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The following is applicable to a special order received by Jobe Enterprises:

X in stock (purchased at R7 per kg). Material X is used regularly by the business and
the current purchase price is R10 per kg.
just enough in stock
(purchased at R5 per kg). Material Y has no foreseeable use in the business and if not
used for this order it will be disposed of at a cost of R700.
Machinery required to complete this order is reaching the end of its useful life and
needs to be replaced at a cost of R15 000. Jobe Enterprises uses this machinery in all
their production processes. The expected useful life thereafter is 10 years.
Fixed overheads are normally R6 per unit but are expected to increase to R8 per unit
for this order.

The special order is for 600 units and will take 4 months to complete.

Calculate the minimum price that Jobe Enterprises should accept for the order.

Material X R11 000 (R10 x 1

Material Y (R700)
Machinery replacement cost R0 (not avoidable / same for all alternatives)
Machinery depreciation R0 (not a cash flow / sunk cost)
Fixed overheads R1 200 (R8 R6 = R2 x 600)
Minimum price R11 500

How would the cost for accounting purposes differ to the cost for decision making
purposes?

Calculate the accounting cost of this order using absorption costing and assuming Jobe
Enterprises values inventory using the FIFO method.

Material X R10 700

Material Y R1 500
Depreciation on machinery R500 (R15 000 / 10 x 4/12)
Fixed overheads R4 800 (R8 x 600)
Accounting cost R17 500

The advantages minimum pricing (basing selling prices on relevant costs):

It distinguishes between relevant and irrelevant costs and indicates the incremental
cash flows incurred in manufacturing and selling a product.
The alternative uses of resources (opportunity costs) are incorporated into the analysis.
It provides the information to enable tenders to be made at more competitive prices.

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The limitations of minimum pricing (basing selling prices on relevant costs):

It is a cost-based pricing method that ignores demand.
There is difficulty in determining the opportunity cost of resources because information
on available opportunities may not be known.
Where special contracts are negotiated that are in excess of relevant (incremental)
costs but less than full costs, resulting in total sales revenue being insufficient to cover
total fixed costs. There is a danger that customers will expect repeat business at this
selling price. Care must be taken -
does not affect the demand for other products.

Relevant cost / minimum pricing is more appropriate for short-term once off pricing decisions.
It is also appropriate in situations where a firm has unutilized capacity or can sell in
differentiated markets at different prices.

5. LONG RUN PRICING DECISIONS

Pricing decisions which relate to . In the long run it is important that
a company covers all costs and makes a profit as opposed to only covering their incremental
costs. In the longer term it is possible for a company to adjust their capacity and spending on
fixed costs. Therefore some costs which are not relevant in the short term can be changed
over the longer term and become relevant.

Organisations have little or no influence over selling prices where there are many suppliers of
similar products. Selling prices are determined by market supply and demand forces and
organisations are referred to as price takers. Where prices are set by the market (and not
with reference to the cost) the organisation needs to undertake a periodic profitability
analysis to ensure that only profitable products are being sold.

Where products are unique or customised organisations will have some discretion in the
setting of selling prices and are referred to as price setters. In this instance the selling price
will be influenced by the cost and cost-plus pricing methods are normally used.

Advantages of cost-plus pricing:

This is a simple way to cost products. The task of pricing products can be delegated to
junior management.
It can be seen as a way of justifying prices and price increases. Organisations who use

Mark-ups can be varied between products and customers depending on market

conditions.
Prices based on full cost should ensure that a company working at normal capacity will
cover its fixed costs and earn a profit.

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Disadvantages of cost-plus pricing:

It fails to recognise that there is a relationship between the price charged and the
quantity sold (e.g. if demand is falling a firm would have to increase its cost per unit
to cover fixed costs, which would increase the selling price).
The price charged by competitors is ignored.
Where a company sells various different products an arbitrary allocation of overheads
to products will cause arbitrary selling prices. Where possible activity-based costing
should be used to allocate overheads to products.
It can lead to a complacent attitude towards cost control and the attitude that cost
increases can be passed onto customers through higher selling prices. This is
dangerous in a competitive environment.
The mark-up applied by the company is influenced by the following:
The demand for the product. Where demand is high a company will be able to
command a higher mark-up.
The level of competition. Mark-ups are likely to decrease where competition is
intensive.
The nature of the product:
o Luxury goods: small changes in the price of products will result in customers
quickly changing their purchasing behaviour or switching to a competitor or
substitute product (demand is elastic).
o Necessities: a change in the price of products does not affect demand (demand
is inelastic).
The pricing strategy of the company.
o Price skimming: High initial prices to take advantage of the novelty appeal of a
new product. Once the market is saturated the price can be reduced to attract
that part of the market that has not yet been exploited.
o Penetration pricing policy: Low prices are charged initially with the intention
of gaining rapid acceptance of the product. Low prices will discourage
competitors from entering the market and enables the company to establish a
large market share.

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The cost of product A is R100. Calculate the selling price if the mark-up is 20% on cost.

Cost 100%
Mark-up 20%
Selling price 120%

The selling price is R120 (R100 x 120%/100%).

This is the profit % on cost.

The cost of product A is R100. Calculate the selling price if the margin is 20% on sales.

Selling price 100%

Margin (20%)
Cost 80%

The selling price is R125 (R100 x 100%/80%).

This is the profit % on sales.

Instead of using the cost-plus pricing method described above a company may choose to use
target costing. First the company determines the target selling price. Then the desired profit
margin is deducted to get the target cost of the product. The aim it to then ensure that the
actual cost is not higher than the target cost. If the actual cost is above the target cost
intensive efforts are made to cut costs and close the gap.

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