ACCT3106 Management

Control
Tutorial Summary on Ch.13

Pricing Decisions and Cost Management

Part One:
Short-run Pricing Decisions
 Lecture notes:
Short-run Pricing Decisions Slide 6

• Short-run decisions usually have a time horizon of less than one

year and include decisions such as:
1. One-time-only special order with no long-run implications (assuming
accepting the special order will not affect the relationship with the existing
normal customers); and
2. Adjusting product mix and output volume in a competitive market.

• Short-run pricing decisions are response to short-run demand

and supply conditions.

• When setting short-run price, we must identify those costs that

are relevant to the decision.
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 Defining Relevant Costs
• Relevant costs are expected future costs that differ among
alternative courses of action.

• The above definition implies

• Past costs are irrelevant as these costs are already incurred. Nothing
can be changed to alter the past.

• We concern costs that are differed:

Alternative 1 Alternative 2
Marketing costs $1M $1M
Admin. costs $3M $4M
Total $4M $5M

Marketing costs do not differ between the 2 alternatives

 Therefore, marketing costs are irrelevant to the decision.
4  What relevant is only the manufacturing costs.
 So, the decision is to choose alternative 2 as this alternative gives
lower manufacturing costs.
 Lecture notes:
SR pricing: with idle capacity In-class Practice
13-35
• E.g. your company has just received a special order to manufacture product
X. Assuming your factory has extra capacity to handle this one-time only
special order and this order will not affect your existing production, the
relevant costs involved are:

• mainly the variable costs, including all the variable costs in the value
chain (e.g. variable marketing costs), but not just the variable
manufacturing costs.

• Fixed costs are irrelevant as the company still needs to incur the fixed
costs no matter the order is taken or not.

• However, if there are special types of fixed costs need to be incurred

because of the special order, then the incremental fixed costs will be
relevant.
The minimum price per unit = Variable cost per unit + incremental fixed cost
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per unit (if any)
 Example: pricing for a special order

X Optical Co. ordinarily sells the X-lens for $50. The

variable production cost is $10, the fixed production cost
is $18 per unit, and the variable selling cost is $1.

A customer has requested a special order for 10,000

units of the X-lens to be imprinted with the customer’s
logo. This special order would not involve any selling
costs, but the company would have to purchase an
imprinting machine for $50,000.

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Assuming the company has idle capacity to
handle the order. What is the minimum price
should be set for this special order?

$10 x 10,000 units

Variable production cost $100,000

Incremental fixed cost 50,000
Total relevant cost $150,000
Number of units 10,000
Relevant cost per unit $15
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 SR pricing: with capacity constraint

• If the special order is taken under the situation of constrained

plant capacity, the minimum price set should also include the
opportunity cost of producing the special order.
• Therefore, the price formula =

V.C. per unit + incremental fixed cost per unit (if any) + opportunity cost per unit

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 Example:
A material “P” can be used to make two products, namely Alpha and Beta.
One unit of Alpha requires 1.5 kilos of material “P” and Alpha has a
contribution margin of $6 per unit.

Costs of making one kilogram of Beta are:

Material “P” (2 kilos x $4/kilo) $8
Direct Labor $4
Variable O/H $3
Fixed O/H allocated $5
Total manufacturing costs $20
The company has just received an order to manufacture 3,000 units of
Beta which also requires material “P” as input.
Now, material “P” is in short supply, what is the min. price per unit that the
company should charge to manufacture Beta?
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 • To manufacture 3,000 units of Beta requires (3,000 units x 2 kilos) 6,000
kilos of material “P”. Since “P” is now the constrained resources, the
company has to forgo the contribution margin brought by Alpha in order to
manufacture Beta.

• Relevant costs:
 Incremental manufacturing costs $15 x 3,000 = $45,000
(fixed O/H is irrelevant*)
 Opportunity costs: CM forgone $6 x 6000/1.5 kilo = $24,000
Total relevant costs $69,000
*Fixed costs are irrelevant in this case as the question does
not mention the company would incur additional fixed costs!

 Therefore, the min price per unit of Beta should be

 $69000/3000 = $23
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Part Two:
Long-run Pricing Decisions:
 Lecture notes:
Long-run pricing Decisions Slides 7-8

• Long-run pricing decisions involve a time horizon of a year or longer.

• In the long-run, almost all costs become variable because firms can change
their capacity by expanding or cutting it.

• For setting long-run prices, firms should determine the full costs (including
all manufacturing costs + all operating costs like R&D, design, marketing,
distribution and customer service) of producing and selling products.

• In other words, we should consider all costs in the value chain.

