ABDT5104 PRICING STRATEGY

TUTORIAL 2 ANSWER

May 26, 2011

Question 2
Not all cost ate relevant for every pricing decision. Only costs that rise or fall when prices change affects the relative profitability of different pricing strategies which is incremental cost. For example, variable costs are the cost of raw materials in a manufacturing process. Because pricing decisions affect the amount of business that a company does, variable costs are always incremental for pricing. However, most fixed costs are not incremental and not relevant in the pricing decision such as those for product design, advertising, and overhead are cost of being in business. For example, a leading manufacturer of industrial cranes also does milling work for other companies wh enever the firm s vertical turret lathes would not otherwise be used. The price for such work does not cover a proportionate share of the equipment cost. However, profitable work since the equipment must be available to produce the firm s primary product. The equipment cost is therefore not incremental to the additional milling work.

Question 3
Four common errors that managers frequently make when attempting to develop useful estimate of true costs are: I. II. III. IV. Beware of averaging total variable costs to estimate the cost of a single unit. The average is correct only when unit variable costs are constant. Beware of accounting depreciation formulas. The relevant expenses are the true decline in an asset s resale value. Beware of treating a single cost as either all r elevant or all irrelevant for pricing. The same cost may have both a fixed and a variable component, or may be only partially sunk. Beware of overlooking opportunity costs. An opportunity cost is the profit that must be forgone when an asset is used to pro duce the product being priced rather than some other product.

Question 4
Per unit price Incremental variable cost = Contribution margin (($, %) Accurate costs are especially relevant to the calculation of the contribution margin (CM). If variable cost (VC) is inflated, then CM will be smaller, leading managers to believe that they have fewer margins available to compete with to retaliate against price cutting competitors, or to reach price sensitive segments. This happens frequently with overhead burd en fixed overhead allocation per unit produced. Per unit price Incremental variable cost = Contribution margin

ABDT5104 PRICING STRATEGY

TUTORIAL 2 ANSWER

May 26, 2011

Question 5
Product B has higher contribution margins (CM) than Product A, the best way to leverage greater profits is by increase sales volume. Product A has lower contribution margin (CM), the best way to leverage greater profits is by raising price or bundling other products to overcome low margins with higher margins add -ons.

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