Pricing Decisions, Target Costing,

Product Life-Cycle Costing

1

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Last Class
2

Spoilage, Rework, and Scrap

Process

costing and job costing

Normal vs. abnormal spoilage
Equivalent

Inspection

units

time points!

Inspection

15% , 55% ,100%

Beginning inventory: 60%
Ending inventory: 50%
Specific

job and all common jobs

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Tata Motors $2,500 Car

3

Tata Motors built a $2,500 entry-level car

Half the price of the cheapest Indian Car

Fuel efficient, 50 miles to the gallon
Meets all current Indian emission, pollution, and safety
standards

Tata Motors engineers

Eschewed traditional long-term supplier relationships,

forced suppliers to compete for business
A hollowed-out steering-wheel shaft, a smaller diameter
drive shaft, a trunk with space for a briefcases, one
windshield wiper instead of two
No radio, no power steering, no power windows, and no air
conditioning
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Learning Objectives
4

Discuss the three major influences on pricing

decisions.
Understand how companies make short- and
long-run pricing decisions.
Price products using the target-costing and
cost-plus approaches.
Apply the concepts of cost incurrence and
locked-in costs.
Use life-cycle budgeting and costing when
making pricing decisions.
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Three major influences on pricing

decisions

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Major Influences on Pricing

Decisions
6

How companies price a product or

service ultimately depends on

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Major Influences on Pricing

Decisions
7

Three influences on demand & supply:

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Weighing Customers,
Competitors, and Costs
8

In a perfectively competitive market

wheat,

rice, steel, and aluminum

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An Almost Perfect Competitive

Market
9

The pricing wars were fought over a

GE microwave oven.

Sellers on Amazon changed its price nine times

in one day, with the price fluctuating between
$744.46 and $871.49. Best Buy responded by
lifting its online price on the oven to $899.99
from $809.99 after the Amazon prices rose,
then lowering it again after Amazon prices for
the oven dropped.

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Weighing Customers,
Competitors, and Costs
10

In a less-competitive market
cameras,

televisions, and cellular phones,

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A Less Perfect Competitive Market

11

The U.S. accused Apple and five of the

nation's largest publishers of conspiring to
raise e-book prices.

In a civil antitrust lawsuit, the Justice

Department alleged that CEOs of the
publishing companies met regularly in private
dining rooms of upscale Manhattan
restaurants to discuss how to respond to
steep discounting of their e-books by
Amazon, a practice they disliked.
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Weighing Customers,
Competitors, and Costs
12

A monopolist
Natural

resources

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A Monopolist Market
13

An energy bill was passed by the Mexican

senate that may end a 75-year-old
monopoly held by Petroleos Mexicanos
(Pemex), which is state-owned.

The bill will allow private companies to drill

for oil and gas through contracts and licence.
The end of Pemexs monopoly is seen by
some as the biggest economic change in
Mexico since the North American Free Trade
Agreement in 1994.
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14

Understand how companies make short-run and longrun pricing decisions.

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Time Horizons and Pricing

15

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Short-Run Pricing Illustration

16

Astel manufactures two brands of personal computers

Deskpoint and Provalue.
Datatech Corporation has asked Astel to bid on
supplying 5,000 Provalue computers over the last three
months of 2008. After this three-month period,
Datatech is unlikely to place any future sales orders
with Astel. Datatech will sell Provalue under its own
brand name in regions and markets where Astel does
not sell Provalue.
Whether Astel accepts or rejects this order will not
affect Astels revenues from existing sales channels.

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Short-Run Pricing Illustration

17

The relevant costs: direct and indirect costs throughout

the value chain that will change in total by accepting
the one-time-only special order from Datatech.
Astels managers outline the relevant costs in the
following table:
Direct materials ($460 per computer x 5,000 computers)

$2,300,000

Direct manufacturing labor ($64 per computer x 5,000

computers)

320,000

Fixed costs of additional capacity to manufacture Provalue

250,000

Total relevant costs

$2,870,000

The relevant cost per computer is $2,870,000/5,000 = $574. Therefore, any

selling price above $574 will improve Astels profitability in the short run.
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Short-Run Pricing Illustration

18

If Astels managers believed accepting the order for

Datatech would undercut Astels selling price in
current markets.