• Two long-run pricing approaches:

1. Target pricing (suitable for homogeneous products)
12 2. Cost-plus pricing (suitable for heterogeneous products)
LR pricing approach: Target pricing (implying target costing)
Lecture notes:
• Target pricing is a market-based approach of long-run pricing. Slides 9-11

• A target price is the estimated price for a product/service that potential

customers will be willing to pay.

• It starts by asking the question: “given what our customers want (e.g.
the customers’ price sensitivity) and how our competitors will react to
what we do, what price should we charge?”

• In other words, target pricing

1. first consider customers’ wants and competitors’ actions,
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2. and then look at the costs.
• Companies operating in markets that are competitive use this approach as
competitive pressures always push down the product prices, companies seldom
have influence over the prices to charge (perfect competition: numerous sellers
selling homogeneous products. The sellers have no authority to set the price. They
must accept the market price).

• The purpose of target pricing is NOT to set price but to cut cost.

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 Target pricing (say, $10 per unit, calculated by using customer and
competitors inputs)

Less: Target Return (say, $2 per unit)

Target cost ($8, the cost that the company wants to

achieve)

Compare the target cost ($8) with the firm’s existing product cost (say, $9)
to calculate the target cost to cut ($9 - $8 = $1 the firm needs to cut $1 to
achieve the target return of $2)
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 • Usually, the target cost per unit is smaller than the
existing full cost per unit.
 Target cost is the goal that a firm must achieve to meet its
strategic objectives of cost reduction and control.
 If the existing full cost per unit > desired target cost
Value Engineering required

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 Lecture notes:
Value Engineering Slides 16-22
• Value engineering is a systematic evaluation of all aspects of the value-chain In-class Practice
business function, with the objective of reducing costs while satisfying customer 13-27
needs.

• When doing value engineering, managers need to distinguish between value-

added and nonvalue-added costs.

• A value-added cost is a cost that customers perceive as adding value, or utility,

to a product or service. Value-added costs are necessary to keep the value-
added activities.
• E.g. costs of increasing the reliability of a product.

• A nonvalue-added costs is a cost that customers do NOT perceive as adding

value, or utility, to a product or service. Nonvalue-added costs are NOT
necessary to incur because these normally involve duplication of resources.
Even these nonvalue-added costs are fully cut, the value of the products will not
17 be affected.
• E.g. rework cost and repair cost
 • Value-engineering seeks to reduce nonvalue-added activities and hence
nonvalue-added costs by reducing the cost drivers of nonvalue-added
activities.
• E.g. Reducing rework hours (cost driver of the rework activities) to reduce the
rework costs

• Value-engineering also seeks to increase the efficiency in value-added

activities to reduce value-added costs.

Discussion question 13-17

1. Classify each of the following costs as value-added (V), nonvalue-added
(N) or in the gray (G) area between:
1. Materials and labor for servicing machine tools $1,100,000 - V
2. Rework costs 90,000 - N
3. Expediting costs caused by work delays 65,000 - N
4. Materials-handling costs 80,000 - G (or V)
5. Materials procurement and inspection costs 45,000 - G (or V)
6. Preventive maintenance of equipment 55,000 - G (or V)
Note that classifications of value added, nonvalue-added and gray are costs
7. Breakdown maintenance of equipment 75,000 - N (or G)
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are sometimes NOT so clear-cut.
2. For any cost classified in the gray area, assume 60% is value-added and
40% is non-value-added. How much of the total of all seven costs is
value-added and how much is non-value-added?

Total value-added costs = $180,000 x 60% + $1,100,000 = $1,208,000

Total non-value-added costs = $180,000 x 40% + $230,000 = $302,000
 • To manage value-added and nonvalue-added costs, management also requires
to distinguish between when costs are locked in (committed) and when costs are
incurred. The reason is that it’s difficult to alter or reduce costs that are already
locked in. (Locked-in costs are costs that have NOT yet been incurred but,
based on decisions that have already been made, will be incurred in the future)

100%
Some argue that up to
Life-Cycle cost %

90% of a product’s cost

is already locked in once
90% of Locked-in cost it leaves product design,
the unit curve (decisions making major cost reduction
costs already been made) difficult after the design stage.

Cost incurrence
Curve (usage of
resources)

Value-chain functions
20 R&D
Manufacturing Marketing, Dist’n
and And customer service
Design
 • At the end of design stage, costs such as
• Direct materials
• Direct labor, and
• Many manufacturing, marketing, distribution and
customer service costs are all locked in.
 Therefore, when a sizable fraction of the costs are
locked in at the design stage, the focus of value
engineering is on making innovations and modifying
designs at the product design stage.

