Accounting for Managers Unit Four

Please complete Exercise 7-50 and upload the Excel file here.

Please complete Problem 8-55 and upload the Excel file here.Using the information covered in Chapter 8, prepare a 3-page report in Word to your manager proposing the implementation of a new piece of equipment. Clearly label each section of the process. The essay should utilize at least 2 external sources and should be prepared in APA format. Examples of Managerial Accounting
Seventh Edition
Chapter 7
Cost-VolumeProfit Analysis: A
Managerial
Planning Tool
© 2019 Cengage. All rights reserved.
Break-Even Point in Units and in Sales
Dollars (1 of 4)
•
Cost-volume-profit (CVP) analysis estimates how
changes in the following three factors affect a
company’s profit
– Costs (both variable and fixed)
– Sales volume
– Price
•
Companies use CVP analysis to help them reach
important benchmarks, such as breakeven point
© 2019 Cengage. All rights reserved.
Break-Even Point in Units and in Sales
Dollars (2 of 4)
•
•
•
The break-even point is the point where total revenue
equals total cost (i.e., the point of zero profit)
The level of sales at which contribution margin just
covers fixed costs and consequently, net income is
equal to zero
Since new companies experience losses (negative
operating income) initially, they view their first breakeven period as a significant milestone
© 2019 Cengage. All rights reserved.
Break-Even Point in Units and in Sales
Dollars (3 of 4)
• CVP analysis can address many other issues:
1. The number of units that must be sold to break even
2. The impact of a given reduction in fixed costs on the
break-even point
3. The impact of an increase in price on profit
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Break-Even Point in Units and in Sales
Dollars (4 of 4)
• The basis of CVP analysis:
1. The contribution margin income statement
2. Calculating the break-even point in units
3. Calculating the contribution margin ratio and the
variable cost ratio
4. Calculating the break-even point in sales dollars
© 2019 Cengage. All rights reserved.
Using Operating Income in Cost-VolumeProfit Analysis (1 of 6)
•
•
In CVP analysis, the terms “cost” and “expense” are
often used interchangeably. This is because the
conceptual foundation of CVP analysis is the
economics of break-even analysis in the short run
It is assumed that all units produced are sold.
Therefore, all product and period costs do end up as
expenses on the income statement
Operating Income = Total Revenue – Total Expense
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Using Operating Income in Cost-VolumeProfit Analysis (2 of 6)
•
•
For the income statement, expenses are classified
according to function; that is, the manufacturing (or
service provision) function, the selling function, and the
administrative function
For CVP analysis, however, it is much more useful to
organize costs into fixed and variable components
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Using Operating Income in Cost-VolumeProfit Analysis (3 of 6)
•
Variable costs are all costs that increase as more units
are sold, including:
–
–
–
–
•
direct materials
direct labor
variable overhead
variable selling expenses
Fixed costs include:
– fixed overhead
– fixed selling and administrative expenses
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Using Operating Income in Cost-VolumeProfit Analysis (4 of 6)
•
The income statement format that is based on the
separation of costs into fixed and variable components
is called the contribution margin income statement
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Using Operating Income in CostVolume-Profit Analysis (5 of 6)
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Using Operating Income in CostVolume-Profit Analysis (6 of 6)
Contribution margin is the difference between sales
and variable expense. It is the amount of sales
revenue left over after all the variable expenses are
covered that can be used to contribute to fixed
expense and operating income
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Example 7.1: How to Prepare a
Contribution Margin Income Statement
(1 of 4)
Whittier Company plans to sell 1,000 mowers at $400
each in the coming year. Product costs include:
Direct materials per mower
$ 180
Direct labor per mower
100
Variable factory overhead per
mower
25
Total fixed factory overhead
15,000
Variable selling expense is a commission of $20 per
mower; fixed selling and administrative expense totals
$30,000.
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Example 7.1: How to Prepare a Contribution
Margin Income Statement (2 of 4)
Required:
1. Calculate the total variable expense per unit.
2. Calculate the total fixed expense for the year.
3. Calculate the unit contribution margin.
4. Prepare a contribution margin income statement for
Whittier for the coming year.
© 2019 Cengage. All rights reserved.
