TRIAL ORDER & PRICING

A. Trial Orders and Pricing: Cost Analysis for

Pricing Decisions

B. Case: Indian Electrical Ltd.

 Learning Objective
2

 How cost information can be useful to

management in framing suitable pricing
policy.
 Factors influencing pricing
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decisions
1. Cost data of the product
2. Firm’s profit and other objective
3. Demand for the product or service and its elasticity
4. Nature of product and its life expectancy
5. Pricing decision as: Long term-short term or one time spare
capacity decision.
6. Type of completion and availability of close substitutes.
7. Economic and political climate
8. Type of industry
9. Government guidelines.
 Empirical Implication:
4

 Belverd E.needles, Henry R.Anderson, and James C.Caldwell,

Financial Managerial accounting, Houghton Mifflin Company, 1988,
pp.905.
Factors
External considered
Factors: when settingInternal
prices:Factors:
1. Total demand for products or services 1.Cost of product or service
2. Number of competing products or services VC, Full absorption cost, total cost.
3. Quality of competing products or services 2. Price geared toward ROI
4. Current prices of competing products or services 3. Loss leader or main product
5. Customer preferences for quality versus price 4. Quality of materials and labor inputs
6. Sole source versus heavy competition 5. Labor intensive or automated process
7. Seasonal demand or continual demand 6. Markup percentage updated
8. Life of the product or service. 7. Usage of scarce resources
 Major Influences
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Among many factors influencing the pricing decisions,

three major influences are:
1.Customers: Managers examine pricing problems through

the eyes of their customers.

2.Competitors: No business operates in vacuum. Competitors
reactions also influence pricing decision
3.Costs: Costs influence prices because they affect supply.
The lower the cost relative to the price, the greater the
quantity of product the company is willing to supply.
 Different methods of pricing
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1. Total cost plus or full cost plus pricing (FCPP):

2. Marginal cost plus pricing
 Different methods of pricing
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1. Total cost plus or full cost plus pricing (FCPP):

 Involves cost plus a profit margin
 Includes both direct and indirect cost incurred by the
company.
 Note: If multiple products are manufactured , the cost
determination process is complex. In this case the non-
manufacturing costs have to be distributed among the
different products.
 Full cost pricing is consistent with absorption costing
system.
 Absorption costing approach
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to cost plus pricing
1. COST BASE
2. MARK-UP RATE
==================================
 Under the absorption approach to cost-plus pricing, the
cost base is the absorption costing unit product cost
rather than the variable cost.
 The cost base includes direct materials, direct labor, and
variable and fixed manufacturing overhead.

Note: Only manufacturing cost.

 An Example:
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Here is information provided by the management of Ritter

Company.
Per Unit Total
Direct materials $ 6
Direct labor 4
Variable manufacturing overhead 3
Fixed manufacturing overhead $ 70,000
Variable S & A expenses 2
Fixed S & A expenses 60,000

Assuming Ritter will produce and sell 10,000 (at

normal capacity) units of the new product, and that
Ritter typically uses a 50% markup percentage, let’s
determine the unit product cost.
 Setting a Target Selling Price
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The first step in the absorption costing approach to cost-

plus pricing is to compute the unit product cost.
Per Unit
Direct materials $ 6
Direct labor 4
Variable manufacturing overhead 3
Fixed manufacturing overhead 7
Unit product cost $ 20

($70,000 ÷ 10,000 units = $7 per unit)

Ritter has a policy of marking up unit product costs by 50%.

Hence target selling price per unit = $20 +$10= $30.
 Determining the Markup Percentage
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A markup percentage can be based on an (A): industry “rule

of thumb,” (B): company tradition, or (C ): it can be
explicitly calculated.
The equation for calculating the markup percentage on
absorption cost is shown below.

Note: The markup must be high enough to cover S & A

expenses and to provide an adequate return on investment.
 Determining the Markup Percentage
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Let’s assume that Ritter must invest $100,000 in

the product and market 10,000 units of product
each year. The company requires a 20% ROI on
all investments. Let’s determine Ritter’s markup
percentage on absorption cost.
 Determining the Markup Percentage
Per Unit Total
13 Direct materials $ 6
Direct labor 4
Variable manufacturing overhead 3
Fixed manufacturing overhead $ 70,000
Variable S & A expenses 2
Fixed S & A expenses 60,000

Markup % = (20% × $100,000) + ($2 × 10,000 + $60,000)

on absorption cost 10,000 × $20
Variable S & A per unit Total fixed S & A
 Analyst’s point
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Problems with the Absorption Costing Approach

The absorption costing approach essentially assumes
that customers need the forecasted unit sales and will
pay whatever price the company decides to charge. This
is flawed logic simply because customers have a choice.
Think:
Let’s assume that Ritter sells only 7,000 units at $30 per
unit, instead of the forecasted 10,000 units.
 Problems in Full Cost Plus Pricing
(FCPP):
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1. Ignores demand and competition: Does not agree with

economic theory.
2. Fixed costs are likely to be distributed on some arbitrary basis
as there are different methods of apportionment.
3. Choice of volume or capacity base is important
4. This method does not distinguish between relevant (variable
costs and incremental fixed costs) and irrelevant (fixed) costs.
5. This method cannot always shield the firm from a loss.
6. Variants of FCPP is:
Total Manufacturing costs
+ Profit margin (say 50% on manufacturing cost)
= Selling Price
 Economic Justification for FCPP
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Most companies rely on full cost information reports when setting

prices. Following are the economic justification:
1.Contracts for customized products. Prices set in regulated

industries such as electric utilities are based on FCPP.

