Cost-Based Pricing

Companies use various strategies to set price. Since cost is animportant determinant of supply and is known to the producer, manycompanies base price on cost. Still other companies use atarget-costing strategy, or strategies based on the initialconditions in the market.

A cost-based pricing approach starts with product cost and thendesired profit is added. Usually, there is some cost base and amarkup. The markup is a percentage applied to base cost; itincludes desired profit and any costs not included in the basecost. Companies that bid for jobs routinely base bid price oncost.

Example: Linder Company makes and sells vitaminsupplements. The following information from last year's accountingrecords showed:


Cost of Goods Sold	$254,000
Selling and administrativeexpense	86,360
Operating income	111,760

The markup percentage must include all costs that are not a partof cost of goods sold plus the desired profit. For Linder Company,the markup on COGS is found as follows:

Markup on COGS	= (Selling and administrativeexpenses + Operating income)/COGS
	= ($86,360 + $111,760)/$254,000 =0.78 or 78%

Now, if Linder Company produces a new product with manufacturingcost of $2 per unit, the unit price at this markup is:

Price = $2 + (0.78 Ã $2) = $2.00 +$1.56 = $3.56

A Company does not have to use Cost of Goods Sold as the basisof the markup. For example, a job-order firm might decide to usethe markup on prime costs (direct materials and direct labor) tocost jobs. Suppose that Carl's Custom Cabinetry wants to price jobsbased on prime costs plus a markup on prime cost. Last year'sincome statement revealed the following information:


Prime costs	$134,000
Overhead	73,700
Selling and administrativeexpense	38,860
Operating income	50,920

Markup on Prime Cost	= (Overhead + Selling andadministrative expenses + Operating income)/Prime cost
	= ($73,700 + $38,860 +$50,920)/$134,000 = 1.22 or 122%

Carl is pricing a new job with estimated direct materials of$4,300 and direct labor of $1,800. The estimated price is:

Price = ($4,300 + $1,800) + (1.22 Ã$6,100) = $6,100 + $7,442 = $13,542

Neither Linder Company nor Carl's Custom Cabinets must use theprice figured according to the markup. This is just a firstapproximation. Carl, for example, may want to set a lower price inhopes of getting more business from this particular customer.Linder Company may want to charge a higher price based on marketconsiderations.

Target Costing

Another approach to pricing a product or service is targetcosting. The target cost is based on the price (target price) thatcustomers are willing to pay. The Marketing Department determineswhat characteristics and price for a product are most acceptable toconsumers. Then, it is the job of the company's engineers to designand develop the product such that cost and profit can be covered bythat price. Japanese firms have been doing this for years; Americancompanies are beginning to use target costing. So first the targetprice is set. Then the desired profit is deducted, and theremaining amount is the target cost.

Target cost = Target price -Desired profit

Determining the target cost is relatively easy. Actuallydesigning and manufacturing a product that will achieve the targetcost and sell for the target price is more difficult. As a result,target costing is an iterative process as the firm works to refinethe proposed product to meet the cost and price targets.

Price Discrimination

Price discrimination refers to the charging of different pricesto different customers for essentially the same product. TheRobinson-Patman Act was passed in 1936 as a means of outlawingprice discrimination by manufacturers or suppliers; services andintangibles are not included under the act.

The Robinson-Patman Act does allow price discrimination undercertain specified conditions: (1) if the competitive situationdemands it and (2) if costs (including costs of manufacture, sale,or delivery) can justify the lower price. According to the secondcondition, a lower price offered to one customer must be justifiedby identifiable cost savings and the amount of the discount must beat least equaled by the amount of cost saved.

To compute a cost differential, the company creates classes ofcustomers based on the average costs of selling to those customers.Then all customers in each group are charged a cost-justifiableprice.

Example: Raul Company manufactures specializedelastic bandages used to reinforce athletes' wrists or ankles. Raulsells to a number of individual physical therapists and athletictrainers as well as to Medallion Gym, a national chain of physicalfitness facilities. The average manufacturing cost is $169 per case(a case contains 100 plastic-wrapped elastic bandages). RaulCompany sold 350,000 cases last year to the following two classesof customer.

