CMA Part 2. Volume 2: Sections C E. Financial Decision Making

Transcription

1 CMA Part 2 Volume 2: Sections C E Financial Decision Making

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3 Fifth Edition CMA Preparatory Program Part 2 Volume 2: Sections C E Financial Decision Making Brian Hock, CMA, CIA and Lynn Roden, CMA with Dave Fairchild, CMA, CPA

4 HOCK international, LLC P.O. Box 204 Oxford, Ohio (866) 807-HOCK or (866) (281) Published May 2010 Acknowledgements Acknowledgement is due to the Institute of Certified Management Accountants for permission to use questions and problems from past CMA Exams. The questions and unofficial answers are copyrighted by the Certified Institute of Management Accountants and have been used here with their permission. The authors would also like to thank the Institute of Internal Auditors for permission to use copyrighted questions and problems from the Certified Internal Auditor Examinations by The Institute of Internal Auditors, Inc., 247 Maitland Avenue, Altamonte Springs, Florida USA. Reprinted with permission. The authors also wish to thank the IT Governance Institute for permission to make use of concepts from the publication Control Objectives for Information and related Technology (COBIT) 3rd Edition, 2000, IT Governance Institute, Reproduction without permission is not permitted HOCK international, LLC No part of this work may be used, transmitted, reproduced or sold in any form or by any means without prior written permission from HOCK international, LLC. ISBN:

5 Thanks The authors would like to thank the following people for their assistance in the production of this material: Kevin Hock for his work in the formatting and layout of the material, All of the staff of HOCK Training and HOCK international for their patience in the multiple revisions of the material, The students of HOCK Training in all of our classrooms and the students of HOCK international in our Distance Learning Program who have made suggestions, comments and recommendations for the material, Most importantly, to our families and spouses, for their patience in the long hours and travel that have gone into these materials. Editorial Notes Throughout these materials, we have chosen particular language, spellings, structures and grammar in order to be consistent and comprehensible for all readers. HOCK study materials are used by candidates from countries throughout the world, and for many, English is a second language. We are aware that our choices may not always adhere to formal standards, but our efforts are focused on making the study process easy for all of our candidates. Nonetheless, we continue to welcome your meaningful corrections and ideas for creating better materials. This material is designed exclusively to assist people in their exam preparation. No information in the material should be construed as authoritative business, accounting or consulting advice. Appropriate professionals should be consulted for such advice and consulting.

6 Dear Future CMA: Welcome to HOCK international! You have made a wonderful commitment to yourself and your profession by choosing to pursue this prestigious credential. The process of certification is an important one that demonstrates your skills, knowledge and commitment to your work. We are honored that you have chosen HOCK as your partner in this process. We know that this is a great responsibility, and it is our goal to make this process as painless and efficient as possible for you. To do so, HOCK has developed the following tools for your use: A Study Plan that guides you, week by week, through the study process. You can also create a personalized study plan online to adapt the plan to fit your schedule. Your personalized plan can also be ed to you at the beginning of each week. The Textbook that you are currently reading. This is your main study source and contains all of the information necessary to pass the exam. This textbook follows the exam contents and provides all necessary background information so that you don t need to purchase or read other books. The Flash Cards include short summaries of main topics, key formulas and concepts. You can use them to review whenever you have a few minutes, but don t want to take your textbook along. ExamSuccess contains original questions and questions from past exams that are relevant to the current syllabus. Answer explanations for the correct and incorrect answers are also included for each question. Practice Questions taken from past CMA Exams that provide the opportunity to practice the essay-style questions on the Exam. Teacher Support via our online student forum, , and telephone throughout your studies to answer any questions that may arise. Class Recordings are audio recordings of classes conducted and taught by HOCK lecturers. With the Class Recordings you are able to have the benefits of attending classes without actually being required to be near a location where classes are held. We understand the commitment that you have made to the exams, and we will match that commitment in our efforts to help you. Furthermore, we understand that your time is too valuable to study for an exam twice, so we will do everything possible to make sure that you pass the first time. I wish you success in your studies, and if there is anything I can do to assist you, please contact me directly at brian.hock@hockinternational.com. Sincerely, Brian Hock, CMA, CIA President and CEO

7 CMA Part 2 Table of Contents Table of Contents Section C Decision Analysis and Risk Management... 1 Introduction to the Decision Analysis and Risk Management Section 1 The Decision-Making Process... 2 Marginal Analysis... 3 Relevant Information 3 Decision-making About Production Using Economics Concepts 6 Average Cost 10 Costs and Cost Objects 10 Cost Behavior Patterns 12 Marginal Analysis Applications Make-or-Buy Decisions 14 Special Order Decisions 17 Sell or Process Further Decisions 21 Disinvestment Decisions 23 Pricing Impact of Market Structure on Pricing 26 Impact of Supply and Demand on Pricing 27 Short-Run Equilibrium Pricing 32 Pricing Strategy Internal Factors Affecting Pricing Decisions 37 External Factors Affecting Pricing Decisions 38 Short-Run and Long-Run Pricing Decisions 42 Cost-Plus and Target Pricing Used Together 45 Product Life-Cycle Pricing and Costing 45 Product Life-Cycle (PLC) Strategies 46 Other Considerations in Price Setting 49 Illegal Pricing 50 Cost-Volume-Profit (CVP) Analysis Contribution Margin Income Statement 53 Breakeven Analysis 54 Profit Requirement 57 Using Breakeven Analysis in Decision-Making 62 Breakeven Analysis when More than One Product Is Sold Sales Quantity Mix (Dollar Amount of Contribution per Basket) 65 Sales Revenue Mix (Contribution Margin Ratio for the Basket) 67 Effect of Changes in Sales Mix 68 Choosing Between Two Cost Options 70 Choosing Between Production Options 71 i

8 Table of Contents CMA Part 2 Fixed Versus Variable Cost Inputs 73 Product-Mix Decisions Under Constraints 76 CVP and Conditions of Risk and Uncertainty The Use of Sensitivity Analysis With CVP Analysis 77 Expected Value 79 Deterministic Approach 79 High-Low Points Method Risk Assessment Four Categories of Risk 84 Concepts of Losses 85 Responses to Risk 86 Inherent Risk and Residual Risk 87 Benefits of Risk Management 88 The Steps in the Risk Management Process 88 Managing Operational Risk 89 Financial Risk Management Methods 89 Qualitative Risk Assessment Tools 90 Quantitative Risk Assessment Tools 91 Enterprise Risk Management Cost-Benefit Analysis In Risk Assessment and Decision Making 94 Risk Measurement in Banks 94 Section D Investment Decisions Introduction to the Investment Decisions Section 95 Capital Budgeting Process The Stages in Capital Budgeting Terms Used in Capital Budgeting 98 Identifying and Calculating the Relevant Cash Flows Other Tax Considerations 105 Example of Calculation of After-Tax Relevant Cash Flows 106 Capital Budgeting Methods Payback Method 108 Discounted Payback Method 111 Bailout Payback 113 Discounted Cash Flow Methods Net Present Value (NPV) Method 117 Using NPV 117 Internal Rate-of-Return (IRR) 124 The Accounting Rate of Return 130 The Profitability (or Excess Present Value) Index 131 ii

9 CMA Part 2 Table of Contents Use of the Profitability Index 133 Difficulties With the Different Capital Budgeting Methods Capital Rationing in Capital Budgeting Internal Capital Markets as an Alternative Solution to Capital Funding Limitations 136 Capital Budgeting and Inflation Summary and Review of Relevant Cash Flows Risk in Capital Budgeting Types of Risk 148 Analysis of Risk 149 Adjustments to the Discount Rate for Risk or Inflation 156 Real Options in Capital Budgeting Decision Trees and Valuing Real Options 161 Other Methods of Valuing Real Options 167 The Qualitative Factor in Capital Budgeting Decisions Valuation Valuation of Stock 169 Valuing Businesses, Business Segments, and Business Combinations 174 Addressing Risk in Business Valuation 181 Section E Professional Ethics Ethical Considerations for the Organization Appendix A Time Value of Money (Present/Future Value) Appendix B Example of IRR Answers to Questions iii

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11 Section C Section C Decision Analysis and Risk Management Section C Decision Analysis and Risk Management Introduction to the Decision Analysis and Risk Management Section The Decision Analysis and Risk Management section represents 25% of the CMA Part 2 exam. The exam is a four-hour exam that will contain 100 multiple-choice questions and 2 essay questions. Topics within an examination part and the subject areas within topics may be combined in individual questions. Therefore, we cannot predict how many multiple choice questions you may get from this section, nor can we predict whether you will get any essay questions from this section. The best approach to preparing for this exam is to know and understand the concepts well and be ready for anything. There are basically four main parts to this section: Marginal analysis, Pricing, Cost-volume-profit analysis (or breakeven analysis), and Risk Management In marginal analysis, you need to be able to recognize relevant revenues and costs as well as irrelevant ones in order to make a decision in a question to determine what minimum price will be charged for the product, or whether or not the company should accept the one-time order, for example. This requires a solid understanding of variable and fixed costs. While variable costs are usually relevant and fixed costs usually are not, that is not always the case. In pricing, you must understand the different cost bases that are used to calculate the price, and you may also need to calculate the necessary price in order to achieve some specific goal of the company. In CVP analysis you will need to be able to calculate the number of units (or the sales revenue) required to break even, and also calculate additional items, such the number of units above or below breakeven, including how many units need to be sold to achieve a certain profit level. 1

12 The Decision-Making Process CMA Part 2 The Decision-Making Process No matter what position someone has within a firm, if they are in management or in planning, their job requires decision-making. The goal of decision-making is to maximize the benefits and/or reduce the costs to the company by selecting the best option from among the available options. While on the surface this seems easy enough, determining the best option is not always easy. Many times this is because the company may have more than one objective that it is trying to meet. An option that is the best choice for one objective may not be the best option for another objective. In these situations, it is important that top management has communicated the goals of the organization so individuals know which objective is more important. As a starting point, some of the types of decisions managers make every day are: 1) Pricing. Should the price be based upon our costs, or upon the market (target pricing)? Will a customer be profitable enough to justify aggressive pricing? 2) Alternative manufacturing options. What is the most cost-efficient and best way to manufacture the product? What is the most profitable output level? Should a one-time special order be accepted? 3) Research and development. What new products should we be exploring? 4) Marketing. What or who is our target market? What is the best way to reach that market? Is an individual customer profitable, or should that customer be dropped? 5) Distribution. What is the best way (or ways) to deliver the product? 6) Contract negotiations. What must the company attain in a negotiating situation in order to operate profitably? 7) Outsourcing decisions. These are essentially make-or-buy decisions. 8) Capital budgeting decisions. Should a proposed long-term project, such as a new plant or a product line, be implemented? Should an unprofitable branch be closed? Note: Factors and information that are relevant to a decision will probably include both quantitative and qualitative items. Qualitative factors are factors that cannot be measured in numerical terms, such as employee morale. Although qualitative factors cannot be measured numerically, they can be judged and assessed and, therefore, they may be very relevant in decision-making. For example, if the company is going to choose to buy from outside, management must be certain that the product will be manufactured to the necessary quality standards and delivered in a timely manner. If either of these will not be met, the company would probably be better off continuing to make the product, even if this is the more expensive option. The company must also assess the social impact and the reaction of the public if they close a factory or lay off workers as a result of buying from the outside instead of producing internally. Quantitative factors are those that can be measured in numerical terms. Some quantitative factors are financial, such as costs of direct materials, direct labor and selling costs. Other quantitative factors are nonfinancial, such as reduction in product development time or improvements in customer service. 2

13 Section C Marginal Analysis Marginal Analysis Relevant Information In decision-making, one of the primary challenges is distinguishing between factors that are relevant to the decision and those that are not relevant. Relevant revenues and relevant costs are those expected future revenues and costs that differ among alternatives. Only relevant revenues and costs need to be considered in the decision-making process. This is because: It is important to focus on the future since nothing can be done to change past costs that have already been incurred (called sunk costs). Because decisions focus on selecting future courses of action, sunk costs are irrelevant to the decision process. We must focus only on the factors that differ among alternatives. Revenues and costs that are the same between options are not relevant because they will be the same no matter which option is selected. In considering what factors to include in the decision process, we must ask ourselves, What difference will this decision make? What will be different as a result of making this decision versus a different decision? Marginal Costs and Marginal Revenues Marginal costs and marginal revenues are the addition to total cost or the addition to total revenue that results from a one-unit increase in production. The terms can also be used in the context of decision analysis to refer to the addition to total cost or the addition to total revenue that would result from a project that is under consideration. Incremental and Differential Costs Relevant revenues and costs are further classified as incremental revenues and costs or differential revenues and costs. The terms incremental and differential are often used interchangeably; however, they are not the same. Incremental revenues and costs are incurred additionally as a result of an activity. Differential revenues and costs are those that differ between two alternatives. As an illustration of a differential cost, let s say a company s existing machine has worn out and can no longer be repaired. Management has a choice: it can either replace the worn-out machine with an updated model of the same type; or it can upgrade to a fully automated, totally different system. Keeping things as they are is not an option. The company has to buy one machine or the other. So the difference in costs between the replacement machine and the upgraded machine the differential costs are the relevant costs in this decision. The cost of doing nothing is not relevant, because it is not an option. On the other hand, if the old machine were not worn out, then the choice would be between keeping the old machine at its existing costs and upgrading to a new machine. The relevant costs would be the difference between the costs for the old machine and the costs for the upgraded machine. These costs would be incremental costs. Avoidable and Unavoidable Costs Avoidable and unavoidable costs are another classification of costs that is part of the relevant cost discussion. An avoidable cost is a cost that can be avoided if a particular option is selected. It is a cost that would go away. For example, if production is outsourced, the variable cost to produce the product in-house will go away and be replaced by the cost to purchase the product externally. Avoidable costs are relevant costs to the decision-making process because they will continue if one course of action is taken but they will not continue if another course of action is taken. An unavoidable cost is an expenditure that will not be avoided (i.e., will not go away) regardless of which course of action is taken. Continuing the example from above, an unavoidable cost would be a payment on a noncancelable lease for production equipment that would have to continue to be paid even if production were outsourced. 3

