Question

1.How would a manager use economic theory to maximize profit price for a service or product?

2. What is the process of target costing? How is target costing calculated?

Answer 1

1.How would a manager use economic theory to maximize profit price for a service or product

Managerial economics provides a, logical way to analyze business decisions that focuses on the economic forces that shape both day-to-day decisions and long-run planning decisions. It applies microeconomic theory { the study of the behavior of individual economic agents} to business problems in order to teach business decision makers how to use economic analysis to make decisions that will achieve the firm's goal: the maximization of profit.

Economic theory helps managers understand real-world business problems by using simplifying assumptions to abstract away from irrelevant ideas and information and turn complexity into relative simplicity. Like a road map, economic theory ignores everything irrelevant to the problem and reduces business problems to their most essential components.

The opportunity cost of using resources to produce goods and services is the amount the firm's owner gives up by using these resources. Opportunity costs are either explicit opportunity costs or implicit opportunity costs. Explicit costs are the costs of using market-supplied resources, which equal the monetary payments to hire, rent, or lease resources owned by others. Implicit costs are the costs of using owner-supplied resources, which are the best earnings forgone from using resources owned by the firm in the firm's own production process. Total economic cost is the sum of explicit and implicit costs. Economic profit is the difference between total revenue and total economic cost:
Economic profit = Total revenue - Total economic cost

= Total revenue - Explicit costs - Implicit costs

Accounting profit differs from economic profit because accounting profit does not subtract from total revenue the implicit costs of using resources:

Accounting profit = Total revenue - Explicit costs

Thus accounting profit will be larger than economic profit for firms using owner-supplied resources. Since all costs matter to owners of a firm, maximizing economic profit is the objective of the firm's owners.

The value of a firm is the price for which it can be sold, and that price is equal to the present value of the expected future profits of the firm. The risk associated with not knowing future profits of a firm is accounted for by using a higher risk-adjusted discount rate to calculate the present value of the firm's future profits. The larger (smaller) the risk associated with future profits, the higher (lower) the risk-adjusted discount rate used to compute the value of the firm, and the lower (higher) will be the value of the firm. In the absence of any agency problems, the objective of a manager is to maximize the value of the firm. A manager will maximize the value of a firm by making decisions that maximize profit in every single time period, unless cost and/or revenue conditions in any period depend upon decisions made in other time periods.

In firms where the managers are not also the owners, the managers are agents of the owners, or principals. A principal–agent problem exists when the agent has objectives different from those of the principal, and the principal either has difficulty enforcing agreements with the agent or finds it too difficult and costly to monitor the agent to verify that he or she is furthering the principal's objectives. Agency problems arise because of moral hazard. Moral hazard exists when either party to an agreement has an incentive not to abide by all the provisions of the agreement and one party cannot cost effectively find out if the other party is abiding by the agreement or cannot enforce the agreement even when the information is available.

In order to address agency problems, shareholders can employ a variety of corporate control mechanisms. Shareholders can reduce or eliminate agency problems by (1) requiring that managers hold a stipulated amount of the firm's equity, (2) increasing the percentage of outsiders serving on the company's board of directors, and (3) financing corporate investments with debt instead of equity. Corporate takeovers also create an incentive for managers to make decisions that maximize the value of a firm.

The structure of the market in which a firm operates can limit the ability of managers to increase the price of the firm's products. In some markets, firms are price-takers. In these markets prices are determined not by managers but by market forces that cannot be controlled. In other markets, managers of price-setting firms possess some degree of market power and can raise price without losing all their sales.

A market is any arrangement that enables buyers and sellers to exchange goods and services, usually for money payments. A market may be a location at a certain time, a newspaper advertisement, a website on the Internet, or any other arrangement that works to bring buyers and sellers together. Markets exist to reduce transaction costs, the costs of making a transaction.

A market structure is a set of market characteristics that determines the economic environment in which a firm operates: (1) the number and size of the firms operating in the market, (2) the degree of product differentiation, and (3) the likelihood of new firms entering. A perfectly competitive market has a large number of relatively small firms selling an undifferentiated product with no barriers to entry. A monopoly market is one in which a single firm, protected by barriers to entry, produces a product that has no close substitutes. In a monopolistically competitive market, a large number of relatively small firms produce differentiated products without any barriers to entry. Finally, in an oligopoly market, there are only a few firms experiencing interdependence—each firm's pricing decision affects all other firms' profits—with varying degrees of product differentiation and barriers to entry.

2. What is the process of target costing? How is target costing calculated?

Target costing is an approach to determine a product’s life-cycle cost which should be sufficient to develop specified functionality and quality, while ensuring its desired profit. It involves setting a target cost by subtracting a desired profit margin from a competitive market price.  A target cost is the maximum amount of cost that can be incurred on a product, however, the firm can still earn the required profit margin from that product at a particular selling price. Target costing decomposes the target cost from product level to component level. Through this decomposition, target costing spread the competitive pressure faced by the company to product’s designers and suppliers. Target costing consists of cost planning in the design phase of production as well as cost control throughout the resulting product life cycle. The cardinal rule of target costing is to never exceed the target cost. However, the focus of target costing is not to minimize costs, but to achieve a desired level of cost reduction determined by target costing process.

Target cost = selling price – profit margin

Profit margin may be based on cost or selling price.

In most of the industries competition is high which means that prices are determined by the interaction of market demand and supply which the market participants i.e. producers can’t change. However, they can control their costs. In target costing, companies leverage their ability to monitor and control their cost to generate a profit.

Target costing can be contrasted with cost-plus pricing, in which companies set price by adding a profit margin to whatever cost they incur. Target costing is a more effective approach because it emphasizes efficiency in order to keep costs low. Target costing is particularly useful in industries that have low profit margins and high competition.

Formula

Where the profit margin is based on selling price, target total cost can be calculated as follows:

Target cost = selling price – profit percentage × selling price

Where the profit margin is based on cost, target cost can be found as follows:

Target cost = [selling price] / [1 + profit percentage]

Targets can be set for each individual cost component based on the standard costing.