COST MANAGEMENT Accounting Control HansenMowenGuan Chapter 19 Pricing

COST MANAGEMENT Accounting & Control Hansen▪Mowen▪Guan • Chapter 19 • Pricing and Profitability Analysis 1

Study Objectives 1. 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 volume, sales mix, market share, and market size variances. 7. Describe some of the limitations of profit measurement. 2

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. 3

Market Structure and Price 4

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 5

Pricing Policies Cost-Plus Pricing Audio. Pro Company sells and installs audio equipment in homes, cars, and trucks. Audio. Pro’s income statement for last year is as follows: Revenues Cost of goods sold: Direct materials Direct labor Overhead Gross profit Selling and administrative expenses Operating income $350, 350 $122, 500 73, 500 49, 000 245, 000 $105, 350 25, 000 $ 80, 350 6

Pricing Policies Cost-Plus Pricing 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% 7

Pricing Policies Cost-Plus Pricing 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% 8

Pricing Policies Cost-Plus Pricing Audio. Pro 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) Direct labor (2. 5 hours x $12) Overhead (65% of direct labor cost) Estimated cost of one job Plus 43% markup on COGS Bid price $ 40. 00 30. 00 19. 50 $ 89. 50 38. 49 $127. 99 9

Pricing Policies Target Costing and Pricing • Determine the cost of a product or service based on the price that the customers are willing to pay. Other installers price the remote car door opener at $110. Possible actions: Direct materials (component and two remotes) $ 40. 00 Include one remote instead of two Direct labor (2. 5 hours x $12) 30. 00 Train workers to reduce time (2 hours x $12) Overhead (65% of direct labor cost) 19. 50 Reduce overhead (50% of direct labor cost) Estimated cost of one job Bid price$is 89. 50 now Revised cost of one job competitive; markup Plus 43% markup on COGS 38. 49 preserved Bid price $127. 99 $35. 00 24. 00 12. 00 $ 71. 00 30. 53 $101. 53 10

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. 11

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 12

The Legal System and Pricing Cobalt, Inc. manufactures vitamin supplements that costs an average of $163 per case. Cobalt sold 250, 000 cases last year as follows: Customer Large drug store chain Small local pharmacies Individual health clubs Price per Cases Sold $200 232 250 125, 000 100, 000 25, 000 Cobalt is practicing price discrimination … is it justifiable? 13

The Legal System and Pricing Profits vary within a narrow 1 percent range. The cost differences among the three classes of customer appear to explain the price differences. 14

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. 15

Measuring Profit Absorption-Costing 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 Direct labor Variable overhead Fixed overhead Total manufacturing cost $ 5, 000 15, 000 3, 000 20, 000 $43, 000 During August, these cartridges were sold at $60 each. Variable marketing cost was $1. 25 per unit. Fixed expenses were $12, 000. 16

Measuring Profit Absorption-Costing 1, 000 units produced; 1, 000 units sold *Direct materials ($5 x 1, 000) $ 5, 000 Direct labor ($15 x 1, 000) 15, 000 Variable overhead ($3 x 1, 000) 3, 000 Fixed overhead 20, 000 Total manufacturing overhead and cost of goods sold $43, 000 17

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

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 19

Measuring Profit *Direct materials $ 5, 000 Direct labor 15, 000 Variable overhead Total variable manufacturing expenses Add: Variable marketing expenses Total variable expenses 3, 000 $23, 000 1, 250 $24, 250 20

Measuring Profit *1, 300 × $39 = $50, 700 21

Measuring Profit 22

Profitability of Segments Profit by Product Line 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. Basic Number of units Direct labor hours Price Prime cost per unit Overhead per unit 20, 000 40, 000 $200 $55 $30 Multi-Function 10, 000 15, 000 $350 $95 $22. 50 23

Profitability of Segments Profit by Product Line 24

Profitability of Segments Profit by Product Line 25

Profitability of Segments Profit by Product Line 26

Profitability of Segments Profit by Product Line 27

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

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 customer 2) Determine which customers add value to the company 29

Analysis of Profit-Related Variances Overall Sales Variance [actual vs. expected revenue] Sales Price Variance Price Volume Variance 30

Analysis of Profit-Related Variances 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. 31

Analysis of Profit-Related Variances Contribution Margin Variance [actual vs. expected contribution margin] Sales Mix Variance Contribution Margin Volume Variance 32

Analysis of Profit-Related Variances Sales Mix Variance = The sales mix variance is favorable if the sales mix is weighted to the more profitable products. The contribution margin volume variance gives management information about gained or lost profit due to changes in the quantity of sales. 33

Analysis of Profit-Related Variances 34

Analysis of Profit-Related Variances Birdwell, Inc. : contribution margin variance $14, 375 − $13, 500 = $875 favorable sales mix contribution margin variance volume variance (2, 000 − 1, 875) × $6. 75 = $1, 718. 75 favorable = $843. 75 unfavorable 35

Analysis of Profit-Related Variances Market share variance = Market size variance = 36

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. 37

COST MANAGEMENT Accounting & Control Hansen▪Mowen▪Guan • End Chapter 19 38