We start our discussion on decision making by looking at regular pricing decisions and special pricing decisions. In the past, managers did not consider pricing to be a short-term decision. However, product life cycles are getting shorter in most industries. Companies often sell products for only a few months before replacing them with an updated model, even if the updating is small. The clothing and technology industries have always had short life cycles. Even auto and housing styles change frequently. Pricing has become a shorter- term decision than it was in the past.
Setting Regular Prices
There are three basic questions managers must answer when setting regular prices for their products or services:
• What is the company’s target profit?
• How much will customers pay?
• Is the company a price-taker or a price-setter for this product or service?
The answers to these questions are complex and ever changing. Stockholders expect the company to achieve certain profits. Economic conditions, historical company earnings, industry risk, competition, and new business developments all affect the level of profit that stockholders expect. Stockholders usually tie their profit expectations to the amount of assets invested in the company. For example, stockholders may expect a 10% annual return on investment (ROI). A company’s stock price tends to decline if it does not meet target profits, so managers must keep costs low while generating enough revenue to meet target profits.
This leads to the second question: How much will customers pay? Managers cannot set prices above what customers are willing to pay, or sales volume will decline. The amount customers will pay depends on supply and demand, which is influenced by the competi- tion, the product’s uniqueness, the effectiveness of marketing campaigns, general economic conditions, and so forth.
To address the third pricing question, whether a company is a price-taker or a price- setter, imagine a horizontal line with price-takers at one end and price-setters at the other end. A company falls somewhere along this line for each of its products and services. Com- panies are price-takers when they have little or no control over the prices of their products or services and take the price set by the market. This occurs when their products and ser- vices are not unique or when competition is intense. Examples include food commodities (milk and corn), natural resources (oil and lumber), and generic consumer products and services (paper towels, dry cleaning, and banking).
Companies are price-setters when they have more control over pricing—in other words, they can set the price to some extent. Companies are price-setters when their products are unique, which results in less competition. Unique products, such as original art and jew- elry, specially manufactured machinery, patented perfume scents, and the latest technologi- cal gadget, can command higher prices.
Obviously, managers would rather be price-setters than price-takers. To gain more control over pricing, companies try to differentiate their products. They want to make their products unique in terms of features, service, or quality or at least make the buyer think their
Learning Objective 2 Make regular and special pricing decisions
Price-Taker
A company that has little control over the prices of its products and services because its products and services are not unique or competition is intense.
Price-Setter
A company that has control over the prices of its products and services because its products and services are unique and there is little competition.
are willing to pay more for their product or service. What is the downside? These companies must charge higher prices or sell more just to cover their advertising costs.
A company’s approach to pricing depends on whether it is on the price-taking or price-setting side of the spectrum. Price-takers emphasize a target-pricing approach.
Price-setters emphasize a cost-plus pricing approach. Keep in mind that most com- panies provide many products and services; a company may be a price-taker for some products and a price-setter for other products. Therefore, managers tend to use both approaches to some extent. Exhibit 25-2 summarizes the difference between price-takers and price-setters.
Exhibit25-2 | Price-Takers Versus Price-Setters
Companies Are Price-Takers for a Product When:
• Product lacks uniqueness
• Intense competition
• Pricing approach emphasizes target pricing
Companies Are Price-Setters for a Product When:
• Product is more unique
• Less competition
• Pricing approach emphasizes cost-plus pricing
Target Pricing
When a company is a price-taker, it emphasizes a target-pricing approach to managing costs and profits. Target pricing starts with the market price of the product (the price custom- ers are willing to pay) and then subtracts the company’s desired profit to determine the maximum allowed target full product cost—the full cost to develop, produce, and deliver the product or service. Target pricing is sometimes called target costing because the desired target cost is derived from the target price. The target pricing formula is:
Target Pricing A method to manage costs and profits by determining the target full product cost. Revenue at market price - Desired profit= Target full product cost.
