CHAPTER

CHAPTER 88
Pricing Decisions, Analyzing
Customer Profitability, and
Activity-Based Pricing

Slide 8-2

Pricing
Pricing Decisions
Decisions
Pricing decisions often the most difficult
decisions that managers face
Pricing Methods:
- profit maximizing price using economic
theory
- Pricing of special orders
- Cost Plus pricing
- Target costing
- Activity based pricing

Slide 8-3

The
The Profit
Maximizing Price
Price
Profit Maximizing
Economic theory

Slide 8-4

The quantity demanded is a function of the

price that is charged

Generally, the higher the price, the lower the

quantity demanded

To calculate profit maximizing price:

- Subtract variable costs from price to
obtain the contribution margin
- Multiply by the quantity demanded
- Subtract fixed costs and estimate profits
- Select the price with the highest profit
Learning objective 1: Compute the profit
maximizing price for a product or service

The
The Profit
Maximizing Price
Price
Profit Maximizing

Slide 8-5

Learning objective 1: Compute the profit

maximizing price for a product or service

 Estimates of price and quantity demanded

Price = $6.95, quantity demanded = 20,000
Price = $5.95, quantity demanded = 25,000
Price = $4.95, quantity demanded = 32,000

Variable cost = $1.50 per unit

Fixed cost = $80,000
Find the profit maximizing price

Slide 8-6

Learning objective 1: Compute the profit

maximizing price for a product or service

Pricing
Pricing Special
Special Orders
Orders
Special orders are for goods and services not
considered part of a companys normal business
Price charged will not affect prices charged in
normal course of business
Price may deviate from what is common
May charge a price less than full cost

Slide 8-7

Learning objective 2: Perform incremental analysis

related to pricing a special order

Pricing
Pricing Special
Special Orders
Orders
Two alternatives: accept or reject
Consider incremental revenues and
expenses
- Income before special order is the same
for both alternatives, not incremental
- Calculate incremental revenue
- Calculate incremental expenses i.e.,
materials, labor and variable overhead

Slide 8-8

Learning objective 2: Perform incremental analysis

related to pricing a special order

Special
Special Orders
Orders
Premier
Premier Lens
Lens
Example
Example
Should Premier Lens accept special order of
20,000 lenses to be sold to Blix Camera for
$73 per lens?
Below is the full cost of $75 per lens

Slide 8-9

Learning objective 2: Perform incremental analysis

related to pricing a special order

Special
Special Orders
Orders
Premier
Premier Lens
Lens
Example
Example
Perform incremental analysis
Fixed costs are not incremental, they will
not change if the order is accepted

Slide 8-10

Learning objective 2: Perform incremental analysis

related to pricing a special order

Commonwealth
Commonwealth Edison
Edison

Slide 8-11

Learning objective 2: Perform incremental analysis

related to pricing a special order

Which of the following are relevant for a

special order?
a. Total company income before the order
b. Fixed costs
c. Incremental revenues and expenses
d. Fixed manufacturing overhead
Answer: c
Incremental revenues and expenses
Slide 8-12

Learning objective 2: Perform incremental analysis

related to pricing a special order

Cost-Plus
Cost-Plus Pricing
Pricing
Company estimates product cost and adds a
markup to arrive at price which allows for a
reasonable profit

Benefits
- Simple approach
- Guarantees profit if sufficient quantity can
be sold at the specified price

Slide 8-13

Learning objective 3: Explain the cost-plus approach to pricing and why

it is inherently circular for manufacturing firms

Cost-Plus
Cost-Plus Pricing
Pricing
Limitations
What markup percentage to use?
Requires considerable judgment and
experimentation
Inherently circular for manufacturing
firms:
- Need to estimate demand to determine
fixed manufacturing costs
- Price affects the quantity demanded
Slide 8-14

Learning objective 3: Explain the cost-plus approach to pricing and why

it is inherently circular for manufacturing firms

Cost-Plus
Cost-Plus Pricing
Pricing

Slide 8-15

Learning objective 3: Explain the cost-plus approach to pricing and why

it is inherently circular for manufacturing firms

Cost-plus pricing:
a. Leads to profit maximization
b. Is inherently circular for
manufacturing firms
c. Is difficult to perform
d. None of the above are correct
Answer: b
Is inherently circular for mfg firms
Slide 8-16

