CHAPTER 18
PRICING AND PROFITABILITY ANALYSIS
What is profit? How do we measure it? Many considerations factor into the determination of price. In this
chapter, the authors focus on the measurement of cost, price, and revenues. Economic factors, legal
considerations, and ethical issues are also addressed.
LEARNING OBJECTIVES
After studying Chapter 18, students should be able to:
1. Discuss basic pricing concepts.
2. Calculate a markup on cost and a target cost.
3. Discuss the impact of the legal system and ethics on pricing.
4. Explain why firms measure profit, and calculate measures of profit using absorption and variable
costing.
5. Compute the sales price, price volume, contribution margin, contribution margin volume, sales mix,
market share, and market size variances.
6. Discuss the variations in price, cost, and profit over the product life cycle.
7. Describe some of the limitations of profit measurement.
KEY TOPICS
The following major topics are covered in this chapter (related learning objectives are listed for each
topic):
1. Basic Pricing Concepts (LO 1)
2. Cost and Pricing Policies (LO 2)
3. The Legal System and Pricing (LO 3)
4. Measuring Profit (LO 4)
5. Analysis of Profit-Related Variances (LO 5)
6. The Product Life Cycle (LO 6)
7. Limitations of Profit Measurement (LO 7)
I. BASIC PRICING CONCEPTS
One of the most difficult decisions faced by a company is pricing. With all else equal, customers will buy
more at lower prices and less at higher prices. Producers, on the other hand, are able to supply more at
higher prices than they can at lower prices. The equilibrium price is located at the intersection of the
supply and demand curves. At this price, the amount that producers supply just equals the amount that
consumers demand.
Because price affects quantity sold, producers want to know just how much a price change will change
quantity. Price elasticity of demand is measured as the percentage change in quantity divided by the
percentage change in price. If demand is relatively elastic, a small percent change in price will lead to a
greater percent change in quantity demanded. The opposite is true for inelastic demand. Goods that are
price elastic tend to have many substitutes, are not necessities, and take a relatively large amount of
consumer income. Goods that are price inelastic have few substitutes, are necessities, or constitute a
relatively small percentage of consumer income.
Market structure affects price, as well as the costs necessary to support that price. There are four types of
market structures:
1. Perfect competition
2. Monopolistic competition
3. Oligopoly
4. Monopoly
The various types of market structure and their characteristics are summarized in Exhibit 18.1 (p. 924).
II. COST AND PRICING POLICIES
A. Cost-Based Pricing
With cost-based pricing, a desired markup is generally added to the product’s cost. The markup is a
percentage applied to base cost; it includes desired profit and any costs not included in the base cost.
Common markups can be calculated as follows:
Markup on cost of goods sold = (Selling and administrative expenses
+ Operating income)/Cost of goods sold
Markup on direct materials = (Direct labor + Overhead + Selling and administrative
expenses + Operating income)/Direct materials
Cornerstone 18.1 (p. 924) is a good illustration of showing the how and why of calculating a markup on
cost.
B. Target Costing and Pricing
Target costing is a method of determining the cost of a product or service based on the price (target price)
that customers are willing to pay. The Marketing Department determines what characteristics and price
for a product are the most acceptable to consumers. Then, it is the job of the company’s engineers to
design and develop the product such that cost and profit can be covered by that price.
C. Other Pricing Policies
Penetration pricing is the pricing of a new product at a low initial price to build market share quickly or
establish a customer base. This is useful when the product or service is new and customers have great
uncertainty as to its value. Penetration pricing is not meant to destroy competition or it would be
predatory pricing.
Price skimming involves charging a higher price when a product or service is first introduced. It is used
when the product or service is new, a small group of consumers values it, and the company enjoys a
monopolistic advantage. Price skimming may be done in order to recoup the expenses of research and
development through high initial pricing.
Price gouging occurs when firms with market power price products “too high.”
III. THE LEGAL SYSTEM AND PRICING
Government has an important impact on pricing. Several laws have been passed to regulate the way firms
set prices. Two methods that firms might use to limit competition are predatory pricing and price
discrimination.
Predatory pricing is the practice of setting prices below cost for the purpose of injuring competitors and
eliminating competition. Predatory pricing on the international market is called dumping. This occurs
when companies sell below cost in other countries, and domestic industry is injured.