Example 7.1: How to Prepare a Contribution
Margin Income Statement (3 of 4)
Solution:
1. Total variable expense per unit:
Total Variable Expense per Unit = Direct Materials + Direct
Labor + Variable Overhead + Variable Selling Expense
= $180 + $100 + $25 + $20
= $325
2. Total Fixed Expense = Fixed Factory Overhead +
Fixed Selling and Administrative Expense
= $15,000 + $30,000 = $45,000
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Example 7.1: How to Prepare a
Contribution Margin Income Statement
(4 of 4)
3. Unit Contribution Margin = Price – Unit Variable Cost
= $400 – $325 = $75
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Break-Even Point in Units (1 of 2)
•
If the contribution margin income statement is recast as
an equation, it becomes more useful for solving CVP
problems
• Basic CVP Equations:
Operating Income = Sales – Total Variable Expenses – Total
Fixed Expenses
Operating Income = (Price × Number of Units Sold) –
(Variable Cost per Unit × Number of Units Sold) – Total
Fixed Cost
• The break-even point tells managers how many units must
be sold to cover all costs. Once more than the break-even
units are sold, the company begins to earn a profit
© 2019 Cengage. All rights reserved.
Example 7.2: How to Calculate the BreakEven Point in Units (1 of 3)
Refer to the Whittier Company information in Example 7.1.
Recall that mowers sell for $400 each, and variable cost
per mower is $325. Total fixed cost equals $45,000.
Required:
1. Calculate the number of mowers that Whittier must sell
to break even, using the operating income equation.
2. Calculate the number of mowers that Whittier must sell
to break even, using the contribution margin equation.
3. Check your answer by preparing a contribution margin
income statement based on the break-even point.
© 2019 Cengage. All rights reserved.
Example 7.2: How to Calculate the BreakEven Point in Units (2 of 3)
Solution:
1. Operating Income = (Price × Units) – (Variable Cost ×
Units) – Total Fixed Cost
0 = ($400 × Units) – ($325 × Units) – $45,000
Units = $45,000/($400 – $325)
= 600
2. Break-Even Number of Mowers = Total Fixed Cost/Unit
Contribution Margin
= $45,000/$75 = 600
3. Contribution margin income statement based on 600
mowers.
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Example 7.2: How to Calculate the
Break-Even Point in Units (3 of 3)
Sales ($400 × 600 mowers)
$240,000
Total variable expense ($325 × 600)
195,000
Total contribution margin
$ 45,000
Total fixed expense
45,000
Operating income
$0
Indeed, selling 600 units does yield a zero profit.
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Break-Even Point in Units (2 of 2)
•
Break-even units are equal to the fixed cost divided by
the contribution margin per unit
Total Fixed Cost
Break − Even Units =
Unit Contribution Margin
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Break-Even Point in Sales Dollars
•
Managers using CVP analysis may use sales revenue
as the measure of sales activity instead of units sold. A
units sold measure can be converted to a sales
revenue measure by multiplying the unit selling price
by the units sold:
Sales Revenue = Price × Units Sold
For example, the break-even point for Whittier is 600
mulching mowers; the selling cost is $400 per mower.
Breakeven in Sales $’s = 600 x $400 = $240,000
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Variable Cost Ratio and Contribution
Margin Ratio (1 of 2)
Any answer expressed in units sold can be easily
converted to one expressed in sales revenues
• Variable Cost Ratio
–
–
Price – Variable cost per unit = $10 – $6 = $4
Variable Cost × Units Sold = $6 × 10 units = $60
VariableCost per Unit
$6
=
= 60%
Price
$10
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Variable Cost Ratio and Contribution
Margin Ratio (2 of 2)
Contribution Margin Ratio
Total Contribution Margin $40
=
= 40%
Total Sales
$100
Alternativ ely :
Contribution Margin per Unit $4
=
= 40%
Price
$10
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Calculating Break-Even Point in Sales
Dollars
•
•
•
The break-even point in sales dollars makes it easy for
managers to see instantly how close they are to
breaking even using only sales revenue data
Since sales are typically recorded immediately, the
manager does not have to wait to have an income
statement prepared in order to see how close the
company is to breaking even
The equation to figure the break-even sales dollars is:
Total Fixed Expenses
Break − Even Sales =
Contribution Margin Ratio
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Units And Sales Dollars Needed to Achieve
a Target Income (1 of 2)
•
•
By looking at the number of units or sales dollars
needed to earn a target operating income, managers
turn their focus away from a point of zero profit and
can aim toward making a particular positive profit
Managers can easily compare, at any point in time, the
actual sales revenue made with the sales revenue
needed to earn a particular profit objective
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Units And Sales Dollars Needed to Achieve
a Target Income (2 of 2)
•
•
•
The break-even point is useful information and an
important benchmark for relatively young companies,
most companies would like to earn operating income
greater than $0
CVP allows us to do this by adding the target income
amount to the fixed cost
First, let’s look in terms of units that must be sold
Number of Units to Earn Target Income =
Total Fixed Cost + Target Income
Contribution Margin per Unit
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Example 7.5: How to Calculate the Number of Units to
Be Sold to Earn a Target Operating Income (1 of 3)
Whittier Company sells mowers at $400 each. Variable
cost per unit is $325, and total fixed cost is $45,000.
Required:
1. Calculate the number of units that Whittier must sell to
earn operating income of $37,500.
2. Check your answer by preparing a contribution margin
income statement based on the number of units
calculated.
© 2019 Cengage. All rights reserved.
Impact of Change in Revenue on
Change in Profit
•
•
Assuming that fixed costs remain unchanged, the
contribution margin ratio can be used to find the profit
impact of a change in sales revenue
To obtain the total change in profits from a change in
revenues, multiply the contribution margin ratio times
the change in sales:
Change in Profits = Contribution Margin Ratio × Change in
Sales
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Graphs of cost-Volume-Profit
Relationships
•
•
Graphing sales revenue and total costs against units
sold helps managers clearly see the difference
between variable cost and revenue
It may also help them understand quickly what impact
an increase or decrease in sales will have on the
break-even point
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The Cost-Volume-Profit Graph (1 of 3)
•
•
The cost-volume-profit graph depicts the relationships
among cost, volume, and profits (operating income) by
plotting the total revenue line and the total cost line on
a graph
To obtain the more detailed relationships, it is
necessary to graph two separate lines—the total
revenue line and the total cost line
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The Cost-Volume-Profit Graph (2 of 3)
•
These two lines are represented by the following two
equations:
Revenue = Price × Units
Total Cost = (Unit Variable Cost × Units) + Fixed Cost
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The Cost-Volume-Profit Graph (3 of 3)
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CVP Analysis Assumptions
Major assumptions of CVP analysis include:
1. Linear revenue and cost functions remain constant
over the relevant range
2. Selling prices and costs are known with certainty
3. All units produced are sold; there are no finished
goods inventories
4. Sales mix is known with certainty for multiple-product
break-even settings
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Multiple-Product Analysis (1 of 2)
•
•
•
Cost-volume-profit analysis is simple in a singleproduct setting. However, most firms produce and sell
a number of products or services
When managers calculate the break-even point for
individual products, they can see the contribution each
makes to profit and can tell at any point in time how
close a product is to breaking even
How do we adapt the formulas used in a singleproduct setting to a multiple-product setting?
© 2019 Cengage. All rights reserved.
Multiple-Product Analysis (2 of 2)
•
One important distinction is to separate direct fixed
expenses from common fixed expenses
– Direct fixed expenses are those fixed costs that can be
traced to each segment and would be avoided if the
segment did not exist
– Common fixed expenses are the fixed costs that are
not traceable to the segments and would remain even if
one of the segments was eliminated
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Break-Even Calculations for Multiple
Products
•
•
When more than one product is produced and sold,
managers must estimate the sales mix and calculate a
package contribution margin
Sales mix is the relative combination of products
being sold by a firm
Total Fixed Costs
Break – Even Packages =
Package Contribution Margin
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Introducing Risk and Uncertainty
•
•
An important assumption of CVP analysis is that prices
and costs are known with certainty
However, risk and uncertainty are a part of business
decision making and must be dealt with
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Methods to Deal with Uncertainty and Risk
1. Management must realize the uncertain nature of
future prices, costs, and quantities
2. Management must assume a “break-even band” rather
than a breakeven point
3. Managers should use sensitivity or “what-if” analysis
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Example 7.9: How to Calculate the Margin
of Safety (1 of 2)
Recall that Whittier plans to sell 1,000 mowers at $400
each in the coming year. Whittier has unit variable cost of
$325 and total fixed cost of $45,000. Break-even units
were previously calculated as 600.
Required:
1. Calculate the margin of safety for Whittier in terms of
the number of units.
2. Calculate the margin of safety for Whittier in terms of
sales revenue.
© 2019 Cengage. All rights reserved.
Example 7.9: How to Calculate the Margin
of Safety (2 of 2)
Solution:
1. Margin of Safety in Units = 1,000 – 600 = 400
2. Margin of Safety in Sales Revenue = $400(1,000) –
$400(600) = $160,000
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Operating Leverage
•
•
•
Operating leverage is the use of fixed costs to extract
higher percentage changes in profits as sales activity
changes
It is the measure of the proportion of fixed costs in a
company’s cost structure
It is used as an indicator of how sensitive profit
changes in sales volume
© 2019 Cengage. All rights reserved.