14 Marginal Analysis CMA Part 2 Avoidable and unavoidable costs are relevant in a decision to close a plant or other business unit. If closing the unit would avoid certain costs, those avoidable costs are relevant to the decision. Unavoidable costs, however, are irrelevant because they do not differ between the two alternatives. If the fixed plant costs would continue even if the plant were closed, those fixed plant costs are unavoidable costs and they are not relevant to the decision. A central administrative cost that has been allocated to a division is another example of an unavoidable cost, because if that division were to be closed, the cost would continue to be incurred by central administration. It would simply be allocated to another division or divisions. So for the company as a whole, it would not differ between the two alternatives of closing the division or keeping it open. Only costs that would be avoided (i.e., costs that would go away) if the division were closed are relevant to the decision to close a division or not close it. Sunk Cost As mentioned above, a sunk cost is a cost for which the money has already been spent and cannot be recovered. Sunk costs are not relevant to decision-making because they will not be any different regardless of what decision is made. Explicit and Implicit Costs An explicit cost is a cost that can be identified and accounted for. Explicit costs represent obvious cash outflows from a business. On the other hand, an implicit cost is an implied cost. It is more difficult to identify, and it does not clearly show up in the accounting records, although it is there. Opportunity Costs Relevant revenues and costs may include opportunity costs. An opportunity cost is the contribution to income that is forgone by not using a limited resource in its best alternative use. Opportunity costs are examples of implicit costs. Opportunity costs can and should be estimated in any decision where they are a factor. For instance, in a make-or-buy decision, if the facilities to make an item could be used in the production of an alternative item, the contribution to income from the alternative item (the item that is foregone to use the facilities to make the first item) is an opportunity cost, if the first item is made. The relevant portion of the opportunity cost is the difference between the contribution to income that could be earned on the alternative item and the contribution to income that can be earned on the item to be produced. When calculating the opportunity cost, it is critical to keep in mind that the opportunity cost is calculated only from the revenues that would not be received and expenditures that would not be made for the other available alternatives. Similarly, any interest cost that is part of the opportunity cost can only be calculated for the time period when the cash flows are different between or among the options. Note: Opportunity costs exist only if there is a constraint (limitation) on the availability of a resource. If there is no constraint, there is no opportunity cost because all of the available options are able to be selected. For example, if a company has unused production capacity, it can accept a new order without having to stop production of other orders. But if the company is producing at capacity, to accept a new order it would need to stop production of another order or orders. Although the company would earn a contribution margin from the production of the new order, it would have to give up the contribution margin it could have earned from the other order(s) that it can t produce. The contribution margin given up is an opportunity cost that should be included in the cost of the new order in deciding whether or not to accept the new order. 4

15 Section C Marginal Analysis Relevant Revenues Like relevant costs, relevant revenues are revenues that differ between or among alternatives. In a decision about whether or not to invest in a new project, the forecasted revenues that the project would generate are relevant revenues. Summary: Revenues and costs are relevant if they: 1) Occur in the future, and 2) Differ among the various alternatives available. Question 1: American Coat Company estimates that 60,000 special zippers will be used in the manufacture of men's jackets during the next year. Reese Zipper Company has quoted a price of $.60 per zipper. American would prefer to purchase 5,000 units per month, but Reese is unable to guarantee this delivery schedule. In order to ensure availability of these zippers, American is considering the purchase of all 60,000 units at the beginning of the year. Assuming American can invest cash at 8%, the company's opportunity cost of purchasing the 60,000 units at the beginning of the year is: a) $2,640 b) $1,320 c) $1,500 d) $1,440 (CMA Adapted) Question 2: A printing company is considering replacing an old printing press. The old printing press has a book value of $24,000 and a trade-in value of $14,000. A new printing press would cost $85,000 after trade-in of the old press. It is estimated that the new printing press would reduce operating costs by $20,000 per year. If the company decides not to purchase the new press, the $85,000 could instead be used to retire debt that is currently costing $9,000 per year in interest. Which of the given is an example of a sunk cost? a) The trade-in value of the old printing press. b) The interest on the existing debt. c) The estimated reduction in operating costs. d) The book value of the old printing press. (CIA Adapted) Differences Between Economic and Accounting Concepts of Costs One of the major distinguishing factors between accountants and economists in the way they evaluate situations depends on the concept of opportunity cost. Accountants ignore the opportunity cost because it is hard to calculate due to a lack of precise numbers and costs. The notion of opportunity cost, however, is an important part of decision making, because opportunity costs are different between alternatives just as surely as accounting costs are, and so they are relevant to the decision. For the economists, not only the typical costs such as monetary expenditures are part of all the costs that a company or an individual incur, but the forgone alternatives that had to be dismissed in order to achieve that one goal should also be considered. For example, in order to make a deal a businessperson has to devote 5

16 Marginal Analysis CMA Part 2 time to prepare for the contracts and negotiations, and that is the forgone time that can no longer be used for another deal. Hence, this lost time is also part of the costs that should be considered. Similarly, a truck that is carrying aluminum cannot simultaneously (at the same time) transfer iron. Comparing how much a company is giving up if it chooses to carry aluminum instead of iron is part of the determination of the opportunity cost and economic costs in general. Opportunity cost guides decisions on how to distribute resources the most efficient way and that is why it is important in determining economic costs. It highlights not only the monetary costs associated with each action, but the forgone time and use of resources, creating a bigger picture of the total effort that must be undertaken. It is important to understand that opportunity cost is the cost of the next best alternative or the next highest valued alternative. It is the price of not only some other alternative that should be considered, but also the highest other opportunity that is given up in order to achieve one project. In calculating economic costs and in making decisions, both explicit and implicit costs must be used. In the accounting perspective, only explicit costs are considered. Decision-making About Production Using Economics Concepts The responsiveness of consumers to changes in the price of a good must be considered in the profitmaximizing decisions of a financial manager. Optimal decision-making requires information derived from marginal analysis. Marginal Analysis Marginal analysis is the process of looking at one more unit and asking, what will be the effect of selling/producing one more unit? There are many different marginal measures that can be used, some of which we have already discussed. Marginal Revenue Marginal Cost Marginal Profit Marginal Product (or Marginal Physical Product) Marginal Resource Cost Marginal Revenue Product The addition to total revenue gained by producing an additional unit of output. The addition to total cost by increasing production by one unit. Marginal revenue minus marginal cost. This is the additional profit that the company would get by producing and selling one more unit. The additional output that is produced from adding one additional unit of input. The change in the total cost that results from using one additional unit of a resource. This is the change in total revenue that arises from using one more unit of a resource. Marginal Revenue Marginal revenue is the additional revenue that a firm receives when it increases output and sales by one more unit. If a company is producing and selling 1,000 units per month and it increases that to 1,001 units, it will take in some additional amount of revenue each month. In order to understand how much total revenue will increase when production increases by one unit, though, it is necessary to understand the difference in the various economic market structures, because marginal revenue behaves differently under different market structures. The market structures are covered in detail in the HOCK Assumed Knowledge e-book, Vol. 1, so they will be described just briefly here. 6

17 Section C Marginal Analysis Perfect competition In a perfectly competitive market, there are many buyers and sellers and customers are indifferent as to which seller they buy from. The product is standardized, so the same product is available from every seller. Sellers in a perfectly competitive market can sell as much of their product as they want to at the market price. If they try to charge more than the market price, they will sell nothing. If they drop their price below the market price, they can still sell as much of their product as they want to. But if they drop their price below the market price, their total revenue will be lower than it could have been, because they could have sold the same amount at the market price and earned more total revenue. In a perfectly competitive market, the marginal revenue from the sale of one more unit is equal to the market price. Monopoly A natural monopoly exists when economic and technical conditions are present in the industry or economy that permit only one efficient supplier in a location. A common example of a natural monopoly is a municipal water company. Characteristics of a monopoly include a single supplier of a product that is unique where there are very high barriers to entry for new suppliers. A monopoly has control over the price it charges, in contrast to the perfectly competitive firm that must sell its product at the market price. Even though the monopolist has control over the price it charges, it cannot increase prices and expect to sell the same amount of product. The monopolist faces a downward sloping demand curve, and when it increases its prices, it sells fewer units. Similarly, when it decreases its prices, it will sell more units. The marginal revenue curve of a monopolist is below its demand curve because as production increases, a monopolist that charges the same price for all of its output will have to lower its price in order to get consumers to buy the additional output. Therefore, the additional (marginal) revenue received from producing an additional unit will be less than the price received for that unit. This idea is illustrated in the example below. Price Quantity Sold Total Revenue Marginal Revenue $ 20 0 $ $ (2) Monopolistic Competition There are many firms operating in the market, and they do not collude with one another in setting prices. The products produced by the various firms are similar but not identical. There are differences among them. The firms in the market have limited control over prices, even though there are many firms, because of the differences in the products. One firm can charge more than another one because of offering more features, and so forth. Just as with a monopoly, firms operating under monopolistic competition have marginal revenue curves that are below the demand curve. So a firm in monopolistic competition must also drop its price in order to sell additional units, although this is mitigated somewhat by the product differentiation. Oligopoly In an oligopoly, there are only a few firms operating in the market. Each one is affected by what the others do. The market can be either for standardized or for differentiated products. Participants in an oligopolistic market will exhibit strategic behavior, meaning that each company will consider the impact of its actions on its competitors and the reaction that it expects from its competitors. In an oligopoly, it is theorized that a price decrease by one company will usually be matched by others price decreases, but a price increase by one company will usually not be followed by the other companies. 7

18 Marginal Analysis CMA Part 2 Thus, if one firm increases its price, it will lose volume to the other producers since they will not increase their prices and thus they will secure more volume. If the other firms did not match the lower price, a price decrease by one firm would allow that firm to capture more of the market. However, competitors tend to match a price decrease; so any increase in volume that the firm would received would not be enough to offset the lower price, and total revenue will decrease. Given that there is a negative effect to either increasing or decreasing the price, prices in an oligopoly tend to be sticky (meaning that they do not change easily). Marginal Revenue for a Firm in Monopolistic Competition For a firm in monopolistic competition, marginal revenue typically declines as production and sales increase, because companies generally must cut their prices in order to increase their sales. Note that price cuts apply to all units sold, not just to the incremental increases in sales. For example, let s say that during a one month period, a monopolistically competitive company could set the price of its product at $420 per unit, and it could sell 4 units at that price for a total revenue of $1,680. Or, it could drop its price to $400 per unit, and it would be able to sell 5 units, for a total revenue of $2,000. The company would not have been able to sell 4 units at $420 per unit and then drop the price and sell 1 more unit at $400 per unit, however. If it had tried to do that, the month would have been over by the time the first 4 units had been sold! So at the beginning of the month, the company must set the price at $400 per unit if it wants to sell 5 units, and it must sell all 5 units at that lower price. During that month, it will sell 5 units instead of 4 units. Its total revenue is $2,000 (5 $400), and that is $320 more than the $1,680 that total revenue would have been if it had set the price at $420 per unit (4 $420). So the marginal revenue of the additional unit is $320 ($2,000 $1,680). Here is the schedule of marginal revenue for this firm: Price/ Unit Units Sold Total Revenue Marginal Revenue $480 1 $ 480 $ , , , , , , Notice that the marginal revenue falls with each price decrease. Also notice that the marginal revenue on each line is lower than the price. Marginal Cost As total revenue increases, total cost is also increasing. The interaction of revenue and costs is what creates profits. It does no good to increase total revenue if total cost increases by more than the increase in total revenue. When that happens, profit decreases. Remember the difference between accounting cost and economic cost. For the economists, not only the typical costs such as monetary expenditures are part of all the costs that a company or an individual incur, but the forgone alternatives that had to be dismissed in order to achieve that one goal should also be considered. So whenever we talk about accounting concepts such as marginal cost, average cost, and so forth, we are talking about both the explicit and the implicit, or opportunity, costs. Marginal cost, also called incremental cost, is the additional cost (including opportunity cost) that results from increasing production by one more unit. As production increases, marginal cost generally decreases, up to a point. However, further production increases beyond that point lead to increasing marginal costs. 8

19 Section C Marginal Analysis Here is a schedule of marginal costs for our firm: Cost/ Units Unit Produced Total Cost Marginal Cost $850 1 $ 850 $ , , , , , , , Marginal Revenue and Marginal Cost Output should be planned so that the Marginal Revenue = Marginal Cost. This is the point of production and sales that will maximize profit. Sales beyond this point produce a loss on each additional (marginal) item and will decrease the total profit of the firm. For a firm in monopolistic competition, the marginal revenue from selling another unit declines as volume increases. The marginal cost of production declines up to a point as production increases, and beyond that point, it tends to increase. A firm should expand production so long as the marginal revenue from selling another unit exceeds the marginal cost, since selling this additional unit this will cause total profit to increase. Production should stop at the point where marginal revenue equals marginal cost, because if it expands beyond this point, the increasing marginal cost of production will rise above the marginal revenue, and profit will decline. Profit Now, let s put the two charts together and calculate the profit at each level of production and sales. Units Price/ Cost/ Produced Total Marginal Total Marginal Unit Unit and Sold Revenue Revenue Cost Cost Profit $480 $850 1 $ 480 $480 $850 $850 $(370) , (180) , , , , , , , , , , , , (160) The highest profit is at the level of 5 units. That is also the point where marginal revenue is equal to marginal cost: the point where both are $320. At the point where 6 units are produced and sold, profit begins to drop. Therefore, it would not be profitable for this firm, under its current cost structure, to produce more than 5 units per month. 9

20 Marginal Analysis CMA Part 2 Average Cost Average cost per unit is the total cost divided by the total units produced. Here is a schedule for our firm of its average costs at each volume level. As you can see, average cost is also equal to the cost per unit at each level of production. Cost/ Units Total Average Unit Produced Cost Total Cost $850 1 $ 850 $ , , , , , , , Average total cost can be split into average fixed cost, which is total fixed cost divided by the total units produced, and average variable cost, which is total variable cost divided by the total units produced. Average variable cost rises or falls as production increases, but average fixed cost declines continuously as production increases, because the total fixed cost is being divided by an ever-increasing level of production. Here is our firm s cost schedule again, this time divided between fixed and variable costs: Total Cost/ Units Total Fixed Variable Average Average Unit Produced Cost Cost Cost Fixed Cost Variable Cost $850 1 $ 850 $630 $ 220 $ , , , , , , , , , , , Costs and Cost Objects Many costs that the management accountant works with are not recorded in the accounting system. Future costs, replacement costs, incremental costs and opportunity costs are all involved in decision-making but are not recorded in the accounting system. Though all expenses (items recognized in the accounting records) are costs, not all costs are expenses. A cost could be an expense, or it could represent an asset for example, inventory purchased. A building might cost $1,000,000 to purchase (the cost is an asset in this case), or it might cost $100,000 a year to rent (the cost is an expense in this case). In this section, we are interested more in the cost object than in whether it is accounted for as an asset or as an expense. A cost object is any item or activity for which we can measure the costs. It answers the question, The cost of what? In both of the situations mentioned above in respect to the building, the cost object is the building. 10

