12- taraget costing and pricing.ppt

CHAPTER 12
Pricing Decisions
and
Cost Management

12-2
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
Pricing and Business
 How companies price a product or service
ultimately depends on the demand and
supply for it
 Three influences on demand and supply:
1. Customers
2. Competitors
3. Costs

12-3
Influences on Demand and Supply
1. Customers – influence price through their effect on
the demand for a product or service, based on
factors such as quality and product features
2. Competitors – influence price through their pricing
schemes, product features, and production volume
3. Costs – influence prices because they affect supply
(the lower the cost, the greater the quantity a firm is
willing to supply)

12-4
Time Horizons and Pricing
 Short-run pricing decisions have a time horizon of
less than one year and include decisions such as:
 Pricing a one-time-only special order with no long-run
implications
 Adjusting product mix and output volume in a
competitive market
 Long-run pricing decisions have a time horizon of one
year or longer and include decisions such as:
 Pricing a product in a major market where there is
some leeway in setting price

12-5
Differences Affecting Pricing:
Long Run vs. Short Run
1. Costs that are often irrelevant for short-run policy
decisions, such as fixed costs that cannot be
changed, are generally relevant in the long run
because costs can be altered in the long run
2. Profit margins in long-run pricing decisions are
often set to earn a reasonable return on investment
– prices are decreased when demand is weak and
increased when demand is strong

12-6
Alternative Long-Run Pricing
Approaches
 Market-Based: price charge is based on what
customers want and how competitors react
 Cost-Based: price charge is based on what it
costs to produce, coupled with the ability to
recoup the costs and still achieve a required
rate of return

12-7
Markets and Pricing
 Competitive Markets – use the market-based
approach
 Less-Competitive Markets – can use either
the market-based or cost-based approach
 Noncompetitive Markets – use cost-based
approaches

12-8
Market-Based Approach
 Starts with a target price
 Target Price – estimated price for a product
or service that potential customers will pay
 Estimated on customers’ perceived value for
a product or service and how competitors will
price competing products or services

12-9
Understanding the
Market Environment
 Understanding customers and competitors
is important because:
1. - Competition from lower cost producers has
meant that prices cannot be increased
2. - Products are on the market for shorter
periods of time, leaving less time and
opportunity to recover from pricing mistakes
3. - Customers have become more
knowledgeable and demand quality products
at reasonable prices

12-10
Five Steps in Developing
Target Prices and Target Costs
1. Develop a product that satisfies the needs of
potential customers
2. Choose a target price – based on market research
and perceived competition pricing
3. Estimate desired profit margin:
- for each product or for a portfolio of products?
- a rate of return on investment or on sales?

12-11
4. Target cost per unit = target price minus Target Operating
Income per unit
5. Estimate cost of producing a unit of the product
6. Identify cost gap = estimated cost – target cost
7. Eliminate the cost gap
- value engineering (tear down analysis or reverse
engineering
- re-engineering

12-12
Value Engineering
 Value Engineering is a systematic evaluation of all
aspects of the value chain, with the objective of
reducing costs while improving quality and
satisfying customer needs
 Evaluation of competitor’s product to identify
opportunities of improving own product for cost
reduction purposes.
 Disentangle the competitor’s product to uncover its
design, functions, and parts and infer the required
processing

12-13
Value Engineering Terminology
 Managers must distinguish value-added activities and
costs from non-value-added activities and costs
 Value-Added Costs – a cost that, if eliminated, would
reduce the actual or perceived value or utility
(usefulness) customers obtain from using the product
or service
 Non-Value-Added Costs – a cost that, if eliminated,
would not reduce the actual or perceived value or
utility customers obtain from using the product or
service. It is a cost the customer is unwilling to pay
for

12-14
Value Engineering Terminology
 Cost Incurrence – describes when a resource
is consumed (or benefit forgone) to meet a
specific objective
 Locked-in Costs (Designed-in Costs) – are
costs that have not yet been incurred but,
based on decisions that have already been
made, will be incurred in the future
 Are a key to managing costs well

12-15
Re-engineering
 While value engineering focuses primarily on product
design re-engineering focuses on production processes
 This technique focus on re-planning preplanned processes
for cost reduction purposes

12-16
Illustrative example -1
 A company estimated the market price of a modified
product at $75 per unit. The company requires 20% profit
margin on sales.
 Estimated unit cost of the product under the current
conditions is $64.
 Information gathered about the company’s principal
competitor shows
- a competitor’s cost advantage (parts and components)
of producing similar products is $8 per unit.
- an own cost advantage (in operations and processing)
of $5 per unit
Find the target cost for the product.

12-17
Solution to example -1
Comments
$75 Estimated price From market research and
value analysis
(15) Profit target (20%) Based on competition and
profit plan
$60 (Initial) target cost
(8) Competitor’s cost
advantage
From competitor’s study (a
difficulty that raises target cost)
5 Own cost advantage A leverage for the company
$57 (competitive) target cost
(64) Estimated cost From company analysis
$7 Cost gap Company must eliminate it

12-18
Illustrative example -2
An auto manufacturer produces different motors. From
customer interviews, and internal and external producing
departments, four performance attributes are identified: (1) motor
power, (2) fuel consumption, (3) weight, and (4) noise.
The company decided to introduce 2 motors that are variations
on the current motors, representing different combinations of the
four attributes. Possible alterations on these models can be
implemented upon customer demand.
Following are various estimates pertaining to the two proposed
motors.