	Price	Quantity
Medallion Gym	$235	175,000
Individual trainers and physicaltherapists	$241	175,000

Medallion Gym requires that the bandages be individuallypackaged in boxes with the Medallion name on the label. This boxand special labelling costs $0.34 per unit. Raul also pays allshipping costs, which amounted to $1,400,000 last year.

The individual trainers and physical therapists order in smalllots that require special picking and packing in the factory; thespecial handling adds $20 to the cost of each case sold. Salescommissions to the independent jobbers who sell Raul products tothe trainers and physical therapists average 10 percent of sales.Bad debts expense amounts to 1 percent of sales.

The cost per case for each customer category can be computed asfollows:

Medallion Gym:
Manufacturing cost per case	$169.00
Box and special labelling ($0.34 Ã100)	34.00
Shipping ($1,400,000/175,000cases)	8.00
Total cost per case	$211.00

Individual Trainers and PhysicalTherapists:
Manufacturing cost per case	$169.00
Special handling	20.00
Sales commission ($241 x 0.10)	24.10
Bad debts expense ($241 x0.01)	2.41
Total cost per case	$215.51

Profit and profit percentages are as follows:

	Medallion Gym	Trainers and Physical Therapists
Price per case	$235.00	$241.00
Less: cost per case	211.00	215.51
Profit per case	$24.00	$25.49
Profit percentage	10.21%	10.58%

The company will need to see if the profit percentages range areclose to one another; if so, there would be a cost justificationfor the price differential. If not, the company may need toconsider potential price discrimination and change its price forthe customer group that it considers to be "out of line."

For each of the following situations, determine whether or notthere is price discrimination according to the Robinson-PatmanAct.

1.	Dr. Jeffrey Lowman, M.D., chargesless to patients who he feels cannot afford his usual fee.- Selectyour answer -YesNoItem 1

2.	Damian Company manufacturesspecialty jams and jellies. Damian is located in Amarillo, Texas,and sells only to stores in the Amarillo area. Sometimes Damianoffers a price break to store owners whose children attend the sameschools as Damian's children. - Select your answer -YesNoItem2

3.	A national manufacturer of hairproducts charges a significantly lower price to large chain storesthan to smaller stores. The price differential is not supported bycost differences. - Select your answer -YesNo

redshark999

.Camelback Communications, Inc. (CCI), located near Phoenix,Arizona, manufactured radio and television antennas. The firm hadfour distinct product lines, each serving a different aspect of theantenna market.

The first product line consisted of simple "rabbit ear"antennas. There were several models in the line ranging from thesimplest FM and TV antennas to more complicated designs that couldimprove reception by rejecting multipath signals.

The second product line contained dipole antennas for FM and TVreception. These were more sophisticated antennas than the "rabbitear" line and were the type typically seen attached tochimneys.

The third product line was rotators for the dipole line.Rotators consisted of an electric motor that rotated the dipole anda controller that resided by the receiving unit (FM radio or TV).There was little variation in the motors, but the controllersvaried considerably from simple controllers that were operated byturning a knob on the controller base to more sophisticatedversions that had present antenna positions keyed to the channelbeing received.

The final product line consisted of two electronic antennas, onefor FM and the other for TV. These were used in weak receptionareas and, in addition to acting as antennas, amplified the signalso that it was strong enough for the receiver to be able toreproduce it properly.

In the last five years, CCI had doubled the number of productsoffered, expanded the production facility twice, and just recentlyintroduced the electronic antenna line. While CCI was veryprofitable, company president Lincoln McDowell was concerned aboutits ability to cost products accurately. In particular, someproduct seemed exceptionally profitable, while other potentialproducts which the firm should have been able to make, appearedimpossible to manufacture at a profit. The production manager wasconvinced that his production processes were as good as any in theindustry, and he was unable to explain the apparent high cost ofproducing these potential products.

McDowell agreed with his production manager and was convincedthat the cost accounting system was at fault. He had just recentlyhired Glenn Peterzon, a management consultant, to analyze thefirm's cost system and to prepare a presentation to the seniormanagement team. Specifically, McDowell had asked Peterzon toprepare a simple example that demonstrated how the cost systemdistorted the firm's knowledge of its product costs.

