Target costing. Target cost gap. Methods to reduce the gap.
Difficulties of using target costing. Target cost.
1) Target costing involves setting a target cost by subtracting a
desired profit from a competitive market price  opposite of
conventional ‘cost plus pricing’.
The target cost of a product is its expected selling price minus the
desired profit from selling it.
The target cost = Target price – Target profit
Difficulties of using target costing:
 Bureaucracy: formal procedures to assess customers’ needs,
determine target prices&costs
 Intangibility: difficult to define the ‘service’ and attribute costs
 Heterogeneity: absence of standards or benchmarks to assess
services
 Employee de-motivation: the continual pressure to ensure costs
are kept to a minimum
6 basic steps of Target Costing:
1. Product is developed to be needed by customers and thus will
attract adequate sales volume
2. Target price is set up, based on customers’ perceived value of the
product
3. The required target operating profit per unit is then calculated
(based on sales, or ROI)
4. The target cost = Target price – Target profit
5. If there is cost gap - close it.
6. Negotiation with customers before deciding whether to go ahead
with the project
2) The target cost gap is established in a final step of the target
costing process.
Target cost gap = Estimated product cost – Target cost
Questions to consider to close the gap:
 Can any materials be eliminated?
 Can a cheaper material be used?
 Can labor savings be made (using lower skilled workers)?
 Can productivity be improved (improving motivation)?
 Can production volume be increased to achieve economies of
scale?
 Could cost savings be made by reviewing the supply chain?
 Can part assembled components be bought in to save on
assembly time?
 Can the incidence of the cost drivers be reduced?
 Is there any overlap between the product related FC that could be
eliminated by combining service departments?
Target Cost Gap Techniques:
Examine alternative product designs (search for potential areas
of cost reduction)
‘Value analysis’: which features of the product are essential to
customer and which are not.
Pricing strategies. Market Skimming, Penetration. Cost-plus.
Pricing strategy can be used to defend an existing market from new
entrants, to increase market share within a market or to enter a new
market. Finding the right pricing strategy is an important element in
running a successful business.
1) Market skimming involves charging high prices when a product
is first launched in order to maximize short-term profitability.
Initially high prices may be charged to take advantage of the novelty
appeal of a new product when demand is initially inelastic. Once the
market becomes saturated the price can be reduced to attract that
part of the market that has not been exploited. Market skimming is
often used in relation to electronic products when a new range is
first released onto the market at a high price.
Circumstances:
• Product is new and different and has little direct competition
• Strength of demand and the sensitivity of demand to price are
unknown
• Product has short life cycle (need to recover costs quickly + make
profit)
• A firm with liquidity problems wants to generate high cash flows
early
Example: MS is often used in relation to electronic products when
new ranges are first released at a high price.
2) Penetration pricing is the charging of low prices when a new
product is initially launched in order to gain rapid acceptance of the
product. Once market share is achieved, prices are increased. It is an
alternative to market skimming when launching a new product.
Circumstances:
• A firm wants to increase market share
• A firm wants to discourage new entrants from entering the market
• If there are significant economies of scale to be achieved from high
volume output
• If demand is highly elastic
Example: The 2006 launch of Microsoft’s anti-virus product was an
example of penetration pricing. Microsoft’s competitors reportedly
lost material market share within a few months of its launch.
3) Cost-plus pricing - when selling price is determined by adding a
percentage markup to a product's unit cost. Two basic steps:
1. Establish the cost per unit
2. Add target profit (mark-up or margin) to arrive at selling price
Advantages:
widely used;
simple to calculate;
may encourage price stability
Disadvantages:
ignores economic relationship between price and demand;
different absorption methods give  different costs and prices.
Example: Suppose, a there is petrol company. Full cost/l. of fuel =
30 rubles. If company has a desired mark-up 25%  selling price of
1l. will be: 30x1.25 = 37.5 rub.
Target Profit or Revenue in single and multiproduct situations
Single product - target profit calculation:
1. Calculate BEP in units: FC / contribution per unit
2. Calculate Level of activity to earn a required profit: (required
profit + FC) / contribution per unit
3. Calculate the Margin of safety: budgeted level of activity – BE
level of activity
4. Calculate contribution/sales ratio: contribution / sales
5. Calculate BEP in terms of sales revenue: FC / C/S ratio
6. Calculate Sales revenue required to generate required profit:
(required profit + FC) / C/S ratio
Example: Company produces Coke. Selling price=$25, VC=$20p.u.,
FC= $50000.
