COST MANAGEMENT
Accounting & Control
Hansen▪Mowen▪Guan
Chapter 19
Pricing and Profitability
Analysis
COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning.
Cengage Learning and South-Western are trademarks used herein under license.
1
Study Objectives
1. Discuss basic pricing concepts.
2. Calculate a markup on cost and a target cost.
3. Discuss the impact of the legal system and ethics on
pricing.
4. Calculate measures of profit using absorption and
variable costing.
5. Determine the profitability of segments.
6. Compute the sales price, price volume, contribution
margin, contribution margin volume, sales mix, market
share, and market size variances.
7. Describe some of the limitations of profit measurement.
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Basic Pricing Concepts
Market Structure and Price
• 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. 3
Market Structure and Price
4
Pricing Policies
• Cost-based pricing
– Established using “cost plus markup”
• Target costing and pricing
– Determine the cost of a product or service
based on the price (target price) that
customers are willing to pay
– Effectively used in conjunction with marketing
decisions
• Penetration pricing
• Price skimming
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Pricing Policies
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
Cost of goods sold:
Direct materials
Direct labor
Overhead
Gross profit
Selling and administrative expenses
Operating income
$350,350
$122,500
73,500
49,000
245,000
$105,350
25,000
$ 80,350
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Pricing Policies
Cost-Plus Pricing
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 or 43%
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Pricing Policies
Cost-Plus Pricing
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 or 186%
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Pricing Policies
Cost-Plus Pricing
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)
Direct labor (2.5 hours x $12)
Overhead (65% of direct labor cost)
Estimated cost of one job
Plus 43% markup on COGS
Bid price
$ 40.00
30.00
19.50
$ 89.50
38.49
$127.99
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Pricing Policies
Target Costing and Pricing
• Determine the cost of a product or service based on the
price that the customers are willing to pay.
Other installers price the remote car door opener at $110.
Possible actions:
Direct materials (component and two remotes)
$ 40.00
Include one remote instead of two
$35.00
Direct labor (2.5 hours x $12)
30.00
Train workers to reduce time (2 hours x $12)
24.00
Overhead (65% of direct labor cost)
19.50
Reduce overhead (50% of direct labor cost)
12.00
Estimated cost of one job
Bid price$is 89.50
now
Revised cost of one job
competitive; markup $ 71.00
Plus 43% markup on COGS
38.49
30.53
preserved
Bid price
$127.99 $101.53
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The Legal System and Pricing
• Predatory pricing
– The practice of setting prices below cost for
the purpose of injuring competitors and
eliminating competition
• Dumping
– Predatory pricing on the international market
– Companies sell below cost in other countries;
the domestic industry is injured.
11
The Legal System and Pricing
• Price discrimination
– Charging different prices to different
customers for essentially the same product.
– Robinson-Patman Act of 1936 prohibits
• Manufacturers or suppliers are covered by the act
• Price discrimination is allowed if
– If the competitive situation demands it and
– If costs (including costs of manufacture, sale, or delivery)
can justify the lower price
12
The Legal System and Pricing
Cobalt, Inc. manufactures vitamin supplements that costs
an average of $163 per case. Cobalt sold 250,000 cases
last year as follows:
Customer
Large drug store chain
Small local pharmacies
Individual health clubs
Price per Case
$200
232
250
Cases Sold
125,000
100,000
25,000
Cobalt is practicing price
discrimination … is it
justifiable?
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The Legal System and Pricing
$200  $178.40
 10.8%
$200
$232  $208.52
 10.1%
$232
$250  $222
 11.2%
$250
Profits vary within a narrow 1 percent range. The cost differences
among the three classes of customer appear to explain the price differences.
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Measuring Profit
Absorption Costing
– Also referred to as full costing
– Required for external financial reporting
– Assigns all manufacturing costs, direct
materials, direct labor, variable overhead, and
a share of fixed overhead to each unit of
product
– Each unit of product absorbs some of the
fixed manufacturing overhead in addition to
the variable costs incurred to manufacture it.
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Measuring Profit
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
Direct labor
Variable overhead
Fixed overhead
Total manufacturing cost
$ 5,000
15,000
3,000
20,000
$43,000
During August, these cartridges were sold at $60
each. Variable marketing cost was $1.25 per unit.
Fixed expenses were $12,000.
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Measuring Profit
Absorption-Costing
1,000 units produced; 1,000 units sold
*Direct materials ($5 x 1,000) $ 5,000
Direct labor ($15 x 1,000)
15,000
Variable overhead ($3 x 1,000)
3,000
Fixed overhead
20,000
Total manufacturing overhead
and cost of goods sold
$43,000
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Measuring Profit
Absorption-Costing
1,250 units produced; 1,000 units sold
*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 ($16 per unit) 20,000
Total manufacturing overhead $48,750
Add: Beginning inventory
0
Less: Ending inventory
(9,750)
Cost of goods sold
$39,000
Production exceeded sales by 250
units; fixed overhead of $16 per unit is
carried in inventory thus reducing cost
of goods sold and increasing net
income
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Measuring Profit
Variable-costing
• Also referred to as direct costing
• Assigns only unit-level variable
manufacturing costs to the product
– Direct materials
– Direct labor
– Variable overhead
• Fixed overhead is treated as a period cost
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Measuring Profit
*Direct materials
$ 5,000
Direct labor
15,000
Variable overhead
Total variable manufacturing expenses
Add: Variable marketing expenses
Total variable expenses
3,000
$23,000
1,250
$24,250
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Measuring Profit
*1,300 × $39 = $50,700
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Measuring Profit
22
Profitability of Segments
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
Number of units
Direct labor hours
Price
Prime cost per unit
Overhead per unit
20,000
40,000
$200
$55
$30
Multi-Function
10,000
15,000
$350
$95
$22.50
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Profitability of Segments
Profit by Product Line
24
Profitability of Segments
Profit by Product Line
25
Profitability of Segments
Profit by Product Line
26
Profitability of Segments
Profit by Product Line
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Profitability of Segments
Divisional Profit
Sales
Cost of goods sold
Gross profit
Division expenses
Corporate expenses
Operating income
(loss)
Alpha
Beta
Gamma Delta Total
$ 90
35
$ 55
-20
-3
$ 60
20
$ 40
-10
-2
$ 30
11
$ 19
-15
-1
$120
98
$ 22
-20
-4
$300
164
$136
-65
-10
$ 32
$ 28
$ 3
$ -2
$ 61
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Profitability of Segments
Customer profitability
•
Companies that assess the profitability of
various customer groups can more
accurately target their markets and
increase profits.
1) Identify the customer
2) Determine which customers add value to the
company
29
Analysis of Profit-Related
Variances
Overall Sales Variance
[actual vs. expected revenue]
Sales Price Variance
Price Volume Variance
30
Analysis of Profit-Related
Variances




