Management Accounting - Setting Prices

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Management Accounting Tutorial 5

15-3. List and briefly describe 4 major influences on pricing decisions

Customer Demand: the demands of customers are of paramount importance in all phases of business operations, from the design of a product to the setting of its price. Product-design issues and pricing considerations are interrelated, so they must be examined simultaneously. For example, for a higher quality product; you need higher quality materials which will affect a higher cost and needs more time and this will lead to a higher pricing on a product. Also, a manager must not price its product out of the market price range.

Actions of Competitors: companies must keep an eye on its competitors. If its competitor reduces its pricing on a product, they might have to follow suit to avoid losing its market share. However, one must not follow the actions of its competitors’ blindly as a company has to predict competitive reactions to its product-design and pricing strategy. The company must also be careful to properly define its product, such that if they increase the price of the product; will the consumers continue purchasing the product?

Costs: some prices are determined almost entirely by market forces. Industries such as agriculture; where most products are market-driven. To make a profit, farmers must produce at a cost below the market price. This is very risky as it is not always possible to produce at a price lower than the market price and this will inevitably lead to losses for the farmers. In other industries, prices are set by adding a markup to production costs so managers do have some latitude in determining the markup.

Therefore, both market forces and cost considerations heavily influence prices. No organization or industry can price its products below their production costs indefinitely. And no company’s management can set prices blindly at a cost plus a markup without keeping an eye on the market.

Political, Legal and image-related issues: managers must adhere to certain laws. The law generally prohibits companies from discriminating among their customers in setting prices. It is also forbidden in collusion in price setting between major firms.

Political considerations also can be relevant. For example, if the firms in an industry are perceived by the public as reaping unfairly large profits, there may be political pressure on legislators to tax those profits differentially or to intervene in some way to regulate prices

Companies also consider their public image in the price-setting process. A firm with a reputation for very high quality products may set the price of a new product high to be consistent with its image.

15-11. Write the general formula for cost-plus pricing, and briefly explain its use.

Price = Cost + (Markup % * Cost)

15-12. List the 4 common cost bases used in cost-plus pricing. How can they all result in the same price?

- Variable manufacturing cost + (Markup % * Variable manufacturing cost)

- Absorption manufacturing cost + (Markup % * Absorption manufacturing cost)

- Total cost + (Markup % * Total cost)

- Total variable cost + (Markup % * Total variable cost)

Several different definitions of cost, each combined with a different markup percentage can result in the same price for a product or service.

15-13. List 4 reasons often cited for the widespread use of absorption cost as the cost base in cost-plus pricing formulas.

- In the long run, the price must over all costs and a normal profit margin. Basing the cost-plus formula on only variable costs could encourage managers to set too low a price in order to boost sales. This will not happen if managers understand that a variable cost-plus pricing formula requires a higher markup to cover fixed costs and profit. Nevertheless, many managers argue that people tend to view the costs base in a cost-plus pricing formula as the floor for setting prices. If...
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