8 Pricing

Learning Objectives
1 Compute a target cost when the market determines a product price.

2 Compute a target selling price using cost-plus pricing.

Use time-and-material pricing to determine the cost of services

3 provided.

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LEARNING
1
Compute a target cost when the market Pricing Goods for External Sales
OBJECTIVE determines a product price.

The price of a good or service is affected by many factors. The price of a good or service is affected by many factors.

Illustration 8-1
 Company must have a good understanding of market
Pricing factors
forces.

 Where products are not easily differentiated from

competitor goods, prices are not set by the company, but
rather by the laws of supply and demand – such
companies are called price takers.

 Where products are unique or clearly distinguishable from

competitor goods, prices are set by the company.
Regardless of the factors involved, the price must cover the costs
of the good or service as well as earn a reasonable profit.
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Target Costing Target Costing

 Laws of supply and demand significantly affect product  Target cost: Cost that provides the desired profit when the
price. market determines a product’s price. Illustration 8-2
Target cost as related
to price and profit
 To earn a profit, companies must focus on controlling
costs.

 Requires setting a target cost that will provide the

company’s desired profit.  If a company can produce its product for the target cost or
less, it will meet its profit goal.

 Target cost includes all product and period costs

necessary to make and market the product or service.

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Target Costing 1 Target Costing

 First, company should identify its market niche (luxury Fine Line Phones is considering introducing a fashion cover for its
vs. economy goods) where it wants to compete. phones. Market research indicates that 200,000 units can be sold if
the price is no more than $20. If Fine Line decides to produce the
 Second, company conducts market research to
covers, it will need to invest $1,000,000 in new production equipment.
determine the target price – the price the company
Fine Line requires a minimum rate of return of 25% on all
believes will place it in the optimal position for the target investments. Determine the target cost per unit for the cover.
consumers.
The desired profit for this new product line is
 Third, company determines its target cost by setting a
$1,000,000 x 25% = $250,000
desired profit.
Each cover must result in profit of $250,000 ÷ 200,000 units = $1.25
 Last, company assembles a team to develop a product
to meet the company’s goals. Market price Desired profit Target cost per unit
$20 - $1.25 = $18.75 per unit

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LEARNING
2
Compute a target selling price using cost-plus Cost-Plus Pricing
OBJECTIVE pricing.

 In determining the proper markup, a company must

Cost-Plus Pricing
consider competitive and market conditions.
 In an environment with little or no competition, a
 Size of the markup (the “plus”) depends on the desired
company may have to set its own price.
return on investment for the product:
 When a company sets price, the price is normally a
ROI = net income ÷ invested assets
function of product cost: cost-plus pricing.

 Approach requires establishing a cost base and adding a

markup to determine a target selling price.
Illustration 8-3
Relation of markup to cost
and selling price

Illustration 8-4
Cost-plus pricing formula
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Cost-Plus Pricing Cost-Plus Pricing

Illustration: Thinkmore Products, Inc. is in the process of In addition, Thinkmore has the following fixed costs per unit
setting a selling price on its new video camera pen. It is a at a budgeted sales volume of 10,000 units.
functioning pen that will record up to 2 hours of audio and
video. The per unit variable cost estimates for the new video
camera pen are as follows.

Illustration 8-6
Fixed cost per unit, 10,000 units

Illustration 8-5
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Cost-Plus Pricing Cost-Plus Pricing

Thinkmore has decided to price its new video camera pen to Use markup on cost to set a selling price:
earn a 20% return on its investment (ROI) of $2,000,000.  Compute the markup percentage to achieve
Illustration 8-9

Markup = 20% ROI of $2,000,000 a desired ROI of $20 per unit: Computation of
markup percentage

Expected ROI = $400,000 ÷ 10,000 units = $40

Markup price
per unit =  Compute the target selling price:
Illustration 8-10
Computation of selling
price—markup approach

Illustration 8-8
Computation of
selling price,
10,000 units

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Cost-Plus Pricing LIMITATIONS OF COST-PLUS PRICING

LIMITATIONS OF COST-PLUS PRICING Illustration: If budgeted sales volume for Thinkmore’s Products
was 5,000 instead of 10,000, Thinkmore’s variable cost per
 Advantage of cost-plus pricing: Easy to compute.
unit would remain the same. However, the fixed cost per unit
 Disadvantages: would change as follows. Illustration 8-11
Fixed cost per unit, 5,000 units
► Does not consider demand side:

 Will the customer pay the price?

