CHAPTER 12. PRICING DECISIONS, PRODUCT PROFITABILITY DECISIONS, AND COST MANAGEMENT
Influences of costs vary among products, and pricing decisions differ greatly in both their time horizons
and their contexts. The key to profitability is that companies sell units at the price a customer is willing to
Major influence of pricing:
3 Pricing strategies:
1. Target pricing: price is based on what customers are willing to pay
2. Cost-plus pricing: flat rate target profit percentage is added to the full product cost
3. Life- cycle pricing/cradle to grave? Includes environmental costs of production, reclamation,
recycling , and reuse of materials.
3 major influences on pricing decisions:
1. Customers: examine through their eyes-price, availability, customization and quality affect
willingness to pay
2. Costs: whether company follows throughput, variable and full absorption costing models. Note:
ABC systems provide superior information upon which to base pricing decisions.
3. Competitors: market characteristics: Monopoly, Oligopoly, Perfect competition etc.
Product cost categories and the time horizon:
- Customer satisfaction, continuous improvement and dual internal/ external focus converge
when it comes to pricing.
- Cost reduction includes all six value-chain business funcations from R&D to customer service-
upstream and downstream costs.
- Relevant cost is important: depends on capacity available, alternatives uses of capacity, and the
time horizon. Short run ( less than 6 months), long run ( 1 year+)
The decision framework: relevant costs in short- run pricing
One time special order from customers- depends on capacity use by special order relative to ordinary
1. Identify the problem
2. Gather information: relevant cost. Note: in case of insufficient capacity, investment into fixed
asset is relevant cost. Indirect MOH is relevant
3. Forecast future outcomes on the basis of available information:
4. Decide among alternatives
5. Evaluate performance Target pricing using target costing
The starting point for pricing decisions can be
- Market- based ( target pricing): starts with what price should u charge after looking into
customer and competitors behaviour
- Cost based ( cost plus pricing):looks at cost and then reaction
- Life cycle ( cradle to grave costs, including reclamation, recycling, reusing)
Target pricing and target costing:
Starts with Target pricing
Target price per unit: estimated price for a product or service that potential customers will pay < based
on customer and competitors behaviours>
Target Margin percentage ( $ amount / revenue)
- Full absorption cost: target gross margin percentage
- Full product cost: operating margin/ operating profit percentage
- Full variable cost recovery: contribution or profit percentage
- Full cost recovery: net margin percentage
Long run: full cost recovery…. Short run: anything else than full cost recovery is good.
- Relies on sales and marketing organization
- Close contact and interaction with customers
- Identify customers needs and perceived value
- Conduct market research studies
- Target pricing is difficult for product differentiated goods and those with short consumer life
cycle. Eg. Electronics
The decision framework and long-term pricing
Target cost per unit: based on full product cost instead of full absorption cost and achieve target
operating income per unit.
Full product cost: includes all manufacturing and non manufacturing costs ( period costs)
In the long run, a new design maybe implemented that requires different capacity and labour skills or
changes in existing capacity management. It is Based on a thorough value analysis to help eliminate
superfluous design features and non value added costs.
If it’s unable to achieve target cost- alternative is to shut down
Value analysis: focuses on product design stage where there is the greatest opportunity to change
design, materials, and manufacturing processes to reduce costs. VALUE ANALYSIS AND CROSS FUNCTIONAL TEAMS
Value analysis team: top management experts in marketing, product design and engineering, process
improvement, supply-chain management, distribution, customer service and management accounting.
- Evaluate the impact of the design innovations and modifications on all business functions of the
value chain and choose the best that provides the greatest value to the customers relative to the
Reverse engineering- disassembling and analyzing competitors’ products to determine product designs
and materials and to become acquainted with the technologies competitors use.
1. Cost incurrence: arises when a resource is sacrificed or consumed.
2. Locked in costs (designed in costs) : cost that have not yet been incurred but that will be
incurred in the future on the basis of decisions that have already been made. ( unavoidable)
3. Cost reduction can be achieved upto the time when costs are incurred.
4. Companies combine value engineering with kaizen/ continuous improvement methods that seek
to improve productivity and eliminate waste during production and delivery of products.
5. Eliminating or reducing non value added cost may entail process improvements, but also reason
to re-examine the production process is the anticipated volume of production.
6. Reducing variable cost requires reducing unit input cost –by negotiation/changing suppliers/
quantity of input consumed
7. Other factors: appropriate training, production scheduling and maintenance also reduce DL cost.
Systematic evaluation of all aspects of the value chain- to reduce cost while retaining both product
attributes and quality the customer desires and will pay for.
Some undesirable effects:
- Decreased morale if employees fail to attain performance targets
- A poorly designed product as the cross functional team compromises on various customer
- A protracted development cycle causing a missed market opportunity
- Conflict among the business functions as the goal is to remove non-value added costs wherever
they arise, but the burden of cost reduction will be unequal
- Strong employee partic