Chapter 15 – Target Costing and Cost Analysis for Pricing Decisions
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CHAPTER 15
TARGET COSTING AND COST ANALYSIS FOR
PRICING DECISIONS
Learning Objectives
1. List and describe the four major influences on pricing decisions.
2. Explain and use the economic, profit-maximizing pricing model.
4. Discuss the issues involved in the strategic pricing of new products.
5. List and discuss the key principles of target costing.
6. Explain the role of activity-based costing in setting a target cost.
8. Explain the process of value engineering and its role in target costing.
9. Determine prices using the time and material pricing approach.
10. Set prices in special-order or competitive-bidding situations by analyzing the
relevant costs.
Chapter 15 – Target Costing and Cost Analysis for Pricing Decisions
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Chapter Overview
I. Major Influences on Pricing Decisions
A. Customer demand
B. Actions of competitors
C. Costs
D. Political, legal, and image-related issues
II. Economic Profit-Maximization Pricing
A. Total revenue, demand and marginal revenue curves
B. Total cost and marginal cost curves
III. Role of Accounting Product Costs in Pricing
A. Cost-plus pricing
B. Absorption-cost pricing formulas
C. Variable-cost pricing formulas
D. Determining the markup
E. Cost-plus pricing: summary and evaluation
IV. Strategic Pricing of New Products
V. Target Costing
A. A strategic profit and cost management process
V. Time and Material Pricing
VI. Competitive Bidding
VII. Effect of Antitrust Laws on Pricing
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Key Lecture Concepts
I. Major Influences on Pricing Decisions
• Customer demand is a major influence on all aspects of operations.
Consideration is given to the price that customers are willing to pay, the
quality desired, and any accompanying trade-offs.
• A company cannot set prices without considering the products and
pricing strategies of competitors.
• Costs are a factor in the pricing process, more in some industries than in
others.
➢ Generally speaking, prices are set by considering both cost and
market influences.
Teaching Tip: Airline fares change frequently and also vary significantly on a per-
mile basis based on the departure and arrival airports. The reason: It has little to
do with cost and more—much more—to do with competition. As an interesting
II. Economic Profit-Maximization Pricing
• Companies are sometimes price takers. This means their products’ prices
are determined totally by the market.
• The total revenue curve graphs the relationship between total sale
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revenue and quality sold. The demand curve (or average revenue curve)
shows the relationship between the sales price and the quantity of units
demanded. The marginal revenue curve shows the change in total
revenue that accompanies a change in the quantity sold.
• The total cost curve graphs the relationship between total cost and the
quantity produced and sold each month. The marginal cost curve shows
the change in total cost that accompanies a change in the quantity
produced and sold.
• The impact of price changes on sales volume is known as price elasticity.
Demand is elastic if a price increase has a large negative impact on sales
volume, and vice versa. Cross-elasticity refers to the extent to which a
change in a product’s price affects the demand for other substitute
products.
➢ The measurement of price elasticity is an important objective of
• There are several limitations to using the economist’s model in practice:
➢ Market research is seldom sufficient to predict the exact effect of a
price change on demand, because many other factors (e.g., product
➢ Practically speaking, cost-accounting systems cannot provide the
marginal cost information needed in the model for a company’s
various product lines. The cost of gaining such information would
outweigh the benefits.
▪ Companies face a cost-benefit trade-off and operate between
the prices suggested by the expensive-to-use marginal
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expensive cost-based approach to pricing.
III. Role of Accounting Product Costs in Pricing
• Product costs give managers a starting point when setting prices. No
organization can price its products below total cost indefinitely and
continue in business.
➢ The price floor is total cost, and the price ceiling is the amount that
The general cost-plus formula is: Price = Cost + (Markup percentage x
Cost)
There are several ways to define the cost factor in the formula, and for
each, the markup is adjusted to yield the same target price.
➢ For long-term pricing, cost may be defined as absorption cost (direct
materials, direct labor, variable manufacturing overhead, and fixed
manufacturing overhead).