21 Section C Marginal Analysis Examples of cost objects: A product A batch of like units A customer order A contract A product line A process A department A division A project A strategic goal The proper identification of the cost object is important because it affects any cost measurement that is undertaken. For instance, whether a cost is considered to be a direct cost or an indirect cost depends on the cost object. If the cost object is the company s Montvale, New Jersey plant, the plant manager s salary is a direct cost, because it can be traced directly to that cost object. However, if the cost object is one of the products manufactured in the Montvale, New Jersey plant, the plant manager s salary is an indirect cost, because it is not traceable directly to any one product but is allocated among all the products produced. Allocation is the assignment of indirect costs to a particular cost object. Cost assignment is the general term that refers to both (1) tracing costs to a cost object, and (2) allocating costs to a cost object. We will look at each of these terms in more detail. Tracing and Allocating Costs Cost tracing means assigning direct costs to a particular cost object. Direct costs (also called traceable costs) are costs that are incurred specifically because of the cost object. If it were not for the cost object, the direct cost would not have been incurred. Traceable costs may be raw materials that can be identified as part of a finished product. Direct labor required to convert the raw materials into a finished product can also be directly traced to the product. The traceability of other costs is less clear. For example, should the cost of defective units be included in the cost of good units? Whether they should be, and if so how much, depends on how management wants to use the information. Setup costs can be identified with a batch; so if the batch is defined as the cost object, setup costs can be considered directly traceable. However, if the cost object is an individual unit produced, setup costs can only be allocated to each individual unit. Cost allocation is the process of assigning costs other than direct costs to cost objects according to some predetermined formula or allocation base. The accurate and proper tracing and allocation of costs is important because without it, the cost of producing each item will be calculated incorrectly. If the cost is calculated incorrectly, the company may not be able to price its product properly and will run the risk of either pricing it too low, thereby losing money on each sale, or too high and not selling enough units. 11

22 Marginal Analysis CMA Part 2 Other Factors in Cost Classifications Whether a particular cost will be classified as direct or indirect depends on several factors. Among these are: Materiality. It must be economically feasible to trace a cost to a particular cost object. Therefore, the greater the amount of the cost, the more likely it is to be traced as a direct cost to a cost object. Available technology. Technology can make it economically feasible to trace costs that at one time would have been considered indirect. For example, bar codes on component parts can be scanned at each point in the production process, thereby tracing the parts and their costs to the end product. Organizational design. It is easier to classify a cost as a direct cost if the company is organized in such a way that a given facility is used exclusively for a specific cost object such as a specific product. Contractual arrangements. A production contract may specify a specific component for use in a product, which makes it easier to classify that component as a direct cost of that product. Cost Behavior Patterns There are two main types of cost behavior patterns: 1) Variable Costs change in total in proportion to changes in the level of activity. A variable cost is constant on a per-unit basis. For example, a cost of $6 per unit is a variable cost. Direct materials are a variable cost. 2) Fixed Costs do not change in total as long as the volume remains within a designated range, known as the relevant range. This means that, within the relevant range, the cost per unit changes as the volume changes, but the total remains the same. For example, a cost of $100,000 for a volume of between 50,000 and 80,000 means that the per-unit cost will be $2 per unit at a volume of 50,000 and only $1.25 per unit at a volume of 80,000. Furthermore, some costs may be either fixed or variable, depending on the circumstances. What is a variable cost under one circumstance may be a fixed cost under other circumstances. For example, direct labor will ordinarily be a variable cost. However, in some instances it could be a fixed cost if, for instance, a labor contract prohibits layoffs. It is important to review all relevant information before deciding whether a cost is fixed or variable. Mixed Costs In reality, many costs are a combination of fixed and variable elements. These are mixed costs. Mixed costs may be semi-variable costs or semi-fixed costs. A semi-variable cost has both a fixed component and a variable component. There is a basic fixed amount that must be paid regardless of activity, even if there is no activity. And added to that fixed amount is an amount which varies with activity. Utilities are an example. Some basic utility expenses are required just to maintain a factory building, even if no production is taking place. Electric service, water service, and other utilities usually must be continued. So that basic amount is the fixed component of utilities. If production begins (or resumes), the cost for utilities increases by a variable amount, depending upon the production level. But the fixed amount does not change. Another example of a semi-variable cost is a salesperson who receives a base salary plus a commission for each sale made. The base salary is the fixed component of the salesperson s salary, and the commission is the variable component. 12

23 Section C Marginal Analysis A semi-fixed cost, also called a step cost, is fixed over a given, small range of activity, and above that level of activity, the cost suddenly jumps. It stays fixed again for a while at the higher range of activity, and when the activity moves out of that range, it jumps again. A semi-fixed cost moves upward in a step fashion, staying at a certain level over a small range and then moving to the next level quickly. All fixed costs behave this way, and a wholly fixed cost is also fixed only as long as activity remains within the relevant range. However, a semi-fixed cost is fixed over a smaller range than the relevant range of a wholly fixed cost. An example of a semi-fixed cost is the nursing staff in a hospital. If the hospital needs one nurse for every 25 patients, then each time the patient load increases by 25 patients, one additional nurse will be hired and total nursing salaries will jump by the additional nurse s salary. That is in contrast to administrative staff salaries at the same hospital, which might remain fixed until the patient load increases by 250 patients, at which point an additional admitting clerk would be needed. The administrative staff salaries are wholly fixed costs (over the relevant range), whereas the nursing staff salaries are semi-fixed costs. The difference between a semi-variable and a semi-fixed cost is that the semi-variable cost starts out at a given base level and moves upward smoothly from there as activity increases. A semi-fixed cost moves upward in steps. Cost Drivers A cost driver is a characteristic of an activity that affects costs, such as a given level of activity or volume over a given time span. A change in the level of activity or volume affects the level of that cost object s total costs. For a variable cost, the cost driver is the level of activity or volume. A fixed cost has no cost driver in the short run, because fixed costs are fixed over the relevant range. However, in the long run, all costs are variable costs. This is the case because once the time period for which a cost is fixed (for example, a 10- year lease agreement will cause rent to be fixed cost) is over, the cost can again be looked at and may become variable. This means that over the long run, the cost driver for a fixed cost is also the level of activity or volume. Other Cost Terms An imputed cost is one that does not show up in the accounting records and is not a cash outlay, but it represents a cost that must be considered in decision-making. An opportunity cost is a type of imputed cost. For example, if a business uses space in its own production activities that it could have rented out to a tenant, the rent that it could have received and did not receive is an imputed cost. A postponable cost is a cost that may be delayed to a future period with very little, if any, effect on the current operations and efficiency of the company. (Example: Training costs may be, and commonly are, delayed during a difficult financial period because training has a long-term rather than a short-term impact.) Whether these items are relevant or not will depend on the different options available. Income Tax Effects in Decision Making In any analysis including incremental or differential revenues or costs, the tax effects must be included in the analysis. A net incremental revenue should be reduced by the resulting tax liability. A net incremental expense is also reduced by the tax benefit that results from the tax deductible expense. Differences in depreciation expense between one alternative and another alternative, if not included with other expenses, should be used to calculate the depreciation tax shield. Depreciation expense is a tax-deductible expense. The amount of tax savings that results is called a depreciation tax shield. It is usually calculated as the amount of the depreciation multiplied by the company s tax rate. The amount of change in tax-deductible depreciation will cause an equivalent change (either an increase or a reduction) in the company s taxable income. That will, in turn, cause a change in the amount of tax that will be due and a change in the depreciation tax shield. The depreciation tax shield will be covered in more detail in the section on Capital Budgeting in this textbook. 13

24 Marginal Analysis Applications CMA Part 2 Marginal Analysis Applications Marginal analysis is the process of making a decision between or among two or more alternatives. A company makes these decisions based upon which opportunities will provide the most benefit to the company. As we have already covered, in this process of making the decision, a company must focus only on the incremental or differential revenues and costs of the projects, rather than the total revenues and costs. This is because these are the only relevant revenues and costs for the company. The types of situations in which marginal analysis may be used are: Make-or-buy decisions (insourcing versus outsourcing products and services), Accepting or rejecting a one-time special order, Introduction of a new product or a change in output levels of existing products, Adding or dropping product lines or divisions, and Selling or processing further decisions. Note: In marginal analysis, total costs per unit are irrelevant because they include some costs that are not incremental, such as fixed overhead costs or other costs that are common to both alternatives. Generally, it is the variable costs per unit that are relevant, but in some cases not all variable costs are relevant if they will be the same between the alternative options. Make-or-Buy Decisions Make-or-buy decisions are often framed in the context of whether the company should produce something itself or buy it from outside. In these decisions, as with all other decisions, the only costs that need to be considered are the relevant costs. These relevant costs are the costs that are different between the two options and usually consist of the variable costs and avoidable fixed costs. Fixed costs that will simply be transferred to another department as allocated costs would be are not avoidable, because the company as a whole will still incur those costs in total. These unavoidable costs are therefore irrelevant to the decision making process. Sunk costs are also ignored. Because they are historical costs that cannot be changed, they will be the same for every option that the company has. Management must compare the relevant costs for each option (the costs that would be incurred only if this option is chosen), and then choose the option with the lowest incremental costs. If the cost to purchase the product from outside is lower than the avoidable costs of producing the item internally, the company should buy the product from the outside supplier. Note: It is possible that a problem will state that some of the variable costs are not avoidable, meaning that they will still be incurred, even if the product is purchased. Thus, these costs should not be treated as relevant costs as they are unavoidable. When determining relevant costs for such types of decisions, the following must be kept in mind: The purchasing costs (purchase price, ordering costs, transportation costs, carrying costs, etc.) relating to the purchase from an outsider are all relevant variable costs and must be included in the cost of purchasing the item. Only avoidable fixed and variable costs of in-house production are relevant and need to be included in the cost of producing the item internally. In a problem on the exam, you must be able to determine the maximum price that the company will be willing to pay an outside supplier for a product that they currently make. This price is the amount of internal production costs that will not be incurred (i.e., that will be avoided) by purchasing the product from outside. 14

25 Section C Marginal Analysis Applications Usually, the maximum price that a company would be willing to pay for purchasing outside the company is: Maximum Price to Pay = Total Internal Production Costs Unavoidable Costs (Fixed and Variable) What we have looked at so far are the quantitative factors in the decision. However, other qualitative considerations are also potentially very important to the decision. Factors such as quality, reliability of delivery, service, flexibility in delivery terms and even possibly public relations with the community in which the factory is located may all be important factors in the decision. Unfortunately, even though these are very important factors, it is often very difficult to give a monetary value to them. For example, if the quality of the product that is purchased from another company is not up to the standards of the company, what will be the lost profit in the future resulting from a poorer quality product? Or, what will the impact be of the company closing a facility because it has outsourced its production to another region of the country or to another country? Example: Paterno Co. produces football goal posts for sale to college and professional football teams. The variable and fixed costs to produce a goal post are as follows: Direct Materials Direct Labor Indirect Variable Costs Fixed Costs Selling and Administrative Total $200 per goal post $150 per goal post $75 per goal past $125 per goal post $100 per goal post $650 per goal post Bowden Corp. has recently approached Paterno with an offer to supply Paterno with finished goal posts that Paterno would then resell under the Paterno name. The price of one goal post from Bowden is $490. If Paterno purchased goal posts from Bowden, all of its fixed costs would continue to be incurred, but Paterno would be able to eliminate half of the selling and administrative costs that are associated with the production and sale of their own goal posts. The other variable costs would not be incurred because they would not need to pay any production costs if they purchase goal posts from an outside supplier. The two questions that we need to look at are whether or not Paterno should accept the offer, and if not, what is the maximum price they would pay to Bowden. Should Paterno accept Bowden s offer, and if not, at what price would Paterno be willing to accept the offer? Paterno should not accept the offer from Bowden. If they accept the offer, their total costs incurred would be $665 per goal post. Goal Post itself $490 Fixed Costs 125 Selling and Admin Costs 50 Total Purchase Price $665 What is the maximum price Paterno would be willing to pay Bowden? Given that Paterno will have $175 of costs that will continue even if they purchase from Bowden, the maximum price that they would be willing to pay is $175 less than their cost of production, or $475. Other Considerations Even if Bowden s offer had been acceptable from a quantitative standpoint, Paterno would need to determine if it is acceptable from a qualitative standpoint. Paterno is going to put its own name on these goalposts and therefore, before accepting any offer to let another company do the manufacturing, they would need to evaluate other things such as the quality of Bowden s manufacturing processes, reliability of delivery, and availability of service if necessary. 15

26 Marginal Analysis Applications CMA Part 2 The following information is for the next two Questions: Leland Manufacturing uses 10 units of Part Number KJ37 each month in the production of radar equipment. The unit cost to manufacture 1 unit of KJ37 is presented below. Direct materials $ 1,000 Materials handling (20% of direct material cost) 200 Direct labor 8,000 Manufacturing overhead (150% of direct labor) 12,000 Total manufacturing cost $21,200 Material handling represents the direct variable costs of the Receiving Department that are applied to direct materials and purchased components on the basis of their cost. This is a separate charge additional to manufacturing overhead. Leland's annual manufacturing overhead budget is one-third variable and two-thirds fixed. Scott Supply, one of Leland's reliable vendors, has offered to supply Part Number KJ37 at a unit price of $15,000. Question 3: If Leland purchases the KJ37 units from Scott, the capacity Leland used to manufacture these parts would be idle. Should Leland decide to purchase the parts from Scott, the unit cost of KJ37 would: a) Decrease by $6,200. b) Increase by $4,800. c) Decrease by $3,200. d) Change by some amount other than those given. Question 4: Assume Leland Manufacturing is able to rent all idle capacity for $25,000 per month. If Leland decides to purchase the 10 units from Scott Supply, Leland's monthly cost for KJ37 would: a) Increase $23,000. b) Decrease $7,000. c) Change by some amount other than those given. d) Increase $48,000. (CMA Adapted) 16

27 Section C Marginal Analysis Applications Question 5: Listed below are a company's unit costs to manufacture and market a particular product. Manufacturing costs Marketing Costs Direct materials $2.00 Variable $2.50 Direct labor 2.40 Fixed $1.50 Variable indirect 1.60 Fixed indirect 1.00 The company must decide to continue making the product or buy it from an outside supplier. The supplier has offered to make the product at the same level of quality that the company can make it. Fixed marketing costs would be unaffected, but variable marketing costs would be reduced by 30% if the company were to accept the proposal. What is the maximum amount per unit that the company can pay the supplier without decreasing operating income? a) $7.75 b) $8.50 c) $6.75 d) $5.25 (CMA Adapted) Special Order Decisions In a special order situation, a company has approached our company with a request for a special, one-time order and we must determine the minimum price that we will charge. In the determination of this minimum price, there are two things that must be taken into account. These are the direct costs of production and the level of capacity at which the company is operating. Direct (or Avoidable) Costs of Production The minimum price charged must include all of the costs that will be incurred directly as a result of this specific order. These would be the costs that would be avoidable if the company did not produce this order. Generally, this includes the variable costs of production direct materials, direct labor and variable overheads. Nonmanufacturing costs and fixed manufacturing costs will usually continue, even if this order is not produced. Note: Variable overhead is usually considered to be an avoidable cost for special orders as well as for make-or-buy decisions. Level of Operating Capacity The minimum price will also be affected by the percentage of capacity at which the company is operating. The issue is that if the company is operating at full capacity, in order to produce the units for this order, they will need to not produce some other order that they could have produced and sold instead. Therefore, if they choose to make this special order, they will need to recover not only the direct costs of producing this order but also the contribution that is lost on the units that they are not going to be able to produce and sell because of producing this order. Note: Contribution is the difference between the selling price and the variable costs associated with the unit. This is looked at in much more detail in CVP Analysis. 17

28 Marginal Analysis Applications CMA Part 2 Operating at Less than Full Capacity If the company is operating at less than full capacity and there is sufficient capacity to produce this new order, then the answer to the pricing question is fairly straightforward. Only the avoidable (direct) costs of production are used in determining the minimum price to be charged for the order. If the company can sell the product for $.01 more than this avoidable cost of production, then from a purely financial standpoint, it should accept the order. Note: If the company is able to charge $.01 more for an order when they have excess capacity, they will be better off from a financial standpoint. Even so, they might not accept the order because of qualitative considerations. For example, existing customers may find out about the deeply discounted sale to someone else. This could place a tremendous strain on the relationship with the existing clients and may lead some to find a new supplier. Operating at Full Capacity In a situation where the company is operating at full capacity, it must also include the opportunity cost of producing this order as a cost to be charged to the new order. Because the company is producing at full capacity, it is going to have to not produce something else in order to produce this special order. As a result, it will lose the contribution that would have been associated with the other sale, and that contribution needs to be covered in the special order. Therefore, when operating at full capacity, the company needs to make sure that it recovers not only the direct (avoidable) costs of producing this order, but also the contribution that is lost from the products that are not going to be sold as a result of accepting this order. Scenario: Cowher Co. produces two products refrigerators and microwave ovens. Cowher has the following information in respect to each unit produced of each product: Refrigerator Microwave Units produced Sales price $ 300 $ 200 Variable costs (100) ( 75) Contribution per unit Fixed costs per unit ( 75) ( 50) Profit per unit $ 125 $ 75 All of the variable costs will be avoided if a unit is not produced and all of the fixed costs will continue if a unit is not produced as the fixed costs will simply be allocated to the other units that are produced. Example 1: Assume that a one-time customer comes to Cowher and offers to buy 200 refrigerators if Cowher is able to provide the refrigerators at a lower price than other companies. At this time, Cowher is operating at 60% capacity and has the ability to produce these refrigerators and all of what is currently being produced. The minimum price that Cowher should charge for the 200 refrigerators is $101. This is the amount of the variable costs that will be incurred to produce this order, plus $1. If the price were only $100, then Cowher would be indifferent to producing the refrigerators because there would be no additional contribution from them. 18

29 Section C Marginal Analysis Applications Example 2: Assume that a one-time customer comes to Cowher and offers to buy 200 refrigerators if Cowher is able to provide the refrigerators at a lower price than other companies. At this time, Cowher is operating at 100% capacity and in order to produce these 200 refrigerators they would need to not produce 300 microwaves. In this case, the minimum price that Cowher must charge will include not only the variable costs of production, but also the contribution that will be lost by not producing the 300 microwaves. We already know that the variable costs are $100, so we will need to look at the lost contribution. The contribution per microwave is $125 per unit and since there are 300 microwaves that will not be produced, the lost contribution is $37,500. This is the amount of contribution that the 200 refrigerators will need to provide. Dividing this amount among the 200 refrigerators, we get an amount of $ per refrigerator, bringing the total cost to $ This means that Cowher will need to charge at least $288 per refrigerator in order to accept this order. We can prove it this way. Currently, Cowher has $162,500 of total contribution. If they were to set the price at $ for the new refrigerator order, their contribution would still be exactly $162,500. It is calculated as follows: Original refrigerators 500 units $200 = $100,000 Remaining microwaves 200 units $125 = 25,000 New refrigerator order 200 units $ = 37,500 Total contribution $162,500 If they were to sell the refrigerators for less than $287.50, their total contribution would be less than it currently is. Question 6: Power Systems Co. manufactures jet engines for the United States armed forces on a costplus basis (meaning the price will be the cost of production plus some amount or %). The cost of a particular jet engine the company manufactures is shown as follows. Direct materials $200,000 Direct labor 150,000 Overhead: Supervisor's salary 20,000 Fringe benefits on direct labor 15,000 Depreciation 12,000 Rent 11,000 Total cost $408,000 If production of this engine were discontinued, the production capacity would be idle, and the supervisor would be laid off. When asked to bid on the next contract for this engine, the minimum unit price that Power Systems should bid is: a) $385,000 b) $365,000 c) $397,000 d) $408,000 (CMA Adapted) 19

30 Marginal Analysis Applications CMA Part 2 The following information is for the next two Questions: KCollins Corp. produces equipment that is sold to cities for use in parks and playgrounds for children. One of their products is backstops for baseball fields. KCollins Corp. received a first-time, one-time request for 500 backstops from the city of Cincinnati. The selling price and the costs associated with the backstops are below. Selling price $ 250 Costs: Direct materials 90 Direct labor 25 Variable manufacturing overhead 18 Fixed manufacturing overhead 30 Variable selling costs 4 Fixed selling costs 15 (182) Operating profit $ 68 Question 7: Currently KCollins has sufficient capacity to produce this order without having to reduce production of any other items. The minimum price per backstop that KCollins would charge Cincinnati for this order is: a) $68 b) $133 c) $137 d) $182 Question 8: Currently KCollins is operating at 100% capacity and in order to produce this order for Cincinnati they would need to stop production of another product completely. This other product provides $15,000 of contribution to KCollins. Under these circumstances, the minimum amount that KCollins would charge Cincinnati is: a) $98 b) $167 c) $250 d) $280 (HOCK) 20

31 Section C Marginal Analysis Applications Sell or Process Further Decisions If the decision is between selling the product as-is or processing it further, presumably in order to sell it for a higher price, the decision is based on the incremental operating income that is attainable beyond the as-is point. This kind of situation may be encountered when dealing with joint production process or obsolete inventory. Joint Production Process A joint production process results when the same production process (and therefore the same costs of that production process) yields more than one product. For example, the processing of petroleum yields crude oil, gas and raw liquid propane gas. The further processing of the crude oil may yield heating oil, lubricating oil and various petrochemicals. With joint costs (these are the costs that are shared by the joint production process), the place in the production process where the various products become individually identifiable is called the splitoff point. Costs incurred up to the splitoff point are joint costs. Costs incurred after the splitoff point are separable costs. The products of a joint manufacturing process may have value at the splitoff point, and they may also have greater value if processed further as separate products. The decision needs to be made as to whether they will be sold at the splitoff point, or whether they will be processed further and then sold. When joint costs have already been incurred for a product, management making a decision to process further or sell at the splitoff point should not even consider the joint costs or the portion of those joint costs that have been allocated to the individual products. This is because these are sunk costs. The only factors that are relevant are incremental revenues and costs. The increased revenues attainable by processing further should be balanced against the increased costs to process further. The increase in net operating income as a result of the additional processing is the only basis for the decision. Obsolete Inventory With obsolete inventory, the original cost of the inventory is a sunk cost and is irrelevant. If the choice is between selling the inventory as-is for whatever price it can bring versus re-working it, compare the revenue from selling minus the cost of re-working it with the proceeds from selling the inventory as-is (or the cost of disposal, if the inventory has no value). It is better to process further or incur additional other costs if the sale of the re-worked product at the expected price is certain, and 1) If incremental revenues for re-worked product minus incremental expenses of re-work is greater than the proceeds would be from selling as-is; or 2) If there is a cost to dispose of the obsolete inventory instead of any proceeds, the difference between the two options will be the sum of the absolute values of the net of incremental revenue minus incremental expense and the cost to dispose. If income tax is a consideration, then the difference in the net cash flow will need to be adjusted for the tax effects on each option; and this would require calculation of taxable income or loss. However, the book value of the inventory is used only to calculate taxable income or loss it is not a factor in the comparison of relevant incremental revenues and costs because it is a sunk cost. 21

32 Marginal Analysis Applications CMA Part 2 Example 1: CCC Computers has ten computers in inventory that are obsolete. CCC Computers purchased the computers four years ago for its inventory at a cost of $800 but has never been able to sell them. The company has a customer who would buy them for $175 each if CCC upgrades them; or CCC could sell them to another customer as is for $100 each. The cost to upgrade the computers would be $100 per computer, including labor. CCC Computer s tax rate is 40%. Would the company be better off selling the computers now for $100 each or upgrading them and selling them for $175 each; and how much is the difference? A B B A Sell Now Upgrade & Sell Difference Revenue $1,000 $1,750 +$ 750 Less: Cost to upgrade 0 1, ,000 Cash flow from sale $1,000 $750 $ 250 Less: Cost of goods sold $8,000 $8,000 0 Taxable income/(loss) (7,000) (7,250) 250 Income tax benefit 2,800 2, Net cash flow after tax $3,800 $3,650 $ 150 The tax loss is relevant to the decision only because they will shelter other income from tax. This means that this loss will be used to offset other profit and will reduce the total tax liability of the company. After tax considerations, CCC would be better off selling the computers now, because its net after tax cash flow would be $150 greater than if they upgrade and sell them. Example 2: Assume the same facts as before, except CCC Computers has no customer to purchase the computers in their present state. They could sell them to the same customer as above for the same $175 after upgrading them. CCC must get rid of the computers to make room for new merchandise. Since the computers contain toxic components, they would have to be sent to a recycling center that will charge $15 per computer to recycle them. Now, the choice is between upgrading and selling them, or paying a recycler. Which way is CCC better off, and by how much? A B B A Recycle Upgrade & Sell Difference Revenue $ 0 $1,750 +$1,750 Plus: Additional cost 150 1, Cash flow from sale ($150) $750 +$ 900 Less: Cost of goods sold $8,000 $8,000 0 Taxable income/(loss) (8,150) (7,250) Income tax benefit 3,260 2, Net cash flow after tax $3,110 $3,650 +$ 540 Because CCC would have to pay to dispose of the computers, it is better off upgrading and selling them. 22

33 Section C Marginal Analysis Applications Disinvestment Decisions When making a decision whether to terminate a product, division or operation, the decision-making process is very similar to the decisions we have already looked at. It is simply a matter of determining what the profit (or cost, depending on the way the question is set up) would be under both the current situation and what it would be if the product, division or operation were terminated. The decision can then be made based upon which option provides a greater benefit for the company. In this decision-making process, it is critical to remember that some of the fixed costs of the division may not be avoided even if the division is terminated. This is because some of the fixed costs may be allocations of central fixed costs or are costs that cannot be terminated (such as a non-cancelable lease). Because those costs will simply be transferred to another division if the division in question is terminated, these are not avoidable costs. There are three main steps that a company must follow in this process: 1) Identify any unavoidable fixed costs that are allocated to or incurred by the division that would continue even if the division were terminated. These are the unavoidable costs that would simply be transferred to another division if this division were terminated. 2) Identify any unavoidable variable costs that would continue even if the division were terminated. These are again the unavoidable variable costs that would be absorbed by another division after this one is closed. 3) Identify any avoidable costs (both fixed and variable) that will be incurred only if the division continues to operate and compare this to the revenue of the division. If the revenue from this division is less than the avoidable costs of the division, the division should be terminated. Step 3 essentially calculates the contribution of the division. If the revenue is greater than the costs that are incurred only if the division operates, the company as a whole is better off because there is contribution that is able to contribute to the coverage of the fixed costs of the company as a whole. Note: The division does not need to be profitable from a bottom-line standpoint for it to be beneficial to continue. As long as the division is providing some amount of contribution to the continuing fixed costs of the company, it should be continued in the short-run because the company s overall profitability would increase. What the company is doing is determining whether the marginal revenues (the revenues that will be received only if they allow the division to continue) are greater than the marginal costs of the project or division (the costs that are incurred only if the division continues). If the marginal costs are greater than the marginal revenues, then the division should be closed (or the product eliminated, whatever the case may be). On the exam, you will need to calculate the amount by which a company s contribution, i.e., profit, or in some cases costs, will increase or decrease as a result of specific actions (such as the termination of a division). The best way to approach this problem is to calculate the requested information for both possibilities (to discontinue or to not discontinue) and then compare the results. Note: In addition to these numerical calculations about the benefit or cost of closing a division, there are also nonfinancial considerations that need to be included in the decision-making process. These may include the impact on a local community, public opinion, longer-term corporate goals and other similar items. 23

34 Marginal Analysis Applications CMA Part 2 The following information is for the next three Questions: Condensed monthly operating income data for Korbin Inc. for May follows: Urban Store Suburban Store Total Sales $80,000 $ 120,000 $200,000 Variable costs 32,000 84, ,000 Contribution margin $48,000 $ 36,000 $ 84,000 Direct fixed costs 20,000 40,000 60,000 Store segment margin $28,000 $ (4,000) $ 24,000 Common fixed cost 4,000 6,000 10,000 Operating income $24,000 $(10,000) $ 14,000 Additional information regarding Korbin's operations follows: One-fourth of each store's direct fixed costs would continue if either store were closed. Korbin allocates common fixed costs to each store on the basis of sales dollars. Management estimates that closing the Suburban Store would result in a 10% decrease in the Urban Store's sales, while closing the Urban Store would not affect the Suburban Store's sales. The operating results for May are representative of all months. Question 9: A decision by Korbin to close the Suburban Store would result in a monthly increase (decrease) in Korbin's operating income of: a) $(10,800) b) $(1,200) c) $(6,000) d) $4,000 Question 10: Korbin is considering a promotional campaign at the Suburban Store that would not affect the Urban Store. Increasing annual promotional expense at the Suburban Store by $60,000 in order to increase this store's sales by 10% would result in a monthly change in Korbin's income of: a) $(5,000) b) $(1,400) c) $7,000 d) $487 Question 11: One-half of the Suburban Store's dollar sales are from items sold at variable cost to attract customers to the store. Korbin is considering the deletion of these items, a move that would reduce the Suburban Store's direct fixed expenses by 15% and result in a 20% loss of the Suburban Store's remaining sales volume. This change would not affect the Urban Store. A decision by Korbin to eliminate the items sold at cost would result in a monthly increase (decrease) in Korbin's operating income of: a) $(7,200) b) $(1,200) c) $2,000 d) $(5,200) (CMA Adapted) 24

35 Section C Marginal Analysis Applications The following information is for the next two Questions: Hermo Company has just completed a hydroelectric plant at a cost of $21,000,000. The plant will provide the company's power needs for the next 20 years. Hermo will use only 60% of the power output annually. At this level of capacity, Hermo's annual operating costs will amount to $1,800,000, of which 80% are fixed. Quigley Company currently purchases its power from MP Electric at an annual cost of $1,200,000. Hermo could supply this power, thus increasing output of the plant to 90% of capacity. This would reduce the estimated life of the plant to 14 years. Question 12: If Hermo decides to supply power to Quigley, it wants to be compensated for the decrease in the life of the plant and the appropriate variable costs. Hermo has decided that the charge for the decreased life should be based on the original cost of the plant calculated on a straight-line basis. The minimum annual amount that Hermo would charge Quigley would be: a) $450,000 b) $630,000 c) $990,000 d) Some amount other than those given. Question 13: The maximum amount Quigley would pay Hermo annually for the power is: a) $600,000 b) $1,050,000 c) $1,200,000 d) Some amount other than those given. (CMA Adapted) If you purchased this book from HOCK international or through an authorized training center, an individually numbered orange hologram with the HOCK globe logo should be on the color cover. If your book does not have a color cover or does not have this hologram, it is not a genuine HOCK book. Please report the sale of books without color covers and orange holograms and we will help you obtain a legal copy. If you printed this book for yourself, it is watermarked at the top and bottom with your name and address. These printouts are licensed only for your individual use and may not be lent, copied, sold or otherwise distributed without permission directly from HOCK international. You may not remove, alter or edit the watermark. Using genuine HOCK books assures that you have complete, accurate and up-to-date materials. Books from unauthorized sources are likely outdated and will not include access to our online library of material or access to our HOCK teachers. 25

36 Pricing CMA Part 2 Pricing Determining the selling price of a product is one of the most critical decisions a company makes. If the price is too high, the company runs the risk of not selling enough units and losing money, even though they make a lot of profit on each unit sold. If the price is too low, there is the risk that the company will not cover all of its costs and will lose money even though they are selling a lot of units. This decision is even more critical for start-up companies as they usually do not have a large cash reserve to cover any pricing mistakes in the short-term. In general, the price of a product or service is dependent upon its demand and supply. The three major influences on price are often labeled as the Three Cs : Customers. Customers desire for the product and their willingness to pay for it constitutes demand. When a product is in high demand, its supply becomes limited, and the price is driven up. Competitors. Prices charged by competitors for substitute products, or market comparables, affect the demand as well as the price a company can charge for its product. If a competitor s price is significantly below the market price, demand for the output of a company in the same market will be decreased. The company may be forced to lower its price to stay in business. Costs. Costs of production affect supply. The lower the cost, the higher the profit, and the more product the company will be willing to supply. In managing their costs the company needs to try to reduce and eliminate all of the costs that do not add value to the final product. All three factors are important when setting prices: the value that customers place on the product, and thus are willing to pay, and the prices competitors charge for competing products affect demand, while the costs of producing and delivering the product influence supply. Impact of Market Structure on Pricing We discussed market structure earlier in the context of marginal revenue. Marginal revenue is affected by the market structure of an industry because market prices are set differently under the different market structures. The market structures are covered in detail in the HOCK Assumed Knowledge e-book, vol. 1, so they will be discussed briefly here as they pertain to pricing. Perfect competition Sellers in a perfectly competitive market can sell as much of their product as they want to at the market price, but they must sell at the market price. If they try to charge more than the market price, they will sell nothing. If they drop their price below the market price, they can still sell as much of their product as they want to. But if they drop their price below the market price, their total revenue will be lower than it could have been, because they could have sold the same amount at the market price and earned more total revenue. Therefore, pricing decisions for a firm in a perfectly competitive market are easy the perfectly competitive firm is a price taker and simply sells at the market price. However, and this is a big however perfect competition is a theoretical market structure. There probably are no perfectly competitive firms. The closest any market comes to being perfectly competitive is the agricultural market, where farmers bring their produce to market when it is ready to sell, and most of them must sell it at the market price or it will spoil. Monopoly A monopoly has control over the price it charges, in contrast to the perfectly competitive firm that must sell its product at the market price. However, even though the monopolist has control over the price it charges, it cannot increase prices and expect to sell the same amount of product. The monopolist faces a downward sloping demand curve, and when it increases its prices, it sells fewer units. Similarly, when it decreases its prices, it will sell more units. 26

37 Section C Pricing Monopolistic Competition There are many firms operating in the market, and they do not collude with one another in setting prices. The products produced by the various firms are similar but not identical. There are differences among them. The firms in the market have limited control over prices, even though there are many firms, because of the differences in the products. One firm can charge more than another one because of offering more features, and so forth. A firm in monopolistic competition must also drop its price in order to sell additional units, although this is mitigated somewhat by the product differentiation. Oligopoly In an oligopoly, there are only a few firms operating in the market and each company will consider the impact of its actions on its competitors and the reaction that it expects from its competitors. A price decrease by one company will usually be matched by others price decreases, but a price increase by one company will usually not be followed by the other companies. Thus, if one firm increases its price, it will lose volume to the other producers since they will not increase their prices and thus they will secure more volume. If the other firms did not match the lower price, a price decrease by one firm would allow that firm to capture more of the market. However, competitors tend to match a price decrease; so any increase in volume that the firm would received would not be enough to offset the lower price, and total revenue will decrease. Given that there is a negative effect to either increasing or decreasing the price, prices in an oligopoly tend to be sticky (meaning that they do not change easily). Impact of Supply and Demand on Pricing Supply and demand are covered in detail in the HOCK Assumed Knowledge e-book. Some highlights are reviewed here. Demand The law of demand states that the price of a product is inversely (negatively) related to the quantity demanded of that same product. Therefore, as the price of the product is reduced, the quantity demanded for that same product will increase, and vice versa. This is represented on a graph as a downward sloping line. Monopolistic firms, monopolistically competitive firms and oligopolistic firms all face downward sloping demand curves. A firm operating in an oligopoly faces a kinked demand curve but it is, nonetheless, downward sloping. Elasticity of Demand The elasticity of the demand for a particular product or service will determine how much effect a price increase or decrease will have on the demand for that product or service. Elasticity of demand is calculated in general as the percentage change in quantity demanded divided by the percentage change in price. The demand for a product is said to be elastic ( responsive ) if a 1% change in the price of the good causes more than a 1% change in the quantity demanded. More generally, the demand for a product is elastic if the quantity demanded changes by a larger percentage than the associated change in the product s price. Therefore, if the demand for a good is elastic, the price elasticity of demand will be greater than 1. Similarly, the demand for a product is said to be inelastic ( unresponsive ) if a 1% change in the price of the good causes less than a 1% change in the quantity demanded. More generally, the demand for a product is inelastic if quantity demanded changes by a smaller percentage than the associated change in the product s price. Therefore, if the demand for a good is inelastic, the price elasticity of demand will be less than 1. The concept of elasticity is shown in the graphs that follow. The demand curve on the left is relatively elastic because a small change in price leads to a large change in the quantity demanded. The curve on the right has only a small change in the quantity demanded given a larger change in price, so it is relatively inelastic. 27

38 Pricing CMA Part 2 Elastic vs. Inelastic Demand Curves Price P 1 P 2 P P D Elastic D Inelastic Q Q Quantity A perfectly elastic demand curve is represented by a horizontal demand line on a graph, whereas a perfectly inelastic demand curve is represented by a vertical demand line on a graph. Calculating the Elasticity of Demand There are two ways in which the price elasticity can be calculated. The two methods are the percentage method and the midpoint (or arc) method and they produce similar results. However the midpoint method is less precise because it relies upon approximation. Though the two methods will give a slightly different result, the overall effect, whether the outcome is elastic or inelastic, will be preserved. For the exam, you should know the midpoint formula. We will discuss the percentage method as well, though, to assist in your understanding of the concept. The Percentage Method Under the percentage method we simply take the % change in quantity and divide it by the % change in the price of the product. This method is used if percentages are given. The Price Elasticity of Demand (E d ) Percentage Method E d = Percentage Change in Quantity Demanded = % Q Percentage Change in Price % P Note: Following the law of demand, which is that the demand curve is downward sloping, the elasticity coefficient (E d ) calculated by the formula is negative since, for example, lower prices (a negative change in price) will bring about a higher quantity demanded (a positive change in quantity). The absolute value is typically used when interpreting E d, meaning that when the effects of price changes on the quantity demanded for a single good is calculated, the number is always considered to be positive. 28

39 Section C Pricing The Midpoint (or Arc) Method The midpoint method is used when we are given different numerical and dollar figures for different points on the demand curve. This method also eliminates the fact that the percentage method will give different elasticities, depending upon the direction of the movement along the curve that is used in the calculation. This method is less accurate due to approximation of the midpoint. The Price Elasticity of Demand (E d ) Midpoint Method E d = (Q 2 Q 1 ) / [(Q 2 + Q 1 ) / 2] (P 2 P 1 ) / [(P 2 + P 1 ) / 2] Where: Q 1 and 2 = First and second quantity point P 1 and 2 = First and second price point Example: Let us assume the following information for two points along the demand curve: Point A: Price = $4; Quantity = 120 Point B: Price = $5; Quantity = 80 The calculation of elasticity using the midpoint method is done as follows: E d = (80 120) / [( ) / 2] = 40 / 100 = 1.80 (5 4) / [(5 + 4) / 2] 1 / 4.5 Classifications of Levels of Elasticity Once the elasticity coefficient has been calculated, it can be classified as one of the following: E d =0 E d <1 E d =1 E d >1 Perfectly Inelastic This means that no matter what happens to the price, the quantity that is demanded will remain the same. For a market, this situation is quite unlikely. However, some individual consumers may have a near zero elasticity of demand for certain goods. Example: a diabetic s demand for insulin (given the importance of insulin to the user s health, and the fact that there are no reasonable substitutes for insulin). Inelastic Any given percentage change in price will result in a smaller percentage change in the quantity demanded. Example: a 9% decrease in price will cause the quantity demanded to rise by less than 9%. Unitary Elasticity Any given percentage change in price will cause the quantity demanded to change by the same percent. Example: a 12% increase in price will cause the quantity demanded to fall by exactly 12%. Elastic Any given percentage change in price will result in a larger percentage change in the quantity demanded. Example: a 2.5% decrease in price will cause the quantity demanded to rise by more than 2.5%. 29

40 Pricing CMA Part 2 Note: While it is unlikely that the market demand for a good would ever be infinitely elastic (that is, an essentially unlimited demand for the product at one price, but a zero quantity demanded at any higher price), the demand for a single perfectly competitive firm can best be described as infinitely elastic. Consider for example white socks. Suppose the market for white socks is perfectly competitive. If the market price for white socks in equilibrium is $2 per pair, any single producer of white socks being such a small part of the larger market operates as if it can sell as many pairs of white socks as it desires at the price of $2. If any firm tried to sell white socks for more than $2 per pair, the demand for its socks would fall to zero, since consumers will simply buy their socks from one of the many other firms selling white socks for $2 per pair. As a result, graphically the demand curve for a single firm operating within this perfectly competitive industry is best represented by a horizontal line at the price of $2, which suggests an infinite elasticity of demand. Question 14: If a product has a price elasticity of demand of 2.0, the demand is considered to be: a) Perfectly elastic. b) Perfectly inelastic. c) Relatively elastic. d) Relatively inelastic. (CMA Adapted) Question 15: If the pastry shop has increased its price for a brioche from $2 to $2.30, what would the elasticity of 1.9 imply about the quantity of these brioches sold: a) Demand for the brioches is inelastic, so price changes do not affect quantity. b) Given the relatively elastic demand, percentage change decline in quantity is c) Given the relatively elastic demand, percentage change decline in quantity is 7.9. d) This change in price of the brioche would imply an increase in the quantity sold. (HOCK) Elasticity and Total Revenue The mathematical relationship between price changes and changes in total revenue is dependent upon the elasticity of demand. The total revenue formula is one that is fairly straightforward: Total Revenue = Price Quantity Given this equation, we can see how the elasticity of demand will impact the total revenues. If we raise the price, we know that quantity will fall. However, the most important question is whether total revenue will increase or decrease as a result. Recall that the elasticity of demand tells us the percentage change in quantity demanded (e.g., sales) that will occur for some given percentage change in price. If demand is elastic, the quantity demanded will change by a larger percentage than a good s price. To see the relationship between elasticity and revenue, suppose the elasticity of demand for DVD players is 2. If the price of DVD players falls by 6%, this suggests that the quantity of DVD players demanded (sold) will rise by 12%. The 6% decrease in price is more than offset by the 12% increase in sales (quantity), so Total Revenue rises. On the other hand, if the price of DVD players were to increase by 8%, sales (the quantity) demanded would fall by 16%, and this would push Total Revenue down. Thus, when demand is elastic, Total Revenue rises when price falls (output rises), and Total Revenue falls when price increases (output falls). 30

41 Section C Pricing When demand is inelastic, the quantity demanded changes by a smaller percentage than price. Now, suppose the elasticity of demand for bread is.25. If the price of bread falls by 20%, this suggests that the quantity of bread sold will rise by 5% (25% of 20%). The 20% decrease in price is larger than the 5% increase in sales (quantity), so Total Revenue falls. On the other hand, if the price of bread were to increase by 16%, sales (quantity) would fall by 4%, and this would push Total Revenue up. Thus, when demand is inelastic, Total Revenue rises when price rises (output falls), and Total Revenue falls when price falls (output rises). To a management accountant, understanding this relationship is important because if the coefficient of elasticity is known, then one can advise whether an increase or decrease in prices will maximize total revenue for the firm. The relationship is shown in the table below: Elastic E > 1 Inelastic E < 1 Unitary Elasticity E = 1 Price Increases (TR Decreases) TR Increases TR Is Unchanged Price Decreases TR Increases (TR Decreases) TR Is Unchanged Note: Memorizing this table for the exam will be helpful. Question 16: If a product's demand is elastic and there is a decrease in price, the effect will be: a) A decrease in total revenue. b) No change in total revenue. c) A decrease in total revenue and the demand curve shifts to the left. d) An increase in total revenue. (CMA Adapted) Question 17: If the elasticity of demand for a normal good is expected to be 2.5, a 10% reduction in its price would cause: a) Total revenue to fall by 10%. b) Total revenue to fall by 25%. c) Quantity demanded to rise by 25%. d) Demand to decrease by 10%. (CMA Adapted) Supply The law of supply states that in the short run, there is a positive relationship between the price of a good or service and the quantity supplied. As the price of a good increases, producers are willing to supply more of the good to the market, causing an increase in the total quantity supplied. Similarly, as the price of the good decreases, producers are willing to supply less of it to the market because of the lower selling price. This causes a decrease in the total quantity supplied to the market as prices fall. The law of supply is represented graphically as an upward sloping line. 31

42 Pricing CMA Part 2 Market Equilibrium Market equilibrium is defined as the point where the demand curve intersects with the supply curve. This point determines the market price and the quantity that will be exchanged of a good, because at this point of intersection, the market price (the equilibrium price ) is such that the quantity demanded by consumers is exactly equal to the quantity supplied by firms. Therefore, the pricing of any product or service is affected by the demand for and the supply of the product or service. Many other factors affect pricing as well, including the market structure a particular firm operates in, the ways in which the firm differentiates its product from its competition, customers perceptions of the value in the firm s products or services, what the competition is doing, and so forth. Short-Run Equilibrium Pricing Nearly every firm has some fixed costs. As long as the revenue the firm can earn from producing and selling its product is greater than the firm s variable cost for that unit, the sale of that unit is contributing something to covering the fixed costs. However, if the equilibrium price at every level of output is lower than the firm s average variable cost, the firm will shut down because it will lose more by producing anything than it loses by producing nothing at all. The price where the firm is just covering its average variable cost but where there is nothing extra to put toward covering the fixed costs is called the shut-down price. At this price, the firm is indifferent between producing or not producing. At any price below the shut-down price, the firm will shut down because there is no output level at which any variable costs can be covered. If the equilibrium price is greater than the firm s average variable cost, any profit-maximizing firm will produce at the point where its marginal revenue is equal to marginal cost, because that is the output level at which its profit will be the greatest. Any time the marginal revenue of a unit is greater than that unit s marginal cost, producing and selling the unit will add to net income. If the marginal cost is greater than the marginal revenue, producing and selling that unit will reduce net income. So the point where further increases to output stop is the point where marginal revenue and marginal cost are equal. This determines how much the firm will produce. Short-Run Equilibrium Pricing In Pure Competition The demand curve for a firm in pure competition is a horizontal line. The Demand Curve in Perfect Competition Price Demand in Perfect Competition Quantity Produced 32

43 Section C Pricing The short-run equilibrium price for a firm in a perfectly competitive market is the market price. For a firm that is a price taker, as a firm in a perfectly competitive market is, the firm s price is also its average revenue as well as its marginal revenue. The horizontal demand line on the graph above is all of those things: Demand = AR = MR = P. As the firm increases its sales, its total revenue increases by the same amount for each unit sold. Since a firm in a perfectly competitive market wants to maximize its profits, it will produce at the level where its marginal cost of production is equal to the market price of the product (which is equal to its marginal revenue), as long as that market price is greater than the firm s average variable cost. So in a perfectly competitive market, the price is determined by the market, and then the member firms pick the quantity of output that will maximize their profits where their marginal revenue (the market price) equals their marginal cost. A perfectly competitive firm adjusts its level of output in response to changes in the market price to maximize its profit. However, this adjustment of output will have an immaterial effect on the total supply of the product available, because any individual firm constitutes a very small part of the total market. Thus, the output decisions that individual firms make have no effect on the market price. The individual firm in pure competition is a price taker. In all other market structures (monopoly, monopolistic competition and oligopoly), where member firms face downward sloping demand curves, the individual firms are price makers, because firms in those industries can influence the product price to one degree or another through their output decisions. Short-Run Equilibrium Pricing in Monopoly The demand and marginal revenue curves for a monopolist are illustrated in the graph below. $ Price Per Unit MR Demand Quantity Sold The marginal revenue curve (MR) is below the demand curve because as production increases, a monopolist that charges the same price for all of its output will have to lower its price in order to get consumers to buy that additional output. Therefore, the additional (marginal) revenue received from producing an additional unit will be less than the price received for that unit. Monopolies determine the quantity to produce in the same manner as firms in perfect competition they will produce as many units as they can until the marginal cost of production exceeds the marginal revenue from selling one more unit. Monopoly quantity is determined at the point where MR=MC. The determination of the price is done differently for a monopoly than it is for a firm in perfect competition. For the perfectly competitive firm, the price is set by the market and the individual firm cannot change it. However, in a monopoly, the monopolistic firm is able to influence the price that is charged. After the firm determines the quantity it will produce, it simply extends this quantity to the demand curve and sees what the maximum selling price is that it can charge for that number of units. The graph on the following page shows the determination of quantity and price along with the economic profit that monopolies achieve. Economic profit is the amount by which total revenue exceeds the total economic costs of the company. Total economic costs include all of the explicit (cash) costs that are paid by the firm as well as the relevant implicit (opportunity) costs. 33

44 Pricing CMA Part 2 Monopoly Economic Profit Price MC ATC P M Long-Run Economic Profit A B MC = Marginal Cost ATC = Average Total Cost MR = Marginal Revenue D = Demand & Average Revenue P M = Monopoly Price Q M = Monopoly Quantity D Q M MR Quantity By determining the point at which MR equals MC (point B), the monopoly can determine the quantity that it will sell. After this is known, it will determine the highest price that it can charge and still sell this number of units. This is the point on the market demand curve at that quantity (point A above). The monopoly will then earn an economic profit in the long run represented by the shaded box. This is the area between the price and average total cost for the number of units produced. To produce any larger quantity would reduce profits, as MR would be less than MC for the additional units produced. In a monopoly, the firm produces less than the ideal output level as the price of the product exceeds the marginal cost of its production. Compared with a perfectly competitive market, prices will be higher and output levels lower in a monopolized market. Additionally, options are limited to consumers as there is only one supplier of the product in the market. In other market structures, the existence of economic profit in the industry would entice other firms to enter the market. The resulting increase in supply and in competitive pricing would cause the price to decrease to the point where there was no more economic profit for the member firms. However, one of the characteristics of a monopoly is that the barriers to entry are very high. Because of this, other firms cannot easily enter the market and so the economic profit or loss that a monopoly generates will usually not have any impact on the number of firms operating in the market. There will always be a single firm in the market, and that single firm will continue to charge higher prices and to generate economic profit. Short-Run Equilibrium Pricing in Monopolistic Competition The demand curve of a monopolistically competitive firm is highly elastic. Remember we said that the demand for a product is elastic if the quantity demanded changes by a larger percentage than the associated change in the product s price. The elasticity of the monopolistically competitive firm s demand schedule is what distinguishes it from pure monopoly and from pure competition. The monopolistic competitor s demand is more elastic than the demand curve of the pure monopolist because the monopolistically competitive firm has many competitors that are selling products that are close substitutes for its product. Since the monopoly firm has no competitors, its demand curve is much less elastic. But the monopolistic competitor s demand is not perfectly elastic (a horizontal line) as the demand of the firm in pure competition is. The monopolistically competitive firm has 34

45 Section C Pricing less competition than the purely competitive firm has, and its products are differentiated from those of its competitors. The products are similar but they are not perfect substitutes as is the case with pure competition. In the short run, the monopolistically competitive firm maximizes its profit (or minimizes its loss) by producing at the level where marginal revenue equals marginal cost. After it sets its production level, it can do on a smaller scale the same thing the monopolist does: it can increase its price to the point on its demand line that indicates what it can charge for the quantity it wants to produce. In the short run, it realizes an economic profit, the area between P 1 and P 2 on the graph that follows. However, in the long run, other firms will enter the industry because of the economic profits to be earned and as a result, the monopolistically competitive firm will ultimately have to lower its price to the point where there is no economic profit but MR and MC are equal. Short-Run Equilibrium for a Monopolistically Competitive Firm MC Price P 2 P 1 P D MR Q Quantity Short-Run Equilibrium Pricing in Oligopoly In one model of oligopoly, it is theorized that a price decrease by one company will usually be matched by another s price decreases, but a price increase by one company will usually not be followed by the other companies. If a firm increases its price, it will lose volume to the other producers because by doing nothing, the other producers will secure more volume. If other firms fail to match a lower price, a price decrease would allow an oligopolist to capture more of the market. However, competitors tend to match a price decrease; so although a lower price will capture a higher volume, the increase in volume will not be enough to offset the lower price, and total revenue will decrease. Because of this, an oligopolist faces a demand curve that has distinctly elastic and inelastic parts to it. The curve is relatively elastic when prices increase because the other firms will not follow a price increase and the firm will lose sales. This means that a small increase in price will lead to a large decrease in demand. Because of this, the firm is unlikely to raise its prices. The curve is relatively inelastic when a firm decreases its price. This is because the other firms will match the price decrease. Therefore, the firm will need to make a large price decrease in order to gain any sales. Because the decrease in price will be larger than the increase in sales, the firm is unlikely to lower its price. Given that there is a negative effect of either increasing or decreasing the price, prices in an oligopoly tend to be sticky (meaning that they do not change easily). This kinked demand curve is shown below. 35

46 Pricing CMA Part 2 Kinked Demand Curve of an Oligopolistic Firm A Ignore B Price $5 $4 C D $2 Match Quantity If an oligopolistic firm believes if it increases its price from $4 to $5, that its rivals will match its price increase, then the firm will expect to gain $150 (350 $5) (400 $4) in sales. But it is more likely that its rivals will ignore the price increase, so the firm that raises its prices will be able to sell only 200 units after it raises its price to $5 rather than the 350 units it expects (Point B). Thus, the firm s total revenue would fall from the oligopolistic equilibrium (Point C) of $1,600 to $1,000. For any price increase that is unmatched by the other oligopolistic firms, this particular firm s demand segment (AC) will be quite elastic. Now suppose that one of the oligopolistic firms tries decreasing its price from $4 to $2. If the firm expects that its rivals will ignore its price decrease, it will expect to gain $200 (900 $2) (400 $4) in sales. But it is more likely that its rivals will match the price decrease, and instead the firm will lose $400 in total revenue (400 $4) (600 $2), as it will be able to capture only 600 units, or an additional 200 units of sales following the price reduction rather than the 900 units it expects (Point D). So an oligopolist actually faces two demand curves: one if its competitors match any price change that it makes and one if its competitors ignore any price change that it makes. Since competitors are likely to match a price decrease and ignore a price increase, the true demand curve faced by an oligopolistic firm will be kinked, as in the solid sections of the two demand curves shown above. This illustrates the fact that oligopolistic firms strategically interact, and that every time a firm makes a decision about price or output, it must think about how its rivals will respond. Such strategic interaction may result in firms attempting to collude, or act in unison, to keep prices artificially high, for instance, at the level that would be expected if there were only one firm in the market with no competition. Such behavior (price fixing) is illegal in the U.S. under antitrust regulations. Even for parts of the world where it is not illegal, however, such agreements are many times doomed to failure, as individual firms will eventually succumb to the temptation to cheat on the collusive agreement by lowering its prices in order to capture a larger share of the market. Economists using game theory, a branch of mathematics, model this type of strategic interaction between firms. 36

47 Section C Pricing Strategy Pricing Strategy Both internal company factors and external factors in the company s environment affect a company s pricing decisions. Internal Factors Affecting Pricing Decisions Internal factors that the company takes into consideration in setting prices are: Its marketing objectives Its target market and the positioning the company has chosen for the product will affect the price. For example, if Martin Logan develops a new type of speaker for audiophiles (an audiophile is a person for whom the quality of sound in an audio system is very important) they will probably charge a very high price for it. This is known as product quality leadership. Other examples of objectives include: 1) Survival, by a firm that has too much capacity and not enough sales; 2) Profit maximization, when the company estimates what its demand and its costs will be at different price levels and chooses the price that produces the maximum current profit; 3) Market share leadership, which will require that prices be set as low as possible; 4) Setting prices low to discourage competition; and 5) Setting prices to maintain resellers loyalty, to avoid government intervention, to stabilize the market, to draw customers into a retail store, or setting the price of one product in order to improve sales of other products of the company. Its marketing mix strategy Pricing decisions need to be coordinated with the other decisions in the marketing mix product design, distribution (place), and promotion plans to create a consistent marketing program. Decisions made about quality, promotion and distribution will affect pricing decisions. Marketers must consider the total marketing mix, because customers want products that give them the best value for the price they pay. 1) Target costing may be used. Target costing begins with the selling price and then figures out how to produce the product at a cost that permits an adequate profit. 2) Price and quality may be determined by customer needs. For instance, a piece of equipment could be manufactured inexpensively and sold cheaply; but its ongoing maintenance might be high. Customers might prefer equipment that they pay more for but which will be maintenance-free. Its costs The company will want to charge a price that covers all of its costs, both fixed and variable, and gives it a fair profit. Costs include not only production costs but also distribution costs and selling costs. Costs determine the lower limit for prices. If a company s costs are higher than those of its competitors for the same product, the company will have to either price the product above its competitors prices, or it will be less profitable than its competitors. This will put it at a competitive disadvantage. Organizational considerations The company s management needs to decide who has the authority to set prices. In large companies, prices are usually set by division or product managers. In some cases, salespeople negotiate with customers within set price ranges. Others with input into the pricing decision are sales managers, production managers, finance managers, and accountants. However, senior management still determines pricing policies and may even approve prices proposed by lower-level managers. 37

48 Pricing Strategy CMA Part 2 External Factors Affecting Pricing Decisions External factors also affect pricing decisions, such as: The market and demand The market and demand for the product set the upper limit for prices. Factors include what type of market the company operates in (monopoly, oligopoly, oligopolistic competition, or pure competition); what consumers perceive the value of the product to be; and what the product s demand curve and its price elasticity of demand is. Since these topics are covered extensively in the Part 1 CMA exam, they will not be elaborated on here. Competitors activities Competitors prices, offers, and possible competitor reactions to the company s pricing is another external factor to consider. Companies need to know the prices and the quality of their competitors products, and they need to compare their costs with those of their competitors. Consumers considering a purchase compare products in terms of value and price. If Martin Logan s speakers sound better than Bose s speakers, for example, Martin Logan can charge more. But if Martin Logan s speakers sound about the same as Bose s speakers, Martin Logan will have to price its speakers close to Bose s prices, or it will lose sales. Other external factors Factors such as inflation, recession, and interest rates affect pricing strategies, because they affect the product costs as well as consumers perceptions of the product s value to them. Resellers reactions are also important, because the company s price needs to be set so that its resellers make a fair profit. The government also affects pricing decisions, with taxes and regulations being a concern. Social concerns may also be a factor that needs to be considered. INTERNAL FACTORS EXTERNAL FACTORS Marketing Objectives The Market and Demand Marketing Mix Strategy Competitors Activities Costs Other External Factors Organizational Considerations In summary, the company will follow a six-step, or similar, process in setting its pricing policy, as shown below: Six Steps for Setting Pricing Policy Select Estimate Estimate Analyze Determine Decide the demand costs competitors: pricing on pricing prices, costs method final price objective and offers 38

49 Section C Pricing Strategy General Pricing Approaches The price the company decides on will be higher than an amount that would not produce a profit and lower than one that is too high to produce adequate demand. The price floor is product cost. The ceiling is customer perception of the product s value. The best price is between these extremes and is determined by competitors prices as well as the internal and external factors discussed above. Thus, the basic factors that go into pricing decisions are: (1) product cost; (2) customer perception of the product s value; and (3) competitors prices. Prices are usually set by a general pricing approach that includes one or more of these considerations. Three general pricing approaches are used: 1) the cost-based approach, 2) the value-based approach, and 3) the competition-based approach. Cost-Based Approaches Cost-based pricing includes cost-plus pricing, break-even pricing, and target profit pricing. When cost-plus pricing is used, the company simply determines what its costs are and then adds a standard markup to the cost to arrive at the price for the product. Manufacturers often use cost-plus pricing, as do construction companies and printers. Professionals such as attorneys and accountants typically do the same thing. Some government contracts are also based on cost plus a specified markup. The drawback to cost-plus pricing is that it ignores both customer demand and competitors prices. But markup pricing persists, for several reasons: 1) Sellers can be more confident about their costs than about demand for their product. If the price is tied to the cost, then they do not have to make pricing adjustments to reflect changes in demand. 2) If all of the companies in an industry use the same pricing method, prices are similar and price competition is minimized. Many decision-makers believe that cost-plus pricing is a fair way to set prices, because the sellers earn a fair return on their investments while not increasing their prices in response to an increase in demand. In break-even pricing and target profit pricing, the firm determines a price at which it will break even or make a target profit. Target pricing is based on forecasts of total cost and total revenue at various sales volume levels. However, as the price increases, demand decreases, and vice versa. Break-even pricing and target profit pricing do not take the price-demand relationship into account. So when this method is used, the company must also realize that sales volume will be affected by price and must build that into the model. In cost-based pricing, the company designs a product, figures out the total costs to make the product, and sets a price that covers its cost plus a factor for profit. The marketing people must then convince the buyers that the product is worth that price. If the market decides that the price is too high, the company has to reduce its price and settle for lower profits, or leave the price high and settle for lower sales, also resulting in lower profits. Value-Based Approaches Value-based pricing (also called buyer-based pricing) bases prices on buyers perceptions of the value of the product instead of on the seller s cost. Value-based pricing is the reverse of cost-based pricing. The target price is based on customer perceptions of the value of the product. The targeted value and price are then used in making all the decisions about the product s design and what its costs must be. The pricing process begins with consumer needs and value perceptions, and the price is set to match that. Thus, price is a part of the marketing mix variables that are considered before the marketing program is set. 39

50 Pricing Strategy CMA Part 2 The company must, of course, be able to find out what value future buyers will assign to various products, and measuring perceived value can be difficult. If the company overestimates perceived value, it will price the product too high and sales will suffer. If the company underestimates the product s perceived value, it will underprice the product. Sales will be good, but the low price will produce less revenue than would be possible. More companies are adopting value pricing strategies, and this has led to introduction of less expensive versions of brand-name products. An important type of value pricing is called everyday low pricing. Everyday low pricing is used at the retail level to charge an everyday low price with few temporary price reductions. Another type of pricing is called high-low pricing, and it involves charging high everyday prices but offering frequent discounts and sales. But constant sales and promotions increase costs and erode consumer confidence in the everyday prices. Consumers also lack the patience to wait for specials in order to make their purchases. But to offer everyday low prices, a company s costs must be low. If a retailer lowers its prices but its costs remain high, it will not be in business for long. Competition-Based Approaches Customers use competitors prices to form their perceived value of a product, and going-rate pricing is based almost entirely on competitors prices. This does not mean that the company charges the same price as its competitors charge. It may charge the same price as its competitors, or it may charge more or less. The firm s strategy may be determined by whether its products are homogeneous with (identical to) or nonhomogeneous with (different from) its competitors products. If the industry is one selling a commodity, i.e., a homogeneous good with little differentiation among producers, competing firms normally all charge the same price. Smaller firms follow the lead of large firms. However, if a company is a market leader faced with lower-priced competitors, it can elect to maintain its price while raising the perceived value or quality of its product, or perhaps launch a lower-priced fighter line. If the company cannot find ways to enhance its product or service, it will have to meet the competitor s price reduction. Responding to price cuts by competitors is complicated. It is important to attempt to understand the competitor s intent and potential duration of the price change. Going-rate pricing is used extensively. Companies accept the going price as representative of the price that will yield a fair return. Bidding on jobs also involves competition-based pricing. A company submits a bid that is based more on how it thinks its competitors will bid rather than on its costs. The winning bid will be the lowest price. The company tries to bid low enough to get the business without going so low as to make the contract unprofitable. At the same time, it wants to get as much as possible for the contract, so it doesn t want to underprice it. New Product Pricing Strategies When a company introduces a new product, it has to determine a positioning strategy for its product on quality and price and set the price. A company generally uses a pricing structure or pricing strategy that it applies to all the different items it produces and/or sells. The pricing structure incorporates changes in product prices, because a new product will be priced differently from an established one. Prices will be adjusted from time to time to reflect changes in costs and demand. And prices of an individual product will change as the product moves through its life cycle. 40

51 Section C Pricing Strategy Some pricing strategies that may be followed when a new product is introduced are the following: Market penetration pricing When a company wants to penetrate a market quickly and maximize its market share with a new product, it may set a low initial price with the expectation that high sales volume will result. The resulting high sales volume is expected to lead to lower unit costs and higher long-term profit. The goal is to win market share, stimulate market growth and discourage competition. In order for this strategy to work, the market must be price-sensitive, so that sales will increase as a result of the low price. Production and distribution costs must decrease as sales volume increases. The low price must be sustainable, and it must be effective at keeping competitors out. Market skimming A company unveiling a new technology may set an initial high price to skim the market and then quickly reduce the price to attract new customers after those who could afford to pay the highest price have purchased. This is often followed by subsequent lowering of prices, thereby skimming maximum revenues from the different market segments. Product Mix Pricing Strategies A product that is part of a product mix where the various products have related demand and costs and face different amounts of competition needs to be priced so as to maximize the profits of the entire product mix. Product mix pricing strategies include product line pricing, optional-product pricing, captive-product pricing, by-product pricing, and product bundle pricing. Product-line pricing A company generally creates product lines rather than single products. Each successive item in the line offers more features and costs more. An example could be a jewelry store that offers ladies earrings at four price levels: $10 for very low; $25 for low; $50 for average; and $100 for high quality. Price points are used in product-line pricing to establish levels such as the ladies earrings, and customers shop at their preferred price point. Optional-product (feature) pricing Optional products, features and services can be offered along with the main product, such as a personal computer with a minimum amount of memory and speed advertised at a low price with optional upgrades available. Pricing is difficult because the company must decide what features are included as standard, and which are options. Captive-product pricing When a product requires the use of additional or captive products, such as a low-priced razor that requires high-priced replacement blades, this is captive-product pricing. Ink-jet printers are typically priced low, because the company makes its money on the sale of ink cartridges for them. By-product pricing Production of certain goods such as steel or chemicals may result in byproducts. These by-products have no real value to the manufacturer that generates them. However, storing and/or disposing of them will create additional costs, which will impact the profitability and thus the price of the main product. Instead, the manufacturer will try to find a place to sell the byproducts, perhaps to other manufacturers that can use them as raw materials. By-products should be priced at as high a price as possible, but the manufacturer should accept any price that is higher than the cost of storing and delivering them to the purchaser. Whatever the manufacturer can receive from their sale reduces the cost of the main product, and some by-products can even be profitable in themselves. Furthermore, recycling industrial waste from one manufacturing process into raw material for another manufacturing process is an environmentally responsible business practice. Product-bundling pricing Product bundling occurs when a sellers bundles products, features or services together and offers the bundle at a price that is lower than the price of the items if purchased individually. For example, a software vendor may create a suite of programs and offer them together at a reduced price. If the customer has only one option to purchase the entire bundle or to purchase nothing that is called pure bundling. However, if the consumer has a choice between buying the bundle or buying one or more of the bundled items individually (at a higher per-unit price), that is called mixed bundling. 41

52 Pricing Strategy CMA Part 2 Short-Run and Long-Run Pricing Decisions Most pricing decisions are either short-run (less than a year) or long-run (longer than a year). Two key differences affect pricing for the long run in relation to the short-run: 1) Costs that are irrelevant for short-run pricing, such as fixed costs, may be relevant in the long run as they become variable costs. In the long run, all costs are variable. 2) Profit margins in long-run pricing decisions are set to earn a return on investment. In the short run, prices are decreased when demand is low and increased when demand is strong. Short-term decisions maximize contribution. Short-run pricing decisions are usually influenced by short-run conditions that affect the demand and supply, such as capacity either too much or too little or competitors prices. Over the long run, however, customers prefer stable and predictable prices. Greater price stability is also better for the company selling the goods, because it (1) reduces the need to monitor competitors prices; (2) improves the company s ability to plan; and (3) builds long-term business relationships. Both short-run pricing and long-run pricing take into consideration the three Cs, customers, competitors and costs. However, their starting points differ. Short-Run Pricing Short-run pricing is opportunistic and more responsive to changes in demand than long-run pricing. In short-run pricing decisions, fixed costs are frequently irrelevant, because they cannot be changed in the short term. This means that at a minimum the selling price needs to be at least the variable costs of production. For instance, the cost of a special order will be only the variable costs associated with its production, since the fixed costs will not increase because of the special order (as long as the company has the excess capacity to fill the order without reducing production of other goods). Availability of production capacity also plays an important part in short-term pricing. If a company has unused (excess) capacity, it will be more likely to price its products lower than it would be if it were operating at 100% capacity. They will do this because it is better to make a small profit and use the capacity than to have the factory sit unused. Another consideration in short-run pricing is competitors and what they are bidding. If bidding on a one-time special order, the company would want to bid a price that covers its incremental costs but is lower than competing bids. Long-Run Pricing To determine a long-run price that will be stable over time and also earn the desired long-run return, a company must know its long-run costs, including all costs involved in the production and sale of the product. This incorporates fixed costs and indirect manufacturing costs. There are two approaches to setting long-run prices: (1) a market-based approach, or (2) a cost-based approach, also called cost-plus. The market-based approach starts with the customer and competitor, and then looks at costs. The cost-based approach looks first at costs and considers customers and competitors secondarily. Which strategy an individual company uses generally depends on what type of market the company is operating in. 42

