Appendix A: Pricing Products and Services

Appendix A
Pricing Products and Services

Solutions to Questions
A-1 Cost-plus pricing refers to setting prices by applying a predetermined markup (usually a percentage) to a cost base. A-2 The price elasticity of demand measures the degree to which unit sales are affected by a change in price. The unit sales of a product with inelastic demand are relatively insensitive to the price charged for the product. In contrast, the unit sales of a product with elastic demand are sensitive to the price charged for the product. A-3 The profit-ma imi!ing price should depend only on the variable (marginal) cost per unit and on the price elasticity of demand. "i ed costs do not enter into the pricing decision at all. They are relevant in a decision of whether to offer a product or service, but are not relevant in deciding what to charge for the product or service. #ince price affects the amount of units sold, the variable costs (in total) are affected by the pricing decision and therefore are relevant. A-4 The markup over variable cost depends on the price elasticity of demand. $ product whose demand is elastic should have a lower markup over cost than a product whose demand is inelastic. If demand for a product is inelastic, the price can be increased without cutting as drastically into unit sales. A-5 %hen the absorption costing approach is used, the markup is supposed to cover selling, general, and administrative e penses as well as providing an ade&uate return on the assets tied . up in the product. "ull cost is an alternative approach not discussed in the chapter that is used almost as fre&uently as the absorption approach. 'nder the full cost approach, all costs (including #)*$ e penses(are included in the cost base. If full cost is used, the markup is only supposed to provide for an ade&uate return on the assets. A-6 +ssentially, the absorption costing approach assumes that consumers do not react to prices at all(consumers will purchase the forecasted unit sales regardless of the price that is charged. A-7 The protection offered by full cost pricing is an illusion. $ll costs will be covered only if actual sales e&ual or e ceed the forecasted sales on which the absorption costing price is based. There is no assurance that a sufficient number of units will be sold. A-8 Target costing is used in new product development. The target cost is the e pected selling price of the new product less the desired profit per unit. The product development team is charged with the responsibility of ensuring that actual costs do not e ceed this target cost. This is the reverse of the way most companies have traditionally approached the pricing decision. ,ost companies start with cost and then add their markup to arrive at the selling price. The traditional cost-plus pricing approach attempts to ignore how much customers are willing to pay for the product.
- The ,c)raw-.ill Companies, Inc., /001. $ll rights reserved. #olutions ,anual, 2ricing $ppendi 34
Exercise A-1 (30 minutes) 4. ,aria makes more money selling the ice cream cones at the lower price, as shown below5 'nit sales....................... #ales.............................. Cost of sales : 80.73. . . Contribution margin........ "i ed e penses.............. =et operating income..... $1.89 Price $1.49 Price 4,600 /,370 8/,936.00 83,791.10 176.00 4,001./0 /,4;0.00 /,790.70 1<6.00 1<6.00 84,646.00 84,906.70
/. The price elasticity of demand, as defined in the te t, is computed as follows5 d > ln(4? @ change in &uantity sold) ln(4? @ change in price)
/,370-4,600 ln(4? ) 4,600 > 4.7;-4.9; ln(4? ) 4.9; > > > ln(4? 0.61000) ln(4-0./4417) ln(4.61000) ln(0.<9931) 0.7771; > -4.9< -0./3<90
- The ,c)raw-.ill Companies, Inc., /001. $ll rights reserved. 3/ ,anagerial $ccounting, 44th +dition
Exercise A-1 (continued) 3. The profit-ma imi!ing price can be estimated using the following formula from the te t5 Ad 2rofit-ma imi!ing price > Bariable cost per unit 4?A d -4.9< > 80.73 4? (-4.9<) > /.47;7 C 80.73 > 80.;/ This price is much lower than the prices ,aria has been charging in the past. Dather than immediately dropping the price to 80.;/, it would be prudent to drop the price a bit and see what happens to unit sales and to profits. The formula assumes that the price elasticity is constant, which may not be the case.
Exercise A-2 (46 minutes) 4. ,arkup percentage > on absorption cost > > De&uired DEI ? #)*$ e penses (C Investment ) 'nit sales C 'nit product cost
( 4/@
C 8<60,000) ? 860,000
47,000 units C 8/6 per unit 8470,000 > 70@ 8360,000 8/6 40 836
/. 'nit product cost................ ,arkup (70@ C 8/6)........... #elling price per unit...........
- The ,c)raw-.ill Companies, Inc., /001. $ll rights reserved. 37 ,anagerial $ccounting, 44th +dition
Exercise A-3 (40 minutes) #ales (300,000 units C 846 per unit).......... Fess desired profit (4/@ C 86,000,000)..... Target cost for 300,000 units..................... 87,600,000 100,000 83,;00,000
Target cost per unit > 83,;00,000 G 300,000 units > 843 per unit
Problem A-4 (30 minutes) 4. The postal service makes more money selling the souvenir sheets at the lower price, as shown below5 'nit sales................................. #ales........................................ Cost of sales : 80.90 per unit. Contribution margin.................. $7 Price 400,000 8<00,000 90,000 81/0,000 $8 Price 96,000 8190,000 19,000 814/,000
/. The price elasticity of demand, as defined in the te t, is computed as follows5 d > ln(4 ? @ change in &uantity sold) ln(4 ? @ change in price)
96,000 - 400,000 ln(4 ? ) 400,000 > 9 - < ln(4 ? ) < > > > ln(4 - 0.4600) ln(4 ? 0.47/;) ln(0.9600) ln(4.47/;) -0.41/6 0.4331
> -4./413
Problem A-4 (continued) 3. The profit-ma imi!ing price can be estimated using the following formula from the te t5 Ad 2rofit-ma imi!ing price > 4?A Bariable cost per unit d
-4./413 80.90 > 4? (-4./413) > 6.1/3/ C 80.90 > 87.60 This price is much lower than the price the postal service has been charging in the past. Dather than immediately dropping the price to 87.60, it would be prudent for the postal service to drop the price a bit and observe what happens to unit sales and to profits. The formula assumes that the price elasticity of demand is constant, which may not be true.
- The ,c)raw-.ill Companies, Inc., /001. $ll rights reserved. #olutions ,anual, 2ricing $ppendi 3<
Problem A-4 (continued) The critical assumption in these calculations is that the percentage increase (decrease) in &uantity sold is always the same for a given percentage decrease (increase) in price. If this is true, we can estimate the demand schedule for souvenir sheets as follows5 Price* 89.00 8<.00 81.43 86.31 87.1; 87.40 83.6; 83.47 8/.<6 8/.74
H
Quantity Sold 96,000 400,000 44<,17< 439,709 41/,933 4;4,61; //6,3<6 /16,47< 344,;3< 311,;96
The price in each cell in the table is computed by taking <I9 of the price Just above it in the table. "or e ample, 81.43 is <I9 of 8<.00 and 86.31 is <I9 of 81.43. K The &uantity sold in each cell of the table is computed by multiplying the &uantity sold Just above it in the table by 400,000I96,000. "or e ample, 44<,17< is computed by multiplying 400,000 by the fraction 400,000I96,000.
Problem A-4 (continued) The profit at each price in the above demand schedule can be computed as follows5 Price (a) 89.00 8<.00 81.43 86.31 87.1; 87.40 83.6; 83.47 8/.<6 8/.74 Quantity Sold (b) 96,000 400,000 44<,17< 439,709 41/,933 4;4,61; //6,3<6 /16,47< 344,;3< 311,;96 Sales (a) (b) 8190,000 8<00,000 8</4,4<1 8<74,91< 8<13,19< 8<96,733 890;,0;1 893/,61/ 896<,9/< 8997,737 Cost o Sales $!.8! (b) 819,000 890,000 8;7,449 8440,</1 8430,/11 8463,/66 8490,300 8/4/,449 8/7;,660 8/;3,699 Contribution "ar#in 814/,000 81/0,000 81/<,069 8134,474 8133,7/4 813/,4<9 81/9,<;1 81/0,777 8109,/<< 86;0,971
- The ,c)raw-.ill Companies, Inc., /001. $ll rights reserved. #olutions ,anual, 2ricing $ppendi 3;
Problem A-4 (continued) The contribution margin is plotted below as a function of the selling price5
$640,000 $630,000 $620,000 $610,000 $600,000 $590,000 $580,000 $2.00
$3.00
$4.00
$5.00
$6.00
$7.00
$8.00
Selling Price
The plot confirms that the profit-ma imi!ing price is about 87.60.
Problem A-4 (continued) 7. If the postal service wants to ma imi!e the contribution margin and profit from sales of souvenir sheets, the new price should be5 Ad 2rofit-ma imi!ing price > 4?A Bariable cost per unit d
