15-1   In the long run, every organization must price its product or service above the total cost of production. While the market for the product also is critically important, costs cannot be ignored.

15-2   The statement that prices are determined by production costs is too simplistic. Although firms must price their products and services above their total costs in the long run, management cannot ignore demand issues and the economic environment. Setting prices generally is a balance between cost-related issues and economic market forces.

15-3   Four major influences on pricing decisions are as follows:

(1)   Customer demand: Management must consider customers’ demand for their product, which reflects the price that customers are willing to pay for the product.

(2)   Actions of competitors: When pricing its product, management must consider the likely pricing decisions and product design decisions of competing firms.

(3)   Costs: No organization or industry can price its product below total production costs indefinitely.

(4)   Political, legal, and image-related issues: Management must consider the way the public perceives the firm and must adhere to certain laws when setting prices.

15-4   It is crucial to define the firm’s product when considering the reaction of competitors, so that the competitors can be identified. For example, is a firm that produces glass bottles competing only with other firms that produce glass bottles, or is the firm competing with all companies that produce containers? Defining the product as glass bottles or containers is an important step in identifying who the firm’s competitors are.

15-5   In most industries, both market forces and cost considerations heavily influence prices. No organization can price its products below their production costs in the long run. On the other hand, no company can set prices at cost plus a markup without keeping an eye on the market. The product or service must be sold at a price customers are willing to pay.

15-6   The profit-maximizing price is the price for which the associated quantity is determined by the intersection of the marginal cost and marginal revenue curves. This intersection is shown in Exhibit 15-3 in the text.

15-7   (a)  Total revenue: Price multiplied by quantity sold.

(b)   Marginal revenue: The amount by which total revenue increases when one additional unit is sold.

(c)   Demand curve: A graphical or mathematical expression of the relationship between the price and the quantity sold.

(d)   Price elasticity: The impact of price changes on sales volume.

(e)   Cross-elasticity: The extent to which a change in a product’s price affects the demand for substitute products.

15-8  (a)  Total cost: Unit cost multiplied by quantity produced.

(b)   Marginal cost: Additional cost when one more unit is produced.

15-9   Three limitations of the economic, profit-maximizing model of pricing are as follows:

(1)   The firm’s demand and marginal revenue curves are difficult to determine with precision.

(2)   The marginal-cost, marginal-revenue paradigm, as described in the text, is not valid for all forms of market organization.

(3)   Cost-accounting systems are not designed to measure the marginal changes in cost incurred as production and sales increase unit by unit. To measure marginal cost would entail a very costly information system.

15-10   Determining the best approach to pricing requires a cost-benefit trade-off. While the marginal-cost, marginal-revenue paradigm results in a profit-maximizing price, only a sophisticated and costly information system can collect marginal-cost data. Thus, the firm will incur greater cost in order to obtain information for better decisions.

15-11   The general formula for cost-plus pricing is as follows:

Price = cost + (markup percentage ´ cost)

 The price is equal to cost plus a markup. Depending on how cost is defined, the markup percentage may differ. Several different definitions of cost, each combined with a different markup percentage, can result in the same price for a product or service.

15-12  The four cost bases commonly used in cost-plus pricing are the following: absorption manufacturing cost, total cost, variable manufacturing cost, and total variable cost. Each of these cost bases can result in the same price under cost-based pricing if the markup percentage used in the cost-plus pricing formula is changed. For example, a lower markup percentage would be applied to total cost than would be applied to total variable cost.

15-13   Four reasons often cited for the widespread use of absorption cost as the cost base in cost-plus pricing formulas are as follows:

(1)   In the long run, the price must cover all costs and a normal profit margin.

(2)   Absorption-cost and total-cost pricing formulas provide a justifiable price that tends to be perceived as equitable by all parties.

(3)   When a company’s competitors have similar operations and cost structures, cost-plus pricing based on full costs gives management an idea of how competitors may set prices.

(4)   Absorption-cost information is provided by a firm’s cost-accounting system, because it is required for external financial reporting under generally accepted accounting principles. Since absorption-cost information already exists, it is cost-effective to use for pricing.

15-14   The primary disadvantage of absorption-cost or total-cost pricing formulas is that they obscure the cost behavior pattern of the firm. Since absorption-cost and total-cost data include allocated fixed costs, it is not clear from these data how the firm’s total costs will change as volume changes.

15-15   Three advantages of pricing based on variable cost are as follows:

(1)   Variable-cost data do not obscure the cost behavior pattern by unitizing fixed costs and making them appear variable.

(2)   Variable-cost data do not require allocation of common fixed costs to individual product lines.

(3)   Variable-cost data are exactly the type of information managers need when facing certain decisions, such as whether to accept a special order.

15-16   The behavioral problem that can result from the use of a variable-cost pricing formula is that managers may perceive the variable cost of a product or service as the floor for the price. They may tend to set the price too low for the firm to cover its fixed costs.

15-17   Return-on-investment pricing is an approach under which the price is set so that it will cover costs and also earn a profit that will provide a target return on the invested capital.

15-18   Price-led costing refers to the process under target costing of first determining the acceptable market price for a product or service and then determining the cost at which the product or service must be produced.

15-19   To be successful at target costing, management must listen to the company’s customers. By doing so, management will learn the products, features, and quality that customers are willing to buy as well as the price they are willing to pay.

15-20   Value-engineering is a cost-reduction and process-improvement technique used to help bring the cost of manufacturing a product or providing a service into line with its target cost.

15-21   Tear-down methods can be used in a service-industry firm just as they are used in the manufacturing industry. The various steps in providing a service can be analyzed for cost improvements just as a product’s materials and manufacturing operations can be analyzed for the same purpose.

15-22   Under time-and-material pricing, the price includes a cost-based charge for labor, a cost-based charge for material, and generally a markup on one or both of these production-cost factors.

15-23   When a firm has excess capacity, there is no opportunity cost in accepting an additional production job. Therefore, it is not necessary to reflect such an opportunity cost in setting a bid price. On the other hand, if the firm is already at full capacity, there is an opportunity cost to accepting another production job. In this case, it is appropriate to include in the price an estimate of the opportunity cost associated with the job for which the bid is being prepared.

15-24   The decision to accept or reject a special order and the selection of a price for a special order are similar decisions. If a price has been offered for a special order, management can base its acceptance or rejection decision on whether or not that price covers the incremental cost of producing the order. Another way of viewing the problem is to set the minimum price for the special order at a level sufficient to cover the incremental cost of producing the order.

15-25   (a)  Skimming pricing: Setting a high initial price for a new product in order to reap short-run profits. Over time, the price is reduced gradually.

(b)   Penetration pricing: Setting a low initial price for a new product in order to penetrate a market deeply and gain a large and broad market share.

(c)   Target costing: Conducting market research to determine the price at which a new product will sell and then, given the likely sales price, computing the cost for which the product must be manufactured in order to provide the firm with an acceptable profit margin. Then engineers and cost analysts work together to design a product that can be manufactured for the allowable cost. This process is used widely in the development stages of new products.

15-26  (a)  Unlawful price discrimination: Quoting different prices to different customers for the same product or service, even though the different prices cannot be justified by differences in the cost incurred to produce, sell, and deliver the product or service.

(b)   Predatory pricing: Temporarily cutting a price to broaden demand for a product with the intention of later restricting the supply and raising the price again.

15-27  Traditional, volume-based product-costing systems often overcost high-volume and relatively simple products while undercosting low-volume and complex products. This practice can result in overpricing high-volume and relatively simple products and underpricing low-volume and complex products. Such strategic pricing errors can have a disastrous impact on a firm’s competitive position.

1.  Tabulated price, quantity, and revenue data:

2.  Total revenue curve: