COST MANAGEMENTAccounting & Control

Hansen▪Mowen▪Guan

COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning.Cengage Learning and South-Western are trademarks used herein under license.

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Chapter 19Pricing and Profitability

Analysis

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Study Objectives1. Discuss basic pricing concepts.2. Calculate a markup on cost and a target cost.3. Discuss the impact of the legal system and ethics on

pricing.4. Calculate measures of profit using absorption and

variable costing.5. Determine the profitability of segments.6. Compute the sales price, price volume, contribution

margin, contribution margin volume, sales mix, market share, and market size variances.

7. Describe some of the limitations of profit measurement.

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Basic Pricing Concepts

Market Structure and Price• Perfect Competition: Many buyers and sellers;

no one of which is large enough to influence the market.

• Monopolistic Competition: Has both the characteristics of both monopoly and perfect competition.

• Oligopoly: Few sellers.• Monopoly: Barriers to entry are so high that

there is only one firm in the market.

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Market Structure and Price

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Pricing Policies• Cost-based pricing

– Established using “cost plus markup”

• Target costing and pricing– Determine the cost of a product or service based

on the price (target price) that customers are willing to pay

– Effectively used in conjunction with marketing decisions

• Penetration pricing• Price skimming

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Cost-Plus PricingAudioPro Company sells and installs audio equipment in homes, cars, and trucks. AudioPro’s income statement for last year is as follows:

Revenues $350,350Cost of goods sold:

Direct materials $122,500Direct labor 73,500Overhead 49,000 245,000

Gross profit $105,350Selling and administrative expenses 25,000Operating income $ 80,350

Pricing Policies

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The firm wants to earn the same amount of profit on each job as was earned last year:

Markup on COGS = (Selling and administrative expenses + Operating income) ÷ COGS

Markup on COGS = ($25,000 + $80,350) ÷ $245,000

Markup on COGS = 0.43 or 43%

Cost-Plus Pricing

Pricing Policies

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The markup can be calculated using a variety of bases. The calculation for markup on direct materials is as follows:

Markup on DM = (Direct labor + Overhead + Selling and administrative expense + Operating income) ÷ Direct materials

Markup on DM = ($73,500 + $49,000 + $25,000 + $80,350) ÷ $122,500

Markup on DM = 1.86 or 186%

Cost-Plus Pricing

Pricing Policies

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AudioPro wants to expand the company’s product line to include automobile alarm systems and electronic car door openers. The cost for the sale and installation of one electronic remote car door opener is as follows:

Direct materials (component and two remote controls) $ 40.00Direct labor (2.5 hours x $12) 30.00Overhead (65% of direct labor cost) 19.50Estimated cost of one job $ 89.50Plus 43% markup on COGS 38.49 Bid price $127.99

Cost-Plus Pricing

Pricing Policies

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Target Costing and Pricing

Pricing Policies

• Determine the cost of a product or service based on the price that the customers are willing to pay.

Direct materials (component and two remotes) $ 40.00Include one remote instead of two

$35.00Direct labor (2.5 hours x $12) 30.00

Train workers to reduce time (2 hours x $12)24.00Overhead (65% of direct labor cost) 19.50

Reduce overhead (50% of direct labor cost)12.00Estimated cost of one job $ 89.50

Revised cost of one job $ 71.00Plus 43% markup on COGS 38.4930.53 Bid price $127.99$101.53

Other installers price the remote car door opener at $110. Possible actions:

Bid price is now competitive; markup

preserved

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The Legal System and Pricing

• Predatory pricing– The practice of setting prices below cost for the

purpose of injuring competitors and eliminating competition

• Dumping– Predatory pricing on the international market– Companies sell below cost in other countries; the

domestic industry is injured.

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The Legal System and Pricing

• Price discrimination– Charging different prices to different

customers for essentially the same product. – Robinson-Patman Act of 1936 prohibits

• Manufacturers or suppliers are covered by the act• Price discrimination is allowed if

– If the competitive situation demands it and– If costs (including costs of manufacture, sale, or delivery)

can justify the lower price

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Cobalt, Inc. manufactures vitamin supplements that costs an average of $163 per case. Cobalt sold 250,000 cases last year as follows:

Customer Price per Case Cases Sold

Large drug store chain $200125,000

Small local pharmacies 232100,000

Individual health clubs 25025,000Cobalt is practicing price discrimination

… is it justifiable?

The Legal System and Pricing

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The Legal System and Pricing

$200 $178.40 10.8%$200

$232 $208.52 10.1%$232

$250 $222 11.2%$250

Profits vary within a narrow 1 percent range. The cost differencesamong the three classes of customer appear to explain the price differences.

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Measuring Profit

Absorption Costing

– Also referred to as full costing– Required for external financial reporting– Assigns all manufacturing costs, direct

materials, direct labor, variable overhead, and a share of fixed overhead to each unit of product

– Each unit of product absorbs some of the fixed manufacturing overhead in addition to the variable costs incurred to manufacture it.

