Appendix A: Pricing Products and Services

Appendix A
Pricing Products and Services

Solutions to Questions
A-1 In cost-plus pricing, prices are set
by applying a markup percentage to a
products cost.
A-2 The price elasticity of demand
measures the degree to which a change in
price afects unit sales. The unit sales of a
product with inelastic demand are
relatively insensitive to the price charged
for the product. In contrast, the unit sales
of a product with elastic demand are
sensitive to the price charged for the
product.
A-3 The proft-maimi!ing price should
depend only on the variable "marginal#
cost per unit and on the price elasticity of
demand. $ied costs do not enter into the
pricing decision at all. $ied costs are
relevant in a decision of whether to ofer a
product or service at all, but are not
relevant in deciding what to charge for the
product or service once the decision to
ofer it has been made. %ecause price
afects unit sales, total variable costs are
afected by the pricing decision and
therefore are relevant.
A-4 The markup over variable cost
depends on the price elasticity of demand.
& product whose demand is elastic should
have a lower markup over cost than a
product whose demand is inelastic. If
demand for a product is inelastic, the price
can be increased without cutting as
drastically into 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 tied up in the product. $ull
cost is an alternative approach not
discussed in the chapter that is used
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 is used, 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 ofered by full cost
pricing is an illusion. &ll costs will be
covered only if actual sales e'ual or
eceed the forecasted sales on which the
absorption costing price is based. 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
selling price of the new product less the
desired proft per unit. The product
development team is charged 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
the pricing decision. +ost companies start
with their full cost and then add their
markup to arrive at the selling price. In
contrast to target costing, this traditional
, The +c-raw-.ill /ompanies, Inc., 0121. &ll rights reserved.
3olutions +anual, 4ricing &ppendi 256
approach ignores how much customers
are willing to pay for the product.
.
261 +anagerial &ccounting, 27th 8dition
Exercise A-1 "71 minutes#
2. +aria makes more money selling the ice cream cones at the
lower price, as shown below9
$1.89
Price
$1.49
Price
(nit sales................... 2,:11 0,7;1
3ales.......................... <0,57:.11 <7,;5=.=1
/ost of sales > <1.;7 =;:.11 2,11=.01
/ontribution margin... 0,261.11 0,;51.;1
$ied epenses.......... =?:.11 =?:.11
@et operating income <2,:2:.11 <2,51:.;1
0. The price elasticity of demand, as defned in the tet, is
computed as follows9
d
A
ln"2BC change in 'uantity sold#
ln"2BC change in price#
A
0,7;1-2,:11
ln"2B #
2,:11
2.;6-2.56
ln"2B #
2.56
D E
F
G
F
G
F
F G
H I
D E
F
G
F
G
FF G
H I
A
ln"2B1.:=111#
ln"2-1.022=;#
A
ln"2.:=111#
ln"1.?557=#
A
1.;;;=6
-1.07?51
A -2.5?
Exercise A-1 "continued#
7. The proft-maimi!ing price can be estimated using the
following formula from the tet9
d
d
J
4roft-maimi!ing price A Kariable cost per unit
2BJ
-2.5?
A <1.;7
2B"-2.5?#
A 0.2;6; L <1.;7 A <1.60
D E
F
G
F
G
F
G
F G
H I
D E
F
G
F
G
F
F GG
H I
This price is much lower than the prices +aria has been
charging in the past. Mather than immediately dropping the
price to <1.60, it would be prudent to drop the price a bit and
see what happens to unit sales and to profts. The formula
assumes that the price elasticity is constant, which may not be
the case.
Exercise A-2 "2: minutes#
2.
