply to manufacturers, not service providers.
 Price discrimination is permissible if differences in prices
can be justified by differences in costs.
 Predatory pricing occur when…
 …the predator company charges a price that is
below an appropriate measure of its costs, and
 …the predator company has a reasonable prospect of
recovering in the future the money it lost by pricing below
cost.

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  Most courts in the United States have defined the
“appropriate measure of costs” as the short-run marginal
and average variable costs.
 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 of its creation, and its action injures
an industry in the United States.
 Collusive pricing occurs when companies in an industry
conspire in their pricing and output decisions to achieve
a price above the competitive price.

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 Peak-load pricing
Peak-load pricing is the practice of charging a higher price
for the same product or service when the demand for the
product or service approaches the physical limit of the
capacity to produce that product or service.
 When demand is high and production capacity is limited,
customers are willing to pay more to get the product or
service.
In contrast, slack or excess capacity leads companies to
lower prices in order to stimulate demand and utilize
capacity.
Peak-load pricing occurs in the telephone,
telecommunications, hotel, car rental, and electric-utility
industries.
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