12-19
Solution to example – 2:
Motor A Motor B
Estimated sales in units (over entire life of motor) 70,000 95,000
Average estimated selling price $6,000 $4,000
Target profit margin per unit (15%, 12% on sales) 900 480
Preliminary target cost per unit 5,100 3,520
Estimated unit cost $6,300 $4,570
Cost gap per unit $1,200 $1,050

12-20
In view of the identified cost gap, the following efforts were made:
 Value and (reverse engineering - - alternative designs were
developed with the elimination of some unnecessary and non-value
added functions. This resulted in the following savings and cost
reduction:
Motor A Motor B
Direct materials 200 150
Parts & components 400 250
Assembly & rework labor 150 38
total $750 $438

12-21
Revised calculations follow:
1 (6,300-850)
2 (4,570-438)
Motor A Motor B
Estimated unit cost $5,550(1) $4,1322)
Cost gap per unit $450 $612

12-22
 Functional analysis - - since the cost reductions from value
engineering were not sufficient to close the cost gap, functional
analysis was undertaken. The result was alterations in the four
product attributes (power, fuel consumption, weight, and noise). This
resulted in changes in costs and target prices, as follows:
Motor A Motor B
Change in price +100 -
Direct materials 50 80
Assembly & handling 150 120
Total cost reduction $200 $200

12-23
Revised calculations after functional analysis
Motor A Motor B
Estimated unit cost $5,350 $3,932
Cost gap per unit $150 $412

12-24
 Re-engineering - - cost gap still exists, re-engineering is another type of
analysis to close the gap. This analysis examines process design including
considering alterations in assembling motors. With collaboration of suppliers,
the company adopted the JIT system and eliminated non-value added
activities which resulted in significant reduction in all manufacturing activities.
The result is a reduction of the cost per unit as indicated in the following
table:
Motor A Motor B
Assembly & testing 90 150
Setup 80 200
Handling and movement 60 80
Total $230 $430

12-25
Motor A Motor B
Estimated sales in units (over entire life of
motor)
70,000 95,000
Target profit margin per unit (15%, 12%
on sales)
900 480
target cost per unit $ 5,200 $3,520
Estimated unit cost $5,120(1) $3,502(2)
Excess profit above the targetedper unit $80 $18
(1) 5,350 – 230 =5,120
(2) 3,932 – 430 = 3,502

12-26
Problems with Value Engineering and
Target Costing
1. Employees may feel frustrated if they fail to attain
targets
2. A cross-functional team may add too many features
just to accommodate the wishes of team members
3. A product may be in development for a long time as
alternative designs are repeatedly evaluated
4. Organizational conflicts may develop as the burden
of cutting costs falls unequally on different business
functions in the firm’s value chain

12-27
Cost-Based (Cost-Plus) Pricing
 The general formula adds a markup
component to the cost base to determine a
prospective selling price
 Usually only a starting point in the price-
setting process
 Markup is somewhat flexible, based partially
on customers and competitors

12-28
Forms of Cost-Plus Pricing
 Setting a Target Rate of Return on Investment: the
Target Annual Operating Return that an organization
aims to achieve, divided by Invested Capital
 Selecting different cost bases for the “cost-plus”
calculation:
 Variable Manufacturing Cost
 Variable Cost
 Manufacturing Cost
 Full Cost

12-29
Common Business Practice
 Most firms use full cost for their cost-based
pricing decisions, because it
 allows for full recovery of all costs of the
product
 allows for price stability
 is a simple approach

12-30
Life-Cycle Product
Budgeting and Costing
 Product Life-Cycle spans the time from initial
R&D on a product to when customer service
and support are no longer offered on that
product (orphaned)

12-31
Life-Cycle Product
Budgeting and Costing
 Life-Cycle Budgeting involves estimating the
revenues and individual value-chain costs
attributable to each product from its initial
R&D to its final customer service and support
 Life-Cycle Costing tracks and accumulates
individual value-chain costs attributable to
each product from its initial R&D to its final
customer service and support

12-32
Important Considerations for
Life-Cycle Budgeting
 Nonproduction costs are large
 Development period for R&D and design is
long and costly
 Many costs are locked-in at the R&D and
design stages, even if R&D and design costs
are themselves small

12-33
Other Important Considerations in
Pricing Decisions
 Price Discrimination – the practice of
charging different customers different prices
for the same product or service
 Legal implications
 Peak-Load Pricing – the practice of charging
a higher price for the same product or service
when the demand for it approaches the
physical limit of the capacity to produce that
product or service

12-34
The Legal Dimension of
Price Setting
 Price Discrimination is illegal if the intent is to
lessen or prevent competition for customers
 Predatory Pricing – deliberately lowering
prices below costs in an effort to drive
competitors out of the market and restrict
supply, and then raising prices

12-35
The Legal Dimension of
Price Setting
 Dumping – a non-US firm sells a product in the US 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 US
 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

12-36
End of chapter

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