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Lasersave, Inc., a company that recycles used toner cartridges for laser printers. During August the firm manufactured 1,000 cartridges at the following costs:

Direct materials $ 5,000Direct labor 15,000Variable overhead 3,000Fixed overhead 20,000 Total manufacturing cost $43,000

During August, these cartridges were sold at $60 each. Variable marketing cost was $1.25 per unit. Fixed expenses were $12,000.

Absorption-Costing

Measuring Profit

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Measuring ProfitAbsorption-Costing

*Direct materials ($5 x 1,000) $ 5,000Direct labor ($15 x 1,000) 15,000Variable overhead ($3 x 1,000) 3,000Fixed overhead 20,000Total manufacturing overheadand cost of goods sold $43,000

1,000 units produced; 1,000 units sold

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*Direct materials ($5 x 1,250) $ 6,250Direct labor ($15 x 1,250) 18,750Variable overhead ($3 x 1,250) 3,750Fixed overhead ($16 per unit) 20,000Total manufacturing overhead $48,750Add: Beginning inventory 0Less: Ending inventory (9,750)Cost of goods sold $39,000

Measuring ProfitAbsorption-Costing

Production exceeded sales by 250 units; fixed overhead of $16 per unit is carried in inventory thus reducing cost of goods sold and increasing net income

1,250 units produced; 1,000 units sold

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Measuring Profit

Variable-costing

• Also referred to as direct costing• Assigns only unit-level variable manufacturing

costs to the product– Direct materials– Direct labor– Variable overhead

• Fixed overhead is treated as a period cost

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*Direct materials $ 5,000

Direct labor 15,000

Variable overhead 3,000

Total variable manufacturing expenses $23,000

Add: Variable marketing expenses 1,250

Total variable expenses $24,250

Measuring Profit

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Measuring Profit

*1,300 × $39 = $50,700

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Measuring Profit

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Alden Company manufactures two products: basic fax machines and multi-function fax machines. The multi-function fax uses more advanced technology;

therefore, it is more expensive to manufacture.

Profit by Product Line

Basic Multi-Function

Number of units 20,000 10,000Direct labor hours 40,000 15,000Price $200 $350Prime cost per unit $55 $95Overhead per unit $30 $22.50

Profitability of Segments

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Profitability of SegmentsProfit by Product Line

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Profitability of SegmentsProfit by Product Line

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Profitability of SegmentsProfit by Product Line

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Profitability of SegmentsProfit by Product Line

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Alpha Beta Gamma Delta Total

Sales $ 90 $ 60 $ 30 $120 $300Cost of goods sold 35 20 11 98 164Gross profit $ 55 $ 40 $ 19 $ 22 $136Division expenses -20 -10 -15 -20 -65Corporate expenses -3 -2 -1 -4 -10 Operating income (loss) $ 32 $ 28 $ 3 $ -2 $ 61

Profitability of SegmentsDivisional Profit

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Profitability of Segments

Customer profitability• Companies that assess the profitability of

various customer groups can more accurately target their markets and increase profits.

1) Identify the customer2) Determine which customers add value to the

company

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Analysis of Profit-Related Variances

Overall Sales Variance[actual vs. expected revenue]

Sales Price Variance Price Volume Variance

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Analysis of Profit-Related Variances

Sales price Actual Expected Quantity= -variance price price sold

Price volume Actual Expected Expected= -variance volume volume price

The sales price and price volume variances are labeled favorable if the variance increases profit above the amount expected. They are

labeled unfavorable if the variance decreases profit below the amount expected.

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Analysis of Profit-Related Variances

Contribution Margin Variance[actual vs. expected contribution margin]

Sales Mix Variance Contribution Margin Volume Variance

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Analysis of Profit-Related Variances

P1 actual units P1 budgeted CM- P1 budgeted units - Budgeted average unit CM P2 actual units P2 budgeted CM+ - P2 budgeted units - Budgeted average unit CM

Sales Mix Variance =

The sales mix variance is favorable if the sales mix is weighted to the more profitable products.

BudgetedContribution Actual Budgeted average unitmargin volume = quantity - quantity contributionvariance sold sold margin

The contribution margin volume variance gives management information about gained or lost profit due to changes in the quantity of sales.

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Analysis of Profit-Related Variances

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Analysis of Profit-Related Variances

contribution margin variance$14,375 − $13,500= $875 favorable

sales mixvariance

contribution margin volume variance

(2,000 − 1,875) × $6.75

= $1,718.75 favorable = $843.75 unfavorable

1,250 $4.00- 1,500 - $6.75

625 $15.00+ - 500 - $6.75

Birdwell, Inc.:

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Analysis of Profit-Related Variances

Actual BudgetedActual Budgeted industry averagemarket share - market share sales unitpercentage percentage in units CM

Market share variance =

Budgeted BudgetedActual Budgeted market averageindustry sales - industry sales share unitin units in units percentage CM

Market size variance =

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Limitations of Profit Measurement

• Limitations of profitability analysis– Focus on past performance– Emphasis on quantifiable measures– Impact on behavior

• Successful firms measure far more than accounting profit.

COST MANAGEMENTAccounting & Control

Hansen▪Mowen▪Guan

COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning.Cengage Learning and South-Western are trademarks used herein under license.

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End Chapter 19