Managerial accounting 6e jams jambalvo chapter 08

CHAPTER 8
Pricing Decisions, Customer
Profitability Analysis, and
Activity-Based Pricing

Slide 8-2


Pricing Decisions
 Pricing decisions are often the most
difficult decisions that managers face
 Pricing decisions examined in this chapter
include
 Profit-maximizing price from the standpoint
of economic theory
 Pricing of special orders
 Marking up costs and target costing
 Measuring customer profitability and
activity based pricing

Slide 8-3


The Profit-Maximizing Price
 Economic theory suggests that the
quantity demanded is a function of the
price that is charged
 Generally, the higher the price, the lower
the quantity demanded
 If managers can estimate the quantity

demanded at various prices, determining
the optimal price is straightforward

Slide 8-4

Learning objective 1: Compute the profit-maximizing price for a
product or service, and perform incremental analysis related to
pricing a special order.


The Profit-Maximizing Price
 To calculate the profit-maximizing price:
 Subtract unit variable costs from price to
obtain the contribution margin
 Multiply the contribution margin by the
quantity demanded
 Subtract fixed costs and estimate profits
 Select the price with the highest profit

Slide 8-5

Learning objective 1: Compute the profit-maximizing price for a
product or service, and perform incremental analysis related to
pricing a special order.


Estimating the Profit-Maximizing
Price

Slide 8-6

Learning objective 1: Compute the profit-maximizing price for a
product or service, and perform incremental analysis related to
pricing a special order.


Estimating Demand
 The most difficult part of determining the
profit-maximizing price is determining
the demand function
 A number of approaches can be used
 Sales managers in various regions could
estimate the total quantity demanded at
various prices
 The product could be test marketed with a
number of potential customers at various
prices

Slide 8-7

Learning objective 1: Compute the profit-maximizing price for a
product or service, and perform incremental analysis related to
pricing a special order.


Test Your Knowledge 1
 Estimates of price and quantity demanded
Price = $6.95, quantity demanded = 20,000
Price = $5.95, quantity demanded = 25,000
Price = $4.95, quantity demanded = 32,000

 Variable cost = $1.50 per unit
 Fixed cost = $80,000
Find the profit-maximizing price

Slide 8-8

Learning objective 1: Compute the profit-maximizing price for a
product or service, and perform incremental analysis related to
pricing a special order.


Pricing Special Orders
 Special orders are for goods and services
not considered part of a company’s
normal business
 Price charged will not affect prices
charged in the normal course of business
 The company may be better off charging a
price that is below full cost

Slide 8-9

Learning objective 1: Compute the profit-maximizing price for a
product or service, and perform incremental analysis related to
pricing a special order.


Pricing Special Orders
 The special order decision presents two

alternatives
 Accept
 Reject

 Income from the main business is the
same under both alternatives
 It is not incremental and need not be
considered in the special order

Slide 8-10

Learning objective 1: Compute the profit-maximizing price for a
product or service, and perform incremental analysis related to
pricing a special order.


Pricing Special Orders
 Need to consider incremental revenues
and incremental costs
 The incremental revenue is the revenue
associated with the special order
 Incremental costs can include
 Direct materials
 Direct labor
 Variable overhead
 Incremental fixed costs
Slide 8-11

Learning objective 1: Compute the profit-maximizing price for a
product or service, and perform incremental analysis related to

pricing a special order.


Special Orders – Premier Lens
Example
Should Premier Lens accept special order of
20,000 lenses to be sold to Blix Camera for $73 per
lens?
Below is the full cost of $75 per lens

Slide 8-12

Learning objective 1: Compute the profit-maximizing price for a
product or service, and perform incremental analysis related to
pricing a special order.


Special Orders – Premier Lens
Example
 Perform incremental analysis
 Fixed costs are not incremental, they will not
change if the order is accepted

Slide 8-13

Learning objective 1: Compute the profit-maximizing price for a
product or service, and perform incremental analysis related to
pricing a special order.

Importance of Pricing Power

Slide 8-14

Learning objective 1: Compute the profit-maximizing price for a
product or service, and perform incremental analysis related to
pricing a special order.