" #
" #
Me'uired MNI 3elling and administraive
B
L Investment epenses
+arkup percentage
A
on absorption cost
(nit sales L (nit product cost
20C L <?:1,111 B <:1,111
A
2;,111 units L <0: per unit
<2;1,111
A A ;
<7:1,111
1C
0. (nit product cost........... <0:
+arkup ";1C L <0:#..... 21
3elling price per unit..... <7:
Exercise A-3 "21 minutes#
3ales "711,111 units L <2: per unit#. <;,:11,111
Oess desired proft "20C L
<:,111,111#.................................... =11,111
Target cost for 711,111 units............. <7,611,111
Target cost per unit A <7,611,111 F 711,111 units A <27 per unit
26; +anagerial &ccounting, 27th 8dition
Problem A-4 ";: minutes#
2. a. 3upporting computations9
@umber of pads manufactured each year9
75,;11 labor-hours F 0.; labor-hours per pad A 2=,111
pads.
3elling and administrative epenses9
Kariable "2=,111 pads L <6 per
pad#.............................................. <2;;,111
$ied............................................... ?70,111
Total................................................ <5?=,111
" #
" #
Me'uired MNI 3elling and administrative
B
+arkup percentage
A
on absorption cost
0;C L <2,7:1,111 B <5?=,111
A
2=,111 pads L <=1 per pad
<2,011,111
A
<6=1,111
A 20:C
b. Pirect materials................................. < 21.51
Pirect labor....................................... 26.01
+anufacturing overhead................... 71.11
(nit product cost............................... =1.11
&dd markup9 20:C of unit product
cost................................................. ?:.11
3elling price...................................... <27:.11
3olutions +anual, 4ricing &ppendi 26:
Problem A-4 "continued#
c. The income statement will be9
3ales "2=,111 pads L <27: per pad#.......
<0,2=1,11
1
/ost of goods sold
"2=,111 pads L <=1 per pad#................
6=1,11
1
-ross margin........................................... 2,011,111
3elling and administrative epenses9
3ales commissions...............................
<2;;,11
1
3alaries................................................. 50,111
Qarehouse rent.................................... :1,111
&dvertising and other........................... =11,111
Total selling and administrative epense. 5?=,111
@et operating income.............................
< 70;,11
1
The companys MNI computation for the pads will be9
@et Nperating Income 3ales
MNI A L
3ales &verage Nperating &ssets
<70;,111 <0,2=1,111
A L
<0,2=1,111 <2,7:1,111
A 2:C L 2.= A 0;C
0. Kariable cost per unit9
Pirect materials........................................ <21.51
Pirect labor............................................... 26.01
Kariable manufacturing overhead "2R: L
<71#....................................................... =.11
3ales commissions.................................... 6.11
Total.......................................................... <;:.11
If the company has idle capacity and sales to the retail outlet
would not afect regular sales, any price above the variable
cost of <;: per pad would add to profts. The company should
aggressively bargain for more than this priceS <;: is simply the
rock-bottom Toor below which the company should not go in its
26= +anagerial &ccounting, 27th 8dition
pricing.
3olutions +anual, 4ricing &ppendi 26?
2. The postal service makes more money selling the souvenir
sheets at the lower price, as shown below9
$7 Price $8 Price
(nit sales............................ 211,111 5:,111
3ales................................... <?11,111 <=51,111
/ost of sales > <1.51 per
unit................................... 51,111 =5,111
/ontribution margin............ <=01,111 <=20,111
d
A
ln"2 B C change in 'uantity sold#
ln"2 B C change in price#
A
5:,111 - 211,111
ln"2 B #
211,111
5 - ?
ln"2 B #
?
D E
F
G
F
G
F
F G
H I
D E
F
G
F
G
FF G
H I
A
ln"2 - 1.2:11#
ln"2 B 1.2;06#
A
ln"1.5:11#
ln"2.2;06#
A
-1.2=0:
1.277=
A -2.02=7
7. The proft-maimi!ing price can be estimated using the
4roft-maimi!ing price A
d
d
J
Kariable cost per unit
2BJ
D E
F
G
F
G
F
G
F G
H I
A
-2.02=7
<1.51
2B"-2.02=7#
D E
F
G
F
G
F
F GG
H I
A :.=070 L <1.51 A <;.:1
This price is much lower than the price the postal service has
been charging in the past. Mather than immediately dropping
the price to <;.:1, it would be prudent for the postal service to
drop the price a bit and observe what happens to unit sales and
to profts. The formula assumes that the price elasticity of
demand is constant, which may not be true.
