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Study Objectives1. Discuss basic pricing concepts.2. Calculate a markup on cost and a target cost.3. Discuss the impact of the legal system and ethics on
pricing.4. Calculate measures of profit using absorption and
variable costing.5. Determine the profitability of segments.6. Compute the sales price, price volume, contribution
7. Describe some of the limitations of profit measurement.
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Basic Pricing Concepts
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.
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Market Structure and Price
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Pricing Policies• Cost-based pricing
– Established using “cost plus markup”
• Target costing and pricing– Determine the cost of a product or service based
on the price (target price) that customers are willing to pay
– Effectively used in conjunction with marketing decisions
• Penetration pricing• Price skimming
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Cost-Plus PricingAudioPro Company sells and installs audio equipment in homes, cars, and trucks. AudioPro’s income statement for last year is as follows:
Revenues $350,350Cost of goods sold:
Direct materials $122,500Direct labor 73,500Overhead 49,000 245,000
Gross profit $105,350Selling and administrative expenses 25,000Operating income $ 80,350
Pricing Policies
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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 or 43%
Cost-Plus Pricing
Pricing Policies
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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
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) $ 40.00Direct labor (2.5 hours x $12) 30.00Overhead (65% of direct labor cost) 19.50Estimated cost of one job $ 89.50Plus 43% markup on COGS 38.49 Bid price $127.99
Cost-Plus Pricing
Pricing Policies
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Target Costing and Pricing
Pricing Policies
• Determine the cost of a product or service based on the price that the customers are willing to pay.
Direct materials (component and two remotes) $ 40.00Include one remote instead of two
$35.00Direct labor (2.5 hours x $12) 30.00
Train workers to reduce time (2 hours x $12)24.00Overhead (65% of direct labor cost) 19.50
Reduce overhead (50% of direct labor cost)12.00Estimated cost of one job $ 89.50
Revised cost of one job $ 71.00Plus 43% markup on COGS 38.4930.53 Bid price $127.99$101.53
Other installers price the remote car door opener at $110. Possible actions:
Bid price is now competitive; markup
preserved
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The Legal System and Pricing
• Predatory pricing– The practice of setting prices below cost for the
purpose of injuring competitors and eliminating competition
• Dumping– Predatory pricing on the international market– Companies sell below cost in other countries; the
domestic industry is injured.
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The Legal System and Pricing
• Price discrimination– Charging different prices to different
customers for essentially the same product. – Robinson-Patman Act of 1936 prohibits
• Manufacturers or suppliers are covered by the act• Price discrimination is allowed if
– If the competitive situation demands it and– If costs (including costs of manufacture, sale, or delivery)
can justify the lower price
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Cobalt, Inc. manufactures vitamin supplements that costs an average of $163 per case. Cobalt sold 250,000 cases last year as follows:
Customer Price per Case Cases Sold
Large drug store chain $200125,000
Small local pharmacies 232100,000
Individual health clubs 25025,000Cobalt is practicing price discrimination
… is it justifiable?
The Legal System and Pricing
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The Legal System and Pricing
$200 $178.40 10.8%$200
$232 $208.52 10.1%$232
$250 $222 11.2%$250
Profits vary within a narrow 1 percent range. The cost differencesamong the three classes of customer appear to explain the price differences.
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Measuring Profit
Absorption Costing
– Also referred to as full costing– Required for external financial reporting– Assigns all manufacturing costs, direct
materials, direct labor, variable overhead, and a share of fixed overhead to each unit of product
– Each unit of product absorbs some of the fixed manufacturing overhead in addition to the variable costs incurred to manufacture it.
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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 $ 5,000Direct labor 15,000Variable overhead 3,000Fixed overhead 20,000 Total manufacturing cost $43,000
During August, these cartridges were sold at $60 each. Variable marketing cost was $1.25 per unit. Fixed expenses were $12,000.
Absorption-Costing
Measuring Profit
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Measuring ProfitAbsorption-Costing
*Direct materials ($5 x 1,000) $ 5,000Direct labor ($15 x 1,000) 15,000Variable overhead ($3 x 1,000) 3,000Fixed overhead 20,000Total manufacturing overheadand cost of goods sold $43,000
1,000 units produced; 1,000 units sold
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*Direct materials ($5 x 1,250) $ 6,250Direct labor ($15 x 1,250) 18,750Variable overhead ($3 x 1,250) 3,750Fixed overhead ($16 per unit) 20,000Total manufacturing overhead $48,750Add: Beginning inventory 0Less: Ending inventory (9,750)Cost of goods sold $39,000
Measuring ProfitAbsorption-Costing
Production exceeded sales by 250 units; fixed overhead of $16 per unit is carried in inventory thus reducing cost of goods sold and increasing net income
1,250 units produced; 1,000 units sold
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Measuring Profit
Variable-costing
• Also referred to as direct costing• Assigns only unit-level variable manufacturing
costs to the product– Direct materials– Direct labor– Variable overhead
• Fixed overhead is treated as a period cost
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*Direct materials $ 5,000
Direct labor 15,000
Variable overhead 3,000
Total variable manufacturing expenses $23,000
Add: Variable marketing expenses 1,250
Total variable expenses $24,250
Measuring Profit
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Measuring Profit
*1,300 × $39 = $50,700
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Measuring Profit
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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.
Profit by Product Line
Basic Multi-Function
Number of units 20,000 10,000Direct labor hours 40,000 15,000Price $200 $350Prime cost per unit $55 $95Overhead per unit $30 $22.50
P1 actual units P1 budgeted CM- P1 budgeted units - Budgeted average unit CM P2 actual units P2 budgeted CM+ - P2 budgeted units - Budgeted average unit CM
Sales Mix Variance =
The sales mix variance is favorable if the sales mix is weighted to the more profitable products.
BudgetedContribution Actual Budgeted average unitmargin volume = quantity - quantity contributionvariance sold sold margin
The contribution margin volume variance gives management information about gained or lost profit due to changes in the quantity of sales.