Pricing and

Profitability
Analysis
Prepared
Preparedby
by

Douglas
DouglasCloud
Cloud

Pepperdine
PepperdineUniversity
University
22-1

Objectives
Objectives
1. Discuss basic
pricing
concepts.
After
studying
this
After
studying
this
chapter,
you
should
2. Calculate a markup
cost
and a target cost.
chapter,on
you
should
be
be able
able
to:
3. Discuss the impact
of
theto:
legal system and
ethics on pricing.
4. Explain why firms measure profit, and
calculate measures of profit using absorption
and variable costing.
5. Determine the profitability of segments.
Continued
Continued

22-2

Objectives
Objectives
6. Compute the sales price, price volume,
contribution margin, contribution margin
volume, sales mix, market share, and market
size variances.
7. Discuss the variations in price, cost, and
profit over the product life cycle.
8. Describe some of the limitations of profit
measurement.
22-3

Economic
Economic Pricing
Pricing Concepts
Concepts
Price

Supply

P*

Demand
Q*

Quantity
22-4

Market
Market Structure
Structure and
and Price
Price
Perfect CompetitionMany buyers and sellers; no one
of which is large enough to influence the market.
Monopolistic CompetitionHas both the characteristics
of both monopoly and perfect competition.
OligopolyFew sellers.
MonopolyBarriers to entry are so high that there is
only one firm in the market.

22-5

Market
Market Structures
Structures and
and
Characteristics
Characteristics
Market
Structure
Type

Number of
Firms in
Industry

Barriers
to Entry

Uniqueness
of Product

Expenses
Related to
Structure Type

Perfect
Competition

Many

Very low

Not unique

No special expenses

Monopolistic

Many

Low

Some unique

Advertising, coupons,

features

costs of differentiation

Competition
Oligopoly

Few

High

Fairly unique Costs of

differentiation,
advertising, rebates,
coupons

Monopoly

One

Very High

Very unique

Legal and lobbying

expenditures
22-6

Two
Two Approaches
Approaches to
to Pricing
Pricing

1. Cost-based prices are established using cost

plus markup.
2. Target prices are influenced by market
conditions.

22-7

Cost-Plus
Cost-Plus Pricing
Pricing
AudioPro Company sells and installs audio
equipment in homes, cars, and trucks. AudioPros
income statement for last year is as follows:
Revenues
Cost of goods sold:
Direct materials
Direct labor
Overhead
Gross profit
Selling and administrative expenses
Operating income

$350,350
$122,500
73,500
49,000

245,000
$105,350
25,000
$ 80,350
22-8

Cost-Plus
Cost-Plus Pricing
Pricing
The firm wants to earn the same amount of profit on
each job as was earned last year:
Markup on COGS = (Selling and administrative expenses +
Operating income)/COGS
Markup on COGS = ($25,000 + $80,350)/$245,000
Markup on COGS = 0.43

22-9

Cost-Plus
Cost-Plus Pricing
Pricing
The markup can be calculated using a variety of
bases. The calculation for markup on direct
materials is as follows:
Markup on DM = (Direct labor + Overhead + Selling and
administrative expense + Operating
income)/Direct materials
Markup on DM = ($73,500 + $49,000 + $25,000 + $80,350)/
$122,500
Markup on DM = 1.86
22-10

Cost-Plus
Cost-Plus Pricing
Pricing
AudioPro wants to expand the companys product line
to include automobile alarm systems and electronic car
door openers. The cost for the sale and installation of
one electronic remote car door opener is as follows:
Direct materials (component and two remote controls) $ 40.00
Direct labor (2.5 hours x $12)
30.00
Overhead (65% of direct labor cost)
19.50
Estimated cost of one job
$ 89.50
Plus 43% markup on COGS
38.49
Bid price
$127.99
22-11

Target
Target Costing
Costing and
and Pricing
Pricing
Target
Target costing
costing isis aa method
method
of
the
cost
of
aa
of determining
determining
the
cost
of
Target
costing
involves
Target costing involves much
much
product
service
based
on
product or
or
service
based
on than
more
upfront
work
more
upfront
work
than costcostthe
that
the
customers
the price
pricebased
that
the
customers
pricing.
However,
based pricing.
However,ifif the
the
are
willing
pay.
arecost-plus
willing to
topricing
pay. turns
cost-plus
pricing
turns out
out to
to be
be
higher
higher than
than what
what customers
customers will
will
accept,
accept, additional
additional work
work or
or lost
lost
opportunity
opportunity will
will result.
result.
22-12

Predatory
Predatory Pricing
Pricing
Predatory pricing is the practice of setting prices
below cost for the purpose of injuring competitors
and eliminating competition.