The critical assumption in these calculations 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 the demand schedule for souvenir
sheets as follows9
Price
*
Quantity Sold
<5.11 5:,111
<?.11 211,111
<=.27 22?,=;?
<:.7= 275,;15
<;.=6 2=0,577
<;.21 262,:=6
<7.:6 00:,7?:
<7.2; 0=:,2;?
<0.?: 722,67?
<0.;2 7==,65:
U
The price in each cell in the table is computed by taking ?R5 of
the price Vust above it in the table. $or eample, <=.27 is ?R5 of
<?.11 and <:.7= is ?R5 of <=.27.
W
The 'uantity sold in each cell of the table is computed by
multiplying the 'uantity sold Vust above it in the table by
211,111R5:,111. $or eample, 22?,=;? is computed by
multiplying 211,111 by the fraction 211,111R5:,111.
The proft at each price in the above demand schedule can
be computed as follows9
Price
(a)
Quantity
Sold (b)
Sales
(a) (b)
Cost o
Sales
$!.8! (b)
Contributio
n "ar#in
<5.11 5:,111 <=51,111 <=5,111 <=20,111
<?.11 211,111 <?11,111 <51,111 <=01,111
<=.27 22?,=;? <?02,2?= <6;,225 <=0?,1:5
<:.7= 275,;15 <?;2,5=? <221,?0= <=72,2;2
<;.=6 2=0,577 <?=7,=5? <271,0== <=77,;02
<;.21 262,:=6 <?5:,;77 <2:7,0:: <=70,2?5
<7.:6 00:,7?: <516,16= <251,711 <=05,?6=
<7.2; 0=:,2;? <570,:=0 <020,225 <=01,;;;
<0.?: 722,67? <5:?,50? <0;6,::1 <=15,0??
<0.;2 7==,65: <55;,;7; <067,:55 <:61,5;=
The contribution margin is plotted below as a function of the
selling price9
The plot confrms that the proft-maimi!ing price is about
<;.:1.
$580,000
$590,000
$600,000
$610,000
$620,000
$630,000
$640,000
$2.00 $3.00 $4.00 $5.00 $6.00 $7.00 $8.00
Selling Price
;. If the postal service wants to maimi!e the contribution margin
and proft from sales of souvenir sheets, the new price should
be9
d
d
J
2BJ
D E
F
G
F
G
F
G
F G
H I
A
-2.02=7
<2.11
2B"-2.02=7#
D E
F
G
F
G
F
F G
H I
A :.=070 L <2.11 A <:.=0
@ote that a <1.01 increase in cost has led to a <2.20 "<:.=0 X
<;.:1# increase in selling price. This is because the proft-
maimi!ing price is computed by multiplying the variable cost
by :.=070. %ecause the variable cost has increased by <1.01,
the proft-maimi!ing price has increased by <1.01 L :.=070,
or <2.20.
3ome people may obVect to such a large increase in price as
YunfairZ and some may even suggest that only the <1.01
increase in cost should be passed on to the consumer. The
enduring popularity of full-cost pricing may be eplained to
some degree by the notion that prices should be YfairZ rather
than calculated to maimi!e profts.
Problem A-6 "=1 minutes#
2. The complete, flled-in table appears below9
Sellin#
Price
$sti%ate
d &nit
Sales Sales
'ariable
Cost
(i)ed
$)*enses
+et
,*eratin
#
-nco%e
<0:.11 :1,111 <2,0:1,111 <711,111 <6=1,111 -<21,111
<07.?: :;,111 <2,050,:11 <70;,111 <6=1,111 -<2,:11
<00.:= :5,701 <2,72:,=66 <7;6,601 <6=1,111 <:,??6
<02.;7 =0,65= <2,7;6,?61 <7??,62= <6=1,111 <22,5?;
<01.7= =5,10: <2,75;,656 <;15,2:1 <6=1,111 <2=,576
<26.7; ?7,;=? <2,;01,5:0 <;;1,510 <6=1,111 <01,1:1
<25.7? ?6,7;; <2,;:?,:;6 <;?=,1=; <6=1,111 <02,;5:
<2?.;: 5:,=60 <2,;6:,70: <:2;,2:0 <6=1,111 <02,2?7
<2=.:5 60,:;? <2,:7;,;06 <:::,050 <6=1,111 <26,2;?
