A-1
PRICING DECISIONS
BACKGROUND
• The price of a product or service should exceed its out-of-pocket costs,
but by how much?
• The dilemma is that price and unit sales move in opposite directions—
the higher the price, the lower unit sales.
• In most situations, the price should largely be a marketing decision
that takes into account cost and the delicate balance between price
and unit sales.
• The cost-plus pricing formula is commonly used as a starting point in
the pricing decision.
COST-PLUS PRICING FORMULA
Selling price = Cost + (Markup% × Cost)
• What cost should be used?
• What markup percentage should be used?
A-2
THE ECONOMISTS’ APPROACH
• The economists’ approach to cost-plus pricing is based on the price
elasticity of demand.
• A product whose unit sales volume is very sensitive to price is a
product with elastic demand.
• A product whose unit sales volume is not very sensitive to price is a
product with inelastic demand.
• The price elasticity of demand, d, for a product can be estimated with
the following formula:
d =
ln(1+ % change in quantity sold)
ln(1+ % change in price)
EXAMPLE: The management of Roxy Entertainment International, a chain
of theaters, is wondering how to price popcorn. Management experimented
with the price of popcorn over the last two days with the following results:
Price
Unit Sales
Day 1 ............................................................................
$1.19 24,000 tubs
Day 2 ............................................................................
$1.29 21,600 tubs
æ æ21,600-24,000 öö
÷
÷
÷
ln çç1+ çç
÷
÷
÷
÷
ln (1+ (-0.1000 ))
çè çè
24,000
øø
d =
=
æ æ1.29-1.19 ö÷
ö
ln (1+ (+0.0840 ))
÷
ln çç1+ çç
÷
÷
÷
çè çè 1.19 ÷
ø÷
ø
=
ln(0.9000)
-0.10536
=
= -1.306
0.08066
ln(1.0840)
A-3
THE ECONOMISTS’ APPROACH (cont’d)
• Assuming that all costs are either strictly variable or strictly fixed and
that the price elasticity of demand is constant, the profit-maximizing
price is given by the following formula:
öVariable cost
Profit-maximizing = æ
çç ε d ÷
÷
price
çè1+ε d ÷
ø per unit
EXAMPLE: The price elasticity of demand for popcorn, according to the
computations above, is –1.306. Suppose the variable cost of a tub of
popcorn is just $0.35. Then the profit-maximizing price for a tub of
popcorn, according to this formula, is:
æ -1.306 ö
÷
÷
Profit maximizing price = ççç
$0.35 = 4.268 × $0.35 = $1.49
÷
÷
èç1+(-1.306)ø
This is equivalent to a 326.8% markup on variable cost.
A-4
THE ECONOMISTS’ APPROACH (cont’d)
• Summary of economists’ approach to cost-plus pricing:
• The cost base is variable cost.
• The markup depends only on the price elasticity of demand. The more
elastic the demand (the more sensitive consumers are to price), the
lower the markup.
• The formula for the profit-maximizing price works if all costs are
strictly variable or strictly fixed and the price elasticity of demand is
constant for a given product.
• Fixed costs play no role in pricing. Prices affect volume, which affect
variable costs—not fixed costs. Therefore, fixed costs are irrelevant.
A-5
THE ABSORPTION APPROACH
• The absorption approach to cost-plus pricing:
• The cost base consists of the product’s absorption costing unit product
cost.
• The markup must be high enough to cover selling, general, and
administrative expenses and to provide for a profit.
EXAMPLE: Aspen Company hopes to sell 20,000 units next year. Cost data
concerning this product follow:
Per Unit
Total
Direct materials..............................................................
$6
Direct labor....................................................................
$4
Variable manufacturing overhead ....................................
$1
Fixed manufacturing overhead ........................................
$380,000
Variable SG&A expense ..................................................
$4
Fixed SG&A expense ......................................................
$100,000
Assume that target selling prices are determined by adding a 40%
markup to unit product cost. Compute the target selling price.
Direct materials..............................................................
$ 6
Direct labor....................................................................
4
Variable manufacturing overhead ....................................
1
Fixed manufacturing overhead* ......................................
19
Unit product cost ...........................................................
30
Markup at 40% ..............................................................
12
Target selling price .........................................................
$42
* ($380,000 ÷ 20,000 unit) = $19 per unit
A-6
THE MARKUP ON AN ABSORPTION BASIS
• Why is the markup 40%? It could be:
• an industry practice.
• a time-honored rule of thumb in the company.
• managers’ judgment of how much markup the market will bear.
• the result of a markup computation.
MARKUP COMPUTATION
The markup on absorption costs, given the assumed unit sales volume,
can be computed using the following formula.
Markup % on
absorption cost
Required ROI + SG&A expenses
(
× Investment )
=
Unit sales × Unit product cost
EXAMPLE: Suppose Aspen Company requires a 15% return on investment
(ROI) and has invested $400,000 in the product. SG&A expenses are
$180,000 ($4 per unit × 20,000 units + $100,000). Compute the markup
%.