Target Full Product Cost The full cost to develop, produce,
and deliver the product or service. Revenue at market price
- Desired profit Target full product cost
In this relationship, the sales price is taken from the market. It is the amount set by the market—the maximum amount customers are willing to pay. The com- pany has no control over this amount and, therefore, must focus on controlling costs to obtain the desired profit. Recall that a product’s full cost contains all elements from the value chain—both product costs (direct materials, direct labor, and manufacturing over- head) and period costs (selling and administrative costs). Both product costs and period costs include fixed and variable costs. If the product’s current cost is higher than the target full product cost, the company must find ways to reduce the product’s cost or it will not meet its profit goals. Managers often use activity-based costing along with value engineer- ing (as discussed in a previous chapter) to find ways to cut costs.
Let’s return to Smart Touch Learning, a fictitious company that manufactures tablet computers. Assume Smart Touch Learning determines the current market price is $500 per tablet. Exhibit 25-3 shows the expected operating income for Smart Touch Learning for 2019 for 2,400 tablets.
How will I know the revenue at market price?
Because there is intense competition, Smart Touch Learning will emphasize a target- pricing approach. Assume the company’s stockholders expect a 10% annual return on the company’s assets (ROI). If the company has $2,500,000 average assets, the desired profit is
$250,000 ($2,500,000 * 10%). The target full product cost at the current sales volume of 2,400 tablets is calculated as follows:
Exhibit25-3 | Smart Touch Learning’s Budgeted Income Statement SMART TOUCH LEARNING
Budgeted Income Statement Year Ended December 31, 2019
Manufacturing Net Sales Revenue Variable Costs:
Selling and Administrative Contribution Margin Fixed Costs:
Manufacturing
Selling and Administrative Operating Income
$ 1,200,000
$ 236,000 462,000
226,000
$ 588,000
150,000 738,000
116,000 110,000
Revenue at market price (2,400 tablets @ $500 each, from Exhibit 25-3) (calculated above)
Less: Desired profit Target full product cost
$ 1,200,000 250,000
$ 950,000
Once we know the target full product cost, we can analyze the fixed and variable cost components separately. Can Smart Touch Learning make and sell 2,400 tablets at a full product cost of $950,000? We know from Smart Touch Learning’s contribution margin income statement (Exhibit 25-3) that the company’s variable costs are $307.50 per unit ($738,000 / 2,400 tablets). This variable cost per unit includes both manufacturing costs and selling and administrative costs. We also know the company incurs $226,000 in fixed costs in its current relevant range. Again, some fixed costs stem from manufacturing and some from selling and administrative activities. In setting regular sales prices, companies must cover all of their costs—whether the costs are product or period, fixed or variable.
Making and selling 2,400 tablets currently cost the company $964,000 [(2,400 units
* $307.50 variable cost per unit) + $226,000 of fixed costs], which is $14,000 more than the target full product cost of $950,000. What options does Smart Touch Learning have?
1. Accept the lower operating income of $236,000, which is a 9.44% return on invest- ment ($236,000 operating income / $2,500,000 average assets), not the 10% target return required by stockholders.
5. Change or add to its product mix (covered later in this chapter).
6. Attempt to differentiate its tablet computer from the competition to gain more control over sales prices (become a price-setter).
7. A combination of the above strategies that would increase revenues and/or decrease costs by $14,000.
Smart Touch Learning’s managers can use cost-volume-profit (CVP) analysis, as you learned in a previous chapter, to determine how many tablets the company would have to sell to achieve its target profit. The company would have to consider how to increase demand for the tablets and the additional costs that would be incurred, such as advertising costs. Managers do not have an easy task when the current cost exceeds the target full prod- uct cost. Sometimes companies just cannot compete given the current market price. If that is the case, they may have no other choice than to quit making that product. (This decision is also covered later in the chapter.)
Cost-Plus Pricing
When a company is a price-setter, it emphasizes a cost-plus approach to pricing. This pricing approach is essentially the opposite of the target-pricing approach. Cost-plus pricing starts with the company’s full product costs (as a given) and adds its desired profit to determine a cost-plus price.
