CHAPTER Pricing Decisions, Customer Profitability Analysis, 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, and perform incremental analysis related to pricing a special order 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, and perform incremental analysis related to pricing a special order Estimating the Profit-Maximizing Price Slide 8-6 Learning objective 1: Compute the profit-maximizing price for a product or service, and perform incremental analysis related to pricing a special order 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, and perform incremental analysis related to pricing a special order Test Your Knowledge  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 Slide 8-8 Learning objective 1: Compute the profit-maximizing price for a product or service, and perform incremental analysis related to pricing a special order 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 1: Compute the profit-maximizing price for a product or service, and 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 1: Compute the profit-maximizing price for a product or service, and perform incremental analysis related to pricing a special order 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 2: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms Also, explain the target costing process for a new product Target Costing Slide 8-23 Learning objective 2: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms Also, explain the target costing process for a new product Test Your Knowledge 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 2: Explain the cost-plus approach to pricing and why it is inherently circular for manufacturing firms Also, 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 3: Analyze customer profitability, and explain the activity-based pricing approach Test Your Knowledge 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 3: Analyze customer profitability, and explain the activity-based pricing approach Customer Profitability Measurement System Slide 8-27 Learning objective 3: Analyze customer profitability, and explain the activity-based pricing approach Cost Pools and Cost Drivers to Service Customers Slide 8-28 Learning objective 3: Analyze customer profitability, and explain the activity-based pricing approach Customer Profitability Analysis Slide 8-29 Learning objective 3: Analyze customer profitability, and explain the activity-based pricing approach Test Your Knowledge A customer profitability measurement (CPM) system does all of the following EXCEPT: a Allocates indirect costs to individual customers b Traces revenue to individual customers c Traces cost of goods sold to individual customers d Traces costs to individual products Answer: d Traces costs to individual products Slide 8-30 Learning objective 3: Analyze customer profitability, and explain the activity-based pricing approach Customer Profitability Analysis Slide 8-31 Learning objective 3: Analyze customer profitability, and explain the activity-based pricing approach 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 3: Analyze customer profitability, and explain the activity-based 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 8-33 Learning objective 3: Analyze customer profitability, and explain the activity-based 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 3: Analyze customer profitability, and explain the activity-based pricing approach Pricing Decisions Slide 8-35 Learning objective 3: Analyze customer profitability, and explain the activity-based pricing approach Copyright © 2016 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein Slide 8-36 .. .CHAPTER Pricing Decisions, Customer Profitability Analysis, and Activity-Based Pricing Slide 8-2... 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... 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