Markup % on = (15% × $400,000) + $180,000
absorption cost
20,000 units × $30 per unit
=
$60,000 + $180,000
$600,000
= 40%
A-7
VERIFICATION OF THE MARKUP
Suppose 20,000 units are sold as planned at the price of $42 per unit.
Income Statement
Aspen Company
Revenue ($42 per unit × 20,000 units) ...........................
$840,000
COGS ($30 per unit × 20,000 units) ................................
600,000
Gross margin .................................................................
240,000
SG&A expenses ($4 × 20,000 + $100,000) .....................
180,000
Net operating income .....................................................
$ 60,000
WEAKNESSES OF THE ABSORPTION APPROACH
• Some sales volume must be assumed to compute the selling price and
markup percentage, but in reality the sales volume depends on the
selling price.
• If the actual sales volume is less than assumed, the profit will be less
than desired and a loss could occur. The protection provided by the
markup is more illusory than real.
• As unit sales volume drops, the unit production cost increases. Applying
a preset markup to this higher unit production cost results in higher
selling prices. This further depresses unit sales volume, which leads to
an increase in selling prices, and so on.
A-8
TARGET COSTING
Some companies approach the pricing problem from an entirely different
perspective when they develop new products. They use target costing.
TRADITIONAL APPROACH
The absorption costing approach to cost-plus pricing takes cost as given
and marks it up. The company hopes consumers will be willing to pay the
resulting price.
TARGET COSTING APPROACH
In the target costing approach, the selling price is taken as a given and
the company strives to design and manufacture the product so that its cost
is low enough to yield a satisfactory profit.
Target costing is a market-driven approach that puts the emphasis on
managing processes inside the company, rather than hoping that
consumers will accept a price high enough to cover all of the costs the
company has incurred.
A-9
EXAMPLE: Kiromoto Ltd. is planning to launch a new CD-ROM player with
advanced features.
a)
The marketing department believes that such a product should sell for
about $95 and would have total annual sales of about 400,000 units.
b)
In order to design, develop, and produce this CD-ROM player, an
investment of $10 million would be required.
c)
Due to the very short product lives of such products, the company
requires a return on investment (ROI) of 40%.
Compute the average target cost per player.
Projected sales (400,000 players × $95 per player) .........
Less desired profit (40% × $10,000,000) ........................
Target cost for 400,000 players ......................................
Average target cost per player
($34,000,000 ÷ 400,000 players) .................................
$38,000,000
4,000,000
$34,000,000
$85
A-10
TIME AND MATERIAL PRICING
Service organizations (repair shops, printing shops, attorneys, etc.)
often use time and material pricing.
Two pricing rates are established—one based on labor time and the
other based on materials used.
EXAMPLE: Speedy Appliance Repair incurs the following costs in a typical
year:
Service
Parts
Service employee wages ................................................
$260,000
Parts employee wages ...................................................
$ 40,000
Shop supervision ...........................................................
36,000
Parts supervision ...........................................................
38,000
Fringe benefits...............................................................
59,000
15,000
Supplies ........................................................................
6,000
2,000
Utilities ..........................................................................
12,000
5,000
Rent..............................................................................
30,000
15,000
Depreciation ..................................................................
40,000
5,000
Other ............................................................................
7,000
2,000
Total .............................................................................
$450,000 $122,000
The costs of parts used in repairs are billed directly to customers and are
not included in the above table.
A-11
Time Component
The service personnel work a total of 15,000 billable hours in a typical
year. Based on these data and a desired margin of $5 per billable hour, the
labor time rate would be computed as follows:
Service costs per billable hour
($450,000 ÷ 15,000 hours) .......................................... $30
Desired margin per billable hour ......................................
5
Time component charge ................................................. $35
Thus, customers will be charged $35 per hour for service personnel
time.
Material Component
The $122,000 cost of the parts department is recovered by marking up
the invoice cost of parts ($305,000 per year). In addition, the company
adds a 20% profit margin to the invoice cost.
Charge for ordering, handling, and carrying
parts ($122,000 ÷ $305,000) .......................................
40% of invoice cost
Desired profit margin on parts ........................................
20% of invoice cost
Material loading charge ..................................................
60% of invoice cost
Thus, the amount charged for parts on a job will consist of the invoice
cost of the parts plus a material loading charge equal to 60% of this cost.
A-12
BILLING A JOB
In billing a job, the time and material components are added together.
Example: To complete the Speedy Appliance Repair example, assume that
a repair job is completed that required 3 hours of labor time and $40 in
parts.
Time charge (3 hours × $35 per hour) ............................
$105
Materials charge:
Invoice cost of parts ....................................................
$40
Material loading charge ($40 × 60%) ...........................
24
64
Total price of the job ......................................................
$169
A-13
Other Pricing Procedures Not Covered in Text
 Breakeven Approach:
Breakeven + Desired Profit
 Cost-Plus using variable costing
Variable cost plus desired return