PerMan Ch08 Pricing Decisions

Managerial Accounting
Seventh Edition
James Jiambalvo
Chapter 8
Pricing Decisions, Customer Profitability

Analysis, and Activity-Based Pricing
Copyright ©2020 John Wiley & Sons, Inc.
Chapter Outline
Learning Objectives
LO 1 Compute the profit-maximizing price for a product or service, and perform

incremental analysis related to pricing a special order.
LO 2 Explain the cost-plus approach to pricing and why it is inherently circular for
manufacturing firms. Also, explain the target costing process for a new
product.
LO 3 Analyze customer profitability, and explain the activity-based pricing

approach.
LO 1 Copyright ©2020 John Wiley & Sons, Inc. 2

Learning Objective 1
Compute the profit-maximizing price for a product or service,

and perform incremental analysis related to pricing a special
order.

Pricing Decisions (1 of 2)
• Pricing decisions are often the most difficult decisions that

managers face
• Pricing decisions examined in this chapter include
o Profit-maximizing price from the standpoint of economic
theory
o Pricing of special orders
o Marking up costs and target costing
o Measuring customer profitability and activity based pricing

The Profit-Maximizing Price (1 of 2)
• Economic theory suggests that the quantity demanded is a

function of the price that is charged
• Generally, the higher the price, the lower the quantity
demanded
o If managers can estimate the quantity demanded at various
prices, determining the optimal price is straightforward

The Profit-Maximizing Price (2 of 2)
• To calculate the profit-maximizing price:

o Subtract unit variable costs from price to obtain the
contribution margin
o Multiply the contribution margin by the quantity demanded
o Subtract fixed costs and estimate profits
o Select the price with the highest profit

Estimating the Profit-Maximizing Price
A B C D=A−C E=B×D F G=E−F
Price Quantity Variable Contribution Total Contribution

Cost per Fixed Costs Profit
per Unit Demanded Unit Margin per Unit Margin
$6,000 1,000 $1,500 $4,500 $4,500,000 $7,000,000 ($ 2,500,000)
5,500 2,000 1,500 4,000 8,000,000 7,000,000 1,000,000
5,000 4,000 1,500 3,500 14,000,000 7,000,000 7,000,000
4,500 6,000 1,500 3,000 18,000,000 7,000,000 11,000,000
4,000 9,000 1,500 2,500 22,500,000 7,000,000 15,500,000
3,500 12,000 1,500 2,000 24,000,000 7,000,000 17,000,000
3,000 15,000 1,500 1,500 22,500,000 7,000,000 15,500,000
2,500 19,000 1,500 1,000 19,000,000 7,000,000 12,000,000

Estimating Demand
• The most difficult part of determining the profit-

maximizing price is determining the demand function
o A number of approaches can be used
• Sales managers in various regions could estimate the total
quantity demanded at various prices
• The product could be test marketed with a number of
potential customers at various prices

Test Your Knowledge 1
• Estimates of price and quantity demanded
Price = $6.95, quantity demanded = 20,000
• Variable cost = $1.50 per unit
• Fixed cost = $80,000
Find the profit-maximizing price
(Price - Variable) X Quantity − Fixed Cost = Profit
(6.95 − 1.50) X 20,000 − 80,000 = 29,000
(5.95 − 1.50) X 25,000 − 80,000 = 31,250
(4.95 − 1.50) X 32,000 − 80,000 = 30,400
$5.95 is the profit maximizing price

Pricing Special Orders (1 of 3)
• Special orders are for goods and services not considered

part of a company’s normal business
o Price charged will not affect prices charged in the normal
course of business
o The company may be better off charging a price that is
below full cost

• The special order decision presents two alternatives

o Accept
o Reject
• Income from the main business is the same under both
alternatives
o It is not incremental and need not be considered in the
special order

• Need to consider incremental revenues and incremental

costs
o The incremental revenue is the revenue associated with the
special order
o Incremental costs can include
• Direct materials
• Direct labor
• Variable overhead
• Incremental fixed costs

Special Orders – Premier Lens Example (1 of 2)
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

Special Orders – Premier Lens Example (2 of 2)
• Perform incremental analysis

• Fixed costs are not incremental, they will not change if the
order is accepted

Importance of Pricing Power

Which of the following is true?

a. In pricing special orders, fixed costs typically are not
relevant←
b. In pricing special orders, fixed costs typically are
relevant
Answer: a
Fixed costs typically are not relevant

Explain the cost-plus approach to pricing and why it is

inherently circular for manufacturing firms. Also, explain the
target costing process for a new product.

Cost-Plus Pricing (1 of 4)
• With a cost plus approach, the company starts with an

estimate of product cost
o Typically excluding any selling or administrative costs
• Adds a markup to arrive at a price that allows for a
reasonable level of profit

• Advantages
o The cost plus approach is simple to apply
o The company will earn a reasonable profit if a sufficient
quantity can be sold at the specified price
• The approach also has limitations

• Limitations
o Determination of an appropriate markup requires
considerable judgment
o Experimentation with different markups may be necessary
o Inherently circular for manufacturing firms
• Need to estimate demand to determine fixed costs and the
price, yet the price affects the quantity demanded


All of the following are limitations of cost plus pricing except

a. Determination of the markup percentage requires
judgment
b. Is inherently circular for manufacturing firms
c. Experimentation may be necessary
d. Cost plus is simple to apply←
Answer: d
Simplicity is an advantage of cost plus pricing

Target Costing (1 of 3)
• Once a product is designed it is difficult to make changes

that reduce costs
o 80% of a product’s costs cannot be reduced once it is
designed
o Product features drive costs
• Target costing
o Integrated approach to determine features, price, costs and
design to ensure a profit

• The process begins with an analysis of competing products

o This leads to a specification of features and price attractive
to customers
• The second step is to specify a desired level of profit
• Then the engineering department with input from the cost
accounting department develops a design that can be
produced at a cost which will earn the desired level of
profit


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

Analyze customer profitability, and explain the activity-based

pricing approach.

Analyzing Customer Profitability
• Customer Profitability Measurement System (CPM)

o Indirect costs of servicing customers are assigned to cost
pools
• Indirect costs include processing orders, handling returns, and
shipments
o Costs are allocated to specific customers using cost drivers
to determine customer profitability
• Subtracting these costs and product costs from customer
revenue yields a measure of 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

Customer Profitability Measurement System

Cost Pools and Cost Drivers to Service
Customers

Customer Profitability Analysis (1 of 2)
Customer 1: Customer 1: Customer 2: Customer 2:
Cost Quantity Amount Quantity Amount
Revenue
Less COGS 732,600 727,650
Gross margin (666,000) (661,500)
Less indirect costs 66,600 66,150
Internet orders $1.20/order 165 (198) 0 0
Fax orders $4.50/order 20 (90) 320 (1,440)
Line items $0.90/item 2,500 (2,250) 5,100 (4,590)
Miles $0.36/mile 1,200 (432) 3,300 (1,188)
Weight $0.40/pound 900 (360) 870 (348)
Items returned $0.80/item 210 (168) 910 (728)
Profit 63,102 57,856
Profit as a percent of sales 8.61% 7.95%

A customer profitability measurement (CPM) system does all

of the following EXCEPT:
a. Allocates indirect costs to individual customers
b. Traces revenue to individual customers
c. Traces cost of goods sold to individual customers
d. Traces costs to individual products←
Answer: d
Traces costs to individual products

Customer Profitability Analysis (2 of 2)

Customer Profitability and Performance
Measures
• Some examples of performance measures that will drive
managers to improve customer profitability
o Percent of customers who are not profitable
o Dollar loss for customers who are not profitable
o Average profit per customer
o Number of customer service requests per 100 customers
o Percent of customers who return items
o Dollar value of returned items

Activity-Based Pricing (1 of 2)
• Customers are presented with separate prices for services

they request in addition to the cost of goods purchased
o Customers will carefully consider the services they request
o May lead them to impose less cost on the supplier
• Also called menu-based pricing

Activity-Based Pricing (2 of 2)
• Customers might object as the price they pay should cover

these costs
o Ways to deal with this resistance
• Lower prices slightly and then encourage customers to make
fewer but larger purchases
• Customers could be encouraged to limit the variety of goods
they order
• Activity-based pricing could be used only on the least
profitable customers

Pricing Decisions (2 of 2)

Copyright
Copyright © 2020 John Wiley & Sons, Inc.

