COST MANAGEMENT

Guan▪ Hansen▪ Mowen

Chapter 19
Pricing and Profitability
Analysis

COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. 1

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.
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Market Structure and Price

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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.
 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
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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

÷ COGS
+ Operating income)
Markup on COGS = ($25,000 + $80,350)
 ÷ $245,000

Markup on COGS = 0.43 or 

  43%

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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% 

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Pricing Policies
Cost-Plus Pricing
 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

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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 $12) 24.00
Overhead (65% of direct labor cost) 19.50
Reduce overhead (50% of direct labor cost) 12.00
Estimated cost of one job Bid price is$now
89.50
Revised cost of one job competitive; markup $ 71.00
Plus 43% markup on COGS preserved 38.49 30.53
Bid price $127.99$101.53
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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
a n d it

 – 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 $ 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.

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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) 3,000
Fixed overhead 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 Production exceeded sales by 250

Direct labor ($15 x 1,250) 18,750
units; fixed overhead of $16 per unit is
Variable overhead ($3 x 1,250) 3,750
Fixed overhead ($16 per unit) 20,000
carried in inventory thus reducing cost
Total manufacturing overhead $48,750 of goods sold and increasing net
 Add: Beginning inventory 0 income
Less: Ending inventory (9,750)
Cost of goods sold $39,000
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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 3,000
Total variable manufacturing expenses $23,000
 Add: Variable marketing expenses 1,250
Total variable expenses $24,250
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Measuring Profit

*1,300 × $39 = $50,700

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Measuring Profit

22
 

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 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

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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

26
 

Profitability of Segments
Profit by Product Line

27
 

Profitability of Segments
Divisional Profit
 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

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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

29
 

 Analysis of Profit-Related
Variances
Overall Sales Variance
[actualvs. expected revenue]

Sales Price Variance Price Volume Variance

30
 

 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. 31
 

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

32
 

 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.

Contribution Actual Budgeted Budgeted

  average unit
margin volume = quantity - quantity
variance sold sold contribution
margin
The contribution margin volume variance gives management information
about gained or lost profit due to changes in the quantity of sales.
33
 

 Analysis of Profit-Related
Variances

34
 

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

= $1,718.75 favorable = $843.75 unfavorable

35
 

 Analysis of Profit-Related
Variances
Market share variance =

 Actual Budgeted  Actual Budgeted

  industry
market share - market share average
percentage percentage sales unit
in units CM

Market size variance =

 Actual Budgeted Budgeted Budgeted

 
industry sales - industry sales market average
in units in units share unit
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

Guan▪ Hansen▪ Mowen

End Chapter 19

COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. 38

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