Managerial Accounting: Target Costing, Cost-Plus Pricing, and Time and Material Pricing

Course Schedule and Examination Overview

• Chapter 21 is introduced today and will conclude next Monday.

• An Exam 2 review session will occur next Wednesday.

• Exam 2 will take place the following Monday, allowing approximately one and a half weeks for preparation.

• A practice exam will be posted following Monday's lecture; it can be completed at home for extra credit based on performance.

• Examination 2 parameters:

  • Open-note format (identical to Exam 1).

  • Scope covers the preceding four chapters (Chapters 18 through 21).

Fundamentals of Pricing Decisions

• Transition in managerial accounting focus:

  • Prior modules analyzed manufacturing cost accumulation: determining how much a product costs to produce.

  • Pricing focuses on setting a price above cost to ensure profitability. For example, a product costing $\$10$ cannot be sold at $\$10$ if the business expects to generate positive earnings.

• The Pricing Sweet Spot:

  • Pricing too high leads to unsold inventory as consumer demand drops to zero.

  • Pricing too low leads to revenue insufficiency, preventing the company from generating profit.

  • Management must locate the optimal balance between cost coverage, profit generation, and consumer willingness to pay.

• Four to five specific pricing strategies and methods are analyzed across diverse operational models:

  • Target costing.

  • Cost-plus pricing.

  • Time and material pricing (for service jobs).

  • Transfer pricing (for transfers between domestic or international company divisions).

Target Costing and Price Takers

• Determinants of Product Pricing:

  • Demand: Higher consumer volume or urgency allows a company to charge higher rates.

  • Supply: Availability of product inventory directly influences market equilibrium price.

  • Cost: Sets the baseline floor; prices must exceed this floor to yield profitability.

  • Competition: A market saturated with thousands of substitute goods (e.g., standard water bottles) prevents sellers from setting arbitrary high prices (e.g., $\$1{,}000$). In contrast, specialized goods with near-monopoly branding (e.g., luxury designer bags, high-end Apple hardware relative to Samsung) possess pricing power due to lack of identical substitutes.

  • Economic Environment: Recessions constrain consumer spending and suppress market prices, whereas economic expansions permit higher prices.

• Price Takers:

  • Defined as companies that lack unilateral market power to set product selling prices because their goods or services are not easily differentiated from competitors.

  • Common Price Taker Sectors: Commodity producers, gasoline retail, wholesale milk, standard shampoos.

  • Gasoline Station Example: Retail fuel prices cluster tightly within a prevailing market range (e.g., between $\$5.00$ and $\$7.00$ per gallon). Stations do not price fuel at $\$11.00$, $\$12.00$, or $\$3.00$ per gallon because consumers treat competing brands (e.g., Arco vs. Shell) as virtually interchangeable commodities.

• Operating Model for Price Takers:

  • A price taker cannot use a traditional cost-plus model (calculating total costs and adding desired profit to determine selling price).

  • Management must accept the market price determined by external competitive forces.

  • Management focuses on controlling internal costs to ensure the desired profit margin is achieved.

• Target Cost Equation and Definitions:

  • Formula:     $\text{Target Cost} = \text{Market Price} - \text{Desired Profit}$

  • Definition: Target cost is the maximum allowable unit cost that yields the desired profit per unit when the selling price is dictated entirely by the market.

  • Target cost encompasses total manufacturing costs (direct materials, direct labor, variable and fixed manufacturing overhead) plus total selling and administrative expenses.

  • Gasoline Example:

  • Given a market selling price of $\$7.00/\text{gallon}$ and a desired profit margin of $\$2.00/\text{gallon}$, the allowable target cost is:       $\$7.00 - \$2.00 = \$5.00/\text{gallon}$

  • The retailer must procure wholesale fuel from suppliers at or below $\$5.00/\text{gallon}$.

  • If the desired profit is $\$5.00/\text{gallon}$, the target cost drops to $\$2.00/\text{gallon}$, forcing management to pursue extreme operational cost reductions.

Target Costing Practice Problems

• Automatic Treat Dispenser (Paws and Lattes / Poznanoptic):

  • Market Price: $\$47.00$

  • Desired Profit: $\$13.00$

  • Target Cost Calculation:     $\text{Target Cost} = \$47.00 - \$13.00 = \$34.00$

  • Operational requirement: The automatic treat dispenser must be manufactured and delivered for $\$34.00$ or less.

• Practice Problem 1:

  • Market Price: $\$32.00$

  • Desired Profit: $\$9.00$

  • Target Cost Calculation:     $\text{Target Cost} = \$32.00 - \$9.00 = \$23.00$

• Application to Street Food Business Planning:

  • Street food items (e.g., tacos, matcha) operate in competitive local markets where retail prices are pre-established.

  • Standard market price for a street taco is $\$3.00$.

  • To achieve a desired profit of $\$1.00$ per taco, the allowable target cost is:     $\$3.00 - \$1.00 = \$2.00$

  • All production inputs (tortillas, meat, seasonings, garnishes, packaging) must total $\$2.00$ or less per taco. Management must choose lower-cost ingredient cuts or reduce expensive components to avoid exceeding this $\$2.00$ ceiling.

• Target Costing Unit Box Example:

  • Market Price: $\$4.60$

  • Desired Profit: $\$0.40$

  • Target Cost Calculation:     $\text{Target Cost} = \$4.60 - \$0.40 = \$4.20$

Cost-Plus Pricing and ROI Markups

• Operating Environment:

  • Used when a company manufactures specialized, differentiated products with limited direct competition, giving the firm substantial control over pricing.

  • Example: Luxury handbag brands incur production costs of approximately $\$200.00$ per unit and apply markups of $\$20{,}000.00$, selling the final product for $\$20{,}200.00$, because consumer perception views the good as unique.

• General Structure:

  • Management determines a cost base and adds a targeted markup to arrive at the target selling price.

  • Basic Formula:     $\text{Cost Base} + \text{Markup} = \text{Target Selling Price}$

  • Markup represents the profit desired per unit:     $\text{Target Selling Price} - \text{Total Cost} = \text{Markup}$

• Role of Return on Investment (ROI):

  • The dollar markup is typically determined by the firm's required Return on Investment.

  • Formula for ROI:     $\text{ROI} = \frac{\text{Net Income}}{\text{Invested Assets}}$

• Full Cost Approach Equations:

  • Total Unit Cost combines all variable manufacturing and selling costs with all fixed manufacturing and selling costs:     $\text{Total Unit Cost} = \text{Variable Cost Per Unit} + \text{Fixed Cost Per Unit}$

  • Markup Percentage formula:     $\text{Markup Percentage} = \frac{\text{Desired Profit Per Unit}}{\text{Total Unit Cost}}$

  • Target Selling Price formula:     $\text{Target Selling Price} = \text{Total Unit Cost} + (\text{Total Unit Cost} \times \text{Markup Percentage})$

Cost-Plus Pricing Practice Problems

• Practice Problem 4 (Premium Birthday Treat Box):

  • Given Cost Data per Unit:

  • Direct Materials (Variable): Included in variable base.

  • Direct Labor (Variable): Included in variable base.

  • Variable and Fixed Overhead + Variable and Fixed Selling Expenses.

  • Sum of all unit costs: Total Unit Cost = $\$58.00$.

  • Applied Markup Percentage: $35\%$ on total unit cost.

  • Dollar Markup per Unit:     \text{Markup} = \58.00 \times 35\% = \$20.30$

  • Target Selling Price Calculation:     $\text{Target Selling Price} = \$58.00 + \$20.30 = \$78.30$

• Practice Problem 5 (Budgeted Full Cost and ROI Model):

  • Budgeted Costs and Asset Base:

  • Total Budgeted Costs (Variable Costs + Fixed Costs of $\$107{,}000$): $\$1{,}100{,}000$

  • Total Production Volume: $11{,}000\,\text{units}$

  • Invested Assets: $\$1{,}100{,}000$

  • Budgeted Required ROI: $20\%$

  • Step 1: Calculate Total Cost per Unit:     \text{Total Unit Cost} = \frac{\text{Total Budgeted Cost}}{\text{Budgeted Units}} = \frac{\1{,}100{,}000}{11{,}000\,\text{units}} = \$100.00$

  • Step 2: Calculate Total Desired Profit (Net Income):     \text{Total Markup} = \text{Invested Assets} \times \text{ROI} = \1{,}100{,}000 \times 20\% = \$220{,}000$

  • Step 3: Calculate Desired Profit (Markup) per Unit:     \text{Markup Per Unit} = \frac{\text{Total Desired Profit}}{\text{Budgeted Units}} = \frac{\220{,}000}{11{,}000\,\text{units}} = \$20.00$

  • Step 4: Calculate Budgeted Markup Percentage:     $\text{Markup Percentage} = \frac{\text{Desired Profit Per Unit}}{\text{Total Unit Cost}} = \frac{\$20.00}{\$100.00} = 20\%$

• Practice Problem 6 (Target Selling Price per Unit):

  • Given Cost and Investment Parameters:

  • Total Cost Base (Variable Costs + Fixed Costs): $\$637{,}500$

  • Invested Assets: $\$3{,}000{,}000$

  • Budgeted ROI: $14\%$

  • Budgeted Volume: $150{,}000\,\text{units}$

  • Step 1: Calculate Total Required Profit:     \text{Desired Profit} = \3{,}000{,}000 \times 14\% = \$420{,}000$

  • Step 2: Determine Cost and Markup per Unit:     \text{Cost Per Unit} = \frac{\637{,}500}{150{,}000\,\text{units}} = \$4.25$     \text{Markup Per Unit} = \frac{\420{,}000}{150{,}000\,\text{units}} = \$2.80$

  • Step 3: Compute Target Selling Price per Unit:     $\text{Selling Price} = \text{Cost Per Unit} + \text{Markup Per Unit} = \$4.25 + \$2.80 = \$7.05$

• Practice Problem 7 (Markup Percentage and Selling Price):

  • Given Cost and Investment Parameters:

  • Total Cost Base (Variable + Fixed): $\$600{,}000$

  • Invested Assets: $\$1{,}800{,}000$

  • Required ROI: $16\%$

  • Volume: $200{,}000\,\text{units}$

  • Step 1: Calculate Desired Profit:     \text{Total Desired Profit} = \1{,}800{,}000 \times 16\% = \$288{,}000$

  • Step 2: Calculate Markup Percentage:     $\text{Markup Percentage} = \frac{\text{Total Desired Profit}}{\text{Total Cost Base}} = \frac{\$288{,}000}{\$600{,}000} = 48\%$

  • Alternative Per-Unit Approach:     \text{Cost Per Unit} = \frac{\600{,}000}{200{,}000\,\text{units}} = \$3.00$     \text{Markup Per Unit} = \frac{\288{,}000}{200{,}000\,\text{units}} = \$1.44$     $\text{Markup Percentage} = \frac{\$1.44}{\$3.00} = 48\%$

  • Supplemental Target Selling Price:     $\text{Selling Price} = \$3.00 + \$1.44 = \$4.44$

Limitations of the Cost-Plus Pricing Approach

• Failure to Account for Consumer Demand:

  • Cost-plus models operate strictly on internal supply-side metrics without evaluating whether customers are willing to purchase the product at the calculated price point.

• Sensitivity of Unit Fixed Cost to Sales Volume Fluctuations:

  • Total fixed costs remain constant in total regardless of output volume.

  • When sales volume falls below projections, total fixed costs must be spread over fewer units, driving up the fixed cost per unit.

  • Higher unit costs require setting a higher selling price to achieve the target ROI.

• Flaw of Inverse Economic Logic:

  • When demand falls, market dynamics dictate that prices should be lowered to stimulate sales.

  • Cost-plus pricing dictates that when demand falls, prices must be increased to maintain target returns, aggravating falling demand.

• Numerical Proof: Paws and Lattes Product Line Volume Contraction:

  • Base Parameters: Invested Assets = $\$2{,}000{,}000$; Desired ROI = $20\%$.     \text{Total Desired Profit} = \2{,}000{,}000 \times 20\% = \$400{,}000$

  • Scenario A: Expected Sales Volume = $10{,}000\,\text{boxes}$

  • Desired Profit per Unit:       \frac{\400{,}000}{10{,}000\,\text{boxes}} = \$40.00$

  • Production Cost per Unit: Variable Cost = $\$60.00$; Fixed Cost = $\$65.00$. Total Cost = $\$125.00$.

  • Selling Price:       $\text{Selling Price} = \$125.00 + \$40.00 = \$165.00$

  • Scenario B: Expected Sales Volume Collapses by 50% to $5{,}000\,\text{boxes}$

  • Desired Profit per Unit:       \frac{\400{,}000}{5{,}000\,\text{boxes}} = \$80.00$

  • Unit Costs: Variable cost remains constant at $\$60.00$ per unit.

  • Total fixed costs remain fixed in aggregate, meaning fixed cost per unit must double (from $\$65.00$ to $\$130.00$ per unit).

  • If fixed costs were mistakenly kept static at $\$65.00$, target selling price would calculate to:       $\$60.00 + \$65.00 + \$80.00 = \$205.00$

  • Accounting for the doubling of actual unit fixed cost ($\$130.00$), the target selling price increases further, illustrating the pricing death spiral caused by cost-plus methodologies.

Time and Material Pricing for Service Organizations

• Application Scope:

  • Service companies that furnish customized jobs combining skilled trade labor with replacement components (e.g., auto body repair shops, custom catering operations, commercial repair services).

  • Utilizes two independent pricing rates: a labor charge per hour and a material loading charge percentage.

Step 1: Calculate the Billed Labor Rate

• Components of the Hourly Labor Rate:

  • Direct technician wages.

  • Employee fringe benefits.

  • Related operating overhead (shop floor space, supervisor compensation, utilities).

  • Desired profit margin per labor hour for the business owner.

• Formula:   $\text{Labor Rate Per Hour} = \frac{\text{Total Annual Direct Labor Costs} + \text{Fringe Benefits} + \text{Labor Overhead}}{\text{Estimated Annual Labor Hours}} + \text{Desired Profit Per Hour}$

• Application: Janet's Custom Catering Operations:

  • Direct employee wages, fringe benefits, and related labor overhead sum to $\$110{,}000$.

  • Estimated annual operating hours: $5{,}000\,\text{hours}$.

  • Base Labor Cost per Hour:     \frac{\110{,}000}{5{,}000\,\text{hours}} = \$22.00/\text{hour}$

  • Required Ownership Profit Allowance: $\$20.00/\text{hour}$.

  • Billed Labor Rate per Hour:     $\text{Labor Rate} = \$22.00 + \$20.00 = \$42.00/\text{hour}$

Step 2: Calculate the Material Loading Charge Percentage

• Material Loading Charge Function:

  • Covers all support costs associated with acquiring and holding physical stock (ordering, receiving, freight, storage handling, inspection, warehousing).

  • Adds an ownership profit margin applied directly to wholesale component costs.

• Formula:   $\text{Material Loading Percentage} = \frac{\text{Material Related Overhead Costs}}{\text{Estimated Total Annual Invoice Material Cost}} + \text{Desired Profit Percentage on Materials}$

• Application: Catering Supply Warehouse Calculations:

  • Material support wages, benefits, and storage overhead sum to $\$41{,}500$.

