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CHAPTER 13: JOINT MANAGEMENT OF
REVENUES AND COSTS
Cost Management, Canadian Edition
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 1
Learning Objectives
• Q1: How is value chain analysis used to improve
operations?
• Q2: What is target costing and how is it performed?
• Q3: What is kaizen costing and how does it compare
to target costing?
• Q4: What is life cycle costing?
• Q5: How are cost-based prices established?
• Q6: How are market-based prices established?
• Q7: What are the uses and limitations of cost-based
and market-based pricing?
• Q8: What additional factors affect prices?
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 2
Q1: How is value chain analysis
used to improve operations?
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide 3
Value Chain Analysis
• The value chain is the series of sequential business
processes an organization completes in order to
deliver goods and services to customers.
• To manage costs, companies analyze the activities
in the value chain.
– Non-value-added activities are those that can be
reduced or eliminated without affecting the value of
the goods to the customer.
– Value-added activities are necessary activities and
support the value of the goods to the customer.
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 4
Q2: What is target costing and
how is it performed?
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide 5
Target Costing
• In competitive markets, companies may have no
control over selling prices.
• The company’s only method to manage profits,
then, is to manage costs.
• The selling price is used to back into the target cost
of the product.
Target
=
cost
© John Wiley & Sons, 2009
Selling
price
–
Required
profit margin
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 6
Target Costing
• Target costing takes place before the decision to
produce the product is final.
• It is most likely to be successful when:
– production and design processes are complex,
– relationships with suppliers are flexible, and
– potential customers may be willing to pay for product
attributes that will differentiate the product from the
competition.
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 7
Target Costing Example
Ted’s Trailers is considering the design, production, and distribution of a new
motorcycle trailer. The selling price of similar trailers is $1,200. Ted believes
he can sell 10,000 trailers at this price, and he demands a margin of 25% of
selling price on all products. Compute the target cost of the trailers.
Target cost = $1,200 – ($1,200 x 25%) = $900
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 8
Target Costing Example
The estimated production costs for the new trailer are shown below.
Discuss the types of issues that Ted should investigate as he seeks to reduce
these estimated costs to meet the target cost.
Direct materials
Direct labour
Variable mfg overhead
Fixed mfg overhead
Variable selling expenses
Fixed selling & admin expenses
$500
210
50
70
40
70
$940
• Can the product be redesigned so that the
quantity of materials and/or labour can be
reduced?
• Can the purchase price of any of the materials be re-negotiated with the supplier(s)?
• Can the production process be redesigned
so that the quantity of materials and/or
labour can be reduced?
• Can the design of the product be changed to incorporate features that the
customer would be willing to pay for?
• Can variable selling expenses, for example, commissions, be reduced on this new
product?
• Can more than 10,000 units be produced and sold so that the allocation of fixed
costs per unit decreases?
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 9
Q3: What is kaizen costing and
how does it compare to target
costing?
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide 10
Kaizen Costing
• In kaizen costing, explicit cost reductions are
planned over time.
• Kaizen costing takes place after the production
process has begun.
• Kaizen costing is a continuous improvement
process that takes place over a longer planning
horizon than target costing.
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 11
Q4: What is life cycle costing?
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide 12
Life Cycle Costing
• Life cycle costing takes the product’s selling prices
and costs over its entire life cycle into consideration.
• It is useful in industries with products that are
expected to produce losses when first introduced,
but rapid technological changes and increased
volume are expected in future years.
• Initial production and process design costs will be
viewed as costs to be matched against the revenues
generated over the product’s entire life.
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 13
Q5: How are cost-based prices
established?
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide 14
Cost-Based Pricing
• A selling price that is computed as the product’s
cost plus a markup is known as a cost-based price.
• The costs included in the base cost can be variable
costs only or variable plus fixed costs.
• Some companies include only production costs in
the cost base and others include production, selling,
and administrative costs.
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 15
Q6: How are market-based
prices established?
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide 16
Market-Based Pricing
• A product’s selling price depends on the degree of
competition and the degree to which the company’s
product is differentiated from competitors’ products.
• Market-based prices are based on customer
demand for the product.
• The sensitivity of customer demand to changes in
the selling price is called the price elasticity of
demand.
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 17
Market-Based Pricing
• An increase in selling price should decrease
customer demand for the product so that fewer
units are sold.
– When the decrease in units sales offsets the
increased selling price, the price increase causes
total revenue to decrease. This is known as elastic
demand.