Test Your Knowledge 2
Which of the following is true?
a. In pricing special orders, fixed costs
typically are not relevant
b. In pricing special orders, fixed costs
typically are relevant
Answer: a
Fixed costs typically are not relevant

Slide 8-15

Learning objective 1: Compute the profit-maximizing price for a
product or service, and perform incremental analysis related to
pricing a special order.


Cost-Plus Pricing
 With a cost plus approach, the company
starts with an estimate of product cost
 Typically excluding any selling or
administrative costs

 Adds a markup to arrive at a price that
allows for a reasonable level of profit

Slide 8-16

Learning objective 2: Explain the cost-plus approach to pricing and why it is
inherently circular for manufacturing firms. Also, explain the target costing
process for a new product.


Cost-Plus Pricing
 Advantages
 The cost plus approach is simple to apply
 The company will earn a reasonable profit
if a sufficient quantity can be sold at the
specified price

 The approach also has limitations

Slide 8-17

Learning objective 2: Explain the cost-plus approach to pricing and why it is
inherently circular for manufacturing firms. Also, explain the target costing
process for a new product.


Cost-Plus Pricing
 Limitations
 Determination of an appropriate markup

requires considerable judgment
 Experimentation with different markups may
be necessary
 Inherently circular for manufacturing firms
 Need to estimate demand to determine fixed
costs and the price, yet the price affects the
quantity demanded

Slide 8-18

Learning objective 2: Explain the cost-plus approach to pricing and why it is
inherently circular for manufacturing firms. Also, explain the target costing
process for a new product.


Cost-Plus Pricing

Slide 8-19

Learning objective 2: Explain the cost-plus approach to pricing and why it is
inherently circular for manufacturing firms. Also, explain the target costing
process for a new product.


Test Your Knowledge 3
All of the following are limitations of cost plus
pricing except
a. Determination of the markup percentage
requires judgment
b. Is inherently circular for manufacturing

firms
c. Experimentation may be necessary
d. Cost plus is simple to apply
Answer: d
Simplicity is an advantage of cost plus pricing
Slide 8-20

Learning objective 2: Explain the cost-plus approach to pricing and why it is
inherently circular for manufacturing firms. Also, explain the target costing
process for a new product.


Target Costing
 Once a product is designed it is difficult to
make changes that reduce costs
 80% of a product’s costs cannot be reduced
once it is designed
 Product features drive costs

 Target costing
 Integrated approach to determine features,
price, costs and design to ensure a profit

Slide 8-21

Learning objective 2: Explain the cost-plus approach to pricing and why it is
inherently circular for manufacturing firms. Also, explain the target costing
process for a new product.

Target Costing
 The process begins with an analysis of
competing products
 This leads to a specification of features and
price attractive to customers
 The second step is to specify a desired level of
profit
 Then the engineering department with input
from the cost accounting department develops
a design that can be produced at a cost which
will earn the desired level of profit

Slide 8-22

Learning objective 2: Explain the cost-plus approach to pricing and why it is
inherently circular for manufacturing firms. Also, explain the target costing
process for a new product.


Target Costing

Slide 8-23

Learning objective 2: Explain the cost-plus approach to pricing and why it is
inherently circular for manufacturing firms. Also, explain the target costing
process for a new product.


Test Your Knowledge 4
Target costing:

a. Requires specification of desired level of
profit
b. Adds desired profit to existing costs
c. Is used primarily with products that are
already in production
d. Leads to profit maximization
Answer: a
Requires specification of desired profit
Slide 8-24

Learning objective 2: Explain the cost-plus approach to pricing and why it is
inherently circular for manufacturing firms. Also, explain the target costing
process for a new product.


Analyzing Customer Profitability
 Customer Profitability Measurement System
(CPM)
 Indirect costs of servicing customers are
assigned to cost pools
 Indirect costs include processing orders,
handling returns, and shipments

 Costs are allocated to specific customers
using cost drivers to determine customer
profitability
 Subtracting these costs and product costs
from customer revenue yields a measure of
customer profitability
Slide 8-25

Learning objective 3: Analyze customer
profitability, and explain the activity-based pricing
approach.