AppA solution

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Appendix A Pricing Products and Services

Appendix APricing Products and Services

Solutions to Questions

A-1 In cost-plus pricing, prices are set by adding a markup to a products cost. Themarkup is usually a percentage.

A-2 The price elasticity of demand measures the degree to which a change in priceaects unit sales. The unit sales of a product with inelastic demand are relatively insensitiveto the price charged for the product. In contrast, the unit sales of a product with elasticdemand aresensitive to the price charged for the product.

A-3 The prot-maimi!ing price should depend only on the variable "marginal# cost perunit and on the price elasticity of demand. $ied costs do not enter into the pricing decision.$ied costs are relevant in a decision of whether to oer a product or service at all, but arenot relevant in deciding what to charge for the product or service once the decision to oerit has been made. %ecause price aects unit sales, total variable costs are aected by thepricing decision and therefore are relevant.

A-4 The markup over variable cost depends on the price elasticity of demand. & productwhose demand is elastic should have a lower markup over cost than a product whosedemand is inelastic. If demand for a product is inelastic, the price can be increased withoutas drastically reducing unit sales.

A-5 The markup in the absorption costing approach to pricing is supposed to cover selling

and administrative epenses as well as providing for an ade'uate return on the assets tiedup in the product. $ull cost is an alternative approach not discussed in the chapter that isused almost as fre'uently as the absorption approach. (nder the full cost approach, all costs)including selling and administrative epenses)are included in the cost base. If full cost isused, the markup is only supposed to provide for an ade'uate return on the assets.

A-6 The absorption costing approach assumes that consumers do not react to prices at all)consumers will purchase the forecasted unit sales regardless of the price that is charged.

This is clearly an unrealistic assumption ecept under very special circumstances.

A-7 The protection oered by full cost pricing is an illusion. &ll costs will be covered onlyif actual sales e'ual or eceed the forecasted sales on which the absorption costing price isbased. There is no assurance that a su*cient number of units will be sold.

A-8 Target costing is used to price new products. The target cost is the epected sellingprice of the new product less the desired prot per unit. The product development team ischarged with the responsibility of ensuring that actual costs do not eceed this target cost.

This is the reverse of the way most companies have traditionally approached thepricing decision. +ost companies start with their full cost and then add their markup toarrive at the selling price. In contrast to target costing, the traditional approach ignores howmuch customers are willing to pay for the product.

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Exercise A-1" minutes#

. /imio makes more money selling the ice cream cones at thelower price, as shown below0

$1.79Price $1.39Price(nit sales............................. 12 ,3

4ales.................................... 5,67.3 5,128.29ost of goods sold : 5.3.. 68.2 637.39ontribution margin............. ,12.1 ,.8$ied epenses.................... 386. 386.;et operating income.......... 5 ? change in price#

=

,3 - 12ln" > #

12

.7 - . .6613#

ln" - .8832#

=ln".6613#

ln".


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Exercise A-1"continued#

. The prot-maimi!ing price can be estimated using thefollowing formulas from the tet0

d

-Frot-maimi!ing =markup on variable cost > G

-= = .

> "-. .# 5.3 = 5.72

This price is much lower than the prices /imio has beencharging in the past. Jather than immediately dropping theprice to 5.72, it would be prudent to drop the price a bit andsee what happens to unit sales and to prots. The formulaassumes that the price elasticity is constant, which may not bethe case.

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Exercise A-2 "6 minutes#

.

" #

" #

Je'uired JKI 4elling and administrative> Investment epenses+arkup percentage=

on absorption cost (nit product cost (nit sales

1? 56, > 52,=

5 per unit 8,6 units

56,=

5


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Exercise A-3 " minutes#

4ales "6, batteries 526 perbattery#................................................ 5,86,

Less desired prot "8? 58,6,#. . 6,

Target cost for 6, batteries.............. 58,


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Prole! A-4 "36 minutes#

. The postal service makes more money selling the souvenirsheets at the lower price, as shown below0

$5 Price $6 Price(nit sales...................................... 6, 3,

4ales............................................. 586, 583,9ost of goods sold : 5.2 per

unit............................................. , 83,9ontribution margin...................... 588, 582,

8. The price elasticity of demand, as dened in the tet, iscomputed as follows0

d =ln" > ? change in 'uantity sold#

ln" > ? change in price#

=

3, - 6,ln" > #

6,

2. - 6.ln" > #

6.

@ ABC BC BBCD E

@ ABC BC BBCD E

=ln" - .8#

ln" > .8#

=ln".1#

ln".8#

=-.88

.18

= -.887

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Prole! A-4 "continued#

. The prot-maimi!ing price can be estimated using thefollowing formulas from the tet0

d

-Frot-maimi!ing =markup on variable cost > G

-= = 3.322

> "-.887#

" #Frot-maimi!ing Frot-maimi!ing Hariable cost= > price markup on variable cost per unit= " > 3.322# 5.2 = 5.81

This price is much lower than the price the postal service hasbeen charging in the past. Jather than immediately droppingthe price to 5.81, it would be prudent for the postal service todrop the price a bit and observe what happens to unit sales andto prots. The formula assumes that the price elasticity ofdemand is constant, which may not be true.