In summary, you can regard target pricing is a technique to reduce costs

rather than to set price.
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 Assignment question

22
23
 1)
$
Direct materials costs ($182,000 – 2.2 x 7,000) 166,600
Direct labor costs ($28,000 – 0.5 x 7,000) 24,500
Machining costs (these fixed costs are unchanged) 31,500
Testing costs [(1-20%) x 2.5 x $2 x 7,000 28,000
Rework costs (4% x 7,000 x $20) 5,600
Ordering costs (50 x 2 x $21) 2,100
Engineering costs (these fixed costs are unchanged) 21,140
Total costs 279,440

Unit cost = $279,440/7,000 = $39.92

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 Old manufacturing costs 315,000
Less: new manufacturing costs (279,440)
Cost savings 35,560

Per unit cost savings = 35,560/7,000 units = $5.08

The cost-reduction target of $6 cannot be achieved.

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 The cost reduction of modifying product design is $5.08, whereas the cost reduction of
improving manufacturing efficiency is only $1.5. Therefore, modifying design can have
larger cost impact on Cutler.

Since many manufacturing costs are locked-in once the design is completed, thus
modifying design can reduce not only the direct costs like direct materials and direct labor
but also the O/H costs like testing and ordering.

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 Lecture notes:
Slides 16-22
Long-run pricing approach – In-class Practice
cost-plus pricing 24-30

• Cost-plus pricing is a cost-based approach to long-run pricing

• Its starting point differs from target pricing
1. First we look at costs and
2. then consider customers or competitors.

• In industries that are less competitive, companies can use market-

based or cost-based approaches.
• E.g. If a firm is selling a very distinctive product, then it can exert
influence on its product price, and cost-based pricing can be used.

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 When setting a cost-based price, a mark-up component adds
to the cost base.

Note for the cost base used for calculating the cost-plus price

Cost Base (full cost / total variable cost / variable manuf. cost base)

+ Mark Up (e.g. per unit target ROI – explained in slide 30)

Prospective Cost-plus Selling Price

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 • The cost base
• alternative cost bases can be used to set the selling price
• Full cost (all costs in the value chain business functions)
• Total manufacturing costs (DM+DL+V. O/H + F. O/H)
• Variable manufacturing costs (DM + DL + V. O/H)
• Total variable costs (V. manufacturing + V. Non-manufacturing)

• Full cost base seems to be the most popular one to use, why?
• In the long-run, full costs should be recovered to continue in business.
• Simple to use as managers do not require to perform a detailed cost
analysis

• The markup component

• Target rate of return on investment (ROI) can be used.

• ROI = Target annual operating income/invested capital

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 Example on Cost-plus Pricing
A company manufactures and sells 15,000 units of product A in 2020.
The full cost per unit is $200. The company earns a 20% ROI of
$1,800,000 in 2020.

What is the selling price of product A?

 Return on investment (ROI) = $1.8M x 20% = 0.36M

 per unit return = 0.36M/15,000 units = $24

 selling price = $200 full cost + per unit ROI $24 = $224

What is the markup % on the full cost per unit?

$24/$200 = 12%
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 Example on Target Pricing (in connection with the previous example)
In response to competitive pressures, the company must
reduce the price of product A to $210 to achieve sales of
15,000 units. The company plans to reduce its investment
to $1,650,000. If it wants to maintain 20% ROI, what is the
target cost per unit.

Target revenue ($210 x 15,000 = $3.15M)

Less: Target O.I. (20% x 1.65M = $0.33M)

Target costs ($3.15M - $0.33M = $2.82M)

31 Target cost per unit $2.82M/15,000 units = $188

 Assignment question

32
 1. Revenue ?
Less: V.C. (4 x 500,000) (2,000,000)
Less: Fixed costs (2,500,000) - given
Operating income 180,000 - given

 (a) So, the total revenue = $4,680,000

 (b) Selling price = total revenue/ 500,000 = $9.36
 (c) ROI = operating income/investment in assets =
$180,000/$2,250,000 = 8%
 (d) Markup = $180,000/4.5m = 4%

2. Revised total costs = revised FC + revised VC

(2,500,000 – 225,000) + (4 - 0.3) x 500000 = 4,125,000
Keeping the same markup %, the revised operating income
= 4,125,000 x 4% = 165,000
 New selling price = (165,000 + 4,125,000)/500,000 units = $8.58

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 3) Revenues (8.58 x 500,000 x 0.95) $4,075,500
Less: variable costs [($4-0.3) x 475,000)] (1,757,500)
Less: fixed costs (2,500,000 – 225,000) (2,275,000)
---------------
Operating profit 43,000
=====

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