53 Section C Pricing Strategy The Market-Based Pricing Approach Note: This is the first of the two long-run pricing approaches. The market-based approach focuses on what the customers want and how competitors will react to what the company does. Companies operating in competitive markets, such as oil and gas, use this approach. In this market, one company s products or services are very similar to another company s, so an individual company has no influence over the price to charge. Each company accepts the market price. Target pricing is an important form of market-based pricing. A target price is a price based on knowledge of customer perception of the value of the product or service and what customers are willing to pay, as well as knowledge of competitors responses. Steps in establishing a target price and a target cost are: 1) The company develops a new product that meets the needs of potential customers. 2) The company estimates the price that potential customers will be willing to pay, based on customers perceived value for the product, as well as projected sales at that price. Prices that customers will be willing to pay and projected sales come from marketing department input, which may be determined through market research or other marketing techniques. Pricing would also be based on expected responses from competitors. This information could come from competitors customers, suppliers and employees. Or it may be derived by means of reverse engineering, which is the process of taking apart competitors products and analyzing them to determine design, materials and technology used. 3) The target price then determines what the target cost per unit needs to be in order to earn the target operating income per unit. The target cost per unit is the target price minus the target operating income per unit. Calculation of the target cost must include all future costs, both variable and fixed. But the target cost is only that: a target to shoot for. The target cost may be lower than the company s actual current costs. The company must then find ways to reduce costs such as seeking cost concessions from suppliers. 4) Value engineering is performed. Value engineering is an evaluation of all the business functions in the value chain with the objective of reducing costs while satisfying customer needs. This may lead to design improvements, materials specification changes or modifications in manufacturing methods. In value engineering, management distinguishes between a value-added cost and a non-valueadded cost. If a value-added cost were eliminated, it would reduce the product s value, or usefulness, to customers. Since value-added costs cannot be eliminated, value engineering seeks to reduce their costs by improving efficiency. On the other hand, if a non-value-added cost were eliminated, it would not reduce the value or utility of the product. A non-value-added cost is a cost the customer is not willing to pay for. Examples of non-value-added costs are costs for expediting, re-work and repair; and these are costs that can be reduced through improvements to the manufacturing process. Locked-in costs must also be recognized in value engineering. For example, direct materials costs per unit are locked in (or designed in) at an early stage in the development of a product, and they are difficult to reduce later. Scrap and re-work costs may be locked in by a faulty design. For example, in the software industry, costly and difficult-to-fix errors that appear during coding and testing are already locked in by bad design at the beginning. The costs may not have been incurred yet, but they will be. If the costs have not been locked in early, costs can be reduced right up to the time they are incurred, and the costs may be reduced by improved operating efficiency and productivity measures. However, when locked-in costs are a factor, the key to reducing them is in the product design, and value engineering must focus on making innovations and modifications at this early stage. 43

54 Pricing Strategy CMA Part 2 The Cost-Based Pricing Approach Note: This is the second of the two long-run pricing approaches. The cost-based approach focuses on what it costs to manufacture the product and the price necessary to both recoup the company s investment and achieve a desired return on its investment. It is used in a market where there is product differentiation, such as automobile manufacturing. A company using this method calculates the cost of production and then adds a markup. This markup is a percentage of the cost of production. The company may use whatever it wants as the cost of production, but the most common costs to use are: 1) Total cost, 2) Absorption manufacturing costs, 3) Variable manufacturing costs, or 4) Total Variable costs. The company must be certain that it does not take into account the cost of any unused fixed assets when calculating its cost of production. If the cost of these unused fixed assets were included in the cost of the product, it would cause the price to be based on a figure that is higher than the actual cost of production. The higher price would, in turn, lead to a decreased demand and further idle fixed assets. This is called the downward demand spiral. In order to prevent this, the company should not include the costs of idle fixed assets in its calculation of the cost of production for the purpose of determining prices. In cost-plus pricing, a target percentage markup over cost is determined, and the price is based on the full cost per unit to manufacture the product, plus the markup. The target percentage markup is based on the target annual operating income the company desires, divided by invested capital. Invested capital for this purpose is defined in many ways, but one of the more common is that it is equal to Total Assets, both long-term and current. However, the target percentage markup is not the same percentage as the target rate of return on investment, because the divisors are different. The company must first calculate what its target rate of return on investment is, then express that as a dollar amount per unit, and then use that dollar amount to determine the markup percentage that is needed to achieve that return. Example (if a company has one product only): ABC Industries has total invested capital (total assets) of $100,000,000. If ABC s pre-tax target return on invested capital is 15%, its target annual pre-tax operating income needs to be 15% $100,000,000, or $15,000,000. ABC estimates that it can sell 200,000 widgets per year. Therefore, ABC will require pre-tax operating income of $75 per unit ($15,000, ,000) to achieve a pre-tax net operating income of $15,000,000. Therefore, $75 must be added to the cost per unit to derive the price to charge. If the cost per unit is $750, the markup percentage is $75 $750, or 10%, and the price will be $825 per unit ($750 + $75). In practice, of course, companies rarely have only one product, and so it can be difficult to determine the invested capital for one product out of the number of products produced. Therefore in practice, companies usually estimate the markup percentage that will be sufficient to earn the required return on invested capital. The markup percentage used is also affected by competition. If a market is highly competitive, markups and thus profit margins will tend to be lower. 44

55 Section C Pricing Strategy Question 18: A newly developed product by Paterno Co. is expected to sell 5,000 units per year and the costs of producing this product are expected to be, in total, $450,000 per year. Paterno would like to have a gross profit of 30% of the sales price. In order to achieve this, what price (rounded to the nearest dollar) does Paterno need to set for this product? a) $117 b) $120 c) $129 d) $135 (HOCK) Government Contracts, the CASB, and Cost Plus Pricing In 1970, the US Congress established the Cost Accounting Standards Board (CASB) to achieve uniformity and consistency in cost accounting standards for contracts and subcontracts with the US government. The CASB established standards regarding cost measurement, assignment and allocation in contracts with the US government. The standards are applicable only to contracts greater than $500,000. This was a result of the fact that often the US had paid large amounts for simple products because of contracts that were negotiated as cost plus, and the suppliers had been very liberal in their interpretation of what was a cost. Cost-Plus and Target Pricing Used Together In a market where there is product differentiation, companies would be more likely to consider both the market and the costs giving equal emphasis to both strategies. Sales prices set by cost-plus pricing are prospective prices only. In the above example, ABC s price for widgets was determined to be $825 per unit. However, ABC operates in a fairly competitive market, and customer and competitor reactions to this price may require a price reduction to $780 per unit. This will reduce the markup percentage to only 4%, unless costs are reduced. ABC will need to employ the value engineering described under target pricing in order to reduce its costs if it expects to produce the widgets at its required rate of return. Target pricing used alone reduces the need to go back and forth between setting a cost-plus price, then evaluating that price in light of customer preferences and competitor responses, then calculating a target cost. Instead, target pricing begins with the customer preferences and competitor responses. The market and the market price then motivate managers to reduce costs to achieve the target cost. If they are not able to reduce costs sufficiently, the company must either redesign the product or accept a smaller profit margin. Product Life-Cycle Pricing and Costing The product life cycle is the time from the initial research and development on a product to the point when the company no longer offers customer servicing and support for the product. Life-cycle costing tracks and accumulates all the costs of each product all the way through the value chain. Other terms for life-cycle costing are cradle-to-grave costing and womb-to-tomb costing. A product s life cycle usually spans several years. Life-cycle budgeted costs are used in pricing decisions because they incorporate costs that might not otherwise be considered. If costs for research and development and other nonproduction costs such as marketing, distribution and customer service are significant, it is essential to include them in the product s cost along with the direct manufacturing costs. 45

56 Pricing Strategy CMA Part 2 The price set is the price that will maximize life-cycle operating income. A company may decide to bring the new product out at an exceptionally high or exceptionally low price and then adjust the price later. A life-cycle budget will incorporate this strategy. Target pricing and target costing often utilize life-cycle costing in order to develop life-cycle budgets for products that estimate costs and revenues over the entire life of the product. Product Life-Cycle (PLC) Strategies Brands, products and technologies all have life cycles. The stages in the life cycle of a product are: Product development stage During product development, there are no sales and so no revenues. The company s investment costs increase. Introduction stage This stage is typically one of slow growth and minimal profits, because of the heavy upfront expenses to introduce a new product. Growth stage If the introduction stage is successful, the product will experience rapid sales growth and increasing profits in the growth stage. Maturity stage Sales growth usually slows down in this stage and profits level off or decrease. The company has to spend more for marketing to defend the product against the competition. Decline stage Sales drop and profits fall. Some products remain in the maturity stage for a long time, and some enter the decline stage but then cycle back to the growth stage, perhaps because the company successfully repositions the product. Specific marketing strategies are used at each stage of the product life cycle. Introduction Stage Strategies When the product is first launched, the introduction takes time, and sales growth is slow. The marketing objective at this stage is to create trial of the product. Promotion spending needs to be high in order to educate consumers about the new product and to get them to try it. Distribution channels are selectively built. The company, as well as its competitors, produce only basic versions of the product and focus sales promotion efforts on buyers who are the most ready to buy, the so-called early-adopters. Pricing at this stage may be high, assuming a skim pricing strategy for a high profit margin as the early adopters buy the product and the firm seeks to recoup development costs quickly. However, in some cases a penetration pricing strategy is used and introductory prices are set low to gain market share rapidly. Growth Stage strategies If the new product gets through the introduction stage successfully, it will enter the growth stage, when sales increase rapidly. In addition to the early-adopters, who continue to buy, the later buyers will begin buying if they hear favorable information about the product. New competitors will enter the market because of the opportunity for profits and will introduce new product features, causing the market to expand. Prices remain at the same level, or they may fall slightly. Companies keep their promotional spending at a high level, possibly increasing it slightly. The company still needs to educate the consumers, but now it must counter the competition s efforts, as well. Profits increase because promotion costs and fixed manufacturing costs are spread over a larger volume. The marketing objective at this stage is to maximize market share. The firm s strategy in this stage will include continuously improving product quality and adding new product features and models. Pricing may be maintained at a high level if demand is high, or it may be reduced to capture more of the market, as in market penetration pricing. Although product awareness advertising continues, some advertising will be shifted from the goal of building product awareness to the goal of building product conviction and purchase. Sales promotion is less important because consumer demand is heavy. The company will lower prices at appropriate times to attract more buyers. The company uses this time to build an intensive distribution channel. If the company invests heavily in product improvement, promotion, and distribution, it should attain a dominant position in the market. However, it gives up current profits to do so. 46

57 Section C Pricing Strategy Maturity Stage strategies The maturity stage usually lasts longer than the other stages, and it creates more challenges to the marketer. Most existing products are in their maturity stage, and most of marketing management is dealing with mature products. Sales peak during this stage, but sales growth slows down. Because of the slowdown in sales growth, many producers with many products are in the market, so there is overcapacity in the market. Although profits are still high, prices begin to decrease while at the same time promotion costs increase, leading to lower profits. Weaker companies drop out of the market, and only the stronger companies remain. The marketing objective at this stage is to maximize profit while defending market share. At this stage, product managers should look for ways to modify the market, product, and marketing mix. Modifying the market means increasing total consumption of the current product by the market. The company will look for new market segments as users and for new ways to increase usage among current customers. Modifying the product involves changing things like the product s quality, its performance, its features, or its style in order to attract new users and increase usage. Modifying the market mix includes changing one or more of the marketing mix elements (the four Ps - product, price, promotion and place) to improve sales. It might cut prices in response to competition or launch a new advertising campaign or use sales promotions such as coupons or premiums. Decline Stage Strategies Technological advances and other factors ultimately cause sales to decline. In the decline stage, more firms withdraw from the market. The ones that remain may cut back on their product offerings, and they may cut the promotion budget and reduce prices further. The marketing objective at this stage is to reduce expenditures and milk (make the most of) the brand. Management needs to identify products that are in the decline stage by monitoring sales, market share, costs and profits, in order to decide whether to maintain, harvest, or drop each of the declining products. If management decides to maintain the brand, they may do that without change, if they believe that other competitors will leave the industry. Or, management may decide to maintain the product but reposition it or reformulate it in hopes of moving it back to the growth stage. Alternatively, management may decide to harvest the product. This includes reducing costs by withdrawing R&D, advertising, sales promotion and selling support and hope that sales will hold up anyway. The price will probably be cut at this point. If sales do hold up, this tactic will increase short-term profits. Prices may be maintained for products that will be continued because they serve a niche market if they are profitable. The last option is to drop the product from the line. The company may be able to sell the product to another firm, or simply liquidate it. If the goal is to liquidate the inventory of discontinued products, the price will be cut to accomplish that. If the company is planning to find a buyer, it will want to maintain the product until it can be sold and not harvest it. Boston Consulting Group Growth-Share Matrix Another way of analyzing a product s position in its life cycle was developed by the Boston Consulting Group in the 1970s. It is called the BCG Matrix, or Growth-Share Matrix. The BCG Matrix was developed to assist corporations in analyzing the life cycles of their product lines in order to make better decisions about allocation of resources. The BCG Matrix classifies products into four categories based on the growth of the markets they are in and their share of those markets. The matrix is a square with four quadrants. Market growth rate is along the side and relative market share is along the top. A product s position on the relative market share scale (high or low) indicates its cash generation capability; and its position on the market growth rate scale (high or low) indicates its need for cash for investment. 47

58 Pricing Strategy CMA Part 2 BCG Growth-Share Matrix Relative Market Share (Cash Generation) High Low STARS QUESTION MARKS Market Growth Rate (Cash Usage) Low High CASH COWS DOGS A star is in an industry that has a high market growth rate, and the product has a high share of the market. A star generates a lot of cash because it has a high share of its market. However, because the market is growing rapidly, the star s sales are also growing rapidly. As a result, it has a high need for cash for investment. Therefore, the net amount of cash a star generates is not great. If a star can maintain a high market share, the star will become a cash cow when the market s growth rate declines, generating more cash than it consumes. Stars are important because they ensure future cash generation. The company may adjust the price of a star several times, decreasing it to claim market share and as the product s market share and popularity grow, increasing the price to maximize revenue. A question mark is a product in an industry with a high market growth rate, but the product has a low share of the market. Because the market is growing rapidly, the question mark s sales are also growing rapidly, so it will consume a lot of cash for investment. However, because of its low market share, it does not generate much cash. A question mark has potential to gain market share and become a star and then eventually a cash cow when the growth rate of the market slows. But for the present, a question mark is considered a problem child because its net cash generated is negative. Furthermore, if the question mark does not attain a greater share of its market, it will turn into a dog when the growth rate of the market declines. A question mark may or may not be worthy of the additional investment that would be required to increase its market share. It needs careful analysis to determine whether or not to invest more money in it. Because a question mark needs to increase its market share quickly in order to avoid turning into a dog, pricing of a question mark should be aggressive. A cash cow is in an industry with a low market growth rate, but the product has a high share of the market. Cash cows are in mature markets in which the growth rate has slowed, but they are market leaders. Cash cows generate more cash than they consume. They are regarded as boring, but any company would be glad to have them. They should be milked to extract their profits without investing much cash in them. Investment in a cash cow would be wasted money because of the slow growth of the industry. The characteristics of a cash cow product do not change much, customers know what they are getting, and the price does not change much either. A dog is in a mature industry with a low market growth rate, and it has a low share of the market. A dog does not consume much cash, but it does not generate much cash, either. It is usually barely breaking even. The investment money tied up in it has little potential, and it depresses the company s Return on Assets. Dogs should be sold off, and pricing is not a major concern. 48