Pricing Decisions Lecture 12 PDF

Pricing Decision Absorption method, contribution method, Pricing Decision  Pricing decision are based on customer demand and Cost of product  The prices must be reasonable and attractive to customers  Relevant price- predict future  Irrelevant price – past figures  The data which ch...

Pricing Decision Absorption method, contribution method, Pricing Decision  Pricing decision are based on customer demand and Cost of product  The prices must be reasonable and attractive to customers  Relevant price- predict future  Irrelevant price – past figures  The data which changes from alternative to alternative is relevant – manger salary effects project then on it is relevant  Criterion for cost to meet (i) it is expected future cost (ii) It differs between alternatives The information should be relevant and precisely accurate but usually accountants are forced to choose between more relevance and more accurate Selling price decision sales 300,000 supplies 1000 Variable overhead Direct material 40000 v Direct labour 20000 v Indirect labour 10000 Fixed overhead Advertising 1,20,000 F Property tax (HQ) 10000 F Factory rent 20000 F Sales person 20000 V commission  Absorption costing Method Sales 300000 Less : Manufacturing COGs Direct labour 20000 Direct Material 40000 Factory overhead (rent+ indirect labour 20000+10000+10 +supplies) 00 91000 GP 209000 Less : non manufacturing cost Advertising expense 4000 Office salaries 120000 Property tax 10000 Sales person commission 20000 154000 Operating income 55000 Contribution margin method Sales 300000 Less Variable cost Direct Material 40000 Direct labour 20000 Variable overhead 1000 Variable cost (COGS) 61000 Sales commission 20000 Variable cost 81000 contribution 219000 Fixed cost Advertising 4000 Office salary 120000 Property tax 10000 Indirect labour 10000 Factory rent 20000 Total fixed cost and Fixed per unit  Suppose FC per unit = total Fc/ units = 60,00,000/10,00,000 = 6 rs cost per = 30 rs per unit Special order = 100000 Capacity of the facility = 11,00,000 units  For product costing purpose , however , using the total unit manufacturing cost implies that these fixed costs have a variable cost behavior pattern , which is contrary to fixed cost behavior  The addition of 100000 units will not add any fixed costs as long as total output is within the relevant range. The incorrect analysis includes 100000*6 = 600000 of additional fixed cost in the prediction of increase in total cost  If FC = 100000* 6rs = will be wrong One should entirely avoid this pitfall  Therefore ABC should be used to identify the cost drivers and use only those cost drivers which are involved in the cost Pricing approaches  Market based (I)How will our competitors react to what we do? What price should we charge? based on this the manager should control cost on target return on investment. Eg competitive market (commodities , natural gas, steel,)  Cost Plus pricing Given what it cost us to make the product , what should we charge that will recoup our cost andachieve a target ROI. (automobile computer , management consulting, legal services) can use both. What is cost-plus pricing?  Cost-plus pricing is a pricing method companies use to arrive at a sale price for their product or service. Cost-plus pricing takes into account a product's direct material, labor and overhead costs and a markup percentage. This type of pricing works for products, services and customer contracts, where the customer agrees to reimburse the seller for the price of their labor or service plus a pre-negotiated profit on top of seller costs. 3 Steps to Computing Cost-Plus Pricing There are three steps involved in computing cost-plus pricing for a product: Step 1: Determine the total cost of the product or service, which is the sum of fixed and variable cost (fixed costs do not vary by the number of units, while variable costs do). Step 2: Divide the total cost by the number of units to determine the unit cost. Step 3: Multiply the unit cost by the markup percentage to arrive at Cost the selling cost and the plus profit price = margin of78 the product. *1.25 if the profit margin is 25% Cost plus pricing  Determine the total cost  Avg VC+ avg FC = avg total cost  Divide the total cost by the output for per unit cost  Calculate the selling cost  Price = Ag total cost (1+ mark up)  Mark up = (P-ATC)/ATC Target costing  In today’s business context mangers need to understand customers and competitors for three reasons.  Lower cost competitors continually restrain prices  Products have shorter lives , which leaves companies less time and opportunity to recover from pricing mistakes , loss of market share , and loss of profitability.  Customer are more knowledgeable because they have easy access to price and other information online and demand high quality products at low prices. Target Costing Target costing Features of target costing Factors influencing market- driven costing  The intensity of competition and the nature of the customer affect market-driven costing. Competitors introducing similar products have been shown to drive rival companies to expend energy on implementing target costing systems such as in the case of Toyota and Nissan or Apple and Google. The costing process is also affected by the level of customer sophistication, changing requirements, and the degree to which theThe automotive and camera industries are prime examples for how customers affect target costing based on their ir future requirements are known. exact requirements. Factors influencing product-level costing  Product strategy and product characteristics affect product-level target costing. Characteristics of product strategy such as number of products in line, rate of redesign operations and level of innovation are shown to have an effect. Higher number of products has a direct correlation with the benefits of target costing. Frequent redesigns lead to the introduction of new products that have created better benefits to target costing. The value of historical information reduces with greater innovation, thereby, reducing the benefits of product level target costing.  The degree of complexity of the product, level of investments required and the duration of product development process make up the factors that affect the target costing process based on product characteristics. Product viability is determined by the aforementioned factors. In turn, the target costing process is also modified to suit the different degrees of complexity required. Factors influencing component-level costing  Supplier-Base strategy is the main factor that determines component-level target costing because it is known to play a key role in the details a firm has about its supplier capabilities. Three characteristics make up the supplier-base strategy, including the degree of horizontal integration, power over suppliers and nature of supplier relations. Horizontal integration captures the fraction of product costs sourced externally. Cost pressures on suppliers can drive target costing if the buying power of firms is high enough. In turn, this may lead to better benefits. More cooperative supplier relations have been shown to increase mutual benefits in terms of target costs, particularly at a component level.  Target selling price =100  Royalty 15%= 15, therefore New price is100-15=85  Target profit 25% = 25 Rs , 85-25= 60  Target cost = 60  Estimated cost = 8.5+7+24+13.80 = 53.3 + 9.6= 63  Other material 16*0.6= 9.6 Rs  Cost reduction target 63-60 = 3 rs  SP = 1000  reduce the SP by 20% = 800  10% is the profit margin then target cost = 800-80 = 720  Direct cost total = 495  Manufacturing over heads (i) no. of orders (per unit order cost) = (21,250*80)/200000 =8.5 (ii) Testing hours = (30,00,000*2)/200000 = 30 (iii) Unit reworked = (13000 *100)/200000 = 6.5 Total manufacturing over head = 8.5 +30+6.5 =45 +495 = 540 + 30 +150 = 720