Appendix A

Pricing Products and Services

Solutions to Questions
A-1 In cost-plus pricing, prices are set by applying a markup percentage to a products cost. A-2 The price elasticity of demand measures the degree to which a change in price affects unit sales. 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-maximizing price should depend only on the variable marginal! cost per unit and on the price elasticity of demand. "ixed costs do not enter into the pricing decision at all. "ixed costs are relevant in a decision of whether to offer a product or service at all, but are not relevant in deciding what to charge for the product or service once the decision to offer it has been made. #ecause price affects unit sales, total variable costs 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 The markup in the absorption costing approach to pricing is supposed to cover selling and administrative expenses as well as providing for 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 selling and administrative expenses '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 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. This is clearly an unrealistic assumption except under very special circumstances. A-7 The protection offered by full cost pricing is an illusion. $ll costs will be covered only if actual sales e%ual or exceed 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 to price new products. The target cost is the expected 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 exceed this target cost. This is the reverse of the way most companies have traditionally approached the pricing decision. (ost companies start with their full cost and then add their markup to arrive at the selling price. In contrast to target costing, this traditional approach ignores how much customers are willing to pay for the product.

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Exercise A-1 4. minutes! /. (aria makes more money selling the ice cream cones at the lower price, as shown below5 &nit sales....................... 0ales.............................. ,ost of sales : 8..74. . . ,ontribution margin........ "ixed expenses.............. <et operating income..... $1.89 Price $1.49 Price /,6.. -,47. 8-,246... 84,729.9. 976... /,..9.-. -,/3.... -,72..7. 9;6... 9;6... 8/,6/6... 8/,2.6.7.

-. The price elasticity of demand, as defined in the text, is computed as follows5 d = ln /> ? change in %uantity sold! ln /> ? change in price!

-,47.-/,6.. ln /> ! /,6.. = /.73-/.23 ln /> ! /.23 = = = ln /> ..69...! ln /-..-//97! ln /.69...! ln ..;2249! ..77793 = -/.2; -..-4;2.

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Exercise A-1 continued! 4. The profit-maximizing price can be estimated using the following formula from the text5 Ad 1rofit-maximizing price = Bariable cost per unit />A d -/.2; = 8..74 /> -/.2;! = -./737 C 8..74 = 8..3This price is much lower than the prices (aria has been charging in the past. Dather than immediately dropping the price to 8..3-, 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.

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Exercise A-2 /6 minutes! /. (arkup percentage = on absorption cost = = De%uired DEI > 0elling and administraive (C Investment ) expenses &nit sales C &nit product cost

( /-?

C 8;6.,...) > 86.,...

/7,... units C 8-6 per unit 8/7.,... = 7.? 846.,... 8-6 /. 846

-. &nit product cost................ (arkup 7.? C 8-6!.......... 0elling price per unit...........

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Exercise A-3 /. minutes! 0ales 4..,... units C 8/6 per unit!......... Fess desired profit /-? C 86,...,...!.... Target cost for 4..,... units..................... 87,6..,... 9..,... 84,3..,...

Target cost per unit = 84,3..,... G 4..,... units = 8/4 per unit

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Problem A-4 76 minutes! /. a. 0upporting computations5 <umber of pads manufactured each year5 42,7.. labor-hours G -.7 labor-hours per pad = /9,... pads. 0elling and administrative expenses5 Bariable /9,... pads C 83 per pad!...... "ixed....................................................... Total........................................................ (arkup percentage = on absorption cost = = b. 8/77,... ;4-,... 82;9,...

De%uired DEI > 0elling and administrative (C Investment ) expenses &nit sales C &nit product cost

( -7?

C 8/,46.,...) > 82;9,...

/9,... pads C 89. per pad 8/,-..,... = /-6? 839.,... 8/..2. /3.-. 4.... 9.... ;6... 8/46...

Hirect materials.......................................... Hirect labor................................................ (anufacturing overhead............................ &nit product cost........................................ $dd markup5 /-6? of unit product cost..... 0elling price...............................................