Peterzon had begun his study by documenting the existing costsystem. It was a very simple system that used a single burden ratefor all overhead costs. The burden rate for the year was determinedby adding together the budgeted variable and fixed overhead costsand dividing this sum by the number of budgeted direct labor hours.The standard cost of a product was then found by multiplying thenumber of direct labor hours required to manufacture that productby the burden rate and adding this quantity to the direct labor andmaterial cost.

Peterzon became convinced that the cost system was partially toblame for some of the problems the firm was experiencing. However,with over a hundred products, it was difficult to understand howthe cost system was distorting product costs.

To help illustrate the source of these distortions to seniormanagement, Peterzon decided to develop a simple four-productmodel. He decided it would be helpful if the actual productioncosts of the four products were known a priori (see Table A).

	A	B	C	D
Material cost	15	5	10	5
Direct labor	30	5	15	10
Variableoverhead	15	7.5	5	7.5
Variable Cost	60	17.5	30	22.5
Fixed Cost	10	10	12,500	12,500

Product lines A and B used identical equipment that could eachproduce 1,000 units of A
or B. Product lines C and D used identical equipment that couldeach produce 1,000 units of C or D.

He then calculated the direct labor allocation rate that theexisting single burden rate cost system would generate assumingthat each product sold a thousand units, the maximum that could beproduced, and that each direct labor hour cost $5. Under thisscenario, the costs incurred would be:

Variable Product Overhead	Labor Hours PerUnit	VariableOverhead/unit	No. Units	Total LaborHours	Total

A	6	15	1	6	15
B	1	7.5	1	1	7.5
C	3	5	1	3	5
D	2	7.5	1	2	7.5
Total			4	12	35

and the new allocation rate:

Variable overhead	35,000
FixedOverhead	45,000
Total Cost to beAllocated	80,000
Labor Hours($60,000/5)	12,000
Allocationrate/hour	$6.67

Using this allocation rate per hour, Peterzon calculated thestandard cost of the four products.

Product	A	B	C	D
Material	15	5	10	5
Labor	30	5	15	10
AllocatedCost	40	6.67	20	13.33
Standard Cost	$85	16.67	45	28.34

If the firm set out to make a 40% mark-on,b then it would wantto charge the following prices for the four products:

Product	A	B	C	D
Standard Cost	85	16.67	45	28.34
40% Mark-on	34	6.67	18	11.34
Selling Price	$119	23.34	63	39.68

Mark-on % = profit/cost

If industry selling prices were established using actualproduction costs and a 40% mark-on, they would be:

Product	A	B	C	D
Standard Cost	70	27.5	42.5	35
40% Mark-on	28	11	17	14
Selling Price	$98	38.5	59.5	49

By comparing the "industry" prices to the firm's costs and assumingthat the firm had to match industry prices, Peterzon coulddetermine which products would appear profitable.

Selling Price	98	38.5	59.5	49
Standard Cost	85	16.67	45	28.34
Profit	13	21.83	14.5	20.66
Markup	15%	131%	32%	73%

CCI had recently adopted a policy of discontinuing all productswhose mark-ons were under 25%. Under this policy, product A wouldbe dropped and additional product B manufactured. Assuming the firmcould sell all of product B that it could manufacture, then thesales would be

Budgeted	A	B	C	D
CurrentVolume	1,000	1,000	1,000	1,000
Actual Volume	0	2,000	1,000	1,000

aThe unused production capacity was used to produce anadditional 1,000 units of B.

The resulting product mix was so different from the starting mixthat Peterzon decided to recalculate the allocation rate per hourto determine if it had been affected:

Costs Incurred ($ thousand)

Variable Product Overhead	LaborHours/Unit	Variable Overhead/Unit	No. Units	Total LaborHours	Total
B	1	7.5	2,000	2,000	15,000
C	3	5	1,000	3,000	5,000
D	2	7.5	1,000	2,000	7,500
Total			4,000	7,000	27,500

and the new allocation rate:

Variable Overhead : 27,500

Fixed Overhead: 45,000

72,500

Labor Hours ( 35,000/5) : 7,000

Allocation rate/hour: $10.36

Questions:

5. What would happen if the firm modified its costsystem so that all variable costs were traced to the productaccurately but fixed costs were allocated using the existingsystem?

crimsongoldfish660

Camelback Communications, Inc. (CCI), located near Phoenix,Arizona, manufactured radio and television antennas. The firm hadfour distinct product lines, each serving a different aspect of theantenna market.