longer appropriate. In an oligopoly, such as the automobile industry, the reactions of competitors to a firm’s pricing policies must be taken into account.

While economists have studied oligopolistic pricing, the state of the theory is not sufficient to provide a thorough understanding of the impact of prices on demand.

The third limitation of the economic pricing model involves the difficulty of measuring marginal cost. Cost-accounting systems are not designed to measure the marginal changes in cost incurred as production and sales increase unit by unit. To measure marginal costs would entail a very costly information system. Most managers believe that any improvements in pricing decisions made possible by marginal-cost data would not be sufficient to defray the cost of obtaining the information.

Exhibit 4-1. Cost-Benefit Trade Off in Information Production

	Optimal			Suboptimal
	Decisions			Decisions
	Economic model			Cost-based approach
	of pricing			to pricing
	Sophisticated decision			Simplified decision
	model and information			model and information
	requirements			requirements
	Marginal-cost and			Accounting
marginal-revenue data				product-cost data
	More Costly Approach			Less Costly Approach

Best approach, in terms of costs and benefits, typically lies between the extremes.

Costs and Benefits of Information

Managerial accountants always face a cost-benefit trade-off in the production of cost information for pricing and other decisions. As Exhibit 4-1 shows, only a sophisticated information system can collect marginal-cost data. However, such information is more costly to obtain. The result is that the optimal approach

to pricing and other decisions is likely to lie in between the extremes shown in Exhibit 4-1. For this reason, most managers make pricing decisions based on a combination of economic considerations and accounting, product-cost information.

In spite of its limitations, the marginal-revenue, marginal-cost paradigm of pricing serves as a useful conceptual framework for the pricing decision. Within this overall framework, managers typically rely heavily on a cost-based pricing approach, as we shall see next.

ROLE OF ACCOUNTING PRODUCT COSTS IN PRICING

Most managers base prices on accounting product costs, at least to some extent. There are several reasons for this. First, most companies sell many products or services. There simply is not time enough to do a thorough demand and marginal-cost analysis for every product or service. Managers must rely on a quick and straightforward method for setting prices, and cost-based pricing formulas provide it. Second, even though market considerations ultimately may determine the final product price, a cost-based pricing formula gives the manager a place to start. Finally, and most importantly, the cost of a product or service provides a floor below which the price cannot be set in the long run. Although a product may be "given away" initially, at a price below cost, a product’s price ultimately must cover its costs in order for the firm to remain in business. Even a nonprofit organization, unless it is heavily subsidized, cannot forever price products or services below their costs.

Cost-Plus Pricing

Cost-based pricing formulas typically have the following general form.

Price = cost + (markup percentage x cost)

Such a pricing approach often is called cost-plus pricing, because the price is equal to cost plus a markup. Depending on how cost is defined, the markup percentage may differ. Several different definitions of cost, each combined with a different markup percentage, can result in the same price for a product or service.

Absorption-Cost Pricing Formulas

Most companies that use cost-plus pricing use either absorption manufacturing cost or total cost as the basis for pricing products or services.

The reasons generally given for this are as follows:

1.In the long run, the price must cover all costs and a normal profit margin. Basing the cost-plus formula on only variable costs could encourage managers to set too low a price in order to boost sales. This will not happen if managers understand that a variable-cost plus pricing formula requires a higher markup to cover fixed costs and profit. Nevertheless, many managers argue that people tend to view the cost base in a cost-plus pricing formula as the floor for setting prices. If prices are set too close to variable manufacturing cost, the firm will fail to cover its fixed costs. Ultimately, such a practice could result in the failure of the business.

2.Absorption-cost or total-cost pricing formulas provide a justifiable price that tends to be perceived as equitable by all parties. Consumers generally understand that a company must make a profit on its product or service in order to remain in business. Justifying a price as the total cost of production, sales and administrative activities, plus a reasonable profit margin, seems reasonable to buyers.

3.When a company’s competitors have similar operations and cost structures, cost-plus pricing based on full costs gives management an idea of how competitors may set prices.

4.Absorption-cost information is provided by a firm’s cost-accounting system, because it is required for external financial reporting under generally accepted accounting principles. Since absorption-cost information already exists, it is cost-effective to use it for pricing. The alternative would involve preparing special product-cost data specifically for the pricing decision. In a firm with hundreds of products, such data could be expensive to produce.

The primary disadvantage of absorption-cost or total-cost pricing formulas is that they obscure the cost behavior pattern of the firm. Since absorption-cost and total-cost data include allocated fixed costs, it is not clear from these data how the firm’s total costs will change as volume changes. Another way of stating this criticism is that absorption-cost data are not consistent with cost volume-profit analysis. CVP analysis emphasizes the distinction between fixed and variable costs. This approach enables managers to predict the effects of changes in prices and sales volume on profit. Absorption and total cost information obscures the distinction between variable and fixed costs.

Variable-Cost-Pricing Formulas

To avoid blurring the effects of cost behavior on profit, some managers prefer to use cost-plus pricing formulas based on either variable manufacturing costs or total variable costs. Three advantages are attributed to this pricing approach:

1.Variable-cost data do not obscure the cost behavior pattern by unitizing fixed costs and making them appear variable. Thus, variable-cost information is

more consistent with cost-volume-profit analysis often used by managers to see the profit implications of changes in price and volume.

2.Variable-cost data do not require allocation of common fixed costs to individual product lines. For example, the annual salary of Sydney Sailing

Supplies’ vice president of sales is a cost that must be borne by all of the company’s product lines.

3.Variable-cost data are exactly the type of information managers need when facing certain decisions, such as whether to accept a special order. This decision, examined in detail in the preceding chapter , often requires an analysis that separates fixed and variable costs.

The primary disadvantage of the variable-cost pricing formula was described earlier. If managers perceive the variable cost of a product or service as the floor for the price, they may tend to set the price too low for the firm to cover its fixed costs. Eventually this can spell disaster. Therefore, if variable-cost data are used as the basis for cost-plus pricing, managers must understand the need for higher markups to ensure that all costs are covered.

Determining the Markup

Regardless of which cost-plus formula is used, Sydney Sailing Supplies must determine its markup on the Wave Darter. If management uses a variable-cost pricing formula, the markup must cover all fixed costs and a reasonable profit. If management uses an absorption-costing formula, the markup still must be sufficient to cover he firm’s profit on the Wave Darter product line. What constitutes a reasonable or normal profit margin?

Return-on-Investment Pricing A common approach to determining the profit margin in cost-plus pricing is to base profit on the firm’s target return on investment (ROI).

General Formula The general formula for computing the markup percentage in cost-plus pricing to achieve a target ROI is as follows:

		profit required to		total annual cost not
Markup percentage		achieve target ROI	+	included in cost base
applied to cost base in	=
cost-plus pricing formula		annual		cost base per unit
		volume	x	used in cost-plus
				pricing formula

Cost - Plus Pricing: Summary and Evaluation

We have examined two different approaches to setting prices: (1) the economic, profit-maximizing approach and (2) cost-plus pricing. Although the techniques involved in these methods are quite different, the methods complement each other. In setting prices, managers cannot ignore the market, nor can they ignore costs. Cost-plus pricing is used widely in practice to establish a starting point in the process of determining a price. Cost-plus formulas are simple; they can be applied mechanically without taking the time of top management. They make it possible for a company with hundreds of products and setting initial prices for new products or services to cope with the tasks of updating prices for existing products and setting initial prices for new products.

Cost-plus pricing formulas can be used effectively with a variety of cost definitions, but the markup percentage must be appropriate for the type of cost used. It is imperative that price-setting managers understand that ultimately the price must cover all cost and a normal profit margin. Absorption-cost-plus or total-cost-plus pricing has the advantage of keeping of manager’s attention focused on covering total costs. The variable-cost-plus formulas have the advantage of not obscuring important information about cost behavior.

Cost-plus pricing formulas establish a starting point in setting prices. Then the price setter must weight market conditions, likely actions of competitors, and general business conditions. Thus, effective price setting requires a constant interplay of market considerations and cost awareness.

The following illustration points out the potential consequences of low unit costs on a firm’s ability to achieve low prices.

ILLUSTATION FROM MANAGEMENT ACCOUNTIN PRACTICE

FEDERAL EXPRESS

An article in “Fortune” described the strategy used by Federal Express to become the nation’s number-one carrier in one-day delivery of letters and small packages. In contrast to its competitors Federal Express purchased its own fleet of planes and developed its own package-processing facilities in Memphis, Tennessee. Since Federal Express did not rely on sending packages by other commercial carriers, the company was soon able to achieve the lowest costs in the industry. These low costs enabled “Federal Express” to price its services below any of its competitors. This low price, made possible by low unit costs, enabled Federal Express to achieve phenomenal growth and established it as the number-one carrier for overnight delivery.

TIME AND MATERIAL PRICING

Another cost-based approach to pricing is called time and material pricing. Under this approach, the company determines one charge for the labor used on a job and another charge for the materials. The labor typically includes the direct cost of the employee’s time and a charge to cover various overhead costs. The material charge generally includes the direct cost of the material used in a job plus widely by construction companies, printers, repair shops, and professional firms, such as engineering, law, and public accounting firms.

To illustrate, we will examine a special job undertaken by Sydney Sailing

Supplies. The company’s vice president for sales, Richard Moby, was approached by a successful local physician about refurbishing her yacht. She wanted an engine overhaul, complete refurbishment and redecoration of the cabin facilities, and stripping and repainting of the hull and deck. The work would be done in the Repair Department of the company’s Yacht Division, located in Melbourne, Australia.

Data regarding the operators of the Repair Department are as follows:

Labor rate, including fringe benefits .........................................	$ 18.00 per hour
Annual labor hours ......................................................................	10.000 hours
Annual overhead costs:
Material handling and storage ................................................	$ 40.000
Other overhead costs (supervision, utilities, insurance, and
depreciation) .........................................................................	$ 200.000
Annual cost of materials used in Repair Department ...............	$ 1.000.000

Based on this data, the Repair Department computed its time and material prices as follows:

Time Charges

		Annual overhead
Hourly			(excluding material					Hourly charge
Labor	+	handling and storage)					+	to cover
Cost								profit margin
			annual labor hours
		$ 200.000							$ 45 per
$ 18 per hour	+
							+ $ 7per hour =
			10.000 hours					labor hour

Material Charges
Material		material				material handling
cost	+	cost	x			and storage costs
incurred		incurred			annual cost of material used
on job		on job				in Repair Department
Material		material
cost	+	cost		$ 40.000
incurred		incurred		x
on job		on job		$ 1.000.000

$ 04 per dollar of material cost

The effect of the material-charge formula is to include a charge for the costs incurred in the handling and storage of materials.

Richard Moby estimates that the yacht refurbishment job will require 200 hours of labor and $ 8.000 in materials. Moby’s price quotation for the job is shown in Exhibit 14.6.

Exhibit 14-6. Time and Material Pricing.

Price Quotation

Sydney Sailing Supplies

Yacht Division: Repair Department

Job: Refurbishment of 45-foot yacht,

Pride of the Seas

Time charges:	Labor time .......................................................	200 hours
	x Rate .............................................................	x $45 per hour
	Total ...............................................................	$ 9,000
Material charges:	Cost of materials for job ................................	$ 8.000
	+ Charge for material
	handling and storage	320*
	Total ..............................................................	$ 8.320
Total price of job:	Time ..............................................................	$ 9.000
	Material .........................................................	8.320
	Total ...........................................................	$ 17.320

* Charge for material handling and storage:

$ 8.000		$ 0.4 per
material	x	dollar of	= $ 320
cost		material cost

Included in the $17.320 price quotation for the yacht refurbishment are charges for labor costs, overhead, material costs, material handling and storage costs, and a normal profit margin. Some companies also charge an additional markup on the materials used in a job in order to earn a profit on that component of their services. Sydney Sailing Supplies’ practice is to charge a high enough profit charge on its labor to earn an appropriate profit for the Repair Department.

COMPETITIVE BIDDING

In a competitive bidding situation, two or more companies submit sealed bids (or prices) for a product, service or project to a potential buyer. The buyer selects one of the companies for the job on the basis of the bid price and the design specifications for the job. Competitive bidding complicates a manager’s pricing problem, because now the manager is in direct competition with one or more competitors. If all of the companies submitting bids offer a roughly equivalent product or service, the bid price becomes the sole criterion for selecting the contractor. The higher the price that is bid, the greater will be the profit on the job, if the firm gets the contract. However, a higher price also lowers the probability of obtaining the contract to perform the job. Thus, there is a trade-off between bidding high, to make a good profit, and bidding low, to land the contract. Some say there is a “winner’s curse” in competitive bidding, meaning that the company bidding low enough to beat out its competitors probably bid too low to make an acceptable profit on the job. Despite the winner’s curse, competitive bidding is a common form of selecting contractors in many types of business.

Richard Moby was approached recently by the city of Sydney about building a new marina for moderate-sized sailing vessels. Moby decided that his company’s Marine Construction Division should submit a bid on the job. The city announced that three other firms would also be submitting bids. Since all four companies were equally capable of building the marina to the city’s specifications Moby assumed that the bid price would be the deciding factor in selecting the contractor.

Moby consulted with the controller and chief engineer of the Marine Supply Division, and the following data were compiled.

Estimated direct-labor requirements, 1500 hours at $12.00 per hour ............	$ 18.000
Estimated direct-material requirements ..................................... ...................	30.000
Estimated variable overhead (allocated on the basis of direct labor),
1.500 direct-labor hours at $5(x) per hour .................................................	7.500
Total estimated variable costs ........................................................................	55.500
Estimated fixed overhead (allocated on the basis of direct labor),
1.500 direct-labor hours at $8(x) per hour ................................................	12.000
Estimated total cost ......................................................................................	$ 67.500

The Marine Construction Division allocates variable-overhead costs to jobs on the basis of direct-labor hours. These costs consist of indirect-labor costs, such as the wages of equipment-repair personnel, gasoline and lubricants, and incidental supplies such as rope, chains and drill bits. Fixed-overhead costs, also allocated to jobs on the basis of direct-labor hours, include such costs as worker’s compensation insurance, depreciation on vehicles and construction equipment, depreciation of the divisions’s buildings, and supervisory salaries.

It was up to Richard Moby to decide on the bid price for the marina. In his meeting with the divisional controller and the chief engineer, Moby argued that the marina job was important to the company for two reasons. First, the Marine Construction Division had been operating well below capacity for several months. The marina job would not preclude the firm from taking on any other construction work, so it would not entail an opportunity cost. Second, the marina job would be good advertising for Sydney Sailing Supplies. City residents would see the firm’s name on the project, and this would promote sales of the company’s boats and sailing supplies.

Based on these arguments, Moby pressed for a bid price that just covered the firm’s variable costs and allowed for a modest contribution margin. The chief engineer was obstinate, however, and argued for a higher bid price that would give the division a good profit on the job. “My employees work hard to do an outstanding job, and their work is worth a premium to the city”, was the engineer’s final comment on the issue. After the threesome tossed the problem around all morning, the controller agreed with Moby. A bid price of $ 60.000 was finally agreed upon.

This is a typical approach to setting prices for special jobs and competitively bid contracts. When a firm has excess capacity, a price that covers the incremental costs incurred because of the job will contribute toward covering the company’s fixed cost and profit. None of the Marine Construction Division’s fixed costs will increase as a result of taking on the marina job. Thus, a bid price of $ 60 000 will cover the $ 55 500 of variable costs on the job and contribute

$ 4 500 toward covering the division’s fixed costs.

Bid price ..............................................................................	$ 60.000
Variable costs of marina job (incremental costs incurred
only if job is done) ............................................................	55.500

Contribution from marina job (contribution to covering
the division’s fixed costs) .................................................	$ 4.500

Naturally, Sydney Sailing Supplies’ management would like to make a larger profit on the marina job, but bidding a higher price means running a substantial risk of losing the job to a competitor.

No Excess Capacity What if the Marine Construction Division has no excess capacity? If management expects to have enough work to fully occupy the division, a different approach is appropriate in setting the bid price. The fixed costs of the division are capacity-producing costs, which are costs incurred in order to create productive capacity. Depreciation of building and equipment, supervisory salaries, insurance, and property taxes are examples of fixed costs incurred to give a company are capacity to carry on its operations. When such costs are llocated to individual jobs, the costs of each job reflects an estimate of the opportunity cost of using limited capacity to do that particular job. For this reasoning to be valid, however, the organization must be at full capacity.

If the Marine Construction Division has no excess capacity, it would be appropriate to focus on the estimated full cost of the marina job, $ 67 500, which includes an allocation of the division’s fixed, capacity-producing costs. Now Richard Moby might legitimately argue for a bid price in excess of $ 67 500. If the division is awarded the marine contract by the city, a price above $ 67 500 will cover all the costs of the job and make a contribution toward the division’s profit.

However, as Richard Moby pointed out, there will be valuable promotional benefits to Sydney Sailing Supplies if its Marine Construction Division builds the marina. This is a qualitative factor, because these potential benefits are difficult to quantify. Moby will have to make a judgment regarding just how important the marina job is to the company. The greater the perceived qualitative benefits, the lower the big price should be set to maximize the likelihood that the company will be awarded the contract.

STRATEGIC PRICING OF NEW PRODUCTS

Pricing a new product is an especially challenging decision problem. The newer the concept of the product, the more difficult the pricing decision is. For example, if Sydney Sailing Supplies comes out with a new two-person sailboat, its pricing problem is far easier than the pricing problem of a company that first markets products using a radically new technology. Genetic engineering, superconductivity, artificial hearts, and space-grown crystals are all examples of such frontier technologies.

Pricing a new product is harder than pricing a mature product because of the magnitude of the uncertainties involved. New products entail many

uncertainties. For example, what obstacles will be encountered in manufacturing the product, and what will be the costs of product? Moreover, after the product is available, will anyone want to buy it, and what price? If Sydney Sailing Supplies decides to market a new two-person sailboat management can make a good estimate of both the production costs and the potential market of the product. The uncertainties here are far smaller than uncertainties facing a company developing artificial hearts.

In addition to the production and demand uncertainties, new products pose another sort of challenge. There are two widely different strategies that manufacturer of a new product can adopt. One strategy is called skimming pricing, in which the initial product price is set high, and short-term profits are reaped on the new product. The initial market will be small, due in part to the high initial price. The pricing approach often is used for unique products, where there are people who “must have it” whatever the price. As the product gains acceptance and its appeal broadens, the price is lowered gradually. Eventually the product is priced in a range that appeals to several kinds of buyers. An example of product for which skimming pricing was used is the home video game. Initially these games were priced quite high and were affordable only by a few buyers. Eventually the price was lowered, and the games were purchased by a wide range of consumers.

An alternative initial pricing strategy is called penetration pricing, in which the initial price is set relatively low. By setting a low price for a new product, management hopes to penetrate a new market deeply, quickly gaining a large market share. This pricing approach often is used for products that are of good quality, but do not stand out as vastly better than competing products.

The decision between skimming and penetration pricing depends on the type of product and involves trade-offs of price versus volume. Skimming pricing results in much slower acceptance of a new product, but high unit profits. Penetration pricing results in greater initial sales volume, but lower unit profits.

Target Costing

We have described the pricing of new products as a process whereby the cost of the product is determined, and then an appropriate price is chosen. Sometimes the opposite approach is taken. The company first uses market research to determine the price at which the new product will sell. Given the likely sales price, management computes the cost for which the product must be manufactured in order to provide the firm with an acceptable profit margin. Finally, engineers and cost analysts work together to design a product that can be manufactured for the allowable cost. This process, called target costing, is used widely by companies in the development stages of new products. A new product’s target cost is the projected long-run cost that will enable a firm to enter and remain in the market for the product and compete successfully with the

firm’s competitors. In specifying a product’s target cost, analysts must be careful to incorporate all of the product’s life cycle costs. These include the costs of product planning and concept design, preliminary design, detailed design and testing, production, distribution, and customer service. Sometimes the projected cost of a new product is above the target cost. Then efforts are made to eliminate non-value-added costs to bring the projected cost down. In some cases, a close look at the company’s value chain can help managers identify opportunities for cost reduction. For Example, Procter & Gamble placed order-entry computers in Wal-Mart stores. This resulted in substantial savings in order-processing costs for both companies.

Activity-Based Costing and Target Costing An activity-based costing (ABC) system can be particularly helpful as product design engineers try to achieve a product’s target cost. ABC enables designers to break down the production process for a new product into its component activities. Then designers can attempt cost improvement in particular activities to bring a new product’s projected cost in line with its target cost.

To illustrate, Sydney Sailing Supplies’ Marine Instruments Division, located in Perth, Australia, wants to introduce a new depth finder. Target-costing studies indicate that a target cost of $340 must be met in order to successfully compete in this market. ABC was used to bring the depth finder’s initial cost estimate of $399 down to $337, just below the target cost. The company’s design engineers were able to focus on key activities in the production process, such as material handling and inspection, and reduce the projected costs.

Computer-Integrated Manufacturing When a computer-integrated manufacturing (CIM) system is used, the process of target costing sometimes is computerized. A manufacturer’s computer-aided design and cost-accounting software are interconnected. An engineer can try out many different design features and immediately see the product cost implications, without ever heaving the computer terminal.

HEWLETT-PACKARD’S PERSONAL OFFICE COMPUTER DIVISION

At Hewlett-Packard Company’s Personal Office Computer Division, a computer program called COSTIT is maintained by the Accounting Department. The COSTIT program enables a product design engineer to get a quick answer to the question, What will be the new product cost if certain design changes are made in a product? If, for example, the engineer wants to know the cost of changing the exterior case on the division’s personal office computer, this information is easily determined by accessing COSTIT on his or her own computer terminal. Accounting Department personnel estimate that COSTIT is

used by designers over 100 times a month to facilitate the continuing process of product enhancement.

Product-Cost Distortion and Pricing: The Role of Activity-Based

Costing

Use of a traditional, volume-based product-costing system may result in significant cost distortion among product lines. In many cases, high-volume and relatively simple products are overcosted while low-volume and complex products are undercosted. This results from the fact that high-volume and relatively simple products require proportionately less activity per unit for various manufacturing-support activities than do low-volume and complex products. Yet a traditional product-costing system, in which all overhead is assigned on the basis of a single unit-level activity like direct-labor hours, fails to capture the cost implications of product diversity. In contrast, an activitybased costing (ABC) system does measure the extent to which each product line drives costs in the key production-support activities.

Since pricing decisions often are based on accounting product costs, decision makers should be aware that cost-distortion can result in overpricing highvolume and relatively simple products, while low-volume and complex products are undercosted. The competitive implications of such strategic pricing errors can be disastrous.

EFFECT OF ANTITRUST LAWS ON PRICING

Businesses are not free to set any price they wish for their products or services. American antitrust laws, including the Robinson-Patman Act, the Clayton Act, and the Sherman Act, restrict certain types of pricing behavior. These laws prohibit price discrimination, which means quoting different prices to different customers for the same product or service. Managers should keep careful records justifying such cost differences when they exist, because the records may be vital to a legal defense if price differences are challenged in court.

Another pricing practice prohibited by law is predatory pricing. This practice involves temporarily cutting a price to broaden demand for a product with the intention of later restricting the supply and raising the price again. In determining whether a price is predatory, the courts examine a business’s cost records. If the product is sold below cost, the pricing is deemed to be predatory. The laws and court cases are ambiguous as to the appropriate definition of cost. This is one area where a price-setting decision maker is well advised to have an accountant on the left and a lawyer on the right before setting prices that could be deemed predatory.

SUMMARY

Pricing of products and services is one of the most challenging decisions faced by management. Many influences affect pricing decisions. Chief among these are customer demand, the actions of competitors, and the costs of the products or services. Other factors such as political, legal, and image-related issues also affect pricing decisions.

Economic theory shows that under certain assumptions, the profitmaximizing price and quantity are determined by the intersection of the marginal-revenue and marginal-cost curves. While the economic model serves as a useful conceptual framework for the pricing decision, it is limited by its assumptions and the informational demands it implies.

Most companies set prices, at least to some extent, on the basis of costs. Cost-plus pricing formulas add a markup to some version of cost, typically either total variable cost or total absorption cost. Markups often are set to earn the company a target profit on its products, based on a target rate of return on investment.

In industries such as construction, repair, printing, and professional services, time and material pricing is used. Under this approach the price is determined as the sum of a labor-cost component and a material-cost component. Either or both of these components may include a markup to ensure that the company earns a profit on its services.

Pricing special orders and determining competitive bid prices entail an analysis of the relevant costs to be incurred in completing the job. The relevantcost analysis should incorporate the existence of excess capacity or the lack of it.

Strategic pricing of new products is an especially challenging problem for management. Various pricing approaches, such as skimming pricing or penetration pricing, may be appropriate depending on the product. Target costing often is used to design a new product that can be produced at a cost that will enable the firm to sell the product at a competitive price.

KEY TERMS
Average revenue curve	Oligopolistic market	Skimming pricing
Competitive bidding	Penetration pricing	Target cost
Cross-elasticity	Predatory pricing	Target costing
Cost-plus pricing	Price discrimination	Time and material
Demand curve (average	Price elasticity	pricing
revenue curve)	Price taker	Total cost curve
Marginal cost curve	Return-on-investment	Total revenue curve
Marginal revenue curve	pricing

REVIEW QUESTIONS:

1.List and briefly describe four major influences on pricing decisions.

2.“All this marginal revenue and marginal cost stuff is just theory. Prices are determined by production costs”. Evaluate this assertion.

3.Explain what is meant by the following statement: “In considering the reactions of competitors, it is crucial to define your product”.

4.Explain the following assertion: “Price setting generally requires a balance between market forces and cost considerations”.

5.Define the following terms: total revenue, marginal revenue, demand curve, price elasticity, and cross-elasticity.

6.Briefly define total cost and marginal cost.

7.Describe three limitations of the economic, profit-maximizing model of pricing.

8.“Determining the best approach to pricing requires a cost-benefit trade-off”.

9.List four reasons often cited for the widespread use of absorption cost as the

cost base in cost plus pricing formulas.

10.List three advantages of pricing based on variable cost.

11.Explain the behavioral problem that can result when cost-plus prices are based on variable cost.

12.Briefly describe the time-and-material pricing approach.

13.Explain the importance of the excess-capacity issue in setting a competitive bid price.

14.Describe the following approaches to pricing new products: skimming pricing, penetration pricing, and target costing.

15.Explain what is meant by unlawful price discrimination and predatory pricing.

16.Define the term target cost.

GLOSSARY

Account-classification method (also called account analysis) A costestimation method involving a careful examination of the ledger accounts for the purpose of classifying each cost a variable, fixed, or semivariable.

Activity A measure of an organization’s output of goods or services.

Activity accounting The collection of financial or operational performance information about significant activities in the enterprise.

Activity base (or cost driver) A measure of an organization’s activity that is used as a basis for specifying cost behavior. The activity base also is used to compute a predetermined overhead rate. The current trend is to refer to the activity base as a volume-based cost driver.

Activity-based responsibility accounting A system for measuring the performance of an organization’s people and subunits, which focuses not only on the cost of performing activities but on the activities themselves.

Actual manufacturing overhead The actual costs incurred during an accounting period for manufacturing overhead. Includes actual indirect material, indirect labor, and other manufacturing costs.

Actual overhead rate The rate at which overhead costs are actually incurred during an accounting period. Calculated as follows: actual manufacturing overhead – actual cost driver (or activity base).

Administrative costs All costs associated with the management of the organization as a whole.

Average cost per unit The total cost of producing a particular quantity of product divided by the number of units produced.

Batch manufacturing High –volume production of several product lines that differ in some important ways but are nearly identical in others.

Break-even point The volume of activity at which an organization’s revenues and expenses are equal. Maybe measured either in units or in sales dollars.

Certified management accountant (CMA) An accountant who has earned professional certification in managerial accounting.

Committed cost A cost that results from an organization’s ownership or use of facilities and its basic organization structure.

Competitive bidding A situation where two or more companies submit bids (prices) for a product, service, or project to a potential buyer.

Control factor unit A measure of work or activity used in work measurement. Controllable cost A cost that is subject to the control or substantial influence of a particular individual.

Controller (or comptroller) The top managerial and financial accountant in an organization. Supervises the accounting department and assists management at all levels in interpreting and using managerial-accounting information.

Controlling Ensuring that the organization operates in the intended manner and achieves its goals.

Conversion cost Direct-labor cost plus manufacturing-overhead cost.

Cost Accounting Standards Cost-accounting procedures specified by the Cost Accounting Standards Board, an agency of the federal government.

Cost Accounting Standards Board (CASB) A federal agency chartered by the Congress in 1970 to develop cost-accounting standards for large government contractors.

Cost-accounting system Part of the basic accounting system that accumulates cost data for use in both managerial and financial accounting.

Cost behavior The relationship between cost and activity.

Cost driver An event or activity that results in the incurrence of costs. Cost estimation The process of determining how a particular cost behaves.

Cost of goods sold The expense measured by the cost of the finished goods sold during a period of time.

Cost-plus pricing A pricing approach in which the price is equal to cost plus a markup.

Cost prediction Forecast of cost at a particular level of activity.

Cost structure The relative proportions of an organization’s fixed and variable costs.

Cross-elasticity The extent to which a change in a product’s price affects the demand for substitute products.

Curvilinear cost A cost with a curved line for its graph. Decision making Choosing between alternatives.

Decision-support system A computer-based system that is designed to assist managers in making certain types of decisions. Includes access to one or more databases, decision methods pertinent to the decisions facing the user, and various ways of displaying the results.

Demand curve A graph of the relationship between sales price and the quantity of units sold.

Departmental overhead rate An overhead rate calculated for a single production department.

Dependent variable A variable whose value depends on other variables, called independent variables.

Differential cost The difference in a cost item under two decision alternatives. Direct cost A cost that can be traced to a particular department or other subunit of an organization.

Directing operations Running the organization on a day-to-day basis.

Direct labor The costs of compensating employees who work directly on the firm’s product. Should include wages, salary and associated fringe benefits.

Direct materials Materials that are physically incorporated in the finished product.

Discretionary cost A cost that results from a discretionary management decision to spend particular amount of money.

Distribution cost The cost of storing and transporting finished goods for sale. Engineered cost A cost that results from a definitive physical relationship with the active measure.

Engineering method A cost-estimation method in which a detailed study is made of the process that results in cost incurrence.

Expense The consumption of assets for the purpose of generating revenue. Financial accounting The use of accounting information foe reporting to parties outside organization.

Finished goods Completed products awaiting sale.

Fixed cost A cost that does not change in total as activity changes.

Goodness of fit The closeness with which a regression line fits the data upon which it is based.

High-low method A cost-estimation method in which a cost line is fit using exactly two data points – the high and low activity levels.

Hybrid product-costing system A system that incorporates features from two or more alternative product-costing systems, such as job-order and process costing.

Idle time Unproductive time spent by employees due to factors beyond their control, such as power outages and machine breakdowns.

Incremental cost The amount by which the cost of one action exceeds that of another. See also differential cost

Independent variable The variable upon which the estimate is based in leastsquares regression analysis.

Indirect cost A cost that cannot be traced to a particular department.

Indirect labor All costs of compensating employees who do not work directly on the firm’s product but who are necessary for production to occur.

Indirect materials Materials that either are required for the production process to occur but do not become an integral part of the finished product, or are consumed in production but are insignificant in cost.

Information overload The provision of so much information that, due to human limitations in processing information, managers cannot effectively use it. In-process quality controls Procedures designed to assess product quality before production is completed.

Internal auditor An accountant who reviews the accounting procedures, records, and reports in both the controller’s and treasurer’s areas of responsibility.

Internal failure costs Costs of correcting defects found prior to product sale. Inventoriable costs Costs incurred to purchase or manufacture goods. Also see product costs.

Inventoriable goods Goods that can be stored before sale, such as durable goods, mining products, and some agricultural products.

Just-in-time (JIT) inventory and production management system A comprehensive ventory and manufacturing control system in which no materials are purchased and no products manufactured until they are needed.

Learning curve A graphical expression of the decline in the average labor time required per unit as cumulative output increases.

Least-squares regression method. A cost-estimation method in which the cost line is fit to data by statistical analysis. The method minimizes the sum of the squared deviations between the decline and the data points.

Managerial accounting Part of an organization’s management-information system, which provides accounting and other quantitative data to users inside the organization.

Manufacturing The process of converting raw materials into finished products. Manufacturing overhead All manufacturing costs other than direct-material and direct-labor costs.

Manufacturing overhead All manufacturing costs other that direct-material and direct-labor costs.

Marketing cost The cost incurred in selling goods or services. Includes order-getting costs and the amount specified in the flexible budget.

Marginal cost The extra cost incurred in producing one additional unit of output.

Marginal cost curve A graph of the relationship between the change in total revenue and the quantity sold.

Merchandise cost The cost of acquiring finished goods for resale. Includes purchasing and transportation costs.

Multiple regression A statistical method in which a linear (straight-line) relationship is estimated between a dependent variable and two or more independent variables.

Non-value-added costs The costs of activities that can be eliminated without deterioration of product quality, performance, or perceived value. Normal-costing system A product-costing system in which actual directmaterial, actual direct-labor, and applied manufacturing-overhead costs are added to Work-in-Process Inventory.

Oligopolistic market (or oligopoly) A market with a small number of sellers competing among themselves.

Operating activities All activities that are not investing or financing activities. Generally peaking, operating activities include all cash transactions that are involved in the determination of net income.

Operating expenses The costs incurred to produce and sell services, such as transportation repair, financial, and medical services.

Operation costing A hybrid of job-order and process costing. Direct material is accumulated by batch of products using job-order costing methods. Conversion costs are accumulated by department and assigned to product units by processcosting methods.

Opportunity cost The potential benefit given up when the choice of one action precludes selection of a different action.

Outlier A data point that falls far away from the other points in the scatter diagram and is not representative of the data.

Out-of-pocket costs Costs incurred that require the expenditure of cash or other assets.

Overtime premium The extra compensation paid to an employee who works beyond the normal period of time.

Penetration pricing Setting a low initial price for a new product in order to penetrate the market deeply and gain a large and broad market share.

Planning Developing a detailed financial and operational description of anticipated operations.

Pool rate The cost per unit of the cost drive for a particular activity cost pool. Predatory pricing An illegal practice in which the price of a product is set low temporarily to broaden demand. Then the product’s supply is restricted and the price is raised.

Prevention costs Costs of preventing defective products. Price elasticity The impact of price changes on sales volume.

Price taker A firm whose product or service is determined totally by the market.

Prime cost The cost of direct material and direct labor.

Product-costing system The process of accumulating the costs of a production process and assigning them to the products that comprise the organization’s output.

Product costs Costs that are associated with goods for sale until the time period during which the products are sold, at which time the costs become expenses. See also inventoriable costs.

Projected costing The process of assigning costs to projects, cases, contracts, programs or missions in nonmanufacturing organizations.

Raw material Material entered into a manufacturing process.

Regression line A line fit to a set of data points using least-squares regression. Relevant range The range of activity within which management expects the organization to operate.

Research and development costs Costs incurred to develop and test new products or services.

Return on investment (ROI) Income divided by invested capital. Return-on-investment pricing A cost-plus pricing method in which the markup is determined by the amount necessary for the company to earn a target rate of return on investment.

Safety margin Difference between budgeted sales revenue and break-even sales revenue.

Sales margin Income divided by sales revenue.

Scatter diagram A set of plotted cost observations at various activity levels.

Schedule of cost of goods sold A detailed schedule showing the cost of Goods

Sold and the change in Finished-Goods Inventory during an accounting period.

Selling costs Costs of obtaining and filling sales orders, such as advertising costs, compensation of sales personnel, and product promotion costs. Semivariable (or mixed) cost A cost with both a fixed and a variable component.

Service department A subunit an organization that is not involved directly in producing the organization’s output of goods or services.

Service firm A firm engaged in production of a service that is consumed as it is produced, such an air transportation service or medical service.

Skimming pricing Setting a high initial price for a new product in order to reap short-run pro. Over time, the price is reduced gradually.

Standard cost A predetermined cost for the production of goods or services, which serves benchmark against which to compare the actual cost.

Step-fixed cost A cost that remains fixed over wide ranges of activity, but jumps to a different amount for activity levels outside that range.

Step-variable cost A cost that is nearly variable , but increases in small steps instead of continuously.

Strategic cost analysis A broad-based managerial-accounting analysis that support strategic management systems.

Strategic cost management Overall recognition of the cost relationships among the activities in the value chain, and the process of managing those cost relationships to the firm’s advantage.

Sunk cost A cost that was incurred in the past and cannot be altered by any current or future decision.

System An integrated structure designed to accomplish a stated purpose and consisting of a set of inputs, a process, and a set of outputs.

Target cost The projected long-rung product cost that will enable a firm to enter and remain in the market for the product and compete successfully with the firm’s competitors.

Target costing The pricing of a new product before it is designed, to ensure that it will be competitive. Then the product is designed so that it can be produced at a cost that makes the chosen price feasible.

Time and material pricing A cost-plus pricing approach that includes components for labor cost and material cost, plus markups on either or both of these cost components.

Treasurer An accountant in a staff position who is responsible for managing the organization’s relationships with investors and creditors and maintaining custody of the organization’s cash, investment, and other assets.

Value chain An organization’s set of linked, value-creating activities, ranging from securing basic raw materials and energy to the ultimate delivery of products and services.

Variable cost A cost that changes in total in proportion to changes in the organization’s activity.

Visual-fit method A method of cost estimation in which a cost line is drawn through a scatter diagram according to the visual perception of the analyst. Work in process Partially completed products that are not yet ready for sale. Work measurement The systematic analysis of a task for the purpose of determining the inputs needed to perform the task.

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UNIT	1 ......................................................	4-25
UNIT	2 ......................................................	25-44
UNIT	3 ......................................................	44-63
UNIT	4 .......................................................	63-84
GLOSSARY .............................................		84-91