Price discrimination refers to the charging of different prices to different customers for essentially the
same product. The Robinson-Patman Act was passed in 1936 as a means of outlawing price
discrimination. Price discrimination is allowed only under the following conditions:
1. If the competitive situation demands it.
2. If costs can justify the lower price.
This second condition allows price discrimination on the basis of identifiable cost savings. The burden of
proof for firms accused of violating this act is on the firms. Only manufacturers and suppliers are covered
by the Robinson-Patman Act.
Teaching hint: Students enjoy a discussion of the various pricing policies based on real-world
experiences. For example, after a hurricane, some contractors will practice price gouging. Ethics can be
brought into this discussion as well.
IV. MEASURING PROFIT
Profit is a measure of the difference between what a firm puts into making and selling a product or service
and what it receives. Profits are measured for a number of reasons. These include determining the
viability of the firm, measuring managerial performance, determining whether or not a firm adheres to
government regulations, and signaling the market about the opportunities for others to earn a profit.
A. Absorption-Costing Approach to Measuring Profit
Absorption costing, or full costing, is required for external financial reporting. According to GAAP, profit
is a long-run concept and depends on the difference between revenues and expenses. Over the long run, of
course, all costs are variable. Therefore, fixed costs are treated as if they were variable by assigning some
to each unit of production. Absorption costing assigns all manufacturing costs, direct materials, direct
labor, variable overhead, and a share of fixed overhead, to each unit of product. In this way, each unit of
product absorbs some of the fixed manufacturing overhead in addition to its variable manufacturing costs.
When a unit of product is finished, it takes these costs into inventory with it. When it is sold, these
manufacturing costs are shown on the income statement as cost of goods sold. It is absorption costing that
is used to calculate three measures of profit:
1. Gross profit
2. Operating income
3. Net income
Cornerstone 18.3 (p. 933) shows the how and why of calculating the cost of inventory and preparing the
income statement under absorption costing.
B. Variable-Costing Approach to Measuring Profit
Variable costing (sometimes called direct costing) assigns only unit-level variable manufacturing costs to
the product; these include direct materials, direct labor, and variable overhead. Fixed overhead is treated
as a period cost and is not inventories with the other product costs. Instead, it is expressed in the period
incurred. Under variable costing, only direct materials, direct labor, and variable overhead are
inventoried. Cornerstone 18.4 (p. 936) shows the how and why of calculating the variable cost of
inventory and preparing a variable-costing income statement.
Teaching hint: Ask your class why the valuation of the finished goods inventory differs between the two
approaches. Emphasize that the only difference between the two methods is how they treat fixed
overhead. Exercise 18.15 is a good problem to work to illustrate the differences between absorption and
variable costing. Using the information from this exercise, absorption-costing and variable-costing
income statements can be prepared. In discussing the two statements, point out that expenses are
classified by function for the absorption-costing approach and by behavior for the variable-costing
approach.
C. Inventory Valuation
Teaching hint: At this point, it may help to discuss the relationships between production, sales, and
income. This usually helps students visualize how the flow of fixed overhead into and out of inventory
can create differences between the two incomes.
The relationships between production, sales, and income are as follows:
If
Then
1. Production > Sales
Absorption-costing income > Variable-costing income
2. Production < Sales
Absorption-costing income < Variable-costing income
3. Production = Sales
Absorption-costing income = Variable-costing income
Teaching hint: Ask the students why operating income differs under the two approaches. If they have
difficulty with this question, ask them how the two approaches differ. Again, ask why the value of the
finished goods inventory differs under the two approaches. You might also ask how much fixed overhead
is expensed on the income statements for each of the two approaches. A good approach is to place the
production and sales relationships on the board first and ask the students to predict the income
relationships.
D. Summary of Absorption Costing vs. Variable Costing
To summarize, when inventories change from the beginning to the end of the period, the two costing
approaches will give different operating incomes. The reason for this is that absorption costing assigns
fixed manufacturing overhead to units produced. If those units are sold, the fixed overhead appears on the
income statement under cost of goods sold. If the units are not sold, the fixed overhead goes into
inventory. Under variable costing, however, all fixed overhead for the period is expensed. As a result,
absorption costing allows managers to manipulate operating income by producing for inventory.
The variable-costing income statement has an advantage in addition to providing better signals regarding
performance. It also provides more useful information for management decision making.
E. Profitability of Segments and Divisions
Determining the profit attributable to subdivisions of the company is harder than determining overall
profit because of the need to allocate expenses. Variable costing can provide better information than
absorption costing when analyzing the profitability of product lines.
V. ANALYSIS OF PROFIT-RELATED VARIANCES
A. Sales Price and Price Volume Variances
The sales price variance is the difference between actual price and expected price multiplied by the actual
quantity or volume sold. In equation form, it is the following:
Sales price variance = (Actual price – Expected price) × Quantity sold
The sales volume variance is the difference between actual volume sold and expected volume sold
multiplied by the expected price. It can be expressed in the following equation:
Sales volume variance = (Actual volume – Expected volume) × Expected price
The overall sales variance is the sum of the sales price variance and the price volume variance.
Overall sales variance = Sales price variance + Price volume variance
Cornerstone 18.5 (p. 943) shows the how and why of calculating the sales price, price volume, and overall
sales variance.
B. Contribution Margin Variance
The contribution margin variance is the difference between actual and budgeted contribution margin.
Contribution margin variance = Actual contribution margin – Budgeted contribution margin
Cornerstone 18.6 (p. 944) shows the how and why of calculating the contribution margin variance.
The contribution margin volume variance is the difference between the actual quantity sold and the
budgeted quantity sold multiplied by the budgeted average unit contribution margin. The contribution
margin volume variance gives management information about gained or lost profit due to changes in the
quantity of sales.
Contribution margin volume variance = (Actual quantity sold – Budgeted quantity sold)
× Budgeted average unit contribution margin
Cornerstone 18.7 (p. 946) shows the how and why of calculating the contribution margin volume
variance.
The sales mix represents the proportion of total sales yielded by each product. The sales mix variance is
defined as the sum of the change in units for each product multiplied by the difference between the
budgeted contribution margin and the budgeted average unit contribution margin.
Sales mix variance = [(Product 1 actual units – Product 1 budgeted units) × (Product 1 budgeted
contribution margin – Budgeted average unit contribution margin)] + [(Product 2 actual units – Product 2
budgeted units) × (Product 2 budgeted contribution margin – Budgeted average unit contribution margin)]
Cornerstone 18.8 (p. 947) shows the how and why of calculating the sales mix variance.
C. Market Share and Market Size Variances
Market share gives the proportion of industry sales accounted for by a company. Market size is the total
revenue for the industry.
The market share variance is the difference between the actual market share percentage and the budgeted
market share percentage multiplied by actual industry sales in units times budgeted average unit
contribution margin.
Market share variance = [(Actual market share percentage – Budgeted market share percentage) × Actual
industry sales in units] × Budgeted average unit contribution margin
The market size variance is the difference between actual and budgeted industry sales in units multiplied
by the budgeted market share percentage times the budgeted average unit contribution margin.
Market size variance = [(Actual industry sales in units – Budgeted industry sales in units) × Budgeted
market share percentage] × Budgeted average unit contribution margin
Cornerstone 18.9 (p. 949) shows the how and why of calculating the market share variance and the
market size variance.
VI. THE PRODUCT LIFE CYCLE
The product life cycle describes the profit history of the product according to four stages:
1. Introduction
2. Growth
3. Maturity
4. Decline
In the introductory phase, profits are low for two reasons. First, revenues are low as the product gains
market acceptance. Second, investment and learning may be high, leading to higher expenses. The growth
stage is characterized by increasing market acceptance and sales, as well as economies of scale, which
brings down expenses. The product breaks even, and profit rises. In the maturity phase, profits stabilize.
The product has found its market, and revenues are relatively stable. Investment is down, and all learning
effects in production are realized, leading to stable costs. Finally, in the decline phase, the product reaches
the end of its cycle, and revenues and profits decline. Exhibit 18.5 (p. 951) illustrates the interaction of
profit and the product life cycle with its four stages.
The product life cycle is important for planning purposes. The regularities in manufacturing, costs, and
profit make the product life cycle just as important in cost management. Exhibit 18.6 (p. 951) summarizes
the impact of the product life cycle on cost management.
The product life cycle also has implications for activity-based costing. Exhibit 18.7 (p. 953) depicts the
general direction of costs in the ABC categories throughout the product life cycle.
VII. LIMITATIONS OF PROFIT MEASUREMENT
There are limitations of profit measurement. Three of these limitations are its:
1. focus on past performance
2. emphasis on quantifiable measures
3. strong impact on people’s behavior
VIII. INFORMATION ABOUT EXERCISES, PROBLEMS, AND CASES
Exercises and problems are described below and on the following two pages according to coverage of
content, learning objective(s), and level of difficulty. The time required to solve the problems is roughly
proportional to the level of difficulty.
In general, basic exercises/problems are fairly simple and straightforward. The text material is relatively
brief; only one or two concepts are covered. Basic exercises and problems should take about 15 to 20
minutes each.
Moderate exercises/problems may take longer and involve more concepts. These problems may have a
“twist” and require more thought. Moderate exercises and problems may take 20 to 40 minutes each.
Challenging problems are more comprehensive and may cover more concepts. The text material is
relatively longer and may include some ambiguity. Challenging problems may take 60 to 90 minutes
each.
Cornerstone
Exercise (CS)/
Exercise/
Problem/Case
Topic
Learning
Objective
Degree of
Difficulty
CS 18.1
Markup on Cost, Job Pricing
LO 2
Basic
CS 18.2
Costs of Different Customer Classes
LO 3
Basic
CS 18.3
Absorption Costing, Value of Ending Inventory,
Operating Income
LO 4
Basic
CS 18.4
Variable Costing, Value of Ending Inventory,
Operating Income
LO 4
Basic
Cornerstone
Exercise (CS)/
Exercise/
Problem
Topic
Learning
Objective
Degree of
Difficulty
CS 18.5
Sales Price Variance, Price Volume Variance, Overall
Sales Variance
LO 5
Basic
CS 18.6
Contribution Margin Variance
LO 5
Basic
CS 18.7
Contribution Margin Volume Variance
LO 5
Basic
CS 18.8
Sales Mix Variance
LO 5
Basic
CS 18.9
Market Share Variance, Market Size Variance
LO 5
Basic
18.10
Elasticity of Demand and Market Structure
LO 1
Basic
18.11
Demand Curve and Characteristics of Market Structure
LO 1
Basic
18.12
Basics of Demand, Life-Cycle Pricing
LO 1, 6
Basic
18.13
Markup on Cost, Cost-Based Pricing
LO 2
Basic
18.14
Markup on Cost
LO 2
Basic
18.15
Absorption and Variable Costing with Over- and
Underapplied Overhead
LO 4
Moderate
18.16
Variable Costing, Absorption Costing
LO 4
Moderate
18.17
Cost-Based Pricing, Target Pricing
LO 2
Basic
18.18
Cost-Based Pricing
LO 2
Moderate
18.19
Life-Cycle Pricing, Sales Price and Price Volume
Variances
LO 5, 6
Basic
18.20
Pricing Strategy, Sales Variances
LO 1, 5, 6
Basic
18.21
Price Discrimination, Customer Costs
LO 3
Moderate
18.22
Unit Costs, Inventory Valuation, Variable and
Absorption Costing
LO 4
Moderate
18.23
Income Statements, Variable and Absorption Costing
LO 4
Moderate
18.24
Income Statements and Firm Performance: Variable
and Absorption Costing
LO 4
Moderate
18.25
Absorption- and Variable-Costing Income Statements
LO 4
Challenging
18.26
Contribution Margin Variance, Contribution Margin
Volume Variance, Sales Mix Variance
LO 5
Moderate
18.27
Contribution Margin Variance, Contribution Margin
Volume Variance, Market Share Variance, Market Size
Variance
LO 5
Moderate
18.28
Contribution Margin Variance, Contribution Margin
Volume Variance, Sales Mix Variance
LO 5
Challenging
18.29
Impact of Inventory Changes on Absorption-Costing
Income, Divisional Profitability
LO 4
Challenging
18.30
Ethical Issues, Absorption Costing, Performance
Measurement
LO 3, 4, 7
Moderate
18.31
Segmented Income Statements, Adding and Dropping
Product Lines
LO 4
Challenging
18.32
Operating Income for Segments
LO 4
Moderate
18.33
Product Profitability
LO 4, 6
Challenging
18.34
Customer Profitability, Life-Cycle Revenue
LO 4, 6
Challenging
18.35
Customer Profitability
LO 4
Challenging
18.36
Segmented Income Statements, Analysis of Proposals
to Improve Profits
LO 4
Challenging
Cornerstone
Exercise (CS)/
Exercise/
Problem
Topic
Learning
Objective
Degree of
Difficulty
18.37
Segmented Reporting and Variances
LO 4, 5
Challenging
18.38
Cyber Research Case
LO 1, 6
Challenging
LIST OF ILLUSTRATIONS
Topic
Characteristics of the Four Basic Types of Market Structure
Changes in Inventory under Absorption and Variable Costing
Alden Company Absorption-Costing Income Statement (In Thousands of Dollars)
Alden Company Variable-Costing Income Statement (In Thousands of Dollars)
Product Life Cycle and Profitability
Impact of the Product Life Cycle on Cost Management
Product Life-Cycle Costs in the ABC Categories