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from the use of the information contained herein.
Copyright ©2020 John Wiley & Sons, Inc. 39

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Managerial Accounting

Pricing Decisions, Customer Profitability

LO 1 Compute the profit-maximizing price for a product or service, and perform

LO 3 Analyze customer profitability, and explain the activity-based pricing

LO 1 Copyright ©2020 John Wiley & Sons, Inc. 2

Compute the profit-maximizing price for a product or service,

LO 1 Copyright ©2020 John Wiley & Sons, Inc. 3

• Pricing decisions are often the most difficult decisions that

LO 1 Copyright ©2020 John Wiley & Sons, Inc. 4

• Economic theory suggests that the quantity demanded is a

LO 1 Copyright ©2020 John Wiley & Sons, Inc. 5

• To calculate the profit-maximizing price:

LO 1 Copyright ©2020 John Wiley & Sons, Inc. 6

A B C D=A−C E=B×D F G=E−F

Price Quantity Variable Contribution Total Contribution

$6,000 1,000 $1,500 $4,500 $4,500,000 $7,000,000 ($ 2,500,000)

5,500 2,000 1,500 4,000 8,000,000 7,000,000 1,000,000

5,000 4,000 1,500 3,500 14,000,000 7,000,000 7,000,000

4,500 6,000 1,500 3,000 18,000,000 7,000,000 11,000,000

4,000 9,000 1,500 2,500 22,500,000 7,000,000 15,500,000

3,500 12,000 1,500 2,000 24,000,000 7,000,000 17,000,000

3,000 15,000 1,500 1,500 22,500,000 7,000,000 15,500,000

2,500 19,000 1,500 1,000 19,000,000 7,000,000 12,000,000

LO 1 Copyright ©2020 John Wiley & Sons, Inc. 7

• The most difficult part of determining the profit-

LO 1 Copyright ©2020 John Wiley & Sons, Inc. 8

LO 1 Copyright ©2020 John Wiley & Sons, Inc. 9

• Special orders are for goods and services not considered

LO 1 Copyright ©2020 John Wiley & Sons, Inc. 10

• The special order decision presents two alternatives

LO 1 Copyright ©2020 John Wiley & Sons, Inc. 11

• Need to consider incremental revenues and incremental

LO 1 Copyright ©2020 John Wiley & Sons, Inc. 12

Should Premier Lens accept special order of 20,000 lenses to

LO 1 Copyright ©2020 John Wiley & Sons, Inc. 13

• Perform incremental analysis

LO 1 Copyright ©2020 John Wiley & Sons, Inc. 14

LO 1 Copyright ©2020 John Wiley & Sons, Inc. 15

Which of the following is true?

LO 1 Copyright ©2020 John Wiley & Sons, Inc. 16

Explain the cost-plus approach to pricing and why it is

LO 2 Copyright ©2020 John Wiley & Sons, Inc. 17

• With a cost plus approach, the company starts with an

LO 2 Copyright ©2020 John Wiley & Sons, Inc. 18

LO 2 Copyright ©2020 John Wiley & Sons, Inc. 19

LO 2 Copyright ©2020 John Wiley & Sons, Inc. 20

LO 2 Copyright ©2020 John Wiley & Sons, Inc. 21

All of the following are limitations of cost plus pricing except

LO 2 Copyright ©2020 John Wiley & Sons, Inc. 22

• Once a product is designed it is difficult to make changes

LO 2 Copyright ©2020 John Wiley & Sons, Inc. 23

• The process begins with an analysis of competing products

LO 2 Copyright ©2020 John Wiley & Sons, Inc. 24

LO 2 Copyright ©2020 John Wiley & Sons, Inc. 25

LO 2 Copyright ©2020 John Wiley & Sons, Inc. 26

Analyze customer profitability, and explain the activity-based

LO 3 Copyright ©2020 John Wiley & Sons, Inc. 27

• Customer Profitability Measurement System (CPM)

LO 3 Copyright ©2020 John Wiley & Sons, Inc. 28

Customer profitability is measured as: