CostAccountingSeventeenthEdition,GlobalEditionChapter14PricingDecisionsAndCostManagementLearningObjectives(1of2)14.1Discussthethreemajorfactorsthataffectpricingdecisions14.2Understandhowcompaniesmakelong-runpricingdecisions14.3Priceproductsusingthetarget-costingapproach14.4Applytheconceptsofcostincurrenceandlocked-incosts14.5Priceproductsusingthecost-plusapproachLearningObjectives(2of2)14.6Uselife-cyclebudgetingandcostingwhenmakingpricingdecisions14.7Describetwopricingpracticesinwhichnon-cost factorsareimportantMajorFactorsThatAffectPricingDecisionsHowcompaniespriceaproductorserviceultimatelydependsonthedemandandsupplyforit.Demandandsupplyhavethreeinfluences:CustomersCompetitorsCostsThreeInfluencesonDemandandSupplyCustomersinfluencepricethroughtheireffectonthedemandforaproductorservice,basedonfactorssuchasproductfeaturesandquality.Competitorsinfluencepricethroughtheirtechnologies,plantcapacities,andoperatingstrategiesthataffecttheircosts.Costsinfluencepricesbecausetheyaffectsupply.Thelowerthecostofproducingaproduct,thegreaterthequantityafirmiswillingtosupply.CostingandPricingfortheLongRunShort-runpricingdecisionshaveatimehorizonoflessthanoneyearandincludepricingaone-time-onlyspecialorderwithnolong-runimplicationsandadjustingproductmixandoutputvolumeinacompetitivemarket.Long-runpricingbuildslong-runrelationshipswithcustomersbasedonstableandpredictableprices.Managerspreferastablepricebecauseitreducestheneedforcontinuousmonitoringofprices,improvesplanning,andbuildslong-runbuyer-sellerrelationships.CostAllocationRecallthatindirectcostsofaparticularcostobjectarecoststhatarerelatedtothatcostobjectbutcannotbetracedtoitinaneconomicallyfeasible(cost-effective)way.Thesecostsoftencomprisealargepercentageoftheoverallcostsassignedtocostobjects.Costallocationsandproductprofitabilityanalysesaffecttheproductspromotedbyacompany.Toincreaseprofits,managersfocusonhigh-marginproducts.PurposesofCostAllocation Exhibit14.1PurposesofCostAllocationPurposeExamplesToprovideinformationforeconomicdecisionsTodecideonthesellingpriceforaproductorserviceTodecidewhethertoaddanewproductfeatureTomotivatemanagersandotheremployeesToencouragethedesignofproductsthataresimplertomanufactureorlesscostlytoserviceToencouragesalesrepresentativestoemphasizehigh-marginproductsorservicesTojustifycostsorcomputereimbursementamountsTocostproductsata“fair”price,oftenrequiredbylawandgovernmentcontractsTocomputereimbursementforaconsultingfirmbasedonapercentageofthecostsavingsresultingfromtheimplementationofitsrecommendationsTomeasureincomeandassetsTocostinventoriesforreportingtoexternalpartiesTocostinventoriesforreportingtotaxauthoritiesAlternativeLong-RunPricingApproachesHowshouldmanagersuseproductcostinformationtopricetheirproducts?Therearetwodifferentapproachesforpricingdecisions:Themarket-basedapproachasks:Givenwhatourcustomerswantandhowcompetitorswillreacttowhatwedo,whatpriceshouldwecharge?Thecost-basedapproachasks:Givenwhatitcostsustomakethisproduct,whatpriceshouldwechargethatwillrecoupourcostsandachieveatargetreturnoninvestment(alsoknownascost-plus)?Market-BasedApproach:TargetCostingforTargetPricing(1of3)Beforesettingpricesunderanyapproach,managersneedtounderstandcustomersandcompetitorsforthreereasons:Lower-costcompetitorscontinuallyrestrainprices.Productshaveshorterlives,whichleavescompanieslesstimeandopportunitytorecoverfrompricingmistakes,lossofmarketshare,andlossofprofitability.Customersaremoreknowledgeablebecausetheyhaveeasyaccesstopriceandotherinformationonlineanddemandhigh-qualityproductsatlowprices.Market-BasedApproach:TargetCostingforTargetPricing(2of3)StartswithatargetpricewhichistheestimatedpriceforaproductorservicethatpotentialcustomersarewillingtopayThetargetpriceisestimatedbasedonanunderstandingofcustomers’perceivedvalueforaproductorservice,andhowcompetitorswillpricecompetingproductsorservices.Market-BasedApproach:TargetCostingforTargetPricing(3of3)FourStepsinDevelopingTargetPricesandTargetCostsDevelopaproductthatsatisfiestheneedsofpotentialcustomers.Chooseatargetprice.Deriveatargetcostperunitbysubtractingtargetoperatingincomeperunitfromthetargetprice.Performvalueengineeringtoachievetargetcost.ValueEngineering,CostIncurrence,andLocked-InCosts(1of5)ValueEngineeringValueengineeringisasystematicevaluationofallaspectsofthevaluechain,withtheobjectiveofreducingcostsandachievingaqualitylevelthatsatisfiescustomers.Valueengineeringentailsimprovementsinproductdesigns,changesinmaterialsspecifications,andmodificationsinprocessmethods.Toimplementvalueengineering,managersmustdistinguishvalue-addedactivitiesandcostsfromnon-value-addedactivitiesandcosts.ValueEngineering,CostIncurrence,andLocked-InCosts(2of5)ValueEngineeringTerminologyAvalue-addedcostisacostthat,ifeliminated,wouldreducetheactualorperceivedvalueorutility(usefulness)customersexperiencefromusingtheproductorservice.Non-value-addedcostsarecoststhat,ifeliminated,wouldnotreducetheactualorperceivedvalueorutility(usefulness)customersgainfromusingtheproductorservice.Itisacostthecustomerisunwillingtopayfor.ValueEngineering,CostIncurrence,andLocked-InCosts(3of5)ValueEngineeringTerminologyCostincurrence—describeswhenaresourceisconsumed(orbenefitforgone)tomeetaspecificobjectiveLocked-incosts(designed-incosts)—coststhathavenotyetbeenincurredbutwillbeincurredinthefuturebasedondecisionsthathavealreadybeenmadeThebestopportunitytomanagecostsisbeforetheyarelockedin.ValueEngineering,CostIncurrence,andLocked-InCosts(4of5)Exhibit14.4PatternofCostIncurrenceandLocked-InCostsValueEngineering,CostIncurrence,andLocked-InCosts(5of5)Tosummarize,followingarethekeystepsinvalue-engineering:Understandcustomerrequirementsandvalue-addedandnon-value-addedcosts.Anticipatehowcostsarelockedinbeforetheyareincurred.Usecross-functionalteamstoredesignproductsandprocessestoreducecostswhilemeetingcustomerneeds.PossibleUndesirableEffectsofValueEngineeringandTargetCostingUnlessmanagedproperly,valueengineeringandtargetcostingcanhaveundesirableeffects:Employeesmayfeelfrustratediftheyfailtoattaintargets.Thecross-functionalteammayaddtoomanyfeaturesjusttoaccommodatethedifferentwishesofteammembers.Aproductmaybeindevelopmentforalongtimeastheteamrepeatedlyevaluatesalternativedesigns.Organizationalconflictsmaydevelopastheburdenofcuttingcostsfallsunequallyondifferentbusinessfunctionsinthecompany’svaluechain.AvoidingPossibleUndesirableEffectsToavoidthosepossibleundesirableeffects,target-costingeffortsshouldalwaysdothefollowing:Encourageemployeeparticipationandcelebratesmallimprovementstowardachievingthetargetcost.Focusonthecustomer.Payattentiontoschedules.Setcost-cuttingtargetsforallvalue-chainfunctionstoencourageacultureofteamworkandcooperation.Cost-PlusPricing(1of5)Insteadofusingthemarket-basedapproachforlong-runpricingdecisions,managerssometimesuseacost-basedapproach.Thegeneralformulaforsettingacost-basedsellingpriceaddsamarkupcomponenttothecostbase.Usually,itisonlyastartingpointintheprice-settingprocess.Markupissomewhatflexible,basedpartiallyoncustomersandcompetitors.Becauseamarkupisadded,cost-basedpricingisoftencalledcost-pluspricing,wheretheplusreferstothemarkupcomponent.Cost-PlusPricing(2of5)Cost-pluspricingcanbedeterminedseveralways:Chooseamarkuptoearnatargetrateofreturnoninvestment,whichisthetargetannualoperatingincomedividedbyinvestedcapital.Computethespecificamountofcapitalinvestedinaproduct,whichischallengingbecauseitrequiresdifficultandarbitraryallocationsofinvestmentsinequipmentandbuildingstoindividualproducts.Cost-PlusPricing(3of5)Becausecomputingthespecificamountofcapitalinvestedinaproductischallenging,sometimesmanagersusealternatecostbasestosetprospectivesellingprices:VariablemanufacturingcostVariablecostManufacturingcostFullcostCost-PlusPricing(4of5)CommonBusinessPracticeManymanagersusefullcostfortheircost-basedpricingdecisions:Itallowsforfullrecoveryofallcostsoftheproduct.Itallowsforpricestability.Itisasimpleapproach.Cost-PlusPricing(5of5)Thesellingpricescomputedundercost-pluspricingareprospectiveprices.Thetarget-pricingapproachreducestheneedtogobackandforthamongprospectivecost-plusprices,customerreactions,anddesignmodifications.Target-pricingfirstdeterminesproductcharacteristicsandtargetpriceonthebasisofcustomerpreferencesandexpectedcompetitorresponsesandthencomputesatargetcost.Life-CycleProductBudgetingandCostingManagerssometimesneedtoconsidertargetpricesandtargetcostsoveramultiple-yearproductlifecycle.ProductlifecyclesspanthetimefrominitialR&Dtowhencustomerserviceandsupportarenolongeroffered.Inlife-cyclebudgeting,managersestimatetherevenuesandbusinessfunctioncostsacrosstheentirevalue-chain,fromitsinitialR&Dtoitsfinalcustomerserviceandsupport.Life-cyclecostingtracksandaccumulatesbusinessfunctioncostsacrosstheentirevaluechain,fromaproduct’sinitialR&Dtoitsfinalcustomerserviceandsupport.Life-cyclebudgetingandlife-cyclecostingspanseveralyears.Life-CycleBudgetingandPricingDecisionsBudgetedlife-cyclecostsprovideusefulinformationforstrategicallyevaluatingpricingdecisions.Thesetwofeaturesofcostsmakelife-cyclebudgetingparticularlyimportant.ThedevelopmentperiodforR&Danddesignislongandcostly.ManycostsarelockedinattheR&Danddesignstages,evenifR&Danddesigncostsarethemselvessmall.ManagingEnvironmentalandSustainabilityCostsManagingenvironmentalcostsisacriticalareawheremanagersapplylife-cyclecostingandvalueengineering.Environmentalcoststhatareincurredoverseveralyearsoftheproduct’slifecycleareoftenlockedinattheproduct-andprocess-designstage.Aneworganization,theSustainabilityAccountingStandardsBoard(SASB)hasbegundefiningstandardsforenvironmental,social,andgovernance(ESG)performancefordifferentindustries.Whenmeasuredovermultipleperiods,companiesthathavehigherrelevantESGratings,havehigherfutureprofitabilityandfinancialperformance,perhapsbecauseofcustomerloyaltyandsatisfaction,employeeengagement,orbrandandreputation.CustomerLife-CycleCostingCustomerlife-cyclecostsfocusonthetotalcostsincurredbyacustomertoacquires,use,maintain,anddisposeofaproductorservice.Thesecostsinfluencethepricesacompanycanchargeforitsproducts.Asanexample,Maytagcanchargehigherpricesforappliancesthatsaveelectricityandhavelowmaintenancecosts.Non-CostFactorsinPricingDecisions(1of2)Predatorypricing—whenacompanydeliberatelypricesbelowitscostsinanefforttodrivecompetitorsoutofthemarkettorestrictsupplyandthenrecoupsitslossesbyraisingpricesorenlargingdemandCollusivepricing—whencompaniesinanindustryconspireintheir