Chapter 6

Pricing Decisions and Cost

Management

Cost and Management Accounting II

(AcFn 3032)

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 Contents
• What are pricing decisions?
• Major influences on Pricing Decision
• Costing and pricing:
– Short-term and
– Long-term
• Cost Plus target return on investment (ROI)

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What are pricing decisions?
• Pricing decisions are:
– Strategic management decisions
– about what to charge for products and services.
• They affect the quantity produced and sold:
– => Cost and Revenue.
• So, to max’z OI, companies should produce and sell
units so long as the marginal revenue exceeds the
marginal cost.
• Hence, understanding cost behavior patterns, cost
drivers, and the concept of relevant information is a
must

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Major influences on Pricing decisions
• Price of a product depends on DD and SS.
• The three influences on DD and SS are customers,
competitors and costs.

• Influence prices through their effect on

Customers
the DD for a product or service

Competitors • influence prices through their actions

• Influence prices because they affect

Costs
supply

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 Distinguish between short-run
and long-run pricing decisions

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 Time Horizon of Pricing Decisions

Short-run decisions:

have a time horizon

of less than a year: Long-run decisions:
▪ pricing a one-time-
only special order involve a time horizon
▪ adjusting product of a year or longer:
mix and output volume ▪ pricing a product in
a major market where
price setting has
some leeway
 Time Horizon of Pricing Decisions
1. Costs that are often
irrelevant for short-run
pricing decisions
(fixed costs) are often
relevant in the long run.

2. Profit margins in
long-run pricing
decisions are often set
to earn a reasonable
return on investment (ROI).
 Costing and Pricing for the Short Run –
Example
▪ LM Corp. operates a plant with a monthly
capacity of 500,000 cases of tomato
sauce. The corp. is currently produces
300,000 cases.
▪ DX Co. has asked LM Corp. and two other
companies to bid on supplying 150,000
cases each month for the next four
months.
▪ At what price should LM Corp. bid?

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 Costing and Pricing for the Short Run – Example
• The current cost structure for a case looks like this:.
Cost Per Case
▪ Variable manufacturing $38
▪ Variable marketing and distribution 13
▪ Fixed manufacturing 14
▪ Fixed marketing and distribution 15
Total $80

• Besides, if LM Corp. makes the extra 150,000 cases, the

existing total fixed manufacturing overhead $4,200,000
per month, (i.e. $14 * 300,000) would continue, plus an
additional $165,000 of fixed overhead will be incurred
per month.
• The total fixed marketing and distribution costs will not
change
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Costing and Pricing for the Short Run –
Example

Relevant Costs:
Variable manufacturing $38.00
Fixed manufacturing 1.10
Total $39.10

$165,000 ÷ 150,000 = $1.10

Any bid above $39.10 will improve

LM Corp’s profitability in the short run.
Costing and Pricing for the Short Run –
Example

Suppose that LM Corp. believes that DX Co.

will sell the tomato sauce in LM Corp’s current
markets but at a lower price than LM.

Relevant costs of the bidding decision

should include revenues lost on sales
to existing customers.
 Costing and Pricing for the Long Run –
Example

Little Computer Corporation manufactures

two brands of computers: Simple Computer (SC)
and Complex Computer (CC).

Little uses a long-run time horizon to price

Complex Computer (CC).
 Costing and Pricing for the Long Run – Example

• DM costs vary with the number of units produced

• DL costs vary with direct labor hours
• Ordering and receiving, testing and inspection, and
rework costs vary with their chosen cost drivers. These
are:
– Ordering: $78 per order
– Testing: $ 2 per inspection hour
– Rework: $38 per unit reworked
• Further, the following unit cost data provided
– Direct materials $450.00
– Direct labor: 3.50 hours @ $19 per hour 66.50
– Total
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$516.50 13
 Costing and Pricing for the Long Run –
Example
Number of orders placed: 17,000
Number of testing hours: 3,000,000
Number of units reworked: 8,000

The direct fixed costs of machines used

exclusively for the manufacture of
Complex Computer total $7,000,000.

What is the cost of producing 100,000

units of Complex Computer?
 Costing and Pricing
for the Long Run – Example

Direct material and labor $51,650,000

Direct fixed costs 7,000,000
Ordering (17,000 × $78) 1,326,000
Testing (3,000,000 × $2) 6,000,000
Rework (8,000 × $38) 304,000
Total $66,280,000

$66,280,000 ÷ 100,000 units = $662.80/unit

Alternative Long-Run Pricing Approaches

Market-based

Cost-based
(also called cost-plus)
 Market Based Vs Cost Based (cost plus)
• The Market Based Approach:
– Starts by asking, given what our customers want and
how our competitors will reach to what we do, what
price should we charge?
– Good for companies that operate in a competitive market
(very similar products and services sold)
• Oil and gas commodities
• The Cost Based Approach:
– Starts by asking, given what it costs us to make this
product, what price should we charge that will recoup
our costs and achieve a required ROI?
– Good for companies where their industries show product
differentiation.
• Automobiles, management consultancy, legal services

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 Cost Plus Target of Return on
Investment

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Target Costing for Target pricing
• Target pricing is one form of market-based pricing
• A target price is the estimated price for a product or
service that potential customers will pay.
• This estimate is based on an understanding of customers’
perceived value for a product and how competitors will price
competing products.
• Information from customers by:
– Having close contact with them
– Undertaking market research (survey)
• Information about competitors through their:
– Customers, employees and suppliers
– Reverse engineering: disassembling and analyzing
competitors products to determine product design and
materials and becoming acquainted with the technologies
used by competitors.
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Target Costing for Target pricing
• Target pricing, as calculated using information from
customers and competitors, forms the basis for
calculating target cost.
• Target cost per unit: is the target price minus target
operating income per unit.
– Target operating income per unit is the operating income
that a company aims to earn per unit of a product or
service sold.
• Target cost per unit is the estimated long-run cost per
unit of a product or service that enables the company to
achieve its target operating income per unit when selling
at the target price.
• Target cost per unit is often lower than the existing full
cost per unit of the product
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 Target Price and Target Cost
Steps in developing target prices and target costs:

1. Develop a product that satisfies the needs of

potential customers.

2. Choose a target price.

3. Derive a target cost per unit.

4. Perform value engineering to achieve target costs.

Implementing Target Pricing and Target
Costing
Little Co.’s management wants a 15% target
operating income on sales revenues of CC.

Target sales revenue is $750 per unit.

What is the target cost per unit?

So, target operating income is; $750 × .15 = $112.50,

Then, Target cost is; $750 – $112.50 = $637.50

Current full cost per unit of CC is $662.80

 Repeated
Costing and Pricing
for the Long Run – Example

Direct material and labor $51,650,000

Direct fixed costs 7,000,000
Ordering (17,000 × $78) 1,326,000
Testing (3,000,000 × $2) 6,000,000
Rework (8,000 × $38) 304,000
Total $66,280,000

$66,280,000 ÷ 100,000 units = $662.80/unit

 Cost-based approach – cost-plus pricing

✓ definition
➢ one form of cost-based pricing
➢ sets selling price by adding a markup component to the cost
base
Example 4
Astel Plc. uses a 12% markup on the full unit cost of one of its
SY product when computing selling price of the product. The full
cost of SY is determined to be Birr 720.00.

Required: Determine selling price of SY.

Answer:
Full cost Birr 720.00
Add: Mark-up on full cost (Birr720 x 12%) 86.40
Forecasted selling price Birr 806.40
 End of Chapter Six

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 Chapter 7
Decentralization and Transfer
Pricing

Cost and Management Accounting II

(AcFn 3032)

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 Contents
• MCS: Overview
• What is :
– Decentralization?
– Responsibility Center
– Transfer pricing

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MCS: An overview
• Management Control Systems (MCS):
– refers formal and informal systems
– is a means of gathering and using information

• Importance of MCS:
– aids and coordinates the planning and control decisions
throughout an organization and
– guides the behavior of its managers and employees.

• Features of Effective MCS:

– closely aligned to a company’s strategies and goals
– designed to fit a company’s structure and decision making
responsibility of individual managers
– motivates managers and employees

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Decentralization: Meaning, Benefits and Costs
• Meaning of decentralization:
– Is the freedom for managers at lower levels of the
organization to make decisions.
• Benefits of decentralization:
✓ Creates greater responsiveness to local needs
✓ Leads to gains from faster decision making

✓ Increases motivation of subunit managers

✓ Assist management development and learning

✓ Sharpens the focus of subunit managers

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 Decentralization: Benefits and Costs
• Costs of decentralization:
– Leads to suboptimal decision making aka incongruent
or dysfunctional decision
• May occur when there is:
– lack of harmony among overall company goals, the subunits
and the individual goals of decision makers.
– no guidance to subunit managers concerning the effects of
their decisions on other parts of the company.
– independence among subunits.
– Focuses the manger’s attention on the subunit rater than
the company as a whole
– Increases the costs of gathering information
– Results in duplication of activities

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 What is a responsibility center?

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 What is a responsibility center?
• A responsibility center:
– is an operational unit or entity within an organization,
– responsible for all the activities and tasks structured
for that unit.
– Has its own goal, staffs, objectives, policies and
procedures, and financial reports.

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• Definition:
• is the price one subunit (department/division)
charges for a product or service supplied to
another subunit of the same organization.

Assembly Plant Engine factory

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 Transfer Pricing
• Transfer pricing should help achieve a company’s
strategies and goals.

– fit the organization’s structure

– promote goal congruence

– promote a sustained high level of

management effort
Transfer Pricing: Methods
• There are four methods of TP

Market-based
• TP uses price of a similar product or
service publicly listed

• TP is based on the costs of producing

Cost-based
the product in question

• TP is determined by Negotiation
Negotiated
between subunits

• TP considers both cost & market

Hybrid
information (e.g., cost plus mark-up)
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 Transfer Pricing: Example
▪ ABC is a multinational company having a manufacturing division (Division A) and a
distribution division (Division B) in two different countries with different tax rates.
Division A produces a standardized component that Division B sells to external
customers. The unit cost of producing the component by Division A consists of $10
variable costs and $5 fixed costs. Division A sells the component to unrelated third
party at $17 per unit. The mark-up for Division A is 20%. On the other hand,
Division B incurs additional $3 per unit variable cost (including packaging,,
shipping, etc.) and sell the component to external customers at $25 per unit.

▪ Required:
▪ Determine transfer price using (a) market-based, (b) full-cost-based and (c)
hybrid approaches.
Division A Division B Company
▪ Market-based $17 - $15 = $2 profit $25 - $17 = $8 $2 + $8 = $10
▪ Full-cost-based $15 - $15 = $0 profit $25 - $15 = $10 $0 + $10 = $10
▪ Hybrid $15 x (1.20) - $15 = $3 profit $25 - $18 = $7 $3 + $7 = $10
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 End of Chapter Seven

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