Cost Information for Pricing and Product Planning

2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Cost Informationfor

Pricingand

Product Planning

Chapter 6


6-2

Role Of Product Costs In Pricing And Product Mix Decisions

• Understanding how to analyze product costs is important for making pricing decisions:– At most firms whose managers make decisions about

establishing or accepting a price for their products, managers need to make decisions about, for example, whether they should offer discounts for large orders or to valued customers

– Even when prices are set by overall market supply and demand forces and the firm has little or no influence on product prices, management still has to decide the best mix of products to manufacture and sell


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Role of Product Costs

• Product cost analysis is also significant when a firm is deciding how best to deploy marketing and promotion resources– How much commission (or how many other

incentives) to provide the sales force for different products

– How large a discount to offer off list prices

• This chapter examines some of the more traditional methods of pricing and considers short- and long-run factors


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Short-term and Long-termPricing Considerations (1 of 3)

• Managers must consider both the short-term and long-term consequences of their decisions

• The costs of many resources committed to activities are likely to be committed costs in the short-term because firms cannot easily alter the capacities made available for many production and support activities– So for short-term decisions, it is important to pay

special attention to whether surplus capacity is available for additional production, or whether shortages of available capacity limit additional production alternatives


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• Of special concern when evaluating a particular order is how long a firm must commit its production capacity to fill that order

• The length of time is relevant because a long-term capacity commitment to a marginally profitable order may:– Prevent the firm from deploying its capacity for more

profitable products or orders, should demand for them arise in the future

– Force the firm to add expensive new capacity to handle future sales increases


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• If production is constrained by inadequate capacity, managers need to consider whether overtime production or the use of subcontractors can help augment capacity in the short term

• In the long term, managers have considerably more flexibility to adjust the capacities of activity resources to match the demand for them in producing various products

• Decisions about whether to introduce new products or eliminate existing products have long-term consequences– The emphasis is, therefore, on analyzing how such

product decisions will affect the demand placed on the firms capacity resources


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Ability To Influence Prices (1 of 2)

• We also classify decisions based on whether the firm can influence the price of its products– If the firm is one of a large number of firms in an

industry, and if there is little to distinguish the products of different firms from each other:• Economic theory states that prices will be set by the aggregate

market forces of supply and demand• No single firm can influence prices significantly by its own

decisions• The result will be similar if prices are set by one or more large

firms leading an industry, while a smaller firm on the fringe must match the prices set by the industry leaders

– Such a firm is a price taker, and it chooses its product mix given the prices set in the marketplace for its products


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Ability To Influence Prices (2 of 2)

– In contrast, firms in an industry with relatively little competition, who enjoy large market shares and exercise leadership in an industry, must decide what prices to set for their products

– Firms in industries in which products are highly customized or otherwise differentiated from each other (because of special features, characteristics, or customer service) also need to set the prices for their differentiated products

– Such firms are price setters; they announce their prices, customers place orders, and production follows


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Price Takers• A small firm, or a firm with a negligible market share in this

industry, behaves as a price taker– It takes the industry prices for its products as given and then

decides how many units of each product it should produce and sell– If the small firm demands a higher price for any of its products, it

risks losing its customers to other competing firms in the industry, unless it can successfully differentiate its products by offering special features or services

– Conversely, if the small firm seeks to increase its market share by asking a price lower than the industry prices, then it risks a price war that would make the firm, and the entire industry, worse off than if the firm had complied with industry prices• This action is most painful to smaller firms that have fewer

resources to rely on should an unprofitable price war occur


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Short-Term Decisions for Price Takers• A price taker should produce and sell as much as it can

of all products whose costs are less than industry prices• Although this may appear to be a simple decision rule,

two important considerations complicate matters– First, managers must decide which costs are relevant to the

short-term product mix decision• Should all the product costs identified in Chapter 3 be

considered?• Should only those costs that vary in the short term be

considered?– Second, in the short-term, managers may have little flexibility to

alter the capacities of some of the firm’s resources• The available equipment capacity may limit the ability of a

firm to produce and sell more products whose costs are lower than their prices


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Garment Manufacturer (1 of 3)

• Consider a company that sells five types of ready-made garments to discount stores such as Kmart and Wal-Mart

• The company is operating at full capacity and is contemplating short-term adjustments to its product mix