  • Total annual budgeted material acquisition cost: $\$166{,}000$.

  • Handling Overhead Percentage:     $\frac{\$41{,}500}{\$166{,}000} = 25\%$

  • Desired Profit Percentage on Material: $38\%$

  • Total Material Loading Percentage:     $\text{Total Loading Percentage} = 25\% + 38\% = 63\%$

• Economic Interpretation:

  • If a replacement component (such as an OEM Tesla bumper) has an invoice cost of $\$100.00$, the customer is billed $\$163.00$:

  • $\$100.00$ reimburses the supplier invoice.

  • $\$25.00$ ($25\%$) covers internal procurement, handling, and warehouse holding overhead.

  • $\$38.00$ ($38\%$) is retained as owner markup.

Step 3: Calculate the Total Job Quotation

• Total Job Billing Formula:   $\text{Total Job Charge} = (\text{Actual Labor Hours} \times \text{Hourly Labor Rate}) + \text{Direct Material Cost} + (\text{Direct Material Cost} \times \text{Material Loading Percentage})$

• Application Job 1 (Custom Event Catering Package):

  • Estimated Labor Requirement: $20\,\text{hours}$.

  • Direct Material Costs (balloons, custom food supplies, specialty cakes): $\$180.00$.

  • Calculation of Line Items:

  • Billed Labor Charge:       20\,\text{hours} \times \42.00/\text{hour} = \$840.00$

  • Wholesale Material Cost: $\$180.00$

  • Material Loading Charge:       \180.00 \times 63\% = \$113.40$

  • Total Customer Quotation:     $\text{Total Job Charge} = \$840.00 + \$180.00 + \$113.40 = \$1{,}133.40$

• Application Job 2 (Practice Problem 9 - Collision / Service Job):

  • Labor Hours: $11\,\text{hours}$.

  • Labor Rate: $\$46.00/\text{hour}$.

  • Parts / Materials Base Cost: $\$500.00$.

  • Material Loading Percentage: $38\%$

  • Calculation of Line Items:

  • Total Labor Charge:       11\,\text{hours} \times \46.00/\text{hour} = \$506.00$

  • Direct Parts Cost: $\$500.00$

  • Material Loading Charge:       \500.00 \times 38\% = \$190.00$

  • Total Billed Invoice:     $\text{Total Invoice} = \$506.00 + \$500.00 + \$190.00 = \$1{,}196.00$

Questions and Project Discussion

• Class Project Setup and Cost Accumulation Guidance:

  • Variable Cost Per Unit:

  • Students must calculate variable costs strictly on a per-unit basis (e.g., cost per individual cup of matcha, cost per individual taco).

  • Unit costs cannot simply reflect the bulk package invoice price shown on wholesale supplier websites.

  • Ingredient-Level Costing Procedure:

  • Build a complete inventory list of every input item (e.g., for tacos: tortillas, beef cuts, limes, onions, seasoning).

  • Provide direct online hyperlinks to verify raw purchase prices for each specific input.

• Fixed Costs and Marketing Budgets:

  • Physical vs. Digital Expense Classification:

  • Equipment expenses, such as a specialized mobile street cart featuring custom corporate logo wraps, represent fixed capital investments.

  • Digital Advertising Strategies:

  • Advertising platforms (e.g., Reddit advertising) allow daily expenditure caps (e.g., $\$5.00$ or $\$10.00$ daily budget).

  • Online campaigns generate variable impression volumes (e.g., $\$10.00$ delivering up to a designated impression cap), stopping ad distribution once the daily allocation is depleted.

  • When evaluating non-linkable digital ad costs, students can cite platform standards (such as Reddit ad tiers).

  • Teams can choose zero-dollar baseline marketing strategies relying entirely on natural pedestrian street traffic around the food cart.