This document discusses various pricing concepts and profitability analysis techniques. It covers determining pricing using cost-plus pricing or target costing. It also discusses measuring profit using absorption costing and variable costing. Finally, it examines analyzing variances in sales price, volume, contribution margin, and market share to evaluate profitability. The overall document provides an overview of different pricing strategies and profitability analysis methods used by companies.

1. COST MANAGEMENT
Accounting & Control
Hansen▪Mowen▪Guan
COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning.
Cengage Learning and South-Western are trademarks used herein under license.
1
Chapter 19
Pricing and Profitability
Analysis

2. 2
Study Objectives
1. Discuss basic pricing concepts.
2. Calculate a markup on cost and a target cost.
3. Discuss the impact of the legal system and ethics on
pricing.
4. Calculate measures of profit using absorption and
variable costing.
5. Determine the profitability of segments.
6. Compute the sales price, price volume, contribution
margin, contribution margin volume, sales mix, market
share, and market size variances.
7. Describe some of the limitations of profit measurement.

3. 3
Basic Pricing Concepts
Market Structure and Price
• Perfect Competition: Many buyers and
sellers; no one of which is large enough to
influence the market.
• Monopolistic Competition: Has both the
characteristics of both monopoly and
perfect competition.
• Oligopoly: Few sellers.
• Monopoly: Barriers to entry are so high
that there is only one firm in the market.

4. 4
Market Structure and Price

5. 5
Pricing Policies
• Cost-based pricing
– Established using “cost plus markup”
• Target costing and pricing
– Determine the cost of a product or service
based on the price (target price) that
customers are willing to pay
– Effectively used in conjunction with marketing
decisions
• Penetration pricing
• Price skimming

6. 6
Cost-Plus Pricing
AudioPro Company sells and installs audio
equipment in homes, cars, and trucks.
AudioPro’s income statement for last year is as
follows:
Revenues $350,350
Cost of goods sold:
Direct materials $122,500
Direct labor 73,500
Overhead 49,000 245,000
Gross profit $105,350
Selling and administrative expenses 25,000
Operating income $ 80,350
Pricing Policies

7. 7
The firm wants to earn the same amount of profit on each
job as was earned last year:
Markup on COGS = (Selling and administrative expenses
+ Operating income) ÷ COGS
Markup on COGS = ($25,000 + $80,350) ÷ $245,000
Markup on COGS = 0.43 or 43%
Cost-Plus Pricing
Pricing Policies

8. 8
The markup can be calculated using a variety of bases.
The calculation for markup on direct materials is as follows:
Markup on DM = (Direct labor + Overhead + Selling and
administrative expense + Operating
income) ÷ Direct materials
Markup on DM = ($73,500 + $49,000 + $25,000 +
$80,350) ÷ $122,500
Markup on DM = 1.86 or 186%
Cost-Plus Pricing
Pricing Policies

9. 9
AudioPro wants to expand the company’s product line to
include automobile alarm systems and electronic car door
openers. The cost for the sale and installation of one
electronic remote car door opener is as follows:
Direct materials (component and two remote controls) $ 40.00
Direct labor (2.5 hours x $12) 30.00
Overhead (65% of direct labor cost) 19.50
Estimated cost of one job $ 89.50
Plus 43% markup on COGS 38.49
Bid price $127.99
Cost-Plus Pricing
Pricing Policies

10. 10
Target Costing and Pricing
Pricing Policies
• Determine the cost of a product or service based on the
price that the customers are willing to pay.
Direct materials (component and two remotes) $ 40.00
Include one remote instead of two
$35.00
Direct labor (2.5 hours x $12) 30.00
Train workers to reduce time (2 hours x $12)
24.00
Overhead (65% of direct labor cost) 19.50
Reduce overhead (50% of direct labor cost)
12.00
Estimated cost of one job $ 89.50
Revised cost of one job $
Other installers price the remote car door opener at $110.
Possible actions:
Bid price is now
competitive; markup
preserved

11. 11
The Legal System and Pricing
• Predatory pricing
– The practice of setting prices below cost for
the purpose of injuring competitors and
eliminating competition
• Dumping
– Predatory pricing on the international market
– Companies sell below cost in other countries;
the domestic industry is injured.

12. 12
The Legal System and Pricing
• Price discrimination
– Charging different prices to different
customers for essentially the same product.
– Robinson-Patman Act of 1936 prohibits
• Manufacturers or suppliers are covered by the act
• Price discrimination is allowed if
– If the competitive situation demands it and
– If costs (including costs of manufacture, sale, or delivery)
can justify the lower price

13. 13
Cobalt, Inc. manufactures vitamin supplements that costs
an average of $163 per case. Cobalt sold 250,000 cases
last year as follows:
Customer Price per Case Cases Sold
Large drug store chain $200
125,000
Small local pharmacies 232
100,000
Individual health clubs 250
25,000
Cobalt is practicing price discrimination … is
it justifiable?
The Legal System and Pricing

14. 14
The Legal System and Pricing
$200 $178.40
10.8%
$200
−
=
$232 $208.52
10.1%
$232
−
=
$250 $222
11.2%
$250
−
=
Profits vary within a narrow 1 percent range. The cost differences
among the three classes of customer appear to explain the price differences.

15. 15
Measuring Profit
Absorption Costing
– Also referred to as full costing
– Required for external financial reporting
– Assigns all manufacturing costs, direct
materials, direct labor, variable overhead, and
a share of fixed overhead to each unit of
product
– Each unit of product absorbs some of the
fixed manufacturing overhead in addition to
the variable costs incurred to manufacture it.

16. 16
Lasersave, Inc., a company that recycles used toner
cartridges for laser printers. During August the firm
manufactured 1,000 cartridges at the following costs:
Direct materials $ 5,000
Direct labor 15,000
Variable overhead 3,000
Fixed overhead 20,000
Total manufacturing cost $43,000
During August, these cartridges were sold at $60
each. Variable marketing cost was $1.25 per unit.
Fixed expenses were $12,000.
Absorption-Costing
Measuring Profit

17. 17
Measuring Profit
Absorption-Costing
*Direct materials ($5 x 1,000) $ 5,000
Direct labor ($15 x 1,000) 15,000
Variable overhead ($3 x 1,000) 3,000
Fixed overhead 20,000
Total manufacturing overhead
and cost of goods sold $43,000
1,000 units produced; 1,000 units sold

18. 18
*Direct materials ($5 x 1,250) $ 6,250
Direct labor ($15 x 1,250) 18,750
Variable overhead ($3 x 1,250) 3,750
Fixed overhead ($16 per unit) 20,000
Total manufacturing overhead $48,750
Add: Beginning inventory 0
Less: Ending inventory (9,750)
Cost of goods sold $39,000
Measuring Profit
Absorption-Costing
Production exceeded sales by 250
units; fixed overhead of $16 per unit is
carried in inventory thus reducing cost
of goods sold and increasing net
income
1,250 units produced; 1,000 units sold

19. 19
Measuring Profit
Variable-costing
• Also referred to as direct costing
• Assigns only unit-level variable
manufacturing costs to the product
– Direct materials
– Direct labor
– Variable overhead
• Fixed overhead is treated as a period cost

20. 20
*Direct materials $ 5,000
Direct labor 15,000
Variable overhead 3,000
Total variable manufacturing expenses $23,000
Add: Variable marketing expenses 1,250
Total variable expenses $24,250
Measuring Profit

21. 21
Measuring Profit
*1,300 × $39 = $50,700

22. 22
Measuring Profit

23. 23
Alden Company manufactures two products: basic
fax machines and multi-function fax machines. The
multi-function fax uses more advanced technology;
therefore, it is more expensive to manufacture.
Profit by Product Line
Basic Multi-Function
Number of units 20,000 10,000
Direct labor hours 40,000 15,000
Price $200 $350
Prime cost per unit $55 $95
Overhead per unit $30 $22.50
Profitability of Segments

24. 24
Profitability of Segments
Profit by Product Line

25. 25
Profitability of Segments
Profit by Product Line

26. 26
Profitability of Segments
Profit by Product Line

27. 27
Profitability of Segments
Profit by Product Line

28. 28
Alpha Beta Gamma Delta Total
Sales $ 90 $ 60 $ 30 $120 $300
Cost of goods sold 35 20 11 98 164
Gross profit $ 55 $ 40 $ 19 $ 22 $136
Division expenses -20 -10 -15 -20 -65
Corporate expenses -3 -2 -1 -4 -10
Operating income
(loss) $ 32 $ 28 $ 3 $ -2 $ 61
Profitability of Segments
Divisional Profit

29. 29
Profitability of Segments
Customer profitability
• Companies that assess the profitability of
various customer groups can more
accurately target their markets and
increase profits.
1) Identify the customer
2) Determine which customers add value to the
company

30. 30
Analysis of Profit-Related
Variances
Overall Sales Variance
[actual vs. expected revenue]
Sales Price Variance Price Volume Variance

31. 31
Analysis of Profit-Related
Variances
( )Sales price Actual Expected Quantity= -
variance price price sold
×
( )Price volume Actual Expected Expected= -
variance volume volume price
×
The sales price and price volume variances are labeled favorable if
the variance increases profit above the amount expected. They are
labeled unfavorable if the variance decreases profit below the amount
expected.

32. 32
Analysis of Profit-Related
Variances
Contribution Margin Variance
[actual vs. expected contribution margin]
Sales Mix Variance
Contribution Margin
Volume Variance

33. 33
Analysis of Profit-Related
Variances
( ) ( )
( ) ( )
P1 actual units P1 budgeted CM
- P1 budgeted units - Budgeted average unit CM
P2 actual units P2 budgeted CM+
- P2 budgeted units - Budgeted average unit CM
×
×
Sales Mix Variance =
The sales mix variance is favorable if the sales mix is weighted to the
more profitable products.
BudgetedContribution Actual Budgeted
average unitmargin volume = quantity - quantity
contributionvariance sold sold
margin
 
 ÷ ×
 ÷
 
The contribution margin volume variance gives management information
about gained or lost profit due to changes in the quantity of sales.

34. 34
Analysis of Profit-Related
Variances

35. 35
Analysis of Profit-Related
Variances
contribution margin variance
$14,375 − $13,500
= $875 favorable
sales mix
variance
contribution margin
volume variance
(2,000 − 1,875) × $6.75
= $1,718.75 favorable = $843.75 unfavorable
( ) ( )
( ) ( )
1,250 $4.00
- 1,500 - $6.75
625 $15.00+
- 500 - $6.75
×
×
Birdwell, Inc.:

36. 36
Analysis of Profit-Related
Variances
Actual BudgetedActual Budgeted
industry averagemarket share - market share
sales unitpercentage percentage
in units CM
 
 ÷ × ×
 ÷
 
Market share variance =
Budgeted BudgetedActual Budgeted
market averageindustry sales - industry sales
share unitin units in units
percentage CM
 
 ÷ × ×
 ÷
 
Market size variance =

37. 37
Limitations of Profit Measurement
• Limitations of profitability analysis
– Focus on past performance
– Emphasis on quantifiable measures
– Impact on behavior
• Successful firms measure far more than
accounting profit.

38. COST MANAGEMENT
Accounting & Control
Hansen▪Mowen▪Guan
COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning.
Cengage Learning and South-Western are trademarks used herein under license.
38
End Chapter 19