COST MANAGEMENT Accounting & Control Hansen▪Mowen▪Guan Chapter 19 Pricing and Profitability Analysis COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning Cengage Learning and South-Western are trademarks used herein under license Study Objectives Discuss basic pricing concepts Calculate a markup on cost and a target cost Discuss the impact of the legal system and ethics on pricing Calculate measures of profit using absorption and variable costing Determine the profitability of segments Compute the sales price, price volume, contribution margin, contribution margin volume, sales mix, market share, and market size variances Describe some of the limitations of profit measurement Basic Pricing Concepts Market Structure and Price • Perfect Competition: Many buyers and sellers; no one of which is large enough to influence the market • Monopolistic Competition: Has both the characteristics of both monopoly and perfect competition • Oligopoly: Few sellers • Monopoly: Barriers to entry are so high that there is only one firm in the market Market Structure and Price Pricing Policies • Cost-based pricing – Established using “cost plus markup” • Target costing and pricing – Determine the cost of a product or service based on the price (target price) that customers are willing to pay – Effectively used in conjunction with marketing decisions • Penetration pricing • Price skimming Pricing Policies Cost-Plus Pricing AudioPro Company sells and installs audio equipment in homes, cars, and trucks AudioPro’s income statement for last year is as follows: Revenues Cost of goods sold: Direct materials Direct labor Overhead Gross profit Selling and administrative expenses Operating income $350,350 $122,500 73,500 49,000 245,000 $105,350 25,000 $ 80,350 Pricing Policies Cost-Plus Pricing The firm wants to earn the same amount of profit on each job as was earned last year: Markup on COGS = (Selling and administrative expenses + Operating income) ÷ COGS Markup on COGS = ($25,000 + $80,350) ÷ $245,000 Markup on COGS = 0.43 or 43% Pricing Policies Cost-Plus Pricing The markup can be calculated using a variety of bases The calculation for markup on direct materials is as follows: Markup on DM = (Direct labor + Overhead + Selling and administrative expense + Operating income) ÷ Direct materials Markup on DM = ($73,500 + $49,000 + $25,000 + $80,350) ÷ $122,500 Markup on DM = 1.86 or 186% Pricing Policies Cost-Plus Pricing AudioPro wants to expand the company’s product line to include automobile alarm systems and electronic car door openers The cost for the sale and installation of one electronic remote car door opener is as follows: Direct materials (component and two remote controls) Direct labor (2.5 hours x $12) Overhead (65% of direct labor cost) Estimated cost of one job Plus 43% markup on COGS Bid price $ 40.00 30.00 19.50 $ 89.50 38.49 $127.99 Pricing Policies Target Costing and Pricing • Determine the cost of a product or service based on the price that the customers are willing to pay Other installers price the remote car door opener at $110 Possible actions: Direct materials (component and two remotes) $ 40.00 Include one remote instead of two $35.00 Direct labor (2.5 hours x $12) 30.00 Train workers to reduce time (2 hours x $12) 24.00 Overhead (65% of direct labor cost) Bid price is 19.50 now Reduce overhead (50% of direct labor cost) markup competitive; 12.00 preserved Estimated cost of one job $ 89.50 10 Revised cost of one job $ Profitability of Segments Profit by Product Line 24 Profitability of Segments Profit by Product Line 25 Profitability of Segments Profit by Product Line 26 Profitability of Segments Profit by Product Line 27 Profitability of Segments Divisional Profit Sales Cost of goods sold Gross profit Division expenses Corporate expenses Operating income (loss) Alpha Beta Gamma Delta Total $ 90 35 $ 55 -20 -3 $ 60 20 $ 40 -10 -2 $ 30 11 $ 19 -15 -1 $120 98 $ 22 -20 -4 $300 164 $136 -65 -10 $ 32 $ 28 $ $ -2 $ 61 28 Profitability of Segments Customer profitability • Companies that assess the profitability of various customer groups can more accurately target their markets and increase profits 1) Identify the customer 2) Determine which customers add value to the company 29 Analysis of Profit-Related Variances Overall Sales Variance [actual vs expected revenue] Sales Price Variance Price Volume Variance 30 Analysis of Profit-Related Variances   Sales price = Actual - Expected �Quantity variance price price sold   Price volume = Actual - Expected �Expected variance volume volume price The sales price and price volume variances are labeled favorable if the variance increases profit above the amount expected They are labeled unfavorable if the variance decreases profit below the amount expected 31 Analysis of Profit-Related Variances Contribution Margin Variance [actual vs expected contribution margin] Sales Mix Variance Contribution Margin Volume Variance 32 Analysis of Profit-Related Variances Sales Mix Variance =       P1 actual units � P1 budgeted CM - P1 budgeted units - Budgeted average unit CM + P2 actual units � P2 budgeted CM - P2 budgeted units - Budgeted average unit CM The sales mix variance is favorable if the sales mix is weighted to the more profitable products Budgeted Contribution �Actual Budgeted � average unit margin volume = � quantity - quantity �� � sold � contribution variance sold � � margin The contribution margin volume variance gives management information about gained or lost profit due to changes in the quantity of sales 33   Analysis of Profit-Related Variances 34 Analysis of Profit-Related Variances Birdwell, Inc.: contribution margin variance $14,375 − $13,500 = $875 favorable  sales mix variance     1,250 � $4.00 - 1,500 - $6.75 625 � $15.00 + - 500 - $6.75    = $1,718.75 favorable contribution margin volume variance (2,000 − 1,875) × $6.75 = $843.75 unfavorable 35 Analysis of Profit-Related Variances Market share variance = Budgeted Budgeted � Actual � Actual � market share - market share ��industry � average unit �percentage � sales percentage � � in units CM Market size variance = Budgeted Budgeted � Budgeted � Actual � industry sales - industry sales �� market � average share unit � in units � in units � � percentage CM 36 Limitations of Profit Measurement • Limitations of profitability analysis – Focus on past performance – Emphasis on quantifiable measures – Impact on behavior • Successful firms measure far more than accounting profit 37 COST MANAGEMENT Accounting & Control Hansen▪Mowen▪Guan End Chapter 19 COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning Cengage Learning and South-Western are trademarks used herein under license 38 ... concepts Calculate a markup on cost and a target cost Discuss the impact of the legal system and ethics on pricing Calculate measures of profit using absorption and variable costing Determine the profitability... materials (component and two remote controls) Direct labor (2.5 hours x $12) Overhead (65% of direct labor cost) Estimated cost of one job Plus 43% markup on COGS Bid price $ 40.00 30.00 19. 50 $ 89.50... Bid price is 19. 50 now Reduce overhead (50% of direct labor cost) markup competitive; 12.00 preserved Estimated cost of one job $ 89.50 10 Revised cost of one job $ The Legal System and Pricing