Financial managerial accounting 3rd kieso ch21(pricing)

Financial & Managerial
Accounting

3

rd

Edition

Jerry Weygandt, Paul Kimmel, Don
Kieso
Prepared by
Coby Harmon
University of California, Santa Barbara
Westmont College

21-1


CHAPTER 21

Pricing
Chapter Outline
LEARNING OBJECTIVES

21-2

LO 1

Compute a target cost when the market determines a product price.

LO 2

Compute a target selling price using cost-plus pricing.

LO 3

Use time-and-material pricing to determine the cost of services provided.

LO 4

Determine a transfer price using the negotiated, cost-based, and market-based approaches.


Target Costing

LEARNING OBJECTIVE 1
Compute a target cost when the market determines a product price.

ILLUSTRATION 21-1
Pricing factors
21-3

LO 1


Target Costing

The price of a good or service is affected by many factors.



Company must have a good understanding of market forces.



Where products are not easily differentiated from competitor goods, prices are not set by
the company, but rather by the laws of supply and demand – such companies are called
price takers.



Where products are unique or clearly distinguishable from competitor goods, prices are set
by the company.

21-4

LO 1


Target Costing

Establishing a Target Cost

21-5



Laws of supply and demand significantly affect product price.



To earn a profit, companies must focus on controlling costs.



Requires setting a target cost that will provide the company’s desired profit.

LO 1


Establishing a Target Cost



Target cost: Cost that provides the desired profit when the market determines a product’s price.
ILLUSTRATION 21.2
Target cost as related to price and
profit



If a company can reach it’s sales targets, produce its product for the target cost or less, it will
meet its profit goal.

21-6

LO 1


Establishing a Target Cost



First, company should identify the segment of the market where it wants to compete.



Second, company conducts market research to determine the target price – the price the
company believes will place it in the optimal position for the target consumers.

21-7



Third, company determines its target cost by setting a desired profit.



Last, company assembles a team to develop a product to meet the company’s goals.

LO 1


DO IT! 1

Target Costing

Fine Line Phones is considering introducing a fashion cover for its phones. Market research indicates that 200,000
units can be sold if the price is no more than $20. If Fine Line decides to produce the covers, it will need to invest
$1,000,000 in new production equipment. Fine Line requires a minimum rate of return of 25% on all investments.

Determine the target cost per unit for the cover.

The desired profit for this new product line is
$1,000,000 x 25% = $250,000
Each cover must result in profit of $250,000 ÷ 200,000 units = $1.25
Market price
$20

21-8

Desired profit

-

$1.25

Target cost per unit

=

$18.75 per unit

LO 1


Target Costing

Question
Target cost related to price and profit means that:

21-9

a.

Cost and desired profit must be determined before selling price.

b.

Cost and selling price must be determined before desired profit.

c.

Price and desired profit must be determined before costs.

d.

Costs can be achieved only if the company is at full capacity.

LO 1


Cost-Plus and Variable-Cost Pricing

LEARNING OBJECTIVE 2
Compute a target selling price using cost-plus pricing.

Cost-Plus Pricing



In an environment with little or no competition, a company may have to set its own price.



When a company sets price, the price is normally a function of product cost: cost-plus
pricing.



Approach requires establishing a cost base and adding a markup to determine a target
selling price.

21-10

LO 2


Cost-Plus Pricing

ILLUSTRATION 21.3
Relation of markup to cost and selling price

Selling Price - Cost = Markup (Profit)



In determining the proper markup, a company must consider competitive and market conditions.



Size of the markup (the “plus”) depends on the desired return on investment for the product:

ROI = net income ÷ invested assets

Cost + Markup = Target Selling Price
ILLUSTRATION 21.4
Cost-plus pricing formula

21-11

LO 2


Cost-Plus Pricing

Illustration: Thinkmore Products, Inc. is in the process of setting a selling price on its new video
camera pen. It is a functioning pen that will record up to 2 hours of audio and video. The per unit
variable cost estimates for the new video camera pen are as follows.

Per Unit
Direct materials

$23

Direct labor

17

Variable manufacturing overhead

12

Variable selling and administrative expenses
Variable cost per unit

8
$60

ILLUSTRATION 21.5
Variable cost per unit

21-12

LO 2


Cost-Plus Pricing

In addition, Thinkmore has the following fixed costs per unit at a budgeted sales volume of 10,000 units.

ILLUSTRATION 21.6
Fixed cost per unit, 10,000 units

21-13

LO 2


Cost-Plus Pricing

Thinkmore has decided to price its new video camera pen to earn a 20% return on its investment (ROI)
of $2,000,000.