Number of units to BE: 50000/(25-20) = 10000 units
Level of activity to generate profit: (40000+50000)/5=18000 units
Multiproduct.
Steps are the same as for single profit, except for:
Weighted average C/S ratio = Total contribution / Total sales
revenue
BE revenue = FC / Weighted average C/S ratio
Sales revenue to earn a required profit = (FC+Required profit) /
Weighted average C/S ratio
Example: Company produces X and Y. Fixed overhead costs =
$200000 a year. Budgeted data: Sales price X=$50, Y X =$60; VC
X=$30,Y=$45; Contribution per unit X=$20, Y=$15; Budgeted
sales X=20000, Y=10000.
Required: Calculate BE revenue for the next year
Solution:
1) Weighted average C/S ratio = [(20000*20)+(1000*15)] /
[(20000*50)+(10000*60)] = 34,375%
2) BE revenue = 200000 / 0.34375 = 581.819
BEP. Traditional BE Chart and Contribution BE Chart.
Breakeven analysis is the study of the effects on future profit of
changes in FC, VC, sales price, quantity and mix.
BEP is the level of activity at which neither profit nor loss is made,
where total contribution = TFC.
A Traditional Breakeven Chart records costs and revenues on the
vertical axis (y) and the level of activity on the horizontal axis (x).
Lines represent costs and sales revenue. The BEP can be read off
where the sales revenue line cuts the total cost line. One of the
problems with this chart is that it is not possible to read contribution
directly from the chart.
A Contribution Breakeven Chart is similar, but it shows VC line
instead of FC line. The same lines for TC and sales revenue are
shown so the BEP and profit can be read off in the same way as with
a basic chart. It is also possible also to read the contribution for any
level of activity.
CVP analysis. Margin of safety. C/S ratio
1. CPV analysis is the study of the effects on future profit of
changes in FC, VC, sales price, quantity and mix.
Main steps:
1) BEP in units: fixed cost / contribution per unit
2) Level of activity to earn a required profit = (required profit + FC)
/ contribution per unit
3) Margin of safety = budgeted level of activity – BE level of
activity
4) Contribution / sales ratio = contribution / sales
5) BEP in sales = FC / C/S ratio
6) Sales revenue to earn a required profit = (required profit + FC) /
C/S ratio
Limitations:
1. Segregation of TC into its fixed and variable components is
difficult
2. FC are unlikely to stay constant as output increases beyond a
certain range of activity
3. The analysis is restricted to the relevant range specified and
beyond that the results can be unreliable
4. Besides volume, elements like inflation, efficiency, capacity and
technology can affect costs
5. Impractical to assume sales mix remains constant since this
depends on the changing demand levels.
2. Margin of safety is the amount by which anticipated or existing
activity exceeds BE.
Margin of safety = Budgeted sales – BE sales
Margin of safety = Budgeted sales - Breakeven sales × 100%
Budgeted sales
3. C/S ratio - proportion of selling price that contributes to fixed
OH and profits.
1) In single product environment:
C/S ratio = Contribution per unit/Selling price per unit or Total
Contribution/Total sales revenue
2) In multi-product situations:
A weighted average C/S ratio = Total contribution/ Total sales
revenue
Interpretation: The C/S ratio specifies how much contribution will
be generated by an increase in sales revenue of $1. In multi-product
situations, sales mix is assumed to remain constant.
Usage: The C/S ratio can be used to find:
BE revenue = FC / Weighted average C/S ratio
Sales revenue required to generate a target profit = FC + required
profit/ Weighted average C/S ratio
Throughput accounting. Bottleneck process. TPAR.
1. The aim of TA is to maximize T, whilst reducing operating
expenses and inventory.
Main assumptions:
1) In the short term, all costs are fixed other than the cost of
materials. Direct labour costs are not variable. Many employees are
salaried and even if paid at a rate per unit, are usually guaranteed a
minimum weekly wage;
2) The company operates following just-in-time principles (keeping
minimum levels of inventory)
2. The bottleneck is the operation that is limited the rate of
production.
