Accounting: The Language of Business - Vol. 1 (Part 151)

History, like nature, has its own economy, its own balancing of forces in the final accounting. Nothing can be lost, except to awareness.

Helen Foster Snow

 Differential Analysis and Product Pricing (Part E)

by

Charles Lamson 

Setting Normal Product Selling Prices 

Differential analysis may be useful in deciding to lower selling prices for special short-run decisions, such as whether to accept business at a price lower than the normal price. In such cases, the minimum short-run price is set high enough to cover all variable costs. Any price above this minimum price will improve profits in the short run. In the long run, however, the normal selling price must be set high enough to cover all costs and expenses [both fixed (any number of expenses, including rental lease payments, salaries, insurance, property taxes, interest expenses, depreciation, and potentially some utilities) and variable (costs that change as the quantity of the good or service that a business produces changes)] and provide a reasonable profit. Otherwise, the business may not survive.

The normal selling price can be viewed as the target selling price to be achieved in the long run. The basic approaches to setting this price are as follows:

Managers using the market methods refer to the external market to determine the price. Demand-based methods set the price according to the demand for the product. If there is high demand for the product, then the price may be set high, while lower demand may require the price to be set low.

Competition-based methods set the price according to the price offered by competitors. For example, if a competitor reduces the price, then management may be required to adjust the price to meet the competition.

Managers using the cost-plus methods price the product in order to achieve a target profit. Managers add to the cost an amount called a markup, so that all costs plus a profit are included in the selling price. In the next two posts, we describe and illustrate the three cost concepts often used in applying the cost-plus approach: (1) total cost, (2) product cost, and (3) variable cost. A cost reduction method that uses market-method pricing, called target costing, is discussed in a later post.

Total Cost Concept

Using the total cost concept all costs of manufacturing a product plus the selling and administrative expenses are included in the cost amount to which the markup is added. Since all costs and expenses are included in the cost amount, the dollar amount of the markup equals the desired profit.

The first step in applying the total cost concept is to determine the total cost of manufacturing the product. This cost includes the costs of direct materials, direct labor, and factory overhead and should be available from the accounting records. The next step is to add the estimated selling and administrative expenses to the total cost of manufacturing the product. The cost amount per unit is then computed by dividing the total costs by the total units expected to be produced and sold.

After the cost amount per unit has been determined, the dollar amount of the markup is determined,. For this purpose, the markup is expressed as a percentage of cost. This percentage is then multiplied by the cost amount per unit. The dollar amount of the markup is then added to the cost amount per unit to arrive at the selling price.

The markup percentage for the total cost concept is determined by applying the following formula:

Markup percentage = Desired profit / Total costs

The numerator of the formula is only the desired profit. This is because all costs and expenses are included in the cost amount to which the markup is added. The denominator of the formula is the total costs.

To illustrate assume that the costs for calculators of Digital Solutions Inc. are as follows:

 Digital Solutions Inc. desires a profit equal to a 20% rate of return on assets, $800,000 of assets are devoted to producing calculators, and 100,000 units are expected to be produced and sold. The calculators' total cost is $1,670,000, or $16.70 per unit, computed as follows: 

The desired profit is $160,000 (20% x $800,000), and the markup percentage for a calculator is 9.6%, computed as follows:

Markup percentage = Desired profit / Total costs

Markup percentage = $160,000 / $1,670,000 = 9.6%

Based on the total cost per unit and the markup percentage for a calculator, Digital Solutions Inc. Would price each calculator at $18.30 per unit, as shown below.

The ability of the selling price of $18.30 to generate the desired profit of $160,000 is shown by the following income statement:

The total cost concept of applying the cost-plus approach to product pricing is often used by contractors who sell products to government agencies. In many cases, government contractors are required by law to be reimbursed for their products on a total-cost-plus-profit basis. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 1001-1003*

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