11 Bbma3203 T7

Topic X Accounting
7 Information
for Pricing
Decisions
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Identify the main factors that influence pricing;
2. Analyse economic pricing model;
3. Calculate pricing using cost-based formula;
4. Apply activity-based costing in evaluating customersÊ
profitability; and
5. Discuss the importance of target costing and pricing.
X INTRODUCTION
You may be used to haggling prices when making purchases at the market or
making price comparisons before deciding to buy your essential goods. Actually,
pricing decisions are important to some organisations because a high price may
deter customers from making purchases, while a very low price may result in the
organisation having to bear the cost. Manufacturers determine the price for the
goods they produce, the retailer determines the price of the goods they sell, while
service organisations determine the price for plane tickets or legal services
offered.
However, for some organisations that sell a product which has a pre-determined
price in the market, pricing becomes much easier. For example, raw palm oil has
a set market price. Customers will not pay more for the product, and the seller,
rationally will not want to sell it at a lower price. In this topic, you will be
Copyright © Open University Malaysia (OUM)

178 X TOPIC 7 ACCOUNTING INFORMATION FOR PRICING DECISIONS
exposed to pricing methods and issues related with pricing decisions such as the
ones faced by the management of an organisation.
7.1 MAIN FACTORS INFLUENCING PRICING

Many people will surely complain when price of goods in the market increase.
But do you know that there are many factors that influence pricing? Among the
main factors include:
(a) Demand and supply;

(b) Competitors and customers behaviour;
(c) Cost; and
(d) Political and image issues.
CustomersÊ demands for a product can influence the price of the product, and in
the case of some goods, the government has to intervene and control the price of
such goods because it is the basic necessity of the community. High demand for
certain goods or services is associated with high price, and when demand falls,
the price will also be set lower.
You will notice that low-peak season room rates are offered by the hotel
management during non-school term breaks or weekends. The hotel
management realises this low demand thus makes an effort to attract customers
by offering a lower price to ensure their services can continue to operate.
Therefore, the management has to understand and continuously project customer

demand because it is extremely critical to the continuance of their operations.
This can be done through market research and obtaining feedback from
questionnaires completed by customers.
Supply of certain goods will also influence price where, a high supply is
associated with low price and vice versa. You may still remember the sugar
shortage in the market in mid-2006 which resulted in sugar being sold at a higher
price in some supermarkets in Malaysia.
Apart from demand and supply in the market, competitor behaviour can
influence the price of a particular product. During the Âshopping monthÊ period,
certain products sold in the supermarket can be obtained at a lower price because
the supermarketÊs management must ensure that they can maintain their market
share.

TOPIC 7 ACCOUNTING INFORMATION FOR PRICING DECISIONS W 179
At the same time, customer reaction in obtaining high quality goods can also
influence high pricing, for example, treatment cost in a private hospital is much
higher than that in government hospitals because the services are for those who
can afford to pay such a price in return for guaranteed satisfactory services.
Therefore, the management must practise due care in identifying their products
and market.
Cost is another factor that can influence price even though the cost advantage in
this case may be different according to the type of industry. In some industries,
price is solely determined by market forces. However, to earn profits, production
cost must be below the market price, if not, the company will incur losses. In
general, the balance between the market price that the customer is willing to pay
and the costs incurred by the company will determine the price of the particular
product.
Another factor just as important in influencing price other than market forces
and costs is political and image factor. The image of a brand often influences
price because of publicÊs perception associates it with quality. For example, the
public do not expect any car models from Mercedes will be sold at a comparable
price as a Nissan.
Meanwhile, political influence plays a part when the public realises that an
industry is excessively profiting through their pricing. A ceiling price will be set
to counter some problems, for example a ceiling price will be set when the price
of dressed chickens increases, even though the price increase can be attributed to
reduced supply. Political influence may also possibly allow certain industries to
increase the price of their products or services even though the public may not
agree with this increase, for example, price increase for petrol and tolls.
ACTIVITY 7.1
Do you still remember the increase in world petrol price in the early
20th century? The impact of this price increase was felt by all level of
society in Malaysia until now. Why do you think this happened?
Discuss.

7.2 ECONOMIC PRICING MODEL

Many economists have devoted their careers studying the core theory of pricing.
According to economic models, the goal of an organisation is to maximise profit,
while revealing the function of cost and revenue. The increase in quantity of sales
is followed by the reduction of selling price, causing marginal revenue to
decrease with the increase in sales. Following that, the increase in production will
result in the increase in marginal cost.
What is meant by marginal revenue?
Marginal revenue is the change in the increase of total revenue due to the sale
of one additional unit of product. Marginal cost is the incremental change in
total cost needed to produce and sell an additional unit of product.
In an economic model, maximum profit can be attained when the sales volume is
at a level where marginal revenue equals marginal cost and at this point the ideal
price is achieved.
7.2.1 Problems of Economic Pricing Model

Even though the economic model for pricing will provide a useful framework in
determining price, a survey has shown that the managers, in practice, do not use
it. Among the limitations of this economic model is the difficulty in determining
accurately the ideal price where marginal revenue equals marginal cost. Perfect
information is needed in an unending time period. Many profit-oriented
organisations will try to achieve target profit and not maximum profit.
This is because it is difficult to determine a set of actions that will lead to

maximum profits. When sourcing for information, the management accountant
will often consider the question of cost and benefit from that information.
Therefore, for the purpose of making pricing decisions, they will also consider
the question of production cost itself.

Figure 7.1: Marginal revenue and marginal cost curve
SELF-CHECK 7.1
Why is pricing using the economic model not used widely in practice?
7.3 PRICING USING PRODUCTION COST

INFORMATION
Many managers weigh into consideration the product cost in determining price.
The use of product cost in pricing becomes important because a price based on
this is easy to defend. The price of products or sevices determined based on cost
is said to provide justified profit to producers.
In addition, information about cost is readily available. This is because, for

organisations that produce various types of products and services, they will need
a long period of time to conduct a market analysis for all of their products.
Therefore, cost information will provide them a quick and easily defended basis
in determining pricing.
Traditionally, the basis of pricing for a new product is initiated through a market
survey on customers needs, followed by product design, pricing and adding
mark-up on costs.

Figure 7.2: The basis of pricing for a new product
Using cost as a basis, the price for products and services cost is added with
sufficient mark-up to bear costs that are not allocated and to earn profits.
7.3.1 Cost Approach for Companies with Single

Product
Here, we will discuss the cost approach for companies with a single product. If a
company only produces one type of product, pricing is easier as long as all costs
incurred, the amount of units sold and profit desired are known.
Example 1
Perkilangan Ubi Sedap produces flavoured potato crisps with a fixed cost of
RM10,000 per year. The management requires RM5,000 profit for 5,000 packets of
potato crisps. The variable cost for a packet of crisp is RM1. Assume all flavours
have similar costs. Using the profit calculation formula, the price of one packet of
potato crisp is RM4.00 which is calculated as follows:
Profit = Total Revenue ă Total Cost

RM5,000 = (Price per unit X 5,000 units) ă (RM1 X 5,000 + RM10,000)
5,000 x Price = RM5,000 + RM15,000
Price = RM4

Even though the price can be calculated based on available cost information,
pricing has to be done by taking into account market conditions such as the
readiness of customers to pay that price or the behaviour of the competitor.
7.3.2 Cost Approach for Companies with Multiple

Products
We have discussed the cost approach for companies with single product. Now,
we will discuss the cost approach for companies with multiple products. Before
this, have you ever thought how companies ensure that price determined for
each type of product produced will be profitable?
Products and services pricing for companies that produce multiple products will
take into account the profit required for the whole company and the price for
each different types of product. For this cost approach, this will generally be
done by taking into account costs incurred in producing the products and
suitable mark-up to bear unallocated costs for the product and at the same time
earn profits as desired by the company.
Price = Cost + (Mark-up Percentage X cost)
Using the price formula as stated, you may ask, what is the best basis to calculate
cost and how is the mark-up calculated? For the purpose of cost calculation,
actually there is not one definition for the purpose of pricing. It depends on
whether price estimated is for the short-term or long-term. Product cost of a
company can be defined using:
(a) Absorption cost, or
(b) Variable cost.
Most companies find it easier to justify cost by using an absorption cost-based

formula where all manufacturing costs are taken into account as product cost.
Perhaps, a wider definition is used where product cost takes into account all
manufacturing costs and sales and administrative costs. One weakness in using
this absorption cost approach is, it does not describe the behaviour pattern of
companyÊs cost.
This means, it is not clear how the total cost of the company will change with the
change in the production or sales volume because the fixed cost element is also
taken into account in the calculation of cost. (You can refer to the absorption and
variable costs approach explanation before this to see how the effect of fixed cost
is taken into account in the calculation of product cost).
If variable cost is used, product cost takes into account all variable manufacturing
costs or all variable costs including variable sales and administrative cost. Using
the variable cost to calculate consistent product cost through profit volume cost
analysis can be used by managers to evaluate the implication on profits when
there is a change in price or volume. The use of this variable cost approach does
not require allocation of fixed cost on production cost which may be done
arbitrarily.
Following that, this fixed cost is usually calculated on per unit basis until it is
treated as variable cost and this can confuse the behaviour pattern of cost. In the
short-term, variable cost may be suitable for use, especially if the company needs
to determine price of a specially ordered product from a customer.
However, in the long run, the approach of taking into account only variable cost
can cause the company to set a low price and the company having to bear the
whole production cost to remain sustainable. Because of this, the company has to
be clear about using a higher mark-up if the variable cost approach is to be used.
To make it easier to understand the use of absorption cost and variable cost in
pricing, try and follow the following example:
Example 2
Syarikat Jaya is a producer of leather handbags. The company would like to set
the price of a newly-introduced handbag model. The Accounting Department
has prepared information for the new product with estimated costs as follows:
Cost Per Unit Total
Raw materials 3
Direct labour 2
Variable manufacturing overhead 5
Fixed manufacturing overhead 30,000
Sales and administrative expenses (variable) 2
Sales and administrative expenses (fixed) 40,000
The company produces 10,000 units of bags and RM5,000 profit is required
above the cost for the bag.

If Syarikat Jaya uses the absorption cost approach where it takes into account the
manufacturing costs (raw materials cost, direct materials cost, fixed and variable
manufacturing overheads) in the calculation of product cost, the price can be
determined as follows:
Price = Cost + (Mark-up percentage X

cost)
= RM13 + (50% X RM13)
= RM19.50
If Syarikat Jaya uses the variable cost approach where it takes into account the
variable manufacturing costs (raw materials cost, direct materials cost, fixed and
variable manufacturing overheads) in the calculation of product cost, the price
can be determined as follows:
Price = Cost + (Mark-up percentage X

cost)
= RM10 + (95% X RM10)
= RM19.50
Notice that in the pricing example above, Syarikat Jaya will set the same price for
the product produced even though different cost-basis are used. This is because
the mark-up percentage used is different. Assuming that the mark-up percentage
used is the same, surely the price is lower if the variable manufacturing cost is
used. Here, we can see how important it is for the company to understand what
costs should be covered, determining mark-up on different cost-basis so that the
company can continue enjoying profits.
7.3.3 Determining the Mark-up Percentage

Next, we will learn how to determine the mark-up percentage. Look at the
statement as follows.
There are situations that make it possible for a company to give a special price to
a certain customer where not all costs are borne in pricing. Think of how fitting
this decision is and whether this situation will cause losses to the company.
In general, if the manufacturing cost is made the basis for calculating product
cost, mark-up calculated must be able to cover non-manufacturing cost and
generate profit as required by the company. If variable manufacturing cost is

used, the mark-up calculated will cover fixed manufacturing cost, non-
manufacturing costs and generate profit to the company.
The general formula for calculating mark-up is as follows:
Cost not included in basic cost + Required profit

Mark-up cost =
Basic cost
Using the above example, the mark-up charged is derived as follows:
When product cost is calculated based on manufacturing cost:

Mark-up cost =
Basic cost
RM60,000 + RM5,000
=
RM130,000
= 0.50
When product cost is calculated based on variable manufacturing cost:

Mark-up cost =
Basic cost
RM90,000 + RM5,000
=
RM100,000
= 0.95
You may also like to know how a company determines the amount of profit that
it requires, in the example of Syarikat Jaya, how the amount RM5,000 determined
as the profit required? What is considered normal or reasonable profit margin?
Even though managers usually use their judgement and experience in
determining the most appropriate mark-up, a more formal method is usually
based on target profit on the capital invested.

Assuming Syarikat Jaya invested a capital of RM25,000 for the purpose of

producing a new model of leather handbag. The company hopes to attain 20
percent return from total assets invested. The target profit of RM5,000 is shown
in setting the mark-up above is calculated as follows:
Average Investment of Capital X Target Return on

Investment = Target Profit
= RM25,000 X 20%
= RM5,000
Whatever basic cost is used, a manager who is rational will determine the
percentage of mark-up to be able to bear the comprehensive product cost
produced and simultaneously generate profit for the company.
7.3.4 Limitations on the Use of Cost Approach

If the product life span is long and relatively, the market is not as competitive,
the cost approach can provide a starting point in setting price. However, current
competitiveness in the business world limits purely cost-based formula and
requires the manager to consider a lot of other factors. Among the limitations of
cost approach in determining price are:
(a) Pricing using basic cost requires accurate calculation of product cost.
Mistakes in cost calculation can cause setting a too high price resulting in
loss of market share or too low price will result in reasonable profit will not
be enjoyed by the company;
(b) Costs must be allocated to the product accurately. The more parts of costs not
allocated, the higher the possibility of lower pricing than is reasonable; and
(c) Pricing using cost approach assumes that customers are willing to pay for
that price. This assumption can be questioned especially when there exists
intense competition for that product in the market.
Even though relative pricing is easier by taking into account available
information in companyÊs records (that is total product cost and adding it with
target profit), the use of basic cost in pricing for a less competitive product and
services, especially when the difference in price is minimal for the same product
can determine the success of a company.

ACTIVITY 7.2
What happens when a price determined by a company is not accepted

in the market? Can you imagine the pricing situation that is faced by
managers? Discuss.
7.4 CUSTOMER PROFITABILITY ANALYSIS

USING ACTIVITY-BASED COSTING
In the Management Accounting I course, you were introduced to the concept of
activity-based costing (ABC). You can refer to that topic on how the ABC
approach is able to give a more accurate view in the calculation of product cost
when the activities are classified according to the levels of units, batches and
facilities.
Indirectly, limitations in the use of cost approach stated in section 7.3.4 can be
overcome when cost allocation, especially costs classified as indirect in
traditional costing can be done accurately using ABC. This will simultaneously
assist managers in determining price and following that calculate profits with
confidence. ABC will also provide a more accurate information on profit
generated from different lines of products and identify the presence of activities
that do not add value to the customer.
Something which is apparent is the importance of customers in contributing to

the profit of the company. However, some customers can be more profitable
compared to others and it is not surprising that there are customers who can
cause losses to the company. The rationale is, by making an assessment on the
potential of their customers, the company can accurately target their required
profit and following that increase their overall profits. However, how does a
company identify these groups?
ABC assists in the preparation of information for managers to conduct an

evaluation on their clients through customer profitability analysis.

Example 3
Serama Inds receives an order from its customer, Syarikat Sedili, for the supply
of two products, namely Standard Bricks and Special Bricks. Serama Inds uses
ABC to calculate its production costs.
Activity cost level as calculated by the companyÊs accountant is as follows:
Customer order RM31.50 per order
Product design RM128.50 per design
Order size RM1.90 per labour hour
Customer relations RM367.50 per customer
Information related to product ordered by Sedili is shown below:
Standard Bricks Special Bricks
(no design activity (new design activity
required) required)
Price per unit RM3.40 RM65
Order unit 400 units Per unit
Number of orders 2 orders Once a year
Raw material cost RM211 RM1.30
Labour cost RM185 RM5.00
Delivery cost RM 18 RM2.50
Labour hours required 0.5 hours 4 hours
Required:
The company would like to know the margin for both of its products and the
sales margin for Sedili.

Calculation:
Product Margin
Standard Bricks
Sales RM1,360
Cost:
Raw materials RM211
Direct labour 185
Delivery cost 18
Customer order (RM31.50 X 2) 63
Product design -
Order size (RM1.90 X 400 units X 0.5 hours) 380 857
Product margin RM503
Special Bricks
Sales RM65.00
Cost:
Raw materials RM1.30
Direct labour 5.00
Delivery cost 2.50
Customer order (RM31.50 X 1) 31.50
Product design 128.50
Order size (RM1.90 X 1 units X 4 hours) 7.60 176.40
Product margin (RM111.40)
Customer Margin:
Syarikat Sedili
Product Margin:
• Standard Bricks RM503.00
• Special Bricks (111.40)
Total Product Margin 391.60
Less: Customer Relations 367.50
Customer Margin RM24.10

Example 4
Serama Inds receives an order from its customer, Syarikat Sedili, for the
supply of two products, namely Standard Bricks and Special Bricks. Serama
Inds uses ABC to calculate its production costs.
Activity cost level as calculated by the companyÊs accountant is as follows:
Customer order RM31.50 per order
Product design RM128.50 per design
Order size RM1.90 per labour hour
Customer relations RM367.50 per customer
Information related to product ordered by Sedili is shown below:
Standard Bricks Special Bricks
(no design activity (new design activity
required) required)
Price per unit RM3.40 RM65
Order unit 400 units Per unit
Number of Orders 2 orders Once a year
Raw material cost RM211 RM1.30
Labour cost RM185 RM5.00
Delivery cost RM 18 RM2.50
Labour hours required 0.5 hours 4 hours
Required:
The company would like to know the margin for both of its products and the
sales margin for Sedili.
Calculation:
Product Margin
Standard Bricks
Sales RM1,360
Cost:
Raw materials RM211
Direct labour 185
Delivery cost 18
Customer order (RM31.50 X 2) 63
Product design -
Order size (RM1.90 X 400 units X 0.5 hours) 380 857
Product margin RM503

Special Bricks
Sales RM65.00
Cost:
Raw materials RM1.30
Direct labour 5.00
Delivery cost 2.50
Customer order (RM31.50 X 1) 31.50
Product design 128.50
Order size (RM1.90 X 1 units X 4 hours) 7.60 176.40
Product margin (RM111.40)
Customer Margin:
Syarikat Sedili
Product Margin:
• Standard Bricks RM503.00
• Special Bricks (111.40)
Total Product Margin 391.60
Less: Customer Relations 367.50
Customer Margin RM24.10
From the example above, the product margin calculated shows that Special
Bricks is causing a loss to Serama Inds. Following that, when wanting to know
whether it would be profitable or otherwise to retain its customer, Sedili, Serama
Inds calculates the customer margin and finds that the loss can be absorbed with
the order for Standard Bricks. Note that the incurred cost from customer relations
activities was deducted from the margin at this level. What the management can
probably act upon is the pricing set for Special Bricks, which is low compared to
its production cost.
7.5 TARGET COSTING AND PRICING

In the previous section, it was explained that pricing begins with the calculation
of product cost and the determination of mark-up to attain a suitable price. The
discussion assumes that the product has already been developed, costs have
already been calculated and is ready to be marketed when the price is set.
However, in the current business environment that focuses on customers needs,
these pricing steps may not necessarily be followed. Especially for companies
that produce new products, market research will be conducted to survey
marketability and price the customer is willing to pay if the product is produced.
At times, for some products and services, the price has been agreed upon and the

managementÊs task is to develop the products or services that can be marketed at

the desired price.
Target costing is the process of determining the maximun cost allowed for a new
product designed and manufactured in a profitable way. The target cost is
calculated by estimating the sale price less the desired profit.
Target Cost = Target Sale Price ă Desired Profit
Assuming that Syarikat Jaya feels that there is market for leather handbags with
a distinctive handle. Through a market survey, the company finds that the price
of RM60 is suitable for that bag. At that price, the company expects to sell 4,000
units of bags per year. To design, develop and produce the bag, capital
investment of RM200,000 is needed. The company requires a 15% return on the
investment. The target cost can be calculated as follows:
Expected sales (4,000 X RM60) RM240,000

Less: Required profit (15% X RM200,000) 30,000
Target cost for 4,000 bags 210,000
Target cost per unit 52.50
This cost of RM52.50 will then be further divided according to the various
functions, among others, production, marketing and distribution. Each function
will be responsible for ensuring that their costs remain as targetted.
ACTIVITY 7.3
How does ABC assist companies in using target costing in pricing?

• Decision-making in setting price requires careful consideration and would

have to take into account many factors that can be controlled by the company
internally, such as costs, and external factors, such as consumer needs and
competitor situation.
• According to economic theory, under certain assumptions, the price that

generates maximum profit is determined by the meeting point between the
marginal revenue and marginal cost curves.
• However, the economic pricing model is too restricted by its assumption and
the need for information that is difficult to acquire.
• Most companies set price by using cost as a foundation.
• Price formula based on additional mark-up needs a clear definition of

production cost and justification in the calculation of mark-up.
• Mark-up calculated must be sufficient to enable the price attained to bear

incurred costs and generate profits to the company.
• Using cost information from activity-based costing approach (ABC) increases

accuracy for the setting of price in most situations.
• Customer profitability analysis can be conducted to provide information to

the organisation whether to retain or proceed with an action towards their
profitable or unprofitable customers.
• However, one thing that must be given due attention is the role of the market
in determining price.
• Target costing focuses on the customer and the price they are willing to pay.
This is different from cost-based costing.
• Target costing sets price first before working backwards to ensure that the
production cost incurred is less than the price and the organisation can still
gain profit. This is especially necessary for new products to be marketed.
• Indirectly, the organisation can ensure that the product produced will be
accepted in the market.

Cost-based pricing Mark-up

Marginal cost curve Production cost
Marginal revenue curve Target costing

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Topic X Accounting

Copyright © Open University Malaysia (OUM)

7.1 MAIN FACTORS INFLUENCING PRICING

(a) Demand and supply;

Therefore, the management has to understand and continuously project customer

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

7.2 ECONOMIC PRICING MODEL

What is meant by marginal revenue?

7.2.1 Problems of Economic Pricing Model

This is because it is difficult to determine a set of actions that will lead to

Copyright © Open University Malaysia (OUM)

Figure 7.1: Marginal revenue and marginal cost curve

7.3 PRICING USING PRODUCTION COST

In addition, information about cost is readily available. This is because, for

Copyright © Open University Malaysia (OUM)

Figure 7.2: The basis of pricing for a new product

7.3.1 Cost Approach for Companies with Single

Profit = Total Revenue ă Total Cost

Copyright © Open University Malaysia (OUM)

7.3.2 Cost Approach for Companies with Multiple

Price = Cost + (Mark-up Percentage X cost)

Most companies find it easier to justify cost by using an absorption cost-based

Cost Per Unit Total

Copyright © Open University Malaysia (OUM)

Price = Cost + (Mark-up percentage X

Price = Cost + (Mark-up percentage X

7.3.3 Determining the Mark-up Percentage

Copyright © Open University Malaysia (OUM)

The general formula for calculating mark-up is as follows:

Cost not included in basic cost + Required profit

Using the above example, the mark-up charged is derived as follows:

When product cost is calculated based on manufacturing cost:

Cost not included in basic cost + Required profit

When product cost is calculated based on variable manufacturing cost:

Cost not included in basic cost + Required profit

Copyright © Open University Malaysia (OUM)

Assuming Syarikat Jaya invested a capital of RM25,000 for the purpose of

Average Investment of Capital X Target Return on

7.3.4 Limitations on the Use of Cost Approach

Copyright © Open University Malaysia (OUM)

What happens when a price determined by a company is not accepted

7.4 CUSTOMER PROFITABILITY ANALYSIS

Something which is apparent is the importance of customers in contributing to

ABC assists in the preparation of information for managers to conduct an

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

7.5 TARGET COSTING AND PRICING

Copyright © Open University Malaysia (OUM)

managementÊs task is to develop the products or services that can be marketed at

Target Cost = Target Sale Price ă Desired Profit

Expected sales (4,000 X RM60) RM240,000

How does ABC assist companies in using target costing in pricing?

Copyright © Open University Malaysia (OUM)

• Decision-making in setting price requires careful consideration and would

• According to economic theory, under certain assumptions, the price that

• Most companies set price by using cost as a foundation.

• Price formula based on additional mark-up needs a clear definition of

• Mark-up calculated must be sufficient to enable the price attained to bear

• Using cost information from activity-based costing approach (ABC) increases

• Customer profitability analysis can be conducted to provide information to