Example:
In 1980s Goldratt and Cox argued that profits are maximized by
maximizing the T of a factory. Bottleneck is factors preventing T of
being higher (a machine that is already operating at full capacity).
Process to maximize profit:
(1) Identify the systems bottlenecks.
(2) Decide which products to make, given the bottlenecks.
(3) Other resources souldnt produce at higher rate than bottleneck.
(4) Eliminate bottlenecks (buying additional machines, training
machine operators, reducing time spent on the bottleneck resource).
(5) When bottleneck is broken, another resource becomes such
3. TPAR is a performance measurement tool used in evaluating the
performance of managers.
TPAR = Return per factory hour / Cost per factory hour
Return per factory hour = T per unit / Hours of bottleneck resource
used per unit
Cost per factory hour = Other factory costs / Bottleneck resource
hours available
If TPAR >1 the product is profitable; as the T contribution exceeds
the FC
If TPAR =1 the product breaks even
If TPAR <1 the product is loss making. The T contribution
generated does not cover the FC
Mathematically TPAR could be improved by:
Increase the sales price for each unit sold, to increase T per unit
Reduce material costs per unit, to increase the T per unit
Reduce total operating expenses, to reduce the cost per factory
hour
Improve the productivity of the bottleneck. T per factory hour and
TPAR would increase
Criticism of TPAR:
- Concentration on the short-term, when a business has a fixed
supply of resources and operating expenses are fixed, but most
businesses cannot produce products based only on the short term;
- It is more difficult to apply TA concepts to the longer term when
all costs are variable and vary with the volume of production and
sales or another cost driver, long-term view should be carefully
considered before rejecting products with TPAR<1;
- In the long-term ABC is more appropriate for measuring and
controlling performance.
Lifecycle costing. Different stages of the lifecycle.
Life-cycle costing - system which tracks and accumulates the actual
costs and revenues attributable to each product from development
through to abandonment.
Features:
All costs should be considered for working out the cost of a unit
Attention to all costs will reduce the cost per unit, and
organization will achieve its target cost.
Many costs will be linked. More attention to design can reduce
manufacturing and warranty costs.
Costs are committed and incurred at different times.
Benefits of LLC:
It results in earlier actions to generate revenue or to lower costs
Better decisions follow from a more accurate and realistic
assessment of revenues and costs
It can promote long-term rewarding in contrast to short-term
rewarding.
It helps managers to understand acquisition costs vs. operating and
support costs.
STAGES.
Pre-production/Product development stage:
■ High setup costs, including R&D, product design and building of
production facilities.
Launch/Market development stage:
■ Extensive marketing and promotion costs.
■ Trial products by customers.
Growth stage:
■ Continue marketing and promotion.
■ Sales volume increases and unit costs fall as FC are recovered
over greater volumes.
Maturity stage:
■ Initial setup and fixed costs are recovered. Profits rise.
■ Marketing and distribution economies are achieved.
■ Price competition and product differentiation will start to erode
profitability.
Decline stage:
■ Marketing costs are cut.
■ Production economies may be lost as volumes fall.
■ New levels of R&D and other product setup costs.
■ Additional development costs may be incurred to refine model.
Example:
So, cost per unit:
ABC. Benefits and drawbacks.
Reasons for the ABC development:
■ OH were small in relation to other costs in traditional
manufacturing - it was more labor intensive and direct costs were
higher than indirect costs.
■ OH are a larger proportion of TC in modern manufacturing - it is
more machine intensive and the proportion of production OH,
compared to direct costs, has increased. It is important that an
accurate estimate is made of the production OH per unit.
■ The nature of manufacturing changed and the diversity and
complexity of products has increased
Advantages of ABC:
- It provides more accurate cost per unit  pricing, sales strategy,
decision-making are improved
- It provides better insight into what drives OH costs
- ABC recognizes that overhead costs are not all related to
production and sales volume.
- OH costs are often a significant proportion of TC  need to
understand the drivers of OH costs - can be controlled by managing
cost drivers.
- It can be applied to derive realistic costs in business environment
- It can be applied to all OH costs, not just production OH
- It can be used in service costing (as in product costing)
Disadvantages of ABC:
- It will have limited benefit if the overhead costs are primarily
volume related or if the overhead is a small proportion of the overall
cost
- It is impossible to allocate all overhead costs to specific activities
- The choice of both activities and cost drivers might be
inappropriate
- It can be more complex to explain to the stakeholders of the
costing exercise
- The benefits obtained from ABC might not justify the costs
Overhead absorption. Traditional methods...
Absorption costing - a method for accumulating the costs and
apportioning them to individual products. This is required by the
accounting standards to create an inventory valuation that is stated
in an organization's balance sheet. A product may absorb a broad
range of FC and VC. These costs are not recognized as expenses in
the month when an entity pays for them. Instead, they remain in
inventory as an asset until such time as the inventory is sold; at that
point, they are charged to the COGS. The key costs assigned to
products under this system are: direct materials; direct labor;
variable manufacturing overhead; fixed manufacturing overhead.
Absorbed overhead is manufacturing overhead that has been
applied to products or other cost objects. Overhead is usually
applied based on a predetermined overhead allocation rate.
Overhead is overabsorbed when the amount allocated to a product or
other cost object is higher than the actual amount of overhead, while
the amount is underabsorbed when the amount allocated is lower
than the actual amount of overhead.
Steps to complete periodic assignment of costs to produced
goods:
Assign costs to cost pools.
Determine the amount of usage of activity measure used to assign
OH costs.
Divide usage measure into the TC in the cost pools to arrive at the
allocation rate per unit of activity, and assign OH costs to produced
goods based on this usage rate.
Advantages:
1) It recognizes FC in product cost.
2) It shows correct profit calculation than variable costing when
production is done to have sales in future
3) It conforms with accrual and matching accounting concepts
which requires matching costs with revenue for a particular
accounting period.
4) It is recognized for the purpose of preparing external reports and
for stock valuation purposes.
5) The allocation and apportionment of fixed factory OH to cost
centers makes manager more responsible for the cost and services
provided to others.
Disadvantages:
1) It is not useful for decision making. It considers fixed
manufacturing overhead as product cost which increases the cost of
output - it does not help in accepting offered price for the product.
2) It is not helpful in control of cost and planning and control
functions, in fixing the responsibility for incurrence of costs.
3) Some current product costs can be removed from the income
statement by producing for inventory.
Expected values. Simulation. Sensitivity.
1) EV: what an outcome is likely to be in the long run with
repetition. Where probabilities are assigned to different outcomes,
we can evaluate the worth of a decision as the EV, or weighted
average, of these outcomes.
EV p*x  x – possible outcome;p – probability of the outcome;

Advantages:
- Takes uncertainty into account.
- The information is reduced to a single number.
- Calculation is relatively simple.
Disadvantages:
- The probability used are usually very subjective.
- The EV has little meaning for a one-off project.
- The EV gives no indication of the dispersion of possible outcomes
- The EV may not correspond to any of the actual possible outcomes
Example: A manager has to choose between mutually exclusive
options A and B, and the probable outcomes of each option are:
Option A gives profit $5,000 with probability of 0.8 and $6,000 with
probability of 0.2; Option B gives loss of $2,000 with probability of
0.1 and profit $7,000 with probability 0.9.
EV of profit of each option would be:
Option A: 0.8×5,000+0.2×6,000=5,200
Option B: 0.1×(2,000)+0.9×7,000=6,100
In this example option B would be selected in preference to A.
2) Simulation models deal with decision problems involving a
number of uncertain variables. It allows the company to change
more than one variable in one time for the decision making. Random
numbers are used to assign values to the variables.
3) Sensitivity analysis can be used in any situation so long as the
relationships between the key variables can be established.
Example: Company has estimated the following sales and profits for
a new product. Sales (2,000 units) $4,000; Variable costs: materials
$2,000, labour $1,000  Contribution $1,000; Less: incremental FC
$800  Profit $200. Analyse the sensitivity of the project.
Solution: If incremental FC are more than 25% above estimate, the
project would make a loss. If unit costs of materials are more than
10% above estimate, the project would make a loss. Similarly, the
project would be sensitivity to an increase in unit labour costs of
more than $200, which is 20% above estimate, or else to a drop in
the unit selling price of more than 5%. The margin of safety, given a
BEP of 1,600 units, is (400/2,000) × 100% = 20%
Management would then be able to judge whether the product is
likely to be profitable. The items to which profitability is more
sensitive are the selling price (5%) and material costs (10%).
Learning curve. Learning effect.
Wrights Law: as cumulative output doubles, the cumulative
average time per unit falls to a fixed percentage of the previous
average time.
The curve becomes almost horizontal when many units have been
produced, as the learning effect is lost and production time per unit
becomes a constant.
Calculation:
Method 1: set up a table and reduce the average time by the
learning rate each time the output doubles.
Method 2: using the formula y=axb
y = cumulative average time (or average cost) per unit
a = time (or cost) for first unit
b = log r/log 2 (r = rate of learning, expressed as a decimal)
x = cumulative output in units
Applications of the learning effect:
■ Pricing decisions: prices will be set too high based on the costs of
making the first few units.
■ Work scheduling: less labor per unit as more units are made.
■ Product viability: the viability of a product may change.
■ Standard setting: if a product enjoys this effect but it is ignored,
the standard cost will be too high.
■ Budgeting: the presence of this effect should be taken into account
when setting budgets.
Limitations:
The stable conditions necessary for the learning curve not be
present – due to changes in production techniques or labor turnover
Eemployees’ motivation may not hold
Accurate and appropriate learning curve data may be difficult to
estimate.
Inaccuracy in estimating the initial labor requirement for the first
unit.
Inaccuracy in estimating the output required before reaching a
‘steady state’ time rate.
It assumes a constant rate learning factor.


Risk and uncertainty.
Risk - probabilities of possible outcomes are known.
Example: Based on past experience of digging for oil in a particular
area, an oil company may estimate that they have a 60% chance of
finding oil and a 40% chance of not finding it.
Uncertainty - probabilities of possible outcomes are not known.
Example: The same oil company may dig for oil in a previously
unexplored area. The company knows that it is possible for them to
either find or not find oil but it does not know the probabilities.
Research techniques:
1) Focus Groups - research tool with small groups selected from the
population.
Problems: Results are qualitative; Results may not be representative;
Individuals may feel under pressure; Their costs and logistical
complexity is frequently cited as a barrier.
2) Desk research - analysing of information, collected from
secondary sources.
Can often eliminate the need for extensive field work. Factors to
consider: It may not be totally accurate and exactly what the
researcher wants.
3) Field research - data is collected from primary sources by direct
contact with a targeted group. Two types:
Motivational research-Depth interviewing, Group interviewing,
Word association testing, Triad testing;
Measurement research- Random sampling, Quota sampling,
Panelling, Surveying by post, Observation;
4)* Expected Values (EVs): a weighted average of all possible
outcomes.
 x – possible outcome; p – probability
of the outcome;
5) A profit table
- The maximax rule - selecting the alternative that maximises the
maximum pay-off achievable.
- The maximin rule - selecting the alternative that maximises the
minimum pay-off achievable.
- The minimax regret strategy - minimises the maximum regret.
“Regret” - opportunity loss through having made the wrong
decision.
6) A decision tree - all possible courses of action are represented,
every possible outcome is shown. Should be used when a problem
involves a series of decisions being made and several outcomes
arise.
Flexing budgets.
A flexible budget calculates different expenditure levels for VC,
depending upon changes in actual revenue. The result is a budget
that varies, depending on the activity levels experienced. You input
the actual revenues or other activity measures into the flexible
budget once an accounting period has been completed, and it
generates a budget that is specific to the inputs.
Example: your master budget assumed that you’d produce 5000
units; you actually produce 5100 units. The flexible budget
rearranges the master budget to reflect this new number, making all
the appropriate adjustments to sales and expenses based on the
unexpected change in volume.
When applying planning and operating principles to cost variances,
care must be taken over flexing the budgets. The accepted approach
is to flex both the original and revised budgets to actual production
levels:
Performance measurement. Since the flexible budget restructures
itself based on activity levels, it is a good tool for evaluating the
performance of managers - the budget should closely align to
expectations at any number of activity levels. It is also a useful
planning tool for managers, who can use it to model the likely
financial results at a variety of different activity levels.
Fixed overhead variances.
Two possible variances:
he expenditure variance compares the actual FC with the original
budget. If the company uses marginal costing, this is the only
variance that is calculated.
If the company used absorption costing a second variance is
calculated, called the volume variance. The idea of this variance is
that if more items are made, then the FC is “absorbed” into more
units of production.
Types of fixed overhead variances: fixed overhead expenditure
variance, fixed overhead volume variance, fixed overhead capacity
and efficiency variances.
If the fixed overhead is absorbed using labor hours, then the fixed
overhead volume variance can be further analysed into two
additional variances:
- The capacity variance compares actual labor hours worked with
the budget. If more hours were worked than budget, then more fixed
overheads are absorbed, so there will be a favorable variance. If
fewer hours were worked than budget, then there will be an adverse
variance.
- The efficiency variance compares the actual labor hours worked
with the standard labor hours for actual output.
Standard costs in budgeting.
Principal uses
To value inventories and cost production
To act as control technique
Also can be used:
Setting budgets and evaluation managerial performance
Enables “management by exception”
Forecast for decision making
Targets set up-motivation
Simplification of accounting
Standard costing as control technique involves:
Standard costs are set
Actuals are collected
Variances are analysed
Types of standards
- Ideal - no wastage, scrap, idle time. Behavior: adverse motivational
impact
- Attainable - includes allowances for normal material losses,
machines breakdowns. Behavior: if they provide realistic but
challenging target, might encourage to work harder.
- Current - current wastage, current inefficiencies. Behavior: will not
motivate to do more.
- Basic - used to show trends. Behavior: not motivational impact is
easily achieved.
Where to get into for setting standards:
Material costs
Purchase contracts signed, pricing discussions with suppliers
Forecast of market prices/ inflation
Knowledge of bulk purchase discounts
Quality of material required
Labor - payroll
Material usage / labor efficiency - technical specifications
Overheads
OAR = budgeted fixed production OH/ production volume
Production volume depends on:
- Volume capacity
- Efficiency
- Production volume (budgeted output)
- Sales price and margin - Manufacturing cost, Demand,
Competition, Inflation
Maximax, maximin and minimax regret. Profit tables.
1) The maximax rule - selecting the alternative that maximises the
maximum pay-off achievable. Suitable for an optimistic investor.
Maximax possible pay-off is $100  product C
2) The maximin rule - selecting the alternative that maximises the
minimum pay-off achievable. The investor would look at the worst
possible outcome at each supply level, then selects the highest one
of these. The decision maker therefore chooses the outcome which is
guaranteed to minimise his losses.
Maximin possible pay-off is $20  product A
3) The minimax regret strategy minimises the maximum regret. It
is useful for a risk-neutral decision maker. “Regret” - opportunity
loss through having made the wrong decision. We need to find the
biggest pay-off for each demand row, then subtract all other
numbers in this row from the largest number.
Minimax regret possible regret is $60  product B
High-low method. Regression method.
There are various techniques, which can be used to try to predict
future costs from historical data. The aim is to predict levels of costs
at different output levels to assist in decision making and planning.
1) High-low method - method of estimating a value of y (cost) for a
value of x (volume). It selects costs associated with the highest and
lowest levels of activity and assumes all other costs lie on a straight
line.
The following steps shall be made:
1.Select the highest and lowest activity levels, and their costs.
2. Find the VC per unit: (Cost at high level - Cost at low level)
/(High level - Low level)
3. Find the FC: TC at activity level – TVC
4. Use the VC and FC to forecast the TC for a specified level of
activity.
Advantages:
Ssimplicity
It is easy to understand and easy to use.
Disadvantages:
It assumes that activity is the only factor affecting costs.
It assumes that historical costs reliably predict future costs.
It uses only two values, so the results may be distorted due to
random variations in these values.
2) Regression involves using historical data to find the line of best
fit between two variables (one dependent on the other).
The dependent variable (y) - vertical axis
The independent variable (x) - horizontal axis.
Aim: to find the best line through the center of this diagram, which
can be used for forecasting.
The equation of a straight line is y = a + bx
a) a is the intercept with the y axis
b) b is the gradient or slope
Material price, mix and yield variances.
1) A material price variance spots instances where a business is
overpaying for raw materials and components.
2) A mix variance monitors the cost of material. If more of
expensive material is used and less of cheap, the cost is higher and
the variance is adverse.
3) A yield variance measures the efficiency of turning the inputs
into outputs. If the yield variance is adverse, it suggests that actual
input is lower than the expected output (due to labour inefficiencies,
higher waste, inferior materials, or using a cheaper mix with a lower
yield).
All of these variances are used to spot the imperfections of the way
input materials are used and improve production process. The PV
tracks differences in raw material prices, and YV tracks differences
in the amount of raw materials used and MV tracks difference in the
proportion of different materials used in production.
Other performance measures for controlling production processes:
■ quality measures (reject rate, time spent reworking goods, %
waste, % yield)
■ average cost of inputs
■ average cost of outputs
■ average prices achieved for finished products
■ average margins
■ customer satisfaction ratings
■ detailed timesheets
■ % idle time
Price strategies: complementary product pricing; product-line;
volume discounting
1) Complementary product pricing is used with another product,
these goods provide suppliers with additional power over the
consumer.
Strategies:
- The major product is priced relatively low to encourage the
purchase and force the consumer into buying complementary
product at relatively high price. (printer & printer cartridge)
- The major product is priced relatively high to create a barrier to
entry and exit and the consumer is locked into purchases of low
price complementary products (membership in golf club & court
fees).
2) A product line - a range of products that are related, but may
vary in terms of style, color, quality, price etc.
It is based on:
(1) capitalising on consumer interest in a number of products within
a range;
(2) making the price entry point for the basic product relatively
cheap;
(3) pricing other items in the range more highly
3) Volume discounting - offering customers a lower price per unit
if they purchase a particular quantity of a product.
Types:
Quantity discounts for customers that order large quantities at
once
Cumulative quantity discount - increases as the cumulative total
order increases
Pricing of a product or service (factors). Price elasticity of
demand.
Main categories of approaches to pricing:
Perfect & Imperfect competition (dependance on the type of
competition);
Demand-based approaches (Inverse linear relationship between
selling price and demand. Two methods to establish an optimum
price: the tabular approach and algebraic approach);
Cost-based approaches (‘Cost plus’ pricing enables establish the
price by calculating unit cost, adding a mark-up or margin to
provide profit);
Marketing-based approaches; (Customers` perceptions of the
benefits from purchasing the product, pricing reflects these
benefits).
Price Elasticity of Demand measures the change in demand as a
result of:
Controllability.
The controllability principle is that managers of responsibility
centres should only be held accountable for costs over which they
have some influence.
This is important:
- from a motivation point of view - it can be very demoralizing for
managers who feel that their performance is being judged on the
basis of something over which they have no influence.
- from a control point of view - control reports should ensure that
information on costs is reported to the manager who is able to
control them.
This principle can be implemented:
1) by removing the uncontrollable items from the areas that
managers are accountable for;
2) producing reports which calculate and distinguish between
controllable and uncontrollable items.
• A cost is controllable if a manager is responsible for it being
incurred or is able to authorize the expenditure.
• A manager should only be evaluated on the costs over which they
have control.
The effective control is based on ‘controllability’. The concept of
overhead cost drivers more precisely defines a manager’s
responsibility for the cost.
Volume discounting. Price discrimination. Relevant cost.
1) Volume discounting means offering customers a lower price per
unit if they purchase a particular quantity of a product. Two types:
Quantity discounts - for customers that order large quantities, and
Cumulative quantity discounts - the discount increases as the
cumulative total ordered increases.
Used when:
• Sales margin is substantial allowing profits even after discounting
• The product is bought on price and it is difficult to distinguish it
from competing products
• Products with a limited life may be discounted to shift them
2) Price discrimination strategy is where a company sells the same
product at different prices in different markets.
Requirements:
• Seller must have some degree of monopoly
• Customers can be segregated into different markets
• Customers cannot buy at the lower price in one market and sell at
the higher price in the other one
• There must be different price elasticities of demand in each market
Dangers:
• A black market may develop
• Competitors join the market and undercut the firm's prices
• Customers in the higher priced brackets look for alternatives and
demand becomes more elastic
3) Relevant costs can be used to arrive at a minimum tender price
for a one-off tender or contract. The minimum price should be equal
to the total of all of the relevant cash flows.
It is only suitable for a one-off decision since:
• Fixed costs can become relevant in the long-run
• There are problems estimating increasing cash flows
• There is a conflict between accounting measures such as profit and
this approach