2.When firm enters into long term contractual relationship with a

customer to supply a product.

3.When demand is low, firms adjust the prices downward to acquire

additional business based on the lower incremental costs when surplus

capacity is available. Conversely, when demand for products is high,
firms adjust the prices upward based on the higher incremental costs
when capacity is fully utilized.
Note: Third situation is representative of many industries.
 Business Practice: Research Implication
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A principal reason (for the wider use of pricing policies

based on full cost) is the inability of the decision maker to
quantify the demand curve. This inability to apply
economic theory leads the business manager to apply
intuitive judgment coupled with trial and error methods.
Many decision makers begins with a full cost
approach and then on the basis of buyer’s reaction, adjust
the price. In this way the full cost based price represents a
first approximation- Target price whose markup must be
adjusted to meet the actual market price.
Example-service industries i.e. Airlines, Hotels
 Business Practice: Research Implication
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1. Perhaps the most convincing reasons for the use of cost

based prices is that the costs of a particular firm are
comparable with the costs of other firms in the industry.
2. One firm’s costs are reasonable estimates of its
competitor’s costs and hence its prices are likely to be
comparable to those of its competitors.
3. If most companies use similar facilities to perform
similar activities, they will have similar full costs and
thus similar prices if they produce at about the same
volume level.
 2. Marginal Cost Plus Pricing (MCPP)
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 Also known as contribution approach. Uses only

variable costs as the basis for pricing.
 Fixed costs are not added to the product, service or
contract.
 Establishes the relationship between prices and
costs that vary directly with sales.
 Implication
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Marginal cost approach helps a business firm:

A. to enter into new markets easily,

B. to increase its competitive position in the existing

markets,
C. to survive during trade depressions,

D. to utilize spare available capacity,

E. to dispose off surplus or obsolete stock

F. to make special order decisions.

 Implication
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Marginal cost plus method is useful in those

situations where a firm has recovered its total fixed
costs from sales in the normal market but is unable
to increase its further sales in that market.
If still spare capacity is available the firm may
attempt to sell to some other customers or markets at
lower (MCPP) which will provide some
contribution towards fixed costs and thus profit will
increase.
 Prices Indifference Point (PIP)
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 A PIP is the sales level at which a firm’s net income is

same between two pricing alternatives.
 The PIP indicates the volume of sales at which the new
price gives a profit equal to the profit of old sales volume
and price.
 In case, sales volume at new price is lower than the
sales volume at old price (when there is price
indifference point), firm should reject the price
increase since firm’s profit will decrease.
 Calculating optimal selling prices
using differential calculus
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A. Optimal output is determined at the point where

marginal revenue equals marginal cost.
B. The highest selling price at which the optimum output
can be sold determines the optimal selling price.
C. If demand and cost schedules are known, it is possible
to derive the optimum output level and selling price.
 Example-1
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A division within the Caspian company sells a single

product. Divisional fixed costs are Rs.700,000 per annum.
And a variable cost of Rs.70 is incurred for each additional
unit produced and sold over a very large range of outputs.
The current selling price for the product is Rs.200 and at this
price 10 000 units are demanded per annum. It is estimated
that for each successive increase in price of Rs.2 annual
demand will be reduced by 500 units. Alternatively for each
Rs.2 reduction in price demand will increase by 500 units.
Calculate the optimum output and price for the
product assuming that if prices are set within each Rs.2
range there will be proportionate change in demand.
 Example-2 Note: Value of net fixed assets and other
investments assigned to per set of generator.
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A Company manufactures generators, electric motors, switch gears and other electrical
equipments. Using the same fabrication facility, it wants to quote the minimum price for the
manufacture of four sets of generators. The following estimates of costs were drawn by the
engineering department:
Amount in Rs.Million (per set)
Engineering, design and drawing 0.5
Material 12
Labor 2
Depreciation 1
Other overheads 1.5
Warranties provision 0.5
Cost of sales 17.5
The managements aim is to make profit of 25% on capital employed. The sales manager has
recommended a price of Rs. 17.5 +25%= Rs.21.875 million for the quotation. As head of the
management service division, you are required to give your views on the minimum price to be
adopted. The following additional information per set is available.
Value of net fixed assets (investments required) Rs. 10 Million
Average rate of depreciation 10%
Working capital requirements 6 months cost of sales
Required:
Submit a report to the management detailing your recommendation on the price that can be
quoted.
(a) If there is no advance payment involved and
(b) If the buyer is to make advance payment based on the expected progress of work
every month.
 Example-3
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 Elasticity of Demand-RECAP
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 Example-4
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