Costing and Pricing for the Long Run

Learning Objective 2 Understand how companies make long-run ­pricing decisions

• consider all future variable and fixed costs and earn a target return on investment

Long-run pricing is a strategic decision designed to build long-run relationships with customers based on stable and predictable prices. Managers prefer a stable price because it reduces the need for continuous monitoring of prices, improves planning, and builds long-run buyer–seller relationships. McDonald’s maintains a stable price with its Dollar Menu of fast-food items. Nespresso’s price of $0.70 per coffee pod has also remained stable over an extended period of time. But to charge a stable price and earn the target long-run return, managers must know and manage long-run costs of supplying products to customers, which includes all future direct and indirect costs. Recall that indirect costs of a particular cost object are costs that are related to that cost object, but that cannot easily and unambiguously be traced to it. These costs often comprise a large percentage of the overall costs assigned to products.

Consider cost-allocation issues at Astel Computers. Astel manufactures two products: a high-end computer called Deskpoint and an Intel Core i9 chip–based laptop computer called Provalue. The following figure illustrates six business functions in Astel’s value chain.

Exhibit 14-1 illustrates four purposes of cost allocation. Different sets of costs are appropriate for different purposes described in the exhibit. When making pricing decisions for Deskpoint and Provalue, Astel’s managers allocate indirect costs from all six business functions. Why? Because in the long run, it is only worthwhile to sell a product if the price customers are willing to pay for the product exceeds all costs incurred to produce and sell it while earning a reasonable return on invested capital.

Cost allocations and product profitability analyses affect the products promoted by a company. To increase profits, managers focus on high-margin products. They compensate salespersons based on product profitability, in addition to revenues, to motivate the sales staff to sell products that increase operating income and not just revenues. Cost allocations also influence managers’ cost management decisions. For example, identifying all costs of purchasing and ordering prompts Astel’s managers to design Provalue with fewer components to reduce these costs.

Cost allocations are sometimes used for cost reimbursements. Astel’s contract to supply computers to the U.S. government is based on costs plus a profit margin. The cost reimbursement rules for the U.S. government allow fully allocated manufacturing and design costs, but explicitly exclude marketing costs.

Inventory valuation for income and asset measurement on the income statement and balance sheet requires costs to be allocated to calculate the cost of manufacturing inventory. For this purpose, Astel allocates only manufacturing costs to products and no costs from other parts of the value chain such as research and development (R&D), marketing, or distribution.

Cost allocation is another example of the different costs for different purposes theme of the text. We will discuss cost allocation in the next several chapters. In this chapter, we focus on the role of cost allocation when making long-run pricing decisions based on costs incurred throughout the value chain.

Calculating Product Costs for Long-Run Pricing Decisions

Astel’s market research indicates that the market for Provalue is becoming increasingly competitive. Astel’s managers face an important decision about the price to charge for Provalue.

Managers first review data for the year just ended—2019. Astel has no beginning or ending inventory of Provalue and manufactures and sells 150,000 units during the year. Astel uses activity-based costing (ABC) to allocate costs and calculate the manufacturing cost of Provalue. Astel’s ABC system has the following features:

• Three direct manufacturing costs: direct materials, direct manufacturing labor, and direct machining costs.
• Three manufacturing overhead cost pools: ordering and receiving components, testing and inspection of final products, and rework (correcting and fixing errors and defects).

Astel considers machining costs as a direct cost of Provalue because these machines are dedicated to manufacturing Provalue.^*

Astel uses a long-run time horizon (1 year) to price Provalue. Over this horizon, Astel’s managers observe the following:

• Direct material costs vary with the number of units of Provalue produced.
• Direct manufacturing labor costs vary with the number of direct manufacturing labor-hours used.
• Direct machining costs are fixed costs of leasing 300,000 machine-hours of capacity each year for multiple years. These costs do not vary with the number of machine-hours used each year. Each unit of Provalue requires 2 machine-hours. In 2019, Astel uses the entire machining capacity to manufacture Provalue $(2\hspace{0.17em}\text{machine}‐\text{hours}\hspace{0.17em}\text{per}\hspace{0.17em}\text{unit}\times \text{150,000}\hspace{0.17em}\text{units}=\text{300,000}\hspace{0.17em}\text{machine}‐\text{hours}).$
• Ordering and receiving, testing and inspection, and rework costs vary with the quantity of their respective cost drivers. For example, ordering and receiving costs vary with the number of orders. In the long run, staff members responsible for placing orders can be reassigned or laid off if fewer orders need to be placed or increased if more orders need to be processed.

The following Excel spreadsheet summarizes manufacturing cost information to produce 150,000 units of Provalue in 2019. As described in Chapter 5, management accountants calculate the indirect cost per unit of the cost driver in column (6) by dividing Astel’s total costs in each cost pool by the total quantity of the cost driver for that cost pool. (Calculations not shown.)

Exhibit 14-2 shows the total cost of manufacturing Provalue in 2019 of $102 million by various categories of direct costs and indirect costs. The manufacturing cost per unit in Exhibit 14-2 is $680. Manufacturing, however, is just one business function in the value chain. To set long-run prices, Astel’s managers must calculate the full cost of producing and selling Provalue by allocating costs in all functions of the value chain.

Exhibit 14-3 shows the full cost for Provalue. For each nonmanufacturing business function, Astel’s managers trace direct costs to products and allocate indirect costs using cost pools and cost drivers that measure cause-and-effect relationships (supporting calculations not shown). The exhibit summarizes Provalue’s 2019 operating income and shows that Astel earned $15 million from Provalue, or $100 per unit sold in 2019.