<2:.?: 66,6:2 <2,:?;,005 <:66,?1= <6=1,111 <2;,:00
0. & chart based on the above table would look like the following9
%ased on this chart, a selling price of about <25 would
maimi!e net operating income.
3olutions +anual, 4ricing &ppendi 01:
d
A
ln"2 B C change in 'uantity sold#
ln"2 B C change in price#
A
ln"2B1.15#
ln"2-1.1:#
A
ln"2.15#
ln"1.6:#
A
1.1?=6=
-1.1:206
A -2.:11
The proft-maimi!ing price can be estimated using the
d
d
J
2BJ
D E
F
G
F
G
F
G
F G
H I
A
-2.:
<=.11
2B"-2.:#
D E
F
G
F
G
F
F GG
H I
A 7.11 L <=.11 A <25.11
@ote that this answer is consistent with the plot of the data in
part "0# above. The formula for the proft-maimi!ing price
works in this case because the demand is characteri!ed by
constant price elasticity. 8very :C decrease in price results in
an 5C increase in unit sales.
01= +anagerial &ccounting, 27th 8dition
;. Qe must frst compute the markup percentage, which is a
function of the re'uired MNI of 0C, the investment of
<0,111,111, the unit product cost of <=, and the 3-[&
epenses of <6=1,111.
" #
B
+arkup percentage
A
on absorption cost
"0C L <0,111,111# B <6=1,111
A
:1,111 units L <= per unit
A 7.77 "rounded# or 777C
(nit product cost......... < =.11
+arkup "<=.11 L 7.77#. 26.65
3elling price................. <0:.65
/harging <0:.65 "or <0= without rounding# for the software
would be a big mistake if the marketing manager is correct
about the efect of price changes on unit sales. The chart
prepared in part "0# above strongly suggests that the company
would lose lots of money selling the software at this price.
@ote9 It can be shown that the unit sales at the <0:.65 price
would be about ;?,265 units if the marketing manager is
correct about demand. If so, the company would lose about
<2=,65; per month9
3ales ";?,265 units L <0:.65 per unit# <2,00=,01;
Kariable cost ";?,265 units L <= per
unit#................................................... 057,255
/ontribution margin............................. 6;7,12=
$ied epenses.................................... 6=1,111
@et operating income "loss#................. < "2=,65;#
:. If the marketing manager is correct about demand, increasing
the price above <25 per unit will result in a decrease in net
operating income and hence in the return on investment. To
increase the net operating income, the owners should look
elsewhere. They should attempt to decrease costs or increase
3olutions +anual, 4ricing &ppendi 01?
the perceived value of the product to more customers so that
more units can be sold at any given price or the price can be
increased without sacrifcing unit sales.
Problem A-7 "=1 minutes#
2. 3upporting computations9
@umber of hours worked per year9
01 workers L ;1 hours per week L :1 weeks A ;1,111 hours
@umber of surfboards produced per year9
;1,111 hours F 0 hours per surfboard A 01,111 surfboards.
3tandard cost per surfboard9 <2,=11,111 F 01,111 surfboards A
<51 per surfboard.
$ied manufacturing overhead cost per surfboard9
<=11,111 F 01,111 surfboards A <71 per surfboard.
+anufacturing overhead per surfboard9 <: variable B <71 fed
A <7:.
Pirect labor cost per surfboard9 <51 X "<0? B <7:# A <25.
-iven the computations above, the completed standard cost
card would be as follows9
Standar
d
Quantity
or .ours
Standard Price
or /ate
Standar
d Cost
Pirect materials............ = feet <;.:1 per foot <0?
Pirect labor................... 0 hours <6.11 per hourU 25
+anufacturing overhead
0 hours
<2?.:
1
per
hourUU 7:
Total standard cost per
surfboard.................... <51
U <25 F 0 hours A <6 per hour
UU <7: F 0 hours A <2?.:1 per hour
0. a.
" #
" #
B
+arkup percentage
A
on absorption cost
25C L <2,:11,111 B <2,271,111
A
01,111 units L <51 per unit
<2,;11,111
A
<2,=1
A 5?.:C
1,111
b. Pirect materials............... < 0?
Pirect labor..................... 25
+anufacturing overhead. 7:
Total cost to manufacture 51
&dd markup9 5?.:C......... ?1
3elling price.................... <2:1
c. 3ales "01,111 boards L <2:1 per board#. . . .
<7,111,11
1
/ost of goods sold
"01,111 boards L <51 per board#............. 2,=11,111
-ross margin............................................... 2,;11,111
3elling and administrative epenses........... 2,271,111
@et operating income................................. < 0?1,111
@et Nperating Income 3ales
MNI A L
3ales &verage Nperating &ssets
<0?1,111 <7,111,111
A L
<7,111,111 <2,:11,111
A 6C L 0 A 25C
7. 3upporting computations9
Total fed costs9
+anufacturing overhead................................. < =11,111
3elling and administrative
\<2,271,111 X "01,111 boards L <21 per
board#]......................................................... 671,111
Total fed costs..............................................
<2,:71,11
1
Kariable costs per board9
Pirect materials............................ <0?
Pirect labor................................... 25
Kariable manufacturing overhead. :
Kariable selling.............................. 21
Kariable cost per board................. <=1
To achieve the 25C MNI, the company would have to sell at
least the 01,111 units assumed in part "0# above. The break-
even volume can be computed as follows9
$ied epenses
%reak-even point
A
in units sold
(nit contribution margin
<2,:71,111
A
<2:1 per board - <=1 per board
A 2?,111 boards
2. 4roVected sales "211 machines L <;,6:1 per
machine#........................................................... <;6:,111
Oess desired proft "2:C L <=11,111#.................. 61,111
Target cost for 211 machines............................... <;1:,111
Target cost per machine "<;1:,111 F 211
machines#.......................................................... <;,1:1
Oess @ational Mestaurant 3upplys variable
selling cost per machine.................................... =:1
+aimum allowable purchase price per machine. <7,;11
0. The relation between the purchase price of the machine and
MNI can be developed as follows9
Total proVected sales - Total cost
MNI A
Investment
<;6:,111 - "<=:1 B 4urchase price of machines# L 211
A
<=11,111
The above formula can be used to compute the MNI for
purchase prices between <7,111 and <;,111 "in increments of
<211# as follows9
Purc0ase
*rice /,-
<7,111 02.?C
<7,211 01.1C
<7,011 25.7C
<7,711 2=.?C
<7,;11 2:.1C
<7,:11 27.7C
<7,=11 22.?C
<7,?11 21.1C
<7,511 5.7C
<7,611 =.?C
<;,111 :.1C
(sing the above data, the relation between purchase price and
MNI can be plotted as follows9
7. & number of options are available in addition to simply giving
up on adding the new sorbet machines to the companys
product lines. These options include9
^ /heck the proVected unit sales fgures. 4erhaps more units
could be sold at the <;,6:1 price. .owever, management
should be careful not to indulge in wishful thinking Vust to
make the numbers come out right.
^ +odify the selling price. This does not necessarily mean
increasing the proVected selling price. Pecreasing the selling
price may generate enough additional unit sales to make
carrying the sorbet machines more proftable.
^ Improve the selling process to decrease the variable selling
costs.
^ Methink the investment that would be re'uired to carry this
new product. /an the si!e of the inventory be reduced_ &re
the new warehouse ftures really necessary_
^ Poes the company really need a 2:C MNI_ Poes it cost the
company this much to ac'uire more funds_

Appendix A: Pricing Products and Services

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Pricing Products and Services

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