Management Accounting - Chapter 06 - Pricing Decision Cost Management

CHAPTER 06
PRICING DECISIONS & COST

MANAGEMENT
30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT 1

CHAPTER 06
CASE STUDY RERIEW
Target Pricing and Tata Motors’ $2,500

Car

LEARNING OBJECTIVE
• Discuss the three major factors that affect pricing

decisions;
• Understand how companies make long-run pricing

decisions;
• Price products using the target-costing approach;
• Apply the concepts of cost incurrence and locked-in

costs;

LEARNING OBJECTIVE
• Price products using the cost-plus approach;
• Use life-cycle budgeting and costing when making

pricing decisions;
• Describe two pricing practices in which non cost factors

are important;
• Explain the effects of antitrust laws on pricing.

CHAPTER CONTENT
6.1. Major Influences on Pricing Decisions;
6.2. Costing and Pricing for the long run;
6.3. Target Costing for Target Pricing;
6.4. Value Engineering, Cost Incurrence, and Locked-In

Costs;

CHAPTER CONTENT
6.5. Cost-Plus Pricing;
6.6. Life-Cycle Product Budgeting and Costing;
6.7. Additional Considerations for Pricing Decisions;
6.8. Antitrust Laws.

6.1. Major Influences on
Pricing Decisions
How companies price a product or service ultimately
depends on the demand and supply for it. Three influences
on demand and supply are:
• Influence • Influence price • Influence

price through through their prices
their effect on technologies, because they
the demand plant affect supply.
for a product capacities…
or service.
Customer Competitor Cost

6.2. Costing and Pricing
for the long run
 Short-run pricing decisions have a time horizon of
less than one year and include decisions such as:
– Pricing a one-time-only special order with no long-run

implications
– Adjusting product mix and output volume in a
competitive market.
 Long-run pricing is a strategic decision designed

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

6.2. Costing and Pricing for the
long run
Variable costs
Must always be Must be included in
covered. both Short and
Long-run Pricing
Decisions
Short-run vs
Long-run
Fixed costs
Must be covered in Long-run Pricing
the long run. Decisions
30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT

6.2. Costing and Pricing for
the long run
Year
0 1
Short-run Pricing Long-run Pricing
Decision Decision
Shorter than Longer than

one year one year
Pricing a one-time Pricing a new

special order. product.
How much material is Do I need a
required? new plant?

for the long run
Cost allocation
• Recall that indirect costs of a particular cost object are

costs that are related to that cost object but cannot be
traced to it in a cost-effective way.
• These costs often comprise a large percentage of the
overall costs assigned to cost objects.
• Cost allocations influence managers’ cost management
decisions as well as the products that managers
promote.

for the long run
Purposes of cost allocation

for the long run
Alternative Long-Run Pricing Approaches
How should managers use product cost information to price
their products? There are two different approaches for
pricing decisions:
COST-BASED
APPROACH
• Given what our
customers want.
• How competitors will • Given what it costs us to
react to what we do? make this product.
• What price should we • What price should we
charge? charge that will recoup
our costs?
MARKET-BASED
APPROACH • Achieve a target return.
6.3. Target Costing for Target
Pricing
 Starts with a target price which is the estimated price for
a product or service that potential customers are willing
to pay
 The target price is estimated based on:
 Understanding of customers’ perceived value for a

product or service, and
 How competitors will price competing products or

services.

Pricing
6.3.1. Understanding Customers’ Perceived Value:
Companies operate in different markets which affect the
approach they’ll use for pricing:
 Companies in COMPETITIVE MARKETS must accept

the prices set by the market (goods or services
provided by competitors are very similar).
 Companies in LESS-COMPETITIVE MARKETS offer

products or services that differ from each other and
can use both approaches for pricing decisions.

Pricing
6.3.1. Understanding Customers’ Perceived Value, Cont’d:
Companies operate in different markets which affect the
approach they’ll use for pricing:
 Remember both approaches consider customers,

competitors and costs, only the starting points differ;
 Managers should always keep in mind market forces
regardless of which pricing approach they use;
 Companies in UNCOMPETITIVE MARKETs favor cost-
based approaches because these companies do not need
to respond or react to competitors’ prices.

Pricing
6.3.2. Doing Competitor Analysis:
A manager should know:
Competitor’s technologies
Nature of product, cost…
Financial conditions

Pricing
6.3.3. Implementing Target Pricing and Target Costing:
Step 1: Develop a product that satisfies the
needs of potential customers.
Step 2: Choose a target price.
Step 3: Derive a target cost per unit by

subtracting target operating income per unit from
the target price.
Step 4: Perform cost analysis
Step 5: Perform value engineering to achieve

target cost.
Pricing
6.3.3. Implementing Target Pricing and Target Costing, cont’d:
The price based on customers’

Target price: perceived value for the product and the
price that competitors charge.
What would a customer pay?
How much profit do I need?
Can I make it at this cost?
Target price Desired profit Target cost

6.4. Value Engineering, Cost
Incurrence, and Locked-In
Costs
Value Engineering:
 Value engineering is a systematic evaluation included
the value chain, with the objective of reducing costs and
achieving a quality level satisfied customers;
 Value engineering entails improvements in product
designs, changes in materials specifications and
modifications in process methods;
 To implement value engineering, managers must
distinguish value-added activities and costs from non-
value-added activities and costs.

Costs
Value Engineering Terminology
 Value-added costs—a cost that, if eliminated, would
reduce the actual or perceived value or utility
(usefulness) customers experiences.
 Non-value-added costs—a cost that, if eliminated,

would not reduce the actual or perceived value or utility
(usefulness) customers gain.

Costs
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 will be incurred in the
future based on decisions that have already been made.
 The best opportunity to manage costs is before they are

locked in.

Cost Incurrence Costs
and Locked-In Costs Graph

Costs
6.4.1.Value Chain Analysis and Cross Functional Team:
Some functional value engineering team’s ideas used to
reduce costs:
1. Using a simple, more reliable motherboard without
complex features;
2. Snap fix rather than solder parts together;
3. Using fewer components.
4. Make provalue lighter.

Costs
6.4.2. Achieving the Target Cost per Unit for Provalue:
Unless managed properly, value engineering and target
costing can have undesirable effects:
1. A product may be in development for a long time as

the team repeatedly evaluates alternative designs;
2. Organizational conflicts may develop as the burden of

cutting costs falls unequally on different business
functions in the company’s value chain.

Costs
To avoid those possible undesirable effects, target-costing
efforts should always:
1. Encourage employee participation and celebrate small
improvements toward achieving the target cost;
2. Focus on the customer;
3. Pay attention to schedules;
4. Set cost-cutting targets for all value-chain functions to
encourage a culture of teamwork and cooperation.

Costs
The target pricing approach is another illustration of the
five-step decision-making process:
1. Identify the problem and uncertainties.
2. Obtain information.
3. Make predictions about the future.
4. Make decisions by choosing among alternatives.
5. Implement the decision, evaluate performance and
learn.

6.5. Cost-Plus Pricing
Instead of using the market-based approach for long-run
pricing decisions, managers sometimes use a cost-based
approach:
 The general formula for setting a cost-based selling price
adds a markup component to the cost base.
 Usually, it is only a starting point in the price-setting
process.
 Markup is somewhat flexible, based partially on
customers and competitors.
 Because a markup is added, cost-based pricing is often
called cost-plus pricing, where the plus refers to the
markup component.

Cost-plus pricing can be determined several ways:
Cost-Plus Target
Rate of Return on
Investment
C+P
Alternative Cost- Cost-Plus Pricing

Plus Methods and Target Pricing

6.5.1. Cost-Plus Target Rate of Return on Investment:
Item Value
Invested Capital (1) $ 96,000,000
Target Rate on Return on
Investment (2) 18%
Target Annual Operating Income (3) =(1) x (2) $ 17,280,000
Product Units (4) units 200,000
Target Operating Income per Unit (5) =(3)/(4) 86.4
Cost Base (6) $ 720
Prospective Selling Price (7) =(5)+(6) $ 806
% of Markup Component (8)=(5)/(6) 0.12

6.5.2. Alternative Cost-Plus Methods:
Because computing the specific amount of
capital invested in a product is challenging,
sometimes managers use alternate cost bases:
 Variable manufacturing cost;
 Variable cost;
 Manufacturing cost;
 Full cost.
6.5.2. Alternative Cost-Plus Methods:
Estimated Mark Markup Prospective
Items Cost Unit up % Component Selling Price
(1) (2) (3)= (1) x (2) (4) = (1) + (3)
Variable
Manufacturing
Cost $ 475 65% 308.75 783.75
Variable Cost
of Product $ 547 45% 246.15 793.15
Manufacturing
Cost $ 540 50% 270 810
Product Full
Cost $ 720 12% 86.4 806.4
6.5.3.Cost-Plus Pricing and Target Pricing:
The selling prices computed under Cost-plus pricing are
prospective prices:
 The Target-pricing approach reduces the need to go

back and forth among prospective cost-plus prices,
customer reactions and design modifications.
 Target-pricing first determines product characteristics

and target price on the basis of customer preferences,
computes a target cost.

6.5.3.Cost-Plus Pricing and Target Pricing:
Estimated Full Cost $ (1) 750

Markup % % (2) 12%
Prospective Price $ (3)=(1)x(2) 840
Target Full Cost $ (4) 720
Target Price $ (5) 800
Target Markup % % (6)=((5)-(4))/(4) 11%

6.6. Life-Cycle Product
Budgeting and Costing
Life-Cycle Product Budgeting and Costing:
Managers sometimes need to consider target prices and
target costs over a multiple-year product life cycle.
 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 (orphaned);
 In Life-cycle budgeting, managers estimate the revenues

and business function costs across the entire value-
chain from its initial R&D to its final customer service and
support;

Life-Cycle Product Budgeting and Costing:
Managers sometimes need to consider target prices and
target costs over a multiple-year product life cycle.
 Life-cycle costing tracks and accumulates business

function costs across the entire value chain from a
product’s initial R&D to its final customer service and
support;
 Life-cycle budgeting and life-cycle costing span several

years.

Life-Cycle Budgeting and pricing decisions:
These two features of costs make life-cycle budgeting
particularly important.
 The 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.

6.7. Additional Considerations
for 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 demand
approaches the physical limit of the capacity to produce.
 International pricing-prices charged in different countries

vary much more than the costs of delivering the product
to each country.

6.8. Antitrust Laws
 Price discrimination is illegal if the intent is to lessen or
prevent competition.
 Predatory pricing occurs when a company deliberately

prices below its costs in an effort to drive competitors out
of the market and restrict supply.

Chapter Summary

Terms to learn
TERMS TO LEARN Vietnamese

Collusive pricing Giá thương lượng
Cost incurrence Phát sinh chi phí
Customer life-cycle costs Chi phí khách hàng
trong vòng đời sản phẩm
Designed-in costs Chi phí thiết kế
Dumping Bán phá giá
Life-cycle budgeting Dự toán dòng đời SP
Life-cycle costing Chi phí dòng đời SP
Locked-in costs CP được kiểm soát

Terms to learn
Target cost per unit Chi phí mục tiêu đơn vị
Target operating income per unit Lợi nhuận hoạt động
mục tiêu đơn vị
Target price Giá bán mục tiêu
Target rate of return on
Tỷ suất đầu tư mục tiêu
investment
Value-added cost Chi phí tăng thêm giá trị
sản phẩm
Value engineering Giá trị công nghệ dây
chuyền sản xuất.

Terms to learn
Non-value-added costs Chi phí tăng thêm lãng
phí
Peak-load pricing Giá giờ cao điểm
Predatory pricing Giá điều chỉnh
Price discrimination Gian lận về giá bán
Product life cycle Đời sống sản phẩm.

Self- Preparation
Exercise: Chapter 13 Text book of Cost Accounting A

Managerial Emphasis 13-16,17,18 P. 562-
P.563.
Q &A :Chapter 9 Text book of Management
Information Study Manual IAEW 6-31, 6-32 (P. 114-
P.118)
Chapter 9 Text book of Management

Information Question Bank IAEW (P. 43- P.55)

Multiple Choices
1) Companies should only produce and sell units as long

as ________.
A) there is customer demand for the product ;
B) the competition allows it;
C) the revenue from an additional unit exceeds the cost of

producing it;
D) there is a generous supply of low-cost direct materials.

Multiple Choices
2) Too high a price may ________.
A) deter a customer from purchasing a product;
B) increase demand for the product;
C) indicate supply is too plentiful;
D) decrease a competitor's market share.
201048- PRICING DECISIONS AND COST MANAGEMENT 47

30-Jul-20
Multiple Choices
3) Companies must always examine their pricing

________.
A) based on the supply of the product;
B) based on the cost of producing the product;
C) through the eyes of their customers;
D) through the eyes of their competitors.

Multiple Choices
4) Which of the following statements is true about the

factors that affect pricing decisions?
A) Information about competitors' technologies is not useful
for pricing decisions;
B) Information about a competitor in a perfect market affects

pricing decisions;
C) Increase in price of a substitute product does not affect

pricing decisions;
D) Fluctuations in exchange rates between different

countries' currencies affect pricing decisions.
D
49

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CHAPTER 06

PRICING DECISIONS & COST

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT 1

CASE STUDY RERIEW

Target Pricing and Tata Motors’ $2,500

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT 2

• Discuss the three major factors that affect pricing

• Understand how companies make long-run pricing

• Price products using the target-costing approach;

• Apply the concepts of cost incurrence and locked-in

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT 3

• Price products using the cost-plus approach;

• Use life-cycle budgeting and costing when making

• Describe two pricing practices in which non cost factors

• Explain the effects of antitrust laws on pricing.

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT 4

6.1. Major Influences on Pricing Decisions;

6.2. Costing and Pricing for the long run;

6.3. Target Costing for Target Pricing;

6.4. Value Engineering, Cost Incurrence, and Locked-In

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT 5

6.5. Cost-Plus Pricing;

6.6. Life-Cycle Product Budgeting and Costing;

6.7. Additional Considerations for Pricing Decisions;

6.8. Antitrust Laws.

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT 6

• Influence • Influence price • Influence

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT 7

– Pricing a one-time-only special order with no long-run

 Long-run pricing is a strategic decision designed

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT 8

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT

Shorter than Longer than

Pricing a one-time Pricing a new

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT

• Recall that indirect costs of a particular cost object are

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT 11

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT 12

 Understanding of customers’ perceived value for a

 How competitors will price competing products or

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT 14

 Companies in COMPETITIVE MARKETS must accept

 Companies in LESS-COMPETITIVE MARKETS offer

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT 15

 Remember both approaches consider customers,

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT 16

Nature of product, cost…

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT 17

Step 2: Choose a target price.

Step 3: Derive a target cost per unit by

Step 5: Perform value engineering to achieve

The price based on customers’

Target price Desired profit Target cost

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT 20

 Non-value-added costs—a cost that, if eliminated,

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT 21

 Locked-in costs (designed-in costs)—are costs that

 The best opportunity to manage costs is before they are

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT 22

30-Jul-20 201048- PRICING DECISIONS AND COST MANAGEMENT 23

2. Snap fix rather than solder parts together;

3. Using fewer components.

4. Make provalue lighter.