► Fixed cost per unit changes with change in sales

volume:

 At lower sales volume, company must charge higher Thinkmore's desired 20% ROI now results in a $80 ROI per unit
price to meet desired ROI.
[(20% x $2,000,000) ÷ 5,000].

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LIMITATIONS OF COST-PLUS PRICING Variable-Cost Pricing

Thinkmore computes the selling price at 5,000 units as follows. Alternative pricing approach:

Simply add a markup to variable costs.

 Avoids the problem of uncertain cost information related to
fixed-cost-per-unit computations.
Illustration 8-12
Computation of selling
 Helpful in pricing special orders or when excess capacity
price, 5,000 units exists.

At 5,000 units, how much would Thinkmore mark up its total Major disadvantage is that managers may set the price too low
unit costs to earn a desired ROI of $80 per unit. and fail to cover fixed costs.

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LEARNING
3
Use time-and-material pricing to determine the Time and Material Pricing
OBJECTIVE cost of services provided.

Illustration: Assume the following data for Lake

Time-and-material pricing is an approach to cost-plus pricing Holiday Marina, a boat and motor repair shop.
Illustration 8-13
Total annual budgeted
in which the company uses two pricing rates: time and material costs

 One for labor used on a job - includes direct labor time and
other employee costs.

 One for material - includes cost of direct parts and

materials and a material loading charge for related
overhead.

Widely used in service industries, especially professional

firms such as public accounting, law, and engineering.

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STEP 1: CALCULATE THE LABOR RATE STEP 1: CALCULATE THE LABOR RATE

 Express as a rate per hour of labor.

 Rate includes:
► Direct labor cost (includes fringe benefits).

► Selling, administrative, and similar overhead costs.

► Allowance for desired profit (ROI) per hour.

 Labor rate for Lake Holiday Marina for 2017 based on:
► 5,000 annual labor hours.
Illustration 8-14
Computation of hourly Multiply the rate of $38.20 by the number of labor hours
► Desired profit margin of $8 per hour of labor. time-charge rate
used on any particular job to determine the labor
charges for the job.
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STEP 2: CALCULATE THE MATERIAL STEP 2: MATERIAL LOADING CHARGE

LOADING CHARGE
The marina estimates that the total invoice cost of parts and
 Material loading charge added to invoice price of materials. materials used in 2017 will be $120,000. The marina desires a
20% profit margin on the invoice cost of parts and materials.
 Covers the costs of purchasing, receiving, handling, storing
+ desired profit margin on materials.

 Expressed as a percentage of estimated costs of parts and

materials for the year:

Estimated purchasing, receiving,

handling, storing costs Desired profit
+ margin on
Estimated costs of parts and materials
materials
Illustration 8-15
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STEP 3: CALCULATE CHARGES FOR A STEP 3: CALCULATE CHARGES FOR A
PARTICULAR JOB PARTICULAR JOB

Lake Holiday Marina prepares a price quotation to estimate the cost

Labor charges to refurbish a used 28-foot pontoon boat. Lake Holiday Marina
estimates the job will require 50 hours of labor and $3,600 in parts
+ and materials.

Material charges
+
Material loading charge

Illustration 8-16
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3 Time-and-Material Pricing 3 Time-and-Material Pricing

Presented below are data for Harmon Electrical Repair Shop for If Harmon repairs a TV that takes 4 hours to repair and uses parts
next year. The desired profit margin per labor hour is $10. The of $50, compute the bill for this job.
material loading charge is 40% of invoice cost. Harmon estimates
that 8,000 labor hours will be worked next year.

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Refer to Lecture Illustrative Example Copyright

 Refer to Pricing Question in handout “Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.
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