Cost-Plus Pricing A method to manage costs and profits by determining the price.
Full product cost +Desired profit = Cost@plus price.
Full product cost + Desired profit Cost@plus price
As you can see, it is the basic profit calculation rearranged to solve for the revenue figure—price.
When the product is unique, the company has more control over pricing—but the company still needs to make sure that the cost-plus price is not higher than what customers are willing to pay. Let’s go back to our Smart Touch Learning example. This time, assume the tablet computers benefit from brand recognition due to the company’s preloaded e-learning software so the company has some control over the price it charges for its tablets.
Using a cost-plus pricing approach, assuming the current level of sales, and a desired profit of 10% of average assets, the cost-plus price is $506, calculated as follows:
Current variable costs ($307.50 per tablet × 2,400 tablets) $ 738,000 Plus: Fixed costs
Full product cost
Plus: Desired profit (10% × $2,500,000 average assets) Target revenue
Divided by number of tablets Cost-plus price per tablet
*rounded
226,000 964,000 250,000
$ 1,214,000
÷ 2,400 units
$ 506 per unit*
If the current market price for generic tablet computers is $500, as we assumed earlier, can Smart Touch Learning sell its brand-name tablet computers for $506 or more? Probably.
The answer depends on how well the company has been able to differentiate its product or brand name. The company may use focus groups or marketing surveys to find out how customers would respond to its cost-plus price. The company may find out that its cost-plus price is too high, or it may find that it could set the price even higher without losing sales.
Notice how pricing decisions (1) focus on relevant information and (2) use a contri- bution margin approach that separates variable costs from fixed costs—our two keys to decision making. In pricing decisions, all cost information is relevant because the company must cover all costs along the value chain before it can generate a profit. However, we still need to consider variable costs and fixed costs separately because they behave differently at different volumes.
To maximize the effectiveness of pricing decisions, our pricing decision rule is as follows:
DECISION RULE: How to approach pricing?
If the company is a price-taker for the product:
Emphasize a target pricing approach
If the company is a price-setter for the product:
Emphasize a cost-plus pricing approach
Special Pricing
A special pricing decision occurs when a customer requests a one-time order at a reduced sales price. Before agreeing to the special deal, management must consider the following questions:
• Does the company have the excess capacity available to fill the order?
• Will the reduced sales price be high enough to cover the differential costs of filling the order?
• Will the special order affect regular sales in the long run?
First, managers must consider available manufacturing capacity. If the company is already using all its existing manufacturing capacity and selling all units made at its regular sales price, it would not be as profitable to fill a special order at a reduced sales price. There- fore, available excess capacity is a necessity for accepting a special order. This is true for service firms as well as manufacturers.
Second, managers need to consider whether the special reduced sales price is high enough to cover the differential costs of filling the special order. Differential costs are the costs that are different if the alternative is chosen. The special price must be greater than the variable costs of filling the order or the company will incur a loss on the deal. In other words, the special order must provide a positive contribution margin.
Additionally, the company must consider differential fixed costs. If the company has excess capacity, fixed costs probably will not be affected by producing more units (or deliv- ering more service). However, in some cases, management may have to incur some other fixed costs to fill the special order, such as additional insurance premiums or the purchase
should determine the answers to these questions and consider how customers will respond.
Managers may decide that any profit from the special sales order is not worth these risks.
Let’s consider a special pricing example. Smart Touch Learning normally sells its tab- let computers for $500 each. Assume that a company has offered Smart Touch Learning
$68,750 for 250 tablets, or $275 per tablet. The special pricing requested is substantially less than the regular sales price. Additional information about this sale includes:
• Production will use manufacturing capacity that would otherwise be idle (excess capacity).
• No change in fixed costs.
• No additional variable nonmanufacturing expenses (because no extra selling or administra- tive costs are incurred with this special order).
• No effect on regular sales.
We have addressed every consideration except one: Is the special sales price high enough to cover the variable manufacturing costs associated with the order?