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Problem A-4 continued! c. The income statement will be5 0ales /9,... pads C 8/46 per pad!................ ,ost of goods sold /9,... pads C 89. per pad!......................... *ross margin.................................................... 0elling and administrative expenses5 0ales commissions........................................ 0alaries......................................................... Iarehouse rent............................................. $dvertising and other.................................... Total selling and administrative expense.......... <et operating income....................................... 8-,/9.,... 39.,... /,-..,... 8/77,... 2-,... 6.,... 9..,... 2;9,... 8 4-7,...

The companys DEI computation for the pads will be5 DEI = = <et Eperating Income 0ales C 0ales $verage Eperating $ssets 84-7,... 8-,/9.,... C 8-,/9.,... 8/,46.,...

= /6? C /.9 = -7? -. Bariable cost per unit5 Hirect materials.................................................. Hirect labor......................................................... Bariable manufacturing overhead /J6 C 84.!.... 0ales commissions............................................ Total....................................................................

8/..2. /3.-. 9... 3... 876...

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 priceK 876 is simply the rock-bottom floor below which the company should not go in its pricing.

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Problem A-5 76 minutes! /. The postal service makes more money selling the souvenir sheets at the lower price, as shown below5 &nit sales................................. 0ales........................................ ,ost of sales : 8..2. per unit. ,ontribution margin.................. $7 Price /..,... 8;..,... 2.,... 89-.,... $8 Price 26,... 892.,... 92,... 89/-,...

-. The price elasticity of demand, as defined in the text, is computed as follows5 d = ln / > ? change in %uantity sold! ln / > ? change in price!

26,... - /..,... ln / > ! /..,... = 2 - ; ln / > ! ; = = = ln / - ../6..! ln / > ../7-3! ln ..26..! ln /./7-3! -../9-6 ../449

= -/.-/94

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Problem A-5 continued! 4. The profit-maximizing price can be estimated using the following formula from the text5 Ad 1rofit-maximizing price = />A Bariable cost per unit d

-/.-/94 8..2. = /> -/.-/94! = 6.9-4- C 8..2. = 87.6. This price is much lower than the price the postal service has been charging in the past. Dather than immediately dropping the price to 87.6., 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.

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Problem A-5 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* 82... 8;... 89./4 86.49 87.93 87./. 84.63 84./7 8-.;6 8-.7/
L

Quantity Sold 26,... /..,... //;,97; /42,7.2 /9-,244 /3/,693 --6,4;6 -96,/7; 4//,34; 499,326

The price in each cell in the table is computed by taking ;J2 of the price Must above it in the table. "or example, 89./4 is ;J2 of 8;... and 86.49 is ;J2 of 89./4. N The %uantity sold in each cell of the table is computed by multiplying the %uantity sold Must above it in the table by /..,...J26,.... "or example, //;,97; is computed by multiplying /..,... by the fraction /..,...J26,....

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Problem A-5 continued! The profit at each price in the above demand schedule can be computed as follows5 Price (a) 82... 8;... 89./4 86.49 87.93 87./. 84.63 84./7 8-.;6 8-.7/ Quantity Sold (b) 26,... /..,... //;,97; /42,7.2 /9-,244 /3/,693 --6,4;6 -96,/7; 4//,34; 499,326 Sales (a) (b) 892.,... 8;..,... 8;-/,/;9 8;7/,29; 8;94,92; 8;26,744 82.3,.39 824-,69826;,2-; 8227,747 Cost o Sales $!.8! (b) 892,... 82.,... 837,//2 8//.,;-9 8/4.,-99 8/64,-66 8/2.,4.. 8-/-,//2 8-73,66. 8-34,622 Contribution "ar#in 89/-,... 89-.,... 89-;,.62 894/,/7/ 8944,7-/ 894-,/;2 89-2,;39 89-.,777 89.2,-;; 863.,279

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Problem A-5 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-maximizing price is about 87.6..

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Problem A-5 continued! 7. If the postal service wants to maximize the contribution margin and profit from sales of souvenir sheets, the new price should be5 Ad 1rofit-maximizing price = />A Bariable cost per unit d

-/.-/94 8/... = /> -/.-/94! = 6.9-4- C 8/... = 86.9<ote that a 8..-. increase in cost has led to a 8/./- 86.9- O 87.6.! increase in selling price. This is because the profit-maximizing price is computed by multiplying the variable cost by 6.9-4-. #ecause the variable cost has increased by 8..-., the profit-maximizing price has increased by 8..-. C 6.9-4-, or 8/./-. 0ome people may obMect to such a large increase in price as PunfairQ and some may even suggest that only the 8..-. increase in cost should be passed on to the consumer. The enduring popularity of full-cost pricing may be explained to some degree by the notion that prices should be PfairQ rather than calculated to maximize profits.

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Problem A-6 9. minutes! /. The complete, filled-in table appears below5 Sellin# Price 8-6... 8-4.;6 8--.69 8-/.74 8-..49 8/3.47 8/2.4; 8/;.76 8/9.62 8/6.;6 $sti%ated &nit Sales 6.,... 67,... 62,4-. 9-,329 92,.-6 ;4,79; ;3,477 26,933-,67; 33,36/ Sales 8/,-6.,... 8/,-2-,6.. 8/,4/6,933 8/,473,;3. 8/,427,323 8/,7-.,268/,76;,673 8/,736,4-6 8/,647,7-3 8/,6;7,--2 'ariable Cost 84..,... 84-7,... 8473,3-. 84;;,3/9 87.2,/6. 877.,2.87;9,.97 86/7,/68666,-28633,;.9 (i)ed $)*enses 839.,... 839.,... 839.,... 839.,... 839.,... 839.,... 839.,... 839.,... 839.,... 839.,... +et ,*eratin# -nco%e -8/.,... -8/,6.. 86,;;3 8//,2;7 8/9,243 8-.,.6. 8-/,726 8-/,/;4 8/3,/7; 8/7,6--

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Problem A-6 continued! -. $ chart based on the above table would look like the following5
8-6,... 8-.,... 8/6,... 8/.,... 86,... 8. 8/6 -86,... -8/.,... -8/6,... Sellin price

m c n i a r p o t e N

8/;

8/3

8-/

8-4

8-6

#ased on this chart, a selling price of about 8/2 would maximize net operating income.

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Problem A-6 continued! 4. The price elasticity of demand, as defined in the text, is computed as follows5 d = = = = ln / > ? change in %uantity sold! ln / > ? change in price! ln /> ...2! ln /-...6! ln /..2! ln ..36! ...;939 -...6/-3

= -/.6.. The profit-maximizing price can be estimated using the following formula from the text5 Ad Bariable cost per unit 1rofit-maximizing price = />A d -/.6 89... = /> -/.6! = 4... C 89... = 8/2... <ote that this answer is consistent with the plot of the data in part -! above. The formula for the profit-maximizing price works in this case because the demand is characterized by constant price elasticity. @very 6? decrease in price results in an 2? increase in unit sales.

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Problem A-6 continued! 7. Ie must first compute the markup percentage, which is a function of the re%uired DEI of -?, the investment of 8-,...,..., the unit product cost of 89, and the 0*R$ expenses of 839.,.... De%uired DEI > 0elling and administrative expenses (arkup percentage = C I nvestment on absorption cost &nit sales C &nit product cost

-? C 8-,...,...! > 839.,... 6.,... units C 89 per unit

= 4.44 rounded! or 444? &nit product cost.............. (arkup 89... C 4.44!...... 0elling price...................... 8 9... /3.32 8-6.32

,harging 8-6.32 or 8-9 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 8-6.32 price would be about 7;,/32 units if the marketing manager is correct about demand. If so, the company would lose about 8/9,327 per month5 0ales 7;,/32 units C 8-6.32 per unit!......... Bariable cost 7;,/32 units C 89 per unit!.... ,ontribution margin...................................... "ixed expenses............................................ <et operating income loss!......................... 8/,--9,-.7 -24,/22 374,./9 39.,... 8 /9,327!

6. If the marketing manager is correct about demand, increasing the price above 8/2 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 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.
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Problem A-7 9. minutes! /. 0upporting computations5 <umber of hours worked per year5 -. workers C 7. hours per week C 6. weeks = 7.,... hours <umber of surfboards produced per year5 7.,... hours G - hours per surfboard = -.,... surfboards. 0tandard cost per surfboard5 8/,9..,... G -.,... surfboards = 82. per surfboard. "ixed manufacturing overhead cost per surfboard5 89..,... G -.,... surfboards = 84. per surfboard. (anufacturing overhead per surfboard5 86 variable > 84. fixed = 846. Hirect labor cost per surfboard5 82. O 8-; > 846! = 8/2. *iven the computations above, the completed standard cost card would be as follows5 Standard Quantity Standard Price Standard or .ours or /ate Cost 9 feet 87.6. per foot 8-; - hours 83... per hourL /2 - hours 8/;.6. per hourLL 46 82.

Hirect materials.................. Hirect labor......................... (anufacturing overhead..... Total standard cost per surfboard.........................

L 8/2 G - hours = 83 per hour LL 846 G - hours = 8/;.6. per hour

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Problem A-7 continued! -. a. (arkup percentage = on absorption cost = = b. De%uired DEI > 0elling and administrative (C Investment ) expenses &nit sales C &nit product cost

( /2?

C 8/,6..,...) > 8/,/4.,...

-.,... units C 82. per unit 8/,7..,... = 2;.6? 8/,9..,... 8 -; /2 46 2. ;. 8/6. 84,...,... /,9..,... /,7..,... /,/4.,... 8 -;.,...

Hirect materials..................... Hirect labor........................... (anufacturing overhead....... Total cost to manufacture...... $dd markup5 2;.6?.............. 0elling price..........................

c. 0ales -.,... boards C 8/6. per board!.............. ,ost of goods sold -.,... boards C 82. per board!....................... *ross margin........................................................ 0elling and administrative expenses.................... <et operating income............................................ DEI = =

<et Eperating Income 0ales C 0ales $verage Eperating $ssets 8-;.,... 84,...,... C 84,...,... 8/,6..,...

= 3? C - = /2?

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Problem A-7 continued! 4. 0upporting computations5 Total fixed costs5 (anufacturing overhead.......................................... 0elling and administrative S8/,/4.,... O -.,... boards C 8/. per board!T.. Total fixed costs....................................................... Bariable costs per board5 Hirect materials..................................... Hirect labor........................................... Bariable manufacturing overhead......... Bariable selling..................................... Bariable cost per board......................... 8-; /2 6 /. 89. 8 9..,... 34.,... 8/,64.,...

To achieve the /2? DEI, the company would have to sell at least the -.,... units assumed in part -! above. The break-even volume can be computed as follows5 "ixed expenses #reak-even point = in units sold &nit contribution margin = 8/,64.,... 8/6. per board - 89. per board

= /;,... boards

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Problem A-8 76 minutes! /. 1roMected sales /.. machines C 87,36. per machine!. Fess desired profit /6? C 89..,...!............................ Target cost for /.. machines......................................... Target cost per machine 87.6,... G /.. machines!.... Fess <ational Destaurant 0upplys variable selling cost per machine................................................................. (aximum allowable purchase price per machine.......... 8736,... 3.,... 87.6,... 87,.6. 96. 84,7..

-. The relation between the purchase price of the machine and DEI can be developed as follows5 DEI = = Total proMected sales - Total cost I nvestment 8736,... - 896. > 1urchase price of machines! C /.. 89..,...

The above formula can be used to compute the DEI for purchase prices between 84,... and 87,... in increments of 8/..! as follows5 Purc0ase *rice 84,... 84,/.. 84,-.. 84,4.. 84,7.. 84,6.. 84,9.. 84,;.. 84,2.. 84,3.. 87,... /,-/.;? -...? /2.4? /9.;? /6..? /4.4? //.;? /...? 2.4? 9.;? 6..?

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Problem A-8 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

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Problem A-8 continued! 4. $ number of options are available in addition to simply giving up on adding the new sorbet machines to the companys product lines. These options include5 U ,heck the proMected unit sales figures. 1erhaps more units could be sold at the 87,36. price. +owever, management should be careful not to indulge in wishful thinking Must to make the numbers come out right. U (odify the selling price. This does not necessarily mean increasing the proMected selling price. Hecreasing the selling price may generate enough additional unit sales to make carrying the sorbet machines more profitable. U Improve the selling process to decrease the variable selling costs. U Dethink the investment that would be re%uired to carry this new product. ,an the size of the inventory be reducedV $re the new warehouse fixtures really necessaryV U Hoes the company really need a /6? DEIV Hoes it cost the company this much to ac%uire more fundsV

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