Chapter 15

Target Costing and

Cost Analysis for
Pricing Decisions

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McGraw-Hill/Irwin
 Major Influences on
Pricing Decisions
Customer Political, legal,
demand and image issues

Pricing
Decisions

Competitors Costs
15-2
 How are Prices Set?

Costs Market
Forces

15-3
 Role of Accounting
Product Costs in Pricing
Optimal Decisions Suboptimal Decisions
Economic pricing model Cost-based pricing
Sophisticated decision Simplified decision
model and information model and information
requirements requirements

Marginal-cost and Accounting product-

marginal-revenue data cost data
More costly Less costly
The best approach, in terms of costs and
benefits, typically lies between the extremes.
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 Cost-Plus Pricing

Price = cost + (markup percentage × cost)

• Depending on how cost is defined, the markup

percentage may differ.
• Several different definitions of cost, each
combined with a different markup percentage,
can result in the same price for a product or
service.

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 Cost-Plus Pricing – Example (1/5)

Variable mfg. cost $ 400

Fixed mfg. cost 250
Full-absorption mfg. cost $ 650
Variable S & A cost 50
Fixed S & A cost 100
Total cost $ 800

We will use this unit cost information to illustrate the

relationship between cost and markup necessary to
achieve the desired unit sales price of $925.

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 Cost-Plus Pricing – Example (2/5)

Variable mfg. cost $ 400

Markup on
Fixed mfg. cost 250
variable
Full-absorption mfg. cost $ 650
manufacturing
Variable S & A cost 50
cost.
Fixed S & A cost 100
Total cost $ 800

Price = cost + (markup percentage × cost)

Price = $400 + (131.25% × $400) = $925
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 Cost-Plus Pricing – Example (3/5)
Markup on
Variable mfg. cost $ 400 total var. cost
Fixed mfg. cost 250 As cost base
Full-absorption mfg. cost $ 650 increases, the
Variable S & A cost 50 required markup
Fixed S & A cost 100 percentage
Total cost $ 800 declines.

Price = cost + (markup percentage × cost)

Price = $450 + (105.56% × $450) = $925
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 Cost-Plus Pricing – Example (4/5)
Markup on
Variable mfg. cost $ 400 full mfg. cost
Fixed mfg. cost 250 As cost base
Full-absorption mfg. cost $ 650 increases, the
Variable S & A cost 50 required markup
Fixed S & A cost 100 percentage
Total cost $ 800 declines.

Price = cost + (markup percentage × cost)

Price = $650 + (42.31% × $650) = $925
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 Cost-Plus Pricing – Example (5/5)
Markup on
Variable mfg. cost $ 400 total cost
Fixed mfg. cost 250 As cost base
Full-absorption mfg. cost $ 650 increases, the
Variable S & A cost 50 required markup
Fixed S & A cost 100 percentage
Total cost $ 800 declines.

Price = cost + (markup percentage × cost)

Price = $800 + (15.63% × $800) = $925
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 Absorption-Cost Pricing Formulas
Advantages Disadvantages
Price covers all costs. Full-absorption unit
price obscures the
Perceived as equitable. distinction between
Comparison with variable and fixed
competitors. costs.
Absorption cost used
for external reporting.
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 Variable-Cost Pricing Formulas

Advantages Disadvantage
Does not obscure Fixed costs may be
cost behavior overlooked in
patterns. pricing decisions,
resulting in prices
Does not require that are too low to
fixed cost cover total costs.
allocations.
More useful for
managers.
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 Determining the Markup:
Return-on-Investment Pricing (1/6)

Solve for the markup percentage that

will yield the desired return on
investment.

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 Determining the Markup:
Return-on-Investment Pricing (2/6)

Recall the example using a 131.25 percent markup

on variable manufacturing cost.

Price = cost + (markup percentage × cost)

Price = $400 + (131.25% × $400) = $925

Let’s solve for the 131.25 percent markup. Invested

capital is $300,000, the desired ROI is 20 percent,
and annual sales volume is 480 units.
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 Determining the Markup:
Return-on-Investment Pricing (3/6)
Step 1: Solve for the income that
will result in an ROI of 20 percent.

Income
ROI =
Invested Capital
Income
20% =
$300,000
Income = 20% × $300,000
Income = $60,000
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 Determining the Markup:
Return-on-Investment Pricing (4/6)
Step 2: Recall the unit cost information below.
Solve for the unit sales price necessary to
result in an income of $60,000.

Variable mfg. cost $ 400

Fixed mfg. cost 250
Full-absorption mfg. cost $ 650
Variable S & A cost 50
Fixed S & A cost 100
Total cost $ 800
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 Determining the Markup:
Return-on-Investment Pricing (5/6)
Step 2: Solve for the unit sales price
necessary to result in an income of $60,000.

480 units × (Unit profit margin) = $60,000

480 units × (Unit sales price − $800 unit cost) = $60,000

$60,000
Unit sales price − $800 unit cost =
480 units
Unit sales price − $800 unit cost = $125 per unit
Unit sales price = $925
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 Determining the Markup:
Return-on-Investment Pricing (6/6)
Step 3: Compute the markup percentage on
the $400 variable manufacturing cost.

Markup Unit sales price − Unit variable cost

=
percentage Unit variable cost
Markup $925 per unit − $400 per unit
=
percentage $400 per unit
Markup
= 131.25 percent
percentage
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End Chapter 15

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