SHORT-RUN DECISION MAKING:

RELEVANT COSTING

PRODUCT MIX AND PRICING

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 Learning Objectives

1. Choose the optimal product mix when faced

with one constrained resource.

2. Explain the impact of cost on pricing decisions.

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 Product Mix Decisions
▪ Organizations have wide flexibility in choosing
their product mix.
▪ Product mix refers to the relative amount of each
product manufactured (or service provided) by a
company.
▪ Decisions about product mix can have a
significant impact on an organization’s
profitability.

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 Product Mix Decisions (cont.)
▪ Every firm faces limited resources and limited
demand for each product. These limitations are
called constraints.
▪ A manager must choose the optimal mix given
the constraints found within the firm.

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 Determining the Optimal Product
Mix with One Constrained Resource

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 Determining the Optimal Product
Mix with One Constrained Resource

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 Optimal Product Mix with One
Constrained Resource, Sales Constraint

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 Optimal Product Mix with One
Constrained Resource, Sales Constraint

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 Quiz
Q2. Sealing Company manufactures three types of DVD storage units. Each of the three types
requires the use of a special machine that has a total operating capacity of 15,000 hours per year.
Information on the three types of storage units is as follows:
Basic Standard Deluxe
Selling price $9.00 $30.00 $35.00
Variable cost $6.00 $20.00 $10.00
Machine hours required 0.10 0.50 0.75
Sealing’s marketing director has assessed demand for the three types of storage units and
believes that the firm can sell as many units as it can produce.
a. How many of each type of unit should be produced and sold to maximize the company’s
contribution margin? What is the total contribution margin for your selection?

b. Now suppose that Sealing Company believes that it can sell no more than 12,000 of the
deluxe model but up to 50,000 each of the basic and standard models at the selling prices
estimated. What product mix would you recommend, and what would be the total contribution
margin?

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 Quiz Solution
Part A
Basic Standard Deluxe
Price $ 9.00 $30.00 $35.00
Less Variable cost 6.00 20.00 10.00
Contribution margin $ 3.00 $10.00 $25.00
÷ Machine hours 0.10 0.50 0.75
= Contribution margin per machine hour $30.00 $20.00 $33.33

The company should sell only the deluxe unit with contribution margin per
machine hour of $33.33. Sealing can produce 20,000 (15,000/0.75) deluxe units per
year. These 20,000 units, multiplied by the $25 contribution margin per unit, would
yield a total contribution margin of $500,000.

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 Quiz Solution
Part B
Basic Standard Deluxe
Price $ 9.00 $30.00 $35.00
Less Variable cost 6.00 20.00 10.00
= Contribution margin $ 3.00 $10.00 $25.00
÷ Machine hours 0.10 0.50 0.75
= Contribution margin per machine hour $30.00 $20.00 $33.33

First, produce and sell 12,000 deluxe units, which would use 9,000 machine hours.
Then, produce and sell 50,000 basic units, which would use 5,000 machine hours.
Finally, with the remaining 1,000 machine hours, produce 2,000 standard units.
Total hours used = 15,000 (9,000 + 5,000 + 1,000)
Total Contribution Margin = ($25 × 12,000) + ($3 × 50,000) + ($10 × 2,000)
= $470,000

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 Multiple Constrained Resources
▪ The presence of only one constrained resource
might not be realistic.
▪ Organizations often face multiple constraints,
including:
▪ limitations of raw materials
▪ limitations of skilled labor
▪ limited demand for each product

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 Multiple Constrained Resources
(cont.)
▪ The solution of the product mix problem in the
presence of multiple constraints is more
complicated and requires the use of a specialized
mathematical technique known as linear
programming, which is reserved for advanced
cost management courses.

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 Pricing strategies
A. Cost-Based Pricing
▪ The cost of a product or service provides a
floor, and the price cannot be set below this
floor to achieve long term success
▪ Ignores the demand for a product
B. Target Costing and Pricing
▪ Many firms set the price of a new product as
the sum of the costs and the desired profit.
▪ The company must earn sufficient revenues to
cover all costs and yield a profit.
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 Cost-Based Pricing
▪ Demand is one side of the pricing equation;
supply is the other side.
▪ Since revenue must cover all costs for the firm to
make a profit, many companies start with cost to
determine price.
▪ That is, they calculate product cost and add the
desired profit.
▪ The mechanics of this approach are
straightforward. Usually, there is a cost base and
a markup.
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 Cost-Based Pricing (cont.)
▪ The markup is a percentage applied to the base
cost.
▪ It includes desired profit and any costs not
included in the base cost.
▪ Companies that bid for jobs routinely base bid
price on cost.

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 Cost-Based Pricing (cont.)

Price = cost + (mark-up percentage × cost)

Two issues
1. what is the best definition of cost to be used in
the cost-plus pricing formula?*
2. how is the desired mark-up determined?
*Full-absorption *Variable
manufacturing manufacturing
cost? cost?

*Total cost, *Total variable cost,

including selling including selling
and administrative? and administrative?
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 Cost-Plus Pricing - Example

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 Cost-Plus Pricing - Example

Variable mfg. cost $ 400

Fixed mfg. Cost 250 Mark-up on
Full-absorption mfg. cost $ 650 variable
Variable S & A cost 50 manufacturing
Fixed S & A cost 100 cost
Total cost $ 800

Price = cost + (mark-up percentage × cost)

$925= $400 + (mark-up percentage × $400)

Mark-up = 131.25%

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 Cost-Plus Pricing - Example

Variable mfg. cost $ 400 Mark-up on

Fixed mfg. Cost 250 total variable cost
Full-absorption mfg. cost $ 650 As cost base
Variable S & A cost 50 increases, the
Fixed S & A cost 100 required mark-up
Total cost $ 800 percentage
declines.

Price = cost + (mark-up percentage × cost)

$925 = $450 + (mark-up percentage × $450)

Markup = 105.56%

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 Cost-Plus Pricing - Example

Variable mfg. cost $ 400

Fixed mfg. Cost 250 Mark-up on
full absorption mfg. cost.
Full-absorption mfg. cost $ 650
Variable S & A cost 50 As cost base
Fixed S & A cost 100 increases, the
required mark-up
Total cost $ 800 percentage
declines.

Price = cost + (mark-up percentage × cost)

$925 = $650 + (mark-up percentage × $650)

Mark-up = 42.3%

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 Cost-Plus Pricing - Example

Variable mfg. cost $ 400 Mark-up on

Fixed mfg. Cost 250 total cost
Full-absorption mfg. cost $ 650
As cost base
Variable S & A cost 50 increases, the
Fixed S & A cost 100 required mark-up
Total cost $ 800 percentage
declines.

Price = cost + (mark-up percentage × cost)

$925 = $800 + (mark-up percentage × $800)

Mark-up = 15.63%

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 Absorption Cost Pricing Formulas

Advantages Disadvantages
• Price covers all costs. • Full-absorption unit
price obscures the
• Perceived as distinction between
equitable. variable and fixed
• Absorption cost used costs.
for external reporting.

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 Variable Cost Pricing Formulas

Advantages Disadvantage
• Do not obscure cost • Fixed costs may be
behaviour patterns. overlooked in pricing
decisions, resulting
• Do not require fixed in prices that are too
cost allocations. low to cover total
• More useful for costs.
managers to make
short-term pricing
decisions

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 Determining the mark-up

• Return on investment pricing

– selling price determined by using the required rate of
return to determine the mark-up on cost
– calculated by:
▪ Average investment x target ROI = target profit

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 Determining the Mark-up:
Return-on-Investment Pricing

Recall the example using a 131.25 percent mark-up

on variable manufacturing cost.

Price = cost + (mark-up percentage × cost)

Price = $400 + (131.25% × $400) = $925

Let’s solve for the 131.25 per cent mark-up, assuming

that we do not know the selling price.
What we know is invested
capital is $300,000, the desired ROI is 20 per cent,
and annual sales volume is 480 units.

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 Determining the Mark-up:
Return-on-Investment Pricing

Step 1: Solve for the profit that

will result in an ROI of 20 percent.

Profit
ROI =
Invested Capital
Profit
20% = $300,000

Profit = 20% × $300,000

Profit = $60,000
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 Determining the Mark-up:
Return-on-Investment Pricing

Step 2: Recall the unit cost information below.

Solve for the unit sales price necessary to result in a profit of $60,000.

Variable manufacturing cost $ 400

Fixed manufacturing Cost 250
Full-absorption manufacturing cost $ 650
Variable Selling & Admin cost $50
Fixed Selling & Admin cost $100
Total cost $ 800

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 Determining the Mark-up:
Return-on-Investment Pricing
Step 2: Solve for the unit sales price necessary to result in a profit of $60,000.

480 units × (Unit profit margin) = $60,000

480 units × (Unit sales price - $800 unit cost) = $60,000

$60,000
Unit sales price - $800 unit cost =
480 units

Unit sales price - $800 unit cost = $125 per unit

Unit sales price = $925

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 Determining the Mark-up:
Return-on-Investment Pricing
Step 3: Compute the mark-up percentage on the $400 variable
manufacturing cost.

Mark-up Unit sales price - Unit variable cost

=
percentage Unit variable cost

Mark-up = $925 per unit - $400 per unit

percentage $400 per unit

Mark-up
= 131.25 per cent
percentage

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 Calculating Price by Applying a
Mark-up Percentage to Cost

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 Target-Costing and Pricing
▪ Target costing is a method of determining the
cost of a product or service based on the price
(target price) that customers are willing to pay.
▪ The marketing department determines what
characteristics and price for a product are most
acceptable to consumers.

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 Calculating a Target Cost

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 Quiz
Sweethome Ltd would like to sell kettles and the
target price is $50. Sweethome Ltd. requires that
the kettles are priced such that 25% of the price is
profit.
a. Calculate the amount of desired profit per unit
of the kettle.
b. Calculate the target cost per unit of the kettle.

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 Quiz Solution
a. Desired Profit = 0.25 × Target Price
= 0.25 × $50
= $12.50

b. Target Cost = Target Price – Desired Profit

= $50.00 – $12.50
= $37.50

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