The relevant costs of the bidding decision would include

the contribution margin lost on sales to existing customers
(opportunity costs).

If there is no opportunity costs, the managements

strategy is to bid as high above $574 as possible
while remaining lower than competitors bids.
In short-run situations where companies experience
strong demand or have limited capacity, companies
strategically increase prices in the short run to as
much as the market will bear.
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19

Effect of Time Horizon on

Short-Run Pricing Decisions

Many costs are irrelevant in short-run

pricing decisions

R&D, design, manufacturing, marketing,

distribution, and customer service

Short-run pricing is opportunistic

Prices are decreased (increased) when demand
is week (strong)
Long-run prices earn a reasonable return

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Long-Run Pricing
20

Long-run pricing is a strategic decision

designed to build long-run relationships
with customers based on stable and
predictable prices.

Relevant costs for long-run pricing

decisions include all future fixed and
variable costs.

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Long-Run Pricing Illustration

21

Assume management of Astel considers the long-run

pricing decision for Provalue.
Astel has no beginning or ending inventory of Provalue
in 2009 and manufactures and sells 150,000 units
during the year. The manufacturing cost of Provalue is
calculated using ABC. Astel has three direct costs
direct materials, direct manufacturing labor, and direct
machining costs and three manufacturing overhead
cost pools ordering and receiving components, testing
and inspection of final products, and rework.

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Long-Run Pricing Illustration

22

The following Excel spreadsheet summarizes manufacturing cost information to

produce 150,000 units of Provalue in 2011

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Long-Run Pricing Illustration

23

Product profitability of Provalue for 2011 Using Value Chain Activity-Based Costing

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Alternative Long-Run Pricing

Approaches

24

Market-Based: price charged is based on what

customers want and how competitors react
Cost-Based (also called Cost-Plus): price
charged is based on what it costs to produce,
coupled with the ability to recoup the costs and
still achieve a required rate of return
Both approaches consider customer, competitors, and costs. Only
their starting points differ.

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25

Market Condition and Pricing

Approaches

Competitive Markets - use the marketbased approach

Less-Competitive Markets can use either

the market-based or cost-based approach

Companies must accept the prices set by the

market

More common

Non-Competitive Markets use cost-based

approaches

Do not need to respond to competitors prices

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Market-Based Approach
26

Starts with a target price

Target Price estimated price for a
product or service that potential
customers will pay. This estimate is
based on customers perceived value for
a product or service and how
competitors will price competing
products or services

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Market-Based Approach
27

Understanding customers perceived value: through

close contact and interaction with customers, or conduct
market research studies.

Nielsen studies consumers in more than 100 countries to

deliver the most complete view of trends and habits worldwide

Doing competitor analysis: company must understand

competitors technologies, products or services, costs, and
financial conditions.
Company usually obtain information about competitors from
former customers, suppliers, and employees of competitors.
Another source of information is reverse engineering.
IMS Health helps drug companies to have access to
competitors information
At no time should a company resort to illegal or unethical means to obtain information
from competitors.

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Understanding the Market

Environment

28

Understanding customers and competitors is

important because:

Competition from lower cost producers has

meant that prices cannot be increased
Products are on the market for shorter periods
of time, leaving less time and opportunity to
recover from pricing mistakes
Customers have become more knowledgeable
and demand quality products at reasonable
prices

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29

Price products using the targetcosting approach

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30

Implementing Target Pricing

and Target Costing

Develop a product that satisfies the needs of

potential customers
Choose a target price
Derive a target cost per unit by subtracting target
operating income per unit from the target price
Perform cost analysis
Perform value engineering to achieve target cost

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31

Implementing Target Pricing

and Target Costing Illustration
Step 1: Develop a product that satisfies
the needs of potential customers

Based on an understanding of customer

requirements and an analysis of competitors
products, Astel plans the product features
and design modifications for Provalue II for
2010
Astels market research indicates that
customers do not value extra features, such
as special audio. They want Astel to redesign
Provalue into a no-frills but reliable PC and to
sell it at a much lower price.
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32

Implementing Target Pricing

and Target Costing Illustration
Step 2: Choose a target price

Astel expects its competitors to lower the

prices of PCs that compete with Provalue
to $850. Astels management wants to
respond aggressively by reducing
Provalues price by 20%, to $800 per unit.
At this lower price, Astels marketing
manager forecasts an increase in annual
sales from 150,000 to 200,000 units.