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The critical assumption in the calculation of the prot-maimi!ing price is that the percentage increase "decrease# in'uantity sold is always the same for a given percentage

decrease "increase# in price. If this is true, we can estimate thedemand schedule for souvenir sheets as follows0

PriceM Quantity SoldN

52. 3,56. 6,53.< 28,65.31


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The prot at each price in the above demand schedule can becomputed as follows0

Price(a)

QuantitySold (b)

Sales(a) (b)

Cost ofSales$.6 (b)

Contribution !ar"in

52. 3, 583, 583, 582,56. 6, 586, 5, 588,53.< 28,6 582,286 5


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The contribution margin is plotted below as a function of theselling price0

The plot conrms that the prot-maimi!ing price is about5.81.

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3. If the postal service wants to maimi!e the contribution marginand prot from sales of souvenir sheets, the new price shouldbe0

Frot-maimi!ing price = 6.322 5.


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. a. ;umber of Packets manufactured each year0

8, labor-hours B .3 labor-hours per Packet = 6,

Packets.4elling and administrative epenses0

Hariable "6, Packets 53 per Packet# 5 2,$ied....................................................... 3


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c. The income statement is0

4ales "6, Packets 57 per

Packet#............................................ 5,6,9ost of goods sold"6, Packets 53 per Packet#... 2,

Vross margin.....................................


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. 4upporting computations0

;umber of pads produced per year0

, labor-hours B 8 labor-hours per pad = 6, pads4tandard cost per pad0

53,, cost of goods sold B 6, pads = 51 cost perpad

$ied manufacturing overhead cost per pad05, 56 ed cost per pad = 538 per

pad

Uirect labor cost per pad051 Q "5 > 538# = 51

Viven the computations above, the completed standard costcard follows0

StandardQuantityor #ours

StandardPrice or

ateStandard Cost

Uirect materials............ 6 yards 52 per yard 5

Uirect labor................... 8 hours 53 per hour M 1+anufacturing

overhead.................... 8 hours58 per

hour MM 38Total standard cost per

pad............................. 51

M 1 B 8 hours = 53 per hour.

MM538 B 8 hours = 58 perhour.

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8. a.

" #

" #

Je'uired JKI 4elling and administrative> Investment epenses+arkup percentage

=on absorption cost (nit product cost (nit sales

83? 5,6, > 58,2,=

51 per pad 6, pads

5,,=

53,,

=


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. Total ed cost0

+anufacturing overhead.......................................5,


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Prole! A-7"36 minutes#

. FroPected sales "1 machines 5,


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Prole! A-7"continued#

(sing the above data, the relation between purchase price andJKI can be plotted as follows0

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. & number of options are available in addition to simply givingup on adding the new gelato machines to the companysproduct lines. These options include0

Z 9heck the proPected unit sales. Ferhaps more units could besold at the 5,


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Prole! A-8"2 minutes#

. The complete, lled-in table appears below0

Sellin"Price

sti*ated +nitSales Sales

,ariableCost

-ied&ense

s

/et

'&eratin"

nco*e51.76 8, 5


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8. The following graph is based on the table in part "# above0

%ased on this graph, a selling price of about 53 wouldmaimi!e net operating income.

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. The price elasticity of demand, as dened in the tet, iscomputed as follows0

d = ln" > ? change in 'uantity sold#ln" > ? change in price#

=ln" > .8#

ln" - .#

=ln".8#

ln".7#

=.188

-.62= -. G

-= = . "-. .


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3. To apply the absorption costing approach, we must rstcompute the markup percentage, which is a function of there'uired JKI of 8? per month, the investment of 58,, the

unit product cost of 56.7, and the 4V^& epenses of5823,.

" #Je'uired JKI > 4V & epenses Investment+arkup percentage=on absorption cost (nit product cost (nit sales

"8? 58,# > 5823, =

56.7 per unit 8, units

= 8.82 "rounded# or 882?

(nit product cost......... 5 6.7+arkup "56.7 8.82#. .

Target selling price....... 57.8

9harging 57.8 for the software would be a big mistake if themarketing manager is correct about the eect of price changeson unit sales. The graph prepared in part "8# above stronglysuggests that the company would lose lots of money selling the

software at this price.;ote0 It can be shown that the unit sales at the 57.8 pricewould be about 7,333 units if the marketing manager iscorrect about demand. If so, the company would lose about53,18 per month0

4ales "7,333 units 57.8 per unit#.......... 5


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increase the net operating income, the owners should lookelsewhere. They should attempt to decrease costs or increasethe perceived value of the product to more customers so thatmore units can be sold at any given price or the price can beincreased without sacricing unit sales.

AppA solution

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