Pricing Products and Services: Appendix A

Pricing Products
and Services
Appendix A
McGrawHill/Irwin
Copyright2008,TheMcGrawHillCompanies,Inc.
A-2
Learning Objective 1
Compute the profitmaximizing price of a

product or service using
the price elasticity of
demands and variable
cost.
McGrawHill/Irwin
A-3
The Economists Approach to Pricing

Elasticity of Demand
The price elasticity of demand measures the degree
to which the unit sales of a product or service is
affected by a change in price.
Change
Change
in
versus in Unit
Price
Sales
McGrawHill/Irwin
A-4
Price Elasticity of Demand

Demand for a product is inelastic if a change
in price has little effect on the number of
units sold.
Example
The demand for designer
perfumes sold at cosmetic
counters in department
stores is relatively inelastic.
McGrawHill/Irwin
A-5

Demand for a product is elastic if a change
in price has a substantial effect on the
number of units sold.
Example
The demand for gasoline is
relatively elastic because if a
gas station raises its price,
unit sales will drop as
customers seek lower prices
elsewhere.
McGrawHill/Irwin
A-6

As a manager, you should set higher
(lower)
lower markups over cost when
demand is inelastic (elastic)
elastic
McGrawHill/Irwin
A-7
d =
ln(1 + % change in quantity sold)

ln(1 + % change in price)
Price elasticity of demand
McGrawHill/Irwin
Natural log function
A-8
Suppose the managers of Natures Garden believe that

every 10 percent increase in the selling price of its applealmond shampoo will result in a 15 percent decrease in
the number of bottles of shampoo sold. Lets calculate the
price elasticity of demand.
For its strawberry glycerin soap, managers of Natures
Garden believe that the company will experience a 20
percent decrease in unit sales if its price is increased by
10 percent.
percent
McGrawHill/Irwin
A-9

For Natures Garden apple-almond shampoo.
McGrawHill/Irwin
d =

d =
ln(1 + (-0.15))
ln(1 + (0.10))
d =
ln(0.85)
= -1.71
ln(1.10)
A-10

For Natures Garden strawberry glycerin soap.
McGrawHill/Irwin
d =

d =
ln(1 + (-0.20))
ln(1 + (0.10))
d =
ln(0.80)
= -2.34
ln(1.10)
A-11

The price elasticity of demand for the
strawberry glycerin soap is larger, in absolute
value, than the apple-almond shampoo. This
indicates that the demand for strawberry
glycerin soap is more elastic than the demand
for apple-almond shampoo.
McGrawHill/Irwin
A-12
The Profit-Maximizing Price
Under certain conditions, the profit-maximizing price

can be determined using the following formula:
Profit-maximizing
markup on
=
variable cost
-1
1 + d
Using the markup above is equivalent to setting the

selling price using the following formula:
Profitmaximizing =
price
McGrawHill/Irwin
1+
-1
1 + d
Variable cost per unit

A-13

Lets determine the profit-maximizing price for the
apple-almond shampoo sold by Natures Garden.
The shampoo has a variable cost per unit of $2.00.
Price elasticity of demand = -1.71
Profit-maximizing
markup
=
on variable cost
McGrawHill/Irwin
-1.71
-1.71 +1
- 1 = 1.41 or 141%
A-14

Now lets turn to the profit-maximizing price for the
strawberry glycerin soap sold by Natures Garden.
The soap has a variable cost per unit of $0.40.
Price elasticity of demand = -2.34
Profit-maximizing
markup
=
on variable cost
McGrawHill/Irwin
-2.34
-2.34 +1
- 1 = 0.75 or 75%
A-15

The 75 percent markup for the strawberry
glycerin soap is lower than the 141 percent
markup for the apple-almond shampoo.
This is because the demand for strawberry
glycerin soap is more elastic than the
demand for apple-almond shampoo.
McGrawHill/Irwin
A-16
This graph depicts how the profit-maximizing markup is

generally affected by how sensitive unit sales are to price.
McGrawHill/Irwin
A-17

Natures Garden is currently selling 200,000 bars
of strawberry glycerin soap per year at the price
of $0.60 a bar. If the change in price has no effect
on the companys fixed costs or on other
products, lets determine the effect on contribution
margin of increasing the price by 10 percent.
McGrawHill/Irwin
A-18

Contribution margin will increase by $1,600.
McGrawHill/Irwin
A-19
Compute the selling

price of a product
using the absorption
costing approach.
McGrawHill/Irwin
A-20
The Absorption Costing Approach
Under the absorption approach to cost-plus

pricing, the cost base is the absorption costing
unit product cost rather than the variable cost.
McGrawHill/Irwin
A-21
Setting a Target Selling Price
Here is information provided by the management of

Ritter Company.
Assuming Ritter will produce and sell 10,000

units of the new product, and that Ritter typically
uses a 50 percent markup percentage, lets
determine the unit product cost.
McGrawHill/Irwin
A-22
Ritter has a policy of marking up unit product costs

by 50 percent. Lets calculate the target selling price.
McGrawHill/Irwin
A-23

Ritter would establish a target selling price to cover
selling, general, and administrative expenses and
contribute to profit $30 per unit.
McGrawHill/Irwin
A-24
Determining the Markup Percentage

The markup percentage can be based on an
industry rule of thumb, company tradition, or it
can be explicitly calculated. The equation to
calculate the markup percentage is:
Markup %
on absorption
cost
McGrawHill/Irwin
(Required ROI Investment) + SG&A expenses

Unit sales Unit product cost
A-25
Lets
Lets assume
assume that
that Ritter
Ritter must
must invest
invest $100,000
$100,000 in
in the
the
product
product and
and market
market 10,000
10,000 units
units of
of product
product each
each
year.
year. The
The company
company requires
requires aa 20
20 percent
percent ROI
ROI on
on all
all
investments.
investments. Lets
Lets determine
determine Ritters
Ritters markup
markup
percentage
percentage on
on absorption
absorption cost.
cost.
McGrawHill/Irwin
A-26
Markup %
(20% $100,000) + ($2 10,000 + $60,000)
on absorption =
10,000 $20
cost
Variable SG&A per unit
Total fixed SG&A
Markup %
on absorption
cost
McGrawHill/Irwin
($20,000 + $80,000)
$200,000
50%
A-27
Problems with the Absorption Costing Approach
The absorption costing approach assumes that

customers need the forecasted unit sales and will
pay whatever price the company decides to
charge. This is flawed logic simply because
customers have a choice.
McGrawHill/Irwin
A-28

Lets assume that Ritter sells only 7,000 units at
$30 per unit, instead of the forecasted 10,000
units. Here is the income statement.
McGrawHill/Irwin
A-29

Lets assume that Ritter sells only 7,000 units at
$30 per unit, instead of the forecasted 10,000
units. Here is the income statement.
Absorption costing approach to pricing is a safe

approach only if customers choose to buy at
least as many units as managers forecasted
they would buy.
McGrawHill/Irwin
A-30
Compute the target

cost for a new
product or service.
McGrawHill/Irwin
A-31
Target Costing
Target costing is the process of determining the

maximum allowable cost for a new product and then
developing a prototype that can be made for that
maximum target cost figure. The equation for
determining the target price is shown below:
Target cost = Anticipated selling price Desired profit
McGrawHill/Irwin
A-32
Reasons for Using Target Costing

Two characteristics of prices and product costs:
1. The market (i.e., supply and demand)
determines price.
2. Most of the cost of a product is determined
in the design stage.
Target
Target costing
costing was
was developed
developed in
in recognition
recognition of
of
these
these two
two characteristics.
characteristics.
McGrawHill/Irwin
A-33

Target costing was developed in
recognition of the two characteristics
shown on the previous screen. More
specifically, Target costing begins the
product development process by
recognizing and responding to existing
market prices.
McGrawHill/Irwin
A-34

Target costing focuses a companys
cost reduction efforts in the product
design stage of production.
McGrawHill/Irwin
A-35
Target Costing
Handy
Handy Appliance
Appliance feels
feels there
there is
is aa niche
niche for
for aa
hand
hand mixer
mixer with
with certain
certain features.
features. The
The
Marketing
Marketing Department
Department believes
believes that
that aa price
price of
of
$30
$30 would
would be
be about
about right
right and
and that
that about
about
40,000
40,000 mixers
mixers could
could be
be sold.
sold. An
An investment
investment of
of
$2,000,000
$2,000,000 is
is required
required to
to gear
gear up
up for
for
production.
production. The
The company
company requires
requires aa 15
15
percent
percent ROI
ROI on
on invested
invested funds.
funds.
Let
Let see
see how
how we
we determine
determine the
the target
target cost.
cost.
McGrawHill/Irwin
A-36
Target Costing
Each functional area within Handy Appliance

would be responsible for keeping its actual costs
within the target established for that area.
McGrawHill/Irwin
A-37
McGrawHill/Irwin
End of Appendix A

Pricing Products and Services: Appendix A

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Pricing Products and Services: Appendix A

Uploaded by

Copyright:

Available Formats

Pricing Products

Compute the profitmaximizing price of a

The Economists Approach to Pricing

Price Elasticity of Demand

Price Elasticity of Demand

Price Elasticity of Demand

Price Elasticity of Demand

ln(1 + % change in quantity sold)

Price elasticity of demand

Natural log function

Price Elasticity of Demand

Suppose the managers of Natures Garden believe that

Price Elasticity of Demand

ln(1 + % change in quantity sold)

Price Elasticity of Demand

ln(1 + % change in quantity sold)

Price Elasticity of Demand

The Profit-Maximizing Price

Under certain conditions, the profit-maximizing price

Using the markup above is equivalent to setting the

Variable cost per unit

The Profit-Maximizing Price

The Profit-Maximizing Price

The Profit-Maximizing Price

The Profit-Maximizing Price

This graph depicts how the profit-maximizing markup is

The Profit-Maximizing Price

The Profit-Maximizing Price

Compute the selling

The Absorption Costing Approach

Under the absorption approach to cost-plus

Setting a Target Selling Price

Here is information provided by the management of

Assuming Ritter will produce and sell 10,000

Setting a Target Selling Price

Ritter has a policy of marking up unit product costs

Setting a Target Selling Price

Determining the Markup Percentage

(Required ROI Investment) + SG&A expenses

Determining the Markup Percentage

Determining the Markup Percentage

Problems with the Absorption Costing Approach

The absorption costing approach assumes that

Problems with the Absorption Costing Approach

Problems with the Absorption Costing Approach

Absorption costing approach to pricing is a safe

Compute the target

Target costing is the process of determining the

Reasons for Using Target Costing

Reasons for Using Target Costing

Reasons for Using Target Costing

Each functional area within Handy Appliance

You might also like