Chapter 12 - Pricing, target costing and customer profitability analysis

Question 1

(1) Name the three major influences on pricing decisions

Answer 1

Customers, Competitors and Costs

Question 2

(2) Distinguish between short-run and long-run pricing decisions

Answer 2

Short-run decisions include (1) pricing for a one-off special order with no long-term implications, and (2) adjusting product mix and output volume in a competitive market

The time horizon used to calculate those costs that differ among the alternatives for short-run decisions is typically six months or less but sometimes as long as a year

Long-run decisions include pricing a product in a major market where price setting has considerable leeway

A time horizon of a year or longer is used when computing relevant costs for these long-run decisions. Many pricing decisions have both short-run and long-run implications.

The time horizon dictates which costs to include

Question 3

(3) Describe the target-costing approach to pricing

Answer 3

One approach to pricing is to use a target price. Target price is the estimated price that potential customers are
willing to pay for a product (or service). A target operating profit per unit is subtracted from the target price to determine the target cost per unit. The target cost per unit is the estimated long-run cost of a product (or service) that when sold enables the firm to achieve the targeted profit. The challenge for the organisation is to make the cost improvements necessary through value-engineering methods to achieve the target cost.

Question 4

(4) Distinguish between cost incurrence and locked-in costs

Answer 4

Two key concepts in value engineering and in managing value-added and non-value-added costs are cost incurrence and locked-in costs

Cost incurrence: occurs when a resource is sacrificed or used up. Costing systems emphasize cost incurrence, they recognise and record costs only when costs are incurred

Locked-in costs (designed-in costs) are those costs that have not yet been incurred but that will be incurred in the future on the basis of decisions that have already been made

Question 5

(5) Describe the cost-plus approach to pricing (and the target return of investment approach)

Answer 5

The cost-plus approach to pricing chooses prospective prices by using a general formula that adds a mark-up to
a cost base. Many different costs (such as full product costs or manufacturing costs) can serve as the cost base in
applying the cost-plus formula. Prices are then modified on the basis of customers’ reactions and competitors’
responses.

Cost base + mark-up component = prospective selling price

One approach is to choose a mark-up to earn a target return of investment (the target operating profit that an organisation must earn divided by invested capital, can e.g. be defined as total assets)

Do not confuse the target return of investment with the mark-up percentage

Question 6

(6) Explain how life-cycle product budgeting and costing assist in pricing decisions

Answer 6

Life-cycle budgeting and life-cycle costing estimate, track and accumulate the costs (and revenues) attributable to each product from its initial R&D to its final customer service and support in the marketplace. Life-cycle costing offers three important benefits: (a) the full set of costs associated with each product become visible; (b) differences among products in the percentage of their total costs incurred at early stages in the life cycle are highlighted; and (c) interrelationships among value-chain business function costs are emphasised. Companies choose prices to maximise the profits earned over a product’s life cycle.

Question 7

(7) Discuss why revenues can differ across customers purchasing the same product

Answer 7

The revenues of customers purchasing the same product can differ due to differences in the quantity of units purchased and discounts from list price.

Customer revenues are inflows of assets from customers received in exchange for products or services being provided to those customers. More accurate customer revenues can likewise be obtained by tracing as many revenue items (such as sales returns and coupons) as possible to individual customers.

The analysis of customer profitability is enhanced by retaining as much detail as possible about revenue. A key concern here is price discounting, which is the reduction of selling prices below listed levels in order to encourage an increase in purchases by customers. Accounting systems differ with respect to how details on discounting are recorded

Question 8

(8) Apply the concept of cost hierarchy to customer costing

Answer 8

Customer-cost hierarchies highlight how some costs can be reliably assigned to individual customers while other costs can be reliably assigned only to distribution channels or to corporate-wide efforts.

Customer cost hierarchy: categorises costs related to customers into different cost pools on the basis of different types of cost drivers (or cost-allocation bases) or different degrees of difficulty in determining cause-and-effect (or benefits received) relationships

Example of five categories:
1 Customer output-unit-level costs – resources sacrificed on activities performed to sell each unit (bottle) to a customer.
2 Customer batch-level costs – resources sacrificed on activities that are related to a group of units (bottles) sold to a customer.
3 Customer-sustaining costs – resources sacrificed on activities undertaken to support individual customers, regardless of the number of units or each batch of product delivered to customers. E.g. cost of customer visits or cost of displays at customer sites.
4 Distribution-channel costs – resources sacrificed on activities that are related to a particular distribution channel rather than to each unit of product, batches of product, or specific customers. An example could be the manager of the retail distribution channel.
5 Corporate-sustaining costs – resources sacrificed on activities that cannot be traced to individual customers or distribution channels. Examples are senior management and general administration costs.