• It is necessary for the company to determine:– What costs will vary with production levels in this period– What costs will remain fixed when a change occurs in the

production mix

• The costs of utilities, plant administration, maintenance, and depreciation for the machinery and plant facility will not alter with a change in the product mix, because the plant is operating at full capacity


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• Varying with the quantity of each garment produced are:– The costs of direct materials– The direct labor that is paid on a piece-rate basis

• Inspectors are paid a monthly fixed salary, but they are employed as required to support the production of different garments– If production increases, the company may have to hire

more inspectors– Therefore, inspection labor costs also vary with quantity

of production of different garments


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• If its capacity were unlimited, the company could produce garments to fill the maximum demand for them

• Capacity is constrained, however, and therefore the company must decide how best to deploy this limited resource

• The capacity is fixed in the short-term, so the company must plan production to maximize the contribution to profit earned for every available machine hour used– Therefore, the company should rank-order the products by their

contribution per machine hour• Not by their contribution per unit

– Contribution per machine hour is obtained by dividing the contribution per unit by the number of machine hours per unit


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The Impact Of Opportunity Costs (1 of 2)

• If the garment manufacturer receives a special order request, it would have to decide the minimum price it would accept

• Its out-of-pocket costs will increase in the short-term by the amount of flexible costs required for the order, but a simple comparison of the price with flexible costs is not adequate for this decision

• Because its production capacity is limited, the company must cut back the production of some other garment to enable it to produce the goods for the special order

• Giving up the production of some profitable product results in an opportunity cost, which equals the lost profit on the garments that the company can no longer make


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The Impact Of Opportunity Costs (2 of 2)

• The lost profit in this case would be the contribution on the goods it will not make

• In deciding which products to take off of the production schedule, the company should once again look at the contribution per machine hour

• The product with the lowest contribution per hour should be sacrificed

• The profit (contribution) lost on those products would need to be covered by the price of the special order


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Short-Term Pricing Decisionsfor Price Setters

• In many businesses, potential customers request that suppliers bid a price for an order before they decide on the supplier with whom they will place the order

• In this section, we examine the relationship between costs and prices bid by a supplier for special orders that do not involve long-term relationships with the customer

• For example, we will use a tool and die company that manufactures customized steel tools and dies for a wide variety of manufacturing businesses

• A new customer has asked for a bid on a set of customized tools


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Determining a Bid Price (1 of 3)

• Based on the tool design, production engineers determine the routing through different production departments and estimate the quantity of different materials required for the order and the number of labor hours required in each department

• This information is used to prepare a job bid sheet as described in Chapter 3

• Then the company uses this information, and materials prices and labor wage rates, to estimate the direct materials and direct labor costs

• Support activity costs are assigned to the job based on activity cost drivers and the corresponding activity cost driver rates as described in Chapter 4


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• Assume that the full costs for the job are estimated to be $28,500 consisting of:– $ 8,400 of direct materials– $ 9,900 of direct labor– $10,200 of support activity costs, consisting of:

• $ 3,400 of Supervision• $ 3,700 of batch related expenses• $ 3,100 of business sustaining expenses

• Setting the price of a product also means determining a markup percentage above cost, an approach known as cost-plus pricing– The markup percentage is determined by a company’s desired

profit margin and overall rate of return– The company has decided the markup percentage is normally to

be 40% of full costs


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• If the bid request came from a regular customer, the bid price would have been $39,900= 1.40 x $28,500

• But for this special order from a new customer, what is the minimum acceptable price?

• One of the critical factors to consider is the level of available capacity

• The example looks at two cases:– There is surplus machine capacity available in the short term to

complete the production of the job– Existing demand for the company’s services already uses all

available capacity and the only way to manufacture the customized tools for the special order is by working overtime or adding an extra shift


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Available Surplus Capacity• The company’s incremental costs of filling the order will be

$ 22,000 (material, direct labor, batch related expenses)• The costs of supervision and business-sustaining support

activities will not increase if excess capacity of these resources is available to meet the production needs of the order

• The price that the company should bid must cover the incremental costs for the job to be profitable– In other words, the minimum acceptable price is $22,000 since

surplus production capacity is available• This is the price at which the company will break even on

the order• The company would likely add a profit margin above

incremental costs and make the bid price something higher than $22,000, depending on competitive and demand conditions


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No Available Surplus Capacity (1 of 3)

• If surplus machine capacity is not available, the company will have to incur additional costs to acquire the needed capacity

• Companies often meet such short-term capacity requirements by operating its plant overtime– Paying its supervisors overtime wages– Incurring additional expenditures for heating, lighting,

cleaning, and security

• More machine maintenance and plant engineering activities will be necessary– Experience has shown that the incidence of machine

breakdowns increases during the overtime shift


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• Under its machinery leasing contract, the company also incurs additional rental costs for the extra use of machines when it adds an overtime shift

• Assume management estimates the order would cause:– $5,100 of incremental supervision costs (including

overtime premium)– $5,400 of incremental business-sustaining costs

• Thus, the total cost of overtime required to manufacture customized tools for the order is $10,500 ($5100 + $5400)


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• Therefore, the minimum acceptable price in this case is $32,500 ($22,000 + $10,500)– The actual price will depend on the amount of markup

charged over the incremental costs

• The principle illustrated here is the same as that described in the previous case: the minimum acceptable price must cover all incremental costs– When the firm must acquire additional capacity to

satisfy the order, there are more incremental costs involved in the decision to accept or reject the order


6-24

Long-Term Pricing Decisionsfor Price Setters

• You may have noticed that the relevant costs for the short-term special order pricing decision differ from the full costs of the job

• Most firms rely on full-cost information reports when setting prices– Typically, the accounting department provides cost

reports to the marketing department, which then adds appropriate markups to the costs to determine benchmark or target prices for all products normally sold by the firm


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Use of Full Costs in Pricing (1 of 3)

• There is economic justification for using full costs for pricing decisions in three types of circumstances:1. Many contracts for the development and production

of customized products and many contracts with governmental agencies specify that prices should equal full costs plus a markup, and prices set in regulated industries are based on full costs

2. When a firm enters into a long-term contractual relationship with a customer to supply a product, it has great flexibility in adjusting the level of commitment for all resources


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• Most activity costs will depend on the production decisions under the long-term contract, and full costs are relevant for the long-term pricing decision

3. In many industries, firms make short-term adjustments in prices, often by offering discounts from list prices instead of rigidly employing a fixed price based on full costs

• When demand for their products is low, the firms recognize the greater likelihood of surplus capacity in the short term


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• They adjust the prices of their products downward to acquire additional business based on the lower incremental costs they incur when surplus capacity is available

• When demand for their products is high, they recognize the greater likelihood that the existing capacity of activity resources is inadequate to satisfy all of the demand

• They adjust the prices upward based on the higher incremental costs they incur when capacity is fully utilize, thereby rationing the available capacity to the highest profit opportunity


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Fluctuating Prices (1 of 2)

• Because demand conditions fluctuate over time, prices also fluctuate with demand conditions over time– Most hotels offer special weekend rates that are

considerably lower than their weekday rates– Many amusement parks offer lower prices on

weekdays when demand is expected to be low– Airfares between New York and London are higher in

summer, when the demand is higher, than in winter, when the demand is lower

– Long-distance telephone rates are lower in the evenings and on the weekends when the demand is lower


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Fluctuating Prices (2 of 2)

• Although fluctuating short-term prices are based on the appropriate incremental costs, over the long term their average tends to equal the price based on the full costs that will be recovered in a long-term contract

• In other words, the price determined by adding on a markup to the full costs of a product serves as a benchmark or target price from which the firm can adjust prices up or down depending on demand conditions

• Most firms use full cost-based prices as target prices, giving sales managers limited authority to modify prices as required by the prevailing competitive conditions


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The Markup Rate (1 of 2)

• Just as prices depend on demand conditions, markups increase with the strength of demand– If more customers demand more of a product, then the firm is

able to command a higher markup

• Markups also depend on the elasticity of demand– Demand is said to be elastic if customers are very sensitive to

the price, that is, if a small increase in the price results in a large decrease in the demand

– Markups are smaller when demand is more elastic

• Markups also fluctuate with the intensity of competition– If competition is intense, it is more difficult for a firm to sustain a

price much higher than its incremental costs


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The Markup Rate (2 of 2)

• Firms decide on markups for strategic reasons:– A firm may choose a low markup for a new product to

penetrate the market and win over market share from an established product of a competing firm

– Many internet businesses have adopted the strategy of setting low prices to build the business, acquire a brand name, build a loyal customer base, and garner market share

– In contrast to this penetration pricing strategy, firms sometimes employ a skimming price strategy, as in the audio and video equipment industry, where initially a higher price is charged to customers who are willing to pay more for the privilege of possessing the latest technological innovations


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Long-Term Decisions for Price Takers• Decisions to add a new product or to drop an existing

product from the portfolio of products usually have significant long-term implications for a firm’s cost structure

• Product-sustaining costs are relevant costs for such decisions– Product design and engineering, vendor and purchasing costs,

part maintenance, and dedicated sales force costs

• Batch-related costs are also likely to alter if a change occurs in the product mix either in favor of or against products manufactured in large batches– Setups, materials handling, and first-item inspections


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Use of Full Costs (1 of 3)

• Bear in mind that managers cannot easily change the amount of resources committed for many product-sustaining and several batch-related activities in the short run

• The cost consequences of either introducing a new product or deleting an existing product evolve over time– Both decisions require careful implementation plans

stretching over several periods


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• As a result, managers use the full costs of products, including the cost of using various resources to produce and sustain the product– Such resources include the number of setup staff, the

number of product and process engineers, and the number of quality inspectors

• Managers use the costs of all resources in their product-related decisions, because in the long-term, the firm is able to adjust the capacity of activity resources to match the resource levels demanded by the product quantities and mix


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• Comparing product costs with their market prices reveals which products are not profitable in the long-term– Over the long-term, firms can adjust activity resource

capacities to match production requirements• If some products have full costs that exceed the market

price, the firm must consider several options– Although dropping these products appears is to be an

obvious option, customers may expect the company to maintain a full product line

– But a comparison of the prices with costs still provides a valuable signal to managers because it indicates the net cost of the strategy to offer a full product line


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Options if Full Cost > Price (1 of 2)

• Managers may consider options other than dropping the product– Reengineering or redesigning unprofitable products, to

eliminate or reduce costly activities and bring their costs in line with market prices

– For example, they could improve the production processes to reduce setup times and streamline material and product flows

• They may want to explore market conditions more carefully and differentiate their products further to raise prices and bring them in line with the costs


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Options if Full Cost > Price (2 of 2)

• Firms may offer customers incentives, such as quantity discounts, to increase order sizes and thereby reduce total batch-related costs

• If these steps fail, and if the marketing strategy of offering such a full product line cannot justify the high net cost of such products, then managers must consider a plan to phase out the products from their line– Customers also need to be shifted to substitute

products still retained in the company’s product line


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Profit Increase is Not Automatic• Dropping products will help improve profitability

only if the managers:1. Eliminate the activity resources no longer required to

support the discontinued product, or2. Redeploy the resources from the eliminated products

to produce more of the profitable products that the firm continues to offer

• Costs result from commitments to supply activity resources– They do not disappear automatically with the

dropping of unprofitable products– Only when companies eliminate or redeploy the

resources themselves will actual expenses decrease


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Summary• Managers use cost information to assist them in pricing and

in product mix decisions• The manner in which they use cost information in making

these decisions depend on whether the firm is a major or minor entity in its industry– A major entity would be able to influence the setting of prices– A minor entity would take the industry prices as given and adjust its

product mix in response to the prices it could charge

• The role of cost information also depends on the time frame involved in the decision– Business-sustaining costs are frequently relevant for long-term

decisions, but less often for short-term decisions– Short-term prices are based on incremental costs that depend on

the availability of activity resource capacity


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Economic Analysis of the Pricing Decision

Appendix 6-1


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Quantity Decision (1 of 2)

• Introductory textbooks in economics usually analyze the profit maximization decision by a firm in terms of the choice of a quantity to produce. In turn, the quantity choice determines the price of the product in the marketplace

• Economists present the quantity choice in terms of equating marginal revenue and marginal cost– Marginal revenue is defined as the increase in revenue

corresponding to a unit increase in the quantity produced and sold– Marginal cost is the increase in cost for a unit increase in the

quantity produced and sold– If marginal revenue is greater than marginal cost, then increasing

the quantity by one unit will increase profit– If marginal revenue is less than the marginal cost, then it is

possible to increase profit by decreasing production


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Quantity Decision (2 of 2)

• In this analysis, the firm chooses the quantity level, and the market demand conditions determine the corresponding price