-4./413 84.00 > 4? (-4./413) > 6.1/3/ C 84.00 > 86.1/ =ote that a 80./0 increase in cost has led to a 84.4/ (86.1/ L 87.60) increase in selling price. This is because the profit-ma imi!ing price is computed by multiplying the variable cost by 6.1/3/. #ince the variable cost has increased by 80./0, the profit-ma imi!ing price has increased by 80./0 C 6.1/3/, or 84.4/. #ome people may obJect to such a large increase in price as MunfairN and some may even suggest that only the 80./0 increase in cost should be passed on to the consumer. The enduring popularity of full-cost pricing may be e plained to some degree by the notion that prices should be MfairN rather than calculated to ma imi!e profits.
Problem A-5 (30 minutes) 4. a. #upporting computations5 =umber of pads manufactured each year5 39,700 labor-hours G /.7 labor-hours per pad > 41,000 pads. #elling, general, and administrative e penses5 Bariable (41,000 pads C 8; per pad)....... "i ed....................................................... Total........................................................ ,arkup percentage > on absorption cost > > b. 8477,000 <3/,000 89<1,000
De&uired DEI ? #)*$ e penses (C Investment ) 'nit sales C 'nit product cost
( /7@
C 84,360,000) ? 89<1,000
41,000 pads C 810 per pad 84,/00,000 > 4/6@ 8;10,000 840.90 4;./0 30.00 10.00 <6.00 8436.00
Oirect materials.......................................... Oirect labor................................................ ,anufacturing overhead............................ 'nit product cost........................................ $dd markup5 4/6@ of unit product cost..... #elling price...............................................
Problem A-5 (continued) c. The income statement will be5 #ales (41,000 pads C 8436 per pad)................ 8/,410,000 Fess cost of goods sold (41,000 pads C 810 per pad)......................... ;10,000 )ross margin.................................................... 4,/00,000 Fess selling, general, and admin. e penses5 #ales commissions........................................ 8477,000 #alaries.......................................................... 9/,000 %arehouse rent............................................. 60,000 $dvertising and other..................................... 100,000 Total selling, general, and admin. e pense...... 9<1,000 =et operating income....................................... 8 3/7,000 The companyPs DEI computation for the pads will be5 DEI > > =et Eperating Income #ales C #ales $verage Eperating $ssets 83/7,000 8/,410,000 C 8/,410,000 84,360,000
> 46@ C 4.1 > /7@ /. Bariable cost per unit5 Oirect materials................................................... Oirect labor......................................................... Bariable manufacturing overhead (4I6 C 830)..... #ales commissions............................................. Total....................................................................
840.90 4;./0 1.00 ;.00 876.00
If the company has idle capacity and sales to the retail outlet would not affect regular sales, any price above the variable cost of 876 per pad would add to profits. The company should aggressively bargain for more than this priceQ 876 is simply the rock-bottom floor below which the company should not go in its pricing.
Problem A-6 (76 minutes) 4. 2roJected sales (400 machines C 87,;60 per machine). Fess desired profit (46@ C 8100,000)............................ Target cost for 400 machines......................................... Target cost per machine (8706,000 G 400 machines).... Fess =ational Destaurant #upplyPs variable selling cost per machine................................................................. ,a imum allowable purchase price per machine.......... 87;6,000 ;0,000 8706,000 87,060 160 83,700
/. The relation between the purchase price of the machine and DEI can be developed as follows5 DEI > > Total proJected sales - Total cost I nvestment 87;6,000 - (8160 ? 2urchase price of machines) C 400 8100,000
