COST MANAGEMENT

Accounting & Control

HansenMowenGuan

Chapter 19
Pricing and Profitability
Analysis
COPYRIGHT 2009 South-Western Publishing, a division of Cengage Learning.
Cengage Learning and South-Western are trademarks used herein under license.

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.
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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.

Market Structure and Price

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
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Pricing Policies
Cost-Plus Pricing
AudioPro Company sells and installs audio
equipment in homes, cars, and trucks.
AudioPros income statement for last year is as
follows:
Revenues
Cost of goods sold:
Direct materials
Direct labor
Overhead
Gross profit
Selling and administrative expenses
Operating income

$350,350
$122,500
73,500
49,000

245,000
$105,350
25,000
$ 80,350
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Pricing Policies
Cost-Plus Pricing
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%

Pricing Policies
Cost-Plus Pricing
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%

Pricing Policies
Cost-Plus Pricing
AudioPro wants to expand the companys 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)
Direct labor (2.5 hours x $12)
Overhead (65% of direct labor cost)
Estimated cost of one job
Plus 43% markup on COGS
Bid price

$ 40.00
30.00
19.50
$ 89.50
38.49
$127.99

Pricing Policies
Target Costing and Pricing

Determine the cost of a product or service based on the

price that the customers are willing to pay.
Other installers price the remote car door opener at $110.
Possible actions:
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)
Bid price is 19.50
now
Reduce overhead (50% of direct labor
cost) markup
competitive;
12.00
preserved
Estimated cost of one job
$ 89.50
Revised cost of one job

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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.
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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

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The Legal System and Pricing

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?
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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.

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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.
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Measuring Profit
Absorption-Costing
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
Direct labor
Variable overhead
Fixed overhead
Total manufacturing cost

$ 5,000
15,000
3,000
20,000
$43,000

During August, these cartridges were sold at $60

each. Variable marketing cost was $1.25 per unit.
Fixed expenses were $12,000.

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Measuring Profit
Absorption-Costing

1,000 units produced; 1,000 units sold

*Direct materials ($5 x 1,000) $ 5,000

Direct labor ($15 x 1,000)

15,000

Variable overhead ($3 x 1,000)

Fixed overhead

3,000
20,000

Total manufacturing overhead

and cost of goods sold

$43,000

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Measuring Profit
Absorption-Costing
1,250 units produced; 1,000 units sold

*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
Less: Ending inventory
Cost of goods sold

0
(9,750)
$39,000

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
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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

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Measuring Profit

*Direct materials

$ 5,000

Direct labor

15,000

Variable overhead
Total variable manufacturing expenses
Add: Variable marketing expenses
Total variable expenses

3,000
$23,000
1,250
$24,250

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Measuring Profit

*1,300 $39 = $50,700

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Measuring Profit

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Profitability of Segments
Profit by Product Line
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.
Basic
Number of units
Direct labor hours
Price
Prime cost per unit
Overhead per unit

20,000
40,000
$200
$55
$30

Multi-Function
10,000
15,000
$350
$95
$22.50

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Profitability of Segments
Profit by Product Line

24

Profitability of Segments
Profit by Product Line

25

Profitability of Segments
Profit by Product Line

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Profitability of Segments
Profit by Product Line

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Profitability of Segments
Divisional Profit
Sales
Cost of goods sold
Gross profit
Division expenses
Corporate expenses
Operating income
(loss)

Alpha

Beta

Gamma Delta Total

$ 90
35
$ 55
-20
-3

$ 60
20
$ 40
-10
-2

$ 30
11
$ 19
-15
-1

$120
98
$ 22
-20
-4

$300
164
$136
-65
-10

$ 32

$ 28

$ 3

$ -2

$ 61

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

Price Volume Variance

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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.

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

Contribution Margin
Volume Variance

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Analysis of Profit-Related
Variances
Sales Mix Variance =
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

The sales mix variance is favorable if the sales mix is weighted to the
more profitable products.

Budgeted
Contribution
Actual Budgeted
margin volume = quantity - quantity average unit
contribution
sold

variance
sold

margin
The contribution margin volume variance gives management information
about gained or lost profit due to changes in the quantity of sales.

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Analysis of Profit-Related
Variances

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Analysis of Profit-Related
Variances

Birdwell, Inc.:

contribution margin variance

$14,375 $13,500
= $875 favorable

sales mix
variance

1,250
- 1,500
625
+
- 500

$4.00
- $6.75
$15.00
- $6.75

= $1,718.75 favorable

contribution margin
volume variance
(2,000 1,875) $6.75

= $843.75 unfavorable
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Analysis of Profit-Related
Variances
Market share variance =

Actual
Budgeted
Actual
Budgeted
market share - market share industry average
sales
unit
percentage

percentage

in units
CM

Market size variance =

Budgeted
Budgeted
Actual
Budgeted
industry sales - industry sales market average
share
unit

in
units
in
units

percentage
CM

36

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.

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COST MANAGEMENT
Accounting & Control
HansenMowenGuan

End Chapter 19

COPYRIGHT 2009 South-Western Publishing, a division of Cengage Learning.

Cengage Learning and South-Western are trademarks used herein under license.

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