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M05_ATRI3622_06_SE_C05.QXD 166 CHAPTER 5 5/29/09 4:22 PM Page 166 COSTING AND PRICING IN A COMPETITIVE ENVIRONMENT REAL WORLD 5.12 Counting the cost plus A fairly recent study surveyed 267 large UK and Australian businesses during the period 1999 to 2002. Their findings were broadly as follows: l l l l l Cost plus is regarded as important in determining selling prices by most of the businesses, but many businesses only use it for a small percentage of their total sales. Retailers base most of their sales prices on their costs. This is not surprising; we might expect that retailers add a mark-up on their cost prices to arrive at selling prices. Retailers and service businesses (both financial services and others) attach more importance to cost-plus pricing than do manufacturers and others. Cost-plus pricing tends to be more important in industries where competition is most intense. This is perhaps surprising, because we might have expected less ‘price makers’ in more competitive markets. The extent of the importance of cost-plus pricing seems to have nothing to do with the size of the business. We might have imagined that larger businesses would have more power in the market and be more likely to be price makers, but the evidence does not support this. The reason could be that many larger businesses are, in effect, groups of smaller businesses. These smaller subsidiaries may not be bigger players in their markets than are small independent businesses. Also, cost-plus pricing tends to be particularly important in retailing and service businesses, where many businesses are quite small. Source: Guilding, C., Drury, C. and Tayles, M., ‘An empirical investigation of the importance of cost-plus pricing’, Management Auditing Journal, Vol. 20, No. 2, 2005. Pricing on the basis of relevant/marginal cost ‘ The relevant/marginal cost approach deduces the minimum price for which the business can offer the product for sale. This minimum price will leave the business better off as a result of making the sale than it would have been had it pursued the next best opportunity. We considered the more general approach to relevant cost pricing in Chapter 2. In Chapter 3, we looked at the more restricted case of relevant cost pricing: marginal cost pricing. Here it is assumed that fixed costs will not be affected by the decision to produce and, therefore, only the variable cost element need be considered. It would normally be the case that a relevant/marginal cost approach would only be used where there is not the opportunity to sell at a price that will cover the full cost. The business can sell at any price above the marginal cost and still be better off, simply because it happens to find itself in the position that certain costs will be incurred in any case. Activity 5.10 A commercial aircraft is due to take off in one hour’s time with 20 seats unsold. What is the minimum price at which these seats could be sold such that the airline would be no worse off as a result? M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 167 PRICING The answer is that any price above the additional cost of carrying one more passenger would represent an acceptable minimum. If there are no such costs, the minimum price is zero. This is not to say that the airline will seek to charge the minimum price; it will presumably seek to charge the highest price that the market will bear. The fact that the market will not bear the full cost, plus a profit margin, should not, in principle, be sufficient for the airline to refuse to sell seats, where there is spare passenger capacity. In practice, airlines are major users of a relevant/marginal costing approach. They often offer low-priced tickets for off-peak travel, where there are not sufficient customers willing to pay ‘normal’ prices. By insisting on a Saturday stopover for return tickets, they tend to exclude ‘business’ travellers, who are probably forced to travel, but for whom a Saturday stopover may be unattractive. UK train operators often offer substantial discounts for off-peak travel, particularly through Apex tickets. Similarly, hotels often charge very low rates for off-peak rooms. A hotel mainly used by business travellers may well offer very low room rates for Friday and Saturday occupancy. Relevant/marginal pricing must be regarded as a short-term or limited approach that can be adopted because a business finds itself in a particular position, for example that of having spare aircraft seats. Ultimately, if the business is to be profitable, all costs must be covered by sales revenue. Activity 5.11 When we considered marginal costing in Chapter 3, we identified three problems with its use. Can you remember what these problems are? The three problems are as follows: l l l The possibility that spare capacity will be ‘sold off’ cheaply when there is another potential customer who will offer a higher price, but, by the time they do so, the capacity will be fully committed. It is a matter of commercial judgement as to how likely this will be. With reference to Activity 5.10, would an hour before take-off be sufficiently close for the airline to be fairly confident that no ‘normal’ passenger will come forward to buy a seat? The problem that selling the same product but at different prices could lead to a loss of customer goodwill. Would a ‘normal’ passenger be happy to be told by another passenger that the latter had bought his or her ticket very cheaply, compared with the normal price? If the business is going to suffer continually from being unable to sell its full production potential at the ‘regular’ price, it might be better, in the long run, to reduce capacity and make fixed-cost savings. Using the spare capacity to produce marginal benefits may lead to the business failing to address this issue. Would it be better for the airline to operate smaller aircraft or to have fewer flights, either of these leading to fixed-cost savings, than to sell off surplus seats at marginal prices? Real World 5.13 provides an unusual example where humanitarian issues are the driving force for adopting marginal pricing. 