– When the decrease in units sales does not offset the
increased selling price, the price increase causes
total revenue to increase. This is known as inelastic
demand.
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 18
Market-Based Pricing
Elastic demand:
Total
Revenue
Selling
price
=
Quantity of
units sold
x
Inelastic demand:
Total
Revenue
© John Wiley & Sons, 2009
=
Selling
price
x
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Quantity of
units sold
Slide # 19
Price Elasticity of Demand
• The price elasticity of demand is calculated as
follows:
Price elasticity
of demand
=
ln(1 + % change in quantity sold)
ln(1 + % change in price)
• This elasticity can be used to compute the profitmaximizing price:
Profitmaximizing
price
© John Wiley & Sons, 2009
=
Elasticity
Elasticity +1
x
Variable cost
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 20
Market-Based Pricing Example
Ted’s Trailers sells horse trailers in a competitive market. The variable costs
of producing the one-horse trailer are $850 per unit. Information from prior
years indicates that a 10% increase in the trailer’s selling price results in a
15% decrease in customer demand. Calculate the price elasticity of demand
and the profit-maximizing price for the one-horse trailer.
Price elasticity
=
of demand
Profitmaximizing
price
© John Wiley & Sons, 2009
=
ln(1 - 0.15)
ln(1 + 0.10)
-1.70516
-0.70516
-0.16252
=
0.09531
= -1.70516
x $850 = $2,055
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 21
Q7: What are the uses and
limitations of cost-based and
market-based pricing?
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide 22
Uses & Limitations of Cost-Based
Pricing
• Cost-based pricing is inappropriate in highly
competitive markets.
– If products are priced based on allocated fixed costs,
and the price is too high for the market, the quantity
sold will decrease.
– This decrease in sales will cause an increase in the
fixed costs allocated to each unit.
– The increase in allocated fixed costs will cause even
higher prices and unit sales will decline even further.
• This is known as the death spiral.
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 23
Uses & Limitations of Cost-Based
Pricing
• Cost-based pricing is best used when a company
produces highly customized products.
• However, there can still be problems in these
instances.
– If the determined price is too high the customer will
not buy the customized product.
– The determined price may be lower than the
customer would have paid
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 24
Q8: What additional factors
affect prices?
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide 25
Other Factors that Affect Pricing
• In peak-load pricing, companies charge higher
prices when they are at higher capacities.
• When companies set high prices for newlyintroduced products, and gradually lower prices to
entice customers who would not have purchased at
the higher price, this is known as price skimming.
• When prices are set unusually high to take
advantage of specific situations, this is known as
price gouging.
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 26
Other Factors that Affect Pricing
• Under penetration pricing, companies charge lower
prices for newly introduced products.
• Companies set prices for the interdepartmental
transfer of goods and services known as transfer
prices (chapter 15).
– When this is done to decrease consumer uncertainty
about the new product it is legal.
– When this is done with the intent to eliminate all
competition, it is illegal and is known as predatory
pricing.
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 27
Other Factors that Affect Pricing
• When for-profit companies charge different prices to
different customers and it is not based on
differential costs, this is illegal and is known as
price discrimination.
– Not-for-profit companies can legally charge different
prices to customers based on their ability to pay.
• Collusive pricing, where competitors get together to
determine prices, is not legal.
• Foreign-based companies selling products at prices
lower than in the home country is known as
dumping.
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 28
Pricing in Not-For-Profit Organizations
• NPOs have objectives other than maximization on
profits which results in more complex pricing
decisions
– NPOs do not necessarily expect to recover all costs of
their products
– NPOs receive funding from government funding, grants,
donations, etc
– Prices may reflect organizational goals.
• Prices that are based on income with the objective of
making services accessible to the wider population
• Tuition fees reduced for high-performing students to
attract quality students to a learning institution
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide # 29
Copyright
Copyright © 2009 John Wiley & Sons Canada, Ltd. All rights reserved.
Reproduction or translation of this work beyond that permitted by Access
Copyright (The Canadian Copyright Licensing Agency) is unlawful.
Requests for further information should be addressed to the Permissions
Department, John Wiley & Sons Canada, Ltd. The purchaser may make
back-up copies for his or her own use only and not for distribution or
resale. The author and the publisher assume no responsibility for errors,
omissions, or damages caused by the use of these programs or from the
use of the information contained herein.
© John Wiley & Sons, 2009
Chapter 13: Joint Management of Revenues and Costs
Cost Management, Cdn Ed, by Eldenburg et al
Slide 30