Example 7.10: How to Calculate the
Degree of Operating Leverage (1 of 2)
Recall that Whittier plans to sell 1,000 mowers at $400
each in the coming year. Whittier has unit variable cost per
unit of $325 and total fixed cost of $45,000. Operating
income at that level of sales was previously computed as
$30,000.
Required:
Calculate the degree of operating leverage for Whittier.
© 2019 Cengage. All rights reserved.
Example 7.10: How to Calculate the
Degree of Operating Leverage (2 of 2)
Solution :
Degree of Operating Leverage =
(
$400 − $325 )(1,000 units )
=
Total Contribution Margin
Operating Income
$30,000
= 2.5
© 2019 Cengage. All rights reserved.
Example 7.11: How to Calculate the Impact of Increased
Sales on Operating Income Using the Degree of Operating
Leverage (1 of 2)
Recall that Whittier had expected to sell 1,000 mowers
and earn operating income equal to $30,000 next year.
Whittier’s degree of operating leverage is equal to 2.5.
The company plans to increase sales by 20% next year.
Required:
1. Calculate the percent change in operating income
expected by Whittier for next year using the degree of
operating leverage.
2. Calculate the operating income expected by Whittier
next year using the percent change in operating
income calculated in Requirement 1.
© 2019 Cengage. All rights reserved.
Example 7.11: How to Calculate the Impact of Increased
Sales on Operating Income Using the Degree of Operating
Leverage (2 of 2)
Solution:
1. Percent Change in Operating Income = DOL ×
Percent Change in Sales
= 2.5 × 20% = 50%
2. Expected Operating Income = $30,000 + (0.5 ×
$30,000) = $45,000
© 2019 Cengage. All rights reserved.
Examples of Managerial Accounting
Seventh Edition
Chapter 8
Short-Run
Decision Making:
Relevant Costing
© 2019 Cengage. All rights reserved.
Short-Run Decision Making
•
•
•
•
•
Short-run decision making consists of choosing among
alternatives with an immediate or limited end in view
Also referred to as tactical decisions because they
involve choosing between alternatives with an
immediate or limited time frame in mind
Example: Accepting a special order for less than the
normal selling price to utilize idle capacity and to
increase this year’s profits
Some decisions tend to be short run in nature
Short-run decisions often have long-run consequences
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The Decision-Making Model (1 of 2)
•
•
A decision model, a specific set of procedures that
produces a decision, can be used to structure the
decision maker’s thinking and to organize the
information to make a good decision
The following is an outline of one decision-making
model:
– Step 1. Recognize and define the problem
– Step 2. Identify alternatives as possible solutions to the
problem. Eliminate alternatives that clearly are not
feasible
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The Decision-Making Model (2 of 2)
– Step 3. Identify the costs and benefits associated with each
feasible alternative. Classify costs and benefits as relevant
or irrelevant, and eliminate irrelevant ones from
consideration
– Step 4. Estimate the relevant costs and benefits for each
feasible alternative
– Step 5. Assess qualitative factors
– Step 6. Make the decision by selecting the alternative with
the greatest overall net benefit
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Step 1: Recognize and Define the Problem
•
The first step is to recognize and define a specific
problem.
– For example, if the members of a management team
recognized the need for additional productive capacity
as well as increased space for raw materials and
finished goods inventories, they would consider:
▪
▪
▪
▪
The number of workers and the amount of space needed
The reasons for the need
How the additional space would be used
However, the central question is how to acquire the
additional capacity
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Step 2: Identify the Alternatives as Possible
Solutions
•
•
•
The second step is to list and consider possible
solutions
Some alternatives are dismissed either because they
involve too much risk, or they are not proven, or they
are outside of cost constraints
One of the best strategies is to link the short-run
decision (like an increase in productive capacity) to the
company’s overall growth strategy by rejecting
alternatives that involved too much risk at a particular
stage of a company’s development
© 2019 Cengage. All rights reserved.