167 M05_ATRI3622_06_SE_C05.QXD 168 CHAPTER 5 5/29/09 4:22 PM Page 168 COSTING AND PRICING IN A COMPETITIVE ENVIRONMENT REAL WORLD 5.13 Drug prices in developing countries FT Large pharmaceutical businesses have recently been under considerable pressure to provide cheap drugs to developing countries. It has been suggested that life-saving therapeutic drugs should be sold to these countries at a price that is close to their marginal cost. Indeed the Department for International Development would like to see HIV drugs sold at marginal cost in the poorest countries. However, a number of obstacles to such a pricing policy have been identified: 1 It may lead to customer revolts in the West (the ‘loss of customer goodwill’ referred to above). 2 There is a concern that the drugs may not reach their intended patients and could be re-exported to Western countries. A major cost of producing a new drug is the research and development costs incurred, and marginal costs of production are usually very low. Thus, a selling price based on marginal cost is likely to be considerably lower than the normal (full-cost) selling price in the West. This, it is feared, may lead to the cheap drugs provided leaking back into the West. Acquiring drugs at a price near to their marginal cost and reselling them at a figure close to the selling price in the West offers unscrupulous individuals an opportunity to make huge profits. 3 Compensation for any adverse consequences that may arise from the drugs sold will be sought in courts in the West, thereby creating the risk of huge payouts. This would make the risk to the pharmaceutical businesses of selling the drugs out of proportion to the benefits to them, in terms of the prices that would be charged. The above problems are not insurmountable and are not the only problems surrounding this issue, but they do appear to have slowed progress towards a speedier response to a humanitarian crisis. Source: Based on information from Jack, A., ‘GSK varies prices to raise sales’, ft.com, 16 March 2008; Epstein, R., ‘Drug pricing is a social problem’, ft.com, 16 June 2005; ‘Pressure builds to cut price of HIV medicine’, ft.com, 11 March 2006; and ‘Patent nonsense’, Financial Times, 24 August 2001. Target pricing We saw earlier in the chapter (pp. 151–152) that, as the starting point of the targetcosting approach to cost management, a target selling price needs to be identified. Using market research, and so on, a target unit selling price and a planned sales volume are set. This is the combination of price and quantity demanded that the business would derive from its estimation of the product’s demand function (see pp. 155–158). Thus the target price is the market-determined price that the business seeks to meet, in terms of costs and profit margin. Pricing strategies ‘ Cost and the market-demand function are not the only determinants of price. Businesses often employ pricing strategies that, in the short term, may not maximise profit. They do this in the expectation that they will gain in the long term. An example of such a strategy is penetration pricing. Here, the product is sold relatively cheaply in order to sell in quantity and to gain a large share of the market. This would tend to have the effect of dissuading competitors from entering the market. Subsequently, M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 169 SUMMARY ‘ once the business has established itself as the market leader, prices would be raised to more profitable levels. By its nature, penetration pricing often applies to new products. It has been argued that some subscription TV broadcasters have charged low prices while they establish themselves and gain market share. Having achieved this they increase prices to what becomes their ‘normal’ price. Price skimming is almost the opposite of penetration pricing. It seeks to exploit the notion that the market can be stratified according to resistance to price. Here a new product is initially priced highly and sold only to those buyers in the stratum that is fairly unconcerned by high prices. Once this stratum of the market is saturated, the price is lowered to attract the next stratum. The price is gradually lowered as each stratum is saturated. This strategy tends only to be able to be employed where there is some significant barrier to entry for other potential suppliers, such as patent protection. DVD players provide a good example of a price-skimming strategy. When they first emerged in the 1990s, DVD players would typically cost over £400. They can now be bought for less than £30. Advancing technology, the economies of scale and increasing competition have undoubtedly contributed to this fall in price, but price skimming almost certainly was a major factor. Certain customers would have regarded a DVD player as a ‘must-have’ product. These ‘early adopters’ would have been