Expected income = 20% ROI of $2,000,000

Desired ROI = $400,000 ÷ 10,000 units = $40

Per Unit

Sales price per unit =

Variable cost
Fixed costs
Total cost
Markup (desired ROI per unit)
Selling price per unit (at 10,000 units)

$60
65
125
40
$165

ILLUSTRATION 21.8
21-14

Computation of selling price, 10,000 units

LO 2

Cost-Plus Pricing

Use markup on cost to set a selling price:



Compute the markup percentage to achieve a desired ROI of $40 per

ILLUSTRATION 21.9
Computation of markup percentage

unit:

Markup (Desired ROI

Total

Markup

per Unit)

÷

Unit Cost

=

Percentage

$40

÷

$125

=

32%
ILLUSTRATION 21.10



Compute the target selling price:

Computation of selling price—markup
approach

Target
Total

+

Unit Cost
$125
21-15

Total

x

Unit Cost
+

($125

Markup

=

Percentage
x

32%)

Selling Price
per Unit

=

$165
LO 2


Cost-Plus Pricing

Limitations of Cost-Plus Pricing



Advantage of cost-plus pricing: Easy to compute.



Disadvantages:

►

Does not consider demand side:


►

Will the customer pay the price?

Fixed cost per unit changes with change in sales volume:



At lower sales volume, company must charge higher price to meet desired
ROI.

21-16

LO 2


Limitations of Cost-Plus Pricing

Illustration: If budgeted sales volume for Thinkmore’s Products was 5,000 instead of 10,000,

Thinkmore’s variable cost per unit would remain the same. However, the fixed cost per unit would
change as follows.
ILLUSTRATION 21.11
Fixed cost per unit, 5,000 units

Thinkmore's desired 20% ROI now results in a $80 ROI per unit [(20% x $2,000,000) ÷ 5,000].

21-17

LO 2


Limitations of Cost-Plus Pricing

Thinkmore computes the selling price at 5,000 units as follows.
Per Unit

ILLUSTRATION 21.12

Variable cost

$60

Fixed costs

130

Total cost

190

Markup (desired ROI per unit)

80

Computation of selling price, 5,000 units

Selling price per unit (at 5,000 units)

$270

At 5,000 units, how much would Thinkmore mark up its total unit costs to earn a desired ROI of $80 per
unit.
$80 (desired ROI per unit)
= 42.11%
21-18

$190 (total unit cost)

LO 2


Variable-Cost Pricing

Alternative pricing approach:
Simply add a markup to variable costs.



Avoids the problem of uncertain cost information related to fixed-cost-per-unit computations.



Helpful in pricing special orders or when excess capacity exists.

Major disadvantage is that managers may set the price too low and fail to cover fixed costs.

21-19

LO 2


Cost-Plus Pricing

Question
Cost-plus pricing means that:

21-20

a.

Selling price = variable cost + (markup percentage + variable cost).

b.

Selling price = cost + (markup percentage X cost).

c.

Selling price = manufacturing cost + (markup percentage + manufacturing cost).

d.

Selling price = fixed cost + (markup percentage X fixed cost).

LO 2


DO IT! 2

Target Selling Price

Air Corporation produces air purifiers. The following per unit cost information is available: direct
materials $16, direct labor $18, variable manufacturing overhead $11, variable selling and
administrative expenses $6. Fixed selling and administrative expenses are $50,000, and fixed
manufacturing overhead is $150,000.
Using a 45% markup percentage on total per unit cost and assuming 10,000 units, compute the target
selling price.

21-21

LO 2


DO IT! 2

Target Selling Price

Compute the target selling price.
Direct materials

$16

Direct labor

18

Variable manufacturing overhead

11

Variable selling and administrative expenses

6

Fixed selling and administrative expenses

5

Fixed manufacturing overhead

15

Total unit cost

Total

$71

+

Unit Cost
$71
21-22

Total

x

Unit Cost
+

($71

Markup

=

Percentage
x

45%)

Target Selling
Price per Unit

=

$102.95
LO 2

Time-and-Material Pricing

LEARNING OBJECTIVE 3
Use time-and-material pricing to determine the cost of services provided.

Time-and-material pricing an approach in which the company uses two pricing rates:



One for labor used on a job - includes direct labor time and other employee costs.



One for material - includes cost of direct parts and materials and a material loading charge
for overhead.

Widely used in service industries, especially professional firms such as public accounting, law, and
engineering.

21-23

LO 3


Illustration: Assume the following data for Lake Holiday Marina, a boat and motor repair shop.

ILLUSTRATION 21.13
21-24

Total annual budgeted time and material costs

LO 3


Step 1: Calculate the Labor Rate


Express as a rate per hour of labor.



Rate includes:



21-25

►

Direct labor cost (includes fringe benefits).

►

Selling, administrative, and similar overhead costs.

►

Allowance for desired profit (ROI) per hour.

Labor rate for Lake Holiday Marina for 2020 based on:

►

5,000 annual labor hours.

►

Desired profit margin of $8 per hour of labor.

LO 3