Step 3: Identify the Costs and Benefits
Associated with Each Feasible Alternative
•
•
•
In the third step, the costs and benefits associated with
each feasible alternative are identified
At this point, clearly irrelevant costs can be eliminated
from consideration
It is fine to include irrelevant costs and benefits in the
analysis as long as they are included for all
alternatives. We usually do not include them because
focusing only on the relevant costs and benefits
reduces the amount of data to be collected
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Step 4: Estimate the Relevant Costs and
Benefits for Each Feasible Alternative
•
The differential cost is the difference between the
summed costs of two alternatives in a decision
– Compares the sum of each alternative’s relevant costs
only
– Emphasis on differential cost allows decision makers to
occasionally include irrelevant costs in the alternatives if
they choose to do so
•
The inclusion of irrelevant costs is acceptable only if all
irrelevant costs are included for each alternative
© 2019 Cengage. All rights reserved.
Step 5: Assess Qualitative Factors (1 of 2)
•
Qualitative factors can significantly affect the
manager’s decision
– Political Pressure: Some managers worry that such
political pressure from customers can have long-term
negative effects on sales that more than offset the labor
cost savings that spurred the decision to offshore
– Product Safety: Product safety represents another key
qualitative factor for outsourcing organizations
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Step 5: Assess Qualitative Factors (2 of 2)
•
Qualitative factors, such as the impact of late orders
on customer relations, must be taken into
consideration in the final step of the decision-making
model—the selection of the alternative with the
greatest overall benefit
© 2019 Cengage. All rights reserved.
Step 6: Make the Decision (1 of 2)
•
•
•
Once all relevant costs and benefits for each
alternative have been assessed and the qualitative
factors weighed, a decision can be made
Ethical concerns revolve around the way in which
decisions are implemented and the possible sacrifice
of long-run objectives for short-run gain
Relevant costs are used in making short-run decisions
© 2019 Cengage. All rights reserved.
Step 6: Make the Decision (2 of 2)
•
•
Decision makers should always maintain an ethical
framework
Whenever relevant costing is used, it is important to
include all costs that are relevant—including those
involving ethical ramifications
© 2019 Cengage. All rights reserved.
Relevant Costs Defined
•
•
The decision-making approach just described
emphasized the importance of identifying and using
relevant financial items
Relevant costs (and revenues) possess two
characteristics:
–
–
•
•
they are future items AND
they differ across alternatives
All pending decisions relate to the future
Accordingly, only future costs and future revenues can
be relevant to decisions
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Opportunity Costs
•
•
•
Opportunity cost is the benefit sacrificed or foregone
when one alternative is chosen over another
An opportunity cost is relevant because it is both a
future cost and one that differs across alternatives
An opportunity cost is never an accounting cost,
because accountants do not record the cost of what
might happen in the future (i.e., they do not appear in
financial statements)
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Sunk Costs (1 of 2)
•
•
•
A sunk cost is a cost that cannot be affected by any
future action
It is important to note the psychology behind
managers’ treatment of sunk costs
Although managers should ignore sunk costs for
relevant decisions, it unfortunately is human nature to
allow sunk costs to affect these decisions
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Sunk Costs (2 of 2)
•
•
For example, depreciation, a sunk cost, is sometimes
allocated to future periods though the original cost is
unavoidable
In choosing between the two alternatives, the original
cost of an asset and its associated depreciation are
not relevant factors
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Cost Behavior and Relevant Costs (1 of 2)
•
•
•
•
Most short-run decisions require extensive
consideration of cost behavior
It is easy to fall into the trap of believing that variable
costs are relevant and fixed costs are not
But this assumption is not true
The key point is that changes in supply and demand
for resources must be considered when assessing
relevance
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Cost Behavior and Relevant Costs (2 of 2)
•
If changes in demand and supply for resources across
alternatives bring about changes in spending, then the
changes in resource spending are the relevant costs
that should be used in assessing the relative
desirability of the two alternatives
© 2019 Cengage. All rights reserved.
Some Common Relevant Cost Applications
•
Relevant costing is of value in solving many different
types of problems. Traditionally, these applications
include decisions:
–
–
–
–
•
to make or buy a component
to keep or drop a segment or product or service line
to accept a special order at less than the usual price
to further process joint products or sell them at the splitoff point
Though by no means an exhaustive list, many of the
same decision-making principles apply to a variety of
problems
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Make-or-Buy Decisions
•
•
Managers face the decision of whether to make a
particular product (or provide a service) or to purchase
it from an outside supplier
Make-or-buy decisions are those decisions involving a
choice between internal and external production
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Special Order Decisions
•
•
A company may consider offering a product or service
at a price different from the usual price
Firms have the opportunity to consider special orders
from potential customers in markets not ordinarily
served
– Special-order decisions focus on whether a specially
priced order should be accepted or rejected
– These orders often can be attractive, especially when
the firm is operating below its maximum productive
capacity
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Keep-or-Drop Decisions (1 of 2)
•
•
•
A manager needs to determine whether a segment,
such as a particular product or service line or a
geographic sales region, should be kept or dropped
Making effective keep-or-drop decisions requires that
managers identify and consider only the relevant
information of the business segment in question
A segment is a subunit of a company of sufficient
importance to warrant the production of performance
reports
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Keep-or-Drop Decisions (2 of 2)
•
•
Segmented reports prepared on a variable-costing
basis are important because they provide managers
with this valuable information
Both the contribution margin and the segment margin
shown on a segmented income statement are useful in
evaluating the performance of segments and, in
particular, identifying the relevant information
necessary for making effective keep-or-drop decisions
© 2019 Cengage. All rights reserved.
Segmented Income Statements Using
Variable Costing
•
•
Variable costing is useful in preparing segmented
income statements because it gives useful information
on variable and fixed expenses
In segmented income statements, fixed expenses are
broken down into two categories:
– direct fixed expenses and
– common fixed expenses
© 2019 Cengage. All rights reserved.
Direct Fixed Expenses
•
•
Direct fixed expenses are fixed expenses that are
directly traceable to a segment
These are sometimes referred to as avoidable fixed
expenses or traceable fixed expenses because they
vanish if the segment is eliminated
– For example, if the segments were sales regions, a
direct fixed expense for each region would be the rent
for the sales office
© 2019 Cengage. All rights reserved.
Common Fixed Expenses
•
•
Common fixed expenses are jointly caused by two or
more segments
These expenses persist even if one of the segments to
which they are common is eliminated
– For example, depreciation on the corporate
headquarters building or the salary of the CEO would be
a common fixed expense for most large companies
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Keep or Drop with Complementary Effects
•
•
•
•
A potential complication of a keep-or-drop analysis is
the implication such a decision might have on other
aspects of the business
Such implications must be included in the analysis
before making a final decision
Sometimes dropping one line would lower sales of
another line, as many customers buy both lines at the
same time
This information can affect the keep-or-drop decision
© 2019 Cengage. All rights reserved.
Further Processing of Joint Products
•
•
•
Joint products have common processes and costs of
production up to a split-off point. At that point, they
become distinguishable as separately identifiable
products
The point of separation is called the split-off point
Sometimes it is more profitable to process a joint
product further, beyond the split-off point, prior to
selling it (sell or-process-further decision)
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Product Mix Decisions (1 of 2)
•
•
•
Organizations have wide flexibility in choosing their
product mix
Product mix refers to the relative amount of each
product manufactured (or service provided) by a
company
Decisions about product mix can have a significant
impact on an organization’s profitability
© 2019 Cengage. All rights reserved.
Product Mix Decisions (2 of 2)
•
•
Every firm faces limited resources and limited demand
for each product. These limitations are called
constraints
A manager must choose the optimal mix given the
constraints found within the firm
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Multiple Constrained Resources (1 of 2)
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The presence of only one constrained resource might
not be realistic
Organizations often face multiple constraints, including:
– limitations of raw materials
– limitations of skilled labor
– limited demand for each product
© 2019 Cengage. All rights reserved.
Multiple Constrained Resources (2 of 2)
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The solution of the product mix problem in the
presence of multiple constraints is more complicated
and requires the use of a specialized mathematical
technique known as linear programming, which is
reserved for advanced cost management courses
© 2019 Cengage. All rights reserved.
Cost-Based Pricing (1 of 2)
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Demand is one side of the pricing equation; supply is
the other side
Since revenue must cover all costs for the firm to make
a profit, many companies start with cost to determine
price
That is, they calculate product (or service) cost and add
the desired profit
The mechanics of this approach involve a cost base
and a markup
© 2019 Cengage. All rights reserved.
Cost-Based Pricing (2 of 2)
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The markup is a percentage applied to the base cost
It includes desired profit and any costs not included in
the base cost
Companies that bid for jobs routinely base bid price on
cost
© 2019 Cengage. All rights reserved.
Target Costing and Pricing
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Many firms set the price of a new product as the sum of
the costs and the desired profit
The company must earn sufficient revenues to cover all
costs and yield a profit
Target costing is a method of determining the cost of a
product or service based on the price (target price) that
customers are willing to pay
The marketing department determines what
characteristics and price for a product are most
demanded by consumers
© 2019 Cengage. All rights reserved.