Unit 2

The Pricing Decision

Target pricing Cost-plus pricing
Revenue at market price Full product cost
Less: Desired profit Plus: Desired profit
= Target full product cost = Cost-plus price

Question 1:

The total hourly rate for the company is $80, which is $50 per hour for direct labour plus $30
per hour for indirect costs. The firm can use cost-plus pricing to set the rate charged to
clients. If the firm desires a profit equal to 75% of the firm’s cost, then how much should the
company charge the clients?

Desired profit = Total cost × Markup percentage

= $80 per hour × 75% = $60 per hour

Price= Total cost + Desired profit

= $80 per hour + $60 per hour = $140 per hour

Question 2:

MC Alexander Industries makes tennis balls. Its only plant can produce as many as 2,500,000
cans of tennis balls per year. Current production is 2,000,000 cans. Annual manufacturing,
selling, and administrative fixed costs total $700,000. The variable cost of making and selling
each can of tennis balls is $1.00. Stockholders expect a 12% annual return on the company’s
$3,000,000 of assets.

Requirements:

1. What is MC Alexander’s current full product cost of making and selling 2,000,000
cans of tennis balls? What is the current full unit product cost of each can of tennis
balls?

The full product cost per unit is as follows:

$
Fixed costs 700,000
Plus Total variable costs (2,000,000 cans × 1.00 per can) 2,000,000
Total full product cost 2,700,000
Divided by the number of cans 2,000,000
Full product cost per can 1.35
 2. Assume MC Alexander is a price-taker, and the current market price is $1.45 per can
of tennis balls (the price at which manufacturers sell to retailers). What the target full
product cost of producing and selling 2,000,000 cans of tennis balls? Given MC
Alexander’s current costs, will the company reach the stockholders’ profit goals?

The target full product cost is as follows:

$
Revenue at market price (2,000,000 × $1.45 per can) 2,900,000
Less: Desired profit (12% × 3,000,000) 360,000
Target full product cost 2,540,000
MC Alexander’s current total full product costs ($2,700,000 from requirement 1) are
$160,000 higher than the target full product cost ($2,450,000). If MC Alexander cannot
reduce product costs, it will not be able to meet stockholders’ profit expectations.

3. If MC Alexander cannot change its fixed costs, what is the target variable cost per can
of tennis balls?

The target variable cost per can is as follows:

$
Target full product cost (from Requirement 2) 2,540,000
Less: Fixed costs 700,000
Target total variable costs 1,840,000
Divided by the number of cans 2,000,000
Target variable cost 0.92
Because MC Alexander cannot reduce its fixed costs, it needs to reduce variable costs by
$0.08 per can ($1.00 − $0.92) to meet its profit goals. This would require an 8% cost
reduction, which may not be possible.

4. Suppose MC Alexander could spend an extra $100,000 on advertising to differentiate

its product so that it could be a price-setter. Assuming the original volume and costs,
plus the $100,000 of new advertising costs, what cost-plus price will MC Alexander
want to charge for a can of tennis balls?

The company’s new cost-plus would be as follows:

$
Current total costs (from requirement 1) 2,700,000
Plus: Additional cost of advertising 100,000
Plus: Desired profit (from requirement 2) 360,000
Target revenue 3,160,000
Divided by the number of cans 2,000,000
Cost-plus price per can 1.58
Question 3:

A manufacturer of electrical appliances is continually reviewing its product range and

enhancing its existing products by developing new models to satisfy the demands of its
customers. The company intends to always have products at each stage of the product life
cycle to ensure the company’s continued presence in the market.
Currently the company is reviewing three products:
1. Product K was introduced to the market some time ago and is now about to enter the
maturity stage of its life cycle. The maturity stage is expected to last for ten weeks.
Each unit has a variable cost of $38 and takes 1 standard hour to produce. The
Managing Director is unsure which of four possible prices the company should charge
during the next ten weeks. The following table shows the results of some market
research into the level of weekly demand at alternative prices:
Selling price per unit $100 $85 $80 $75
Weekly demand (units) 600 800 1,200 1,400
2. Product L was introduced to the market two months ago using a penetration pricing
policy and is now about to enter its growth stage. This stage is expected to last for 20
weeks. Each unit has a variable cost of $45 and takes 1.25 standard hours to produce.
Market research has indicated that there is a linear relationship between its selling
price and the number of units demanded, of the form P = a -bx. At a selling price of
$100 per unit demand is expected to be 1,000 units per week. For every $10 increase
in selling price the weekly demand will reduce by 200 units and for every $10
decrease in selling price the weekly demand will increase by 200 units.
 Required:
1. Undertake the following calculations:
a. Calculate which of the four selling prices should be charged for product K, in
order to maximize its contribution during its maturity stage.
b. In order to utilize all of the spare capacity, from your answer to (a) calculate the
selling price of product L during its growth stage.
 Answer:

a. In order to maximize the contribution during its maturity stage, product K should
be sold for $75 per unit.
b. As a result product L should be sold for $126 per unit during its growth stage.
480 = 1,000 – 20 (P-100)
480 = 1,000 – 20P + 2,000
20P = 2,520
P = 126