• Considered next a firm that must choose a price, not a quantity, to announce to its customers

• Customers then react to the price announced and determine the quantity that they demand

• The price decision analysis uses differential calculus to analyze the firm’s pricing decision


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Pricing Decision (1 of 3)

• Total costs, C, expressed in terms of its fixed and flexible cost components are: C = f + vQ,– Where f is the committed cost, v is the flexible cost per

unit, and Q is the quantity produced in units• Quantity produced is assumed to be the same as quantity

demanded• The demand, Q, is represented as a decreasing linear

function of the price P: Q = a – bP• In general, we may have nonlinear demand functions, but

the linear form provides a convenient characterization for our analysis

• A higher value of b represents a demand function that is more sensitive (elastic) to price


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– An increase of a dollar in the price decreases demand by b units

• A higher value of a reflects a greater strength of demand for the firm’s product. For any given price, P, the demand is greater when the parameter, a, has a higher value

• The total revenue, R, is given by the price, P, multiplied by the quantity sold, Q. Algebraically, we write this:

R = PQ = P(a – bP)

= aP – bP2• The profit, Π, is measured as the difference between the

revenue, R, and the cost, C:


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Π = R - C

= PQ - (f + vQ)

= P(a - bP) - F - v(a - bP)

= aP - bP2 - F - va + vbP • To find the profit-maximizing price, P*, we set the first

derivative of profit P with respect to P equal to zero:

dΠ /dP = A – 2bP + vb = 0• This equation implies:

P* = (a + vb)/2b = a/2b + v/2


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Long-Term Benchmark Prices (1 of 2)

• This simple economic analysis suggests that the price depends only on v, the flexible cost per unit– Committed costs are not relevant for the pricing decision

• A more complex analysis that considers simultaneously the pricing decision and the long-term decisions of the firm to commit resources to facility-sustaining, product-sustaining, and other activity capacities indicates that the costs of these committed resources do play a role in the pricing decision

• The costs of these committed activity resources appear to be committed costs in the short-term, but they can be changed in the long-term


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Long-Term Benchmark Prices (2 of 2)

• The prices that a firm sets and adjusts in the short term, based on changing demand conditions, fluctuate around a long-term benchmark price, pL, that reflects the unit costs of the activity resource capacities:

pL = a/2b + (v + m)/2• Here m = f ÷ X is the cost per unit of normal capacity, X,

of facility-sustaining activities• In this case, the degree of price fluctuations around the

benchmark price increases with the proportion of committed costs

• As a result, prices appear more volatile in capital-intensive industries where a large proportion of costs are for facility-sustaining activities– E.g., airlines, hotels, and petroleum refining


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Competitive Analysis (1 of 3)

• In a situation when other firms compete in the same industry with products that are similar but not identical to each other, some customers may switch their demand to a competing supplier if the competitor reduces its price

• Therefore, a firm’s pricing decision must consider the prices that may be set by its competitors

• Consider two firms, A and B, and represent the demand, QA, for firm A’s product as a function of its own price, PA, and the price, PB, set by its competitor:

QA = a – b PA + e PB

• The demand for firm A’s product falls by b units for each dollar increase in its own price, but increases by e units for each dollar increase in the competitor’s price, because firm A gains some of the market demand that firm B loses


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• The profit, PA, for firm A is represented by the following:

Π A = PA QA - (f + v QA)

Π PA(a - b PA + e PB) - f - v(a - b PA + e PB)

• Profit maximization requires this:d π A ÷ d PA = a - 2b PA + e PB + vb = 0

• Therefore, the profit-maximizing price PA0 given

the other firm’s price PB is:PA

0 = (a + vb + e PB) ÷ 2b

• The pricing decision thus depends on what the competitor’s price is expected to be


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• If the firm expects its competitor to behave as it does and expects it to choose the same price as its own, then we set PA = PB = P* in the equation

a - 2b PA 1 + e PB + vb = 0 to obtain:

a - 2bP* + eP* + vb = 0

P* = a + vb/2b - e• We refer to this price as the equilibrium price, because

no firm can increase its profits by choosing a different price provided the other firm maintains the same price P*

• This analysis is based on a concept called Nash equilibrium, for which its discoverer, John Nash, won the 1994 Nobel Prize in economics.


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Terry M. Lease([email protected])Sonoma State University

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Cost Information for Pricing and Product Planning