CHAPTER 8CHAPTER 8
Pricing Decisions, Analyzing Customer Profitability, and
Activity-Based Pricing
Pricing Decisions, Analyzing Customer Profitability, and
Activity-Based Pricing
Slide 8-2
Pricing DecisionsPricing 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 PriceThe 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
The Profit Maximizing PriceThe 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
Estimating the Profit Maximizing Price
Estimating the Profit Maximizing Price
Slide 8-6 Learning objective 1: Compute the profit maximizing price for a product or service
Estimating DemandEstimating 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
Estimates of price and quantity demandedPrice = $6.95, quantity demanded =
20,000Price = $5.95, quantity demanded =
25,000Price = $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
(Price - Variable) X Quantity - Fixed Cost = Profit(6.95 - 1.50) X 20,000 - 80,000 = 29,000 (5.95 - 1.50) X 25,000 - 80,000 = 31,250 (4.95 - 1.50) X 32,000 - 80,000 = 30,400
$5.95 is the profit maximizing price
Pricing Special OrdersPricing 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 2: Perform incremental analysis related to pricing a special order
Pricing Special OrdersPricing 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 2: Perform incremental analysis related to pricing a special order
Pricing Special OrdersPricing 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 2: Perform incremental analysis related to pricing a special order
Special Orders – Premier Lens Example
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 2: Perform incremental analysis related to pricing a special order
Special Orders – Premier Lens Example
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 2: Perform incremental analysis related to pricing a special order
Commonwealth EdisonCommonwealth Edison
Slide 8-14 Learning objective 2: Perform incremental analysis related to pricing a special order
Which of the following is true?a. In pricing special orders, fixed costs
typically are not relevantb. In pricing special orders, fixed costs
typically are relevant
Answer: aFixed costs typically are not relevant
Slide 8-15 Learning objective 2: Perform incremental analysis related to pricing a special order
Cost-Plus PricingCost-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 3: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms
Cost-Plus PricingCost-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 3: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms
Cost-Plus PricingCost-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 3: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms
Cost-Plus PricingCost-Plus Pricing
Slide 8-19 Learning objective 3: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms
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 necessaryd. Cost plus is simple to apply
Answer: dSimplicity is an advantage of cost plus
pricingSlide 8-20 Learning objective 3: Explain the cost-plus approach to pricing and why
it is inherently circular for manufacturing firms
Target Costing Target Costing
Slide 8-21 Learning objective 4: Explain the target costing process for a new product
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
Target Costing Target Costing
Slide 8-22 Learning objective 4: Explain the target costing process for a new product
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
Target Costing Target Costing
Slide 8-23 Learning objective 4: Explain the target costing process for a new product
Target costing:a. Requires specification of desired
level of profitb. Adds desired profit to existing
costsc. Is used primarily with products
that are already in productiond. Leads to profit maximization
Answer: aRequires specification of desired profit
Slide 8-24 Learning objective 4: Explain the target costing process for a new product
Analyzing Customer Profitability
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 5: Analyze customer profitability
Customer profitability is measured as:a. Revenue minus cost of goods soldb. Revenue minus indirect manufacturing
costsc. Revenue minus cost of goods sold minus
indirect service costsd. Revenue minus cost of goods sold minus
indirect manufacturing costs
Answer: cRevenue minus cost of goods sold minus indirect service costs
Slide 8-26 Learning objective 5: Analyze customer profitability
Customer Profitability Measurement SystemCustomer Profitability Measurement System
Slide 8-27 Learning objective 5: Analyze customer profitability
Cost Pools and Cost Drivers to Service Customers
Cost Pools and Cost Drivers to Service Customers
Slide 8-28 Learning objective 5: Analyze customer profitability
Customer Profitability AnalysisCustomer Profitability Analysis
Slide 8-29 Learning objective 5: Analyze customer profitability
CostRevenue Quantity Amount Quantity AmountLess COGS 732,600 727,650 Gross margin (666,000) (661,500) Less indirect costs 66,600 66,150
Internet orders $1.20 / order 165 (198) 0 0Fax orders $4.50 / order 20 (90) 320 (1,440) Line items $0.90 / item 2,500 (2,250) 5,100 (4,590) Miles $0.36 / mile 1,200 (432) 3,300 (1,188) Weight $0.40 / pound 900 (360) 870 (348) Items returned $0.80 / item 210 (168) 910 (728)
Profit 63,102 57,856 Profit as a percent of sales 8.61% 7.95%
Customer 1 Customer 2
A customer profitability measurement (CPM) system:
a. Allocates indirect costs to individual customers
b. Traces revenue to individual customersc. Traces cost of goods sold to individual
customersd. All of the above are true
Answer: dAll of the above are true
Slide 8-30 Learning objective 5: Analyze customer profitability
Customer Profitability AnalysisCustomer Profitability Analysis
Slide 8-31 Learning objective 5: Analyze customer profitability
Customer Profitability and Performance Measures
Customer Profitability and Performance Measures
Some examples of performance measures that will drive managers to improve customer profitability Percent of customers who are not
profitable Dollar loss for customers who are not
profitable Average profit per customer Number of customer service requests
per 100 customers Percent of customers who return items Dollar value of returned items
Slide 8-32 Learning objective 5: Analyze customer profitability
Activity-Based PricingActivity-Based Pricing
Customers are presented with separate prices for services they request in addition to the cost of goods purchased Customers will carefully consider
the services they request May lead them to impose less cost
on the supplier Also called menu-based pricing
Slide 8-33 Learning objective 6: Explain the activity-based pricing approach
Activity-Based PricingActivity-Based Pricing
Customers might object as the price they pay should cover these costs Ways to deal with this resistance
Lower prices slightly and then encourage customers to make fewer but larger purchases
Customers could be encouraged to limit the variety of goods they order
Activity-based pricing could be used only on the least profitable customers
Slide 8-34 Learning objective 6: Explain the activity-based pricing approach
Pricing DecisionsPricing Decisions
Slide 8-35 Learning objective 6: Explain the activity-based pricing approach
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