▪ This definition reminds managers that all elements of
production must be covered by a firm’s selling price. Also,
these data are readily available because absorption cost is
used for valuing inventory on the balance sheet.
▪ A disadvantage to using absorption cost is the inconsistency
with cost-volume-profit analysis, which allows managers to
study the effects of changes in sales and prices on
profitability.
➢ Variable-cost pricing formulas define cost as all variable costs. Some
managers prefer this method because of its consistency with cost-
volume-profit analysis and special-order decision making.
▪ On the negative side, prices may be set too low because, in
the long run, all costs must be covered by the selling price.
• Regardless of the definition of cost, a markup percentage is determined
that will cover all costs and provide a return to the company (i.e., return-
on-investment pricing). The following formula is used to calculate the
target profit needed in the markup calculation:
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Target profit = Average invested capital x Target ROI %
➢ The target profit is then employed to derive the markup percentage
for the company’s pricing policy:
IV. Strategic Pricing of New Products
• Pricing of new products is more difficult than pricing an existing product
because of the uncertainty associated with production and demand. Two
pricing strategies are frequently used:
➢ Skimming pricing—setting the initial price high to reap profits
before competition enters the market. As the product gains
acceptance, its price is gradually lowered.
V. Target Costing
• A number of firms use target costing in product pricing. Under this
approach:
➢ A company employs market research to determine the price at
which a product will sell.
• Key principles of target costing:
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➢ Price-led costing—The target cost is set by first determining the
price at which a product or service can be sold in the marketplace.
This is unlike cost-plus pricing, which begins with cost and works
toward a selling price.
➢ Focus on process design—Consistent with the above, every aspect
of the production process must be examined to ensure the highest
level of manufacturing efficiency.
➢ Cross-functional teams—Manufacturing a product at or below its
target cost requires a team effort from various areas within the
organization: market research, purchasing, production,
engineering, and cost management.
• Activity-based costing (ABC) can help in target costing, as well as in cost-
plus pricing methods, because the focus on activities assists in eliminating
cost distortion.
➢ In cost-plus methods, incorrect costs could lead to significant errors
in over- and under-pricing a product, perhaps resulting in eventual
lost customers or a sale below cost.
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VI. Time and Material Pricing
• Time and material pricing is used by construction companies, print
shops, repair shops, consultants, and other similar “job-oriented”
businesses.
VII. Competitive Bidding
• Competitive bidding requires the submission of sealed bids in an effort to
secure a contract for a project or product.
➢ The higher the bid price, the greater the profit for the contractor if
the contractor gets the job. Of course, a high-priced bid lowers the
probability of being the ultimate selection.
➢ Capacity issues:
VIII. Effect of Antitrust Laws on Pricing
• Businesses must stay within the legal framework of pricing as regulated
by the Robinson-Patman Act, the Clayton Act, and the Sherman Act.
Careful records must be kept to document that a company does not
engage in either:
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Teaching Overview
This chapter dovetails nicely with relevant costing from Chapter 14, with opportunities
to carry relevancy forward into special-order decisions, time and material pricing, and
competitive bidding (both with excess and no excess capacity). Chapter 15 provides a
brief summary of the economist’s pricing model, reviewing the relationship between
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Links to the Text
Homework Grid – CHAPTER 15
Item No.
Learning
Objectives
Completion
Time (min.)
Exercises:
15-28
1, 2
25
15-29
1, 2
30
15-30
1, 2
30
15-31
1, 2
40
15-32
1, 3
30
15-33
10
15
15-34
1, 3
25
15-35
1, 3
30
15-36
9
15
15-37
4, 5, 8
30
Problems:
15-38
10
45
15-39
9
30
15-40
3, 10
25
15-41
10
25
15-42
3, 5, 6, 8
30
15-43
10
30
15-44
5, 6, 8
25
15-45
5, 6, 8
40
15-46
7
50
15-47
5, 6, 8
35
Cases:
15-48
10
40
15-49
10
50
* W = Written response E = Ethical issue G = Group work
I = International C = Internet use S = Spreadsheet