CHAPTER 8
Pricing Decisions, Analyzing
Customer Profitability, and
Activity-Based Pricing
Slide 8-2
Pricing Decisions
 Pricing decisions often the most difficult
decisions that managers face
 Pricing Methods:
- profit maximizing price using economic
theory
- Pricing of special orders
- Cost Plus pricing
- Target costing
- Activity based pricing
Slide 8-3
The Profit Maximizing Price
Economic theory
Slide 8-4

The quantity demanded is a function of the
price that is charged

Generally, the higher the price, the lower the
quantity demanded

To calculate profit maximizing price:
- Subtract variable costs from price to
obtain the contribution margin
- Multiply by the quantity demanded
- Subtract fixed costs and estimate profits
- Select the price with the highest profit
Learning objective 1: Compute the profit
maximizing price for a product or service
The Profit Maximizing Price
Slide 8-5
Learning objective 1: Compute the profit
maximizing price for a product or service
 Estimates of price and quantity demanded
Price = $6.95, quantity demanded = 20,000
Price = $5.95, quantity demanded = 25,000
Price = $4.95, quantity demanded = 32,000
 Variable cost = $1.50 per unit
 Fixed cost = $80,000
Find the profit maximizing price
(Price - Variable) X Quantity - Fixed Cost =
(6.95 - 1.50)
X 20,000
- 80,000 =
(5.95 - 1.50)
X 25,000
- 80,000 =
(4.95 - 1.50)
X 32,000
- 80,000 =
$5.95 is the profit maximizing price
Slide 8-6
Profit
29,000
31,250
30,400
Learning objective 1: Compute the profit
maximizing price for a product or service
Pricing Special Orders
Special orders are for goods and services not
considered part of a company’s normal business
 Price charged will not affect prices charged in
normal course of business
 Price may deviate from what is common
 May charge a price less than full cost
Slide 8-7
Learning objective 2: Perform incremental analysis
related to pricing a special order
Pricing Special Orders
 Two alternatives: accept or reject
 Consider incremental revenues and
expenses
- Income before special order is the same
for both alternatives, not incremental
- Calculate incremental revenue
- Calculate incremental expenses i.e.,
materials, labor and variable overhead
Slide 8-8
Learning objective 2: Perform incremental analysis
related to pricing a special order
Special Orders – Premier Lens
Example
Should Premier Lens accept special order of
20,000 lenses to be sold to Blix Camera for
$73 per lens?
Below is the full cost of $75 per lens
Slide 8-9
Learning objective 2: Perform incremental analysis
related to pricing a special order
Special Orders – Premier Lens
Example
 Perform incremental analysis
 Fixed costs are not incremental, they will
not change if the order is accepted
Slide 8-10
Learning objective 2: Perform incremental analysis
related to pricing a special order
Commonwealth Edison
Slide 8-11
Learning objective 2: Perform incremental analysis
related to pricing a special order
Which of the following are relevant for a
special order?
a. Total company income before the order
b. Fixed costs
c. Incremental revenues and expenses
d. Fixed manufacturing overhead
Answer: c
Incremental revenues and expenses
Slide 8-12
Learning objective 2: Perform incremental analysis
related to pricing a special order
Cost-Plus Pricing
 Company estimates product cost and adds
a markup to arrive at price which allows
for a reasonable profit
 Benefits
- Simple approach
- Guarantees profit if sufficient quantity
can be sold at the specified price
Slide 8-13
Learning objective 3: Explain the cost-plus approach to pricing and why
it is inherently circular for manufacturing firms
Cost-Plus Pricing
Limitations
 What markup percentage to use?
 Requires considerable judgment and
experimentation
 Inherently circular for manufacturing
firms:
- Need to estimate demand to determine
fixed manufacturing costs
- Price affects the quantity demanded
Slide 8-14
Learning objective 3: Explain the cost-plus approach to pricing and why
it is inherently circular for manufacturing firms
Cost-Plus Pricing
Slide 8-15
Learning objective 3: Explain the cost-plus approach to pricing and why
it is inherently circular for manufacturing firms
Cost-plus pricing:
a. Leads to profit maximization
b. Is inherently circular for
manufacturing firms
c. Is difficult to perform
d. None of the above are correct
Answer: b
Is inherently circular for mfg firms
Slide 8-16
Learning objective 3: Explain the cost-plus approach to pricing and why
it is inherently circular for manufacturing firms
Target Costing
 Once a product is designed it is difficult
to make changes that reduce costs
- 80% of a product’s costs cannot be
reduced once it is designed
- Product features drive costs
 Target costing
- Integrated approach to determine
features, price, costs and design to
ensure a profit
Slide 8-17
Learning objective 4: Explain the target
costing process for a new product
Target Costing
Slide 8-18
Learning objective 4: Explain the target
costing process for a new product
Target Costing
Slide 8-19
Learning objective 4: Explain the target
costing process for a new product
Target costing:
a. Requires specification of desired level
of profit
b. Adds desired profit to existing costs
c. Is used primarily with products that
are already in production
d. Leads to profit maximization
Answer: a
Requires specification of desired profit
Slide 8-20
Learning objective 4: Explain the target
costing process for a new product
Analyzing Customer Profitability
Customer Profitability Measurement
System (CPM)
 Indirect costs of servicing customers are
assigned to cost pools:
- cost of processing orders
- cost of handling returns
 Costs are allocated to specific customers
using cost drivers to determine customer
profitability
Slide 8-21
Learning objective 5: Analyze
customer profitability
Customer profitability is measured as:
a. Revenue minus cost of goods sold
b. Revenue minus indirect manufacturing costs
c. Revenue minus cost of goods sold minus
indirect service costs
d. Revenue minus cost of goods sold minus
indirect manufacturing costs
Answer: c
Revenue minus cost of goods sold minus indirect
service costs
Slide 8-22
Learning objective 5: Analyze
customer profitability
Customer Profitability
Measurement System
Slide 8-23
Learning objective 5: Analyze
customer profitability
Cost Pools and Cost Drivers to
Service Customers
Slide 8-24
Learning objective 5: Analyze
customer profitability
Customer Profitability Analysis
Cost
Customer 1
Customer 2
Revenue
Quantity Amount
Quantity Amount
Less COGS
732,600
727,650
Gross margin
(666,000)
(661,500)
Less indirect costs
66,600
66,150
Internet orders $1.20 /order
165
(198)
0
0
Fax orders
$4.50 / order
20
(90)
320
(1,440)
Line items
$0.90 / item
2,500
(2,250)
5,100
(4,590)
Miles
$0.36 /mile
1,200
(432)
3,300
(1,188)
Weight
$0.40 / pound
900
(360)
870
(348)
Items returned $0.80 / item
210
(168)
910
(728)
Profit
63,102
57,856
Profit as a percent of sales
8.61%
7.95%
Slide 8-25
Learning objective 5: Analyze
customer profitability
Customer Profitability Analysis
Slide 8-26
Learning objective 5: Analyze
customer profitability
 Delta products has determined the following costs
and drivers for the Johnson Brand customer:
Cost
Sales
Cost of sales
Order processing
Line items
Customer service
Relationship management
per order
per item
per call
per account
$ 5.00
$ 8.50
$ 10.00
$ 500.00
Johnson
$ 53,800
$ 48,420
200
120
140
4
orders
items
calls
accounts
Calculate the profitability of the Johnson Brands
customer.
Slide 8-27
Learning objective 5: Analyze
customer profitability
 Delta products has determined the profitability of the
Johnson Brand customer:
Johnson
Sales
$ 53,800
Cost of sales
48,420
Order processing
$5.00 X 200 =
1,000
Line items
$8.50 X 120 =
1,020
Customer service
$10.00 X 140 =
1,400
Relationship management $500.00 X 4 =
2,000
Loss from customer
$
(40)
Slide 8-28
Learning objective 5: Analyze
customer profitability
Customers Can Hurt Profitability
Slide 8-29
Learning objective 5: Analyze
customer profitability
Activity-Based Pricing
 Customers are presented with separate
prices for services they request in
addition to the cost of goods purchased
- Customers will carefully consider the
services they request
- May lead them to impose less cost on the
supplier
 Also called menu-based pricing
Slide 8-30
Learning objective 6: Explain the activitybased pricing approach
Activity-Based Pricing
 Customers are presented with separate
prices for services they request in
addition to the cost of goods purchased
- Customers will carefully consider the
services they request
- May lead them to impose less cost on the
supplier
 Also called menu-based pricing
Slide 8-31
Learning objective 6: Explain the activitybased pricing approach
With activity-based pricing:
a. Customers face a menu of prices for various
services
b. Customers are encouraged to consider the
costs they impose on a supplier
c. Customers may be charged less if they
request less product variety in their orders
d. All of the above are correct
Answer: d
All of the above are correct
Slide 8-32
Pricing Decisions
Slide 8-33
Learning objective 6: Explain the activitybased pricing approach
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Slide 8-34