Competition

Predatory
pricing on the
international
market is called
dumping.

22-13

Price
Price Discrimination
Discrimination
Price discrimination refers to the charging of different
prices to different customers for essentially the same
product. Cobalt, Inc. manufactures vitamin
supplements that costs an average of $163 per case.
Cobalt sold 250,000 cases last year as follows:
Customer
Large drug store chain
Small local pharmacies
Individual health clubs

Prices per Case

Cases Sold

$200
232
250

125,000
100,000
25,000

Cobalt is practicing price discrimination!

22-14

Absorption-Costing
Absorption-Costing Income
Income Statement
Statement
Lasersave, Inc., a company that recycles used toner
cartridges for laser printers. During August the firm
manufactured 1,000 cartridges at the following costs:
Direct materials
Direct labor
Variable overhead
Fixed overhead
Total manufacturing cost

$ 5,000
15,000
3,000
20,000
$43,000

During August, these cartridges were sold at $60

each. Variable marketing cost was $1.25 per unit.
Fixed expenses were $12,000.
22-15

Absorption-Costing
Absorption-Costing Income
Income Statement
Statement
Percent
of Sales

Sales
$ 60,000 100.00 %
Less: Cost of goods sold
43,000 71.67
Gross profit
$ 17,000 28.33 %
Less: Variable marketing expenses -1,250
-2.08
Fixed marketing and administrative
expenses
-12,000 -20.00
Operating income
$ 3,750
6.25 %

Lasersave, Inc. for August

22-16

Absorption-Costing
Absorption-Costing Income
Income Statement
Statement
Percent
of Sales

Sales
$ 60,000 100.00 %
Less: Cost of goods sold
39,000 65.00
Gross profit
$ 21,000 35.00 %
Less: Variable marketing expenses -1,250
-2.08
Fixed marketing and administrative
expenses
-12,000 -20.00
Operating income
$ 7,750 12.92 %

Lasersave, Inc. for September

22-17

Variable-Costing
Variable-Costing Income
Income Statement
Statement
For the Month For the Month
of August
of September

Sales
Less: Variable expenses
Contribution margin
Less:
Fixed manufacturing overhead
Fixed marketing and admin. exp.
Operating income

$ 60,000 $ 60,000
24,250
24,250
$ 35,750 $ 35,750
-20,000 -20,000
-12,000 -12,000
$ 3,750 $ 3,750

Lasersave, Inc.
22-18

Comparative
Comparative Statements
Statements for
for October
October
Absorption Costing
Sales
Less: Cost of goods sold
Gross profit
Less:
Variable marketing expenses
Fixed marketing and administrative exp.
Operating income

Lasersave, Inc.

$ 78,000
50,700
$ 27,300
-1,625
-12,000
$ 13,675
Continued
Continued

22-19

Comparative
Comparative Statements
Statements for
for October
October
Variable Costing
Sales
Less: Variable expenses
Contribution margin
Less:
Fixed manufacturing overhead
Fixed marketing and administrative exp.
Operating income

$ 78,000
31,525
$ 46,475
-20,000
-12,000
$ 14,475

Lasersave, Inc.
22-20

Changes
Changes in
in Inventory
Inventory under
under
Absorption
Absorption and
and Variable
Variable Costing
Costing
If
Production > Sales
Production < Sales
Production = Sales

Then
Absorption NI > Variable NI
Absorption NI < Variable NI
Absorption NI = Variable NI

22-21

Segment
Segment Reporting
Reporting
Alden Company manufactures two products: basic
fax machines and multi-function fax machines. The
multi-function fax uses more advanced technology;
therefore, it is more expensive to manufacture.
Number of units
Direct labor hours
Price
Prime cost per unit
Overhead per unit

Basic
Multi-Function
20,000
10,000
40,000
15,000
$200
$350
$55
$95
$30
$22.50

22-22

Segment
Segment Reporting
Reporting
Alden Company
Absorption-Costing Income Statement, 2004
(In thousands of dollars)
Basic
Multi-Function
Total
Sales
$ 4,000
Less: Cost of good sold
1,700
Gross profit
$ 2,300
Less:
Marketing expense
-400
Administrative exp.
-1,067
Operating income
$ 833