prepared to pay a high price to have one. Once the early adopters had bought their DVD player, the price was gradually reduced, until we reached today’s price. The initial high price can help to recover research and development and production set-up costs quickly. It can also keep demand within manageable levels while production capacity is being built up. Televisions, CD players, home computers and mobile telephones are also examples of where a price-skimming strategy has been applied. SUMMARY The main points of this chapter may be summarised as follows: Activity-based costing is an approach to dealing with overheads (in full costing) that treats all costs as being caused or ‘driven’ by activities. Advocates argue that it is more relevant to the modern commercial environment than is the traditional approach. l It involves identifying the support activities and their costs and then analysing these costs to see what drives them. l The costs of each support activity enter a cost pool and the relevant cost drivers are used to attach an amount of overheads from this pool to each unit of output. l ABC should help provide more accurate costs for each unit of output and should help in better control of overheads. l ABC is, however, time-consuming and costly, can involve measurement problems and is not likely to suit all businesses. Total (whole) life-cycle costing takes account of all of the costs incurred over a product’s entire life. l The life cycle of a product can be broken down into three phases: pre-production, production and post-production. l A high proportion of costs is incurred and/or committed during the pre-production phase. 169 M05_ATRI3622_06_SE_C05.QXD 170 CHAPTER 5 5/29/09 4:22 PM Page 170 COSTING AND PRICING IN A COMPETITIVE ENVIRONMENT l Target costing attempts to reduce costs so that the market price covers the cost plus an acceptable profit. l Ensuring quality output has costs, known as quality costs, typically divided into four aspects: prevention costs, appraisal costs, internal failure costs and external failure costs. l Kaizen costing attempts to reduce costs at the production stage. l Since most costs will have been saved at the pre-production phase and through target costing, only small cost savings are likely to be possible. l Benchmarking attempts to emulate a successful aspect of, for example, another business or division. Pricing output l In theory, profit is maximised where the price is such that Marginal sales revenue = Marginal cost of production l Elasticity of demand indicates the sensitivity of demand to price changes. l Full cost (cost-plus) pricing takes the full cost and adds a mark-up for profit; – It is popular. – The market may not accept the price (most businesses are ‘price takers’). – It can provide a useful benchmark. l Relevant/marginal cost pricing takes the relevant/marginal cost and adds a mark-up for profit. – It can be useful in the short term, but in the longer term it may be better to charge a full cost-plus price. l Target sales prices are those established as the first step in the target costing process. They are market-determined. l Various pricing strategies can be used, including penetration pricing and price skimming. ‘ Key terms Activity-based costing (ABC) p. 138 Cost driver p. 138 Cost pool p. 138 Total life-cycle costing 150 Target costing p. 151 Quality costs p. 152 Kaizen costing p. 153 Benchmarking p. 153 Elasticity of demand p. 155 Full cost (cost-plus) pricing p. 163 Marginal cost pricing p. 166 Penetration pricing p. 168 Price skimming p. 169 Further reading If you would like to explore the topics covered in this chapter in more depth, we recommend the following books: Atkinson, A., Banker, R., Kaplan, R. and Young, S. M., Management Accounting, 5th edn, Prentice Hall, 2007, chapters 4, 5, 6 and 9. Drury, C., Management and Cost Accounting, 7th edn, Cengage Learning, 2007, chapters 10 and 11. Hilton, R., Managerial Accounting, 6th edn, McGraw-Hill Irwin, 2005, chapters 4, 5, 6 and 15. Horngren, C., Foster, G., Datar, S., Rajan, M. and Ittner, C., Cost Accounting: A Managerial Emphasis, 13th edn, Prentice Hall International, 2008, chapters 5 and 12. M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 171 EXERCISES REVIEW QUESTIONS Answers to these questions can be found in Appendix C at the back of the book. 5.1 How does activity-based costing (ABC) differ from the traditional approach? What is the underlying difference in the philosophy of each of them? 5.2 The use of activity-based costing in helping to deduce full costs has been criticised. What has tended to be the basis of this criticism? 5.3 What is meant by elasticity of demand? How does knowledge of the elasticity of demand affect pricing decisions? 5.4 According to economic theory, at what point is profit maximised? Why is it at this point? EXERCISES Exercises 5.6 to 5.8 are more advanced than 5.1 to 5.5. Those with a coloured number have answers in Appendix D at the back of the book. If you wish to try more exercises, visit the students’ side of the Companion Website at www.pearsoned.co.uk/atrillmclaney. 5.1 Woodner Ltd provides a standard service. It is able to provide a maximum of 100 units of this service each week. Experience shows that at a price of £100, no units of the service would be sold. For every £5 below this price, the business is able to sell 10 more units. For example, at a price of £95, 10 units would be sold, at £90, 20 units would be sold, and so on. The business’s fixed costs total £2,500 a week. Variable costs are £20 per unit over the entire range of possible output. The market is such that it is not feasible to charge different prices to different customers. Required: What is the most profitable level of output of the service? 5.2 It appears from research evidence that a cost-plus approach influences many pricing decisions in practice. What is meant by cost-plus pricing and what are the problems of using this approach? 5.3 Kaplan plc makes a range of suitcases of various sizes and shapes. There are 10 different models of suitcase produced by the business. In order to keep inventories of finished suitcases to a minimum, each model is made in a small batch. Each batch is costed as a separate job and the cost for each suitcase is deduced by dividing the batch cost by the number of suitcases in the batch. At present, the business derives the cost of each batch using a traditional job-costing approach. Recently, however, a new management accountant was appointed, who is advocating the use of activity-based costing (ABC) to deduce the cost of the batches. The management accountant claims that ABC leads to much more reliable and relevant costs and that it has other benefits. Required: (a) Explain how the business deduces the cost of each suitcase at present. (b) Discuss the purposes to which the knowledge of the cost for each suitcase, deduced on a traditional basis, can be put and how valid the cost is for the purpose concerned. 171 M05_ATRI3622_06_SE_C05.QXD 172 CHAPTER 5 5/29/09 4:22 PM Page 172 COSTING AND PRICING IN A COMPETITIVE ENVIRONMENT (c) Explain how ABC could be applied to costing the suitcases, highlighting the differences between ABC and the traditional approach. (d) Explain what advantages the new management accountant probably believes ABC to have over the traditional approach. 5.4 Comment critically on the following statements that you have overheard: (a) ‘To maximise profit you need to sell your output at the highest price.’ (b) ‘Elasticity of demand deals with the extent to which costs increase as demand increases.’ (c) ‘Provided that the price is large enough to cover the marginal cost of production, the sale should be made.’ (d) ‘According to economic theory, profit is maximised where total cost equals total revenue.’ (e) ‘Price skimming is charging low prices for the output until you have a good share of the market, and then putting up your prices.’ Explain clearly all technical terms. 5.5 Comment critically on the following statements that you have overheard: (a) ‘Direct labour hours are the most appropriate basis to use to charge indirect cost (overheads) to jobs in the modern manufacturing environment where people are so important.’ (b) ‘Activity-based costing is a means of more accurately accounting for direct labour cost.’ (c) ‘Activity-based costing cannot really be applied to the service sector because the ‘activities’ that it seeks to analyse tend to be related to manufacturing.’ (d) ‘Kaizen costing is an approach where great efforts are made to reduce the costs of developing a new product and setting up its production processes.’ (e) ‘Benchmarking is an approach to job costing where each direct worker keeps a record of the time spent on each job on his or her workbench before it is passed on to the next direct worker or into finished inventories stores.’ 5.6 The GB Company manufactures a variety of electric motors. The business is currently operating at about 70 per cent of capacity and is earning a satisfactory return on investment. International Industries (II) has approached the management of GB with an offer to buy 120,000 units of an electric motor. II manufactures a motor that is almost identical to GB’s motor, but a fire at the II plant has shut down its manufacturing operations. II needs the 120,000 motors over the next four months to meet commitments to its regular customers; II is prepared to pay £19 each for the motors, which it will collect from the GB plant. GB’s product cost, based on current planned cost for the motor, is: Direct materials Direct labour (variable) Manufacturing overheads Total £ 5.00 6.00 9.00 20.00 Manufacturing overheads are applied to production at the rate of £18.00 a direct labour hour. This overheads rate is made up of the following components: Variable factory overhead Fixed factory overhead – direct – allocated Applied manufacturing overhead rate £ 6.00 8.00 4.00 18.00 Additional costs usually incurred in connection with sales of electric motors include sales commissions of 5 per cent and freight expense of £1.00 a unit. M05_ATRI3622_06_SE_C05.QXD 5/29/09 4:22 PM Page 173 EXERCISES In determining selling prices, GB adds a 40 per cent mark-up to the product cost. This provides a suggested selling price of £28 for the motor. The marketing department, however, has set the current selling price at £27.00 to maintain market share. The order would, however, require additional fixed factory overheads of £15,000 a month in the form of supervision and clerical costs. If management accepts the order, 30,000 motors will be manufactured and delivered to II each month for the next four months. Required: (a) Prepare a financial evaluation showing the impact of accepting the International Industries order. What is the minimum unit price that the business’s management could accept without reducing its operating profit? (b) State clearly any assumptions contained in the analysis of (a) above and discuss any other organisational or strategic factors that GB should consider. 5.7 Sillycon Ltd is a business engaged in the development of new products in the electronics industry. Subtotals on the spreadsheet of planned overheads reveal: Overheads: variable (£000) fixed (£000) Planned activity: Direct labour hours (’000) Electronics department Testing department Service department 1,200 2,000 800 600 500 600 700 800 The three departments are cost centres. For the purposes of reallocation of service department’s overheads, it is agreed that variable overhead costs vary with the direct labour hours worked in each cost centre. Fixed overheads of the service cost centre are to be reallocated on the basis of maximum practical capacity of the two product cost centres, which is the same for each. The business has a long-standing practice of marking up full manufacturing costs by between 25 per cent and 35 per cent in order to establish selling prices. It is hoped that one new product, which is in a final development stage, will offer some improvement over competitors’ products, which are currently marketed at between £90 and £110 each. Product development engineers have determined that the direct material content is £7 a unit. The product will take 2 labour hours in the electronics department and 11/2 hours in testing. Hourly labour rates are £20 and £12, respectively. Management estimates that the fixed costs that would be specifically incurred in relation to the product are: supervision £13,000, depreciation of a recently acquired machine £100,000, and advertising £37,000 a year. These fixed costs are included in the table above. Market research indicates that the business could expect to obtain and hold about 25 per cent of the market or, optimistically, 30 per cent. The total market is estimated at 20,000 units. Note: It may be assumed that the existing plan has been prepared to cater for a range of products and no single product decision will cause the business to amend it. Required: (a) Prepare a summary of information that would help with the pricing decision for the new product. Such information should include marginal cost and full cost implications after allocation of service department overheads. (b) Explain and elaborate on the information prepared. 5.8 A business manufactures refrigerators for domestic use. There are three models: Lo, Mid and Hi. The models, their quality and their price are aimed at different markets. 173 M05_ATRI3622_06_SE_C05.QXD 174 CHAPTER 5 5/29/09 4:22 PM Page 174 COSTING AND PRICING IN A COMPETITIVE ENVIRONMENT Product costs are computed on a blanket (business-wide) overhead-rate basis using a labour-hour method. Prices as a general rule are set based on cost plus 20 per cent. The following information is provided: Material cost (£/unit) Direct labour hours (per unit) Budget production/sales (units) Lo Mid Hi 25 1 /2 20,000 62.5 1 1,000 105 1 10,000 The budgeted overheads for the business amount to £4,410,000. Direct labour is costed at £8 an hour. The business is currently facing increasing competition, especially from imported goods. As a result, the selling price of Lo has been reduced to a level that produces a very low profit margin. To address this problem, an activity-based costing approach has been suggested. The overheads are examined and these are grouped around main business activities of machining (£2,780,000), logistics (£590,000) and establishment (£1,040,000) costs. It is maintained that these costs could be allocated based respectively on cost drivers of machine hours, material orders and space, to reflect the use of resources in each of these areas. After analysis, the following proportionate statistics are available in relation to the total volume of products: Machine hours Material orders Space Lo % Mid % Hi % 40 47 42 15 6 18 45 47 40 Required: (a) Calculate for each product the full cost and selling price determined by 1 the original costing method 2 the activity-based costing method. (b) What are the implications of the two systems of costing in the situation given? (c) What business/strategic options exist for the business in the light of the new information? M06_ATRI3622_06_SE_C06.QXD 5/29/09 10:37 AM Page 175 6 Budgeting INTRODUCTION In this chapter we consider the role and nature of budgets. We shall see that budgets set out short-term plans that help managers to run the business. They provide the means to assess whether actual performance has gone as planned and, where it has not, to identify the reasons for this. It is important to recognise that budgets do not exist in a vacuum; they are an integral part of a planning framework that is adopted by well-run businesses. To understand fully the nature of budgets we must, therefore, understand the strategic planning framework within which they are set. We shall also see how budgets are prepared. Preparing budgets relies on an understanding of many of the issues relating to the behaviour of costs and full costing, topics that we explored in Chapters 3 and 4. The chapter begins with a discussion of the budgeting framework and then goes on to consider detailed aspects of the budgeting process. LEARNING OUTCOMES When you have completed this chapter, you should be able to: l Define a budget and show how budgets, strategic objectives and strategic plans are related. l Explain the budgeting process and the interlinking of the various budgets within the business. l Indicate the uses of budgeting and construct various budgets, including the cash budget, from relevant data. l Discuss the criticisms that are made of budgeting.