Cost Management ACCOUNTING AND CONTROL Pricing and Profitability Analysis

1. Cost ManagementACCOUNTING AND CONTROLPricing and Profitability Analysis HANSEN & MOWEN

2. 1 Basic Pricing Concepts OBJECTIVE Economic Pricing Concepts Price Supply P* Demand Q* Quantity

3. 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. 1 Basic Pricing Concepts OBJECTIVE Market Structure and Price

4. 1 Basic Pricing Concepts OBJECTIVE Characteristics of the Four Basic Types of Market Structure

5. 2 Pricing Policies OBJECTIVE Two Approaches to Pricing 1. Cost-based prices are established using “cost” plus markup. 2. Target prices are influenced by market conditions.

6. 2 Pricing Policies OBJECTIVE Cost-Plus Pricing AudioPro Company sells and installs audio equipment in homes, cars, and trucks. AudioPro’s income statement for last year is as follows: 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

7. 2 Pricing Policies OBJECTIVE Cost-Plus Pricing (continued) 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

8. 2 Pricing Policies OBJECTIVE Cost-Plus Pricing (continued) 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

9. 2 Pricing Policies OBJECTIVE Cost-Plus Pricing (continued) AudioPro 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) $ 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

10. 2 Pricing Policies OBJECTIVE Target Costing and Pricing Target costing is a method of determining the cost of a product or service based on the price that the customers are willing to pay. Target costing involves much more upfront work than cost-based pricing. However, if the cost-plus pricing turns out to be higher than what customers will accept, additional work or lost opportunity will result.

11. 3 The Legal System and Pricing OBJECTIVE Predatory pricing is the practice of setting prices below cost for the purpose of injuring competitors and eliminating competition. Predatory pricing on the international market is called dumping. Competition

12. 3 The Legal System and Pricing OBJECTIVE Price discrimination refers to the charging of different prices to different customers for essentially the same product.

13. 3 The Legal System and Pricing OBJECTIVE Customer Prices per Case Cases Sold Large drug store chain $200 125,000 Small local pharmacies 232 100,000 Individual health clubs 250 25,000 Cobalt, Inc. manufactures vitamin supplements that costs an average of $163 per case. Cobalt sold 250,000 cases last year as follows: Cobalt is practicing price discrimination!

14. 3 The Legal System and Pricing OBJECTIVE Analysis of Cobalt, Inc., Customer Class Costs

15. 4 Measuring Profit OBJECTIVE 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 $ 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.

16. 4 Measuring Profit OBJECTIVE Absorption-Costing Income Statement for Lasersave, Inc., for August

17. 4 Measuring Profit OBJECTIVE Absorption-Costing Income Statement for Lasersave, Inc., for September *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 20,000 Total manufacturing overhead $48,750 Add: Beginning inventory 0 Less: Ending inventory (9,750) Cost of goods sold $39,000

18. 4 Measuring Profit OBJECTIVE Variable-Costing Income Statements for Lasersave, Inc. *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

19. 4 Measuring Profit OBJECTIVE Comparative Income Statements for Lasersave, Inc. for the Month of October

20. 4 Measuring Profit OBJECTIVE Changes in Inventory under Absorption and Variable Costing

21. Profitability of Segments 5 OBJECTIVE 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 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

22. Profitability of Segments 5 OBJECTIVE Absorption-Costing Income by Product Line

23. Profitability of Segments 5 OBJECTIVE Variable-Costing Income by Product Line

24. Profitability of Segments 5 OBJECTIVE Overhead Activities and Drivers

25. Profitability of Segments 5 OBJECTIVE Activity-Based Costing Income by Product Line

26. Profitability of Segments 5 OBJECTIVE Divisional Profit 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

27. Analysis of Profit-Related Variances 6 OBJECTIVE Expected price Sales price variance Actual price Quantity sold – x = Price volume variance Expected price Actual volume Expected volume – x =

28. Analysis of Profit-Related Variances 6 OBJECTIVE Contribution margin variance Annual contribution margin Budgeted contribution margin – = Budgeted average unit contribution margin Annual quantity sold Budgeted quantity sold Contribution margin volume variance x – =

29. Analysis of Profit-Related Variances 6 OBJECTIVE Data for Birdwell, Inc.

30. Analysis of Profit-Related Variances 6 OBJECTIVE Sales mix variance = [(Product 1 actual units – Product 1 budgeted units) x (Product 1 budgeted unit contribution margin – Budgeted average unit contribution margin)] + [(Product 2 actual units – Product 2 budgeted units) x (Product 2 budgeted unit contribution margin – Budgeted average unit contribution margin)] Birdwell sales mix variance = [($1,250 – 1,500) x ($4.00 – $6.75)] + [(625 –500) x ($15.00 – $6.75)] = $1,718.75 Favorable

31. Analysis of Profit-Related Variances 6 OBJECTIVE Market share variance = [(Actual market share percentage – Budgeted market share percentage) x (Actual industry sales in units)] x (Budgeted average unit contribution margin) Market size variance = [(Actual industry sales in units – Budgeted industry sales in units) x (Budgeted market share percentage)] x (Budgeted average unit contribution margin)

32. The Product Life Cycle 7 OBJECTIVE Product Life Cycle

33. The Product Life Cycle 7 OBJECTIVE Impact of the Product Life Cycle on Cost Management

34. The Product Life Cycle 7 OBJECTIVE Product Life Cycle Costs in the ABC Categories

35. Limitations of Profit Measurement 8 OBJECTIVE • Limitations of profit include • focus on past performance • uncertain economic conditions • difficulty of capturing all important factors in financial measures Successful firms measure far more than accounting profit.