$ 3,500
1,175
$ 2,325

$ 7,500
2,875
$ 4,625

-350
-933
$ 1,042

-750
-2,000
$ 1,875

22-23

Segment
Segment Reporting
Reporting
Alden Company
Variable-Costing Income Statement, 2004
(In thousands of dollars)
Basic
Multi-Function
Total
Sales
$ 4,000
Less:
Variable COGS
-1,362
Sales commissions
-400
Contribution margin
$ 2,238
Less:
Fixed overhead
Administrative expenses
Operating income

$ 3,500

$ 7,500

-1,048
-350
$ 2,102

-2,410
-750
$ 4,340
-465
-2,000
$ 1,875
22-24

Overhead Activities and Drivers

Overhead
Cost Category

Setups
Maintenance
Supplies
Power
Machine depreciation
Other factory costs

Cost
Driver

Number of setups
Maintenance hours
Direct labor hours
Machine hours
Machine hours
(None)

Total
Cost

$ 40,000
120,000
80,000
280,000
250,000
55,000
$825,000

Continued
Continued
22-25

Overhead Activities and Drivers

Usage of Cost Drivers by Product
Basic
Multi-Function

Number of setups
Maintenance hours
Direct labor hours
Machine hours

10
2,000
40,000
10,000

30
8,000
15,000
90,000

22-26

Alden Company
Activity-Based Costing Income
Statement
(In thousands
Basicof dollars)
Multi-Function Total
$4,000
$3,500
$ 7,500

Sales
Less:
Prime costs
-1,100
Setups
-10
Maintenance
-24
Supplies
-58
Power
-28
Machine depreciation
-25
Sales commissions
-400
Contribution margin
$2,355
Less: Other fixed overhead
Administrative expenses
Operating income

-950
-30
-96
-22
-252
-225
-350
$1,575

-2,050
-40
-120
-80
-280
-250
-750
$ 3,930
-55
-2,000
$ 1,875
22-27

Divisional
Divisional Profit
Profit
Alpha
Sales
$ 90
Cost of goods sold
35
Gross profit
$ 55
Division expenses
-20
Corporate expenses
-3
Operating income
(loss)
$ 32

Beta
$ 60
20
$ 40
-10
-2

Gamma
$ 30
11
$ 19
-15
-1

Delta
$120
98
$ 22
-20
-4

Total
$300
164
$136
-65
-10

$ 28

$ 3

$ -2

$ 61

22-28

Sales
Sales Price
Price and
and Price
Price
Volume
Volume Variables
Variables
Sales price
variance =

Actual Expected
price
price

Quantity
x
sold

Price volume
variance =

Actual Expected
volume
volume

Expected
x
price

22-29

Contribution
Contribution Margin
Margin Variance
Variance
Contribution
margin =
variance

Annual
Budgeted
contribution contribution
margin
margin

Contribution
Contribution Margin
Margin Volume
Volume Variance
Variance
Budgeted
Contribution
Annual
margin volume = quantity quantity
sold
variance
sold

Budgeted
average unit
x
contribution
margin
22-30

Sales
Sales Mix
Mix Variance
Variance
Sales mix variance = [(Product 1 actual units
Product 1 budgeted units) x (Product 1 budgeted unit
contribution margin Budgeted average unit
contribution margin)] + [(Product 2 actual units
Product 2 budgeted units) x (Product 2 budgeted unit
contribution margin Budgeted average unit
contribution margin)]
Birdwell sales mix variance = [($1,250 1,500) x
($4.00 $6.75)] + [(625 500) x ($15.00 $6.75)] =
$1,718.75 Favorable
22-31

Market
Market Share
Share Variance
Variance
Market share variance = [(Actual market share
percentage Budgeted market share percentage) x
(Actual industry sales in units)] x (Budgeted average
unit contribution margin)

Market
Market Size
Size Variance
Variance
Market size variance = [(Actual industry sales in
units Budgeted industry sales in units) x (Budgeted
market share percentage)] x (Budgeted average unit
contribution margin)
22-32

The
The Product
Product Life
Life Cycle
Cycle
Introduction

Growth

Maturity

Decline

Positive
Profit
0
Negative
Profit

22-33

The
The Product
Product Life
Life Cycle
Cycle
Product Life-Cycle Phase
ABC Category Introduction
Unit-level costs
High

Growth Maturity Decline

Lower Low to stable Low

Batch-level costs

High

Lower Higher

Product-level costs

High

Lower Low to stable Low

Facility-level costs

High

Low

Low

Low

Low

22-34

End of

Chapter
22-35

22-36