A note on pricing issues and customer profitability analysis terms in advanced management accounting study

A note on  pricing issues and customer profitability analysis terms in advanced management accounting study

Briefly describe the following pricing issues and customer profitability analysis terms in advanced management accounting study

(Terms used in Chapter 12)

 

1.    Major influences on pricing

2.    Costing and pricing for the short run

3.    Costing and pricing for the long run

4.    Alternative long-run pricing approaches: market-based and cost-based

5.    Target costing for target pricing

6.    Value engineering

7.    Cost incurrence and locked-in costs

8.    Cost-plus target rate of return on investment

9.    Life-cycle product budgeting and costing

10.          Life-cycle product budgeting and pricing

11.          Customer profitability analysis

12.          Assessing customer value

 

 

These terms link pricing decisions to costs, customer demand, competition, and long-term profitability. A key distinction is that short-run decisions focus on incremental consequences, whereas long-run decisions must recover the full economic cost of resources and achieve an adequate return.

Pricing and cost management

1.    Major influences on pricing
The three core influences are customers, competitors, and costs. Customers determine demand and willingness to pay; competitors constrain feasible market prices; and costs affect the supply economics and the minimum sustainable price.

2.    Costing and pricing for the short run
Short-run decisions—typically under one year, such as a one-off special order—use relevant incremental costs. The practical price floor is often variable cost, provided spare capacity exists; however, managers must also include opportunity costs, such as lost contribution from regular sales, and strategic effects such as upsetting established customers.

3.    Costing and pricing for the long run
Long-run decisions usually extend for a year or more. A price must cover the full cost of resources used—including fixed capacity-related costs—and provide a satisfactory return on investment (ROI). Activity-based costing (ABC) can improve estimates where products consume support activities differently.

4.    Alternative long-run pricing approaches: market-based and cost-based
Market-based pricing begins with customers’ perceived value and competitors’ likely reactions, then asks what price the market will accept. Cost-based, or cost-plus, pricing begins with cost and adds a markup to recover costs and earn a target profit. In practice, firms should use both: market evidence to test whether a price is viable and cost data to assess whether it is profitable.

5.    Target costing for target pricing
Target costing starts with a market-derived target price and subtracts required target operating income to calculate the maximum allowable cost:

Target cost per unit = Target price − Target operating income per unit

It is a “design-to-cost” approach: the product must meet customer needs while being designed so it can be produced within that cost limit.

6.    Value engineering
Value engineering is the systematic examination of product design, processes, components, and value-chain activities to reduce cost without reducing the functions, quality, or features customers value. It aims to eliminate non-value-added cost, such as rework or unnecessary complexity, rather than merely cutting useful features.

7.    Cost incurrence and locked-in costs
Cost incurrence is when a resource is actually consumed or sacrificed—for example, when materials are purchased or production labour is used. Locked-in costs are future costs made largely unavoidable by earlier decisions, especially R&D and product-design choices. Thus, most production and support costs may be locked in during design even though they are incurred later; this is why early-stage cost management is critical.  

8.    Cost-plus target rate of return on investment
In cost-plus pricing, the firm adds a markup to a selected cost base to determine selling price:

Selling price = Cost base + Markup

Where the aim is a target ROI, the markup must generate enough operating profit to earn the required return on assets or capital invested. This is useful when costs are measurable and the firm has pricing discretion, but it can fail if the resulting price exceeds customers’ willingness to pay.

Life-cycle perspective

9.    Life-cycle product budgeting and costing
Life-cycle budgeting estimates all revenues and costs attributable to a product from initial research and development through design, production, marketing, distribution, customer service, and withdrawal. It prevents managers from focusing only on manufacturing cost while ignoring substantial pre-production and post-sale costs.

10.                    Life-cycle product budgeting and pricing
Life-cycle pricing uses the total expected life-cycle cost and revenue profile when setting prices and evaluating profitability. It recognises that a product may incur high R&D, launch, warranty, or service costs before, during, or after sales, so pricing should recover total life-cycle costs and required profit—not simply current-period production cost. This is especially relevant for technology products, vehicles, and products with long after-sales support obligations.

Customer profitability

11.                    Customer profitability analysis (CPA)
CPA measures the profit generated by an individual customer or customer segment after deducting the revenues and all traceable costs of serving that customer. Rather than treating all sales revenue as equally valuable, it includes costs such as sales visits, order processing, delivery, returns, credit administration, technical support, and special packaging. ABC is useful because service costs often vary with activities, not simply with sales value.

12.                    Assessing customer value
Assessing customer value extends CPA beyond current-period profit. It considers customer lifetime value (CLV)—the present value of expected future profits—plus wider strategic benefits such as referrals, reputation or influence, learning and feedback, cross-selling potential, retention, and product-development knowledge. A currently low-margin customer may therefore be valuable if they have strong future profitability or strategic influence; conversely, a high-revenue customer may destroy value if their cost to serve is excessive.

For an online sales business, CPA might reveal that a customer with frequent small orders, high return rates, and repeated service queries is less profitable than a lower-revenue customer who places predictable bulk orders and requires little support.