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33

Implementing Target Pricing

and Target Costing Illustration
Step 3: Derive target cost per unit
Target cost per unit is often lower than the
existing full cost per unit of the product
Assume Astels management needs a 10%
target operating income on target revenues:
Total target revenues = $800 x 200,000 units = $160,000,000
Total target operating income = $160,000,000 x 10% =
$16,000,000
Target operating income per unit = $16,000,000/200,000 units
= $80
Target cost per unit = $800 - $80 = $720
Current full cost per unit = $135,000,000 / 150,000 = $900

Reduce cost from R&D to customer service

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34

Implementing Target Pricing

and Target Costing Illustration
Step 4: Perform cost analysis. This step
analyzes which aspects of product or
service to target for cost reduction
The functions performed by different
component parts, such a the motherboard,
disk drives, and the graphic and video cards
The current costs of the different component
parts
The importance that customers place on
different product features. How different
features relate to the functions performed by
different component part.
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35

Implementing Target Pricing

and Target Costing Illustration
Step 5: Perform value engineering to achieve
target cost

Understanding customer requirements,

value added and non-value-added costs
Anticipating how costs are locked in before
they are incurred
Using cross-functional teams to redesign
products and processes to reduce costs
while meeting customer needs.

Use a simpler, more-reliable motherboard without

complex features to reduce manufacturing and repair
costs.
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IKEA
36

IKEAs prices typically run 30-50% below

its competitors prices
Through

aggressive target pricing, coupled

with relentless cost management
IKEA starts with the customer need
Product developers survey competitors and
charge a price 30-50% less than the
competitor

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In-class exercise 1
37

Air Eagle is about to introduce a daily round-trip flight

from NY to LA. The market has business and pleasure
travelers.

Pleasure travelers start their travel during one week,

spend at least one weekend at their destination, and
return the following week or thereafter. Business
travelers usually start and complete their travel within
the same work week.

Round-trip fuel costs are fixed costs of $24,000 and that

fixed costs allocated to the round-trip flight for airplaneNumber of Seats Expected to be Sold
lease costs, ground services, and flight-screw salaries
Price Charged
Variable Cost/Ticket
Business
Pleasure
total $188,000.
$500

$65

200

100

2,100

175

180

20
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38

If you could charge different prices to business

travelers and pleasure travelers, would you?
Show your computations.

500-65=$435, 2,100-175=$1,925

Business travelers

435*200= $87,000; 1925*180= $345,500

Pleasure travelers

435*100=$ 43,500 ; 1,925*20=$ 38,500

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39

Explain the key factor (or factors) for your answer for
the above requirement.

How might Air Eagle implement price discrimination?

That is, what plan could the airline formulate so that
business travelers and pleasure travelers each pay the
price desired by the airline?

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40

Apply the concepts of cost

incurrence and locked-in costs.

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Value Engineering
Terminology

41

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

Nonvalue-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.

specific product features and attributes desired by customers

costs of producing defective products and machine breakdowns

Activities and their costs do not always fall neatly into

value-added or nonvalue-added categories.
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42

Value Engineering
Terminology

Cost Incurrence describes when a resource is

consumed (or benefit foregone) 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
Scrap and rework costs, software errors during
coding and testing
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Cost Incurrence and Locked-In

Costs Graph Illustration
43

Pattern of Cost Incurrence and Locked-In Costs for Provalue

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44

Cost Incurrence and Locked-In

Costs Graph Illustration

Total cumulative cost per unit for both curves is

$900
The graph emphasizes the wide divergence
between the time when costs are locked in and
when they are incurred
Once the product is designed and the operations
to manufacture, market, distribute, and support
the product are determined, more than 86%
($780/$900) of the unit cost of Provalue is locked
in, when only about 8% ($76/$900) of the unit
cost is actually incurred.
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45

Price products using the costplus approach.

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Cost-Based (Cost-Plus) Pricing

46

The general formula adds a markup

component to the cost base to determine a
prospective selling price
Usually only a starting point in the pricesetting process
Markup is somewhat flexible, based
partially on customers and competitors

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Determine Markup Percentage

47

Choose a markup to earn a Target Rate of

Return on Investment which is the target
annual operating return that an organization
aims to achieve, divided by invested capital
Invested capital can be defined in many
ways. In this chapter, we define invested
capital as total assets.