The above formula can be used to compute the DEI for purchase prices between 83,000 and 87,000 (in increments of 8400) as follows5 Purc$ase %rice 83,000 83,400 83,/00 83,300 83,700 83,600 83,100 83,<00 83,900 83,;00 87,000 &'( /4.<@ /0.0@ 49.3@ 41.<@ 46.0@ 43.3@ 44.<@ 40.0@ 9.3@ 1.<@ 6.0@
Problem A-6 (continued) 'sing the above data, the relation between purchase price and DEI can be plotted as follows5
25.0%
20.0%
15.0%
10.0%
5.0%
0.0% $3,000
$3,200
$3,400
$3,600
$3,800
$4,000
Purchase price
Problem A-6 (continued) 3. $ number of options are available in addition to simply giving up on adding the new sorbet machines to the companyPs product lines. These options include5 R Check the proJected unit sales figures. 2erhaps more units could be sold at the 87,;60 price. .owever, management should be careful not to indulge in wishful thinking Just to make the numbers come out right. R ,odify the selling price. This does not necessarily mean increasing the proJected selling price. Oecreasing the selling price may generate enough additional unit sales to make carrying the sorbet machines more profitable. R Improve the selling process to decrease the variable selling costs. R Dethink the investment that would be re&uired to carry this new product. Can the si!e of the inventory be reducedS $re the new warehouse fi tures really necessaryS R Ooes the company really need a 46@ DEIS Ooes it cost the company this much to ac&uire more fundsS
Problem A-7 (10 minutes) 4. The complete, filled-in table appears below5 Sellin# Price 8/6.00 8/3.<6 8//.61 8/4.73 8/0.31 84;.37 849.3< 84<.76 841.69 846.<6 )sti*ated +nit Sales 60,000 67,000 69,3/0 1/,;91 19,0/6 <3,71< <;,377 96,1;/ ;/,67< ;;,;64 Sales 84,/60,000 84,/9/,600 84,346,1;; 84,37;,<;0 84,397,;9; 84,7/0,96/ 84,76<,67; 84,7;6,3/6 84,637,7/; 84,6<7,//9 ,ariable Cost 8300,000 83/7,000 837;,;/0 83<<,;41 8709,460 8770,90/ 87<1,017 8647,46/ 8666,/9/ 86;;,<01 -i.ed ).%enses 8;10,000 8;10,000 8;10,000 8;10,000 8;10,000 8;10,000 8;10,000 8;10,000 8;10,000 8;10,000 /et '%eratin# (nco*e -840,000 -84,600 86,<<; 844,9<7 841,93; 8/0,060 8/4,796 8/4,4<3 84;,47< 847,6//
- The ,c)raw-.ill Companies, Inc., /001. $ll rights reserved. #olutions ,anual, 2ricing $ppendi 7<
Problem A-7 (continued) /. $ chart based on the above table would look like the following5
$25,000 $20,000 $15,000 $10,000 $5,000 $0 $15.00 -$5,000 -$10,000 -$15,000 Selling price
$17.00
$19.00
$21.00
$23.00
$25.00
Tased on this chart, a selling price of about 849 would ma imi!e net operating income.
Problem A-7 (continued) 3. The price elasticity of demand, as defined in the te t, is computed as follows5 d > > > > ln(4 ? @ change in &uantity sold) ln(4 ? @ change in price) ln(4? 0.09) ln(4-0.06) ln(4.09) ln(0.;6) 0.0<1;1 -0.064/;
> -4.600 The profit-ma imi!ing price can be estimated using the following formula from the te t5 Ad Bariable cost per unit 2rofit-ma imi!ing price > 4?A d -4.6 81.00 > 4? (-4.6) > 3.00 C 81.00 > 849.00 =ote that this answer is consistent with the plot of the data in part (/) above. The formula for the profit-ma imi!ing price works in this case because the demand is characteri!ed by constant price elasticity. +very 6@ decrease in price results in an 9@ increase in unit sales.
- The ,c)raw-.ill Companies, Inc., /001. $ll rights reserved. #olutions ,anual, 2ricing $ppendi 7;
Problem A-7 (continued) 7. %e must first compute the markup percentage, which is a function of the re&uired DEI of /@, the investment of 8/,000,000, the unit product cost of 81, and the #)*$ e penses of 8;10,000. De&uired DEI ? #)*$ e penses ,arkup percentage > C I nvestment on absorption cost 'nit sales C 'nit product cost
>
(/@ C 8/,000,000) ? 8;10,000 60,000 units C 81 per unit
> 3.33 (rounded) or 333@ 'nit product cost.............. ,arkup (81.00 C 3.33)...... #elling price...................... 8 1.00 4;.;9 8/6.;9
Charging 8/6.;9 (or 8/1 without rounding) for the software would be a big mistake if the marketing manager is correct about the effect of price changes on unit sales. The chart prepared in part (/) above strongly suggests that the company would lose lots of money selling the software at this price. =ote5 It can be shown that the unit sales at the 8/6.;9 price would be about 7<,4;9 units if the marketing manager is correct about demand. If so, the company would lose about 841,;97 per month5 #ales (7<,4;9 units C 8/6.;9 per unit)......... Bariable cost (7<,4;9 units C 81 per unit).... Contribution margin...................................... "i ed e penses............................................ ;10,000 =et operating income (loss)......................... 8 (41,;97) 6. If the marketing manager is correct about demand, increasing the price above 849 per unit will result in a decrease in net operating income and hence in the return on investment. To increase the net operating income, the owners should look elsewhere. They should attempt to
84,//1,/07 /93,499 ;73,041
decrease costs or increase the perceived value of the product to more customers so that more units can be sold at any given price or the price can be increased without sacrificing unit sales.
Problem A-8 (10 minutes) 4. #upporting computations5 =umber of hours worked per year5 /0 workers C 70 hours per week C 60 weeks > 70,000 hours =umber of surfboards produced per year5 70,000 hours G / hours per surfboard > /0,000 surfboards. #tandard cost per surfboard5 84,100,000 G /0,000 surfboards > 890 per surfboard. "i ed manufacturing overhead cost per surfboard5 8100,000 G /0,000 surfboards > 830 per surfboard. ,anufacturing overhead per surfboard5 86 variable ? 830 fi ed > 836. Oirect labor cost per surfboard5 890 L (8/< ? 836) > 849. )iven the computations above, the completed standard cost card would be as follows5 Standard Quantity Standard Price Standard or 0ours or &ate Cost 1 feet 87.60 per foot 8/< / hours 8;.00 per hourH 49 / hours 84<.60 per hourHH 36 890
Oirect materials................... Oirect labor......................... ,anufacturing overhead..... Total standard cost per surfboard..........................
H 849 G / hours > 8; per hour HH 836 G / hours > 84<.60 per hour
Problem A-8 (continued) /. a. ,arkup percentage > on absorption cost > > b. De&uired DEI ? #)*$ e penses (C Investment ) 'nit sales C 'nit product cost
( 49@
C 84,600,000) ? 84,430,000
/0,000 units C 890 per unit 84,700,000 > 9<.6@ 84,100,000 8 /< 49 36 90 <0 8460 83,000,000 4,100,000 4,700,000 4,430,000 8 /<0,000
Oirect materials..................... Oirect labor............................ ,anufacturing overhead....... Total cost to manufacture...... $dd markup5 9<.6@.............. #elling price..........................
c. #ales (/0,000 boards C 8460 per board).............. Fess cost of goods sold (/0,000 boards C 890 per board)........................ )ross margin......................................................... Fess selling, general, and administrative e pense =et operating income............................................ DEI > >
=et Eperating Income #ales C #ales $verage Eperating $ssets 8/<0,000 83,000,000 C 83,000,000 84,600,000
> ;@ C / > 49@
Problem A-8 (continued) 3. #upporting computations5 Total fi ed costs5 ,anufacturing overhead.......................................... #elling, general, and administrative U84,430,000 L (/0,000 boards C 840 per board)V.. Total fi ed costs....................................................... Bariable costs per board5 Oirect materials..................................... Oirect labor........................................... Bariable manufacturing overhead......... Bariable selling...................................... Bariable cost per board......................... 8/< 49 6 40 810 8 100,000 ;30,000 84,630,000
To achieve the 49@ DEI, the company would have to sell at least the /0,000 units assumed in part (/) above. The break-even volume can be computed as follows5 "i ed e penses Treak-even point > in units sold 'nit contribution margin > 84,630,000 8460 per board - 810 per board
> 4<,000 boards

Appendix A: Pricing Products and Services

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Appendix A: Pricing Products and Services

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Appendix A

Pricing Products and Services

840.90 4;./0 1.00 ;.00 876.00

(/@ C 8/,000,000) ? 8;10,000 60,000 units C 81 per unit

84,//1,/07 /93,499 ;73,041

> ;@ C / > 49@

> 4<,000 boards

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