Question 9

(9) How can customer profitability reports be prepared to highlight differences across customers in their profitability?

Answer 9

Customer profitability reports, shown in a cumulative form, often reveal that a small percentage of customers
contribute a large percentage of profits. It is important that companies devote sufficient resources to maintaining and expanding relationships with these key contributors to profitability.

Question 10

12.4 What is a target price, target operating profit and target cost per unit?

Answer 10

An important form of market-based price is the target price

Target price - the estimated price for a product (or service) that potential customers will be willing to pay (estimate based on an understanding of customers’ perceived value for a product and competitors’ responses)
A target operating profit per unit is the operating profit that a company wants to earn on each unit of a product (or service) sold
Target cost per unit the estimated long-run cost per unit that when sold at the target price, allows the company to achieve the target operating profit
All costs is to be included as in the long run, a company’s prices and revenues must cover all its costs

Question 11

Name five other factors (besides customer profitability) that managers should consider in deciding how to allocate resources across customers

Answer 11

1 Short-run and long-run customer profitability. This factor will be influenced by factors 2 and 3 below as well as by the level of resources likely to be required to retain the accounts.

2 Likelihood of customer retention. The more likely a customer is to continue doing business with a company, the more valuable the customer.

3 Potential for customer growth. This factor will be influenced by the likely growth of the customer’s industry and the likely growth of the customer. This factor will also be influenced by cross-selling opportunities, that is, when a customer of one of the company’s products becomes a customer of one or more of the company’s other products.

4 Increases in overall demand from having well-known customers. Some customers with established reputations are often worth mentioning during customer visits to drive sales. Other customers are valuable because of their willingness to provide product endorsements.

5 Ability to learn from customers. Customers can be an important source of ideas about new products or ways to improve existing products. Customers willing to provide such input can be especially valuable.

Question 12

12.9 Why is customer profitability analysis a vitally important topic to managers?

Answer 12

Customer profitability reports, shown in a cumulative form, often reveal that a small percentage of customers contribute a large percentage of profits. It is important that companies devote sufficient resources to maintaining and expanding relationships with these key contributors to profitability.

Question 13

12.7 Describe two alternative cost plus methods

Why might a company want to use an alternative method?

Answer 13

Companies sometimes find it difficult to determine the capital invested to support a product. Computing invested capital requires allocations of investments in equipment and buildings (used for design, production, marketing, distribution and customer service) to individual products – a difficult and sometimes arbitrary task.

Some companies therefore prefer to use alternative cost bases and mark-up percentages that do not require calculations of invested capital to set price.

Using variable manufacturing costs or variable product costs as the base (quite high percentage, has to take into account the need to earn a profit and to recoup fixed manufacturing costs and other business function costs)

Using full product costs as the base (lower percentage, includes all costs incurred to sell the product)

Question 14

Name three undesired consequences of value engineering (if not managed properly)

Answer 14

(1) The cross-functional team may add too many features in an attempt to accommodate the different wishes of team members.
(2) Long development times may result as alternative designs are evaluated endlessly.
(3) Organisational conflicts may develop as the burden of cutting costs falls unequally on different parts of the organisation.

To avoid these pitfalls, target-costing efforts should always focus on the customer, pay attention to schedules, and build a culture of teamwork and cooperation across business functions.

Question 15

How do we calculate the normal mark-up percentage?

Answer 15

Contribution margin divided by whatever we base the normal mark-up percentage on e.g. variable costs

Question 16

When is profit maximized ?

Answer 16

When marginal cost is equal to marginal revenue

Question 17

Distinguish between penetration and skimming pricing policies when launching a new product

Answer 17

When launching a new product there are two options:
1- Penetration: set low initial price
2- Skimming: set high initial price

Question 18

How can customers influence pricing decisions?

Answer 18

Understanding customers’ price and product characteristic preferences is a core competitive strength for business today
Technology-driven revolution: dynamic prices
Prices can dynamically respond to demand, to create demand, to reduce waste and to turn over stock more rapidly
Companies can harness ‘Big Data’ arising from the flood of customer interactions to enable more effective prices

Question 19

How can competitors influence pricing decisions?

Answer 19

Competitors’ reactions influence pricing decisions
A business with knowledge of its rivals’ technology, plant capacity and operating policies is able to estimate it’s rivals’ costs, which is valuable information in setting competitive prices
Competitor analysis takes different forms
Competitors themselves and their customers, suppliers and former employees are important sources of information
Another way of obtaining information is via reverse engineering - a process of analysing and tearing down competitors’ products - to incorporate the best features, materials and technology in a company’s own designs
Both domestic and international competitors

Question 20

How can costs influence pricing decisions?

Answer 20

The study of cost-behaviour patterns gives insight into the income that results from different combinations of price and output quantities sold for a particular product.

Question 21

Why should managers be particularly careful when deciding to drop customers?

Answer 21

Managers should be particularly cautious when deciding to drop customers. Long-run profitability reports may provide misleading signals about their short-run profitability. Not all costs assigned to a customer are variable in the short run. Dropping a currently unprofitable customer will not necessarily eliminate in the short run all the costs assigned to that customer.

Question 22

Name 3 advantages of using full product costs as the base

Answer 22

Advantages of this method:

1 Full product cost recovery. For long-run pricing decisions, full product costs inform managers of the bare minimum costs they need to recover to continue in business rather than shut down. Using variable costs as a base does not give managers this information. There is then a temptation to engage in excessive long-run price cutting as long as prices give a positive contribution margin. Long-run price cutting, however, may result in long-run revenues being less than long-run (full product) costs, resulting in the company going out of business.

2 Price stability. Managers believe that full-cost formula pricing promotes price stability, because it limits the ability of managers to cut prices. Managers prefer price stability because it facilitates planning.

3 Simplicity. A full-cost formula for pricing does not require a detailed analysis of cost behaviour patterns to separate costs into fixed and variable components for each product. Calculating variable costs for each product is expensive and prone to errors. For these reasons, many managers believe that full-cost formula pricing meets the cost–benefit test.

Question 23

What are the four steps to implement target pricing and target costing?

Answer 23

Implementing target pricing and target costing
Step 1: Develop a product that satisfies the needs of potential customers
Step 2: Choose a target price based on customers’ perceived value for the product and the prices competitors charge, and a target operating profit per unit
Step 3: Derive a target cost per unit by subtracting the target operating profit per unit from target price
Step 4: Perform value engineering to achieve target costs (value engineering is a systematic evaluation of all aspects of the value-chain business functions, with the objective of reducing costs while satisfying customer needs)

Question 24

What is a value-added cost and what is value engineering?

Answer 24

o A value-added cost is a cost that customers perceive as adding value or utility to a product or service
o Value engineering seeks to reduce or eliminate non-value-added activities and hence non-value-added costs by reducing the cost drivers of the non-value-added activities
o Also focus on efficiency

Question 25

What are customer level costs and how can we use them?

Answer 25

Customer-level costs
Customer-level costs include cost of goods sold and costs incurred in the first three categories of the customer cost hierarchy: customer output-unit-level costs, customer batch-level costs and customer-sustaining costs.

Make a table that indicates the cost drivers and cost driver rates for each activity as well as the cost-hierarchy category for each activity
The information can be used to persuade customers to reduce usage of the cost drivers
If the ABC system is used: the ABC system provides a road map that facilitates less use of cost drivers by individual customers in order to promote cost reduction. Furthermore, it highlights how the company itself can take actions to reduce the costs in each of its own activities

Question 26

Why is it important to distinguish between locked-in costs and cost incurrence?

Answer 26

It is important to distinct between the two because it is difficult to alter or reduce costs that have already been locked in
When costs are not locked in early, cost-reduction activities can be successful right up to the time that costs are incurred. In these industries, the key to lowering costs is improved operational efficiency and productivity rather than better design
When a sizeable fraction of the costs is locked in at the design stage, the focus of value engineering is on making innovations and modifying designs at the product design stage

Question 27

What are the advantages of a cross-functional team?

Answer 27

Best to organise a cross-functional team in order to evaluate the impact of design decisions on all value-chain functions
Also makes it easier to choose and implement - all parts of the organisation have ‘bought into’ the new design

Question 28

What is customer profitability analysis and what is the purpose?

Answer 28

Customer profitability analysis refers to the reporting and analysis of customer revenues and customer costs. Managers need to ensure that customers contributing sizably to the profitability of an organisation receive a comparable level of attention from the organisation. An accounting system that reports customer profitability helps managers in this task.

Question 29

How do life-cycle costs further reinforce the importance of locked-in costs?

Answer 29

Life-cycle costs further reinforce the importance of locked-in costs, target costing and value engineering in pricing and cost management. For products with long life cycles, a very small fraction of the total life-cycle costs are actually incurred at the time when costs are locked in. But locked-in costs will determine how costs will be incurred over several years. Motor vehicle manufacturers combine target costing with life-cycle budgeting