Learning objective 3: Explain the cost-plus approach to pricing and why

it is inherently circular for manufacturing firms

Target
Target Costing
Costing
Once a product is designed it is difficult
to make changes that reduce costs
- 80% of a products costs cannot be
reduced once it is designed
- Product features drive costs

Target costing
- Integrated approach to determine
features, price, costs and design to
ensure a profit

Slide 8-17

Learning objective 4: Explain the target

costing process for a new product

Target
Target Costing
Costing

Slide 8-18

Learning objective 4: Explain the target

costing process for a new product

Target
Target Costing
Costing

Slide 8-19

Learning objective 4: Explain the target

costing process for a new product

Target costing:
a. Requires specification of desired level
of profit
b. Adds desired profit to existing costs
c. Is used primarily with products that
are already in production
d. Leads to profit maximization
Answer: a
Requires specification of desired profit
Slide 8-20

Learning objective 4: Explain the target

costing process for a new product

Analyzing
Analyzing Customer
Customer Profitability
Profitability
Customer Profitability Measurement
System (CPM)
Indirect costs of servicing customers are
assigned to cost pools:
- cost of processing orders
- cost of handling returns
Costs are allocated to specific customers
using cost drivers to determine customer
profitability

Slide 8-21

Learning objective 5: Analyze

customer profitability

Customer profitability is measured as:

a. Revenue minus cost of goods sold
b. Revenue minus indirect manufacturing costs
c. Revenue minus cost of goods sold minus
indirect service costs
d. Revenue minus cost of goods sold minus
indirect manufacturing costs
Answer: c
Revenue minus cost of goods sold minus indirect
service costs
Slide 8-22

Learning objective 5: Analyze

customer profitability

Customer
Customer Profitability
Profitability
Measurement
Measurement System
System

Slide 8-23

Learning objective 5: Analyze

customer profitability

Cost
Cost Pools
Pools and
and Cost
Cost Drivers
Drivers to
to
Service
Service Customers
Customers

Slide 8-24

Learning objective 5: Analyze

customer profitability

Customer
Customer Profitability
Profitability Analysis
Analysis

Slide 8-25

Learning objective 5: Analyze

customer profitability

Customer
Customer Profitability
Profitability Analysis
Analysis

Slide 8-26

Learning objective 5: Analyze

customer profitability

 Delta products has determined the following costs

and drivers for the Johnson Brand customer:

Calculate the profitability of the Johnson Brands

customer.

Slide 8-27

Learning objective 5: Analyze

customer profitability

 Delta products has determined the profitability of the

Johnson Brand customer:

Slide 8-28

Learning objective 5: Analyze

customer profitability

Customers
Customers Can
Can Hurt
Hurt Profitability
Profitability

Slide 8-29

Learning objective 5: Analyze

customer profitability

Activity-Based
Activity-Based Pricing
Pricing
Customers are presented with separate
prices for services they request in
addition to the cost of goods purchased
- Customers will carefully consider the
services they request
- May lead them to impose less cost on the
supplier

Also called menu-based pricing

Slide 8-30

Learning objective 6: Explain the activitybased pricing approach

Activity-Based
Activity-Based Pricing
Pricing
Customers are presented with separate
prices for services they request in
addition to the cost of goods purchased
- Customers will carefully consider the
services they request
- May lead them to impose less cost on the
supplier

Also called menu-based pricing

Slide 8-31

Learning objective 6: Explain the activitybased pricing approach

With activity-based pricing:

a. Customers face a menu of prices for various
services
b. Customers are encouraged to consider the
costs they impose on a supplier
c. Customers may be charged less if they
request less product variety in their orders
d. All of the above are correct
Answer: d
All of the above are correct

Slide 8-32

Pricing
Pricing Decisions
Decisions

Slide 8-33

Learning objective 6: Explain the activitybased pricing approach

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Slide 8-34