Sales price = Actual - Expected  Quantity
variance
price
price
sold
Price volume = Actual - Expected  Expected
variance
volume
volume
price
The sales price and price volume variances are labeled favorable if
the variance increases profit above the amount expected. They are
labeled unfavorable if the variance decreases profit below the amount
expected.
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Analysis of Profit-Related
Variances
Contribution Margin Variance
[actual vs. expected contribution margin]
Sales Mix Variance
Contribution Margin
Volume Variance
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Analysis of Profit-Related
Variances
Sales Mix Variance =


 
 
P1 actual units
 P1 budgeted CM
- P1 budgeted units
- Budgeted average unit CM
+ P2 actual units
 P2 budgeted CM
- P2 budgeted units
- Budgeted average unit CM


The sales mix variance is favorable if the sales mix is weighted to the
more profitable products.
Budgeted
Contribution
Budgeted 
 Actual
margin volume =  quantity - quantity   average unit
contribution
 sold

variance
sold


margin
The contribution margin volume variance gives management information
about gained or lost profit due to changes in the quantity of sales.
33
Analysis of Profit-Related
Variances
34
Analysis of Profit-Related
Variances
Birdwell, Inc.:

contribution margin variance
$14,375 − $13,500
= $875 favorable
sales mix
contribution margin
variance
volume variance
 
 
1,250 
- 1,500
625 
+
- 500

$4.00
- $6.75
$15.00
- $6.75


= $1,718.75 favorable
(2,000 − 1,875) × $6.75
= $843.75 unfavorable
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Analysis of Profit-Related
Variances
Market share variance =
Actual
Budgeted
Actual
Budgeted 

 market share - market share   industry  average
sales
unit
 percentage

percentage

 in units
CM
Market size variance =
Budgeted
Budgeted
Actual
Budgeted 

 industry sales - industry sales   market  average
share
unit


in
units
in
units

 percentage
CM
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Limitations of Profit Measurement
• Limitations of profitability analysis
– Focus on past performance
– Emphasis on quantifiable measures
– Impact on behavior
• Successful firms measure far more than
accounting profit.
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COST MANAGEMENT
Accounting & Control
Hansen▪Mowen▪Guan
End Chapter 19
COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning.
Cengage Learning and South-Western are trademarks used herein under license.
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