Pricing and
Profitability
Analysis
Prepared by
Douglas Cloud
Pepperdine University
22-1
Objectives
1. Discuss basicAfter
pricing
concepts.
studying
this
chapter, on
youcost
should
2. Calculate a markup
and a target cost.
be able
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
22-2
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 Pricing Concepts
Price
Supply
P*
Demand
Q*
Quantity
22-4
Market Structure and Price
Perfect Competition—Many buyers and sellers;
no one of which is large enough to influence
the market.
Monopolistic Competition—Has both the
characteristics of both monopoly and perfect
competition.
Oligopoly—Few sellers.
Monopoly—Barriers to entry are so high that
there is only one firm in the market.
22-5
Market Structures and
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,
Monopoly
One
Very High
Very unique
coupons
Legal and lobbying
expenditures
22-6
Two Approaches to Pricing
1. Cost-based prices are established using “cost”
plus markup.
2. Target prices are influenced by market
conditions.
22-7
Cost-Plus Pricing
AudioPro Company sells and installs audio
equipment in homes, cars, and trucks. AudioPro’s
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 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 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 Pricing
AudioPro wants to expand the company’s 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 Costing and Pricing
Target costing is a method
of determining
cost of
a
Targetthe
costing
involves
much
product ormore
service
based
on than costupfront
work
the pricebased
that the
customers
pricing.
However, if the
are cost-plus
willing topricing
pay. turns out to be
higher than what customers will
accept, additional work or lost
opportunity will result.
22-12
Predatory 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 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 Income 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 Income 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 Income 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 Income 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 Statements for 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
22-19
Comparative Statements for 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 in Inventory under
Absorption and Variable Costing
If
Production > Sales
Production < Sales
Production = Sales
Then
Absorption NI > Variable NI
Absorption NI < Variable NI
Absorption NI = Variable NI
22-21
Segment 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 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 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
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 of dollars)
Basic
$4,000
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
Multi-Function Total
$3,500
$ 7,500
-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 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 Price and Price
Volume Variables
Sales price
variance =
Actual – Expected
price
price
Quantity
x
sold
Price volume
=
variance
Actual – Expected
volume
volume
Expected
x
price
22-29
Contribution Margin Variance
Contribution
margin =
variance
Annual
Budgeted
contribution – contribution
margin
margin
Contribution Margin Volume Variance
Budgeted
Contribution
Annual
margin volume = quantity – quantity
sold
variance
sold
Budgeted
average unit
x
contribution
margin
22-30
Sales Mix 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 Share 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 Size 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 Product Life Cycle
Introduction
Growth
Maturity
Decline
Positive
Profit
0
Negative
Profit
22-33
The Product Life 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