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Determine Markup Percentage

Illustration

48

Suppose Astels target rate of return on

investment is 18% and Provalue IIs capital
investment is $96 million:
Invested capital
$96,000,000
Target rate of return on investment
18%
Target annual operating income (96,000,000*18%)
17,280,000
Target operating income per unit (17,280,000/200,000)= 86.4
Prospective selling price = 720+86.4
Markup percentage = 86.4/720=12%

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Forms of Cost-Plus Pricing

49

In practice, company will choose a cost base

that it regards as reliable and a markup
percentage that is based on its experience
in pricing products to recover its costs and
earn a target return on investment.
Computing the specific amount of capital
invested in a product is very difficult

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Alternative Cost-Plus Methods

50

Selecting different cost bases for the costplus calculation:

Variable Manufacturing Cost
Variable Cost
Manufacturing Cost
Full Cost

Cost Base
Variable manufacturing
cost
Variable cost of the
product
Manufacturing cost
Full cost of the product

Estimated Cost per

Unit
$475.00

Markup
Percentage

Prospective
Selling Price

65%

Markup
Component
$308.75

547.00

45%

$246.15

$793.15

540.00
720.00

50%
12%

$270.00
$86.40

$810.00
$806.40

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$783.75

51

Including both fixed and

variable costs

Full recovery of all costs of the product

Variable cost pricing hurts profits, airline industry
Managers are tempted to cut prices to generate
a positive contribution margin

Price stability

It limits the temptations of salespersons to cut

prices

Simplicity

A full-cost formula for pricing does not require a

detailed analysis of cost behavior

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Common Business Practice

52

Most firms use full cost for their cost-based

pricing decisions, because:
Allows

for full recovery of all costs of the product

Allows for price stability
It is a simple approach

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Cost-Plus Pricing and Target

Pricing

53

The selling prices computed under cost-plus

pricing are prospective prices. The eventual
design and cost plus price chosen must balance
the trade-offs among costs, markup, and
customer reactions
The target-pricing approach reduces the need
to go back and forth among prospective costplus prices, customer reactions, and design
modifications

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54

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
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
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55

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

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56

Life Cycle Budgeting

Illustration

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57

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
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58

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
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59

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

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In-class exercise 2
60

The new CEO of Radco Manufacturing has asked

for a variety of information about the operations
of the firm from last year. The CEO is given the
following information, but with some data
missing:
Total sales revenue

Number of units produced and sold:

500,000 units

Selling price

Operating income

$195,000

Total investment in assets

$2,000,000

Variable cost per unit

$3.75

Fixed costs for the year

$3,000,000
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61

Find (a) total sales revenue, (b) selling price, (c) rate of
return on investment, and (d) markup percentage on full
cost for this product.

195,000 (operating income) +3,000,000 (fixed

costs)=3,195,000 (contribution margin)
3,195,000/5,000 units= $ 6.39 (unit contribution margin)
(a)6.39+3.75=10.14 (selling price)
(b)Revenues: $10.14*500,000 units=$5,070,000
(c) $195,000/$2,000,000=9.75%
(d) 10.14-(3.75+3,000,000/500,000 )=10.14-3.75-6=0.39
0.39/9.75=4% (markup percentage)
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62

The new CEO has a plan to reduce fixed costs by $200,000

and variable costs by $0.60 per unit while continuing to
produce and sell 500,000 units. Using the same markup
percentage as in requirement 1, calculate the new selling
price.

New fixed costs: 3,000,000-200,00=2,800,000

New variable costs: 3.75-0.6=$3.15

New total costs 3.15*500,000+2,800,000=$4,375,000

4,375,000*1.04=$4,550,000

New selling price: $4,550,000/500,000 =$9.10

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63

Assume the CEO institutes the changes in requirement 2

including the new selling price. However, the reduction in
variable cost has resulted in lower product quality resulting
in 10% fewer units being sold compared to before the
change. Calculate operating income (loss).

Revenues: 9.10*450,000 =$4,095,000

Variable costs ($3.15*450,000 units)=1,417,500

Contribution margin=$4,095,000-$21,417,500=$2,677,500

Operating income $2,677,500-2,800,000= -$122.500

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64

The End
64

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