Prepared by
Debby Bloom-Hill
CMA, CFM
CHAPTER 8
Pricing Decisions, Analyzing
Customer Profitability, and
Activity-Based Pricing
Slide 8-2
Pricing Decisions
 Pricing decisions are often the most
difficult decisions that managers face
 Pricing decisions examined in this
chapter include
 Profit maximizing price from the
standpoint of economic theory
 Pricing of special orders
 Marking up costs and target costing
 Measuring customer profitability and
activity based pricing
Slide 8-3
The Profit Maximizing Price
 Economic theory suggests that the
quantity demanded is a function of
the price that is charged
 Generally, the higher the price, the
lower the quantity demanded
 If managers can estimate the quantity
demanded at various prices,
determining the optimal price is
straightforward
Slide 8-4
Learning objective 1: Compute the profit
maximizing price for a product or service
The Profit Maximizing Price
 To calculate the profit maximizing
price:
 Subtract unit variable costs from price
to obtain the contribution margin
 Multiply the contribution margin by
the quantity demanded
 Subtract fixed costs and estimate
profits
 Select the price with the highest profit
Slide 8-5
Learning objective 1: Compute the profit
maximizing price for a product or service
Estimating the Profit
Maximizing Price
Slide 8-6
Learning objective 1: Compute the profit
maximizing price for a product or service
Estimating Demand
 The most difficult part of determining
the profit maximizing price is
determining the demand function
 A number of approaches can be used
 Sales managers in various regions
could estimate the total quantity
demanded at various prices
 The product could be test marketed
with a number of potential customers
at various prices
Slide 8-7
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 8-8
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 the normal course of
business
 The company may be better off
charging a price that is below full cost
Slide 8-9
Learning objective 2: Perform incremental analysis
related to pricing a special order
Pricing Special Orders
 The special order decision presents
two alternatives
 Accept
 Reject
 Income from the main business is the
same under both alternatives
 It is not incremental and need not be
considered in the special order
Slide 8-10
Learning objective 2: Perform incremental analysis
related to pricing a special order
Pricing Special Orders
 Need to consider incremental revenues
and incremental costs
 The incremental revenue is the revenue
associated with the special order
 Incremental costs can include
 Direct materials
 Direct labor
 Variable overhead
 Incremental fixed costs
Slide 8-11
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 8-12
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 8-13
Learning objective 2: Perform incremental analysis
related to pricing a special order
Commonwealth Edison
Slide 8-14
Learning objective 2: Perform incremental analysis
related to pricing a special order
Which of the following is true?
a. In pricing special orders, fixed costs
typically are not relevant
b. In pricing special orders, fixed costs
typically are relevant
Answer: a
Fixed costs typically are not relevant
Slide 8-15
Learning objective 2: Perform incremental analysis
related to pricing a special order
Cost-Plus Pricing
 With a cost plus approach, the
company starts with an estimate of
product cost
 Typically excluding any selling or
administrative costs
 Adds a markup to arrive at a price that
allows for a reasonable level of profit
Slide 8-16
Learning objective 3: Explain the cost-plus approach to pricing and why
it is inherently circular for manufacturing firms
Cost-Plus Pricing
 Advantages
 The cost plus approach is simple to
apply
 The company will earn a reasonable
profit if a sufficient quantity can be sold
at the specified price
 The approach also has limitations
Slide 8-17
Learning objective 3: Explain the cost-plus approach to pricing and why
it is inherently circular for manufacturing firms
Cost-Plus Pricing
 Limitations
 Determination of an appropriate markup
requires considerable judgment
 Experimentation with different markups
may be necessary
 Inherently circular for manufacturing
firms
 Need to estimate demand to determine
fixed costs and the price, yet the price
affects the quantity demanded
Slide 8-18
Learning objective 3: Explain the cost-plus approach to pricing and why
it is inherently circular for manufacturing firms
Cost-Plus Pricing
Slide 8-19
Learning objective 3: Explain the cost-plus approach to pricing and why
it is inherently circular for manufacturing firms
All of the following are limitations of cost
plus pricing except
a. Determination of the markup
percentage requires judgment
b. Is inherently circular for
manufacturing firms
c. Experimentation may be necessary
d. Cost plus is simple to apply
Answer: d
Simplicity is an advantage of cost plus pricing
Slide 8-20
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 8-21
Learning objective 4: Explain the target
costing process for a new product
Target Costing
 The process begins with an analysis of
competing products
 This leads to a specification of features
and price attractive to customers
 The second step is to specify a desired level
of profit
 Then the engineering department with input
from the cost accounting department
develops a design that can be produced at a
cost which will earn the desired level of
profit
Slide 8-22
Learning objective 4: Explain the target
costing process for a new product
Target Costing
Slide 8-23
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 8-24
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
 Indirect costs include processing orders,
handling returns, and shipments
 Costs are allocated to specific customers
using cost drivers to determine customer
profitability
 Subtracting these costs and product costs
from customer revenue yields a measure
of customer profitability
Slide 8-25
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 8-26
Learning objective 5: Analyze
customer profitability
Customer Profitability
Measurement System
Slide 8-27
Learning objective 5: Analyze
customer profitability
Cost Pools and Cost Drivers to
Service Customers
Slide 8-28
Learning objective 5: Analyze
customer profitability
Customer Profitability Analysis
Cost
Revenue
Less COGS
Gross margin
Less indirect costs
Internet orders
$1.20
Fax orders
$4.50
Line items
$0.90
Miles
$0.36
Weight
$0.40
Items returned
$0.80
Profit
Profit as a percent of sales
Slide 8-29
Customer 1
Customer 2
Quantity
Amount
Quantity Amount
732,600
727,650
(666,000)
(661,500)
66,600
66,150
/ order
165
(198)
0
0
/ order
20
(90)
320
(1,440)
/ item
2,500
(2,250)
5,100
(4,590)
/ mile
1,200
(432)
3,300
(1,188)
/ pound
900
(360)
870
(348)
/ item
210
(168)
910
(728)
63,102
57,856
8.61%
7.95%
Learning objective 5: Analyze
customer profitability
A customer profitability measurement (CPM)
system:
a. Allocates indirect costs to individual
customers
b. Traces revenue to individual customers
c. Traces cost of goods sold to individual
customers
d. All of the above are true
Answer: d
All of the above are true
Slide 8-30
Learning objective 5: Analyze
customer profitability
Customer Profitability Analysis
Slide 8-31
Learning objective 5: Analyze
customer profitability
Customer Profitability and
Performance Measures
 Some examples of performance measures
that will drive managers to improve
customer profitability
 Percent of customers who are not profitable
 Dollar loss for customers who are not
profitable
 Average profit per customer
 Number of customer service requests per
100 customers
 Percent of customers who return items
 Dollar value of returned items
Slide 8-32
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 8-33
Learning objective 6: Explain the activitybased pricing approach
Activity-Based Pricing
 Customers might object as the price
they pay should cover these costs
 Ways to deal with this resistance
 Lower prices slightly and then
encourage customers to make fewer but
larger purchases
 Customers could be encouraged to limit
the variety of goods they order
 Activity-based pricing could be used
only on the least profitable customers
Slide 8-34
Learning objective 6: Explain the activitybased pricing approach
Pricing Decisions
Slide 8-35
Learning objective 6: Explain the activitybased pricing approach
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Slide 8-36