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Guan Hansen Mowen

COPYRIGHT 2009 South-Western Publishing, a division of Cengage Learning.
Cengage Learning and South-Western are trademarks used herein under license.
Chapter 19
Pricing and Profitability
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
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, contribution margin volume, sales mix, market
share, and market size variances.
7. Describe some of the limitations of profit measurement.
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.
Market Structure and Price
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
Penetration pricing
Price skimming
Cost-Plus Pricing
AudioPro Company sells and installs audio
equipment in homes, cars, and trucks.
AudioPros income statement for last year is as
Revenues $350,350
Cost of goods sold:
Direct materials $122,500
Direct labor 73,500
Overhead 49,000 245,000
Gross profit $105,350
Selling and administrative expenses 25,000
Operating income $ 80,350
Pricing Policies
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%
Cost-Plus Pricing
Pricing Policies
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%
Cost-Plus Pricing
Pricing Policies
AudioPro wants to expand the companys 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) $ 40.00
Direct labor (2.5 hours x $12) 30.00
Overhead (65% of direct labor cost) 19.50
Estimated cost of one job $ 89.50
Plus 43% markup on COGS 38.49
Bid price $127.99
Cost-Plus Pricing
Pricing Policies
Target Costing and Pricing
Pricing Policies
Determine the cost of a product or service based on the
price that the customers are willing to pay.
Direct materials (component and two remotes) $ 40.00
Include one remote instead of two $35.00
Direct labor (2.5 hours x $12) 30.00
Train workers to reduce time (2 hours x $12) 24.00
Overhead (65% of direct labor cost) 19.50
Reduce overhead (50% of direct labor cost) 12.00
Estimated cost of one job $ 89.50
Revised cost of one job $ 71.00
Plus 43% markup on COGS 38.49 30.53
Bid price $127.99 $101.53
Other installers price the remote car door opener at $110.
Possible actions:
Bid price is now
competitive; markup
The Legal System and Pricing
Predatory pricing
The practice of setting prices below cost for
the purpose of injuring competitors and
eliminating competition
Predatory pricing on the international market
Companies sell below cost in other countries;
the domestic industry is injured.

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
Cobalt, Inc. manufactures vitamin supplements that costs
an average of $163 per case. Cobalt sold 250,000 cases
last year as follows:
Customer Price per Case Cases Sold
Large drug store chain $200 125,000
Small local pharmacies 232 100,000
Individual health clubs 250 25,000
Cobalt is practicing price
discrimination is it
The Legal System and Pricing
The Legal System and Pricing
$200 $178.40

$232 $208.52

$250 $222

Profits vary within a narrow 1 percent range. The cost differences
among the three classes of customer appear to explain the price differences.
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
Each unit of product absorbs some of the
fixed manufacturing overhead in addition to
the variable costs incurred to manufacture it.
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 $ 5,000
Direct labor 15,000
Variable overhead 3,000
Fixed overhead 20,000
Total manufacturing cost $43,000
During August, these cartridges were sold at $60
each. Variable marketing cost was $1.25 per unit.
Fixed expenses were $12,000.
Measuring Profit
Measuring Profit
*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

1,000 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
Measuring Profit
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
1,250 units produced; 1,000 units sold
Measuring Profit
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
*Direct materials $ 5,000
Direct labor 15,000
Variable overhead 3,000
Total variable manufacturing expenses $23,000
Add: Variable marketing expenses 1,250
Total variable expenses $24,250
Measuring Profit
Measuring Profit
*1,300 $39 = $50,700
Measuring Profit
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.
Profit by Product Line
Basic Multi-Function
Number of units 20,000 10,000
Direct labor hours 40,000 15,000
Price $200 $350
Prime cost per unit $55 $95
Overhead per unit $30 $22.50
Profitability of Segments
Profitability of Segments
Profit by Product Line
Profitability of Segments
Profit by Product Line
Profitability of Segments
Profit by Product Line
Profitability of Segments
Profit by Product Line
Alpha Beta Gamma Delta Total
Sales $ 90 $ 60 $ 30 $120 $300
Cost of goods sold 35 20 11 98 164
Gross profit $ 55 $ 40 $ 19 $ 22 $136
Division expenses -20 -10 -15 -20 -65
Corporate expenses -3 -2 -1 -4 -10
Operating income
(loss) $ 32 $ 28 $ 3 $ -2 $ 61
Profitability of Segments
Divisional Profit
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
Analysis of Profit-Related
Overall Sales Variance
[actual vs. expected revenue]
Sales Price Variance Price Volume Variance
Analysis of Profit-Related
( )
Sales price Actual Expected Quantity
= -
variance price price sold

( )
Price volume Actual Expected Expected
= -
variance volume volume price

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
Analysis of Profit-Related
Contribution Margin Variance
[actual vs. expected contribution margin]
Sales Mix Variance
Contribution Margin
Volume Variance
Analysis of Profit-Related
( ) ( )
( ) ( )
P1 actual units P1 budgeted CM
- P1 budgeted units - Budgeted average unit CM
P2 actual units P2 budgeted CM
- P2 budgeted units - Budgeted average unit CM

Sales Mix Variance =

The sales mix variance is favorable if the sales mix is weighted to the
more profitable products.
Contribution Actual Budgeted
average unit
margin volume = quantity - quantity
variance sold sold
| |
\ .
The contribution margin volume variance gives management information
about gained or lost profit due to changes in the quantity of sales.
Analysis of Profit-Related
Analysis of Profit-Related
contribution margin variance
$14,375 $13,500
= $875 favorable
sales mix
contribution margin
volume variance
(2,000 1,875) $6.75

= $1,718.75 favorable = $843.75 unfavorable
( ) ( )
( ) ( )
1,250 $4.00
- 1,500 - $6.75
625 $15.00
- 500 - $6.75

Birdwell, Inc.:
Analysis of Profit-Related
Actual Budgeted
Actual Budgeted
industry average
market share - market share
sales unit
percentage percentage
in units CM
| |
\ .
Market share variance =
Budgeted Budgeted
Actual Budgeted
market average
industry sales - industry sales
share unit
in units in units
percentage CM
| |
\ .
Market size variance =
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.

Guan Hansen Mowen
COPYRIGHT 2009 South-Western Publishing, a division of Cengage Learning.
Cengage Learning and South-Western are trademarks used herein under license.
End Chapter 19