Suppose Smart Touch Learning expects to make and sell 2,400 tablets before con- sidering the special order. Exhibit 25-4 shows Smart Touch Learning’s budgeted income statement using the traditional income statement on the left side of Exhibit 25-4 and the contribution margin income statement on the right (as previously shown in Exhibit 25-3).
Exhibit25-4 | Smart Touch Learning’s Budgeted Income Statement—Traditional and Contribution Margin Formats
Selling & Administrative Fixed Costs:
Manufacturing Operating Income
Operating Income
Contribution Margin Format
$ 236,000
$ 236,000 266,000
698,000 502,000
$ 1,200,000
226,000 116,000
SMART TOUCH LEARNING Budgeted Income Statement Year Ended December 31, 2019
Gross Profit Manufacturing
Traditional Format
Net Sales Revenue Net Sales Revenue
Cost of Goods Sold Variable Costs:
Selling and Administrative Expenses Selling & Administrative Contribution Margin
110,000
462,000 738,000 150,000
$ 588,000
$ 1,200,000
The traditional format income statement shows product cost of $290.83 per tablet ($698,000 COGS / 2,400 tablets = $290.83 per tablet, rounded). A manager who does not examine these numbers carefully may believe that Smart Touch Learning should not accept the special order at a sales price of $275.00 because each tablet costs $290.83 to manufacture. But appearances can be deceiving! Recall that the manufacturing cost per unit for the tablet is a mixed cost, containing both fixed and variable cost components. To cor- rectly answer our question, we need to find only the variable portion of the manufacturing unit cost. This requires the manager to focus on the relevant data and use a contribution margin approach that separates variable costs from fixed costs.
The right side of Exhibit 25-4 shows the contribution margin income statement that separates variable expenses from fixed expenses. The contribution margin income statement allows us to see that the variable manufacturing cost per tablet is only $245 ($588,000 / 2,400 tablets = $245 per tablet). The special sales price of $275 per tablet is
higher than the variable manufacturing cost of $245. Therefore, the special order will pro- vide a positive contribution margin of $30 per tablet ($275 - $245). Because the special order is for 250 tablets, Smart Touch Learning’s total contribution margin should increase by $7,500 (250 tablets * $30 per tablet) if it accepts this order.
Using a differential analysis approach, Smart Touch Learning compares the additional revenues from the special order with the additional expenses to see if the special order will con- tribute to profits. These are the amounts that will be different if the order is accepted. Exhibit 25-5 shows that the special sales order will increase revenue by $68,750 (250 tablets * $275) but will also increase variable manufacturing costs by $61,250 (250 tablets * $245). As a result, Smart Touch Learning’s contribution margin will increase by $7,500, as previously shown. The other costs shown in Exhibit 25-4 are not relevant to the decision. Variable selling and administrative expenses will be the same whether or not Smart Touch Learning accepts the special order because Smart Touch Learning made no special efforts to acquire this sale.
Fixed manufacturing costs will not change because Smart Touch Learning has enough idle capacity to produce 250 extra tablets without needing additional facilities. Fixed selling and administrative expenses will not be affected by this special order, either. Because there are no additional fixed costs, the total increase in contribution margin flows directly to operating income. As a result, the special sales order will increase operating income by $7,500.
Exhibit25-5 | Differential Analysis of Special Pricing Decision
Expected increase in revenue (250 tablets × $275) (250 tablets × $245) (250 tablets × $ 30) Expected increase in variable manufacturing costs
Expected increase in operating income
$ 68,750 (61,250)
$ 7,500
In differential analysis, items are shown with their effect on profits.
The increase in revenues will increase profits, so it is shown as a positive amount. The increase in costs will decrease profits,
so it is shown as a negative amount.
DECISION RULE: Accept special pricing order?
Notice that the analysis follows the two keys to making short-term business decisions discussed earlier: (1) Focus on relevant data (revenues and costs that will change if Smart Touch Learning accepts the special order) and (2) use of a contribution margin approach that separates variable costs from fixed costs.
To summarize, for special pricing decisions, the decision rule is as follows: