Pricing Decisions and Cost Management

Pricing and Business

• How companies price a product or service ultimately

depends on the demand and supply for it

• Three influences on demand and supply:

Customers
Competitors
Costs
 Influences on Demand and Supply

• Customers – influence price through their effect on the demand for a product
or service, based on factors such as quality and product features

• Competitors – influence price through their pricing schemes, product

features, and production volume

• Costs – influence prices because they affect supply (the lower the cost, the
greater the quantity a firm is willing to supply)
 Time Horizons and Pricing

• 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 decisions have a time horizon of one year or

longer and include decisions such as:
Pricing a product in a major market where there is some leeway in
setting price
 Differences Affecting Pricing: Long Run versus
Short Run

• Costs that are often irrelevant for short-run policy decisions,

such as fixed costs that cannot be changed, are generally
relevant in the long run because costs can be altered in the
long run

• Profit margins in long-run pricing decisions are often set to earn

a reasonable return on investment – prices are decreased
when demand is weak and increased when demand is strong
 Alternative Long-Run Pricing Approaches

• Market-Based: price charged is based on what

customers want and how competitors react

• Cost-Based: price charged is based on what it cost

to produce, coupled with the ability to recoup the
costs and still achieve a required rate of return
 Market-based Approach

• Starts with a target price

• Target Price – estimated price for a product or service that

potential customers will pay

• Estimated on customers perceived value for a product or

service and how competitors will price competing products or
services
 Five Steps in Developing Target Prices and
Target Costs

• Develop a product that satisfies the needs of potential

customers
• Choose a target price
• Derive a target cost per unit:
Target Price per unit minus Target Operating Income per
unit

• Perform value engineering to achieve target cost

 Value Engineering
• Value Engineering is a systematic evaluation of
all aspects of the value-chain, with the objective
of reducing costs while improving quality and
satisfying customer needs

• Managers must distinguish value-added activities

and costs from non-value-added activities and
costs
ABC Method of Cost Allocation for Astel computers
Direct Manufacturing Cost Unit- 1,50,000 Cost Driver Total Qty of Cost per unit of
Cost Driver Cost Driver
Direct material 1 kit per unit No. of Kit 1,50,000 4600
Direct manufacturing labor 3.2 hrs per unit DML hours 4, 80, 000 200
Direct machining Machine 3,00,000 380
hours
Manufacturing overhead
Costs
Ordering and receiving 50 order per component No. of 22500 800
450 components Orders
Testing and Inspection 30 testing hours per unit Testing 45,00,000 20
hours
Rework 2.5 rework hours per Rework 30,000 400
defective unit hours
*8% defect rate for 1,50,000 units = 12,000 defective units
Manufacturing Cost for 2016 as per ABC
Particulars Total Manufacturing Cost for Manufacturing cost
1,50,000 units per unit
Direct Manufacturing Cost
Direct material cost (1,50,000 x 4600) 69,00,00,000 4600
Direct manufacturing labor (4,80,000 x 9,60,00,000 640
200)
Direct machining (3,00,000 x 380) 11,40,00,000 760
Direct Manufacturing Costs-A 90,00,00,000 6,000
Manufacturing overhead Costs
Ordering and receiving(22,500x800) 1,80,00,000 120
Testing and Inspection(45,00,000x20) 9,00,00,000 600
Rework(30,000 x 400) 1,20,00,000 80
Manufacturing overhead Costs-B 12,00,00,000 800
Total Manufacturing Costs (A+B) 1,02,00,00,000 6800
Product Profitability for 2016 using Value
chain ABC
Particulars Total Amount for Per unit (Rs.)
1,50,000 units
A-Revenue 1,50,00,00,000 10,000
Total Manufacturing 1,02,00,00,000 6800
Cost
Operating Cost 33,00,00,000 2200
B-Total Cost of the 1,35,00,00,000 9000
Product
Operating Income (A-B) 15,00,00,000 1000
 Five Steps in Developing Target Prices and
Target Costs
• Develop a product that satisfies the needs of potential customers: Need to do a market
research

• Choose a target price: Competitors are lowering the price to Rs. 8500 per unit, so the Company
also decided to reduce the price by 20% which will increase the annual sales to 2,00,000 units
(forecast), Target Price=Rs.8000

• Derive a target cost per unit:

Target Price per unit minus Target Operating Income per unit

Target price = Rs. 8,000

Target operating income= 10% of Price = Rs.800
Target cost = 8000-800 = Rs. 7200 per unit

• Perform value engineering to achieve target cost

ABC Method of Cost Allocation for 2017
Direct Manufacturing Cost Unit- 2,00,000 units Cost Driver Total Qty of Cost per unit of
Cost Driver Cost Driver
Direct material 1 kit per unit No. of Kit 2,00,000 3850
Direct manufacturing labor 2.65 hrs per unit DML hours 5,30,000 200
Direct machining Machine 3,00,000 380
hours
Manufacturing overhead
Costs
Ordering and receiving 50 order per component No. of 21250 800
425 components Orders
Testing and Inspection 15 testing hours per unit Testing 30,00,000 20
hours
Rework 2.5 rework hours per Rework 32,500 400
defective unit hours
*6.5% defect rate for 2,00,000 units = 13,000 defective units
Manufacturing Cost for 2017as per ABC
Particulars Total Manufacturing Manufacturing Manufacturing cost per
Cost for 2,00,000 units cost per unit for unit for 2016
2017
Direct Manufacturing Cost
Direct material cost (2,00,000 x 77,00,00,000 3850 4600
3850)
Direct manufacturing labor 10,60,00,000 530 640
(5,30,000 x 200)
Direct machining (3,00,000 x 380) 11,40,00,000 570 760
Direct Manufacturing Costs-A 99,00,00,000 4950 6,000
Manufacturing overhead Costs
Ordering and 1,70,00,000 85 120
receiving(21,250x800)
Testing and 6,00,00,000 300 600
Inspection(30,00,000x20)
Rework(32,500 x 400) 1,30,00,000 65 80
Manufacturing overhead Costs-B 9,00,00,000 450 800
Total Manufacturing Costs (A+B) 1,08,00,00,000 5400 6800
Product Profitability for 2017 using Value
chain ABC
Particulars Total Amount for Per unit (Rs.)
2,00,000 units
Revenue 1,60,00,00,000 8,000
Total Manufacturing 1,08,00,00,000 5400
Cost
Operating Cost 36,00,00,000 1800
Total Cost of the 1,44,00,00,000 7200
Product
Operating Income 16,00,00,000 800
 Cost-Based (Cost-Plus) Pricing
• The general formula adds a markup component to the cost
base to determine a prospective selling price
• Usually only a starting point in the price-setting process
• Markup is somewhat flexible, based partially on customers
and competitors
• Cost base: Rs 7200
• Markup 12%: 864
• Prospective Selling price: 7200+864 = 8064

• How to decide the Markup?

 Forms of Cost-plus Pricing
• Setting a Target Rate of Return on Investment: the Target Annual Operating Return that
an organization aims to achieve, divided by Invested Capital
• Invested capital: 1,15,20,00,000
• Target Rate of Return on Investment : 15%
• Target operating Income (1,15,20,00,000 x 15 %) = 17,28,00,000
• Target operating Income per unit (2,00,000 units) = 864.00
• So, Mark up on Full cost = 864/7200 *100= 12%

• Selecting different cost bases for the “cost-plus” calculation:

Variable Manufacturing Cost
Variable Cost
Manufacturing Cost
Full Cost